Exploring your exit options: Deal Structure and Valuations

Growing a successful business can often be a lifetime’s work. But what happens when you’ve realised your growth ambitions?

As part our Exploring Exits series, we are delving into the options available to business leaders wanting to plot out the best exit route for them, taking in companies of every size and sector.

In this article, Partner Simon Lewis explores the key points around deal structure and valuations.

Selling a business is a daunting prospect and the variety of ways in which a deal can be structured can be bewildering, but they all fall into a few broad categories. At an early stage, it is these categories that you should focus on, once you get further into a sale process your advisors can explain the nuances in detail.

Asset Sale v Share Sale

In an asset sale, the limited company sells its business and assets to the buyer. These deals are often favoured by buyers as they can avoid taking on unknown liabilities, but they do involve the risk of losing contracts and/or regulatory consents. But for Sellers they leave them with the complication of winding up the selling company in order to extract the sale proceeds and dealing with any liabilities that have been ‘left behind’.

A share sale is generally favoured by sellers as they are more straightforward and allow the sellers a ‘clean break’ from the company; they are also more straightforward from a taxation point of view. As a result, the majority of transactions with a deal value in excess of £1m are share sales.

Trade Sale v Private Equity

Trade sales are sales to buyers that will acquire a business with a view to retaining it for the foreseeable future (incorporating it into their existing business or as a new division). Private equity sales are to buyers who acquire businesses with the intention of selling them in a few years after growing their value (3 – 5 years is typical).

Full Exit v Roll Over of Shares

Sellers generally will not retain any shares on a trade sale, even if they continue to work for the business for a period after the sale. On a private equity sale, some or all of the sellers will normally ‘roll over’ some of their shares, meaning they will still be shareholders going forward. This means less cash is received on completion of the sale, but there is the potential to receive a greater sum overall by selling at the same time as private equity (after the business has further grown in value).

Cash on Completion v Deferred Consideration/Earn-out

It is becoming increasingly rare that all of the purchase price is paid on completion; some element of the purchase price is generally paid at some future point. This can be a simple deferral of payment (allowing a buyer time to generate the necessary funds and providing a fund to call upon if a claim needs to be made against the sellers) or may be an earn-out. An earn-out means some of the purchase price is calculated according to the performance of the business after the sale has completed. It allows a seller to be paid for the future performance they anticipate, but allows the buyer to wait and see if that performance is achievable before paying. Below you can see a table setting out the pros and cons of these options.

Valuation

Valuing a company is an art not a science and ultimately it boils down to how much someone is prepared to pay. Notwithstanding this, there are a few basic concepts in how a company is valued depending on the type of business it is.

Profits v Assets

A simple way of valuing a business is to add up the value of all its assets. In a company with relatively low day to day profits but high asset worth (such as a property development company) this can be sensible. But a simple asset valuation doesn’t work for the majority of companies whose value rests in its trading profits rather than physical assets. For those companies a valuation based on profits is generally more suitable.

Why not profits plus assets?

It is rare to see a valuation based on the profits of a company plus its physical assets. The general assumption is that the assets are necessary to achieve the profits, so there should not be any additional costs for those. The exception is for certain capital assets such a property; where value may be paid for the asset (or the asset extracted from the company as part of the sale) provided an adjustment is made to the profits of the company (such as deducting a sum in lieu of the rent that would be payable if the company didn’t own the property).

What is EBITDA?

For many business owners, profit is measured in how much money is left at the end of the year to either take as dividend or invest back into the company; it means that factors such a corporation tax rates or borrowing costs are relevant considerations. For the purposes of a valuation, however, a company’s profits are normally expressed as ‘EBITDA’ which stands for Earnings Before Interest, Taxation, Depreciation and Amortisation. The aim is to get to the bottom of just what the core trading profits of a business are before accounting adjustments are made.

Maintainable EBITDA

The key for any valuation is what the EBITDA will be following the sale once any quirks in accounting treatment under the existing ownership are removed i.e. what is the maintainable EBITDA. It is common for owners to work full time for a company but not take a salary (taking dividends instead). This leads to artificially high EBITDA as there are no costs for senior management; the EBITDA for valuation purposes will therefore be adjusted downwards to factor in the costs for senior management going forward. Conversely, the payroll may be bloated as family members are employed for inflated wages and would cost a lot less to replace; in such circumstances the EBITDA for valuation purposes would be adjusted upwards.

The ‘Multiple’

Valuations are often expressed as a multiple of EBITDA and multiples for companies in the same industry often follow the same trend. Industries which are in demand at a particular time (such as solar panel installers in 2011/12) will have higher multiples across the board, but it is not as straightforward as saying all widget manufacturers a valued at 3 times EBITDA. It tends to be a range for each industry, with companies perceived as low risk and/or high growth potential tending to achieve multiples towards the top end for the industry.

Cash Free/Debt Free

As well as paying the purchase price, a buyer will take the benefit of any cash in the company and/or the burden of any debts owed by the company. As a result most valuations are given on a ‘cash free/debt free basis’ so that the actual price paid for the company will factor in the cash/debt position. For example, a company’s underlying business may be worth £5m, but if the company has net debt of £3m the buyer will only pay £2m to the seller (as it will be taking on/paying off £3m of debt).

Simon Lewis a Partner in Brabners’ corporate team. He handles issues such as corporate acquisitions and disposals, corporate restructuring and shareholder agreements, alongside more general corporate strategy and support.

He also helps to plan transactions alongside corporate finance teams and often acts as a bridge between clients and their other professional advisers – especially in the area of tax planning.

If you would like to discuss any of the points raised in this blog, please contact Simon and he would be happy to assist.

In the next article in this series, corporate solicitor Mairead Platt will focus on all issues around the preliminary stages.