This article is intended for all business owners considering selling or more specifically those desirous of optimising its exit value prior to going to market. All businesses- irrespective of its size and activity- could benefit from this stepped approach of formalising and systematic compliance improvement program.
The Price to Earnings ratio (P:E ratio) and Nett Discounted Cash Flow (NDCF) methods are some of the most important and most commonly used methods applied by the market to establish the value of a business. I wish to use an example of a business that earned an average profit after tax of R5,0m to its shareholders over the past 3 years. I then use the relative degree of formalisation and governance of the business to demonstrate what effect this could have on the same business.
- At the bottom. Sole Proprietor:
These businesses often offers buyers little or no ability to verify its profitability. It perhaps has no accounting system and keeps few or no accurate records. It even sometimes has no bank account. Money in, money out. The selling price of this type of business typically ranges between a 6 and 9 months multiple of the profits and could there only achieve as little as R2,5m selling price to our business in mentioned example.
- Step 2: Close Corporation with annual financial statements.
These statements are most commonly not reflective of the actual profits and commercial activities of the business and as a result requires a large degree of investigation and explanation. This category makes up a very large percentage of small business transactions of which 1000’s are recorded every year. The majority of transaction takes place at a price to earnings ratio of between 1,5 and 2,5 years multiple of the profit. (R7,5m – R12,5m for the business in our example). The range remain big as many other factors such as risks and sustainability would establish if the buyer is going to pay on the lower or higher end of the spectrum. Remember that the range as indicated also reflect the norm and that there are many examples of both higher and lower prices achieved.
- Step 3. Registered Company with annual review.
The gap between Step 2 and Step 3 has narrowed or almost closed when the recently amended Company law determined that an annual audit was no longer required for companies. The general perception with all stakeholders in the market is however that a properly registered company enjoy a higher status and buyers would be prepared to pay a small premium and the prices achieved in our example increases to R10,0m and R15,0m.
- Step 4. Registered Company with audited financial
Having your financial statements audited by a reputable auditor is going a long way to instil confidence with your buyer which in turn result in higher prices achieved. Audited financial statements also present the buyer with a much increased chance of obtaining finance as financial institutions find it almost impossible to part with money based on creative accounting presentations. In addition to increased trust from buyers the seller also achieves a much increased buyer pool which in itself increases the purchase price indirectly. The cost of compliance to this step becomes much larger but it is highly recommended that any business with an annual profit after tax around R5,0m/a should at least achieve this level. The enterprise value in our example can now increase to between R15,0m – R25m.
- Step 5. Company with audited statements and properly constituted board of directors.
A board of directors can play a very important role with all matters of compliance, oversight and strategic direction of the company is considered. This step (together with step 4 to a degree) opens the market field for potential investors in the business who can secure a great source of liquidity and access to funds which can be utilised for strategies of expansion and to unlock opportunities which are inaccessible to smaller businesses. Investors could typically hold a position on the board and a non-executive compliance specialist introduced to secure a high degree of integrity to the business. The same business making R5m profit after tax could now be worth R30m – R35m.
- Step 6. Over the counter (OTC) and ALT X listed businesses:
The largest problem with small businesses is that there is no free trade of shares in the businesses. Step 1 -3 type businesses especially are very illiquid and could easily take 1- 2 years to sell. It is difficult to do a due diligence and almost impossible to secure finance. Only cash buyers with a very large risk appetite would ultimately transact. Any buyer and/or investor would also have to make a very large term decision before buying. OTC and businesses listed on the Alt X exchange on the Johannesburg stock exchange addresses this problem where investors can almost immediately enter and exit businesses of their choice.
Liquidity and lower risk as a result of full compliance as a minimum entry requirement makes it much easier for investors to buy- even without carrying out due diligences. The typical P:E ratio of these companies typically trade at 10 year multiples of their profit and the same R5,0 company is now valued at R50m. It must however be added that the cost of compliance would no longer justify the company only making R5,0m profit to have an OTC or Alt X listing. It is for this reason why many larger businesses consider mergers and acquisitions with other businesses in order to unlock synergies and to achieve the critical mass to consider these listings.
- Step 7. JSE Listed and internationally listed
These are typically the largest businesses we know in the local market and little has to be mentioned about them. The average Price to Earnings ratio on the Johannesburg Stock exchange ranged between 14 and 16 for several decades but has increased over recent years to a multiple of 19.73 where it is today! This brings the business in our example to a whopping R100m! The return on investment is only 5% per annum which is less than inflation. This situation was brought on by a very large injection of cash by all the largest countries in the world during the 2007 – 2010 recession which cash has been very difficult to withdraw again.
Once again: Business valuation is not an exact science. Don’t ever believe anyone that tell you he/she can accurately value your business. It is however very clear from the above what can be achieved when you take a single step in formalising your business.
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