How property considerations can impact your exit value – Part 1 “The Value Trap”
It is often stated that a company’s true valuation is down to its “people”. After-all they are the ones that deliver value, take risks and have the technical knowledge and customer relationships that represents its goodwill. However true this adage is, the reality is that the “inanimate” business property can also present meaningful valuation dynamics since its very ownership, condition, capacity utilisation and compliance can drive potential future business risks and as such impact the ultimate valuation.
The problem in an exit process is that unlike the flashy presentations of future revenue growth, high margins or the enthusiasm of the entrepreneurial management team, property can be considered as rather dull and uneventful. Indeed it is usually the lawyers or (if the Buyer is particularly switched-on) the property diligence advisors that are the ones that usually spoil the party late on in the process through highlighting fundamental issues which can bring commercial risk to the deal. It therefore makes sense to have an initial review of any potential property issues to allow the Seller to get ahead of any problem, allow time for corrective actions or atleast preserve your negotiating position by disclosing them ahead of diligence.
In order to consider some of the common issues that can arise this 2-part article will set out common concerns which Sellers will be well advised to consider before entering a sale process. The most obvious valuation issue relates to the property’s ownership and whether it is leased or owned. Owned property while avoiding many of the issues such as lease terms, condition and to a lessor extent compliance (discussed in the part 2 of this article), still come with an equal share of valuation hangovers which the Seller needs to understand and this is discussed below.
Despite freehold property being viewed by the Seller as a strategically valuable asset giving greater flexible and longer-term control over the business, it is unlikely that Buyers have a particular interest in property development, being instead focused on the target’s actual cash generation. Such a view is simply a legacy of the debt management of both Strategics and PE alike, where there has long been a clear preference from their shareholders to prioritise investments in high-performing opportunities rather than the less glorified returns from “bricks and mortar”. Since most Buyers rely on debt funding, there is understandable preference that the property is also financed by an external party, as well as providing some flexibility for future growth and consolidation options.
It is not therefore unexpected that this divergence of attitudes can lead to differing expectations in the valuation and we will therefore discuss several approaches on how the Buyer’s above view-point manifests itself in the ultimate valuation.
A common Buyer approach (“Approach 1”) is to simply accept that the EBITDA reported by the business is inflated since it would otherwise be weighed down by rental costs if it was a leased premises. They will conclude that the value gained by having a freehold property is thereby adequately compensated through the application of the deal multiple against the inflated EBITDA. To understand the impact of this approach we must first consider the multiple of the Alternate Market Rental if the property were instead leased, against the Property Investment Cost (ie. “Rent to Valuation” multiple) on a variety of scenarios A-C where the multiples increase. We must also acknowledge that any cash resources previously invested in property would have otherwise increased the target’s cash and ultimately its equity value, and so should therefore be deducted from the Enterprise Value (“EV”) to give a Proforma Equity Value. It can be seen in the attached table with A-C scenarios that the risk to the Seller arises when the “Rent to Valuation” multiple is greater than the EBITDA multiple used in the deal value, since while the EV remains unchanged, the effective Proforma Equity Value can be seen to fall. While the corollary is also true whereby a gain would be achieved where the “Rent to Value multiple” is lower than the deal multiple, in reality this is very rarely the case and is therefore not represented.
An alternate approach for Buyers (“Approach 2”) is where the EV is augmented the for the property value, subject to it being corroborated by external market valuation. Such valuations are often desk-top exercises carried out by local property consultants who will be well tuned to the comparable property valuation for similar buildings. The risk to the Seller is that property-prices may have recently crashed or if your subsequent development costs have been excessive in which case your high investment costs will be discounted back to Market Value – impacting your expectation on deal valuation. For larger businesses subject to annual audits or already fully compliant with International Accounting Standards such valuation impairment may have already been made in the accounts, however this is less common in smaller businesses below the audit threshold. Since the Buyer augments the EV with the property market value, they apply a compensating adjustment to reported EBITDA for “Alternate Market Rental” to make the EBITDA comparable to a company with leased properties, before applying a standard EBITDA multiple to drive the EV valuation.
In both cases it can be shown that while the EV remains the same in either approach, a valuation shortfall arises on Buyer’s value expectations when the “Rent to Valuation multiple” and by implication the Property investment cost (against Market Value), is excessive. This often frustrates Sellers who with the best of intentions have invested heavily throughout the years in their beloved property (with extensions, mezzanine floors, new roof) but are located in an area (perhaps a dilapidated industrial estate) which simply cannot justify the equivalent market value. There is unfortunately little to be gained by a Buyer howling at the moon of the injustice and arguing the strategic benefits of owning its property. The Seller must instead understand that the Buyer is merely recognising an inherent problem and has to consider in his valuation the future businesses future cashflows. It is not the Buyers role to compensate you if the market value fails to recognise the past investment ploughed into the property. As painful as it is, the Seller has to consider this on a sunk-cost basis and simply accept the reality and indeed appropriateness of the Buyer’s valuation.
It is not uncommon for an uninformed Seller to have delusions that since the business owns its property that any valuation should be based on a market multiple of his reported EBITDA plus the full property investment cost. In such cases little progress can be made until the Seller engages with credible M&A advisors who are able to educate them to the ways of the world. In the past I engaged with a Seller who insisted that his valuation should be based on an EBITDA market multiple in-addition to the investment cost of his property which was significantly higher than market value. The Seller remained stubborn on his views despite the attempt to have his accountants explain that such an approach was inconsistent and not market – the business remains unsold over 4 years later.
At Red-Swan Partners our team have extensive experience from growing and selling their own businesses, being TIC corporate’s M&A executives, as well as working with a wide range of TIC business owners to support them in the development of their own exit strategy. This wealth of relevant market experience allows us to work with business owners to consider potential deal issues such as property and to best advise the impact and how best to ensure you can achieve a premium value for your business