Following the publication of the second edition of his book, The Valuation of Businesses and Shares, Des Peelo FCA shares his thoughts on best practice when it comes to valuing a business.
The approach to valuation has changed significantly since the first edition of The Valuation of Businesses and Shares was published by Chartered Accountants Ireland in 2010. A major change, for reasons explained below, is a sharper focus on the underlying product or service of the business; though the fundamental principle that a valuation is based on the right to receive future income (i.e. profits) has not changed. A valuation is a best estimate of what a likely purchaser might pay; it is not a removed theoretical concept. There are now many more business sales and share transactions.
Valuations, however, are significantly lower than the levels reached prior to the financial crash in 2008/09. There are no official statistics thereon; the author’s guess or estimate is that, in general, valuations are down by about one-third. This could be interpreted as meaning that business valuations were too high prior to 2008, rather than a current slump in valuations.
The key factor in making a valuation is ‘future maintainable profits’ (FMP). FMP is what gives value to a business, and the willingness of a purchaser to pay a multiple of FMP is what drives the valuation. The multiple is heavily influenced by a trade-off between expectation and risk, as to the likely continuity and/or development of the FMP.
‘Maintainable’ (i.e. an assessment of risk to future profits) now requires closer scrutiny. The previous assumption or approach in valuations, without closer review, that what went before in a business will steadily continue is long gone. There is scarcely a product or service that will have a life of more than five years without obsolescence, significant change in the market, technological improvement, or a new competing development.
‘Disruption’ has entered the lexicon of business, invariably associated with technology. Disruption means an unexpected or unorthodox intrusion that impacts a sector’s way of doing business or indeed the entire displacement of a product or service. This prospect or threat can, of course, create uncertainty as to FMP. All this has led to a sharper focus by valuation practitioners and potential purchasers on what is termed ‘commercial due diligence’ as it relates to the likely continuity of the product or service, separate and additional to customary legal and financial due diligence. This is explained below.
The ‘why’ behind lower business valuations
Multiples (or price-earnings) of FMP paid for medium-sized private Irish companies with good FMP were often eight to 12 times FMP (and sometimes higher) in the seven or eight years prior to the 2008/09 financial crash. Few Irish company sale transactions of a large size happened in the recessionary years following 2009. It appears that the few that happened (apart from rescues and restructurings) were valued at roughly three to five times FMP. It also appears that there is now a general willingness (and valuation practice) to pay five to eight times FMP for well-managed companies of a reasonable size with good trading performance, though this is said with caution, as the acquisitions market is still uncertain.
It can be difficult to attract a purchaser (remembering that a valuation is a best estimate of what a likely purchaser might pay) not necessarily due to lack of interest, but rather a possible inability of a purchaser to finance the transaction. It is evident in the marketplace and press commentaries that Irish and UK banks, with depleted capital resources and heavy regulation (particularly related to what was previously known as investment banking) are hesitant to finance private company share transactions. Lending practice appears to be largely directed to funding for investment and working capital within companies themselves, and not to financing transactions at ownership level. Similar to house mortgage lending restrictions, this hesitation has led to lower business valuations.
In contrast, large quoted companies have access to wider financial sources such as bond markets, investment funds, and other forms of subordinated finance.
The reality that many businesses – probably one half or more of medium sized companies – are likely not saleable has not changed. Erratic history, poor profitability, inadequate finances and uncertain prospects are the usual reasons. If FMP can be ascertained at all, even shakily, the multiple could only be maybe two to three times FMP. Otherwise, the business may be almost valueless, except for the continuity value to its owner as self-employment.
The tech trend
The years 2013-2015 encompassed several high-profile sales by Irish ‘tech’ companies, most originally funded by venture capital companies. The converse failure rate of Irish ‘tech’ companies is not known, though there were some high-profile failures. However, it is noted that there is now considerable ‘tech’ experience and expertise within Irish State support services as well as within experienced venture capital companies.
There is no doubt that the valuation of ‘tech’ businesses continues to cause difficulty for valuation practitioners, particularly in early life where the prospects are unclear or guesswork at best. The product or service, and the likely marketplace demand, can be difficult to understand and to measure in financial terms. Further, there is often the underlying possibility of a ‘one product’ business that quickly runs its course.
A noticeable trend in recent years is that of new businesses (not including ‘self-employment’ type businesses) being set-up in the expectation of an eventual sale. This occurs across a range of sectors, not just ‘tech’, and often involves venture capital. There is no timeframe but, in the author’s experience, a significant proportion of valuations and/or sales of businesses now relate to entities in existence for less than eight years, sometimes much less.
It is interesting to note that the Irish Venture Capital Association (IVCA) has stated that in the seven years from 2009 to 2015, more than 1,200 Irish SMEs have raised venture capital of €2.6 billion.
In this latter context of setting up for eventual sale, it is not always an outright sale of the entire business that is being pursued. Instead, it may be the sale of a significant minority shareholding (or even majority) to either ‘take cash off the table’ by the founding shareholders (often involving venture capital) and/or to finance the next stage of business development.
Selling and buying a business
A new chapter in the second edition is entitled ‘Selling and Buying a Business’. The valuation of a business is often a precursor to the proposed sale or purchase of a business. The valuer, acting for the seller or buyer, may be requested to assist or handle the process (though not necessarily to lead it as the corporate finance advisor).
This new chapter is not intended to act as a definitive guide to all aspects regarding the sale or purchase of a business. Instead, its purpose is to explain the steps necessary for a successful transaction, all of which likely started with a valuation. The Celtic Tiger days spawned a large number of business sale and share transactions.
Unfortunately, in the author’s experience, a number ended unhappily with professional negligence actions against solicitors and accountants. Too often, it transpired that the related legal and/or financial paperwork/due diligence was inadequate, and/or displayed a poor understanding of the processes involved; hence the new chapter ‘Selling and Buying a Business’ which covers lessons learned therefrom.
Due diligence
Earlier in this article, I referred to the sharper focus nowadays on commercial due diligence. In a proposed business sale or purchase, there are three levels of necessary due diligence. These are: legal, financial and commercial. Commercial due diligence may be the most important in valuation practice, although this is not always understood. As explained at the outset, the value of any business is in its future profits (i.e. value lies in the right to receive future income). These profits depend on the strength of the product(s) or service(s) of the business and its ability to sell to the marketplace. The valuation practitioner has to make an assessment in this regard by conducting commercial due diligence.
In terms of commercial due diligence, most industries or sectors – and the products or services involved – are likely easily understood by an experienced valuation practitioner. There is also now a wide range of information readily available to the practitioner at her or his desk. However, there will be circumstances where the practitioner should seek outside informed advice or expertise as to identifiable trends and developments in a particular sector. Many acquisitions have proved overpriced and/or have failed due to inadequate commercial due diligence.
In the six years since the first edition of The Valuation of Businesses and Shares was published, the pace of change and competitive pressures in almost any business sector has accelerated. Compliance and regulation, both in business and professional life, has greatly increased – much of it related to weaknesses exposed by the financial crash. The role and responsibilities of the valuation practitioner too has become more complex, though a focus on future maintainable profits is still what it is all about.
Des Peelo FCA is author of The Valuation of Businesses and Shares, now in its second edition.