Maximising Value on the Sale of a Business (Hawksmere Report)

M

MAXIMISING VALUE ON THE SALE OF A BUSINESS – strategic and financial techniques

Peter Gray

A Hawksmere Report published by Thorogood

IFC

A Hawksmere Report

MAXIMISING VALUE ON THE SALE OF A BUSINESS – strategic and financial techniques

Peter Gray

published by Thorogood Ltd

Published by Thorogood Limited Other Hawksmere Reports published by Thorogood: Legal Liabilities for Insurers Fred Collins

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The author Peter Gray Peter graduated with degrees in Law and Commerce from Melbourne University in 1984. He joined the Corporate Finance Department of Minter Ellison,a leading Australian law firm, where he qualified as a lawyer. In 1989 Peter joined the corporate finance group of Clifford Chance in London. He worked on a wide variety of transactions including management buy-outs, stock market flotations and acquisitions and disposals. After completing an MBA in Finance at City University, Peter joined Cavendish Corporate Finance in 1994 and was appointed as a Director of Cavendish in 1997. Peter is a frequent author and lecturer on the subject of mergers and acquisitions.

Contents Introduction......................................................................................1

1

MARKET OVERVIEW

Review of M&A activity ....................................................................3 Drivers of the M&A market...............................................................3 The late 1980s revisited?...................................................................6

2

MAKING THE DECISION TO SELL

Reviewing the alternatives................................................................8 Reviewing the shareholders’ objectives............................................9 Reasons for sale ..............................................................................10 Getting the timing right..................................................................11

CONTENTS

3 4

OVERVIEW OF THE SALE PROCESS

Informal auction .............................................................................15 Formal auction................................................................................16

GROOMING A BUSINESS FOR SALE

Introduction....................................................................................18 Financial matters.............................................................................18 Operational matters ........................................................................20 Legal review....................................................................................21 Other matters..................................................................................22 Vendor due diligence ......................................................................23 Conclusion......................................................................................23

5

TAX PLANNING

Introduction....................................................................................25 Your sleeping partner – with a 40% profit share ............................25 Retirement relief – while stocks last...............................................27 Re-investing the proceeds...............................................................27 Share exchange ...............................................................................27 Emigration.......................................................................................28 Offshore trusts ................................................................................28 Timing.............................................................................................29 Mix ‘n’ match...................................................................................29 Conclusion......................................................................................30

CONTENTS

6

VALUATION TECHNIQUES

Introduction....................................................................................32 Types of valuation techniques ........................................................33 Case study .......................................................................................34 Illustration ......................................................................................36 Other valuation techniques ............................................................39 Relationship between size and price..............................................40 Conclusion......................................................................................41

7

APPOINTING ADVISORS

Selecting a financial advisor ...........................................................43 Appointing legal advisors ..............................................................46 Appointing tax advisors .................................................................46

8

PREPARING AN INFORMATION MEMORANDUM

Objective of an information memorandum ....................................49 Contents of the memorandum........................................................49

CONTENTS

9

IDENTIFYING POTENTIAL PURCHASERS

Identifying the optimal purchaser ..................................................52 Types of potential purchasers.........................................................53 Conclusion......................................................................................58

10

APPROACHING POTENTIAL PURCHASERS

Formal versus informal auction .....................................................60 Staggering approaches ...................................................................61 Dealing with unsolicited offers ......................................................61 Contacting potential purchasers ....................................................61 Maintaining confidentiality ............................................................62

11

THE NEGOTIATION PROCESS

Introduction ...................................................................................65 Understanding the purchaser’s objectives .....................................65 Releasing information ....................................................................65 Bridging the price expectations gap – earn outs ...........................66 Reviewing offers ............................................................................67 Heads of agreement .......................................................................68 Rules for successful negotiation ....................................................71

CONTENTS

12

THE DUE DILIGENCE PROCESS AND WARRANTIES

Introduction ...................................................................................73 Types of due diligence ...................................................................73 Warranties ......................................................................................75

13

CONCLUSION

Key rules .........................................................................................77 Bibliography....................................................................................78

Introduction Selling a business is one of the most important and stressful events in the life of any proprietor of a private company.There can never be any guarantee of success once a sale exercise is undertaken.Embarking on a sale may involve the business incurring significant costs and unexpected risks and disruption.For example,there may be a breach of confidentiality which can be harmful to the business. It is therefore advisable not to undertake a sale exercise lightly, or simply for the purposes of ascertaining the value of the business. Careful consideration of the procedures outlined in this report will help to minimise the risks and maximise the chances of achieving a successful sale of a business. This report is primarily concerned with the sale of privately owned businesses, which are frequently family concerns. However, it also considers issues faced by quoted companies selling subsidiaries and institutional investors selling investee companies. We commence with an overview of the current market for mergers and acquisitions and examine some of the influences on M&A activity.There then follows an analysis of the procedures involved in selling private companies and the means by which a vendor of a private company can maximise value on a sale of his business.

1

Market overview REVIEW OF M&A ACTIVITY DRIVERS OF THE M&A MARKET T H E L AT E 1 9 8 0 S R E V I S I T E D ?

chapter

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Chapter 1: Market overview

Review of M&A activity 1998 was another record year for M&A activity in the private company sector. The value of recorded private company sales in the UK last year was £22 billion. This surpassed the previous record year of 1996 when the total deal value was £20.2 billion and contrasts with a comparable figure for 1993, when private company sales of a ‘mere’ £4.5 billion were recorded. In terms of activity levels, the picture is somewhat different with 1988 retaining the record for the highest number of private company sales at 1,475 compared to a figure of 1,298 for 1998. The big difference between then and now is that the average value of deals has increased dramatically from £3.6 million in 1988 to approximately £17 million in 1998.One reason for this is the recent spate of building society and life company take-overs which, for the purposes of M&A tables, are categorised as private company sales. Prices being paid for private companies have also increased in recent years with the private company price index standing at an historically high level.What has driven the market to record levels over the past few years? The answer lies in a combination of factors.

Drivers of the M&A market First, corporate profitability has generally been extremely strong. This is significant for two reasons.First,it means that private companies can demonstrate to potential purchasers a solid track record of profits since the end of the last recession. Secondly, it has meant that listed companies have been cash rich and have the financial capability to make acquisitions. Interestingly, corporate profitability can operate in different ways. For example, in the oil exploration sector, the impact of the weak oil price on profitability has resulted in a spate of mergers amongst major oil companies in an effort to reduce costs. Similarly, the weakness of UK engineering companies has resulted in a number of take-overs in that sector as US groups, in particular, snap up their weaker UK counterparts.

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The strong stock market has also assisted listed companies by facilitating equity fund raisings. Moreover, the fact that listed companies are trading on relatively high price earnings ratios has enabled them to pay higher prices for private companies while still generating a positive effect on their earnings per share. Perhaps the most important factor fuelling the boom in private company acquisitions over the past few years has been the liquidity of venture capital funds.Their ability to make acquisitions has been helped by low interest rates and the ready availability of bank finance. In 1998,venture capital firms invested a record £11.4 billion in management buyouts and buy-ins.The amount of funds available for investment in venture capital funds is at an all time high and the intense competition to find a home for these funds has meant that,in many cases,venture capital houses have been significantly outbidding trade buyers. The continuing trend for quoted companies to focus on core activities and to dispose of all non-core businesses has made a significant contribution to M&A activity levels. Disposals of non-core operations has particularly fuelled the growth of the MBO market. Privatisations and demutualisations have also played their part.A higher proportion of the utilities privatised in the early 1990s have now been taken over.The past couple of years have also witnessed a number of large acquisitions of building societies and other mutual organisations, including the recent acquisition of the RAC by Lex Services. Another major contributory factor in the current M&A boom is the trend towards consolidation and globalisation across a broad range of sectors.These include financial services,advertising,automotive,telecoms and the pharmaceutical sector. In many cases, consolidation is customer led. For instance, in the case of consolidation amongst automotive suppliers, the need for car manufacturers to have suppliers who can support their operations on a global basis is driving mergers in that sector.In other cases,such as pharmaceuticals it is the imperative for global distribution and R&D economies which is driving consolidation. There is every reason to believe that consolidation across a number of sectors will be an ongoing process which will underpin M&A activity levels into the foreseeable future, regardless of the state of the underlying economy.

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M&A tables The following charts show the volume and value of mergers and acquisitions activity over the last eleven years broken down between public company bids, divestments of subsidiaries or divisions of quoted companies and private company sales.The table shows M&A activity slumping during the recession of the early 1990s from the cyclical peak in 1988/89 and then recovering strongly over the last five years in line with economic growth. One word of warning about the numbers. The Acquisitions Monthly tables do not pick up very small deals and therefore the number of deals is inevitably understated and the average value overstated to some extent.

UK mergers and acquisition activity by volume 1988-1998 2500

Number of deals

2000

1500

1000

500

0 1988

1989

1990

UK public companies

1991

1992

1993

1994

UK private companies

1995

1996

1997

1998

UK divestments

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UK mergers and acquisition activity by value 1988-1998 100,000 90,000

Number of deals

80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 1988

1989

1990

1991

UK public companies

1992

1993

1994

UK private companies

1995

1996

1997

1998

UK divestments

The late 1980s revisited? Are we back to the halcyon M&A days of the late 1980s? Although current activity levels are broadly comparable with those prevailing in 1988-89,there have been significant changes in the market place since that time. For example, acquisition strategies are now far more focused. By and large, UK companies are focusing on core activities having learnt the lessons from the disastrous diversification strategies of the 1980s. The days when advertising agencies made bids for banks have now long since passed. The 1990s have witnessed the death knell of the large,unfocused conglomerates established during the 1980s with companies such as Hanson and BTR either demerging or falling prey to leaner and more focused competitors. Due diligence is also much more thorough than it once was.Again,the days when deals were struck on the basis of a handshake and some numbers scrawled on the back of an envelope are a relic of the 1980s. In short, the M&A market over the past few years has been a far more sober affair than the M&A frenzy of the late 1980s.

6

Making the decision to sell R E V I E W I N G T H E A LT E R N A T I V E S REVIEWING THE SHAREHOLDERS’ OBJECTIVES REASONS FOR SALE GETTING THE TIMING RIGHT

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Chapter 2: Making the decision to sell

Reviewing the alternatives The first task for someone considering a sale of their business is to determine their objectives, both financial and otherwise, and then to determine whether those objectives are likely to be achieved by selling the business. A sale may be inappropriate or simply not possible for a number of reasons. It may be that a sale is not a viable option,because the business is totally dependent on one person.Alternatively, the company may operate in an industry which is in terminal decline.A case in point was Alpha Airports abortive attempt to sell its duty free operation in 1998 coinciding with the potential abolition of duty free sales within the European Community.Even where a sale might be appropriate at some stage, it may not be the optimal time to sell.The growth profile and the current size of the business may dictate that the sale should be deferred. There are a number of different exit routes for a proprietor seeking to realise value for his business.These include a sale of 100% of the shares in the company, a partial sale of some of the equity or a stock market flotation. In the majority of cases, not all of these options will be available. For example, a company may be too small or may not have a sufficient track record of profits for a flotation.

Caution

Objectives

Type of Exit

Cash Out/Early Retirement

Trade Sale/ MBO/Financial Purchase

Part Cash Out/ Retention of Equity

Partial sale to venture capitalists or strategic buyer Sale with long earnout

Ambition

No Cash Out Capital Growth

Flotation/growth capital

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Where there is a choice of exit routes, the objectives of the proprietor will determine which of these exit routes represents the best alternative.Where the owner wishes to retire and realise cash for his shareholding, a sale of 100% of the business is the only viable option. If, on the other hand, the proprietor is relatively young,wishes to remain with the business and has little or no immediate need for cash, a flotation may be the preferred choice.Alternatively, a proprietor may wish to realise part of the equity in his business by way of a partial sale but retain the balance for an exit in the future.

Reviewing the shareholders’ objectives Consideration of the objectives of the shareholders is especially important where there are several shareholders having different agendas which may give rise to potential conflicts of interest.As far as possible, the exit strategy chosen must fit with the needs of all interested parties, including members of the management team who are not shareholders of the business. Examples of conflicts between shareholders include: •

some shareholders may seek the entire consideration up front on completion, while others may be looking to achieve a higher price through deferred consideration,or an earn-out.Alternatively,some may be prepared to take shares in the purchaser, while others may not;

•

some shareholders, who are also directors or employees, may seek a purchaser who will enhance their careers and employment prospects;

•

where there is an institutional shareholder as well as management shareholders,the institution will not be prepared to give warranties but will expect the management to do so.

In some cases,the shareholders will enter into a formal memorandum in advance of the sale which covers issues such as the minimum price expectation, preparedness to remain with the business following a sale, willingness to give warranties to the purchaser and the type of consideration which is acceptable. This can be an extremely useful exercise in flushing out issues prior to the sale. Disagreement between shareholders once the sale process is underway needs to be avoided at all costs.

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Reasons for sale The most frequent reason given for considering a sale is the desire to realise capital, either for financial security or new projects. There is, however, rarely one reason alone, but generally a combination of the following: •

the recognition that the business has reached a premium value;

•

the realisation that the business cannot grow without a significant capital injection;

•

the need to access new markets by being part of a large, possibly international, group;

•

the business has reached a size where the owner feels unable or unwilling to manage it;

•

a disagreement among shareholders which means that the business is no longer manageable under existing ownership;

•

a perceived boom in the sector has resulted in high valuations,or there are concerns that a downturn is likely to arrive in the foreseeable future;

•

the only alternatives are closure or sale by an administrator,receiver or liquidator; or

•

an imminent retirement/succession problem.

For a group of companies possible reasons for the sale of a business include: •

the business may no longer fit within the group’s core activities or future strategies;

•

the business may have been a poor acquisition;

•

the group may have to sell because of liquidity problems.

External factors In addition to company specific factors, there are a number of external factors which may have a bearing on the optimal time to sell.These include: •

the acquisition strategies of major players in the sector and/or consolidation patterns that may be emerging.Current examples of M&A bubbles in specific industry sectors include the travel industry and the internet;

•

changes in technology;

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•

the state of the economy and, in particular, the stage of the economic cycle;

•

changes in market conditions;

•

recent or impending legislation affecting the business;

•

the strength of the Stock Market.

SELL

It is important that a vendor is not coy about the reasons for sale. It will usually be one of the first questions asked by a potential purchaser and a reluctance to answer the question may make the purchaser suspicious.

Getting the timing right In common with the sale of any investment, it is extremely difficult to pick the optimum time to sell a business.However,there are some general rules in timing a sale which should always be followed.

Recent profits A purchaser will find a three year profit history much more convincing than a three year profit forecast. Unless you are operating in the IT or telecoms sector, it is important to have a good profit track record to show potential purchasers.

Year end Planning a sale exercise to complete shortly after a financial year end will allow the sale to be based on an audited set of accounts.This will reduce uncertainty over the profits on which the purchase price is based and the assets being sold. Furthermore, it means that the vendor is able to provide financial warranties to the purchaser based on a recently audited set of accounts and thereby transfer some of the risk for a breach of the accounts warranties to the auditors. A further advantage is that due diligence by the purchaser’s accountants can take place simultaneously with the year end audit, thereby minimising disruption to the business and helping to maintain confidentiality.Lastly,some purchasers may wish to have an input into the finalisation of the accounts, for example, by creating provisions for release in future periods to enhance the profits of the company in the period following the sale.

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Tax reliefs The current tax regime is always a relevant consideration in timing a disposal. For example, the system of taper relief introduced in the 1998 budget for owner managers may influence some vendors to defer a sale to minimise their exposure to capital gains tax.

The golden rule The one overriding rule in timing the sale of a business is to always sell at a time when there is no absolute need to do so. Buyers will quickly sense a forced sale and use that knowledge to their advantage.

Timescale

Management time commitment

Determining the optimum time to start a sale exercise will be influenced by the following timetable which can be used as a rough guide.The timetable also shows the demands on management time which a typical sale exercise will impose.

Commerce marketing

Receive indicative

Due diligence

Exchange and completion

offers

No. of months 0

1

Advisors appointed

Information memorandum

2

potential purchaser list prepared

3

4

Initial meetings with potential purchasers

Draft heads of agreement

5

6

On average, a sale exercise can be expected to take around six to seven months. However,this is only a rough guide.It can take considerably longer but will rarely be significantly shorter, except in the case of a distressed sale.

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Overview of the sale process INFORMAL AUCTION FORMAL AUCTION

chapter

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Chapter 3: Overview of the sale process The sale process can be divided into two distinct stages, the pre-sale stage, and the sale itself. Both are equally important. The pre-sale period involves making the decision to sell,getting advisors on board and preparing the business for sale.The sale process itself involves the preparation of an information memorandum,simultaneously with compiling a list of potential purchasers for the business.Approaches are then made to potential purchasers which will hopefully lead to a number of offers for the company.Once these initial offers have been negotiated upwards to the maximum extent,a preferred bidder is chosen and given a period of exclusivity in which to conduct due diligence and to prepare the necessary legal documentation. This process varies to some extent depending on whether it is determined to run a formal auction or to conduct a less formal approach.The decision on which route to pursue and the differences between the two approaches are examined in greater detail in Chapter 11. The two approaches are shown diagrammatically on the following two pages.

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Informal auction

Pre-sale period:

Initial assessment

Sale process:

Prepare information

Choosing advisors

Review of alternatives

Pre-sale grooming

Identify purchasers

Contact purchasers

Confidentiality letters

Hold off-site meetings

Obtain indicative offers

Arrange site visits

Negotiations

Heads of agreement

Due diligence

Legal contracts

Legal completion

Deal structures

Exclusivity

Forms of consideration

Conditions

Timetable

Control information flow

Warranties and indemnities disclosure letter

Public announcements

Service contracts

Net asset adjustment

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Formal auction

Pre-sale period:

Initial assessment

Sale process:

Prepare information memorandum

Choosing advisors

Review of alternatives

Vendor due diligence

Pre-sale grooming

Timetable

Identify purchasers

Contact purchasers

Confidentiality letters

Preliminary offers

Shortlist purchasers

Due diligence

Final offers

Preferred bidder

Further due diligence

Legal contracts

Legal completion

Management presentations, site visits, data room, DD Report, contract

Deal structures

Exclusivity

Forms of consideration

Conditions

Control information flow

Vendor DD assigned to purchaser

Warranties and indemnities disclosure letter

Public announcements

Service contracts

Net asset adjustment

16

Grooming a business for sale INTRODUCTION F I N A N C I A L M AT T E R S O P E R AT I O N A L M AT T E R S LEGAL REVIEW O T H E R M AT T E R S VENDOR DUE DILIGENCE CONCLUSION

chapter

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Chapter 4: Grooming a business for sale

Introduction It will never be possible to maximise the proceeds of a company sale unless time is taken before the sale commences to prepare the business for sale. A grooming exercise, which can take place over a few months or even years before a sale exercise,aims to enhance the attractiveness and value of the business to potential purchasers.This is achieved by measures such as: •

maximising recurring profits by reducing or stopping proprietorial or non-business expenses;

•

improving margins by reconsidering proposed ‘non-essential’ expenditure on marketing, R & D, etc or by raising prices;

•

without compromising the above, maximising sustainable sales levels;

•

ensuring the balance sheet is clean,e.g.by removing non-business assets;

•

where possible,securing long term beneficial contractual relationships.

A review of the business to determine appropriate pre-sale grooming measures should cover the following areas:

Financial matters Margins review Whilst a business may historically have priced its products with its long-term future in mind,and,in particular,to deter potential entrants,in a situation where a business enjoys some degree of market power, research could be undertaken to see if a period of higher prices could be sustained in the lead up to a sale.

Review of costs A review should be undertaken to identify and eliminate all proprietorial costs which would not be incurred by an incoming purchaser.These would include

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relatives on the payroll or excessive travel and entertainment costs incurred by the proprietors.Whilst a purchaser might be persuaded that these costs should be added back to determine the company’s underlying profit, the argument is always stronger if the business can be run for a period with these costs removed.

Assets review When a business has assets which may not be required or fully valued by a purchaser,such as surplus property,investments,or indeed,surplus cash,removal before a sale exercise commences should be considered. To enable a pre-sale dividend to be paid, liquidity should be maximised and working capital reduced to the minimum level required to generate the company’s profit stream.Policies concerning stock holding levels,debtors,and creditors should therefore be reviewed at an early stage to ensure that there is no ‘fat’ in working capital.If the company is sold with excess stocks or,due to poor credit collection, excess levels of debtors,the vendor is,in effect,gifting the surplus to the purchaser. Any such surplus should be eliminated and the resultant cash either stripped out or added to the purchase price. Any hidden or undervalued assets of the business should also be identified.If the value of property assets is understated in the company’s balance sheet relative to their market value, they should be re-valued independently prior to a sale.

Tax review All PAYE,VAT and corporate tax matters should be up to date.Tax allowances, if appropriate,should be maximised,and tax computations agreed with the Inland Revenue.Any tax losses available to be carried forward should be identified.

Pension schemes It is extremely difficult for a vendor to obtain full value from a purchaser for a surplus in a final salary pension scheme. It is therefore advisable for a vendor to eliminate the surplus in the lead up to a sale by taking a full or partial pension holiday. Better still, if the vendor avoids final salary schemes completely in favour of defined contribution schemes,as the former can give rise to enormous valuation issues on a sale.

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Operational matters Management review The quality of the company’s management team will generally be of paramount importance to a purchaser,especially where the owner/managers are proposing to leave the business at the time of, or shortly after, a sale. It is important to be able to convince the purchaser that there are competent second tier management available to assume executive control of the business.This will involve devolution of management control by the owners in the lead up to a sale,where second line management are taking executive decisions, this should be documented. For evidentiary purposes, it may help to recognise their input formally by: •

minuting management meetings;

•

issuing formal job descriptions; and/or

•

considering job titles and reviewing organisational structures.

Purchasers attach considerable weight to job titles. For that reason, promotion of senior management to the Board of Directors in advance of a sale will make it easier to convince a purchaser that there will be a self-sufficient management team in place following their departure. It might also help for the owner/managers to take an extended holiday before the sale to show the purchaser that the business can operate effectively in their absence. Most purchasers will also require comfort that management support the idea of a trade sale and vendors may want to take early soundings to gauge how co-operative management will be.This might spark management to consider an MBO. To ensure that there is not a mass exodus of senior management following a sale, most purchasers will wish to see key management secured with service contracts. These should be issued in a form which is likely to be compatible with a larger organisation.

Staffing review Any redundancies made once negotiations with a third party have commenced will normally be treated as unfair dismissal by an industrial tribunal.Accordingly, staffing levels should be reviewed before the sale exercise starts. Staff who would not be required by a purchaser might be employed elsewhere in a group or directly by the proprietor, as appropriate.

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Accounting policies review With a sale exercise in mind, a review should be undertaken of the following accounting policies, with a view to maximising stated earnings: •

recognition of profit, particularly for contract related businesses;

•

depreciation policies, both for tangible and intangible assets;

•

provisions – excessive provisions against stock or even debtors is one of the most commonly used techniques to reduce tax. In the lead up to a sale,excess provisions should be released to boost both profits and asset values, preferably over more than one accounting period;

•

valuations of properties and investments;

•

research and development – this may play a large part in the purchaser’s interest in a private company. Small companies are frequently bought for their innovative skills and product development capabilities.Where all research and development has been written off in the past,this should be identified and highlighted; and

•

accounting treatment of any rent free lease agreements.

Accounting systems It is essential for the vendor to start preparing monthly management accounts if he does not already do so. During a sale process, it is vital to have up-to-date information on the current trading performance of the company and purchasers will be looking for the vendor to warrant a recent set of management accounts. It is equally important for the company to produce budgets. At a minimum, a purchaser will be looking for profit projections for both the current and the following financial year.If the company has not had a history of producing budgets (and hopefully beating them) any projections produced specifically for the sale exercise may lack credibility.

Legal review A legal audit should be carried out in conjunction with legal advisors and should, at a minimum, ensure that: •

all leases and title deeds are located and reviewed;

•

trading contracts are examined to ensure that no change of control restrictions or prohibitions apply.Such provisions are potential ‘poison pills’ for a purchaser and to the extent possible should be resisted;

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•

intellectual property rights are registered;

•

shareholder agreements and articles are examined to review provisions relating to a sale;

•

Companies House filings are up-to-date,as are board minutes and other statutory documents;

•

any outstanding litigation is cleared up.Even if it is covered by insurance, major litigation can be a deterrent to a purchaser;

•

to the extent possible, the ownership structure of the company is simplified.This may involve buying in minority or joint venture interests. Purchasers value simplicity and complex ownership structures can diminish the attractiveness of a business.

SALE

Other matters Environmental audit Potential environmental liabilities will be a major area of concern for any purchaser. Depending on the nature of his business, it may be appropriate for the vendor to conduct an environmental audit prior to the sale to enable him to identify and remedy any potential problems at an early stage.

Year 2000 compliance The vendor will be required to warrant that the business is year 2000 compliant and should therefore ensure that computer systems are compliant in the period leading up to a sale.

PR Potential purchasers are much more amenable to a company they have heard of than one whose name they don’t recognise.It is often advisable therefore to raise the company’s profile prior to a sale, by conducting a PR campaign directed not at the company’s customer base but at potential buyers of the business. Examples of profile PR of this nature include obtaining editorial coverage on the company in trade or financial publications.

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Vendor due diligence Vendor due diligence involves the proprietor instructing accountants to prepare a due diligence report on the business in advance of a sale exercise being undertaken.The report is then given to potential purchasers who have expressed serious interest in the company for use in finalising their offers for the business. The main advantage of vendor due diligence is to flush out financial,tax and other issues relating to the business at the outset of the sale process.As a result, the chances of the deal collapsing once Heads of Agreement have been reached, or an agreed bidder chosen,are significantly reduced.It is unlikely that any material issues will arise from the purchaser’s due diligence which had not already been identified in the vendor due diligence report. In addition, vendor due diligence can form a useful part of the grooming process to the extent it identifies issues which can be addressed before the sale exercise is initiated.In choosing an accountant to provide a due diligence report,it is generally advisable to avoid the temptation to use the company’s auditors as this may impact adversely on the credibility of the report. A purchaser will inevitably have some suspicions that the auditor has been ‘lent on’ to provide a favourable report.

Conclusion The more prepared the business is prior to the commencement of the sale process, the greater will be the proceeds of sale. However, it is important not to groom a business for sale in an over-zealous fashion or attempt to boost profits in artificial ways which will be exposed during due diligence.This will back-fire on the vendor and may destroy a relationship of trust established between the vendor and the purchaser. It is also necessary to commence the grooming process long before the sale process gets underway,principally because the impact of the steps taken to enhance profits will take some time to flow through to the company’s accounts.

23

Tax planning INTRODUCTION Y O U R S L E E P I N G PA RT N E R – W I T H A 4 0 % P R O F I T S H A R E RETIREMENT RELIEF – WHILE STOCKS LAST RE-INVESTING THE PROCEEDS SHARE EXCHANGE E M I G R AT I O N OFFSHORE TRUSTS TIMING M I X ‘ N ’ M AT C H CONCLUSION

chapter

5

Chapter 5: Tax planning

Introduction Tax is an important aspect of any business decision. So it is with the decision to sell your company. In this chapter we shall look at: •

how tax affects the decision to sell your business

•

what you can do to reduce the impact of taxation when you sell.

Your sleeping partner – with a 40% profit share When your company is profitable you pay tax on those profits.When you draw a salary or bonus or dividend you pay tax on what you draw.You might think that when you come to sell your business you will already have paid your fair share of tax. How wrong you would be! When you sell your business the taxman does a calculation.He looks at what you got for selling the business. He looks at what the business cost you (in money that is – blood,sweat and tears do not count!).He works out the difference.Broadly speaking he will want 40% of the profit you make when you sell your business. In effect,throughout the years you have been building up your business you have had a sleeping partner. He wakes up when you sell and wants his 40% cut. In the rest of this chapter we shall look briefly at a variety of ways of cutting down the profit share of this sleeping partner.

Cutting the tax rate to 34% We can begin to cut down the Revenue’s profit share by getting the tax rate down from 40% to 34%.This is done using a UK based trust.A trust is an arrangement under which you transfer your shares to someone you trust (called a trustee) to administer for the benefit of people you nominate (called beneficiaries).As we only need a UK trust you can be a trustee and also a beneficiary. You can transfer your shares to the trust free of CGT (unless you have any nonbusiness assets in your company).But trusts have a special rate of tax of only 34%.

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With the help of some financing this tax rate can be used to cut the Revenue’s share of your profit to 34%. This arrangement is comparatively simple to operate. It is wholly UK-based and you get unrestricted use of the proceeds.The disadvantage is the obvious one that it saves only 6% in tax.So let us consider what we can do to cut the problem down even more.

Cutting the tax rate to 25% In the years before you sell your company you might have accumulated profits in the company after paying corporation tax on them. If so, there is nothing to stop you paying out a large dividend immediately before you sell your company. Because of the strange way in which company dividends are taxed you will only pay 25% tax on the cash you draw. You must remember that you can only use this pre-sale dividend route if you have accumulated profits in your company. Company law prevents dividends being paid if the company has not accumulated profits to support them.

Cutting the tax rate to 10% In the 1998 Budget the Chancellor of the Exchequer introduced a new relief called taper relief. It promised the prospect of paying capital gains tax at only 10%.This relief was described at the time as proof there is no mess a government cannot make worse. For the lucky few there is however the real chance of tax at only 10%. Some of the notable drawbacks of this relief are: •

the 10% rate is only available on business assets

•

the relief can be lost very easily for example by giving shares to your children

•

the 10% rate only operates after 10 years’ ownership

•

the 10 year clock did not start until April 1998 – ownership before then only counted as one year however long it actually was.

Cutting the tax rate to zero It is quite possible you do not have accumulated profits in your company to back a large pre-sale dividend.You may not want to wait ten years before you sell your business.So in the remainder of this chapter we look at a variety of ways of getting the tax rate down to nil.

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Retirement relief – while stocks last Retirement relief is a valuable relief for any businessman selling his business. It is, broadly speaking, available to any businessman who is aged over fifty when he sells his business.The maximum relief allowed you to make a gain of £250,000 completely free of tax and only pay 20% tax on the next £750,000.But retirement relief is retiring. It began to fade away in April 1999.Already the maximum relief is no longer available. So it is important to act quickly if you are not to miss out on this valuable relief. If you are selling your business you should get the sale through before the next 5th. April to maximise your retirement relief. But if you are not selling your business you can still act to lock into retirement relief.This can be done by, for example, transferring your business to a company or transferring your shares to a family trust. By doing this you might be able to lock into £500,000 of tax free capital gains.

Re-investing the proceeds Successive governments have used tax allowances and reliefs to promote investment in various types of business activities or even in certain areas of the country. One such relief can be useful when you sell your business. It is called the reinvestment relief or the entrepreneur relief. To get the benefit of this relief you must reinvest the proceeds of your old business in a new one.The new business must be broadly speaking an unquoted UK trading company.There are several types of business that do not qualify and there is a strict time limit.You must make the new investment within three years of selling your old business.As with the other tax planning arrangements mentioned in this chapter, you should take professional advice before you make your investment.

Share exchange When you sell your business you do not have to take cash.You can take shares or loan notes instead. If you do take shares or loan notes the tax on the sale of the business is deferred until you sell the shares or loan notes.You can even write to the Inland Revenue in advance and get a confirmation that you will not have to pay tax until you sell the shares or loan notes.

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But there is a pitfall to avoid.Special,complicated rules apply to certain loan notes called qualifying corporate bonds (QCBs).If the company that buys your business gets into financial trouble you could find the QCBs they have given you are worthless but you would still get a tax bill. So you should be very careful about selling your business and getting a QCB in return.

Emigration CGT only applies to UK resident taxpayers. So you can avoid CGT when you sell your business by going to live abroad.Since the 1998 Budget you must be abroad for at least five complete UK tax years. You must take care if you go abroad to save tax.You must establish tax residence in another country. There have been cases where taxpayers have told the UK authorities they are resident in Spain but have told the Spanish authorities they are only visiting Spain.The tax authorities regularly swap information now and in these cases they both sent tax demands to the taxpayers. The five year rule does not apply if you go to live in a country with which the UK has a double tax treaty.In such a case you might only need to be abroad three years,this opens up the intriguing possibility of Belgium being a tax haven because it has a tax treaty with the UK and quite favourable rules for taxing capital gains.

Offshore trusts We saw earlier in this chapter how a UK trust could be used to cut the tax rate to 34%.We can use an offshore trust to get the benefits of living abroad without you having to leave the UK.As the trust is a separate taxpayer from you it can live abroad instead of you. Offshore trusts have had much publicity in the last decade – from Richard Branson in the early 1990s to certain government ministers in the recent past. In short what an offshore trust provides is a fund of untaxed capital that can be used to benefit you and your family.The ways in which the funds can be used are many and various.They range across: 1.

Simple investments, such as having the money in a bank deposit account and living off the interest;

2.

More complicated investments, such as stocks and shares, unit trusts, insurance bonds and so on;

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The purchase of assets for you and your family to enjoy, such as properties, yachts, helicopters, racing cars, racehorses and so on.

The main disadvantage of using an offshore trust is that your capital is locked up inside the trust. But this problem can be overcome.You might be able to arrange a period of residence outside the UK:if so you could then have access to the capital free of UK tax. Alternatively, it is possible for you simply to sell off the trust for a tax-free lump sum.

Timing As with many business decisions timing is all important in tax planning.The basic rule is that you must complete your tax planning before you have done a deal with a purchaser.This follows from two tax cases in the Courts called Ramsay and Furness v Dawson. Another potentially complicating factor is that the government is proposing to introduce a general anti-avoidance rule.This might enable the Inland Revenue to strike down any tax planning.However,at the time of writing this is only a proposal. It seems no rule will be introduced until 2000 and will in any event only apply to companies. Furthermore the precise scope of any rule is unclear because the Inland Revenue have admitted they cannot come up with a workable definition of tax avoidance!

Mix’n’match It is important to remember that there is not always a single solution to any tax problem. The best answer in any particular case may be a mixture of the techniques outlined above. So, for example: 1.

You could sell your company in exchange for shares and cash in the shares when you are resident outside the UK;

2.

You could sell some shares for cash to use up your retirement relief and put the rest in an offshore trust;

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Conclusion In this chapter we have looked briefly at a variety of ways of saving tax when you sell your business. As with any major business decision you should take professional advice before you embark on any tax planning. But remember the whole point of any tax planning is to keep as much of your money as possible and keep the share of your ‘sleeping partner’ as low as possible.

30

Valuation techniques INTRODUCTION T Y P E S O F VA L U AT I O N T E C H N I Q U E S CASE STUDY T H E P R I C E E A R N I N G S VA L U AT I O N M E T H O D – W O R K E D E X A M P L E O T H E R VA L U AT I O N T E C H N I Q U E S R E L AT I O N S H I P B E T W E E N S I Z E A N D P R I C E CONCLUSION

chapter

6

Chapter 6: Valuation techniques

Introduction Ultimately, the value of a business is that which a willing purchaser is prepared to pay for it.This will depend on a number of factors not all of which can be foreseen before the sale process commences.Different potential purchasers will place different values on a business.Accordingly,while theoretical valuation models can provide a guide as to the price which a business will achieve on a sale, they can also produce valuations which either significantly under-estimate or overestimate the ultimate selling price. An example of this was the sale of the Scottish supermarket chain William Low. A price was agreed with Sainsburys which the directors and their advisors recommended to the shareholders as a fair price, fully valuing the business. However,Tesco decided that it was prepared to pay significantly more to achieve a presence in the Scottish market.The resultant auction realised a price some 60% higher than the one the directors and their advisors had previously felt able to recommend to shareholders as acceptable. While the predictive power of valuation techniques has limitations,it is necessary for a prospective vendor to obtain an indication from his advisors as to the likely proceeds of sale.If the indication he receives is significantly below the minimum valuation which he would find acceptable, there is no point in initiating a sale exercise. A prospective vendor should obtain this indicative valuation from a professional M&A advisor, not from business associates, his solicitor or a friend at his golf club, the following is a description of the techniques most commonly used by acquirers for valuing a business.

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Types of valuation techniques Earnings ratios The price/earnings ratio (‘PER’) method of valuing a company is a technique commonly used by corporate acquirers. This method of valuation involves ascertaining a company’s sustainable profits and applying an appropriate multiple to that profit stream. In determining the company’s sustainable earnings, adjustments will frequently need to be made to its stated earnings to ascertain what the profits of the business would be under new ownership.Examples of such adjustments include deductions for proprietorial or non-business expenses, such as relatives on the payroll, or the payment by the company of expenses of a private nature or one off items such as a profit on the sale of a property. For the purposes of determining the appropriate price/earnings ratio, there are a number of relevant factors.These include: •

the company’s growth prospects;

•

the attractiveness of the industry;

•

the size of the business;

•

the quality of its management team;

•

the strength of its brand names.

The price/earnings ratios on which comparable quoted companies are trading will also be relevant.As the table below shows, on average, private companies sell on price/earnings multiples representing a discount of some 30-40% relative to PE ratios of similar quoted companies.In addition,if there have been acquisitions of comparable private companies in the recent past,the price earnings ratios paid on those acquisitions will provide some guide to the price which might be expected for the vendor’s business.

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Private company price index 25.0 Four month average FT Non-Financials PER 22.8

22.0

20.0 17.7

18.4 17.0

11.4

11.0

14.7

15.0

PER

17.4

12.2 11.3

11.4

12.4

9.2

10.0

9.8

8.5

Private Company Price Index PER

5.0

0 1991

1992

1993

1994

1995

1996

1997

1998

Sources: FT Non Financials (previously known as the FT500) Index PER – Financial Times Private Company PER – Stoy Hayward/Acquisitions Monthly

Case study The following represents a worked example of a price earnings valuation of a private company.

Manufacturer of stoves The hypothetical company being sold is a manufacturer of stoves which it supplies to electrical retailers.It is a relatively small player in the market,turning over some £20 million and making profits before interest and tax of around £1 million. In order to value the company on a price earnings basis, it is first necessary to determine its sustainable earnings.This involves adjusting stated earnings for any one off items or costs which would not be incurred by a purchaser of the business.For example,the owner/managers pay themselves salaries which exceed the amount which would represent normal arms length salaries for the positions in question.The excess over the relevant market rates should therefore be added back to profit.

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Also, in the last financial year, the company has refurbished its offices, the entire cost of which has been written off through the P&L account.As this is a one off cost which does not impact on underlying earnings, it should be added back to profit. Finally, provisions against stock of £30,000 were made as at the end of the last financial year which are deemed to be excessive.Again, these should be added back to profit.This gives an adjusted figure for earnings before interest and tax of £1,180,000. Over and above these adjustments,depending upon the identity of the purchaser, significant cost savings may be achievable by the purchaser realising synergies by merging the purchaser’s business with that of the vendor. Examples include a reduction in overheads through head office cost savings and cost savings achieved through enhanced buying power. Although it will not be possible for the vendor to obtain all of the benefits of the cost savings accruing to a purchaser, a vendor should attempt to obtain part of the value of these savings. In any event, it is essential for the vendor to estimate these additional cost savings in order to work out what is the maximum purchase price which the purchaser might be prepared to pay. Having determined the underlying earnings of the business the next step is to ascertain the appropriate multiple to apply to the earnings stream. The company has a number of positive attributes including the strength of its management team and its brand name. However, it also has several weaknesses, including the fact that 40% of its turnover is accounted for by one key customer, the loss of which would have disastrous implications for the business.In addition, the relatively small size of the business will mean that it is unlikely to attract much interest from either overseas buyers or financial purchasers. Looking at comparable quoted company multiples, companies in the household goods sector are trading at an average ratio of price to earnings before interest and tax of 10 and there is a quoted manufacturer of stoves which is also trading on a ratio of 10 times its latest earnings before interest and tax. Applying a discount of 30% to this multiple to take account of company’s unquoted status and smaller size gives a ratio of price to earnings before interest and tax (PEBIT) of 7. We are also aware of the fact that a competitor of the company was acquired at a PEBIT ratio of 8 a couple of months ago. On the basis of the above information, it is decided that a PEBIT ratio of 7 to 8 would be appropriate for the company. Applying these figures to underlying earnings of approximately £1.2 million gives a gross valuation range for the

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company of £8.3 million to £9.4 million. From these figures we must deduct the amount of outstanding debt of £1 million leaving a net valuation range of £7.3 million to £8.4 million.

Illustration Manufacturer of stoves STEP 1: Determine sustainable earnings Operating Profit before Interest...........................................................1,000,000 Adjustments Profit on Sale of Property .......................................................................(50,000) Excess Directors Remuneration ..............................................................170,000 Refurbishment of Offices ..........................................................................30,000 Excessive Stock Provisions........................................................................30,000 Adjusted Earnings Before Interest and Tax (EBIT)................................1,180,000

STEP 2: Determine price earnings multiple Positive factors

Negative factors

Strong Management Team

Largest Customer – 40% of Sales

Patented Designs

Retail Environment Very Competitive

Good Brand Name

Relatively Small – Little O/S Interest

Solid Profit Track Record

Growth Prospects Solid, Not Exciting

Good Asset Base

Cyclical Industry

Listed company comparison

Comparable acquisition

Household Goods Sector Av. PBIT Ratio – 10

Quality Stoves Limited bought by XYZ plc at a PEBIT ratio of 8 two months ago.

Listed Manufacturer of Stoves – PBIT Ratio – 10 (10 – 30% discount = 7)

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STEP 3: Valuation Sustainable earnings Pre-Interest & Tax: £1,180,000 PEBIT RANGE 7 – 8 7 x 1,180,000 = £8,260,000 8 x 1,180,000 = £9,440,000 Indicates a Gross Value Between £8.3m and £9.4m Deduct Outstanding Debt of £1m Net Valuation Range £7.3m to £8.4m

Discounted cash flow technique The discounted cash flow technique involves an acquirer determining the future cash flows which the business is anticipated to generate and then discounting those cash flows to determine their present day value. Venture capital houses use the DCF technique by determining whether the expected cash flows will generate the required rate of return on their investment – referred to as an internal rate of return. Every venture capital house has a minimum required rate of return on any investment which it makes,usually around 25% to 30%. Before making an investment, a venture capital firm will determine whether,on the basis of the purchase price being asked for the business,it would be likely to achieve that rate of return. When a corporate acquirer uses the DCF valuation method, they will typically discount the expected cash flows by their cost of capital which is the weighted average cost of its debt and equity finance.Thus, for example, if a company had a cost of capital of 15% it would discount the expected cash flows from an acquisition by that figure. If this generated a positive net present value, the proposal would be accepted. If not, it would be rejected. One of the weaknesses of the discounted cash flow technique is that it will often be difficult to determine, with any degree of accuracy, the future cash flows of a business. For that reason it is necessary to estimate the future cash flows conservatively and test the assumptions underlying the forecasts vigorously during the due diligence process. There follows worked examples of the IRR and the NPV methodologies.

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Worked example The purchaser has concluded that he is likely to hold the investment for six years before looking at an exit.Accordingly, it has estimated the likely cash flows over the intended six year life of the investment.This involves calculating the likely net profit stream of the business and adjusting this by excluding non-cash items such as depreciation or amortisation of goodwill. From this figure there needs to be subtracted an estimate of capital expenditure for the year in question together with the estimated corporation tax payment in each year. At the end of the expected life of the investment,the business will have a residual value which will be based on the expected proceeds of a sale or a flotation of the investment.The critical assumption will be the exit multiple which the company will achieve. Most venture capitalists will assume the same exit multiple as the multiple on which they bought the business. In the example shown below, the projected IRR of the investment is 41%.The venture capital house has a required rate of return of 30% and accordingly decides to proceed with the investment. For a corporate acquirer with a weighted average capital of 15%, the acquisition will generate a net present value of £4.6 million so they too would make the acquisition. Y0 £’000 Purchase Price

Y1 £’000

(3,000)

Y2 £’000

Y3 £’000

Y4 £’000

Y5 £’000

Y6 £’000

(200) 800

Sale of Surplus Assets PBT Tax Paid Depn Cap Ex

700

750

900

1150

1500

1800

(100)

(230)

(250)

(300)

(380)

(500)

100

100

100

100

100

100

(200)

–

(100)

(150)

–

– 9,600

Residual Value (3,000)

500

1,220

650

800

1,220

1,400

0

1.15

1.15 2

1.15 3

1.15 4

1.15 5

1.15 6

NPV

(3,000)

434

922

427

457

606

4,755

Cumm. NPV

(3,000) (2,566) (1,644) (1,217)

(760)

(154)

4,601

Total NPV

£4.6 million RR = 41.2%

Net Cash Discount Rate 15%

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Other valuation techniques Return on investment This technique involves calculating the percentage return on investment which the projected after-tax profits of the target company will generate for the acquirer. This is then compared to the acquirer’s required rate of return.

Pay-back period Under this method, the purchaser determines the number of years it will take the investment to pay for itself,that is,to recoup for the acquirer the initial purchase price of the business. For example, a company might have a minimum required pay-back period of four years during which any investment it makes must recoup, in cash, all of the initial outlay.

Net assets method Valuing a business by reference to its net assets is generally not appropriate for the valuation of a profitable business.However,the method might be appropriate in a situation where the company is loss making or where it consists entirely of property investments. Even where a company is being valued on a price earnings or discounted cash flow basis, the net assets of the company will have some relevance. This is particularly so where the acquisition is being partly funded by debt finance in which case a good asset base will allow a commensurately higher proportion of bank finance relative to equity funding.As debt finance is cheaper than equity finance, this will assist the purchaser in paying a higher price for the business. The net assets of the business are also relevant for purchasers who have to write off acquisition goodwill through their profit and loss account and may therefore be reluctant to pay a substantial premium over the net assets of the company.

Industry specific methods In addition to the general valuation techniques listed above, there are a number of industry specific valuation techniques.For example,investment managers are generally valued by reference to a percentage of their funds under management, nursing homes on a price per bed basis, and insurance brokers on a multiple of commission income.

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Such formulae are typically based on prices which have been historically paid for businesses within a particular sector. While appearing to lack intellectual integrity,the rationale for methodologies based on turnover,and other non-profit related variables, is that a bolt-on acquisition of a company in these sectors by a trade competitor will typically not result in a significant increase in overheads. This allows the profit margin a purchaser would achieve on the acquired company’s earnings stream, to be established on a reasonably accurate basis.

Valuing IT and high tech companies Typically, in the early years of their existence, IT and other high tech companies do not have an established profit stream as they are spending heavily on financing growth or building a customer franchise. In the absence of an established profit stream, valuing IT, high tech and young, high growth enterprises is an extremely difficult exercise.Typically, businesses of this nature are valued on a multiple of either historic or future revenues.A case in point is Amazon.com.,which despite the fact that it has never made a profit,has one of the largest market capitalisations of all NASDAQ quoted companies.

Relationship between size and price As demonstrated by the graph below, as a general rule, the larger the business, the higher the price earnings ratio which one would expect it to achieve on a sale.There are several reasons for this. First, as businesses grow, their quality of earnings and risk profile improve as they become less dependent on one or two key managers,customers or suppliers.Also,up to a point,the larger the business, the greater the number of potential purchasers who come into play.For example, few of the major venture capital houses or overseas purchasers are interested in transactions below £5 million.

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P/E Ratios by deal size 14

12

P/E Ratio

10

8

6

4

2

0 <£2m 1997

£2-5m

£5-10m

£10-20m

£20-50m

Average 1995 to 1997

Source: BDO Stoy Hayward/Acquisitions Monthly

Conclusion Although the valuation techniques described above can provide an indication of the price which would be achieved on the sale of a business,one can never really get an accurate feel for the price a business will fetch until the marketing exercise is under way and the level of interest in the business is gauged. One of the major determinants of the final purchase price will be the amount of interest which the business attracts and the resultant ability to stage a bidding contest between interested parties.

41

Appointing advisors SELECTING A FINANCIAL ADVISOR ROLE OF THE FINANCIAL ADVISOR TYPES OF FINANCIAL ADVISORS CHOOSING A FINANCIAL ADVISOR BASIS OF FEES APPOINTING LEGAL ADVISORS A P P O I N T I N G TA X A D V I S O R S

chapter

7

Chapter 7: Appointing advisors

Selecting a financial advisor Why appoint an advisor? There are a number of reasons why it is generally preferable for a proprietor to engage the services of a professional advisor to sell his business rather than adopt a DIY approach. These include the ability of financial advisors to maintain confidentiality, their superior knowledge of potential purchasers and their negotiation skills.By way of example,although the vendor is likely to have a good idea of the likely UK trade buyers for his business, his advisor is likely to have superior knowledge of potential overseas purchasers and purchasers outside the vendor’s sector. A good financial advisor should be able to add value to the transaction many times the amount of his fees.

Role of the financial advisor The role of a financial advisor acting for the vendor of a business is to: •

advise on appropriate measures to groom the business for sale;

•

advise on timing and give an indicative valuation;

•

prepare the sales memorandum;

•

identify and approach appropriate purchasers;

•

lead the negotiations with potential purchasers;

•

advise on the offers received and the appropriate structure for a sale;

•

manage the due diligence and legal phase of the transaction; and

•

ensure that the transaction is completed on a timely basis.

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APPOINTING

ADVISORS

Types of financial advisors Some advisors merely act as introductory brokers while others provide a full advisory service to the client.The main categories of M&A advisors are as follows: •

Investment banks – investment banks tend to focus on larger transactions including cross-border mergers and acquisitions.The larger investment banks are generally not interested in transactions less than £50 million.It is extremely important that a vendor does not represent a small transaction for an investment bank as this will be reflected in the level of service which they receive including the level of director or partner involvement.

•

Accountancy firms – in volume terms, the top five accountancy firms are among the largest players in the UK M&A advisory market. However, before appointing an accountancy practice to act as his advisor, the vendor needs to be satisfied that the firm does not have any conflicts of interest. Such conflicts can arise if one or more of the likely potential purchasers is an audit client or alternatively has been retained by the accountancy firm on either an acquisition brief or to provide corporate finance advice.

•

Boutiques – There are a number of M&A boutiques which are either generalist M&A advisors or focus on particular industry sectors such as financial services. Care needs to be taken before appointing an advisor within this category that they have adequate resources to provide a comprehensive service.One or two man operations will rarely meet this criteria.Also,before appointing an M&A boutique,the vendor must establish that they have sufficient professional indemnity insurance cover and are SFA registered.

Choosing a financial advisor The personal chemistry that must exist between advisor and principal should not be underestimated.Frequently,a sale exercise will involve stressful negotiations with the need to make important decisions quickly.It is important that a cohesive team is presented to a potential purchaser. In choosing an appropriate financial advisor, a vendor should also have regard to the following considerations: •

make sure that your deal will be an important one for the advisor. In that regard, you are much better off being at the top end rather than the bottom of the advisor’s typical deal size spectrum;

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ADVISORS

•

conduct a ‘beauty parade’of two or three potential advisors,preferably from different types of organisations;

•

ensure an advisor has relevant experience in the type of transaction envisaged.Always insist on both references and fee quotes;

•

if it is likely that the business will attract interest from overseas purchasers, make sure the appointed advisor has a good overseas network;

•

beware of false economy. Don’t allow fees to be the main determinant of the choice of advisor. There is often a reason why an advisor can consistently charge higher fees than his competitors;

•

ensure that an advisor will not face any conflicts of interest if appointed;

•

ascertain who will be working on the transaction on a day to day basis;

•

ensure the advisor is properly authorised under the Financial Services Act, and has adequate professional indemnity insurance;

•

bring a financial advisor on board well before the sale process actually gets underway. The preparation of the business for sale is equally as important as the sale process itself.

Basis of fees Most advisors charge an initial retainer and then a success fee based on the amount of the consideration received. Typically success fees will be in the range of 1 and 3% depending on the size of the deal. Most fee structures contain a ratchet whereby the percentage fee increases if the purchase price exceeds pre agreed levels.This ensures that the advisor is incentivised to achieve the highest price for the business. Care should be taken in fee negotiations with advisors to ensure that: •

the concept of ‘consideration’is fully understood by both parties.Does it include non-cash items, pre-sale dividends and assumption of debts?

•

there are not going to be any abort fees unless specifically agreed;

•

the advisor is not going to seek a fee from the purchaser.It is not in the interests of the vendor that his advisor will be seeking fees from purchasers as it will compromise the advisor’s position, particularly as some purchasers will never pay fees and thus may not be contacted by the advisor;

•

the advisor is not incentivised to push a transaction irrespective of the attractiveness of the offers received from potential purchasers.

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Appointing legal advisors Legal advisors are not a commodity.A good lawyer with commercial flair can add significant value to the transaction, not only in terms of the quality of his or her legal advice,but also in ensuring that the deal completes in a timely manner with as little acrimony between the parties as possible. The following guidelines should be followed when choosing a lawyer to advise on the sale of a business: •

ensure that the lawyer is an M&A specialist.Do not be tempted to appoint the family lawyer who may either be a generalist or worse still an expert in property law.

•

make sure that the chosen law firm has sufficient resources to properly service an M&A transaction.The chosen law firm should have expertise in all relevant practice areas which could include tax, property, intellectual property,pensions and employment law as well as corporate finance. In the later stages of the transaction, the lawyers will need to provide a round the clock service.Be wary of law firms whose answering machine comes on at 5.30 pm;

•

do not underestimate the importance of having a good personal relationship with your lawyer;

•

conduct a beauty parade involving two or three suitably qualified law firms;

•

insist that the partner who attends the presentation is present at all key negotiating meetings;

•

if the transaction has an international aspect, ensure that the lawyers have a network of overseas offices;

•

ensure that the law firm has adequate professional indemnity insurance;

•

get fee quotes up front. Most lawyers are prepared to cap their fees at an agreed level and to offer a reduced fee scale in the event that the deal does not proceed.

Appointing tax advisors It is not so much the purchase price achieved on a sale of a business which is important so much as the amount the vendor gets to keep after paying any capital gains tax on the proceeds of sale.In that regard,the appointment of an appropriate tax advisor is vitally important.

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Once again, the key is to appoint a specialist advisor who has considerable experience in advising vendors of private companies.The alternatives include the law firm retained to advise on the sale,a firm of accountants or a firm of specialist tax advisors. It is always useful to get second opinions and if a tax scheme is proposed which is particularly aggressive, obtaining an opinion on the scheme from leading tax counsel may be a worthwhile investment.

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Preparing an information memorandum O B J E C T I V E O F A N I N F O R M AT I O N M E M O R A N D U M CONTENTS OF THE MEMORANDUM

chapter

8

Chapter 8: Preparing an information memorandum

Objective of an information memorandum The main purpose of an information memorandum is to enable potential purchasers to decide whether or not the company is a suitable acquisition target. Although the information memorandum needs to be accurate, it is essentially a selling tool. Presentation is therefore as important as the substance, and the memorandum needs to reflect the style of the organisation being sold. An information memorandum is not a prospectus and is thus not normally verified by lawyers.Its contents are,however,governed by the Financial Services Act which prohibits misleading or deceptive statements in such a document.Also, any significant discrepancies between the memorandum and the real state of the business will embarrass the vendor and have a detrimental effect generally on the credibility of the document. No potential purchaser will make a final decision on the basis of an information memorandum.The main purpose of the document is to bring a purchaser to the negotiating table. There is no point therefore in making the document too voluminous.The initial reviewer may only have a short period in which to review the document before deciding to reject it, or pass it to a colleague for a more detailed analysis.Therefore,the executive summary must be positive and punchy.

Contents of the memorandum The same information need not be given to all purchasers.Commercially sensitive information, such as the names of customers or suppliers, can be excluded from copies sent to certain recipients such as direct competitors. As certain purchasers might value certain attributes of the business whilst others might be attracted by other features of the business,the information memorandum can also be varied to highlight features of particular interest to specific purchasers. Examples of particular attractions to a purchaser might include: •

Access to the UK market.

•

Potential for overseas growth with a foreign owner.

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•

Ability to cross sell products to the company’s customer base or vice versa.

•

Potential overhead savings.

•

Strength of management.

•

Brand names.

•

Distribution channels.

The financial section should show the sustainable recurring profit, adjusted for costs or income which would not recur under new ownership. Such items may include: •

Expenses of a proprietary nature eg. private staff on the company’s payroll.

•

Directors remuneration in excess of market rates.

•

Management charges to be terminated on a sale.

•

Gains or losses on disposal of fixed assets.

•

Other extraordinary or exceptional items.

In preparing the information memorandum,regard should be had to the following points: •

Hype, glossiness, superlatives and pretentiousness should be avoided. In particular, documents written in the ‘last chance’,‘must buy now’ style are unlikely to be taken seriously in the context of a business sale.

•

Restrict the number of people involved in drafting the information memorandum. The involvement of a large number of people will inevitably lead to a mismatch of styles. It can also extend the timetable unnecessarily.

•

If a profit forecast is included in the financial section ensure it is adequately supported by management accounts.

•

Ensure the memorandum has the appropriate ‘health warnings’ and disclaimers, and that it is issued by a regulated advisor.

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Identifying potential purchases IDENTIFYING THE OPTIMAL PURCHASER TYPES OF POTENTIAL PURCHASERS CONCLUSION

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Chapter 9: Identifying potential purchases

Identifying the optimal purchaser To determine who might represent an appropriate purchaser for the business one must first consider the objectives of the vendor. The vendor’s objectives will influence not only who is targeted as a potential purchaser, but also how the business is presented to purchasers and the way in which the negotiations are handled. For example, there is no point in marketing the business to a purchaser who could only offer shares as purchase consideration if the vendor is looking for cash. The vendor’s objectives will also help to determine the most suitable route for sale,be it a sale to a private individual,a trade sale to a private or public company, a management buy-out or buy-in,or a management buy-in/buy-out,often referred to as a ‘BIMBO’. The ideal potential purchaser will typically be one who will: •

pay a premium price for the business;

•

add value to the business;

•

be acceptable to management;

•

not require shareholder or other approvals;

•

not entail competition commission or other regulatory problems;

•

not have to raise funds to finance the acquisition.

In selecting potential trade or financial buyers,regard must be had to any published acquisition criteria, their acquisition track record (if any) and their ability to finance a deal of the size in question.

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Types of potential purchasers There are several broad categories into which most potential purchasers fall.These include direct competitors, overseas buyers, financial purchasers, companies in related industries and wealthy individuals. For certain companies, it will be appropriate to target all of these categories of potential purchasers. For others, it may be appropriate to only target one or two. Each type of potential purchaser has its own characteristics and the way in which a particular purchaser is approached will vary accordingly. Set out below are the main categories of potential purchasers together with a brief description of each.

Direct competitors For reasons of confidentiality,a vendor may not wish to approach direct competitors at all. Even where information is supplied to competitors on a confidential basis, there is always a danger with competitors that they will attempt to use the fact of the impending sale of the company to their advantage by advising the company’s customers,suppliers and key employees of the impending sale.Accordingly,even if a vendor is prepared to approach direct competitors, he may only wish to do so when he has an offer on the table from another buyer and a sale seems virtually certain to proceed.This approach is usually feasible as a direct competitor will be able to determine very quickly whether it wishes to acquire the company and, if so, the price it would be prepared to pay. If the company fears that a competitor may just be fishing for information and have no real interest in acquiring the business, the intentions of the purchaser can be tested by asking them to provide equivalent information concerning their business as that disclosed by the vendor, sometimes referred to as a mirror disclosure exercise. Before giving exclusivity to a competitor, it is also common to require the competitor to pay a non-refundable deposit to the vendor as a term of the Heads of Agreement.The preparedness of a purchaser to pay such a deposit is generally an indication of serious interest. A direct competitor may not always be prepared to pay the highest price for the business even where it appears to be the most logical purchaser.The willingness of a competitor to pay a premium price for the business may be limited by the extent to which it believes it could obtain the same result by growing its business organically by, for example, significantly increasing its advertising budget or by poaching the vendor’s key employees.On the other hand,there will be some cases

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where the synergistic benefits available to competitors (such as economies of scale) are such that they will inevitably outbid any other category of purchaser.

Companies in related sectors Most companies are now focusing very much on their core business.As a result that diversification,these days,is a rarity. However,companies still make acquisitions in industries related to their core business.The acquisition of Forte by Granada is a case in point.Moreover,such acquirers will often be prepared to pay a premium price for the business as an acquisition may be the only feasible means of entering the relevant market.

Suppliers and customers It is now generally accepted that vertical integration (that is, the purchase of a business by a supplier or customer) is not an advisable acquisition strategy unless there is some particular factor which provides a justification. For example, if the company being sold accounts for a large proportion of a supplier’s sales,the supplier may be interested in acquiring the business as a defensive strategy to prevent it losing its custom to a competitor.As a general rule, however, vertical integration is now a relic of the 1980s.

Management buy-out (MBO)/management buy-in (MBI)/ buy-in/management buy-out (BIMBO) A management buy-out involves the acquisition of a company by its management team, supported by finance provided by a venture capital fund and one or more banks.The potential for a management buy-out of a business should always be considered. For an MBO to be feasible, the management remaining with the business following the sale must be sufficiently strong to assume the executive control of the business. In a situation where the management of the business has been largely confined to the vendors,this may not be the case.In such a situation, it may be that a management buy-in would be appropriate. In this case, the venture capital house introduces an MBI team to the business to take over the running of the company following the sale.The MBI team will take an equity stake in the business alongside the venture capital house which is financing the bid. Where the existing management team has some, but not all, of the skills required to manage the business following a sale, a BIMBO (buy-in/management buy-out) may be appropriate.In this situation,the management team,post-sale,will comprise some of the incumbent management together with one or more additions to the

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team (such as a new chief executive or finance director) introduced by the venture capital house financing the transaction.

UK Management buy-outs and buy-ins 1979-1998 11,000 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Source: CMBOR

The above table shows the phenomenal growth rate in venture capital backed deals in the UK over the past 20 years.

Managing an MBO At an early stage, the vendors need to determine: i)

The likelihood that the management team would be willing to pursue a management buy out;

ii)

Whether management would be backable by a venture capital house;

iii) Even if the first two conditions are met,whether an MBO bid could match the price which trade buyers are likely to offer. It may be that the synergies with potential trade buyers are so great that this would not be the case. If all of the pre-conditions to a successful MBO have been satisfied, a decision then needs to be made as to how best to progress the MBO. One option is to give the management a period of time to make a fully funded offer at an acceptable level.If such an offer materialises by the end of that period, the vendor would agree to run with the MBO bid.In the meantime,the MBO can

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be benchmarked by obtaining expressions of interest from potential trade buyers to provide back up options in the event that the MBO does not materialise. The alternative approach is to run the MBO bid concurrently with seeking offers from potential trade purchasers of the business. One of the problems with this approach is that trade buyers are often reluctant to compete with incumbent management in buying the business. There is also the danger that management may be less than fully co-operative in presenting the business to trade buyers in an attempt to maximise the chances of their MBO bid succeeding. One way of overcoming this potential problem is to offer management a substantial bonus on completion of the transaction and to underwrite the abort costs of the MBO bid. This ensures that the management is motivated to assist in achieving a successful sale of the business. Another alternative is what is called the Vendor Initiated Management Buy-Out or VIMBO. Under this process, the vendor rather than the management team controls the MBO process and it is the vendor’s advisors rather than those of the management team who make the approaches and elicit offers from venture capital houses directly and control access to the management team. The rationale for this approach is to enable the vendor to conduct an auction amongst venture capitalists to extract the highest price and to remove the possibility of the management team restricting the ability of venture capitalists to pay a high price for the business by negotiating a high equity stake for the management team in the acquisition vehicle. One of the advantages of an MBO over a trade sale is that the scope of the warranties is typically not as extensive as is the case with a trade sale.In negotiating warranties, the starting point for the vendor is that he should not give any warranties or, at least, that they should be heavily circumscribed. The basis for this is that the management team will often know as much if not more, about the business than the vendors.The compromise generally reached is that warranties are given but with carve outs for matters known to the management team and with a number of warranties confined to matters within the actual knowledge of the vendors. Another advantage of a management buy-out is a reduced risk of a breach of confidentiality.

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Financial purchasers A financial purchase refers to a situation where a venture capital house buys a business in much the same way as a trade buyer without involving management in the preparation of its offer.In this situation,the venture capital house will usually concern itself with the issue of equity participation by the management team after the transaction is concluded. In so doing, the venture capital house is able to offer a higher purchase price for the business, as they do not have to concede as substantial an equity stake to management as they would with an MBO or MBI. There are certain risks involved in this approach and it tends to work best in situations where management are not pivotal to the business,for example,where the company has very strong brand names.

Overseas purchasers A substantial proportion of acquisitions of UK trade sales (some 47% in 1998) represent purchases by overseas companies. Most of these acquisitions involve purchases of relatively sizeable companies.In the case of smaller companies,the due diligence and post-acquisition management costs are usually prohibitive where the overseas purchaser does not have an existing presence in the UK. In approaching overseas purchasers,regard needs to be had to local customs and particularly the differences in the speed with which purchasers in different countries react.

Trade Sales Nationality of Companies Acquiring UK Companies in 1998

UK 53% Continental Europe 20% North America 21%

Rest of World 6%

Note: By value

Source: AMDATA

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Wealthy individuals For businesses of up to £10 million in value, wealthy individuals or consortia of individuals should not be discounted as a source of potential buyers.In the current market place,there are a number of wealthy individuals who have sold their own businesses and are looking to re-invest the proceeds in other ventures.

Shell companies A shell company is a quoted company which has no or little existing operations. A shell company can be used either as an alternative route to obtain a stock market quotation or as a means of achieving an outcome similar to a trade sale with the vendor shareholders being paid in cash or with a combination of cash and shares in the listed shell. Whether the shell company will be able to outbid trade or financial buyers will largely depend on the people behind the shell.A case in point is the acquisition in 1998 of Belgo Restaurants by Lonsdale Holdings a shell company backed by Luke Johnson for a price of £10m. Johnson’s intention was to replicate his success with the Pizza Express chain by rolling out the Belgo concept in both the UK and the US markets. When the deal was announced, some analysts suggested that Lonsdale Holdings may have overpaid. However the critics were well and truly silenced when following the suspension of dealings in Lonsdale shares, the shares traded at around three times their pre-suspension level.

Conclusion In identifying potential purchasers, regard must be had to the following points: •

It is important to think laterally in identifying potential purchasers – it is often the less obvious buyer who will be prepared to pay a premium price for the business.

•

Start off with a full list including potential purchasers from different sectors and countries.Then reduce this list to a manageable number by dividing them into an ‘A’list and a ‘B’list containing names to be held in reserve.

•

If possible,the proprietor should avoid advertising the business as this can often be seen as a sign of a distressed sale.A highly targeted and confidential approach to 20 or 30 of the most likely buyers within a short period of time should, in most cases, generate offers without the need to advertise.

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Approaching potential purchasers FORMAL VERSUS INFORMAL AUCTION S TA G G E R I N G A P P R O A C H E S DEALING WITH UNSOLICITED OFFERS C O N TA C T I N G P O T E N T I A L P U R C H A S E R S

chapter

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Chapter 10: Approaching potential purchasers

Formal versus informal auction With a formal auction, potential bidders are given a timetable requiring them to give the vendor an indicative valuation by a certain date on the basis of information contained in the sales memorandum. Following receipt of indicative offers, several potential purchasers are short listed and given the opportunity to meet management, conduct site visits and carry out additional due diligence on the company following which they will be required to make a final binding offer for the company (which may include the provision of a vendor due diligence report). This route is only feasible where a strong level of demand for the business is anticipated allowing the vendor to dictate terms to potential purchasers. If no offers have been received by the deadline imposed and the vendor is then forced to give time extensions to interested parties, his negotiating position will be seriously weakened. Accordingly,if there is some doubt as to the likely level of interest in the business, it is best to avoid a formal auction. If, subsequently, the approaches to potential purchasers generate an extremely positive response, the option always exists to convert the exercise into a formal auction at a later time by imposing formal deadlines for bids. In the case of smaller or less attractive businesses, the vendor is compelled to run at the speed at which purchasers are prepared to respond and therefore cannot set deadlines for the receipt of bids. Competition between purchasers can still be generated if sufficient interest is obtained but the resultant auction is less formal than the process described above.

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Staggering approaches In approaching potential purchasers, the objective is to ensure that even where a formal auction is not being deployed, all offers for the company are received at broadly the same time. Some purchasers will require more time than others to assess whether they wish to buy the business and the price they would be prepared to pay. For example, overseas companies and potential purchasers outside the vendor’s sector will require more time to reach a decision than direct competitors and will therefore need to be approached first.The staggered method of approaching potential purchasers can be employed, to some extent, even in the context of a formal auction.

Dealing with unsolicited offers If a proprietor receives an unsolicited offer for his business which is pitched at an acceptable level, should he progress that offer or test the market more widely to determine whether a higher offer could be achieved? There are no hard and fast rules on this issue. If there are no other logical buyers for the business and the offer is at a level which, in the opinion of the vendor’s financial advisors, represents a full price for the business, it may be that the best alternative is to commence negotiations on the offer.This is particularly so where there is a strong chance that the offer may be withdrawn unless it is progressed quickly.Even where it is decided to pursue a ‘rifle shot’approach and talk exclusively to the purchaser in question,in order to support the vendor’s negotiating position,it is often useful to give the purchaser the impression that other buyers are waiting in the wings. It may even be worthwhile for the vendor to have his advisor prepare an information memorandum to show that the vendor has a serious intent to approach other potential buyers of the business in the event that the purchaser does not deliver on his offer.

Contacting potential purchasers Each type of potential purchaser has its own characteristics which will determine the preferred method of approach, but some general rules apply. Sending out anonymous descriptions of the business to potential purchasers is not the preferred method of approaching buyers. Rather than sending out fliers and waiting for a response, it is preferable for the vendor’s advisor to extol the

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merits of the company to the purchaser either face to face or by telephone. Purchasers should be told by the advisor why the acquisition of the company would fit with their corporate strategy. It is generally not advisable to give purchasers an indication of the vendor’s price expectations.If one gives a price indication to a purchaser,offers will automatically be capped at that price and the price given may frighten some purchasers off. It is usually preferable to let purchasers arrive at their own valuation and then work the offers up to an acceptable level. Exceptions to the general rule include possible time wasters or direct competitors. A vendor will not wish to progress with such purchasers unless he is confident that they can meet the minimum price expectation.

Maintaining confidentiality Where a quoted company is intending to sell a division or subsidiary, the Board typically makes an announcement to that effect with a view to attracting interest from potential purchasers. In contrast,with the sale of a private company,concerns regarding confidentiality mean that, in most cases, the sale is kept confidential until it is completed. Proprietors of private companies are typically concerned about the negative impact which a leak about the impending sale would have on its staff, customers and suppliers. It is common for example where competitors become aware of the impending sale of the business to utilise the uncertainty surrounding the future ownership of the business to either poach the vendor’s staff or customers.Vendors of private companies will therefore prefer to target a select number of prospective buyers for the business and approach them confidentially. A number of steps can be taken to maximise the chances of keeping the sale exercise confidential. At a minimum, purchasers should always be asked to sign confidentiality letters before being given the identity of the vendor and receiving the sales memorandum. Clearly this is easier for an advisor to achieve than a principal. Other measures which should be taken include: •

holding initial meetings with potential purchasers at the advisor’s offices:

•

ensuring that the purchaser communicates via the advisor rather than directly with the vendor; and

•

only permit site visits where potential purchasers have evidenced serious intent and possibly given an acceptable broad indication of value.

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Even if one takes the utmost care to maintain confidentiality, it is an advisable precaution to assume that, at some stage, news of the sale will leak out and to adopt a strategy to manage the leak. For that purpose, a ‘hymn sheet’ should be prepared containing a response to a leak agreed by both the vendors and their advisors.These responses may vary, depending on the stage of the transaction, but the golden rule is to never tell an outright lie. An angry denial by the vendor that his company is on the market may merely serve to confirm the accuracy of a rumour. A relaxed and disarming response to the effect that ‘the company is always receiving approaches’ or something similar is preferable. It may also be advisable at the outset of a sale exercise for the vendor to let it be known that he is considering a flotation of the business. This can not only provide a useful smoke screen for a sale exercise but may also help to flush out some potential bidders for the company.

Meetings with potential purchasers Before meeting with a potential buyer of the business, it is essential that, in conjunction with his advisor, the vendor has: •

examined its past acquisitions and the prices it has paid;

•

determined its funding capability;

•

reviewed any published acquisition criteria of the purchaser; and

•

reviewed what has happened to companies previously acquired by the purchaser.

Vendors are often surprised by the fact that meetings with potential buyers are often as much about the purchaser convincing the vendor why they represent an appropriate buyer of the business as they are with the vendor extolling the attractions of his business. If one or more bidders are at broadly the same level, non-price considerations,such as confidence in a purchaser’s ability to complete the transaction and the relationship with the purchaser has developed with the vendor, become important.A purchaser will often attempt to reduce the price he needs to pay for the business by offering sweeteners to the vendor such as a seat on the purchaser’s board of directors or by stressing the benefits which the vendor’s business will receive by becoming part of the purchaser’s group.

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The negotiation process INTRODUCTION U N D E R S TA N D I N G T H E P U R C H A S E R ’ S O B J E C T I V E S R E L E A S I N G I N F O R M AT I O N B R I D G I N G T H E P R I C E E X P E C TAT I O N S G A P – E A R N O U T S REVIEWING OFFERS HEADS OF AGREEMENT R U L E S F O R S U C C E S S F U L N E G O T I AT I O N

chapter

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Chapter 11: The negotiation process

Introduction Once potential purchasers have been contacted, the negotiation process has effectively started. It is not possible to be too definitive as to how to negotiate with potential purchasers. Different purchasers will respond differently to different approaches and accordingly the approach taken must be determined on a case by case basis.There are nevertheless some general rules which should be followed in the context of negotiations with any potential buyers of the business.

Understanding the purchaser’s objectives It is important for the vendor to understand the potential purchaser’s viewpoint and to ascertain what it is seeking to achieve from the acquisition. For example, occasionally a purchaser will be interested in the business for emotive rather than strategic or financial reasons. One frequently encountered objective is status. If the target has an extremely prestigious brand name or a royal warrant,a purchaser may be more interested in the kudos which may attach to the ownership of the business than its profitability. If that is the case, it may be possible to extract a higher price than the financial performance of the business would appear to merit. Similarly,if the potential purchaser is considering the acquisition of the business for strategic reasons, for example, to obtain entry into the European market, it may be prepared to pay considerably more than a conventional multiple of earnings.It is also important to understand what improvements a purchaser could make to the business by way of cost savings or revenue enhancement and to ensure that this is factored into the pricing of the business.

Releasing information The release of information on the business needs to be carefully controlled. It is absolutely essential to disclose all critical information on the business to the purchaser before signing heads of agreement. If price sensitive information is withheld by the vendor,it may provide the purchaser with a basis for withdrawing

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the offer or reducing the purchase price.Different considerations apply after heads of agreement have been signed. If, for example, following the signing of heads of agreement,there is a downturn in the trading performance of the business,it may be advisable to delay conveying that information to the purchaser for as long as possible provided the vendor does not thereby open himself up to accusations of bad faith.The more money the purchaser has spent on lawyers and accountants, the more committed it will be to doing the deal. Similarly, it may be advisable not to inform the purchaser about favourable developments in the business immediately but to withhold the information until a sticking point is reached in the negotiations or to counteract an attempt to reduce the purchase price. The purchaser will generally ask the vendor to warrant the accuracy of all written information supplied to him during the course of negotiations. It is essential therefore for the vendor to maintain an accurate record of all information provided to the purchaser.

Bridging the price expectations gap – earn outs Differences in price expectations can be bridged by a number of techniques.The most obvious of these is an earn-out, whereby further consideration is paid as and when future profits are earned.Vendors can often achieve a higher price via this route as they are assuming part of the risk of the future performance of the business.In effect,a vendor is ‘putting their money where his mouth is’by backing the financial projections provided to the purchaser.Earn outs also help a purchaser to pay a higher price by allowing the payment of part of the price from the future cash flows of the business. Clearly an earn out will only be appropriate where the vendor is both confident of future profits and where the business will remain autonomous and independent after a sale. In many cases, this will not be possible as the purchaser’s rationale in buying the business may be to combine the vendor’s business with his to achieve cost savings and other synergistic benefits.This may make it difficult to identify the target company’s profit stream after the acquisition. Depending on the circumstances and, in particular the length of time which it is agreed that the vendor should remain with the business following the sale, other routes should be considered.These include a retention by the vendor of a minority stake in the company following the sale with put and call option agreements put in place with respect to the vendor’s residual shareholding. Under the terms of these option agreements, after a certain period of time, the vendor has a right to require the purchaser to buy his residual shareholding and the purchaser has a

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corresponding right to buy the shares.The exercise price is usually determined by reference to the profits of the business in the period following completion.

Reviewing offers No two offers will ever be the same. Potential purchasers will make offers in a variety of forms, including cash, shares and loan notes or a combination thereof. It is essential, in evaluating offers, to determine the true value of each element of the consideration being offered and, in the case of consideration other than cash or bank guaranteed loan notes,to make adequate allowance for risk.Qualitatively, an offer which requires the vendor to take a significant proportion of the consideration in shares or in unsecured loan stock or preference shares is inferior to an all cash offer.Other considerations in reviewing offers for the business include: •

Do not assume that an initial value given by a purchaser to tempt the vendor to the table,will always be the final one.Some purchasers have a reputation for ‘chipping’ offers after they have been accepted by the vendor.The acquisition track record of each purchaser must be carefully scrutinised.

•

If the offers received undervalue the business, there is no obligation on the vendor, moral or otherwise, to progress with any of them.

•

Price is not the only factor relevant to an evaluation of an offer. Other terms of the deal,such as the terms of ongoing service agreements with the vendors and the level of warranties or indemnities required are important and must be fully understood before a final offer is accepted.

•

If an offer is subject to the purchaser being able to raise the necessary finance, the purchaser’s fund raising capability needs to be carefully scrutinised.If bank finance is required,as in the case of an MBO,a vendor should seek a letter of support from the bank. If the purchaser in question needs to raise finance on the stock market, the vendor may wish to speak to the purchaser’s brokers to access the chances of the finance being raised.

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Heads of agreement Introduction Once all offers which are likely to be received have been tabled, the next step is to negotiate the terms of those offers.Assuming at the end of this process that one or more of the offers is acceptable, it is then necessary to choose the offer which best meets the objectives of the vendor. It is customary for the essential terms of that offer to be enshrined in heads of agreement. Although, except for provisions relating to exclusivity, costs and confidentiality,the heads of agreement is not a legally binding document,it should cover all of the important points of the deal.It is unwise to defer important issues for subsequent discussion for several reasons.First,the heads of agreement stage is usually a honeymoon period where good relations exist between the vendor and the purchaser.The relationship will often deteriorate once the due diligence process starts and the legal negotiations commence. Secondly, the vendor’s negotiating position is always at its strongest at this stage as hopefully he will have a number of competing offers on the table to which he can revert if he cannot get the concessions he is seeking from the preferred bidder.If a vendor is forced to revert to other bidders after negotiations have been terminated with the preferred bidder, at best his negotiating position will have been seriously impaired.At worst, he may find that the interest of other buyers has dissipated in the meantime as they have moved on to other projects. It is generally not advisable for lawyers to get actively involved in drafting heads of agreement.This can considerably lengthen the process and result in a loss of momentum and a loss of enthusiasm on the part of the buyer. Having said that, it is important for a lawyer to cast his eye over the heads of agreement before they are finalised as it is difficult to negotiate away from a position entrenched in the heads of agreement or to introduce important new elements after the heads are concluded.

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Key issues Exclusivity A purchaser will almost invariably insist on a period of exclusivity to enable him to conduct due diligence and prepare and negotiate the necessary legal documentation. Engaging accountants and lawyers is an expensive exercise and purchasers will rarely be prepared to do so unless they have an assurance that they will not be gazumped by a competing bidder. The length of the exclusivity period is always a matter for negotiation but is generally in the region of six to eight weeks.This period may be longer if the purchaser needs to raise finance or seek shareholder approval for the acquisition. If the purchaser attempts to renegotiate a key element of the transaction, particularly the purchase price, its exclusivity will lapse as a matter of course.This should, however, be stated as a specific term of the heads of agreement.

Timetable From the heads of agreement stage onwards,significant costs will start to be incurred by both parties,and senior members of staff may need to be advised of the potential sale. It is therefore important that a detailed timetable is agreed, planning every week up to completion. The vendor should insert a clause in the heads of agreement that if the purchaser fails to meet key deadlines in the timetable, such as the production of the due diligence report or a draft acquisition agreement by a certain date, its exclusivity will lapse.

Net assets/surplus cash The typical basis of a sale is that there will be a minimum level of net assets in the company at completion.Alternatively,a company may be sold on a ‘cash free/debt free basis’. If a net assets test is used, the minimum net asset figure agreed will typically be determined by reference to the net assets of the company as stated in its most recent set of audited or management accounts.This figure might be subject to an upward adjustment to take account of the increased working capital requirements of the business since the last accounts were prepared. Often,the actual net assets of the business on completion will be determined by a set of completion accounts with the vendor being required to reimburse the purchaser for any shortfall relative to the minimum agreed figure and possibly being entitled to be paid any excess by the purchaser.

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The alternative to a net assets test is a ‘cash free/debt free’ basis. Care needs to be taken, if this technique is used, to ensure that the parties have the same understanding of this concept.A purchaser will often wish to deduct the following items from any cash on the balance sheet to determine surplus cash: •

Any actual corporation tax liabilities of the company.

•

An imputed tax charge in respect of current year earnings.

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Any borrowings, including bank debt, hire purchase obligations and finance leases.

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Any substantial capital expenditure requirements which are due in the immediate future.

The basis for determining surplus cash should be clearly set out in the heads of agreement to avoid subsequent arguments.

Why do deals collapse after heads of agreement? Having prepared the business for sale, identified a purchaser, and negotiated the terms of a deal, why do some sales complete and some fall by the wayside? There is often a tendency for vendors to feel that once the heads of agreement are signed with a purchaser, the deal is done. In fact, often the stage between agreeing terms and completion is the most difficult period of the sale exercise. A whole new group of advisors become involved, including two or more sets of solicitors, reporting accountants, as well as perhaps firms of stockbrokers and other financial advisors.They will not have been party to the original negotiations, nor understand the nuances of what has been agreed.As a result,misunderstandings can and do arise. Alternatively, issues may arise from the due diligence process which cannot be satisfactorily resolved. A third and frequent reason for a deal collapsing after heads of agreement is a deterioration in the financial performance of the business,which results in the purchaser withdrawing or attempting to reduce the purchase price.This may be due to the general business climate or to the fact that the vendor and the rest of the management team have ‘taken their eyes off the ball’ because of their involvement in the sale process. If the owner has established a good relationship with the purchaser,it is very helpful to keep the dialogue going as this can help to ensure that as and when problems do arise, they are resolved sensibly between the principals at an early stage. The vendor should ensure that issues already agreed by the principals are not being renegotiated and that the lawyers do not become bogged down over minor points which can be readily agreed between the principals.

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Rules for successful negotiation In negotiations with purchasers, the following rules should be followed: •

All information that is provided should be correct. Bear in mind that most purchasers will carry out rigorous due diligence to verify all that has been discussed in negotiations.Always assume that all information concerning the business will be unearthed by due diligence.

•

It may be advisable not to reveal all of the Company’s attractions initially, but to keep something back for later to counteract any attempt by the purchaser to renegotiate the terms of the transaction.

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Use advisors to best advantage.Let them pursue the hard points,possibly without the principals. The situation can always be retrieved by the principles if a compromise is necessary.

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Always consider the discussions from the other person’s point of view; negotiations are never one sided.

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Have realistic expectations and stick with them; instruct advisors to follow the same line.

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Be prepared to withdraw if your objectives are not being met.

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The due diligence process and warranties INTRODUCTION TYPES OF DUE DILIGENCE WARRANTIES

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Chapter 12: The due diligence process and warranties

Introduction Due diligence is, in essence, an investigation of the business and the market in which it operates designed to ensure that the assumptions underlying the purchaser’s offer are correct.Vendors often fear the due diligence process, but provided the vendor has not withheld any crucial information concerning the business, it should not give rise to any unpleasant surprises. That said,the extent of the purchaser’s knowledge of the business and its market is an important factor.There is always the possibility that at the time heads of agreement are signed,the purchaser has not adequately understood the business or its market, leaving the vendor in a vulnerable position.The extent to which the purchaser needs to conduct detailed due diligence to supplement his existing knowledge of the business is, therefore, a relevant factor in the vendor’s choice of preferred bidder.In particular,a purchaser which does not require to undertake market due diligence should be favoured over one which does.

Types of due diligence There are several types of due diligence.These can be described as follows:

Financial due diligence Financial due diligence involves a detailed examination of the financial affairs of the company with particular focus on the historic, current and projected performance of the business.Financial due diligence will generally take the form of a lengthy accountants report on the business. One of the critical roles of the reporting accountants will be to test the assumptions underlying the profit projections of the business as it is the future profit stream of the company which forms the essence of what the purchaser is buying. A purchaser will typically ask the vendor to review the accountants report and to warrant the accuracy of the report.The giving of such a blanket warranty should be resisted by the vendor on the basis that the due diligence report will contain

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statements of opinion and assumptions regarding future trends which it is unrealistic to expect the vendor to verify.The compromise which is frequently reached is for the vendor to agree to warrant certain factual matters covered in the report such as historic financial information.

Market due diligence If the purchaser is not already familiar with the market in which the vendor is operating, it may undertake some market due diligence either in-house or by commissioning external consultants. Commercial due diligence of this nature is not only concerned with the future of and underlying trends in the market in which the company operates but will also assess the company’s position within its market and how competitive influences are likely to impact on its future performance.

Customer due diligence Depending on the nature of the business, a purchaser may wish to speak to the target company’s major customers to assess their level of satisfaction with the company and the prospects for their continued patronage. Clearly there are considerable commercial sensitivities involved in customer due diligence as if the deal does not proceed after the customer interviews have taken place it may impact adversely on the company’s ongoing customer relationships.There are a number of ways to overcome this problem. One is to persuade the purchaser to conduct an anonymous customer survey whereby market researchers are engaged to elicit the opinions of customers on both the company and its competitors under the guise of a general market review. If this is not acceptable or appropriate, the vendor should at the very least insist that: i)

customer interviews are left until the very end of the due diligence process;

ii)

all questions to be asked of customers are first approved by the vendor;

iii) the vendor effects introductions to customers; and iv) the purchaser gives an assurance that subject to the satisfactory outcome of the customer visits, the deal will proceed on the basis of the terms agreed.

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Management due diligence Financial buyers will generally wish to carry out due diligence on the senior management team as well as meeting them on an individual and collective basis. The due diligence generally involves taking up personal references from former employees and business associates and checking for any previous bankruptcies or criminal records.

Legal due diligence Legal due diligence focuses on key contracts and other legal documentation of the company.The company’s exposure to litigation or other contingent liabilities and ownership of assets including its properties and intellectual property rights will also be reviewed.

Warranties Many vendors get extremely agitated about the prospect of having to give warranties on the business to the purchaser. In reality, the number of occasions when a claim is made by a purchaser against a vendor for breach of warranty is comparatively small.Again, if the vendor has been honest and forthright in his dealings with the purchaser he will generally have little to worry about. Having said that, the extent of warranty cover sought by a purchaser is a consideration in reviewing competing bids as there will inevitably be some matters covered by the warranties which are outside the vendor’s knowledge or control. The primary role of the vendor’s lawyers in the transaction will be to limit the extent of the vendor’s exposure to warranty claims by negotiating appropriate limitations and exclusions. If the vendor wishes to buy peace of mind, warranty insurance is available. If a vendor puts warranty insurance in place, the liability for claims for a breach of warranty will be assumed by the insurers. Although warranty insurance is relatively cheap, it does have certain disadvantages.There are certain gaps in the coverage provided by warranty insurance,with fraud and liability for environmental matters both being excluded. Putting warranty insurance in place will also add another layer of complexity to the transaction and can delay completion .

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Conclusion KEY RULES

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Chapter 13: Conclusion

Key rules Each business is unique,and each vendor has his own unique characteristics and objectives,but certain key rules nearly always apply in achieving a successful sale: •

determine the objectives of the sale exercise and ensure that they are agreed and understood by all of the company’s shareholders;

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identify the appropriate route to meet the vendor’s objectives;

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start preparing for a sale exercise well in advance;

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always run the business on the assumption that no sale will eventuate – the assumption may prove to be correct;

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set realistic targets, both for timing and price, and regularly review the position;

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never underestimate the detrimental effect that a sales process can have on staff morale, energy or contribution.A decision to undertake a sale exercise should never be made lightly;

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walk away from the deal if the objectives are not being met.

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Bibliography Institute of Chartered Accountants Good Practice Guideline – Selling a Business – Howard Leigh, Director, Cavendish Corporate Finance.

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