This article was originally created for Hayes Knight (now Nexia Auckland).
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As business advisors we are often asked to complete key tasks in the merger and acquisition process. These tasks usually include undertaking due diligence for the purchaser and/or performing a valuation on the business.
Due diligence is about doing your homework – opening the hood and having a thorough look at all aspects of a business. By assessing key risks the due diligence process looks to confirm if your understanding of a target business is correct. It should be non-negotiable and the first item on your purchase checklist yet we still see prospective buyers not investing enough resource into this important task.
People undertake due diligence regularly when making purchase decisions, whether it’s where to go on holiday, buying a new vehicle or perhaps a new house. It is even more important to do your homework thoroughly when purchasing a new business, especially given the significant funds that are often involved.
When considering buying or selling a business, one of the first questions we are asked is ‘how much is it worth’? Ultimately it is worth what someone is willing to pay for it, but there is a lot of solid valuation theory and market data that we can tap into. Business valuations generally revolve around two factors – how much money is an owner likely to make from the business in the future and how much risk is associated with the business. The higher the perceived risk, the higher the return that an investor expects to receive. When people talk about businesses changing hands for a multiple, they are referring to how many years earnings a business has sold for. If a business is making $250,000 a year and sells for $1m, then it sold for a multiple of four and the investor is wanting a return on investment of 25%. A multiple of three represents a required return of 33%, a multiple of five represents a required return of 20% and so on. When valuing a business our role is to determine both the likely future earnings and the key risk areas that the business has.
So what trends are we seeing?
The last year has certainly seen stronger demand for good quality small to medium sized businesses. Generally buyers are astute and are getting the necessary advice. Because of this we are encouraging clients considering selling to get prepared early, well before putting the business on the market. Know what information is likely to be requested during a due diligence process and get it prepared and reviewed in advance. Have up to date, accurate reports and figures readily available. Prospective buyers can lose confidence easily, often when a number of small, almost insignificant items start to add up and cause doubts. In a recent case we saw a deal fall over simply because of a delay in being able to provide accurate current trading data.
We have also seen an increase in companies looking for bolt on opportunities. This involves acquiring a similar business then bolting on or adding the business onto the existing operations, while often stripping out a number of overheads such as rent and administration costs. Some industries are in also in consolidation mode. Demographics are driving activity as owners retire or wish to exit, resulting in fewer, larger players in the industry. This is occurring in the professional services industry in particular. In some industries smaller operators are being forced to merge together simply to survive, often due to either changing technology or cheap imports forcing margins to be reduced.
Businesses and investors are also looking at acquiring companies along the value chain. A supplier or associated business in a similar or related industry is often attractive as skills can sometimes be transferred and profits can be made at numerous stages along the process. As an example, we recently dealt with a construction firm that purchased a scaffolding business.
With the increased demand for businesses, we have seen an increase in the multiples that businesses are changing hands for, especially in smaller businesses. Buyers are willing to accept lower rates of return from a business purchase than they were two years ago. This is in part a reflection of the higher levels of business confidence that New Zealand is experiencing and also an increase in the number of people wanting to be their own boss through purchasing a small business.
Final thoughts
Remember, a due diligence doesn’t only need to happen which you are looking to sell. Many businesses have benefitted from going through an internal due diligence process, asking the hard questions and thoroughly examining all areas of their business. Making improvements and updating systems now not only results in a better sale price at a later date but often means more profit for the owner on the way through.
Likewise, a business valuation involves us examining many areas of risk that a particular business has. By identifying these risks, we can then work with business owners to reduce them. Lower risk equates to a lower rate of return that a purchaser would expect, so you can potentially sell for a higher multiple of earnings.
Hayes Knight has recently completed a large number of due diligence and valuation assignments from small businesses through to multi-million dollar companies with nationwide operations. We have significant experience in these areas and both our approach and reports are well respected by banks and clients alike.
If you are considering purchasing or selling a business and want to find out how Hayes Knight can assist you with the due diligence and/or valuation process, contact your Hayes Knight adviser or Brendon Cutler on 448 3236 or Tristan Dean direct.
Tristan Dean Business Advisory Director T +64 9 448 3231 E tristan.dean@hayesknight.co.nz
