Congratulations! You have received an offer for your business. It’s an exciting moment and testament to all your hard work over the years creating and scaling a business into the attractive prospect it is today. Unfortunately, there are a number of stages that one has to go through before this offer can be realised, and very often the number that is offered in the initial expression of interest is not the number that you end up receiving. This article looks at the key value drivers that are scrutinised and negotiated during financial due diligence, and which ultimately determine how much you receive from the buyers.
Stage 1: Is This Offer Right For Me?
The first question to ask yourself is: what do you want to achieve out of this transaction (financial or otherwise), and does this offer deliver? Does it accurately reflect the value of your business? Are you getting enough consideration on day one? How confident are you that it’s the best offer you're likely to receive? This is a significant decision, and if you haven’t already, it’s always worth speaking to an advisor who understands the sector and knows the market. They can discuss whether the offer represents fair market value and if it can be improved, either through running a process or by leveraging competitive offers. Your strongest negotiating position is prior to granting exclusivity; therefore, address any concerns regarding the proposed terms at this stage.
Stage 2: Due Diligence
Once the indicative terms of the deal have been agreed, a buyer will want to enter exclusivity, which grants them a period of exclusive access in order to conduct a comprehensive review of your company's financial, legal, and operational aspects. Due diligence (DD) is a challenging process for the seller, who must not only manage the day to day operations but also answer hundreds of questions from a buyer and their advisors as they cross examine the business. A skilled corporate finance advisor can help alleviate this burden by ensuring the buyer's inquiries are relevant and value-driven.
Below are some of the most common DD workstreams a buyer will want to conduct:
• Financial DD will scrutinise your historical accounts, forecasts, and assess the balance sheet to form a view on net debt and working capital (to be discussed later).
• Legal DD will examine contracts, intellectual property, and compliance with a view to assessing what sort of protections are required in the share purchase agreement (SPA).
• Commercial DD is the process of evaluating a target company's market position, competitive landscape, and growth potential to inform investment decisions.
• Tech DD is the evaluation of a company's technology assets, infrastructure, and capabilities to assess potential risks and opportunities in a transaction.
Stage 3: Negotiating the Levers of Value
There are effectively three financial levers which determine how much day one value flows to the sellers or remains in the business (i.e. goes to the buyers):
• Enterprise value
This is the number presented in the buyer's indicative offer letter, and is typically based on an EBITDA multiple (see our other article on how private businesses are valued). A buyer’s financial due diligence will assess whether this EBITDA number is the appropriate number to apply a multiple to, and they will often chip away at the price if they consider this number to be inflated or unrepresentative of normalised trading for the business. Eg. If there are any one off or non-recurring revenues or lower costs in the period in question.
• Net Debt/Net Cash
The indicative offer received reflects the enterprise value of the business on a cash free debt free basis. Financial due diligence scrutinises the target's balance sheet to determine the actual net debt (or net cash) position at the transaction's closing. This assessment adjusts the enterprise value to reflect the real financial obligations or liquid assets the buyer will inherit. For instance, higher-than-expected debt levels will decrease the equity value, while significant cash reserves will increase it.
• Working Capital
Alongside net debt, the indicative offer presumes a normalised level of working capital. Due diligence examines the components of working capital - inventory, accounts receivable, and accounts payable - to ensure they align with typical operational needs. Discrepancies, such as excessive inventory or delayed receivables, can indicate inefficiencies or hidden liabilities, leading to adjustments in the purchase price to reflect the true cost of maintaining the business's day-to-day operations.
The complexities of balance sheet treatment are extensive and outside this article's scope, but below is an example of a funds flow showing how the outcomes of these negotiations are set out, and thus how one goes from enterprise value to net equity value (i.e. pounds in your pocket).
For example:
The indicative offer stated an enterprise value of £10.5m which was based on an EBITDA of £1.5m and a multiple of 7x. The DD process and subsequent negotiations resulted in various adjustments to reflect the actual financial position of the company:
• Enterprise Value: DD highlighted that the founder who is stepping down wasn’t taking a salary, and thus to replace them would cost (£0.1m). This would need to be deducted from the EBITDA to get to a normalised number. As a result, the revised enterprise value was agreed to be £1.4m x 7 = £9.8m.
• Net Debt/Cash: the DD process revealed the business has £2 million in debt and debt like items, and £500,000 in cash. Therefore, net debt is £1.5 million (£2m - £0.5m). This amount will be deducted from the enterprise value.
• Working Capital: The agreed normalised working capital over a 12 month period is £1 million. However, the due diligence shows the current working capital is £1.2 million. This means the business has £200,000 more working capital than agreed, and this amount will be added to the enterprise value.
EV to Equity Bridge Table:
Enterprise Value (Adjusted): £9.8m
Less: Net Debt -£1.5m
Plus: Working Capital Adj. +£0.2m
Gross Equity Value £8.5m
£8.5 million represents the gross equity value before fees and taxes, and which would be distributed to the shareholders in accordance with their ownership.
Stage 4: Further Adjustments and Considerations
• Completion Accounts: Depending on the closing mechanism employed, completion accounts may be drawn up after the transaction is completed to finalise the working capital and net debt calculations. This can lead to further adjustments.
• Escrow Accounts: Buyers may request an escrow account, where a portion of the purchase price is held back for a period to cover potential warranty claims or other liabilities.
• Earn-out or Deferred Consideration: If an earn-out is agreed, a portion of the purchase price will be paid based on the future performance of the business, or deferred until a future date.
• Transaction Costs: Legal, advisory, and other transaction costs will reduce the final amount you receive.
• Tax Implications: The tax implications of the sale must be carefully considered, as they can significantly impact your final take-home. It is highly recommended that a tax professional is consulted.
Stage 5: Advice on Maximising Returns
• Engage Experienced Advisors: A skilled corporate finance advisor and legal team are essential to navigate the complexities of the transaction and protect your interests. Experienced advisors often provide value exceeding their cost, while also reducing the stress and workload associated with the transaction.
• Thorough Preparation: Maintaining momentum is crucial for a successful transaction. The more information you have available the more control of the timeline you have and the more competitive tension you can generate. Meticulous preparation ahead of diligence will minimise potential adjustments.
• Clear Upfront Communication: It is essential to be clear and honest about the performance of the business prior to entering exclusivity. Advisors will help emphasise the better features of the business and ensure that you are not leaving value on the table when presenting the business to market, but it is best to be upfront about issues so they don't come as a surprise later on during diligence. Remember the point of maximum leverage for a seller is prior to exclusivity. A buyer will be in a stronger position to reduce the price if they discover a material issue whilst in exclusivity when of all the other potential buyers have been excluded.
• Effective Negotiation: Being aware of the methods used by buyers to capture value is essential for securing favourable terms. Negotiating the enterprise value, net debt and working capital is complex, and experienced guidance is invaluable. Furthermore, negotiating as a principal can be more challenging than having an advisor advocate on your behalf.
Selling a business is a significant event. By understanding the process and seeking expert advice, you can navigate the complexities and maximise your final take-home amount. If you have received an offer for your healthcare business and would like advice on assessing whether it represents good value, or would like assistance negotiating any of the levers of value please contact us.