What are the assets? Tangible/intangible? Tangibles are generally the hard assets like plant & equipment, stock, debtors and cash. Intangibles are things like goodwill and intellectual property rights (IPR).
Purchasers will generally ignore intangibles on a balance sheet as it is effectively double- valuing goodwill when pricing in a goodwill premium for the company.
Very often a company will have its assets valued within its books at a price that can only be justified if the company is still in business, whereas if the company went into receivership those same assets may only be worth a fraction of their book value because of age, specialization or difficulties in removing them from the premises.
If the company is sold for net asset value, there may also be redundancy, lease dilapidation and termination costs to be taken into account by a purchaser, which could depress the valuation.
This is essentially looking at the total amount of money required to buy and run the business (including all bank debt and hire purchase (HP) leases), then looking at the EBIT (= earnings before interest and tax) and deciding whether that is a satisfactory return on the investment given the risks involved.
This is an actuarial calculation involving calculating the overall cashflow demands and returns of the company over a period of, say, seven years and then discounting them back to their net present value. It is safe to say that this method is usually only used for larger corporations or new and substantial businesses.
This method is generally used when the transaction is highly geared and is normally used by venture-capital investors. For example, if you buy a £300,000 investment property with a £250,000 mortgage and then sell it three years later for £500,000, your IRR (assuming that the mortgage has not reduced and the rent has equalled the mortgage interest costs) is going to be your capital gain of £200k as a percentage of your original investment of £50k divided by the number of years you held the investment ie (250/50)/3 = 166% IRR.
This means looking at the pre- and post-tax profit of the company and then multiplying it by a number which is usually somewhere between 1 and 10. The lower the multiple the higher the risk and the less sustainable the profit stream.
The term ‘multiple’ is usually used for pre-tax numbers and ‘p/e’ for post-tax numbers. It is sensible, however, when using these terms to make it clear that you are talking about either pre- or post-tax numbers. There is a big difference between the two; a pre-tax multiple of 4 is about the same as a post-tax p/e of 6.
This method of valuation is relatively easily understood by vendors.I go through the balance sheet and adjust for zero cash zero debt as outlined below. This gives me a net asset figure.
I then look at the P&L and remove all amortization, depreciation, extraordinary/ one-off costs, interest costs and costs relating to the vendor. (NB: If the company is being sold with no debt, then obviously there is no interest cost.)
Having done that, I then impute a sensible salary for replacing the single vendor. If there is a second vendor also working in the business, I would also deduct a sensible replacement salary, bearing in mind that it is often a partner who either just does the books or doesn’t actually do any significant work. Very often an owner will also have other costs within the business; these should be extracted and may need to be identified in
The result of these calculations is that I arrive at an adjusted EBITDA figure.
To give me the goodwill premium, I would then multiply the adjusted EBITDA by somewhere between 1 and 5 depending on the size of the business, the sustainability of the profit, the company history, and the size of the net assets (it would be rare to use a multiple of more than 3). I would then add the net assets to the goodwill premium to arrive at my preliminary valuation figure.
However, as a cross-check on my valuation I would then see what sort of return on investment (ROI) the purchaser will be making, having regard to the risks and size of the deal. If the ROI is less than, say, 20 per cent, I would probably reduce the multiple used to calculate the goodwill premium, which would then reduce my valuation. Most purchasers are looking for between 20 and 50 per cent ROI, with a general average of about 30 per cent.
Some valuations on this ROI basis will show that the company is worth less than its net assets (eg a company that makes an after-tax profit of £50k but has net assets of £500k). I call this ‘the big tail on a small dog’ syndrome.
In that case, it is likely that some pre-sale grooming needs to take place so that the net assets are reduced, such as the directors putting the property into their pension fund and leasing it back to the company. If that is not possible, then the company could be sold either for a value equivalent to its net assets or often a discount to them. There may be situations such as where the company has one very expensive machine costing £500k which allows the company to make a profit of £50k, in which case a purchaser may question the wisdom of risking so much money for such a small return and the business may be unsellable.
Engineering businesses often have significant net assets and yet may also make decent profits. Even so, as a rule of thumb I would use a low multiple of say 1–2 to arrive at the goodwill premium plus the net assets. For example, I would value a company with net assets of £1.3m and a profit of £400k at around £1.9m–2.1m, which would be an ROI of only 19–21 per cent.
When going through the balance sheet I would strongly recommend writing the assets and liabilities onto a separate piece of paper/spreadsheet, leaving out the cash at bank figure and the debt and other liabilities which should be paid off on or before completion, such as bank loans, HP, director’s loans and the corporation tax bill.
This exercise will give you a clear idea of what are to be the net assets on completion and from there you can start to build up your net asset valuation. Generally the revised balance sheet would look something like this: ASSETS ,Plant Stock, Debtors ,LIABILITIES, Trade creditors VAT,PAYE ,Accruals etc.
It will also give you the chance to explain to the vendor that your valuation is on a zero cash zero debt net assets basis (ZCZDNet Assets) and that you are expecting the cash to be removed and the debts to be repaid on or at completion.
In reality, what usually happens on completion is that the cash and debt are left in the company for the purchaser to deal with, and the sale price is adjusted up or down
£1 for £1 for any movement in the ZCZDNet Asset figure (this is known as a ratchet). Likewise the ratchet on the ZCZDNet Asset figure allows for fluctuations in cash, debtors and creditors between the time of your valuation and the completion date.
Sometimes this exercise on the completion balance sheet that you have done will reveal a balance sheet that is too thin or even has negative assets, in which case the vendor may need to leave cash in the business in order to plump up the completion balance sheet and justify the asking price.
Written by Rupert Cattell is a qualified commercial lawyer with over 30 years’ experience in the buying and selling of businesses
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