Corporate finance glossary – key concepts for selling companies
A guide to some of the technical phrases commonly used in the context of selling a business.
Company owners are immersed in the language and jargon of their chosen industry and markets. But when they come to sell their business, they often need to get to grips with the terminology used in the context of mergers & acquisitions. In this post, we have set out a glossary of some of the financial and commercial phrases that are often discussed during the company sale process. We have also explained whey these concepts are important, when it comes to maximising the value of a business.
Barriers to entry
Barriers to entry is the term given to the existence of obstacles preventing new competitors from easily entering a market. Such obstacles might include high start-up costs, difficulty associated with establishing a new brand in a market, regulation enforced by government bodies, patents associated with technology needed to launch a new company or simply the size and scale needed to operate profitably in a market.
A potential buyer will want to understand the advantage they would be gaining in a new market by buying your company, as opposed to the option of setting themselves up as a competitor to your business. By understanding the barriers to entry – and if possible quantifying these – you will be better placed to articulate the value to prospective buyers of purchasing your business.
Change of control clause
A change of control clause in a contract may give the party which is not subject to a change in ownership the right to terminate the contractual agreement in the event that the other party is subject to a change in ownership.
If your contracts with your customers or your suppliers contain a change of control clause, this could give those customers or suppliers the right to terminate their agreement with you if your company is acquired by another party. A prospective buyer will be certain to ask if such clauses exist in order to assess the riskiness of your customer and supplier relationships.
A contingent liability is a liability which the business may incur depending on the outcome of a future event which remains uncertain. An example would be an ongoing Court case, the result of which may or may not be a finding against the company, leading to a fine or other settlement charge.
A potential buyer will need to understand the financial obligations which may arise if they acquire your company. You will need to make them aware of any contingent liabilities such as those which could arise from disputes or legal proceedings, the requirement to make repairs or refurbishment to any rented property at the end of the lease period or warranty claims arising from defective goods.
Customer retention and customer churn
Customer retention refers to a company’s ability to retain repeated customers. Conversely customer churn (also known as customer attrition) refers to the turnover of a company’s customer base. Companies often spend money acquiring new customers, believing this to be a fast route to increasing revenue. However it is often more profitable to focus on retaining existing customers. Or in other words, companies should focus on reducing customer churn.
A potential acquirer will consider customer retention and churn in appraising a company for acquisition purposes. A track record of customer retention and low customer churn rates will indicate that a business has a respected brand and is delivering a high level of customer service.
Director drawings refers to money taken out of the company by directors which is not done via a payroll or as dividends.
A potential buyer of your business will want to understand the actual outgoings of your company and what these would be were they to own the business. It is therefore important you are able to show documentation of any money you have taken out of the company as drawings to allow a potential buyer to appraise whether they need to adjust your financial results to account for these drawings being lower or higher than would be the case under their ownership.
Employee incentivisation, including EMI
Employee incentivisation is the use of a variety of remuneration mechanisms to attract, incentivise and reward employees. Incentivisation packages can take the form of bonuses, commission arrangements or option or share schemes.
The Enterprise Management Incentive (EMI) structure is available to small businesses and involves granting share options to employees with advantageous tax terms attached. It is crucial to get professional legal and tax advice if you are considering implementing an employee incentivisation mechanism as the rules can be complex.
In the run-up to a proposed transaction, a company will need all its employees to be aligned to grow the business to its maximum potential. An employee incentivisation mechanism can support this objective.
Entrepreneurs’ relief is a lower rate of capital gains tax which may apply when a UK-based business is sold. It was introduced in 2008 to encourage entrepreneurs to invest, grow and eventually sell their businesses. It has therefore been a key feature of the M&A market since that date.
Entrepreneurs’ relief is currently set to 10%. This means that those who qualify will pay tax at 10% on all gains on qualifying assets. These might include property, working capital and goodwill. The 10% rate is significantly lower than the standard rate of CGT, giving a real advantage to those who qualify. The basic rules to qualify for the relief are that the shareholder needs to own more than 5% of the equity and also have been an officer of the company for more than 2 years. In this context officer can mean either employee or director.
Compared to the combined rates relating to corporation tax and income/dividend tax, many entrepreneurs feel that this is well worth planning for.
Whilst the relief applies to the majority of company sales, it is always important to take appropriate tax advice relating to your individual situation.
Not everyone finds themselves in the latest industry trend (dotcom, industry 4.0, digital marketing, organic food, coffee shops etc to pick a few from the past 20 years), nor is every sector growing. With that being said, when considering the attractiveness of a business it is important to present it in the best light and one logic that many investors apply is that it is easier to capture a ‘fair share’ of a growing market than to steal market share from your competitors in a shrinking market.
If you find that your definition of the market results in a shrinking view, then redefine the market. Evidence of growing customer appetite is important to external investors.
Market analysis is the process of exploring and understanding the market in which your business operates in order to address the risks faced and exploit the opportunities available.
Whilst most business owners will have a good working understanding of their market, many do not capture this in a formal document. A prospective buyer will want to understand the market of the business they may be acquiring and – crucially – they will want to be reassured that the management team who will be running the business after a transaction also have this understanding. Being able to offer a documented analysis of the market to prospective buyers is an important step in providing this reassurance.
It is worth also bearing in mind that current stakeholders will also benefit from a document containing a market analysis and an appraisal of risks and opportunities.
Whilst your current offering, sales volume and list of competitors may be difficult to change, it is worth considering the definition of market share and understanding the impact it has on the attractiveness of a business.
The truth is that there is a ‘sweet spot’ in terms of market share that represents the balance between having sufficient volume not to be crushed by the competition whilst also having a large enough market to offer plenty of room for growth for the incoming investor.
To add further detail to this, a good rule of thumb is that if you control more than 30% of the market then it will be difficult for the incoming investor to double the size of the business without redefining its market.
If you control less than 1% of the market, as it is defined by you, then it is difficult for an outside party to understand how you are likely to be a leader in the sector and therefore create protecting barriers to prevent the competition from simply taking your business. One way of doing this might be to add a geographic boundary, or add segmentation your customer definition, to the existing definition you apply to the market. In this way you go from trying to be the best Italian restaurant in the country (<1% share) to being the best Italian restaurant in the region. At the other end of the scale, if you control 45% of the combine harvester market, redefine this as the large scale farm machinery market and the percentage then allows the opportunity for more to go for in the future.
Measures of earnings
The commonly-used measures of earnings are:
EBITDA – meaning Earnings before Interest, Tax, Depreciation and Amortisation
EBIT – meaning Earnings before Interest and Tax
Profit before Tax – meaning Earnings before Tax
A prospective buyer will want to understand the different measures of earnings (adjusted for any non-market costs which will not continue post-sale) in order to place a value on your company. You can read our separate blog about EBITDA multiples here.
Onerous terms or provisions
An onerous contract is one in which the costs to fulfil the terms of the contract exceed the benefit that can be gained from the contract. An example would be a contract to lease a piece of machinery, which obliged the lessee to continue making lease payments even if the machinery was no longer in use by the lessee.
A prospective buyer will want to understand the terms of the contractual obligations they would be taking on were they to purchase your company. This will include understanding any onerous terms, as such terms would lead to a net cash outflow.
Related party transactions
Related party transactions are business transaction between two business entities which are already connected by means of a pre-existing special relationship. An example would be a contract awarded by the company to another company which is owned by a family member or other shareholder.
A potential buyer will need to assess whether any transactions that occur between related parties are on an arm’s length, commercial basis. If not, the potential buyer would need to assess that trading relationship as if it were arm’s length and commercial, in order to work out the financial impact on them. As a seller you must therefore be able to disclose all related parties transactions and the terms on which these are undertaken.
A risk register is a document (often in spreadsheet form) used by a company to log and track risks facing the company and how those risks are mitigated. Risks are often categorised by the area of the business to which they relate (for example, operational, commercial, finance, HR, IT and so on). As risks are identified, they are logged on the register, along with a member of staff responsible for monitoring that risk and identifying mitigating actions. Many companies also assign a score for the likelihood of the risk occurring and the impact on that business were that risk to occur. It is the combination of likelihood and potential impact that influences how the business prioritises the monitoring of the risk.
Potential buyers want to be certain they understand the risks facing the business they are buying. They also want to be sure that the post-deal management team will be aware of and focused on monitoring and mitigating these risks. Being able to share a risk register at an appropriate stage of the transaction is evidence that you have a proactive approach to risk management in your company.
Supplier concentration means that your company is making most of its purchases from a few key suppliers. There is no universal guideline on what would be considered a reasonable level of supplier concentration, however, if you are purchasing about 40% from one supplier, this might be considered too high.
It is a very common situation for small / privately-owned businesses as sourcing from fewer trusted business partners can save a lot of internal resources. In the short-term, when the supplier relationships are already established, relying on a small number of key suppliers might seem like a good solution.
Buyers always look at risk when assessing a company for sale. Supplier concentration is one of the risk factors that are examined in a due diligence process as it can adversely impact the cost base and the ability of the company to grow. Typical questions that a buyer will ask are: What if your main supplier goes bankrupt, cannot deliver the necessary output or is sold to one of your competitors and stops supplying your company? Would your main suppliers want to continue working with your company if it was sold? What if your main supplier puts your company under price pressure? How fast can you switch to a different supplier? What are the costs of switching suppliers?
If a supplier falls out, your company might not be able to produce / distribute its products. Finding an alternative supplier in a crisis might be costly. Similarly, if your supplier requests a large price increase, you might be facing increased input costs. Both situations lead to higher costs and lower your EBITDA and might negatively impact your revenues. If there is a level of uncertainty, supplier concentration lowers the price of your business and can become a deal breaker.
In the short term, try to lower at least supplier dependency by having back-up suppliers, even if you are not using them on a regular basis. This keeps your supplier concentration unchanged, but enables switching suppliers in crisis. Secure the current suppliers with written contracts. In the contracts, avoid change of control clauses and unfavourable conditions as termination on short notice or adverse price adjustments. When thinking about a transaction, make sure that your suppliers would be happy to continue working with you after your company is sold to a new owner.
In the long-term, diversify your supplier base where possible to decrease supplier concentration. This would also be beneficial to your bargaining power with suppliers and flexibility in situations of increased demand.
Surplus assets are considered to be those assets which a business owns but does not utilise in the course of current operations. For example, a company may own land which is not needed for current business purposes.
An asset which is surplus to current business purposes will not be captured by a valuation of a going concern business (as this would be calculated based on turnover or earnings and the surplus asset is not contributing to the company’s financial performance). However owners sometimes forget about their unused assets and transfer these along with the operating business as part of a transaction, thus forgoing on the additional value held in the surplus assets.
By understanding all the assets held by your business, you will be able to take a view on whether there are any which are surplus to current business requirements and therefore whether these could be transferred out of the business or whether they could form an additional element of the negotiation.
Tangible and intangible assets
Tangible assets are the physical assets held by your business. Common examples are property, plant, machinery, IT equipment and motor vehicles. Intangible assets are assets which are not physical in nature but which nonetheless contribute to your company’s ability to generate revenue. Common examples of intangible assets are patents, copyright, brands, customer relationships and software technology.
Having an understanding of the assets used to drive company profitability is important for a number of reasons. Firstly it will help you to articulate the value generated by your business and why this could be attractive to a potential purchaser. Secondly when it comes to undertaking a transaction, a prospective buyer will undertake a full diligence exercise on the assets of the business being bought. Being prepared in advance for the rigour of a diligence exercise is advantageous.