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Home > News > Is scaling your business the answer to increasing shareholder value?

Is scaling your business the answer to increasing shareholder value?

13 June 2018 | Paul Hardman

Is scaling your business the answer to increasing shareholder value?

In this article we explore the challenges faced by SME’s when scaling their business and if the returns are worth the effort, something we will be exploring further at our Scale Up and Sell Event.

One way to look at this is to consider the question, is a bigger company simply a scaled up small company? The answer is of course that it is in part but my focus in this article is on those areas where there is an unexpected or disproportionate effect of scale.

The relevance of the PE Ratio for an SME

First, consider a buyer looking at a small company versus a larger company. Readers are probably familiar with one way of valuing companies by using a PE (Price Earnings) ratio and applying it to adjusted sustainable profits. We can all see from the pink pages of business newspapers the PE ratios of listed companies. The ratio tells you how the historic yield on shares relates to their price. The same idea can be applied to purchasing unlisted shares but unlike publicly quoted shares there is no market in private shares so we have to apply a principle of equivalence, notably by reducing the PE factor from that prevailing amongst as near as possible equivalent listed companies to reflect that yield (dividends) on private company shares are uncertain.

That uncertainty is a reflection of scale, the bigger the company the more diverse (in general) the more solid and substantial its overall profit base, the more able it is to endure knocks and set backs and the more predictable it’s short to medium term performance. Typically therefore the PE factor applied to a small company profit figure will be much less than an equivalent medium company.

In addition, the market and market place for small companies is a different one to that for medium. This applies to likely purchasers and to the advisory community. The reason lies in the risk/reward dynamic. The cost of buying a small company is not proportionately less than buying a medium one. With every acquisition there is a minimum amount that needs to be done and the burden therefore becomes disproportionately heavy. Larger companies can afford larger fees and the advisory community knows that and specialise accordingly.

Similar rules apply to the management cost to the purchaser team and for the purchaser there is the additional consideration of the impact of the deal on the balance sheet and profits of the combined group. Or to put it another way, if the deal is small is it really worth bothering with?

Having said this there are specialists who are set up to maximise values for the right small company and big corporates who are very interested in the right small company so scale is not everything, it is a matter of working out what sort of company you have and how important scale is to achieving the best price for it.

Setting and Executing a Scale up Strategy

The first point to make is that the management team will have to be ready to devote time to the scale up strategy which they must be ready to do consistently over time. To allow this to happen the affairs of the core (buyer) company must be running smoothly.

Any strategy will need to consider the purpose of the scale up, whether that is to diversify the product base, enter new markets, spread geographically, acquire transformational technology, secure greater control up or down the supply chain or other but where the strategy is to scale up to sell, and perhaps in any case, the overall strategy should have as the desired outcome a more stable, resilient business that is going to be more attractive to buyers.

Preparation is key to executing the strategy and that starts with selecting the management team to deliver. Consider who should be selected. It will not always be exclusively drawn from the directors but will include a mix of diverse talents and experience with an ability to assess and analyse information quickly and commercially. Gaps in the team should be identified and plugged.

Key to the team will be the FD. The team will want someone who can forecast the needs of the core company and the combined group so that there are no unpleasant surprises along the way. The FD will want at their back an understanding and supportive bank manager and the right banking arrangements. Once these are in place the team can consider corporate finance and legal support. Again finding the right individual is as important as the right firm.

Using Shares as Consideration

One way to pay for acquisitions is to offer shares in the combined company. This is tax neutral to sellers and a great way for buyers to reduce the funding requirements of acquisitions.

For publicly listed companies the shares are, subject to rules around trading, almost as liquid as cash. However for shares in private companies different rules will apply as the shares will only become liquid if either the combined company is sold or the consideration shares are bought back by the company itself or by another one or more of the shareholders.

Typically therefore shares are issued as part a merger where key management members of the target company join forces with the target group as part of a shared vision. At this point the conversations become more like an investment pitch for the buying team. They will want to communicate the vision and get strong commitment from the seller management. Part of these conversations are likely to get into the nitty gritty of pay and perks and the terms on which the consideration shares are to be held, for instance whether good and bad leaver clause will apply to the consideration shares. The more that the buyer team are equipped with well thought through answers the greater the confidence that will exude.

Takeover or Merger

Before we go on, let me quickly touch on the issue of culture. In my experience it is not possible to agree to blend the cultures of 2 different companies and you should not attempt to do so at the negotiation stage. To this extent, it is widely shared wisdom that you should never attempt a merger (even if that is what the parties decide to tell their staff and the wider world). But “takeover” suggests the extinction of target company and that equally may not be what is intended or actually happens. It is certainly simpler to start with one of the 2 established cultures but any management team will know that creating a harmonious workforce includes recognising that at least some of the “old ways” of doing things have merit and should be incorporated as part of the culture of the bigger whole.

Gear Up

As will be apparent from the above when it comes to scaling up your business preparation is essential. This starts with the past, moves to the present and concludes with the future. In other words step 1 is to look at the business you are running and to identify all the nasty issues that may pop out and cause you to take your eye off the scale up plan or worse scupper that plan. Then step 2 is to turn to the resources you have and assess whether they are fit and adequate to the scale up plan and finally step 3 is to look to the issues in the future that may expose your business and the scaled up business to risk including market conditions, new regulation, disruptive and challenging technology and competitive pressures.

Register your place at our Scale Up & Sell Event in association with BCMS, where we will be exploring this topic in greater detail on Wednesday 27 June.

The contents of this article are intended for general information purposes only and shall not be deemed to be, or constitute legal advice. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of this article.

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