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This is the fifth and final post in a series on a buying a business, telling the story of our recent acquisition of a small transport company. Through this blog series we want to show what it’s really like to buy a small business, including the risks, problems and practical details, including financials. If you’re looking at businesses for sale with the intention of buying your first one, we hope this series will be very helpful. You can go back to the first post in this series here.
The New Year had arrived, I had visited Arnold’s container client (the only client relationship we were effectively going to acquire, since Arnold had dropped the curtainsider work as suggested), and it had all checked out. The payment terms of the industry were annoyingly opaque, but everything else had satisfied the criteria I was looking to meet. The sale of the business was not a concern to them: they were happy to carry on with our company as they had with Arnold’s and they were keen to expand and give us more work.
The final step was due diligence of the company’s accounts and bookkeeping. Given that it was a young company (less than one year old), it had not yet filed accounts with Companies House, so we had only figures provided by the company’s accountant to go on. This is inherently risky of course. The numbers provided could simply have been invented. But matching them against bank statements, and against invoices, and matching these with information I received from the container client when I went to meet with them, gave us some confidence that we were not being misled (or at least that it would have required a highly elaborate fraud if we were being misled).
Besides looking for fraud, the most important reason for checking the books was to ascertain profitability. The company had a cash flow problem – this was Arnold’s reason for selling – but we were not interested in taking on a business with a profitability problem. We were not looking for a “turnaround”. The figures, such as they were, did in fact show that the business was profitable, although its cash position was getting progressively worse as it grew. Profitability fluctuated, but we reasoned that it could conservatively generate at least £1,500 net profit per month, without factoring in the lower cost structure that we would benefit from after the acquisition. We knew that Nomad’s positive cash position would be able to fund the cash flow requirements of this business, and the net earnings of (at least) £1,500 per month would be worth acquiring.
More to the point, the acquisition would give our existing business (which was in a small niche of the transport industry) a foothold into a much larger market, with the potential to grow quickly and become much more profitable. Arnold was keen to stay on and help us with this goal. Being relieved of his debts would be a huge weight off his shoulders, and (besides the contractual requirements we could tie him into) he genuinely wanted to stay and help us grow. Working as a self-employed driver within our business gave him the best of both worlds: no debt, and the ability to continue to grow the business he had started and make a success of it.
Now that we were satisfied that the industry was worth entering (and we had already entered it with our own truck with the new client by this point), and that the work we would be acquiring from Arnold with his existing container client would continue after the acquisition, we were ready to proceed with the acquisition. Arnold had increased his work from one truck to two trucks with the container client since the start of the New Year, so we would continue this, in addition to the truck we were already running with the client we had found ourselves.
To limit our risk we would only be purchasing the “business and assets” of Arnold’s company, rather than the company itself. The tangible assets consisted primarily of one truck (he had hired the other trucks and trailers), plus some dash cams and a few tools, valued altogether at £12-13,000. The question was how much extra to pay for goodwill.
Arnold had earlier said that he wanted to pay off a business loan of £20,000 and a loan to his friend of £13,000 (£33,000 total), and he would be happy. But our analysis of his accounts showed a high trade debtors figure that he hadn’t considered. After adjusting for accounts payable and accounts receivable we reasoned that he could pay off his debts with £24,000. Arnold’s accountant agreed with the analysis and Arnold was OK with this conclusion, so the price was agreed.
At £24,000 + VAT we would be paying £11-12,000 for goodwill. Based on the profitability of the existing business we would pay this back in 8 months, and we would pay back the cost of the truck in a further 8 months. The business would add £350-400k revenue to Nomad and £18k profit (before cost synergies and growth). All of this seemed reasonable, so we were happy to proceed with a purchase price of £24,000 + VAT.
Now we just needed to tie up the remaining details and we could sign the deal...
Last Minute Scramble
It always seems to be a sprint to the finish line when you’re signing a deal like this. Partly it’s because the “last few remaining details” actually end up being quite a long list of time-consuming investigations. Things that are almost certainly going to be OK, but still need to be checked: identifications, proof of address, IDs for all of the drivers, vehicle HPI checks, bank loan statements, share ownership statements. Phone calls to suppliers (meetings in some cases) to check that they would carry on supplying the acquiring company at the same rates as the acquired company. Discussions with our own suppliers (insurers especially) regarding the changes that would be required immediately post-acquisition.
And then the things you forgot to ask for at first but you still really need (“Do you mind handing over your email address after the sale?”). Some of the accounting checks mentioned above were still going on during these last few days too, resulting in dozens of emails back and forth between Arnold’s accountant and I.
Then sudden doubts (these always happen, every time). “Wait, are we crazy? We’re only buying one client, and that client does not tell us how much we will earn until after we’ve done the work?” “Do we have the time for this?” “Everyone says there is no money in haulage – what are we missing?”
The doubts never completely leave. It’s more a question of what things would look like in the worst case scenario, if our assumptions were incorrect, and our fears came true, vs the potential upside. The total unsecured risk was only £12,000 + VAT. We would have to devote some cash to funding the cash flow of the business, but the potential upside was huge. It was worth it.
So we eventually checked off all of these last details, signed the papers and I made the bank transfer while sitting in Arnold’s accountant’s office. The deal was done. Relief. Then urgency again, to get on with the next most important things, that had been delayed until now.
Three Months Later
It was completely smooth sailing after the acquisition – everything went perfectly according to plan…
Just kidding. That never happens.
Haulage is hard work. Our team at Nomad were up to the task, as I knew they would be, but it required a lot of reorganisation of the team’s workload and priorities to handle this new division. For one thing, we hadn’t considered the fact that running trucks on double-shift means that things can go wrong at any time of the day or night – this required a new 24h “on call” capability that we had never needed to offer before. Planning and coordinating the truck movements is not without effort either, so a number of hours each day is spent by our team on this work. Maintaining health & safety standards, ensuring compliance with drivers’ hours regulations, and dealing with suppliers (especially driver agencies) also takes a lot of time. Thankfully the Nomad team are very capable, highly adaptable and ceaselessly energetic – if they weren’t, the acquisition would have very quickly failed, regardless of any financial factors.
Arnold was true to his word and has been a great asset too. He has been a great source of guidance and experience in this new field, as well as an intermediary between us and the drivers he brought on board. He really likes working with our Nomad team, probably because he shares their positivity and enthusiasm. Apparently this is not common in haulage (people in transport offices tend to be gruff and blunt), so drivers get on well with our crew.
Financially the project has been more successful than expected… but for completely unexpected reasons. In the first three months of operations the haulage division has generated just over £12k net profit for the company, which is almost three times as fast as expected, paying for the unsecured portion of the purchase price already.
However, none of this was strictly due to the acquisition itself – the profit came entirely from the other contract that we negotiated “on the side” as I was doing my due diligence at the start of January. It turned out that the reason this client was able to guarantee us a fixed rate per shift and fixed number of miles (which the other container client could not) was because the work they wanted us to do wasn’t container work – it was refrigerated transport for one of their clients, with whom they had negotiated a better rate than the typical container rate. In the first three months of the year we had made just over £15k profit on this job, compared to just over £3k loss on the container work we were doing for Arnold’s client.
The key risk we saw with container transport from the start was the fact that the haulier is not told the rate until after the work is completed. We should have added to this the related risk that the client is free to change the rate at any time. Our profitability estimates had been based on the assumption that revenue per shift and per vehicle would continue to be approximately static going forward – we did not have a fixed “rate card” but we assumed that on average the rates would be the same. In reality, the client reduced the rate it was paying, on average, over the following few months and we were powerless to do anything about it.
Comparing this client to others in the container haulage industry, their new rates were not unfair – they had simply come down to a level within the same region as the others across the industry, whereas previously they had been paying Arnold slightly more. Small hauliers find it very difficult to be profitable at the industry standard rates of £1.40 per mile and below, and we too found it difficult when this client paid us at this level instead of the higher rate they had been paying Arnold in the few months leading up to Christmas.
Arnold himself was very disappointed with this, and has been very active in helping the company to find alternative sources of work. This was the only client of the business we acquired, and it turned out to be loss-making after the acquisition.
So was the acquisition a success? I would still say definitely yes.
We are now seven months in and the haulage division is still profitable, with a new client in addition to the original profitable one. Everything is still constantly changing, but our team are getting better and better at managing all of the new and different kinds of risks and opportunities that arise (for example: diesel theft is a new issue they’ve had to find ways to combat). Most of the profit still comes from the first client, but without the losses of the container work from the acquired client.
We would never have found, or even looked for, our most profitable client if we hadn’t been investigating this industry as part of the due diligence around this acquisition. Overall it’s been a lot of work but we’ve learned a huge amount. Some of what we’ve learned will make the Nomad team better at managing and growing the haulage business going forward. The experience has allowed us to better appreciate Nomad’s existing overseas removals business and the profitable niche it is in. It has given Nomad some more scale and increased its turnover and profitability. And finally, the experience has allowed us to identify a new opportunity in a related industry which will are also intending to pursue as a stand-alone business in the coming months.
This is the nature of acquisitions – especially at the small end of the market. Businesses of this size are so exposed to change that very often the acquired company can become quite different after the acquisition than it was before. But along with risk, acquisitions also expose you to opportunity. As long as the down side is managed, the upside often has the potential to more than compensate for it.
This is an interlude from our series on one of our own recent acquisitions, to consider instead the amazing 13-month story of Anand Sanwal, who found himself suddenly taking over a business in India in an industry he knew very little about, running the company and successfully selling it.
This fascinating story is told in full on the CB Insights blog. Sanwal is the CEO of CB Insights, a New York based tech industry analysis firm - an extremely busy job in its own right. After the sudden death of his father he finds himself agreeing to take over the management of the business his father had built over 30 years... in rural India.
His experience in running both companies at the same time provides a number of useful lessons in prioritisation, crisis management, delegation and business strategy. The story details his M&A strategy and how he proceeded to sell the company to the right buyer (without using brokers). It's a wonderful story, with important lessons from an M&A perspective, and larger doses of respect and humility than are normally found on business blogs.
"What the F is the plan?
So I needed a plan.
Not on day 1, but pretty quickly.
Not because anyone was asking for one, but for myself. For Atlas.
How does one develop a plan when you don’t understand the business, the science, the industry, the country, and sometimes even the language?...
In my view, there were 4 options for the business."
We urge you to read the story here.
This is the fourth post in a series on a buying a business, telling the story of our recent acquisition of a small transport company. We did this acquisition in less than a month, over the Christmas and New Year break when our advisors were on holidays, so this post looks at how we did our due diligence without them. If you’re looking at businesses for sale with the intention of buying your first one, we hope this series will be very helpful. You can go back to the first post in this series here.
5,000km a week! That’s what struck us first.
The seller had sent an email with the details he had promised at our meeting earlier in the day. He’d broken down the work into two “jobs” – shipping container transport using the single truck owned by the company with two hired trailers, and curtainsider transport (palletised distribution) using the two hired trucks. This email contained the details of the “container job” for the previous week.
“Hi, here is a confirmation rates for one lorry which works with containers. We used 1414 litres of diesel this week and we made 5150km. Wages for both driver £1400, diesel £1414, parking £75, insurance £125, loan £103, transport manager £88, trailers rent £130 per week.”
Attached to the email was the “rate confirmation” for that week – the statement produced by the client confirming all of the work done during the week and the amount they were paying for it. At the bottom of the document was the total: £4840 + VAT for the week.
Arnold had forgotten some of the costs: there was no allowance in his calculations for maintenance / repairs for the truck, nothing for depreciation, nor for administration (the time involved in actually managing the business), nothing for office expenses and no contribution to annual expenses like licensing. But the rough numbers were enough for a back of the envelope calculation of profitability.
After some adjustments our quick calculations suggested a profit in the region of £900 for the one truck on this “job”, in what was a very busy week. This is a high net margin for haulage. Almost too high.
Arnold’s second email spelled out the “curtainsider job” in similar fashion:
“Hello, as you know already we work with Belgium. Two lorries made 6000km per week. And we used 1600 litres of diesel = £1600, parking £150, insurance £250, manager £170. It wasn’t the best week because we had some issues. If you have any questions please do not hesitate to contact me.”
By “we work with Belgium”, he was referring to the fact that his client was a Belgian company who shipped its own trailers to the UK ports ready for collection. Arnold’s trucks would come down to the ports and collect the trailers, complete the deliveries and return the trailers to the port, switching them with the next trailers to arrive.
Attached to this email was the subcontractor confirmation from this client, confirming the work and the total amount he would be paid: £4845 + VAT for the two trucks on this job for the week. This was marginally profitable based on Arnold’s figures, after similar adjustments were made to the above.
Arnold’s emails had done the job he intended – they were certainly enough to make us want to find out more. Based on our back-of-the-envelope calculations, there was enough profit potential relative to the size of the investment to make this a possible acquisition.
There was enough profit potential relative to the size of the investment to make this a possible acquisition
Without advisors on hand, we had to do our due diligence alone. We knew we could protect ourselves from downside through the structure of the deal, but there was still a lot of risk, and we had to determine the size of the potential upside.
The seller’s two emails had given us some basic data to work with, but had raised more questions than answers. Our queries at this point fitted into 3 groups:
- Were his claims true?
- This is only one week of work – is it representative of what we can typically expect? And if not, will a typical week be profitable? How profitable? What factors determine this, and to what degree will they be in our control?
- Is this an industry in which we want to operate? Can we expect to be able to grow this business?
Testing the accuracy of Arnold’s claims regarding the week of figures he had provided was relatively straightforward. The subcontractor confirmations themselves contained the individual journeys completed by each truck – by simply calculating the mileages of these journeys we were able to confirm that his mileage calculations were reasonably accurate, and that fuel consumption looked reasonable also. The final piece – checking the actual invoices (for fuel etc), and bank statements to check his expenditure and income matched what he was saying, would have to wait until slightly later down the track. We would eventually request these from his accountant, but for the time being we operated on the basis that these would match, and would confirm this later.
At this point it’s worth considering the risk of actual fraud of course. The subcontractor confirmations could have been fraudulently created. Even bank statements can be faked. Depending on the size of the fraud, accountants (or actors pretending to be accountants) can be recruited into the scam. How far to go in testing such hypotheses is a judgement call of course. For a £ multi-million transaction much more scrutiny is required. Even for transactions at this level, vigilance is important. But if you operate on the basis that every single piece of data is an invention until irrefutably proven otherwise, you will quickly run out of time and money in testing these hypotheses, verifying that each bank statement (for example) is indeed an original and not an elaborate counterfeit.
Now that we were operating on the basis that the seller was telling the truth, the next questions revolved around figuring out if he was being overly optimistic in his descriptions. Primarily this relied on asking for more data to see if the numbers for the week he had provided were to be expected in a typical week going forward.
Focusing on the container job, we developed our own understanding of the level of revenue per week and per shift that would be required in order to make a profit. While none of the weeks had revenue quite as high as the first week he had sent us, there were several with revenues above £4,000. Some weeks though – especially in the earlier months of operation – had much lower revenues, closer to £3,000 and even below – and our calculations showed these weeks to be unprofitable, sometimes massively so.
Naturally it was in the seller’s interest to claim that the earlier months were the exception, and the later months were the new rule, but we could not take this at face value. Sensing this, he offered to take me to meet the client in person, to ask them anything I needed to know. This was appreciated (it took trust that I wouldn’t just sign up with his client without buying his business), but in reality it was the only way we could learn enough about the work to have confidence in it.
It was already becoming clear that this client was the only client we were interested in keeping, if we proceeded with the acquisition. The container job paid on 14 day terms instead of 45 days for the curtainsider job, and was generating more profit, both on a per-truck basis and in total. I had recommended to Arnold that he drop the curtainsider work and focus on container work regardless of whether or not he sold his business. So in that context it was even more critical that I meet with the container client. It was now the week between Christmas and New Year (Arnold and I had met at Nomad’s offices), and just about everyone was closed or only operating with a skeleton staff. So we agreed that the next step would be to meet with the container client in the New Year.
Containing Our RISK
In the meantime I started investigating the business of container transport itself, since it was relatively new to us. One huge problem seemed to be the way Arnold was being paid – his company would do the work, then one week later he would be told how much he was going to be paid for that work, and finally he would be paid later still (14 days after the work was completed for containers, 45 days after the work was completed for the curtainsider job). The biggest risk in this seemed to be the fact that hauliers are expected to work first, and find out how much they would be paid later.
The biggest risk in this seemed to be the fact that hauliers are expected to work first, and find out how much they would be paid later
Initial research showed that the industry was indeed massive, and the work was relatively easy to get. Most of the large container haulage companies were actively advertising for “subcontractors”. Truck driver forums were full of information about what the work was like, how much to expect to be paid, and insights into some of the companies operating in the field. As part of this research I approached one of these companies and enquired about working as a subcontractor – which was effectively what Arnold was doing with his company – to find out how easy it would be to get more work in this industry, as well as some insight into how it paid.
The response was encouraging. I sent one very simple email to one container haulage company, and they immediately replied with a subcontractor information pack, asking where we would like to be based from. I replied with our location and that we wanted to run the trucks on double-shift (to test my hypothesis that running trucks day and night, as Arnold was doing, was a normal thing to do and that this kind of work was readily available). They responded that they only had day work available… but only 2 working days later they came back to me with this:
Regarding your request for Day/Night work.
We are now in a position to offer the requested work from our (location removed) depot.
Please confirm if this suits your requirements.
At this point I had only sent that one initial email, plus a reply to their question regarding our location and mentioning that we wanted double-shift. Now they were offering us the work! No questions asked. All we had to do was confirm our licensing and insurance levels and we were good to go. It was completely unexpected.
I had to decide what to do – we weren’t yet prepared for this. We hadn’t even bought the company yet. I was just testing the water. We had the ability to do the work, sure. Inspired by Arnold’s business, I knew we could hire the trucks we needed and agencies could provide the drivers. But were we really going to get into the haulage business ourselves, apart from the acquisition?
Were we really going to get into the haulage business ourselves, apart from the acquisition?
I replied to the email, clarifying what was being offered, and the client confirmed that they were able to start 2 of our trucks immediately on double-shift. Rates on container work were opaque – rather than being on a published “per mile” basis, the client would assign each delivery a “rate” after it was complete, and reserved the right to adjust this rate to “maintain profitability”. I was already uncomfortable with the way Arnold’s container client appeared to be doing this, and from this new client’s initial emails it appeared this was the norm. But his follow-up email contained something surprising: the work he was offering us was on a fixed rate per shift with a maximum number of miles. It was one more risk eliminated.
Based on our calculations for double-shift, this was the equivalent of £400,000 per year of work, and it had come from one enquiry email. Compare this to the kind of transport work our main company was used to (international removals): to win one small job of a few thousand pounds, you have to advertise to tens of thousands of people, attract hundreds of website visitors, manage dozens of enquiries, and provide detailed estimates, quotations and logistical planning. This is for each job, in an industry where most customers only move once every 10 years. On the other hand, I had sent one quick email and been offered £400,000 of continuous work.
This was the equivalent of £400,000 per year of work, and it had come from one enquiry email
The gross margins in haulage were far lower than those in international removals. But the industry was so much bigger. The work was there for the taking. We had some initial data showing that we could do this profitably. Due diligence was only partially complete, and just about everyone (including my accountant and advisors) was still on their Christmas holiday. But the opportunity was too good to pass up, so I agreed. We would start one truck with this new client, on double-shift, from the following Monday 8th January. We were in the haulage business.
More importantly as far as the acquisition was concerned, this experience provided good evidence that the industry, if not the business itself, was worth pursuing. We now saw the target company as a way in to this industry, with trucks and drivers ready to go, and an experienced seller willing to help us learn the ropes. Instead of only considering the profitability of this particular business, we were interested in the potential to use it as a starting point to grow a much bigger business because initial signs about the industry were so positive.
We now had good evidence that the industry, if not the acquisition target itself, was worth pursuing
A benefit of investigating potential acquisitions, besides the opportunity offered by the acquisition itself, is the opportunity to learn. You can’t do this cynically, deliberately looking to steal business practices or trade secrets. But you often get to see things in an entirely new way, through someone else’s eyes, and it can reveal new opportunities and give you insights into your own business. When I me with Arnold it wasn’t my intention to learn about container haulage so that I could do it on my own. But if I hadn’t met with him, and conducted the due diligence about his industry, I would never have found this opportunity.
The story is far from complete – we’d started working in haulage but the actual haulage acquisition we were investigating was still far from a done deal.
The next post will discuss the final pieces of due diligence, timing issues and negotiations, as well as revealing how the new haulage work turned out (it wasn’t what we expected).
This is the third post in a series on a buying a business, telling the story of our recent acquisition of a small transport company. Through this blog series we want to show what it’s really like to buy a small business, including the risks, problems and practical details, including financials. If you’re looking at businesses for sale with the intention of buying your first one, we hope this series will be very helpful. You can go back to the first post in this series here.
Driving the short distance from our warehouse to the meeting point (the seller’s “yard” – his Operating Centre), my colleague Danny and I weren’t expecting much. When I explained to Danny, the General Manager at Nomad, how I had found this business and the very basic details I had so far, he wasn’t optimistic. Neither was I: most acquisition opportunities turn out to have some fatal flaw that kills the deal before we get very far, and this one came with less background than most.
The yard itself was no more than a section of gravel marked out in invisible lines to fit 3 truck & trailer parking spaces, in the corner of a large, empty lot. This is not uncommon in transport – if he had had even a portacabin office I would have been surprised. It was in a disused part of Peterborough, an industrial zone, close to the prison. But the yard wasn’t what we were interested in.
After a quick introduction we were straight down to business. Although it was midday, it was cold in mid-December and the wind ripping through the open yard did not encourage smalltalk. What is he selling? What assets does the business own? What liabilities? Why is he selling? How would we work the company into our existing business? Nomad is in transport, but it is in international removals – a different field entirely to this business. How much administrative burden is there in this kind of haulage? Who does this currently?
The seller, Arnold, was pretty open and direct. He explained his cash flow problem in more detail. He was running two trucks on “distribution” work (collecting curtainsider trailers and delivering pallets at multiple drops, organised by the client) with a client that paid on 45 day terms. His third and final truck was taking containers from the ports (mostly Felixstowe) and delivering them in the East of England, on 14 day terms. He had taken out a business loan and spent most of it on a truck – the company’s main asset, without borrowing sufficient working capital to keep the business running while waiting for payment from his clients. As a result he had had to borrow £13,000 from his friend, who was one of the drivers in the business. He wasn’t paying interest on this loan, but he intended it to be a very short-term arrangement and as it stood, he wasn’t able to pay it back quickly. Each time he expanded to try and get ahead, the delayed payment terms would take up even more working capital. He could utilise invoice factoring to get the money in more quickly, but this comes at a cost and reduces margins, especially for a new business with an inevitably low credit score. On top of that, the distribution work took a lot of planning and communication with the drivers. Arnold was doing this in addition to driving a few shifts himself every week, and it was wearing him down.
We took the details of the truck to work out its value later – our best estimate was £12-13,000 market value (he had paid £16,000 for less than a year before, but he had bought it from the main dealer, overpaying and accelerating the depreciation). The company owned some tools and 3 dash cameras, but not much else. In terms of debts he had the business loan of £20,000 and the £13,000 he owed to his friend. He was looking for someone to take over the business for a price that would simply allow him to pay off his debts. He wanted to continue working, but just as a driver, although he was open to the notion of continuing with administrative and organisational duties too. Mostly he wanted to be debt-free and rid of the financial hassles.
I knew he would have accounts receivable that would reduce the overall debt position of the company and therefore the price of the business. A back-of-the envelope calculation suggested this would be around a £10,000 to £15,000 unsecured risk (the buyer would eventually agree a price in the region of £22 to £28,000 for a business with tangible assets worth £12-13,000).
He gave us the headline turnover figures and promised to email more detail later that day. This part of the discussion revealed the first interesting aspect of this business – he was running each of the trucks on “double shift”. This was new to us but it intuitively made instant sense – general haulage work like this is such low-margin work that it makes perfect sense to maximise the time each truck is working, while keeping fixed costs the same. It would be like a shop owner deciding (and being allowed) to open 24 hours a day instead of just regular shopping hours, since he knows his rent, insurance etc are already covered. When he suggested earnings figures that were significantly more than we had thought possible (£4,000+ revenue per truck, per week), it made much more sense when he explained that each truck was on double shift. He was effectively doing the work of six trucks with his three.
Speaking of trucks, if he only owned one, what of the other two? Were they on long-term leases? This is common in transport – long-term leases of up to 5 years can be used instead of buying vehicles outright. No: he was hiring them. Short-term rentals. I had never thought it would be possible to make a profit on this basis, but he demonstrated (in quick, verbal terms at least – proof was needed of course), that it was possible. He didn’t have long-term contracts with his clients, but since his vehicles were all hired, he minimised his risk while still making a profit. He was also hiring two skeletal trailers (the kind used for transporting shipping containers) on a similar basis.
We explained a little more about our background and how we felt we might be able to help, as well as our concerns about the administrative burden involved in learning this new kind of business, and operating it on a day-to-day basis. Arnold couldn’t quite understand what we were afraid of in terms of administrative work, since we already had offices and staff – luxuries he had managed without. But underestimating costs like this can be very problematic. Someone has to do this work. We did not want to risk taking on an unprofitable business that seemed profitable simply because the administrative costs were not considered. We made some progress in this in the first meeting, but we knew we would have to come back to it.
For his part, Arnold was more keen to focus on highlighting the costs of his operation that we would not have to pay, or would be reduced. He was right that some costs would be eliminated altogether (his external transport manager, for example, since our business had one already), and other costs like parking and insurance would be reduced if we took over. These are advantages with any strategic acquisition, and one of the main drivers for Nomad to be looking for acquisitions in the first place.
The cold weather motivated all of us to agree to wind things up and discuss everything further by email. But already Danny and I could see that there was a lot more promise in this business than we had anticipated before the meeting. If the rough figures were to be believed the turnover from these three trucks would be £400 to 600,000 per annum, and Nomad would be acquiring it for between £10-15k of unsecured funds.
The business was high risk – it had only been operating for seven months, and had not filed any accounts. All of its eggs were in only two baskets. But it was intriguing. The seller seemed to have a genuine reason for selling, and it was due to a problem that we could potentially solve. Nomad, as an international removal company, receives almost all payment in advance – the perfect counterpart to a business with a cash flow problem.
For buyers of businesses at this level (sub £50k in this case) this is the reality of what you are going to find: even the best business opportunities will not be without risk.
If you exclude new franchises (where the offering is not so much buying a business as buying the right to start a business), all businesses at this level have something wrong with them. Most of them are tiny, or highly unpredictable; some are outright scams where the seller is trying to mislead the buyer into paying for something that isn’t real; and most at this level are simply unprofitable, where the seller is doing all of the work and not paying himself a sufficient salary. The figures can be manipulated to show a profit, but on due diligence it is revealed that the work done by the owner (and often his family) is not being paid at market rate in many of these cases, and effectively the profits are just in lieu of wages – in other words it is a job, not a business.
The best opportunities at the sub-£50k (even sub-£250k) level don’t fit into any of these categories. They are rare, but they exist. Businesses that are reasonably stable and profitable, large enough to be predictable, and have the potential to grow much further. But they always involve some degree of risk. With this business, at this stage, it looked like the risk could potentially be well worth it.
The meeting itself had gone well too. Arnold was honest and straightforward and his story added up. First meetings don’t always go this well – the most frequent outcome is that the meeting is disappointing and the business is ruled out at this stage. Often this is because the details of the business, when finally provided at the meeting, do not match what was promised. Reported profit figures do not match the filed accounts, for example, and the owner’s explanation is unsatisfactory (“It says only £20k profit but that’s because I spent £30k on renovating my house and put it through as a business expense”…). Or assets are entirely different to what is described. Or any number of others – the seller has tried to overstate the opportunity offered by the business, and in doing so has destroyed his credibility and made it impossible to trust him. The meeting with Arnold presented none of those issues, and we were able to start forming a basic foundation of trust.
This is as much as we could have hoped for at this stage – an indication that the business might be worth buying, and that the price range would be feasible relative to the risk and potential return. It was a good start, but now we needed more details, and to commence due diligence. We will get into this in the next post.
“Operating Transport Company For Sale”
It wasn’t the title I would have given to the ad, but it was enough to make me look at it. More to the point, the price (<£50k: very unusual for a haulage company) warranted further investigation.
Let’s back up a bit. I don’t always even read the “email alerts” that come through from the various business for sale listing sites. I’ve set my preferences to be sent businesses in the transport and healthcare fields, so these emails inevitably contain long lists of domiciliary care franchises for sale, care homes, and MOT testing centres, none of which are of specific interest to me. But I do try to make an effort to scan through these emails, because sometimes they contain gems – unexpected opportunities that make all of the previous searching worthwhile. This was one of those times.
So here I was scanning through one of these emails (my colleagues and I would generally fit into “Circle C” in the Venn diagram on the types of business buyer – we are actively searching, but not always via the business for sale sites – however we do receive these emails). The usual examples of tangentially-related businesses were listed: a care home, a non-surgical cosmetic medicine business, another care home, a taxi company… then this one. “Operating Transport Company For Sale”. Although it was vague I couldn’t rule it out like the others. It was located in the same town as our existing transport company, Nomad International, which would make integration far easier if ever things progressed to that point. And the price bracket was interesting, so it was worth following the link to the website to find out more.
Unfortunately the ad itself, on the www.businessesforsale.com website, was as brief as the “teaser” description in the email alert. The only details were the three criteria at the top of each listing (asking price, turnover and net profit), and only one of these was disclosed: the asking price of “<£50k” as in the ad. But the effort required to find out more about a business is very low – just a couple of clicks will send a pre-written request for more information to the seller of the business – so that’s what I did. At least there was no broker, so the request would go straight to the seller with no middle man, and no delay.
Quite often when you send these requests for further information, you never hear anything back. While this is surprising, it is partly explained by the nature of the “free trial” for sellers on these sites, which enable them to gauge the interest of buyers but not receive their contact details. Those sellers who choose not to proceed with the fee for advertising never end up receiving your contact details and can’t reply to you. It seems unlikely but it happens more often than you’d think.
After a few days of nothing, I assumed this was one of those ads. Maybe my enquiry was the only one, and the seller didn’t want to pay for the advertising in order to be able to contact me. Maybe he had just changed his mind about selling.
Then I received an email (this is the entire email):
I created the company, the company is fully working. there are drivers, companies with whom I work, as well as parking, transport manager, accountant. International cargo license with three trucks and three trailers, an opportunity to increase. cards for fuel. everything you need for further work .we have a job, we just have no investment for further work, so we sell it.”
OK so the business was real after all. And more importantly, it was a haulage company like I thought – not a courier or a taxi service. From the brief details, until now, it had been impossible to tell for certain. A haulage company with 3 trucks and trailers would be turning over somewhere in the region of £300k to £600k, and may have assets too. Profit is a different story of course, but I had enough to know that it was worth investigating further. The asking price showed that the owner had reasonable price expectations – possibly very reasonable, depending on the profitability and balance sheet – and at this price it was perfectly within the range that could easily be covered by our transport company without requiring finance.
The seller hadn’t sent me an NDA to sign, so I was glad to skip this typical (but onerous) part of the process. As the seller it is always best to do this, but as the buyer it is a minor relief not to have to deal with this part of the process. When sellers engage business brokers they always send NDAs as a first step (as they should), but it can often take several days after you send back the NDA before they actually send you the details of the company. No worries about that here, so I eagerly sent back my reply email asking for more information, and explaining who I was, with my contact details.
Then nothing. Again.
At least his email address revealed the company name so I could start some basic research. The company had been trading for less than one year, and had not filed any accounts – a significant concern. Businesses with only a few years’ trading history are less predictable than more established businesses, but those without even a single year of operation are even worse. And with no officially filed accounts, it would be more difficult to assess the legitimacy of any management accounts the owner would provide. He could produce accounts to show literally anything, and there would be no filed records to compare them against. But there was still hope – although it now seemed less likely that this business would be worth buying, there was still a chance that it might present a good opportunity. But if the discussions were to proceed to an actual acquisition, I already knew enough from this to know that I would have to seriously limit my risk exposure.
After a further 6 days, the seller finally replied, apologising for the delay.
Apologise for delays, but now very busy time. I will try to answer the questions, but the best would be to meet if still you are interested my company.
As I said it was not enough investment. Starting a business, I didn't think that it takes so much money. I always thought that the billing will be on a weekly basis, but large company’s payment monthly, and if you want to receive money beforehand, they pay you less than they earn, and since we are a new company, it's not enough money for us. I really see that it's possible to grow further, just have to money.
If you have any questions don't hesitate to contact me.
(The seller’s full name and phone number)”
This made sense. Although he was answering a question I hadn’t asked (“Why are you selling the business?”), it was fair enough to assume that I was interested in this, and his answer was reasonable. Most of the transportation industry operates on credit – companies pay each other in arrears, with payment terms ranging from 7 to 90 days, often around 30 to 45 days. The seller was describing a cash flow crisis which is common in this industry, particularly amongst newer and faster growing companies. My existing company, Nomad, is in a rare niche within this industry (international removals), where all payments are in advance and cash flow is not an issue. So at face value at least, the problem he was facing appeared to be one that we could solve.
It was now mid-December and the Christmas break was fast approaching. I suspected from his hesitancy (the delay in replying to my emails) that he might be having second thoughts about selling, and if he could find an alternative solution to his cash flow problem he would pursue that instead. There was also the risk that the cash flow squeeze was urgent enough to stop him from trading altogether, or at least cause him to take steps that would damage the business going forward. While this pressure was obviously more on his shoulders than mine, I could foresee that it was important not to delay things.
I offered to meet the following week, and asked a couple of questions in the meantime:
“Hi (seller’s name),
Thanks for your email. I agree it is one of the problems with the haulage industry that payment is so delayed.
I am away for a couple of days from tomorrow but we could speak next week?
In the meantime please just give me an idea of what you are selling. You said you have 3 trucks and 3 trailers - please let me know the details. You also said you have some contracts, please let me know what kind of work it is, etc.
I wanted to get an initial idea of his company’s assets (although not its net assets), as well as a guide to the stability of the business, by way of finding out if he had firm contracts for his work. He replied that he owned one of the trucks and was renting the others. He didn’t specify if the trailers were owned or not, or his debt position, but already the basic balance sheet was starting to look less risky. A truck of this kind (a tractor unit, also called a prime mover) would be worth at least £10k if it was of a reasonable standard and up to 5 years old, up to £70k if it was nearly new. The seller didn’t describe the work he was doing in much detail, other than to say that one of the trucks was doing container haulage and the other two were doing “curtainsider” work. I only knew the basics of this kind of work at this point, so the rest would have to be uncovered in our meeting. But at least this was a start.
By this stage I would be able to rule out most companies, for one reason or another. Often they would be in a sector that didn’t share enough synergies with our current business. On other occasions they would be extremely asset-heavy and require an investment that was greater than the return would warrant. Many owners would have unrealistic price expectations relative to the size, stability and profitability of their businesses, and could be ruled out even without viewing them. Others would be worth investigating further, but in the initial emails / phone discussions before the first in-person meeting, a fatal flaw like these would be found and that would be the end of the process. But this business had passed all of the initial filters.
There were still huge areas where I needed more information, like profitability and the net asset position of the company. Typically I would have been able to gather this information already, from a combination of the filed accounts and the management accounts provided by the seller or the broker, but in this case the seller wasn’t prepared with any such information. His decision to sell had clearly been arrived at quite quickly, so I didn’t hold this against him. I could tell that he wanted to meet in person, both because it was easier for him to communicate that way, and so that he could assess me in much the same way as I wanted to assess him. So I decided not to press further for details of his company’s financial performance via email, and instead just proceed with the meeting as the next step.
We bought a business today (well technically, one of our companies did – Nomad International acquired the assets of a small haulage company based in Peterborough, Cambridegshire).
Our next few blog posts will tell the story of this acquisition, showing you inside the process of buying a business – where to find it, how much to pay, how to structure the deal, and how it feels to risk your own money on a high risk investment like a small business.
The deal was closed within one month of first viewing the business, a record-breaking result for us when you consider that this period included the Christmas and New Year break.
But as I write this – at a motorway services at the end of a long day, before commencing the drive back to London – I’m thinking about how it feels.
And for some reason, at this point, it always feels the same:
Not excitement. Not fear. You’ve had those emotions by this point, and they will return. But at the moment of signing the deal, it's relief.
There are always so many little details that have to be clarified in the last days, even the last hours, that it seems like you’re going to have to call everyone at the 11th hour and change the completion date. Then when it seems like it’s back on track, some new piece of information will be discovered, some new point of confusion will pop up and threaten to derail it. And this was a very small company, with a very straightforward process – our company was buying the assets of the target company, limiting our risk. It was in an industry I was familiar with, only tangentially different to that of my own company. And yet repeatedly over the last 24 hours it seemed that the deal would not complete today.
Then it finally did. Not all questions were answered (they never are) – but all of the ones that mattered, to both sides, were satisfied. Deal signed. Relief.
Then urgency. All of those urgent-but-not-urgent-enough-to-hold-up-the-deal issues are now front of mind:
“The insurers need to be told! The clients need our new details… the leasing company needed confirmation before that truck can leave! Fuel cards – someone has to get those PINS to the drivers so they can use our cards. Let’s go back and tell the team we completed the deal! No, the insurance, then the leasing company, then DVLA… Did someone get back to the client about that trailer? Where did I park? Yes the bank transfer was definitely made – I don’t know what the delay is. Let’s go back and tell the team!”
As the new owner of all of these problems, they all now seem to carry significantly more weight than they did a few hours ago. And although of course you plan before completion to have systems in place to manage these issues after completion, the nature of the process means that gradually, tasks which are not absolutely mission-critical to signing the deal get de-prioritised to the "To Do Next" category. So the planning you would have liked to have done by now, the systems you would have intended to already have in place, aren't there. These are now your immediate focus, and there is a new sense of urgency around them.
But this fades. Problems are dealt with in order, new problems arise, but bit by bit, the chaos becomes more manageable.
It definitely helps to have a great team. Compared to the first time I bought a business, when it was just me, it is much easier now. The chaos is over more quickly. The team at Nomad are exceptionally good at their jobs; efficient and enthusiastic. Even though incorporating this new acquisition is not part of their normal roles, the guys leapt into action to help. Right now, on Day 0, we're still in the urgency phase, scrambling to tie up loose ends. But it is so much easier with a good team.
The vendor – let’s call him Arnold for confidentiality – was also very helpful throughout the process. It would also not have been possible to close the deal so quickly without his efforts, and the mutual trust we developed over the past few weeks.
As a result, the deal was closed within one month of first viewing the business, a record-breaking result for us when you consider that this period included the Christmas and New Year break.
The following blog posts will go into the details of this deal, and what it was like to buy a business in such a short timeframe. We'll go into the financial imperatives, the risks, and the practical details. Join us for the journey.
There are many reasons to buy a small business. Individual buyers list reasons like independence, freedom and financial rewards. Strategic buyers (companies in the same or related industries to the target company) can derive many additional benefits from acquisitions, in addition to the basic earnings of the company: strategic buyers can benefit from economies of scale, cost synergies and access to new markets, for example.
But strategic buyers have one other important incentive for buying other companies which might not be immediately obvious: the valuation multiple. Because of the way valuation multiples work, growing via acquisition can be a powerful way to add value.
Valuation Multiple Mathematics for Strategic Buyers
In business valuation the size of a company has the greatest impact on its valuation multiple. A publicly listed company may trade at 15 x earnings, a mid-market company in the same industry (with revenues of say £20m) might be valued at 7 x earnings and a small business in this industry might be valued at 2-4 x earnings, depending on its exact size and the other factors that affect its valuation.
Let’s say the small business has revenues of £1m, EBITDA of £200,000 and is valued at a 3x multiple of EBITDA (£600,000). The mid-market company mentioned above has revenues of £20m and pre-tax earnings of £4m. With a 7 x valuation multiple the company would be valued at £28m. Now if the mid-market company acquired the small business, it would add £1m to its revenue and £200k to its earnings. This would make it an £8m revenue company, with £4.2m earnings. Based on its 7x valuation multiple, the company would now be worth £29.4m – in other words, it has added £1.4m in value through a £600,000 acquisition.
Remember that this is before any cost synergies are rinsed out, economies of scale are realised, or other strategic benefits achieved. Successful acquisitions will boost profits further through these means, and increase the acquirer’s value even more, via its favourable valuation multiple.
Acquirers can also sometimes increase their own valuation multiple through acquisition. As companies grow in size their valuation multiple rises. The owner of a £900k turnover company will be aware of the fact that growing revenues to above the £2m mark will typically result in an increased valuation multiple (eg: the multiple might currently be 2.5, but companies in this industry with revenues over £2m might trade at a 4 x multiple). In order to get to the £2m turnover mark the company will have to more than double in size – a difficult task through organic growth alone. However, growth through acquisition is much faster. The owner might be able to acquire some smaller competitors turning over £300k, £400k and £500k respectively, bringing the total turnover of the combined company up to £2.1m. Once the company is integrated and stable its valuation should be based on the higher multiple.
Remember that this is before any cost synergies are rinsed out, economies of scale realised, or other strategic benefits achieved
How would the mathematics of a case like this work? Using example figures for now, we’ll say that in each of these companies EBITDA was 20% of turnover. So the original company would have had an EBITDA of £180k and the EBITDA of the acquisitions would have been £60k, £80k and £100k respectively. The valuation multiple of the original company was 2.5, so based on its EBITDA of £180k the valuation would have been £450k. The smaller acquisitions might have had valuation multiples of between 1.5 and 2.5: let’s say an average of 2. Therefore these businesses would have been acquired for £120k, £160k and £200k respectively – a total cost of £480k. This would have added £240k per annum EBITDA to the total company, bringing its EBITDA to £420k and its total revenue to £2.1m. Based on these numbers alone, (note again that this is before cost synergies, economies of scale and other benefits are realised), using the new valuation multiple of 4, the value of the total combined company would be £1.68m (£420k x 4 = £1.68m). So the company has added £1.23m to its value by spending £420k on acquisitions. In this case the bulk of the benefit was achieved by moving the total company up to a higher valuation multiple.
Financial Buyers (Private Equity)
Private equity investors don’t buy the genuinely small (<£2m businesses) that are our core interest and the subject of this blog. But no summary of acquisition mathematics would be complete without mentioning financial buyers and what motivates them.
The last example focused on the benefit achieved by acquiring a business at one multiple and revaluing it at another. This “PE multiple arbitrage” is the primary driver behind a particular acquisition strategy sometimes used by private equity buyers, called a “roll-up”. In a roll-up, several businesses in the same industry are acquired and amalgamated to form one business. The final entity is much larger than any of the individual acquisitions, and is therefore valued using a higher valuation multiple. If four or five companies within the £2-5m turnover range can each be acquired at (say) a 4 x multiple and the combined entity sold at a 7 x multiple, this PE multiple arbitrage alone will generate an outstanding return. As with all acquisitions by “financial buyers” (who intend to sell the acquisitions again within a short time frame), timing the economic cycle is critical: valuation multiples are influenced by the whim of the business cycle so buying during a boom and selling the combined entity in a downturn will make things difficult. But PE multiple arbitrage provides a powerful incentive.
Since strategic buyers can typically derive more benefit from a given acquisition than financial buyers can, and can therefore afford to pay more, how do financial buyers compete? One way is to use leverage.
Let’s say a target company is turning over £5m with net earnings of £1m. The appropriate valuation multiple for this business will be dependent on its industry, the economic cycle and other factors, but let’s say it is a multiple of 4, giving a valuation of £4m. Assuming no growth, an acquisition at this price would give a return on equity of 25% to the private equity buyer. On the other hand, a strategic buyer, understanding the cost synergies, economies of scale and other benefits it can achieve through the acquisition, might be willing to pay £5m for the same company. How does the private equity firm compete? Leverage: it incorporates some debt into the capital structure for the acquisition, allowing it to generate the same return on equity while paying a higher price. Rough guideline figures might be as follows. The private equity fund could pay £5.2m for the acquisition, funded via £3.2m equity and £2m debt (a combination of debt structures with a combined interest rate of 10%). The earnings of the business would now be £0.8m after interest payments, giving a 25% return on the £3.2m equity. Strategic buyers can use debt in capital structures too of course, but this kind of acquisition is more typically associated with financial buyers.
The value created by an acquisition is often largely driven by its impact on the valuation multiple of the final entity. In addition to these mathematically-derived benefits, strategic buyers can benefit in other ways from acquisitions, and can usually pay more than other buyers as a result.
How are assets dealt with in small business valuation? Why do they feature prominently in some valuations and not others? In our previous posts we've discussed the over-riding principle used in the valuation of small businesses:
“A business is worth the sum of its future cash flows (if this is greater than the value of its assets)”
Businesses whose assets are worth more than the sum of their future earnings all fit into one of only two categories:
- Where the “sum of future cash flows” is low (usually because of a low multiple)
- Where the asset value is high
This video explains the different situations where this can occur, and how businesses are valued in each case. It also goes through some examples that are not included in this text.
Assets > Cash Flows
Asset sales are the most obvious category of business where this applies, simply because these businesses no long have any cash flows. Businesses that are closing down or have closed down and are selling their assets fit into this category, as do insolvency cases, where assets are sold to pay back creditors.
But many profitable businesses also fit into this category. Some businesses are profitable but are extremely reliant on the owner. Their personal brand drives all of the company’s business, and without them the company’s future earnings would be negligible. It is often difficult to sell these businesses at all, and if they do change hands it is for the value of their assets only.
Very small businesses that are profitable but not particularly stable will only warrant a very low multiple of their earnings, which would give a meagre valuation, often lower than the value of the assets. Very small shops and restaurants sometimes find themselves in this position.
Other businesses are capital-intensive and hold a lot of assets. Manufacturers, transport companies and rental companies are examples of businesses that hold lots of machinery and vehicles. For small businesses in these sectors, using a multiple appropriate for their small size gives a valuation that is close to or even less than asset value, not because their profits are low, but because the asset value is so high.
Selling for asset value only is an option, and in many cases this is the reality, but it is more of a last resort for the owner.
Thankfully in these capital-intensive industries there is a third option: a hybrid valuation method, incorporating both earnings and assets. In these specific industries the market will often pay more than asset value, and accepted Rules of Thumb exist for this reason. For example, small trucking companies in the United States are often valued at:
2–3 x EBITDA plus Assets
And similar rules of thumb are often applied in the UK.
Some businesses hold a great deal of assets in freehold property. We looked at some of these in the last video on Rules of Thumb. Small hotels, B&Bs, care homes, freehold pubs – all of these businesses have significant property assets. Their valuations are usually still calculated in the traditional way – they are based on their earnings, using the PE multiple method – the only difference is that with these industries the multiple tends to be higher than other small businesses, as we saw in the last video.
However, sometimes the value of the property in these businesses starts to exceed the value of their future cash flows. This can either be because of falling earnings, or quite often because of rising property value. In these cases the value of the business is really the value of the property itself, so the property valuation determines the value of the business.
Some of these businesses can be separated from their property - they can move to rented premises to allow the property to be sold separately, or they can stay where they are and rent the property from the new owner.
Other businesses are dependent on their location and cannot be re-located without effort equivalent to starting from scratch. In these cases, when the property value is greater than the valuation given by the earnings multiple method, the business is usually sold for the property value, and the business itself may be closed down, because the buyer wanted the property for a different reason. For example, in the UK only 50% of freehold pubs that are sold continue to be used as pubs. The remainder are used for other purposes, most commonly residential development.
So how do we actually value the assets of a business?
In some cases it’s relatively easy – wherever there is a liquid market for assets, like vehicles, the valuations are pretty straightforward. Assets like kitchen equipment are traded on marketplaces like eBay, so it is relatively easy to estimate their values quite accurately.
The value of stock or inventory is normally based on its purchase price, although the purchaser will usually try to negotiate a discount on the stock compared to the full price, especially where the stock is perishable or will be obsolete soon (fashion, technology). This is reasonable, and comes down simply to negotiation. Unique items like fixtures and fittings can be based on a percentage of their original purchase price if comparable products can’t be found on marketplaces, but again, much of this comes down to negotiation.
Hiring a professional valuer or appraiser with experience in your specific asset classes can be very helpful, particularly where the values are high and the costs of error can be significant. Expert valuers can be very helpful in providing a view on the value of used machinery for example, or specific inventory.
Intellectual property assets are particularly difficult to value – industry experts can be consulted but the valuations will always be subjective. Most small businesses don’t hold IP like patents and trademarks, but some do, especially in the creative industries and in technology. In some cases the value of this IP represents the bulk of the value of the company.
Reputational assets like trading history, search engine rankings, reviews and testimonials can be very important for a business, but are very difficult to value. These assets will contribute to a higher PE multiple for a business when it is valued the traditional way, based on its future cash flows, but they will usually not be valued as separate assets in their own right.
Similarly, long-term contracts will usually contribute to the overall impression of the future earning potential of a business and result in a higher PE multiple. They can be valued as assets in their own right, but this is not very common.
Leases, on the other hand, are contracts that do often have asset value in their own right, particularly for shops and restaurants. If these can be assigned to new owners, and if they are unique and will give the new owner an advantage, they will have value. A common example is where a small restaurant or takeaway business is selling before the end of its lease – if the location is desirable and the rental terms are lower than market rate, and if the contract allows for the lease to be assigned to a new tenant, then new tenants will be willing to pay a premium for the opportunity to operate a business at this location under the same lease.
Rarely, the owner will close down the business, liquidate some of the assets separately and then look to assign the lease to a new tenant – effectively charging a premium for this favourable lease, as well as any fixtures and fittings that are left in the shop.
More commonly, the owner will look to sell the business as a going concern, with all of the fixtures, fittings and equipment bundled together with the lease and the goodwill as one unit. Larger, successful restaurants and shops will be valued based on their future earnings, as we’ve discussed. But for very small shops with relatively modest profits, where the valuation based on future earnings would give a very low number, the valuation will be driven by the assets. If the lease itself is considered desirable and can be assigned to a new tenant, then this will be one of the assets and the owner will charge a premium for this, along with a premium for “goodwill” in some cases. The eventual sale price will be negotiated of course, but the assets will be the driving factor in the value – especially the lease, if it is particularly desirable.
The exact premium that can be charged for the lease can be calculated using complex formulae similar to the discounted cash flow method – they basically add up the future savings offered by the beneficial lease and convert them into a present value. But in practice, this premium is simply based on how much the market will bear. Comparables can be useful in this regard – comparing the leases that have been transferred on similar properties in the same area, and the premium they were able to achieve, will give you a good idea. Commercial estate agents can give you an indication of this value, although the usual caveats around using agents should be followed.
Bear in mind that if an owner is closing down his business and the lease he is looking to assign is actually unfavourable – in other words, the rent or terms are higher than market rate, or the location is undesirable – he will have to pay someone to take over the lease from him – he will have to pay them a “reverse premium”. Rather than an asset, the lease is a liability in this case.
One other point to note with shops and businesses that have a lot of stock – particularly perishable stock: this inventory is usually added to the valuation at the end. These valuations usually state the suffix “plus SAV” which means “plus stock at valuation”. Adding the inventory value at the end simply allows everything else to be negotiated first, without worrying about the stock level, which will fluctuate on a daily basis. The value of this inventory can also be negotiated of course, but it is left to the end in these cases.
Assets Vs Goodwill
Remember that in the end, from an accounting perspective any price paid for the business in excess of the tangible asset value represents the “goodwill”. So whatever the circumstances – whether it is a hybrid valuation in the case of the transport company, or maybe a traditional PE Multiple valuation that gives a number greater than asset value, or maybe in the case of the shop a premium is charged for the “lease” – in every case, an accountant will simply call this “goodwill”.
So while we can have our reasons for stating why a business is worth more than its asset value, to an accountant, after an acquisition, none of these reasons matter. The buyer has simply purchased assets and “goodwill”.
It’s sobering to remember that this goodwill is purely theoretical. A good case must be made by the seller for the buyer to buy it. If a buyer is going to pay more than tangible asset value for a business, then he has to really be confident in the future earnings that he is buying, and the opportunity that this represents.
Entry Cost Valuation
Before any buyer does this, there is one other type of valuation they will almost always do: the Entry Cost valuation. With this method, they will calculate the costs of starting an identical business from scratch, including buying assets of the same quality and quantity, and developing the business to the exact same state as the target they are considering acquiring, as an alternative instead of buying the business.
If it will cost less to start a competitor from scratch and buy the equivalent assets (or in the case of a strategic buyer, to grow their own business by the same amount as the acquisition would add), and if the timeframe is acceptable, then it would be rational to do this instead.
In reality, it is unusual for a realistic Entry Cost valuation exercise to show a favourable outcome – in most cases the time, expense, work and even luck involved in getting a business to an advanced state is worth paying for, rather than attempting to replicate it from scratch. But it is worth bearing in mind that this form of asset valuation will be conducted by most serious buyers.
When the assets of a business are worth more than the sum of its future cash flows, the valuation will be based on the asset value. This can be either because the asset value is high, the sum of future cash flows is low, or both.
Asset values can be particularly high in capital-intensive industries, where hybrid valuation methods are often used with small businesses, adding asset value to a low multiple of earnings. Businesses that hold a lot of inventory also typically add the inventory to the valuation at the end.
But in all of these cases, the business will not usually sell for less than asset value, because the owner has the option to liquidate the assets for this price.
Also remember that, regardless of the valuation method, buyers will always want to calculate the payback period on their investment – in other words, they will reduce the total valuation back to a multiple of earnings. It is a good sanity check for sellers to do this too.
The value of a business is equivalent to the sum of its future cash flows. For small businesses, the best way to calculate this is using the PE multiple method, as we discussed in our second video in this series.
But how do you decide what multiple to use? There are basic principles to guide us - things like the size of the business and the industry it is in. Comparables can also be very useful, as we saw in the last video.
But some industries have specific "Rules of Thumb" that provide a lot of guidance in the valuation of businesses in that sector.
"Rules of Thumb" are valuation formulae based on the PE multiple approach, but with specific details about the range and type of multiple to use in a given industry.
In industries where rules of thumb are widely accepted, they are very valuable and should be followed. In other industries, rules of thumb are just guidelines that provide another data point in addition to the general principles.
This video explains what rules of thumb are, and how to use them in the valuation of a small business.
One of the first examples of business valuation we looked at in this series was liquor stores in the United States. In this industry there is a rule of thumb stating that the business should be valued by this formula:
(0.4 to 0.5 x Revenue) + Inventory
This rule dictates the range of multiple to use in this industry (0.4 to 0.5), it specifies that this should be a multiple of revenue (not net profit, SDE, EBITDA or any of the other types of earnings we discussed in the first video), and it also specifies that a category of assets (the inventory) should be added to this at the end.
Many other industries use rules of thumb for business valuation. Small web-based businesses ranging from small e-commerce stores to affiliate marketing businesses all tend to sell for within the same multiple range, which is listed on the Empire Flippers website:
20-40 x Monthly Net Profit
This is the equivalent of 1.67 to 3.33 x annual net profit. Although every business is different, these businesses have enough in common with each other that they can all be reduced down to the same formula to give a valuation range.
Like all businesses, the exact valuation within this range will depend on the unique characteristics of the business. But this rule of thumb provides the guide to the range in which the value should be, and it is stuck to fairly closely in this industry. So in this industry this rule of thumb is important, because it would be difficult to justify a valuation outside of this range.
At the other end of the scale, businesses that hold a lot of assets in real estate also tend to have rules of thumb that apply to their valuations. For example, care homes (nursing homes) in the UK sell for 7-11 x EBITDA. Freehold pubs in the UK tend to sell for 5-9 x EBITDA. In the US small hotels sell for 8-11 x EBITDA and B&Bs sell for 8-9 x SDE. These rules of thumb are based on a multiple of earnings (EBITDA or SDE as the case may be), and they include the property and assets of the business.
Valuation Rule of Thumb Databases
In the United States there are some very comprehensive databases of rules of thumb, the largest of which is the Business Reference Guide. The rules of thumb in these publications cover almost every industry sector, and often include several different rules of thumb for each sector.
For example, accountancy practices (CPAs in the US) have several rules of thumb listed:
1.0-1.25 x Revenue + Inventory
1.8-3.0 x SDE + Inventory
2.2 x EBITDA
2.0 x EBIT
And most other industries are the same: they have multiple rules for each. Rules of thumb are the raison d'etre of these publications, and they create rules on top of rules on top of rules. This is not always helpful. What is really important is knowing the rule of thumb (if any) that is widely accepted in a particular field. For accountancy practices it is the first rule above (1 to 1.25 x Revenue) that is most widely accepted in this industry (and often without the addition of inventory, which is not usually substantial in this sector). The rest of the rules are just useful cross-checks for the valuation range.
Rules of Thumb are valuation formulae based on the PE Multiple approach, but with very specific details about the range and type of multiple to use for a given sector. Rules of Thumb exist in almost every industry – especially in the United States – but how important they are in the valuation process varies a lot by industry.
In some industries there will be a key Rule of Thumb that is widely accepted as the gold-standard valuation method. In other industries they aren’t very important; they merely provide additional data points for the valuation range. But this range will be more dependent on the core principles of business valuation that we’ve already discussed, and the available comparable data.
One of the principles of business valuation is the use of “comparables”. Since similar businesses will have similar risk profiles and investors would expect similar payback periods, similar earnings multiples should be used. So by comparing one company to other similar companies that have recently sold, we can gain a lot of insight into the appropriate valuation of the target company.
Comparing public companies is easy because they have to disclose their financials, but finding data on private companies is much more difficult. Some comparable data on large private companies is captured in private M&A databases such as Zephyr, Thomson Reuters and MergerMarket, but subscriptions to these databases are very expensive so they are inaccessible to most small businesses. In the UK the PERDa database captures the PE ratios of recently sold businesses, but it distils the entire market down to an average: just one number to represent every business that was sold in the quarter.
But the biggest problem with these sources is that they focus on much larger companies than our clients are interested in – for example, the average enterprise value of a company in the most recent PERDa analysis was £21.4m, with average pre-tax earnings of £3.6m. The other databases focus on deals most of which are in the $10m+ range. Given that size is the most important determinant of PE multiple, it simply isn’t helpful to compare data from these companies if we are interested in small businesses turning over less than £2m. In other words, the comparables are not very comparable.
So where can we find comparables that are actually useful? The starting point for most people is their own industry knowledge - normally they will be aware of recent sales of a few businesses in the industry. Sale prices of private businesses are usually not made public but occasionally this information can be gleaned through friends and associates, although rarely with any degree of confidence. The financials of the businesses are not public either, but people who know their industry well can usually gauge with some accuracy the relative sizes of their direct competitors. This basic knowledge of a few local sales, with scant details, is often the only comparable data we have.
Thankfully, more data is available. There are two good sources of extensive small business comparables, if you know where to look. Both of these datasets are from the United States, but they provide useful insights where otherwise there is very little available. While the data is not directly transferable to countries outside of the US, we can still draw very useful comparisons from it. Because the size of businesses captured is at the right level, this data is arguably far more useful than local data on businesses of the wrong size.
BizBuySell Insight Reports
The business for sale listing site BizBuySell.com publishes quarterly and annual Insight Reports, which are analyses of its quarterly surveys of business brokers. The second quarter reports are particularly helpful because they report full year data for the previous year, broken down into individual industry and sub-sector. The median revenue of businesses in the dataset is just over $500,000, so it is truly focused on small businesses. And with over 2,500 sales per quarter included in the reports, they represent a large sample.
BizBuySell does not report its methodology in any detail, so it is difficult to use the data to discern trends over time, and all of the findings need to be taken with some caution. The brokers who voluntarily provide the data have a vested interest in its outcome (showing higher sales prices and less time on the market, for example). And BizBuySell itself has an interest in encouraging more people to sell their businesses, so the commentary has an uncannily consistent positivity, always indicating that “now” is a great time to sell your business.
But the findings are useful, both on a global and an industry-specific level. Methodological concerns aside, it is extremely rare to find such a detailed dataset focused on small business sales.
IBBA Market Pulse Reports
The International Business Brokers Association (IBBA) also publishes quarterly reports based on surveys of business brokers – its “Market Pulse” reports. Much smaller in size than the BizBuySell datasets, these ones typically include 250-300 sales per quarter. And they vary in size from very small businesses up to mid-market companies (the largest category of which is $5-50m enterprise value). The data is broken down by company size though, so we can easily see which data points are relevant to smaller businesses and which aren’t. And we can also use the data to understand how company size affects the outcome in each case.
What Does The Data Tell Us
Full analyses of the latest reports from both sources are in the video. They include insights into:
- PE Multiples by Industry
- PE Multiples by Size
- Time on Market
- Deal Structures
- And More
The most interesting insights are the earnings multiples. The BizBuySell report has a full breakdown for last year by industry sector, which is fascinating (we have transferred this data into a spreadsheet also – just email us if you would like a copy). It covers not only earnings multiples (of both revenue and SDE), but the number of sales, median sales prices, median asking prices, revenues and SDE.
Earnings multiples as a function of company size are illustrated best by the IBBA reports. Their tables break down the data into their five categories of business size, enabling comparison between them:
The data showed that, in the most recent quarter, the median multiple for a business valued at less than $500k was 2.0 x the Seller’s Discretionary Earnings (SDE). This multiple increased to 2.3 x for businesses between $500k and $1M in value, and to 3.3 x for businesses that sold for between $1M and $2M. Multiples for larger businesses are shown as a multiple of their EBITDA, as you can see in the table.
Helpfully, the IBBA also provides these multiples in the form of a range, showing where the bulk of the valuations were placed for businesses in each category. The $2-5m category is reported as a multiple of both SDE and EBITDA, so that we can see both the multiples themselves and we can also observe how the choice of earnings metric affects the retrospectively-calculated multiple for the same businesses.
Besides the methodological issues associated with the data collection and reporting, there is one very important point to remember about comparable sales data: they include only sold businesses. Remember that within the realm of small business, most do not sell. This means that the ones that did sell were among the best-in-class in the factors that increase "saleability" - characteristics like systematisation, stability and reliability. When using comparable data it is critical to remember that those businesses that sold, and were therefore included in the data, had higher scores in these metrics than the average business. Sold small businesses are not average small businesses.
In addition to these issues, people outside of the US have to contend a couple of other problems. While some of the multiples are reported as multiples of EBITDA, the key earnings multiples for small businesses use Seller’s Discretionary Earnings, a term that is not widely used outside of North America. In order to use the comparable data, the SDE (or a similar adjusted net profit) must first be calculated for the target company.
In addition to this, there is the concern that data from one country will not directly apply to another. To look into this, we compared the PE multiples from the IBBA data and from a UK study of PE multiples of private companies by the consulting firm Menzies. By comparing the most similar size brackets to each other (both conveniently presented as a multiple of EBITDA) we can compare the PE multiples, and the comparison shows that both datasets produced multiples in the same range.
As discussed in the video, this finding alone does not mean that all of the US data will be directly applicable to the UK or any other country. But it suggests that at least the multiples will be within a reasonable range, and the data should not be widely different. Each industry will vary in how similar it is to the United States, and this will affect how closely the industry-specific multiples apply in a different country.
But given how little data there is on small business sales in most countries, the IBBA and BizBuySell datasets provide much-needed comparable data. As long as the problems and potential biases in the data is understood, these sources can add meaningfully to the process of valuing a small business. Combined with local industry knowledge, and the core valuation principles, they can be very useful.
Business valuation might seem like a black art, but it's not that hard when you understand the concepts behind what gives a business its value. In this video we distill the field of business valuation down to its core principles, and provide a practical system for how to approach the valuation of a small business.
What Is A Business Worth?
The value of a business is the sum of its future cash flows. That’s all. If a business is (in value terms) just a machine that makes profits for its owner, then a fair price to pay for it would be exactly equal to the sum total of the profits and losses it will make in future.
Discounted Cash Flow
Now, we can calculate this figure by making thousands of assumptions to literally forecast the profits and losses of the business each year into the future, and then discounting them at an interest rate to allow for the time value of money – this is the Discounted Cash Flow method. It is a very direct approach, but its accuracy rests on the accuracy of all of the assumptions that it is built on.
Valuation = Sum of Future Cash Flows
Once we know the value of a business, the next thing to calculate is the payback period on an investment into this business. In other words, if an investor was to buy the company for an exactly fair price, how many years’ future earnings would it take to pay back this investment? Since the payback period shows how many years’ earnings are represented by the value of the business (or the “price” of the business in the case of public companies), then it is effectively the ratio of the company’s price to its earnings: the PE Ratio. This is also called the PE Multiple, since it shows what multiple of earnings is represented by the price.
The payback period is really an indication of how confident investors are in the future potential of the businesses. If investors don’t have a lot of confidence in a company, they will demand that their investment is returned quickly – a short payback period – whereas the opposite is true for businesses that they have more confidence in.
PE Multiple Method
Now, very similar businesses would be expected to have very similar payback periods, since investors would weigh them equally. For this reason, we can use the payback periods (or PE Multiples) of businesses where we know these figures, to provide an indication as to the PE Multiples of other similar businesses.
This is the principle of the PE Multiple approach to business valuation. Instead of making thousands of assumptions in order to calculate the future cash flows of the business, and add these up to derive a valuation, we can instead make just one assumption regarding the PE Multiple, which incorporates all of the other assumptions by showing the payback period on the investment. Once we have the PE Multiple we can multiply this by one year’s earnings to calculate the valuation.
Valuation = Earnings x PE Multiple
The crux of the PE Multiple method is how to choose the multiple of course. There are some basic guiding principles involved: for example, a company’s size is the most important factor, followed by its industry. In addition to basic theoretical principles, we can use real-world comparable data – sales prices and PE Multiples of other similar businesses – to provide more evidence. Our next blog post and video will be on comparables. Finally, in some industries there are specific “Rules of Thumb” that are used to define the multiple that should be applied to calculate the valuation. We will come back to Rules of Thumb in the fourth video in this series.
All of these factors together will provide a guide to the range in which the PE Multiple will sit. Exactly where in this range is dependent on the quality of the business itself: for example, whether it has management in place or is dependent on its owner; how stable it is (the presence of long-term contracts, for example); how much growth is forecast for the business and the industry in future. These details, while not as significant as the size of the business in determining the PE multiple, will for smaller businesses often determine whether the business sells at all. Finally, it is important to remember that the inherent value of the business is not the only factor that determines its sale price (and terms). Negotiation will be driven in large part by how well the sale process is handled: especially how many willing buyers are found who are willing to bid against each other to make the acquisition.
Finally, there is one caveat to the principle that “a business is worth the sum of its future cash flows”: this only applies if this figure is greater than the value of the net assets of the business.
For businesses where the total future cash flows (based on realistic assumptions) is less than the value of the net assets, then the net asset value that will determine the valuation. This situation can arise when a business is unprofitable, or when it is “only just” profitable, and the asset value outweighs the valuation given by forecasting the total future profits. Very small businesses are frequently in this situation, but sometimes larger businesses that are very capital-intensive can also be in this position. The sale of a business like this is effectively an asset sale, so an Asset Valuation will be appropriate. We will discuss asset valuations and asset sales in the fifth blog post and video in this series.
Three Methods, One Principle
In summary, a business is worth the sum of its future cash flows (as long as this amount exceeds the value of its net assets). This number can be calculated by making many assumptions that allow us to forecast and add up all of the future cash flows using the Discounted Cash Flow method. Or we can reach this valuation by making one assumption regarding the payback period required on the investment, based on similar businesses, using the PE Multiple method. For cases where the net asset value exceeds the value of the future cash flows, the sale of the business will effectively be an asset sale, so an asset valuation will be the appropriate method.
In our next video we will look at some available sources of industry comparable data, including some hard numbers for businesses of various sizes in various industries.
The most important small business valuation methods are based on using a multiple of profits. But there are so many different ways to describe the earnings of a business – how does the “Net Profit” differ from the “Net Benefit to Owner”, for example? What is the EBITDA? This video will explain the different terms and the context in which they are usually applied.
We’ll also discuss these concepts in a little more depth below.
The net profit of a business is simply its total revenues minus its total costs. It is the net profit before taxation that matters for small to medium businesses (for very large listed companies it is the profit after taxation that is more commonly used). The “Net Profit Before Tax” is often shortened to “Pre-Tax Earnings”, “Net Earnings” or just “Earnings”. They are all the same thing.
Adjustments to the Net Profit
When selling a small business, the seller will typically want to demonstrate not only the net profit of the business, but the rest of the benefit they derive from it. This will include their salary and any other benefits they receive (car, mobile phone, healthcare etc). They want to show the total benefit they receive from the business, so instead of simply listing their company’s net profit, they list something else: the “Net Benefit to Owner”. In the US this is more commonly called the “Seller’s Discretionary Earnings” (SDE). This is supposed to represent the total benefit received by the owner. It is often called “Cash Flow” in the US (which can be confusing, since it has nothing to do with the accounting term referring to cash inflows and outflows). All of these terms mean the same thing: the total benefit derived from the business by the owner.
To maximise the apparent size of this benefit, sellers often adjust the accounts to remove things like depreciation (and where applicable, amortisation). Often they even deduct interest expenses, arguing that different owners will have different debt structures, so the interest payments are not relevant. The extent of the deductions can vary, but in many cases they will deduct unusual one-off expenses that they feel are not likely to be repeated and therefore should not reduce the profit figure. For example, the costs of repairing a roof after a bad storm might be deducted from the expenses (in other words “added-back” onto the profit). Each of these “Add-Backs” has the effect of making the net benefit figure appear higher, which the seller uses to justify a higher valuation.
To be fair, negative adjustments are also made to the accounts. For example, if family members are working for free or for below market wages, this has to be accounted for and the corresponding costs added to the expenses (and therefore deducted from the profit). Similarly, if a business is not currently paying rent because it owns its own freehold property, the cost of rent at the market rate would be deducted from the profit if the new owner would not be expected to buy the freehold and would be required to rent.
All of these adjustments are negotiable, and buyers and sellers always have different views on them. Buyers may argue, for example, that depreciation is a reasonable expense, especially in a capital-intensive business. Equipment does, after all, depreciate over time. Buyers will argue that since this cost will be expected to continue into the future, it should not be deducted from the expenses at all.
Some buyers may argue that the owner’s salary and benefits should not be added back to the net profit, because the new owner does not intend to work in the business himself, and will need to employ someone to do the current owner’s job. While this is a fair argument, and can be negotiated with the seller, it is important to remember that the typical definition of the “Net Benefit to Owner” (or “SDE” / “Cash Flow” in the US), includes the owner’s salary and benefits. So when small businesses are advertised for sale, the Net Benefit or SDE figure has been calculated to include the owner’s salary and benefits.
In fact, in the US it is often considered acceptable for small businesses where the owner is truly not involved, to add on one manager’s salary on top of any salary and benefits taken by the owner, to calculate an SDE that allows for the fact that the new owner will be working in the business. By replacing this manager, he will therefore benefit from that extra salary himself.
This highlights the assumption underlying these metrics: that a small business will be managed by its owner. This does not accurately reflect reality of course. Many small businesses are not managed by their owners, but have instead been systematised and are run by a management team. But it is important to note that this is the assumption that is used when these profit metrics are calculated.
The figure after all of these adjustments are made is the “Adjusted Net Profit”. Sellers will call their version of this the “Net Benefit to Owner” (or “Seller’s Discretionary Earnings”, “SDE” or “Cash Flow” in the US). Buyers will typically make their own adjustments and calculate their own version of the Adjusted Net Profit. The principle is the same: it is the net profit of the company, with adjustments to allow the figure to more closely reflect reality.
EBIT and EBITDA
Two common metrics that are used to describe even the largest companies, EBIT and EBITDA are also sometimes used when valuing small businesses.
EBIT stands for Earnings Before Interest and Tax. Therefore this is simply the “Net Profit Before Tax” with interest added back on (since tax hasn’t been deducted yet). It is useful to compare the profitability of companies after excluding interest payments, since similar companies can have quite different capital structures. As discussed above, small businesses owners will have different debt structures for the same company, so it can be argued that including interest payments would give a distorted view of the company's profitability. EBIT allows them to be excluded.
A more commonly used metric is EBITDA which stands for earnings before Earnings Before Interest, Tax, Depreciation and Amortisation. Commonly used to assess the net profitability of stocks by removing the impact of these accounting adjustments, this metric has been increasingly applied to small and medium-sized companies too.
Which To Use
There is a general rule, followed more closely in the US, that for smaller businesses, SDE (or “Cash Flow”) is the profit metric of most interest and the one that would be displayed in the Information Memorandum or on an advertisement for the business for sale, whereas EBITDA would be used for larger businesses. This is due to the assumption discussed above, that for small businesses the owner will be actively involved and will take a salary from the business.
In the UK and most other markets there is more variation. Advertisements of businesses for sale quote the Net Profit from the accounts in some cases, the Adjusted Net Profit or Net Benefit to Owner in others, with varying inclusions and exclusions.
Also, while the above descriptions represent the strict definitions of each term, in reality there is a lot of variation in their use. “Adjusted Net Profit” and “Cash Flow” in particular can vary greatly, depending on what is included and excluded. And even metrics like EBITDA, which have very clear definitions, are sometimes used by brokers and sellers as short-hand when they mean “Net Benefit to Owner” with the owner’s salary and benefits added in.
Impact on Valuation
While sellers like to make adjustments to the accounts to show that they are receiving a greater benefit from the business than the accounting Net Profit, in reality these adjustments do not have as great an impact on the valuation as one might think. As we will see in our upcoming videos, statistics of small businesses sales show that the valuation multiplier changes in accordance with the profit metric. So while a company’s “SDE” will be a larger number than its “EBITDA” figure according to strict definitions, the sale price of the business would not be affected by this choice. Instead, the sale price would simply reflect a lower multiple of the SDE or a higher multiple of the EBITDA. This is because serious buyers calculate their own earnings metrics from the raw accounting data and act accordingly.
So it is useful for sellers to understand these metrics and choose ones that portray the business in the best light. Getting the attention of the right buyers is critical. But ultimately the negotiation of the sale price and deal terms will come down to the buyer’s estimation of the future profits the business will generate under new ownership, and how important it is to him or her not to miss out on the acquisition opportunity (which will be related to the handling of the sale process itself, including the ability to create a competitive bidding process).
In our next two posts we will explore some of the small business sales data that is available, and discuss how to interpret it.
We’ve written about business brokers before, and how easy it is to be tricked into the common belief that they add more value than they cost. A recent interview on the Mixergy podcast provided a classic example of this, with a business owner who was clearly intelligent and capable, yet was tricked into believing that the best way to sell his business was to use a broker.
The story provides a great insight into how business brokers work, how much they charge, and what can happen when you use them. The example is even more powerful because the broker’s fee was at the extreme upper end of the range, and because it shows how people can become entirely convinced of the necessity of a broker, despite all of the evidence to the contrary.
This is the story of David Rogenmoser, and how he sold his company, PayFunnels. The interview is largely about Rogenmoser’s new company, Proof. But the fascinating part – and the topic of this short post – is the story of selling PayFunnels through a business broker.
Rogenmoser explains that he had thought about selling the business (a software-as-a-service or SAAS business) himself, but wasn’t confident that he knew what he was doing – in particular that the valuation would be incorrect.
“I was just thinking if I go into this alone, either I’m going to get hosed, or the buyer is going to get hosed, and I don’t know which one that’s going to be until down the road, and I didn’t want to mess anything up. And so I decided to go hire a company that had done it before to kind of walk me through the whole process.”
First of all, this is crazy. Learning how to value your business is not that hard. For someone who has built a successful business, it will not even be in the top 100 most difficult things they’ve had to learn. And in this case, a SAAS business, there are established metrics already: industry rules of thumb indicating what SAAS businesses typically sell for, at different sizes and growth rates. There is a relatively liquid market for software companies (compared to other industries), and the data is even more readily available. A quick search provides data here, here and here for example. Even the broker he eventually chose has a guide to the valuation of SAAS companies on its own website. With a little research Mr Rogenmoser would have developed a good understanding of how to value his business and he would have determined an accurate valuation. There was absolutely no reason to use a broker just for this purpose.
Furthermore, “or the buyer is going to get hosed…” Seriously? Buyers are not stupid and do not pay more for businesses than they are worth. The only risk here was that he would lose, not the buyer.
In any case, he Googles and finds a broker, FE International, who agrees to handle the sale for a fee of 20% of the sale price. 20%! This is for a sale price of “mid to a little below mid six figures”, so $500,000 or just below. In the UK a fee of 5% is typical at this level, and even this is an unnecessary expense in most cases. In the US the broker’s commission is typically closer to an eye-watering 10% for businesses of this size. But 20% is extreme.
The interviewer, Andrew Warner, asks him if he thinks it was worth paying this price instead of listing the business on Flippa, a self-service marketplace for selling website businesses which charges 12% commission. (Note: for a business of this size we would never recommend paying 12% commission to a self-service website – there are better ways to find buyers, without the commission). But Warner has a point that Flippa’s 12% fee is, at least, better than the 20% he paid to FE International. Rogenmoser admits that he didn’t really even look into the competition very much. He just found this broker and decided to go with them.
It’s hard to blame him for this. Business owners are incredibly busy people. And this particular broker has carved out a strong niche in the SAAS space, dominating Google listings for search terms in this field, so it is no surprise that he found them and chose them. Sure, he should have searched harder and considered more options. In fact, he shouldn’t have used a broker at all. But given how much we hear about brokers in the media, and how they have positioned themselves as the default choice for business owners, it is understandable that so many people believe their marketing and hire them.
Mr Rogenmoser goes on to explain that he was hesitant about selling the business, but the broker helped him to decide to go through with it.
(Before even reading the next part of the transcript, think about this: a commission-only broker is always going to try to convince you to sell. Like a real estate agent, they get paid on the deal closing, and they just want it to close. They don’t want to get the best price, they just want to sell it. So they put a lot of their effort into convincing the seller to accept a deal, rather than looking for the best deal. The mathematics of their incentives were well captured in the book Freakonomics by Stephen Dubner and Stephen Levitt – explained by the authors in the quick 3 minute video below. Commission-only business brokers are similar to real estate agents: their incentives are simply not aligned with their clients, when it comes to getting the best price. They are incentivised to make sure the deal goes through quickly. Getting a better price for their client is usually not worth the extra work for the broker personally.)
So the business owner explains how he was hesitant, for good reason:
“Yeah, I mean, I pulled out once actually. So we had listed it at a certain price. We were about to get done. I had interested buyers, and I looked at it, and we’d grown significantly in about two or three months the first value of the company. And I was like, ‘It’s worth a lot more. It’s worth 30% more now than we listed it at. We need to pull this thing off. Like this is the wrong price.’ So I pulled it off against their desires, and we ended up relisting it again. And finally got a couple people that were back interested in (it). We kind of went through the due diligence. And on the last day, I mean this is like a five month process, because we’d pulled out once. Finally on the last day I call them to pull out again. And I promise I’m not like that sketchy of a guy here, but it’s just like an emotional decision. You’re selling your business, the most money you’ve ever got in your life. You’re like, ‘This could be worth way more later on.’ I’m like the optimist. And so I call him, and I’m like, ‘Hey, I think we’re just going to go ahead and pass on this, actually. I’m really sorry for the whole hassle. We don’t mean that at all. I think it’s what need to do.’”
Before we go on, think about this. The business was listed, by the broker, at a price that was too low. Who noticed this? Did the broker alert him to it? No, the owner had to recognise this fact himself. The broker wasn’t “supporting him through the process” at all. If it wasn’t for the owner looking into this, he would have sold at this very low price.
So when the owner brought up this issue with the broker, did they apologise for not realising their mistake, and say “Yes, you’re right”? No, they still wanted to sell it at this price! Rogenmoser says that taking it off the market was done against the desires of the brokers.
Thankfully he did it anyway, because when he listed the business again at the higher price, he found buyers again. The previous price would have been a huge bargain for the buyer, and a loss of value for the seller.
In any case, after listing it again at the higher price and finding more buyers, he was again having second thoughts about selling. He believed the business could be worth a lot more in future. So he rang his broker to tell him that he was going to keep the business.
His broker put him through to his boss, the head of the business brokerage firm, who gave him this advice:
“He goes, ‘Listen, I don’t really care whether you sell it or not. This is not a huge piece of our revenue, but I would sell, brother. I would sell. You’re going to have a bad name in the SAAS space. If you like pull out again, it’s going to look bad on us. And I just think you’ve got a really big opportunity here to go focus and use the cash and put it all towards Proof (Mr Rogenmoser’s new venture).’ And at the end of the call I went in thinking I was going to totally pull out, and I left saying, ‘Sell it. Let’s do it.’ And that was a great decision. I’m really thankful for his advice there.”
Surprise, surprise, the broker convinces him to sell. To do that, he suggests that if he doesn’t sell, his reputation will be damaged!
So after taking this advice, Mr Rogenmoser sold. And not only that, he was so convinced by the broker, seemingly spellbound, that he thanked the broker for the advice (in addition to paying him almost $100,000).
We can never tell if selling the business was the right thing to do – maybe his instincts were right, and he would have made more money by keeping the business for longer (he was right the first time). Or maybe selling was the right move.
But we can tell four things:
- Mr Rogenmoser decided to use a business broker because he was worried he would get the valuation wrong – and then the business broker promptly got the valuation wrong
- Mr Rogenmoser wanted the broker to manage the process, but he had to manage a lot of the process himself, including critical decisions around pricing and whether or not to sell at all. Further on in the interview he talks about how he was having Skype meetings with the potential buyers of the business – this is normal, because it is the owner of the business who actually does the work of explaining the business to the buyers – brokers never do this. So he ended up doing most of the work himself, as is always the case
- As expected, the interview suggests that the commission-only broker was more interested in selling for any price, than selling for the best price. If he had taken the broker’s advice in the first instance he would have sold for much less than the business was worth. He had to intervene himself to stop this. And in the end, we still don’t know if the price he sold for was too low
- He paid a fortune (almost $100,000) to the business broker for this privilege
If you are selling your business and you would prefer to avoid an experience like this, we would recommend not using a business broker. This particular broker has a very good reputation: it is not like they are unusually adversarial. And nothing they did was dishonest – it is just the nature of the industry and the way their incentives work. This example, while being extreme in terms of the broker’s fees, is quite typical in most other ways.
We recommend that small business owners manage this process themselves, not only to avoid the brokers’ fees (which is reason enough), but in order to achieve the best sale price and terms.
As this example shows, hiring a business broker can easily result in a lower sale price, especially if the process is simply handed over to them without the owner managing the process every step of the way. And if the owner is going to be required to manage the entire process, including managing the broker, what value is the broker adding?
Search funds are one of the least well-publicised and least well-understood asset classes in the world today. As we mentioned in this post, almost all search fund activity has historically been in the US, but in recent years more search funds have appeared in Europe, and in the UK in particular.
For entrepreneurs who have built a sizeable private business over many years, search funds can be an attractive route to exit. These funds exist to actively search for and acquire exactly the type of small private company that these entrepreneurs are looking to sell. Importantly, search funds back investments over a typically longer period than other private equity vehicles. While some business owners are concerned about selling to private equity groups for fear that they will “slash and burn” their business in order to generate quick profits, this concern is lessened with search funds because of their different approach and longer investment horizon. Search funds typically own the business for longer and are interested primarily in revenue growth rather than simply staff-cutting.
These funds exist to actively search for and acquire exactly the type of small private company that these entrepreneurs are looking to sell
So what are search funds, and what are they looking for? According to the Stanford Graduate School of Business, a leader in education around search funds in the US, a search fund is “an investment vehicle through which investors financially support an entrepreneur’s efforts to locate, acquire, manage, and grow a privately held company”. In other words, these funds will provide equity for the purchase of a business by a young entrepreneur or pair of entrepreneurs (typically MBA graduates), who will use their management expertise to grow the company and eventually sell it, providing a return on the investment. Interestingly, search funds will also finance the entrepreneur’s expenses during the search for the right business, which can take up to two years.
Search funds typically target businesses with revenues of $10m to $30m (£7.5m to £15m) with very strong and stable (>15%) EBIT margins. Some funds’ criteria will be for slightly smaller companies than this: Richard S. Ruback and Royce Yudkoff from Harvard Business School advise searchers to look for businesses with pre-tax profits of $750k to $2m (£500k to £1.5m). Their book, An HBR Guide to Buying A Small Business, is an instruction manual for entrepreneurs who want to go down this path. Some search funds, such as Captiva Partners in the UK, have slightly broader target criteria, incorporating companies with revenues from £500k upwards.
Search funds are looking for opportunities to help stable companies to grow significantly under new management, and as such, they look for signs that the existing management have not capitalised on every available opportunity. Often the target will be a company where the owner is looking to retire and does not have a succession plan for handing the business down to his children. Having built the business from scratch, the owner is already very successful, but has grown the company to the point where his own knowledge and skills are no longer sufficient to enable substantial further growth.
Typically search funds are looking for companies with sustainable recurring revenues (not loss-making ones or startups), although rapid growth is often not considered favourable as it usually brings associated risk. Ruback and Yudkoff favour companies that are growing slowly, but with a sustainable competitive advantage in their industry – they describe these companies as “enduringly profitable” because of the stable position they have achieved and the reliability of future earnings. For there to be potential for substantial growth under new management, the industry should ideally be fragmented (not heavily consolidated), and it does not have to be glamorous or high tech: often quite the opposite. Searchers look for businesses with a strong position in an industry with “straightforward operations”, as Standford GSB puts it, since the new management will likely not have technical expertise in the field. Importantly, the target company’s success should not be very closely tied to the owner, but instead based on a solid second-tier management team.
Searchers look for businesses with a strong position in an industry with “straightforward operations”, as Standford GSB puts it, since the new management will likely not have technical expertise in the field
Valuations of these companies vary slightly by industry and size, but the smaller ones within this range will be purchased for 3-5x net pre-tax earnings, the larger ones occasionally stretching to a slightly higher multiple. While other equity vehicles (or strategic buyers) may be willing to pay a higher price, search funds position themselves as a “friendlier” solution, since their objectives will usually not require sudden dramatic staff cutting. Search funds will be looking to exit eventually, but their investment horizon will often be longer than 5 years.
Inherent in the search fund model is the belief that a relatively young MBA, who usually will not have any industry-specific expertise in the acquired company, will be able to grow the revenues of the company more effectively than the previous owners, simply through superior management skill and enthusiasm. The fact that this model places so much faith in the principle that professional management alone can transform the business, and especially the belief that industry experience is not required (since the fund backs the entrepreneur, before the target company is even found), may partly explain why search funds are still relatively rare beasts. It is not entirely intuitive that this model would work. In addition, funding the search for the target company as well as funding its acquisition is highly unusual for investors outside of this specific ecosystem. But the search fund model has proven very successful since its inception in 1984, and it is here to stay.
For investors these vehicles provide a more reliable return than other classes such as venture capital. While maximum returns are lower than the home-runs possible with VC, the risk of failure is also far lower. As one search fund investor puts it, while 80% of VC funds are expected to fail, 80% of search funds are expected to provide a positive return. Stanford’s 2016 study of 258 search funds showed an aggregate pre-tax internal rate of return of 36.7%, and an aggregate pre-tax return on invested capital of 8.4x. These numbers compare favourably with venture capital, which aims for 30% IRR but achieves, on average, only about 10%. Returns in both classes vary considerably from year to year of course, but the numbers suggest that search funds are an attractive option for the limited partners (LPs) who invest in these funds.
While the vast majority of search funds are still in the US, the model is spreading to Europe and elsewhere. In a 2015 study by the IESE Business School in Barcelona, 45 non-US search funds were identified, of which 9 were based in continental Europe and 12 were in the United Kingdom.
For the entrepreneur, the search fund model provides a unique opportunity to take over the management of a much larger company than he or she would otherwise have the means for. Acquisitions are typically funded with roughly 70% debt and 30% equity, the latter provided by the search fund. The entrepreneur earns equity over time by achieving growth targets: if things go as planned young manager can own as much as 25% of the company within five years.
For the entrepreneur, the search fund model provides a unique opportunity to take over the management of a much larger company than he or she would otherwise have the means for
Stanford’s primer on search funds explains the entrepreneur’s earnings in detail. During the search phase, the young manager or pair of managers (who are the “principals” of the search fund) receives a salary in the range of $80-120,000 per year each in the US, while searching for the target. Once a target is found, principals will typically receive a 15-30% equity stake in the company, in three equal tranches:
- Tranche 1: Received when the company is found and successfully acquired
- Tranche 2: Vests over time (approx. 4-5 years), as long as the principal remains employed by the company
- Tranche 3: Vests when performance benchmarks (such as internal rate of return targets) are met
While managing the company the principal receives a salary of course, in accordance with standard executive pay in the industry of the target company.
A solo principal may end up with 20-25% equity in this way, whereas it is rare for a pair to be granted more than 30% combined, so partnering with another entrepreneur does come at an equity cost. The authors note that it is common for the investors to receive a preference of some kind over the search fund entrepreneur, ensuring that their investment is repaid, usually with a return, before the principal receives anything. So only in the event of the successful growth and sale of the business will the principal benefit from his or her equity stake.
If things go as planned young manager can own as much as 25% of the company within five years
The search fund asset class is a fascinating one, providing an unusual but much-needed solution for all three parties in an M&A transaction: investors, entrepreneurs and the sellers of large private companies. Hopefully we will see more activity from these vehicles in Europe and across the world in future.
Our new infographic summarises the key issues from both the buyer's and the seller's perspectives.
One of the most important choices when buying (or selling) a business is how to structure the sale. Both buyers and sellers will need to understand the implications of this.
Download our infographic on this topic here.
Business sales can be structured as either the sale of the company itself (i.e. the entity, usually a Limited Company in the UK), or the "business and assets" of the company, meaning that the buyer does not take on the entity itself but simply purchases some or all of the assets from the company. The former is known as selling all of the outstanding share capital of the company, or the "shares", and the latter is known as selling the "business and assets" or simply the "assets".
The choice of whether to sell (or to buy, from the buyer's perspective) the whole company or simply the assets is an important one. It is multifaceted and should be addressed on an case-by-case basis under the advice of legal and accounting professionals. But many of the principles apply to all buyers and sellers of businesses in the UK, so we have captured these principles in an easy to follow infographic.
Small business investors have to be able to value businesses themselves, since comparables usually do not exist.
Most people have come across classified listing sites like Businesses for Sale or Daltons (or BizBuySell in the US), when searching for a business for sale. Whether the listings are placed by brokers or the owners themselves, they share one thing in common: they are advertisements, and naturally will be trying to paint the business in the best light.
Other marketplaces, like the ones for homes and cars, have sufficient liquidity that market value can usually be determined within a fairly accurate range by simply comparing the prices of similar listings. One Toyota Prius is, after all, much like another. By filtering by age, mileage and features on Autotrader, one can get a very good idea of what the appropriate market price should be for a specific car.
Small business marketplaces are not like this – each business is so unique that there are usually no close “comparables” like with real estate and cars*. Many of the listings will not have an asking price, and the ones that do might not bear any relation to reality. Brokers very often over-price businesses, while owners who write their own listings might also have unrealistic price expectations. On the other hand, some businesses change hands for less than they are worth, representing a bargain for the buyer.
So how do you as an investor tell the difference between an over-priced business and a bargain? With no comparables available, you must be able to make your own judgement about what should be an appropriate valuation. There is literally nothing else to use for guidance in most cases, short of hiring expert help.
This is why small business valuation skills are so important. If you can weigh up the factors that will affect how much a business is worth on your own, you will be able to scan and filter opportunities much more quickly than if you had to ask advice for each one. With your own system in place for evaluating businesses, you can quickly determine your level of interest in each one and make a judgement as to its potential as an investment. Being able to attribute an initial valuation to each business is a critical part of this.
This principle is true regardless of where you find a business for sale. Besides the classified listing sites, you might come across an opportunity via word of mouth in your own network, from a customer or supplier, from an insolvency practitioner, or even from Facebook. In every case, you still have to be able to gauge the initial attractiveness of the opportunity yourself, before deciding whether to investigate the opportunity further.
Most investors have to scour hundreds of opportunities before finding the right business. This takes time, and anything that can be done to accelerate this process is valuable. No one has the time (or money) to ask their accountant and lawyer about every single opportunity they come across, just as no one would ask their mechanic to take every car on Autotrader out for a test drive. The initial evaluation must be done by the investor.
Searching for a business will never be as simple as searching for a property or a car, but with an understanding of the principles of business valuation the process is much quicker and easier.
If you would like to learn how to value small businesses, download our free eBook now!
* For larger businesses, comparables are easier to find. The PERDA database, for example, shows the price-earnings ratios of companies that have sold recently in the UK, with an average enterprise value of £21.4m in the most recent survey. There is no such database for smaller companies.
The franchise resale market can allow you to peek into your possible future.
If you think buying a franchise is a safer way to enter the world of business ownership for the first time, you’re right… kind of. With an experienced franchisor there to guide you, and a product or service with proven demand, much of the initial start-up risk is removed.
But this comparison isn’t entirely accurate. Buying a new franchise isn’t really buying a business – it is buying the right to start a business. The purchase price is usually a combination of a franchise fee paid to the franchisor, and start-up costs including capital equipment. The business itself will be starting from zero sales, and you will have to build it up, just like starting any other business. Going down this path with a franchise rather than a non-franchise business is less-risky, as statistics show. But it is still starting from zero.
Buying an existing business, on the other hand, means starting from a position of greater than zero: a running start. With existing customers, an existing brand, staff, systems, equipment & trading history, the future performance of the business is easier to predict. Even those things the business is not doing can present an opportunity – “fixing” these issues can provide much-needed quick wins in the early days after taking over. A new business has no such quick wins available.
But buying a business without the guidance of an experienced franchisor can feel lonely. Often there is no playbook to work from to help the new owner decide what to do next. And businesses that are already very successful, where a lot of the start-up risk and effort have been removed, will be expensive to buy.
There is a third way: franchise resales. When a franchisee wants to exit his business, selling it on to a new owner is an attractive first option. As a result, hundreds of franchise resales are advertised on business for sale websites at any one time. Buying an existing business which is also a franchise can provide the best of both worlds: reduced risk and less work than starting a brand new franchise business, plus support from the franchisor and franchise network. Franchises naturally come with restrictions that other businesses don’t have, with the franchise agreement dictating aspects of operations from marketing to sales to administration. And while the up-front franchise fee for new franchisees is usually not applicable, the ongoing franchise management fee (usually a percentage of sales) will still be payable on an ongoing basis.
There are a multitude of factors that determine which is the best business to buy (franchise resale or otherwise), but the purpose of this blog post isn’t to go into these. There is another very specific reason for investigating franchise resales: they provide a look into the future for prospective purchasers of new franchises.
There is another very specific reason for investigating franchise resales: they provide a look into the future
Invest With Your Exit In Mind
Before buying any business, you must have in mind the goal of eventually selling it. Unless you intend to hand it over to your children, the ultimate goal must be to build up the business and sell it for a price that gives you a great return on your investment. By speaking to franchisees who have already reached this stage, you will get important insights into how this process could work for you. On the other hand, it can sometimes be a very sobering experience.
So if you’re considering buying a new franchise, it is imperative that you conduct research on resales of units of the same franchise. The first thing to look for is how saleable the franchise is. Does there appear to be a lot of demand for it? Are there many units for sale, and do they appear to be turning over quickly? Business for sale websites don’t provide data of successful and unsuccessful sales so it is difficult to know for sure, but the length of time businesses are advertised can provide some initial indication. If there are a lot of units for resale, they are staying on the market for a long time, and some are offering price reductions, this is not a great initial sign.
The prices of the franchise resale units are also telling. Successful businesses should sell for a premium to the purchase price of a new franchise, yet in many cases the prices are similar. For existing businesses the price calculation can be more complicated than a new business, with adjustments to be made for stock, working capital, assets and deal terms, among other things, as we cover in our free eBook on business valuation. But the headline asking price figure will provide an initial comparison, before you delve into the details in your discussions with the seller. It might turn out that the business has been priced incorrectly by the seller and represents a bargain, or it could be that the low asking price is simply because the owner can’t attract a buyer at a higher price. If the latter is due to something specific about this particular franchise unit (its location for example), and you have reason to believe you can do better, then it might not put you off buying a new franchise and doing things differently to avoid this problem. But it might also suggest that the reality of running this particular brand is different to the picture presented in the franchise prospectus by the franchisor.
It is definitely worth getting both sides of the story
Remember that franchise units that are struggling may not be representative of the franchise as a whole – by their nature, those ones that are for sale for low prices will generally be the lower-performing units in the network. The franchisor will be able to introduce you to more successful franchise unit owners who can provide a counterpoint to this. But it is definitely worth getting both sides of the story.
Highly profitable franchise units do come up for sale too of course. While these will attract more interest and a higher price, the additional investment will often be worth the money. In these cases you are not only buying into the systems provided by the franchisor, but the proven successful systems used by the high-performing franchisee – the truest example of what franchise sellers like to call a “turn-key” operation.
However, while marketing phrases like this will abound in the brochures for new franchise units, in most cases there will be no such hard-selling from the franchisor in the case of franchise resales. In many cases the franchisee will be largely responsible for selling the franchise on the resale market himself, without a great deal of support from the franchisor, who is not financially incentivised to help since there is no franchise fee paid on these sales.
The Franchisor, Not Just the Franchise
It is very worthwhile to gauge the involvement of the franchisor in the resale process. Besides discussing everything with owner it is obviously critical to speak at length with the franchisor, who you will be in business with should you proceed with either a new franchise or the purchase of a resold franchise. Besides the details of the business, what should look for here is the willingness of the franchisor to support resales of the franchise units. Does the franchisor actively market resale units to new buyers? Or are they only interested in selling new units? Make enquiries directly to the franchisor (under a different name for anonymity if necessary), asking about franchises for resale, and gauge their response and the process that follows.
Some franchisors will be very supportive of the secondary resale market for their franchises and will do everything they can to assist the franchisees who are selling. Other franchisors will be less than helpful with the entire process – mainly because it distracts from (and competes with) their primary objective of selling new franchise units.
Anything that makes it more difficult for you to buy an existing resale franchise unit will make it more difficult for you to sell it in future
Some franchises are structured in such a way that the buyer of a resold franchise unit still has to pay the initial franchise fee to the franchisor, as if they were buying a new unit. It is normal for the buyer of a resold franchise to have to pay a training fee to the franchisor for the initial training they will require, but charging the full initial franchise fee is excessive. This significantly raises the total price of the transaction to the buyer, without any benefit to the seller, thereby dramatically reducing the likelihood of a successful sale.
Franchise agreements also often contain the “right of approval” whereby the franchisor must provide their approval for a franchise to be transferred to a new buyer on the resale market. While not often exercised, these clauses can prevent you (or anyone else) from buying the franchise.
Anything that makes it more difficult for you to potentially buy an existing resale franchise unit will make it more difficult for you to sell the franchise unit in future, and warrants great caution before proceeding with the purchase.
In some cases you may be considering a franchise where there don’t appear to be any units available for resale – in cases like this it is worth investigating why. Some franchises, especially in business services, are so tied to individual relationships within the franchise network that it is not feasible to sell them to an outsider, which means effectively they can’t be sold at all. We once asked a leading UK business services franchisor what happens when the existing franchisees are ready to retire, and he explained that they have the option to sell their current ongoing work to the other franchisees (note: not a multiple of their annual work, only the projects that are still open and haven’t been completed yet), and only at a rate of £0.75 on the pound. This is not selling your business, it is simply subcontracting out your work. It is important to be aware of this eventual outcome in advance.
This is not selling your business, it is simply subcontracting out your work
Before purchasing a new franchise, always investigate resales of the same franchise. Not only will you gain insights about the real-world successes and failures of franchisees, you will gain an understanding of the franchisor’s approach to the resale process, and ultimately the saleability of your own franchise unit when the time comes. If you find a business that you are confident you can build and eventually sell, you can proceed with the rest of your due diligence and complete the purchase. Your final decision might be to proceed with a new franchise, to buy an existing franchise within this brand, or not to proceed at all. But without doing this research it is difficult to make an informed decision on any franchise, new or resale.
In the first post in this series we looked at debt financing. Borrowing money has its advantages, but it also has disadvantages. Loan repayments increase the fixed costs of a business, thereby increasing its risk and the volatility of its returns. For this reason, entrepreneurs are often reluctant to leverage a business to too great an extent, and decide not to borrow to the absolute maximum level. In other cases the entrepreneur may simply be faced with the reality that all available debt financing + entrepreneur’s own funds will fall short of the required purchase price. In this case the entrepreneur can seek equity investment for a proportion of the funds. This means that he or she gives up an ownership stake in the business to an investor in return for money. This investment doesn’t add any debt to the business and no interest is payable, but the entrepreneur’s proportion of ownership in the business is reduced.
Sources of Equity Financing
Not counting family & friends, it is more difficult to find equity investors than it is to secure debt financing for a business purchase. But there are options available depending on your circumstances and the nature of the deal you are seeking to finance.
Private Sector Investors
Firstly we should rule-out a few options. Many private investors prefer to make equity investments into start-ups rather than funding the purchase of existing businesses – this is certainly the case for most angel investors. This preference is driven not only by the tax incentives offered to them via the Enterprise Investment Scheme (EIS) for these kinds of investments, but because of the return they hope to make. Typically they will invest in a large number of start-up businesses expecting to lose money on almost all of them, with success in only one or two outweighing the loss in 20-50 others. The huge (5,000-10,000%) returns required by these investors makes them more suited to risky start-ups aiming at moon shots, rather than investors targeting the purchase of only one or a few businesses.
Equity crowdfunding is a relatively new investment class where many individual investors each contribute smaller amounts than a typical angel investor (investments can be as low as the hundreds of pounds), in exchange for equity. But like angel investing, this investment class is aimed at funding the growth of start-up businesses, rather than funding the purchase of a single business.
Private equity firms do invest in the purchase of a single business, with the intention of increasing its profitability and (typically) selling it again within a few years. They also fund a type of deal structure known as a roll-up: this is the acquisition and combination of multiple businesses with the intention of selling the larger entity (sometimes by listing it on the stock exchange). However, in both cases the deal values are usually in the tens of millions of pounds and upwards – private equity investors are not interested in small purchases.
There is a private equity structure that is suitable to entrepreneurs looking to purchase a business, but it is rare, especially in the UK: the search fund. These funds will back an entrepreneur with a plan to buy an existing business, by providing funds in exchange for equity in the business. In some cases they will even pay the entrepreneur a salary during the search process, which can take up to two years. An entrepreneur might find a suitable business in the £2-10m deal value range, with the intention of funding 70% with debt and 30% with equity. In brief, the search fund will provide the equity financing for the 30% not financed by debt (and not financed by the entrepreneur’s own funds), in exchange for equity in the business. This equity stake will usually outweigh the entrepreneur’s own stake, but it will allow the purchase of a large, stable business that the entrepreneur would not have been able to buy on his own. Unfortunately search funds are still relatively uncommon, even in the US, and much more so in the UK.
If you can’t raise sufficient funds for the purchase of a business yourself, you can consider taking on a business partner, each contributing funds and sharing equity. Like other equity financing sources, this route involves sharing ownership in the business. But unlike passive equity investors (including early “friends and family” investors), a business partner will be working in the business with you – contributing their labour, not just their money. Obviously the choice to take on a business partner involves many more considerations than simply sharing cost, risk and equity. For many people the idea of sharing control with a partner is unthinkable, whereas those who are actively looking for a business partner have the challenge of finding the right person. But in some cases this can be the most successful way to take over a business, both from a funding perspective and in terms of actually operating the business after the purchase.
The best examples of successful partnerships acquiring businesses are often management buy-outs (MBOs), where senior employees at a company acquire the business from its owners. In these cases it is typical for more than one partner to be required to raise sufficient funds for the purchase. But more importantly, these executives will have had experience in working together already, and will have a clear understanding of how the roles and responsibilities will be divided following the takeover. With an existing track-record of already managing the business, and a clear plan going forward, these investments present relatively less risk to outside investors and are often able to attract both debt and equity financing.
Reality: Combined Funding Sources
Most acquisitions are funded by a combination of sources, which can include both debt and equity. The actual breakdown varies depending on the individual circumstances of course. The best case scenario for the entrepreneur is to be able to fund the business entirely with unsecured debt at a low interest rate (with the entire purchase price dependent on an earn-out in the dream scenario). But in reality this is usually not possible, especially for larger investments.
For example, the purchase of a new franchise with a total price of £45,000 might be funded with £15,000 of the entrepreneur’s own funds and £30,000 in unsecured borrowing from one of the major banks. On the other hand, a £500,000 acquisition might be structured with 50% payment to the seller at deal closing and 50% over the following 24 months, subject to an earn-out. The entrepreneur might fund this with £100,000 in cash (eg: from selling an investment property), a £150,000 secured loan against the fixed assets of the target company, a £150,000 mortgage against his own home and £100,000 in earnings from the business itself over the following 24 months, assuming the earn-out milestones are reached.
In another scenario, an entrepreneur might be able to raise £30,000 of a £100,000 purchase price via unsecured debt. Her family members might contribute £20,000 as an equity investment (for 20% of the business*), or this might be a loan. The vendor has agreed to an earn-out arrangement where £25,000 of the price is based on performance over 12 months, but he insists on seeing “proof of funds” in advance, meaning that she cannot rely on paying this proportion simply out of the earnings of the business. The final £50,000 could be funded by an equity release loan against her home, structured in a way that allows the funds to be drawn gradually. This way she can draw down £25,000 from this loan at deal closing in order to pay the full £75,000 up-front payment to the vendor, who will be satisfied that she has the remaining £25,000 funds available to pay the outstanding balance in a year. She would only draw down the remaining £25,000 (or part of it), if she needs to – preferring to use earnings from the business to pay the outstanding amount to the vendor if possible, assuming all milestones are met.
These examples are over-simplified – the exact details of the deal matter enormously and the deal terms require careful attention from finance and legal advisors – but the principle is to illustrate some combinations of financing sources that would be used to structure these deals.
While there are multiple sources of equity financing in the market, most of them are not suitable to the acquisition of a business. Search funds, which we will explore in more depth in future, are an outstanding option for those few highly-qualified (and well-connected) entrepreneurs able to access them. But the majority of equity investments come from partnerships and passive equity investments from friends & family of the entrepreneur. Since debt financing is not unlimited, equity investments are often essential for the entrepreneur and can make the difference in successfully funding a business purchase. Equity investments come at the cost of shared ownership (and sometimes other contractual obligations), but they can make possible a purchase that would otherwise have been out of reach.
* In the case of an equity investment, the exact amount of equity purchased is open to negotiation of course. We used 20% for simplicity, but a case could be made that since the entrepreneur herself is only risking £50,000 of her own money (since the other £30,000 loan is unsecured, ignoring the impact on her personal credit rating for now), then the family members’ investment represents two-sevenths of the risk and therefore they should receive two-sevenths of the equity, or 28.57%. Alternatively the cash injected by the investors could be considered to be additive to the value of the company, making it worth £120,000, which would reduce their proportional ownership. The entrepreneur could claim that the company is actually worth another amount unrelated to the purchase price (eg: a valuation of £200,000 including their £20,000 cash, which would suggest a 10% ownership stake). All of this can be negotiated. The terms of the agreement governing this equity investment also matter enormously, as stated.
Buying a small business can be a life-changing investment. Everyone has different goals when they set out: some people are looking to escape the 9-to-5 “rat race” and work for themselves, and are looking for a business that will provide a secure income with rewards based on their own work. Others are looking for a business that they can build into an asset that operates without them. Some investors are looking for a larger business with more scale.
The type of business you are looking to invest in, and the size of the investment, will determine the financing options available, but all of the options can be categorised fairly simply. At the most basic level the funds for the business can only come from two places: (1) your own funds, or (2) someone else’s. The latter will be the basis of this 2-part blog post.
All of the options for raising external funds for a business purchase can in turn be categorised into either:
• Debt financing
• Equity financing
We would be remiss not to mention “family and friends” as a source of financing: after all, they may be among the most supportive financiers, providing either debt or equity financing (or both). But for the purposes of this post we will assume they have already been considered, and we will move on to other options.
The financing options that people usually think of first in relation to small business investment all fall under the category of debt – in other words, borrowing the money. Debt financing allows the entrepreneur to invest money now and pay it back later, hopefully making a profit in the meantime which is greater than the cost of the debt (the interest). It allows a greater investment than would have been possible without the loan, and therefore a greater potential return for the entrepreneur. Borrowing money to leverage a higher return on investment is such a routinely recommended strategy that the phrase “other people’s money” (shortened to OPM) has become part of the business lexicon.
Loans generally take two forms:
- Secured loans (where assets are used to give assurance that the loan will be repaid)
- Unsecured loans (where the lender has no claim against any assets)
Unsecured loans are riskier for the lender of course, so they are given a higher interest rate. Usually the lender will insist that they are paid back over a shorter length of time also – these two factors together mean that the loan repayments will be much higher than for a secured loan over a longer time period. But if the entrepreneur doesn’t have any assets to borrow against (or doesn’t want to secure the loan using these assets), then unsecured loans can be useful.
There are a number of sources of unsecured loans. Depending on the size of the investment, unsecured loans would usually not be sufficient to fund a business purchase on their own, but if the entrepreneur has some funds available and only needs a smaller amount (eg: to fund working capital), unsecured loan sources can be valuable.
Secured loans are secured against assets – in other words, the lender can take ownership of those assets if the borrower defaults on the loan. But due to the lower risk to the lender, the terms are able to be more attractive for the borrower in terms of lower interest rates and longer payback periods.
Sources of Debt Finance
Business Loans from Retail Banks
The major retail banks all have active business lending facilities, and most will lend substantial amounts on an unsecured basis. Industry sources tell us that the standard limits for unsecured business lending for each of the following banks are as follows:
- Lloyds £20,000
- Barclays £25,000
- HSBC £30,000
- Natwest £35,000
But these limits are not fixed, and will be negotiated on an individual basis. Lenders are often willing to lend nearer their maximum level for franchises, especially those where the franchisor has operated for a long time in the UK and where there is a proven track record of franchisee success. They will only lend over the term of initial franchise agreement though. (It can be argued that buying a franchise is not really the same as buying a business, unless it is a franchise resale – buying a new franchise is actually more like starting a business – but this is a topic for another post).
Banks are willing to lend far greater amounts on a secured basis of course. As with unsecured loans, they are negotiated on a case-by-case basis and much depends on the business plan. But the loan amounts can be much higher, only limited by the security offered and the perceived risk to the bank. When buying a business that has a lot of fixed assets (like machinery or vehicles), the lender will use these assets as security against the loan. Where the business has freehold assets, the loan may be in the form of a commercial mortgage instead.
In some cases the lender will require additional security from the directors of the company that is buying the business, such as mortgages against their own homes. This security adds a lot of personal risk for the borrower and is not something we would recommend if it can be avoided.
The government’s Enterprise Finance Guarantee Scheme is designed to encourage banks to be more willing to lend to businesses, by guaranteeing 75% of the loan. The scheme applies to loans of between £1,000 and £1.2m, with terms of up to 10 years. Individuals are not eligible to receive EFG-backed loans, but companies are, and these loans can be used to acquire businesses under certain circumstances. If the purchase of the shares in the target company will provide a business benefit to the acquiring company (the deal must “add value”) then the loan will be eligible. The existence of the EFG scheme does not guarantee that a bank will approve the loan of course – the final decision is still up to the lender. But the scheme does reduce the lender’s risk, and can help to secure funding that would not otherwise have been possible.
In addition to traditional loans, banks offer other structures such as revolving lines of credit. These tend to be unsecured and as such usually have lower lending limits. They are useful for working capital but would not be used to finance the purchase of a business.
Personal Loans from Retail Banks
An often overlooked form of unsecured lending is the personal loan. Banks frequently have personal loan facilities where the purpose of the loan does not have to be stated. Instead of spending the money on personal expenses or blowing it on a holiday, the money can legitimately be invested into a business instead. Again the loan limits tend to be smaller, loan terms shorter and interest rates higher as per most unsecured lending, but this funding can be useful as a top-up to other funding sources if required. We would advise against using relatively short-term and high-interest options of course, unless lower-interest options have been exhausted.
Personal Credit Cards
Along the same lines as personal loans, but with even higher interest rates, credit cards are another possible funding option. Countless stories have been told of scrappy entrepreneurs financing a business using their personal credit cards. However, with notoriously high interest rates, this is a risky strategy.
Not to be confused with equity finance, “equity release” is a more attractive term for using your own home as security against a loan. There are many lenders who specialise in this kind of loan, and the major banks also offer this service. By taking out a mortgage against their own home (thus “releasing equity”), people can borrow significant sums and use this for almost any purpose they like, including buying a business. The interest rates offered are usually quite favourable since the loan is secured against property. However, this puts the borrower at significant risk, since their own home is at risk if the business should fail.
As stated above, we don’t advise entrepreneurs to use their own homes as security unless they have to – but the reality is that this is necessary in many cases because other funding sources are simply not accessible or won’t provide sufficient funds for the purchase, due to the individual circumstances of the borrower and the target business. If the entrepreneur is releasing an amount of equity that, in the worst case, they are comfortable with paying back via other means (by returning to employment, or selling another investment to pay back the loan), then equity release can be a useful way of raising a large sum for a business purchase, at a relatively low interest rate.
Newer lenders have entered the marketplace in recent years offering both secured (up to £5m) and unsecured (up to £500,000) loans to existing businesses. They claim to make decisions more quickly than the banks, and use lending criteria that are not as restrictive (allowing younger businesses and those with lower credit ratings to access loans). However, they tend to be focused on providing growth financing for existing businesses, rather funds for the actual purchase of a business.
The government-run British Business Bank has a list of platforms it recommends for finding alternative business finance – at the time of writing there are three (Business Finance Compared, Funding Options and Funding Xchange). These platforms are not lenders in their own right – they are platforms for finding lenders. The platforms will attempt to match you to either secured or unsecured loans, depending on your circumstances and requirements.
Some of the lenders on these platforms will be peer-to-peer lenders such as Funding Circle, which allow small investors to contribute to the lending pot and receive a portion of the returns on the loans. The result for entrepreneurs is another source of potential funds, with more aggressive lending terms than the banks.
Although the main focus for most of these lenders is business growth rather than purchase, many of them do offer acquisition finance. This is primarily for businesses acquiring other businesses: if you are already running a company and looking to acquire another, these lenders will consider funding the acquisition. But for entrepreneurs looking to acquire their first business, peer-to-peer lenders generally are not suitable.
A very important and useful funding option in the purchase of an existing business is for the seller of the business to agree to receive part of the payment for the business at a later date (or over a payment schedule). In this case the vendor is effectively lending the buyer some of the funds for the purchase. It is not uncommon for half or more of the purchase price to be financed in this way – especially for larger private businesses. In some cases the seller appreciates that it is the only way to get the deal done. The seller will be paid interest, just like any other loan, and depending on the agreed contract terms will sometimes have security over the assets. Also, since this payment method is not as attractive to the seller as an “all cash” offer (or an offer that is financed by some other lender, so that the seller receives cash), this may be reflected in the agreed price and deal terms.
Vendor finance is not to be confused with an earn-out, which is where the sale price is determined partly by the performance of the business over time. In this case a schedule of payments is agreed based on the achievement of pre-agreed milestones (such as gross revenue). If these are not met, the payment is less. An earn-out reduces the risk for the buyer, since at least part of the purchase price will be based on future earnings. It is obviously inferior for the seller, since it not only delays the payment (and is therefore technically a type of vendor finance), it has the potential to reduce the total payment. But it is very useful for the buyer. As long as the deal price and terms do not outweigh its benefit (with the seller demanding a higher sale price to compensate for the delay and risk), it can be a very useful form of financing.
Entrepreneurs looking to purchase a business do not have to fund the entire purchase themselves: extensive infrastructure exists to provide business loans of all types, both secured and unsecured. Debt financing has its disadvantages though, as we will see in our next post, where we will look at the other main source of deal finance (equity investment) and the way deals are structured using a combination of debt and equity financing.