As mentioned in a previous article, the valuation principles for trading companies have generally been to identify maintainable earnings to which is applied a capitalisation multiplier. The resulting Enterprise Value is then adjusted for either surplus assets and/or the net debt position of the business. The resulting Equity Value being what the selling shareholders receive before tax for their shares.
Earnings are the first part of the valuation equation so what earnings are used? Earnings could be by reference to the historic results of the business, its most recent or current results, its current earnings rate or indeed its future projected earnings. Where a business has an upward earnings profile it would be preferable to use current or future earnings in the calculation of value as this will result in a higher valuation. Our experiences in 2018 have again demonstrated that buyers are prepared to value based on current and future earnings but only where the target has good management information to monitor and control its activities. There is likely to be a partial deferral of consideration or earn out mechanism but this is also usually the case where historic results are used. Where companies have volatile earnings then usually some form of weighting is given to the earnings record which may include future earnings to arrive at a maintainable earnings level.
The earnings figure used is not necessarily that shown in the target’s accounts or financial forecasts. Adjustments are usually made for items considered to be non-recurring and/or exceptional in size. In addition, adjustments are usually made for proprietorial items as most SMEs – controlled by their owners report earnings influenced by how their proprietors reward themselves and family members be it by dividends and/or salaries, benefits and pension contributions. It is necessary to substitute the rates commercially payable for the jobs undertaken for the actual amounts paid. If substantially all remuneration is taken by way of dividend then the adjustment made will likely reduce maintainable earnings rather than increase them.
A final thought on earnings is that it helps to know why a buyer wants to make the acquisition. A buyer usually buys because they believe they can get more out of the business than the vendor. This can be as a result a higher profits rating, of cross selling, through economies of scale or management efficiencies. If the vendor has an appreciation of these benefits it may be possible to agree a higher price and share some of the buyers’ advantages.
The multiplier applied to the maintainable earnings is crucial and the higher it is the better for the vendor. If the company is being sold to a quoted company then the buyer will likely have an earnings rating which can be used to estimate the value of the acquisition to the buyer. The vendor is likely to get a significantly discounted value from this valuation but it is important to know the position. If the buyer is another private company such information will not exist so research needs to be done to see whether comparable private companies have been recently acquired and if so whether there is any helpful information which could give a steer regarding the multiples paid. Much information is available but it needs very careful appraisal because information on items affecting deal values is not always informative or comprehensive. There are a number of general private company sale indices which can give a steer but they also come with the caveat as to the information they are based on. Quoted company information can be of help but due to the size of such companies their business models and risk ratings they usually have very different ratings to SME’s. Research and discussion with professional advisers are in my view the preferred way to establishing a suitable multiplier range.
The final part of the valuation equation is the adjustment for surplus assets and debt to arrive at the equity value of the shares. Surplus assets are those not needed by the business and often one or other of a mixture of freehold properties, investments and cash balances. Debt relates to the commercial borrowings used by the business (this normally includes corporation tax liabilities).
I shall focus on cash and debt here since if a company which is planned to be sold has freehold property or investments on its balance sheet which may not be required by a buyer it is good practice as part of presale planning to consider whether a tax efficient reorganisation of this type of asset should take place. Professional advice is crucial here to make sure tax liabilities do not crystallise as a result of the reorganisation.
Cash balances are likely to be the main surplus asset to be included in the valuation of the company. Cash may be considered surplus if it could be distributed without affecting the trade and a vendor would want a £ for £ uplift to the Enterprise value. Note that if there are extremely high levels of surplus cash then presale planning should consider whether the levels might adversely affect the tax treatment of proceeds of sale in the vendors hand i.e. chargeable to income tax rather than capital gains tax or restriction of ER. As with surplus cash, so commercial debt and corporation tax liabilities are usually a £ for £ adjustment to the Enterprise Value.
Although this final set of adjustments to arrive at the equity value of the company sound pretty straight forward, in my experience this is often the most difficult part of the value equation to agree between buyer and seller. Usually the adjustment is qualified by the requirement for cash and borrowings to be based on “normal” levels and the maintenance of normal levels of working capital and normal is a very ill-defined term which is open to much interpretation. Up front clarity is essential on what these terms mean to buyer and seller.