Guest Blog: How to avoid an overvaluation when selling your business to an EOT

Sean Hackemann of Specialist Accounting Solutions Ltd

Transitioning your business to employee ownership is an exciting step, but legal and financial compliance is key.

In this guest blog, Sean Hackemann – Founder and Director of Specialist Accounting Solutions Ltd – explains the steps company owners should take to avoid an overvaluation when selling their business to an Employee Ownership Trust (EOT).

Please note: this article does not aim to explain the requirement for trustees to have taken ‘all reasonable steps’ to ensure the disposal does not exceed market value per TGCA 1992 (section 236H).

Understanding how your business is valued

Team SAS have been valuing businesses for many years [writes Sean]. During this time, there have been several instances where we have been asked to advise on situations where a business has been overvalued.

You could argue that, with the benefit of hindsight, it is much easier to say a business was overvalued and that the valuer could only work with the facts available at the time.

This type of argument does have some merit, but it only stacks up to a point, especially when the performance of the business over a longer historical timeframe is ignored.

To explain this in more detail, let’s cover the basics of how most SMEs who are considering selling to an EOT are valued.

The standard formula is:

A x B = C

whereby

A = Maintainable earnings, normally expressed as EBITDA (Earnings before Interest, Tax, Depreciation and Amortisation). Let’s assume the figure is £100,000.

B = EBITDA multiple. Let’s assume the figure is 5x.

C = Enterprise Value of the Business.

Note: For the purposes of this example and to keep things simple, we are ignoring any excess cash and/or net debt, which means the enterprise value equals the equity value.

Applying the above figures to our formula, would mean the business is valued at £500,000 (5 x £100,000 = £500,000).

What factors might influence your Maintainable Earnings?

Maintainable Earnings ('A' in our formula above)

Let’s take a look at the Maintainable Earnings. What factors, occurring in the 1 to 3 years leading up to the valuation, could potentially skew this number upwards?

There are multiple reasons why this might occur (and the list below is not exhaustive):

1.    A large and very profitable, one-off project

2.    A key customer, who placed multiple large orders, but reverts back to lower orders

3.    A product line or service, which was (or still is) highly popular, leading high demand, but competitive erosion is likely to occur

4.    The Covid pandemic, which increased the sales of most online businesses for a 1 to 2 year period.

The list above is not exhaustive, but we’re looking for situations that are outside of the norm.

If the most recent trading performance has been significantly uplifted by factors such as those above – and the profits are much higher than they have historically been – it’s tempting to take the view that this will be the ‘new normal’, especially when the individuals requesting the valuation are selling the business.

The key questions shareholders and owners should ask themselves are:

1.    Can we honestly assume that this trading performance will continue in the foreseeable future?

2.    How does the most recent trading performance stack up against the longer-term historical trading over (say) the last 10 years?

If the answer to the first question is ‘probably not’ and/or the answer to the second question is ‘we are doing far better than we done historically, but that’s an anomaly’, then you are potentially in the ‘Danger Zone’ of the business being overvalued.

My personal view is that most business owners would instinctively know whether the earnings used in the valuation are achievable in the long term.

The Earnings Multiple: what you should ask your valuer when selling to an EOT

'My advice is ask questions and get comfortable and close to the research used to derive the earnings multiple. Look at what has been presented and take a considered view on the facts'

Earnings Multiple ('B' in our formula above)

Note: most valuation reports use historical M&A transactions to identify a suitable EBITDA multiple, which is then applied to the business being valued.

Turning our attention to the EBITDA multiple, here are some basic points to consider that you should ask the valuer about:

1.    How has the valuer derived the EBITDA multiple?

2.    What (if any) comparable M&A transactions has the valuer used to derive or calculate the multiple?

3.    Did the comparable transactions occur in the last 5 years (as opposed to, say, 10 years ago)? Note: you should ask this because the older the transactions are, the less relevant they become.

4.    Are the transactions of businesses in a similar sector or similar business model? 

Note: you should ask this because using transactions of businesses that are significantly different to the one being valued means the multiple won’t stack up under scrutiny. 

Essentially, we are trying to understand the facts. Is the source data reliable and a realistic proxy for the business being valued?

My advice is: ask questions and get comfortable and close to the research used to derive the earnings multiple. Take a close look at what has been presented to you and aim to take a considered view on the facts presented by the valuer.

Time to repay the deferred consideration

When digging further into the multiple, there is a second aspect to understand: how long will it take the business to repay the vendor loan (aka the deferred consideration)?

Rule of thumb: if it will take the business anything over and above 9 to 10 years to repay the deferred consideration, then it is potentially overvalued.  

Cash Flows Forecasts

Ask the valuer for a cash flow, which shows the business can afford the deferred consideration payments and the underlying assumptions thereof.  

Bear in mind there should be minimal growth included in the forecasts, because the business will likely have minimal excess cash, as its primary objective will be to repay the vendor loan notes.

Without excess cash to reinvest in human capital, sales and marketing, development and capital expenditure, the sales and profits of the business will not grow.

So, the most likely scenario will be a steady state or very low growth rates.

Also bear in mind that the (EBITDA) Earnings before Interest, Tax, Depreciation and Amortisation Multiple does not factor in any Corporation Tax Payments.

Most businesses will pay corporation tax at 25%, so this means that a 5 x EBITDA multiple usually leads to a repayment period of seven to eight years, because the tax needs to be included in the cash flows before any repayments are made to the vendors.

Conclusions and useful next steps

In conclusion, when a business is overvalued as part of an EOT process, it can cause huge ramifications down the line.

Asking the right questions and taking a considered view of the figures and data presented to you by the valuer should hopefully reduce the risk of the business being overvalued.  

Sean Hackemann is a Director and Founder of Specialist Accounting Solutions Ltd (Team SAS). Team SAS prepares independent business valuation reports for various scenarios, including employee ownership transactions – find out more here .

Discover how Telos Partners' experienced EO team can support you with the leadership, succession, employee engagement and governance aspects of transition here.