MANAGEMENT MATTERS:

Valuing the Business

Our Management Matters series of articles examines different aspects of developing and running a profitable property management business. We invite subscribers to write in with their own experiences and views.

Every small business owner eventually needs to face the prospect of succession and realising the fruits of building up the business. In the previous articles, we looked at the process of starting, building and selling your business. In the final article in this series, Paul Ives explores the options and issues involved with valuing a letting business.

For many business owners, their ultimate ambition, having developed a healthy business, is to sell it for a sizeable sum, and go and retire early on the proceeds. "What's it worth?" is a question that almost every business owner asks himself many times throughout a career.

Of course, there is no simple answer - every business is different and it will also depend on prevailing market conditions, interest rates and finding the right keen buyer in the first place. At the end of the day, as every economist would say, a business is only worth what someone else is willing to pay.

That said, there are some rules of thumb and guidelines within the industry. According to Alan Thurlow, Director of Leaders, one of the well-known acquisitive letting agent chains based in the South of England, "Residential letting businesses are conventionally valued at a figure just above or just below one year's fee income. Strangely enough, this same yardstick is applied to dry cleaners and insurance brokers."

However, in the eyes of a purchaser, the value can increase dramatically if the business to be acquired can be run from  the purchaser's existing office because many of the overheads of the business acquired will cease to exist; examples are premises costs, advertising, and some staffing costs."

Graham Clarke, of Cambridgeshire based Ambassador Property Management has negotiated locally three recent acquisitions. "In the Cambridge market, with a strong rental sector, well-established and sound businesses have been changing hands for in excess of 1.5 times gross annual fee income. It will depend on the quality of the business, its management and the goodwill that goes with it".

In the previous article we examined Graham's own quality checklist. "So much depends on the quality of the business and its client base. If the business has been built on the basis of heavily discounted management fees, it does not leave much profit once salaries and other administration expenses have been paid."

Leaders, one of the better known acquisitive specialist letting agents, have developed a systematic approach in trying to establish a rate of return that any new acquisition will provide. Below, Director Alan Thurlow explains the five steps that they follow in determining what they should pay for a business:

1. Review the history of income; is it continuing to grow or has it become stable or reached a plateau? What opportunity is there for future growth?

2. Review the expenditure to estimate whether there would be any savings through synergy or any increases in costs, e.g. installing a Regional Director, resident locally.

3. We then have an adjusted profit and loss account and depending on our view of the market can draft some forecasts over a three - five year period.

Estimated profits will then be subject to deductions for:

• Depreciation of fixed assets
• Amortisation of goodwill
• Corporation tax

Only then will we see the true sustainable net profit and then be able to calculate how much we may pay for the business in order to achieve the rate of return that will justify the investment, and be acceptable to all our shareholders and our bank.

4. We are forced to deduct depreciation and amortisation of goodwill in our profit and loss accounts in order to comply to with current accounting standards.

5. Finally, we will look at the cash flow effects of an acquisition, including estimating the cost of any capital expenditure we are likely to incur. "Co-Director, Paul Weller and I go through the process for every acquisition we have ever made. The process is not designed to drive down a purchase price, but to establish a value that we can afford to pay and that will not draw our existing business down through an unwise
 nvestment."

Quality counts

"It goes without saying that the quality of the business may lead a purchaser to be more generous" says Alan Thurlow.

"Firms offering sharply reduced fee rates, which in turn often lead to a poor quality of service, will find few buyers, since a better quality acquirer will be unable to raise the fees without losing landlords."

Leaders say that only the most desirable opportunities with real growth potential can persuade them to accept a return on investment of less than 25% before taking into account the degree of risk, the cost of money and corporation tax.

Cashing in

Vendors should also take care to ensure that the consideration for the business is in fact going to be paid. Cash on completion is ideal. A significant portion of cash on completion may be acceptable if the balance is to be paid in the form of loan notes over a comparatively short period, provided that the loan notes are suitably secure, backed by a guarantee from the purchaser and the principals of the purchaser. While "earn outs" and conditional future payments may look attractive, vendors should take careful professional advice.

Graham Clarke of Ambassador Property Management (APM) says that inevitably, the buyer will want to introduce reasonable claw-back clauses to reduce his own risk. Clarke likes to spread some of the purchase price over staged instalments, some or all of which can be held back if breaches of the sale contract occur.

"In practice, this clawback facility is very useful to have in place and is usually used to cover mistakes/errors by the previous owner which are relatively minor - usually a only few hundreds of pounds - but also to prevent the previous owner poaching clients etc."
"Sometimes, we will negotiate a 'consultancy fee'" continues Clarke, "as part of the purchase package which retains the previous owner or key staff for a set period of time. This helps to keep them 'onside' and smoothes any transition pains."

Earnouts

The price that you achieve for selling your business will depend on the confidence of the purchaser in the likely level of sustainable profits going forwards. In a business such as property management, where a lot depends on maintaining good client relationships in terms of retaining the level of the business, and a purchaser may ask you to share some of this future risk in the form of an earnout arrangement.

An earnout involves payment to the owner (in addition to the cash lump sum paid at date of transfer) out of future trading profits. Also, where there is any concern over the likely level of future profits, or simply raising the asking price demanded by the owner, an earn-out can be a way of bridging the gap between the price you are looking for and the upfront price the purchaser is willing or able to pay.

Due Diligence

A programme of due diligence will usually occur before a contract can be signed, or a contract may be signed conditional on the purchaser being satisfied with the due diligence programme that he will wish to complete. This is a series of detailed checks to establish that the business contains no hidden liabilities or nothing else untoward that could affect the value of the business. Depending on the outcome of these checks, a potential
purchaser may revise the price offered for the business.

Business Valuation Methods:

There are a range of ways to value a business. Valuations based on multiples of future earnings and the capitalisation of future cashflows are the most common.

1. Businesses with a record of sustainable profits are often valued at a multiple of earnings.  Profits are adjusted for any unusual, one-off items to arrive at an estimate of "normalised" earnings. Smaller businesses are usually valued at a lower multiple than similar, larger companies - typically at somewhere between five and ten times their annual post-tax profit.
2. Mature, cash-generating businesses can be valued in a similar way but based on cashflow. Future cashflows are estimated and discounted - this is known as discounted cashflow.  Longterm cashflow is worth less than cashflow due shortly.
3. An asset valuation might be appropriate for stable businesses with significant tangible assets - property or manufacturing businesses, for example. Your starting point is the value of assets stated in the accounts - known as the "net book value". These figures are then refined to reflect factors such as changes in the value of assets or bad debts.
4. The cost of creating a business similar to yours can be used as a basis for valuation.  Costs could include buying equipment, employing staff, developing products, attracting customers, and so on. It may be possible to estimate this "entry cost" as a benchmark of your business' value. Of course, if the cost of entry is low there's little likelihood of your achieving a successful sale.
5. In some industries, there are established or rough rules of thumb for valuing businesses.  For example, the gross annual fee income, or number of properties managed by an estate agency.

A potential buyer may use more than one method to get a range of values for your business. In the end, however, any price will be a matter for negotiation.

Summary

Valuation of a business is not an exact science. To use the old adage, it is only worth exactly what a buyer is willing to pay - and this will depend on the quality of the business, prevailing market conditions, and finding the right keen buyer in the first place.

More information

Business Link - the Government sponsored business support organisation publishes information and guidance on buying and selling businesses:
(www.businesslink.gov.uk)

Selling your Business for all it's Worth Mark Blayney - Published by HowtoBooks (ISBN 1 85703 870 3)

Letting Update appreciates the assistance and inputs of Alan Thurlow of Leaders and Graham Clarke of Ambassador Property Management in the preparation of this article.