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Thursday, March 12, 2009

Wake Up to reality Founders and Investors

Time for a valuation reality check
Time for a valuation reality check

If you think your company is still valued at last year’s prices, then you'll need to think again. GrowthBusiness looks at what your business is worth in today's credit-crunched M&A market.

What a difference a year makes. Twelve months ago, vendors were desperate to find a buyer to get taper relief on a sale after Chancellor Alistair Darling introduced a capital gains tax rate of 18 per cent. Today, anyone looking to sell has a host of different and far more challenging problems to face.

Richard Glasson, CEO of marketing agency Gyro International, says: ‘People who have missed the boat of the last three to four years need a pretty good reason to sell at the moment, either because they can see their business model is running out of steam or they are staring in trepidation at their cash flow.’

That’s not a particularly attractive proposition for acquirers when protecting cash flow and margins are the main priorities. Mark Wignall, chief executive of Matrix Private Equity, observes: ‘The reason that so few deals are being completed, and why the pipeline is so thin for everybody at the moment, is that sellers aren’t selling unless they’re distressed.’

Well runs dry

The lack of capital resource from the banks has seen the funding for mergers and acquisitions (M&A) virtually dry up.

Graham Cunning, regional director of Scotland for acquisition finance at Clydesdale Bank, observes that deals are happening, albeit with a far greater degree of caution.

‘To be honest, I think the way a deal is being done now is how it should’ve been before. Perhaps that’s why we’ve got money and other [banks] don’t,’ he says breezily. ‘The process is not that different – it should involve a bank and a private equity house sitting down and conducting an assessment before an initial offer of funding. You’re probably talking an extra ten or 20 per cent on the time to do a deal.’

Using multiples of profit to price a business has always been a less-than-exact science and Cunning notes standard ratios have taken a tumble. ‘Typically, for deals up to £50 million, you’re probably only going to see three times earning before income, tax, depreciation and amortisation (EBITDA). It depends on the sector, but you would have been looking at four or five times EBITDA last year.’

Open for business

The good news is that deals are still going through. At Gyro, Glasson has overseen nine acquisitions over the past two years, seeing turnover rise to around £100 million. He says the company will be looking to make another couple of acquisitions over the next 18 months, with backing from a US-based private equity firm and a credit line with HSBC.

Chris Williams, a partner at Cobalt Corporate Finance, which specialises in mid-market technology, media and telecoms companies, comments that ‘deal volumes are down dramatically. I would say that they will remain so for straightforward M&A for at least another six months and probably for the whole of 2009.’ For good businesses with strong intellectual property rights and technology, Williams says deals remain on the table, especially as ‘there are a lot of corporates with good balance sheets in every sector who can acquire smaller businesses’.

'Egos will have to be put to one side'

For the latter type of disruptive, fast-growth company, surrounded by corporate suitors, ‘standard EBITDA multiples or price-to-earnings (p/e) ratios have never been relevant other than as a background context. If a company creates a new technology that unlocks a market worth £1 billion to a Microsoft-type organisation, it’s never been about a ratio’.

When it comes to less revolutionary types of businesses, Williams also warns against looking at earnings multiples to get a sense of value within a sector. ‘I think it’s one of the worst times in history to use a p/e ratio,’ he states. ‘The pace of change in the market has been so fast, we do not have perfect information.’

Glasson says the earnings multiples of Gyro’s listed competitors are ‘clearly a nonsense’ at the moment, so they couldn’t be used as a reference point when doing a deal in the private sphere. In an age where cash has become the equivalent of a rare mineral, equity will be the mainstay of many deals.

Previously, where a deal might have included 20 or 30 per cent of equity, explains Glasson, it’s more likely to be 50 or 60 per cent now. ‘We haven’t done any 100 per cent equity deals, and I’d be a bit cautious about doing them, but certainly there are lots of those around at the moment, I think.’

Smell the coffee

Adrian Alexander, a partner at professional services firm Mazars, observes that there is less ‘room for gamesmanship’ when negotiating a deal, and that now is ‘the time for realism’. He says: ‘If you had a deal conceived pre-September or October, holding the price and structure has been difficult. People on all sides need to take a deep breath and figure a way to do it. If someone was slightly reluctant or half-hearted, then a deal falls apart very quickly.’

Assuming interest in a deal remains, then the structure may be altered. ‘So what would have been an all-cash deal now involves a loan note,’ he comments, noting that he fully expects a rise in strategic alliances, joint ventures and, like Gyro’s Glasson, mergers with no cash exchanging hands, so that overheads are cut and equity shared. ‘Egos will have to be put to one side,’ adds Alexander.

Whereas debt may have been taken for granted in days gone by, Alexander observes that now it’s the first thing to be discussed. ‘All conventional rules have gone out the window as far as funding goes; you have to get the [backers] around the table early and see what their appetite is.’

Clydesdale’s Cunning says that ‘we’re in a twilight zone’ when it comes to expectations and pricing. The danger is to hold out for the types of prices being paid 12 to 18 months ago. Cunning explains: ‘If I was an entrepreneur, the conundrum I would have is: my business certainly isn’t worth what it was last year. But to be honest with you, last year’s value wasn’t really real. It might have felt real at the time, but we were right at the top of the cycle. So they now have two stark choices. They either accept £12 million or £15 million for a company that had been valued at £20 million, or they trade on for a period and hope the market picks up.’

That uptick in value may not occur for some time. Both Cunning and Wignall use the term ‘reality check’, saying entrepreneurs must adjust to a different, harsher economic order. No one is suggesting such a shift is easy, especially if you’ve spent the previous five or so years building up your business and felt you had everything in place for a sale.

For those management teams that are maintaining or growing market share and remaining profitable, the best option may be to keep focusing on the business. Some would argue that’s what you should be doing anyway.

Dan Conlon, founder of data storage specialist Humyo, doesn’t believe in exit strategies. ‘Businesses are there to make money and as soon as people talk about the value of users or the strategic value of technology, I get extremely worried. The best strategy is to build a product or service that people want and value and are prepared to pay money for. That encapsulates all the other strategic elements.’

Although only 28, Conlon can speak from experience, having sold his first venture for £5.9 million in 2004. His ambition for Humyo is undimmed by the recession and he is confident he can tap the ‘huge potential’ he sees in his business.

While an exit is the last thing on his mind at the moment, he is adamant that creating a profitable concern, by definition, makes a business desirable, whatever the macroeconomic environment. ‘If you have a business that is profitable, you don’t need an exit strategy. It’s entirely up to you what you do and when.’

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