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Selling A Business- Valuation

Business Valuation

Having spent time getting the business ready for sale the business owner will wish to extract as much value from the business as possible. There are many ways of valuing a business with some valuations based on a multiple of recurring income or possibly on gross profit generation but most use a calculation based on recurring net profits. Often a calculation is made of the recurring net profits of the business say over a three year period and a multiple is placed to this average of say between three and ten times the average profit depending on a number of factors such as:-

  1.  The position of the vendor in its chosen marketplace.
  2. The type of business being conducted with some industries achieving a higher multiple than others.
  3. What is happening in that particular marketplace i.e. is there consolidation or a particular appetite for acquisitions in the chosen marketplace.
  4. What is happening in the current economic climate.
  5. The appetite of the purchaser to buy that particular business.  It is possible the purchaser might be trying to grow his own business fairly quickly or expand in a different marketplace and may be inclined to pay a premium to achieve his aim.

The resultant figure using the average profitability and the multiple is termed as the goodwill of the business and the business usually adds the value of shareholders funds in relation to the balance sheet and adjusted for any changes in the value of assets shown in that balance sheet and for any hidden liabilities that do not appear in the balance sheet such as contingent liabilities and potential staff redundancies etc.

Depending on the parties the definition of net profit that is used in the valuation may vary but usually it is net profit before corporation tax and after adding back any excessive management remuneration (this is the amount being paid to the existing owner over and above what was agreed will be paid to a similar management team in the open marketplace) as well as any one off or abnormal item that appears either as income or a cost in a two year average under review.  Some valuation models also add back interest paid and depreciation which would give a higher average net profit that may affect the multiple being applied to the valuation.

It is evident however that whatever basis of valuation is used based on net profit, the higher and more consistent the profits are before sale the better the value.

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Selling A Business

My business is my pension” has been repeated time and time again by Business Owners over the years!

However, very few business owners build a business that is capable of being sold and even fewer achieve a sensible and rewarding price in the marketplace. There are many reasons for this and what is clear is that a business will have little value unless the business owner specifically builds a model that will be capable of a reasonable valuation and a business that would be attractive to other potential purchasers. There is another old adage which says “a business owner spends more time getting his car ready for sale than his business” and potential purchasers of businesses identify this time and time again as a very good reason why they lose interest in businesses or offer unacceptable purchase proposals.

It’s interesting that over 75% of businesses advertised for sale never go through to completion.

Some of the more common reasons as to why a business may not be saleable are as follows:-

  1. Unrealistic valuation by the vendor.
  2. Lack of profitability.
  3. Lack of a cohesive team within the business.
  4. Lack of reliable financial information.
  5. Evidence of a “lifestyle business” where family members and friends are employed or involved in the business who may prove to be difficult for the purchaser to remove.
  6. Absence of a unique selling point.
  7. Insufficient customer loyalty.
  8. Outdated pricing policies.
  9. Lack of taxation strategy which may result in the purchaser potentially being responsible for future taxation liabilities.
  10. Unattractive arrangements relating to business premises such as onerous leases and property commitments.
  11. Insufficient investment in modern fixed assets and information technology meaning that any purchaser would have to embark on a significant investment program to obtain the best out of the business being acquired.
  12. Onerous supplier contracts or outdated supplier and customer terms and conditions.
  13. Lack of liability on the value of major assets particularly stock and work in progress.

The list above although by no means exhaustive clearly shows there are major pitfalls for a business owner who does not plan to build a business that can be passed on to a purchaser as quickly and cleanly as possible whereby extracting the maximum value. The business owner therefore needs to “clean” the business and one of the advantages is that there is greater likelihood of more of the sales consideration being paid up front with less “deferred consideration” or “earn out” than a business that has not attended to all the relevant constituent parts that can affect the valuation.  A business valuation can also be enhanced if a business can be disposed of which operates completely independent from the business owner.  Many business owners attempting to dispose of their business are effectively trying to get the purchaser to buy the owners job and anticipate them paying the previous owner an income for several years.

How can a business owner enhance the value for the potential sale of the business?  Some of the most important matters to do that are as follows:-

  1. Take at least two to three years to get the business ready for sale.
  2. Demonstrate a reasonable position in the chosen marketplace.
  3. Demonstrate that reasonable gross profits can be generated in line with or exceeding industry averages.
  4. Demonstrate that business overheads are under control and in line with the bench mark in the relevant marketplace.
  5. Ensure that there is a consistent and if possible increasing profit record of at least three years before the intended sale.  Profit is generally accepted to be earnings before interest, corporation taxes, depreciation and any abnormal items.
  6. Ensure that all fixed assets are properly owned by the business, in use and properly valued.
  7. Ensure that all current assets, stock and work in progress, debtors and other amounts owed to the business are valued accurately or are collectable.
  8. Ensure that all current liabilities are fully disclosed in the accounts and that any potential liabilities, such as taxation and legal matters, are disclosed at an early stage.
  9. Ensure that all commitments to the crown such as Pay as You Earn, Value Added Tax and Corporation tax are correctly calculated and up to date.
  10. Ensure that there are no onerous restrictions relating to long term liabilities such as business loans, commercial leases, hire purchase contracts or equipment leasing etc.
  11. Ensure that terms and conditions with customers are reviewed and brought up to date.
  12. Ensure that all supplier contracts are reviewed and brought up to date.
  13. Ensure that all contracts of service for employees including directors are up to date with current employment law and fully adhered to.  Taking over existing employees often causes the purchaser great difficulty or can seriously affect the business valuation.

What is clear is that if a business is going to attract maximum value it needs to be presented to a potential purchaser with all matters as clean as possible and with the minimum of liability passing to the potential new owner. The potential purchaser will assess the transaction as relatively low risk and provided that he can see that there is potential in the market place and a reasonable profit stream he will then be happy to pay a price at a higher end of expectations.  Furthermore the vendor will have greater armoury for discussing the method of payment particularly the resisting further consideration for future earn outs as these almost always seem doomed to failure or end up in litigation.

It is also usual for the vendor of a business to indemnify the purchaser for any potential liabilities that may occur during the time that the vendor owned the business. It stands to reason therefore that if the vendor has spent a good deal of time preparing the business for sale, the likelihood of a major liability arising should be significantly reduced and therefore indemnities to the purchaser can be minimised.


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Selling A Business- Taxation

Taxation on a Business Sale

For many years in the United Kingdom there has been a system of capital gains tax which levies tax on profits made on capital sales.  There has also been for many years a system of relief designed to give a lower tax charge on the sale of business assets.

Never however has the taxation regime relating to the sale of business assets been more generous than at this current time.

Currently capital gains tax is charged at 18% for transactions involving basic rate tax payers and 28% for transactions involving higher rate tax payers. However if the sale of assets can be proved to be the sale of a business asset then the effective rate if capital gains tax is reduced to 10%. This method of calculating capital gains tax on business assets is known as “entrepreneurs relief”. Although there can be some complications in calculating the relief such as a sale that involves some business and some non-business assets, it is generally a relatively simple relief to understand. Basically if a UK tax payer has owned a business asset for at least twelve months then disposes of that asset and makes a capital profit then the tax rate is effectively 10%. This relief applies to the sale of shares in private trading companies, the sale of freehold commercial premises owned outside but used in the business provided that this asset is part of the business rather than merely a business asset or simultaneously when the business is disposed of. The relief however is not available to limited companies disposing of business assets and is only available to individuals.

Apart from the effective tax rate, one of the things that makes entrepreneurs relief so exciting is the fact that each UK tax payer has a lifetime allowance of £10 million as far as this relief is concerned.  What this means is that UK tax payers can individually create gains on the sale of business assets up to £10 million at an effective rate of 10%. By its definition as a lifetime allowance the relief is accumulative so that in theory a business owner could sell ten businesses over a period of time at a gain of £1 million each time and only pay an effective rate of 10% on each transaction. When you consider that the most successful business owners have personal tax rates are often 40% and in some cases 50%, it is clear to see the advantage of using the entrepreneurs relief wherever possible.

It is not a requirement that the business owner needs to sell the whole of the business in order to obtain entrepreneurs relief. It is perfectly permissible for a business owner to dispose of part of the business and take advantage of the relief but it does need to be an identifiable part of the business and not merely the sale of business assets.

It is evident therefore that whilst the current personal tax rates prevail in the United Kingdom, it makes absolute sense for any owner of business assets who wishes to dispose of some or all of these can plan a strategy to take advantage of entrepreneurs relief.

Note. Tax rates and relief correct at time of writing. Please check with your advisors to check on current taxation rates and reliefs.