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Risky business

I left you last week with the thought that those relying on their business as the sole means of delivering financial security are effectively making a choice to invest wholly into a single – usually unquoted – equity.

The risk of market forces, technological developments or even Government policy moving against the business at a time when it is planned to realise the capital value cannot be underestimated.

There is also the risk of the owner&#39s ill-health forcing a sale earlier than is necessary or perhaps having a significantly detrimental effect on the value of the business just as a sale is to be made.

This risk of diminution of capital value is particularly high where the business is substantially reliant on the well-being of the owner. Of course, if this is the case, then it may well itself have a detrimental effect on value. It has been proven many times that where a business is virtually entirely reliant on the contribution made by the owner, then the value of the business can be – but is not always – substantially diminished.

Any person buying into the business would be reliant on the owner remaining with the business in order to sustain and build its value. For any business looking to create capital value, it will be essential to have a client base, product and service range and income stream independent of the owner/manager.

In short, relying on one&#39s business as the sole means of providing future financial security may be a high-risk strategy.

Even if value can be built in the business, there is a question mark over who would buy it. Relying on a public offering through a stockmarket flotation is, as has been proved in the recent past, a dangerous and costly strategy.

Perhaps the most obvious sale would be to a competitor or perhaps even a customer or complementary business – in other words, a trade sale.

However, it is important to recognise that the market risks discussed above in relation to the business to be sold may well also apply to acquiring businesses in the same sector. If the sector were affected adversely by a diminution in general market interest, adverse legislation, regulation or a threat to the sector as a whole, then the appetite for acquisition would be likely to be severely diminished, if not non-existent.

Another obvious potential purchaser group are co-owners. However, if this is not being properly planned for, there is a significant risk that there will be insufficient funds available to make the purchase. If all the owners have the same objective in mind and are all roughly the same age, then this route plainly becomes next to impossible.

Naturally, where a purchase is to be made on the death or critical illness of an owner, then this can be planned for, with the funds necessary to make the purchase being provided by suitable life insurance policies in combination with appropriate trusts and agreements.

Leaving aside the possibility of a sale to the co-owners, with the consequent focus on either a public offering or a trade sale, then the importance of timing cannot be overestimated. Sentiment, market conditions and available funds in the hands of the potential buyer will all be essential and they all need to come together at the right time – no mean feat.

Often, the window of opportunity, with all these factors present, is a very small and short one.

Where the business is owned by more than one person, there will also be a need to ensure that all the owners have the same objective in mind with regard to disposal and realisation of capital value. It will be hard, if not impossible, for a minority shareholder in a private company to sell his or her shares to a third party without the others also doing so. They may even be prevented from selling by the shareholders&#39 agreement. Such an agreement would usually give the co-owners the right of first refusal or even the right to block any sale.

The conclusion that emerges from all this is that relying on one&#39s business as the means of producing sufficient funds to deliver financial security is a relatively high-risk strategy. It is not to say that it is impossible. There have been many who have been successful in this but it is equally true to say that many of those who have sold their business will also have had a contingency plan in place in the shape of approved pensions or other investments.

The diminution of profits caused by extracting funds to invest either in pension arrangements or otherwise need not have a detrimental effect on the value of the company. Any buyer who can see the underlying trend of profitability and, with the legally enforceable commitment of the disposer, that the diversifying expenditure that had taken place up to the point of sale will be ceased or severely diminished, should be relatively happy with his purchase.

There is also the fact that, just by having the contingency fund in place, the business owner may be able to make investment decisions concerning his company without the additional pressure of knowing that the company is his single bet for future financial security.

Returning now to the building of value in a private business, there is little doubt that the most obvious way to do so is by creating an excellent earnings record that can be sustained and by doing so contributing significantly to developing the company&#39s goodwill – its intangible value. It is in having sustainable, growing earnings that so much value will reside.

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