Hi Michael,
I thought I might make a few additional comments regarding your options, but given everything that is going on I felt it might be better to use an alternative to your Pivot email address.
As mentioned, I am not familiar with valuing businesses in the construction sector, but my experience with businesses in healthcare, engineering and auto sectors is that EBIT is by far the most common (and sensible) approach for most businesses, with most trading anywhere from 2.5 x EBIT to 7 x EBIT.. Many people get a shock when it comes to selling their business as rates tend to be far below expectations.
One thing we need to keep in mind is that if you (or Matt) are being paid less than someone performing the same role then this will flow through to the valuation.
For example, let’s say we valued your company as 4 x EBIT average for last 3 years. An average EBIT of $400k (eg, $500k, $300k & $400k) would give us a valuation of $1.6m. However, if the market rate to employ you is $150k and you’re only paying yourself $80k p.a., we might have to adjust our EBIT to $330k, which reduces the valuation to $1,320k (reducing the value of your 50% share by $140k). This is just something to be aware of when thinking about valuations. It might pay to look around on Google and make some estimates of what you would be paid if you (and Matt) were employees.
Another option/example: if you bought Matt's shares
Though it sounds like Matt is more motivated to keep the business (or at least the business name) in the family, and therefore more likely to try to buy your shares, it's probably not a bad idea to consider how things might look if you made a bid to buy him out.
Using the example above, let's say we arrive at a valuation of the business at $1.32 m. If Matt was prepared to sell at this price, that would cost about $660k to buy his shares, following which you take claim to the full $400k EBIT.
The challenge would be financing this. With, say, $1m debt on Sep Creek etc, plus $660k to finance the purchase of Matt's shares you would probably need to look at a combination of increasing your (and Petrina’s) salary to satisfy the bank that you can afford Sep Creek, while also making some fairly aggressive repayments on the business loan.
Back of the envelope calculations:
(a) $660k business loan at 9% p.a., P&I over 10 years would cost about $103k p.a.;
(b) Sep Creek at 5% P&I over 20 years would cost another $80k.
So all up $185k give or take. Around $110k of this is tax deductible. If you’re current repayments on Separation Creek are around $50k (5% x $1m), the we are talking a difference of somewhere in the order of $135k p.a., $60k of which is tax deductible and around $75k that isn’t. To satisfy the additional repayments on Separation Creek (ignoring any rental income) you would need an extra $30k p.a. net, which would require additional income (a pay rise) of about $50k p.a. The business would be servicing the $660k; the $60k of interest is deductible, plus $43.4k that is not deductible which would be costing the business about $60k pre-tax. Therefore the business loan is costing $120k pre-tax.
The overall impact on our original $400k EBIT is a reduction of $50k due to additional wages for you & Petrina, and a further reduction of $120k within the business to service and repay the loan. This means our pre-tax profit is $230k, plus you are building equity in the business to the tune of $43k p.a. (principal repayments on business loan), plus building equity in your investment property at a rate of about $30k p.a. (principal repayments on investment property loan).
Therefore, overall position is $230k pre-tax profit + $43k net + $30k net = $303k p.a. On an after-tax basis, if profits are distributed to you and Petrina, the value of this comes in at roughly $200k.
This compares to $200k of EBIT (your 50% share of the $400k) if you only owned half the business; which (for the sake of a like-for-like comparison) is about $110k after tax. In other words, as full owner your after-tax profits and equity increase by about $90k in year one, increasing over time as the level of debt reduces. In fact, after 10 years the business loan would be fully repaid, the debt against Separation Creek would be about $620k, and business EBIT would be around $350k p.a. ($400k original EBIT less the extra $50k p.a. of wages paid to you).
Of course before any of this is even considered, you would want to have both an approximate value for the business and some indication from the bank as to how much of the purchase price they would be willing to lend. For businesses with good books, I've seen banks pretty happy to lend 50% of the enterprise value, which would just about get you over the line purchasing Matt's shares, but would probably mean a pretty harsh low doc rate on Separation Creek. You would likely get a better deal if instead of taking a $660k loan for the business you entered into an earn-out arrangement with Matt (actually this would probably be better for both of you).
Also consider whether $90k p.a. (approx. $160k equivalent pre-tax) leaves enough wiggle room in your working capital. Last thing you would want is a market downturn to reduce your sales in the first few years while at the same time reducing market value of Separation Creek; in this scenario a forced sale of Separation Creek could potentially eat your equity very quickly
Now to be clear, I’m not suggesting this is enough of a reason to making a bid for Matt’s shares, rather trying to make the point that you have options and to make the point that:
Review of Valuation
A final note while I think of it. I think I noticed within the Buy/Sell proposal a recommendation to review business assets and valuation on an annual basis. Though I would agree it's nice to have a current valuation on hand, this could prove a very costly exercise. An alternative might be to use a professional valuation as your starting point, and from there agree on a valuation method.
For example, you might agree with Matt to value of the business like the following:
(1) Part A: from the P&L:
The mid-point between:
(a) 0.5 x average annual sales (or completions?) over last 24 months, and;
(b) 4.0 x average annual EBIT over last 3 full financial years (audited results)
(2) Part B: from the Balance Sheet
- Plus assets (ex cash) at 0.80 book value (prior year audited results)
- Plus cash
- Less liabilities
(3) Part C: Rounding
Sum of Part A and Part B rounded up to the nearest $25,000.
You might find that an approach like this provides a more independent and stable valuation of the business (not to mention much less expensive to review; with a rules-based approach like this anyone should be able to estimate the value very quickly).
Funding the Buy/Sell
I will leave this in the capable hand of your broker, but as he will explain the way that insurance benefits owned are taxed when owned by the business or a person other than the insured (ie, cross-ownership) is in most cases different to how they would be taxed if you were paying for your own insurance. The tax/legal side of this can be a little convoluted, so I won't get into it here, but if I was to make a suggestion: if you find that the prospective valuation of your shares in the business is substantially less than the level you are insured for... it might make sense to reduce cover. For example, if the business was valued at $1.5m ($750k each) but your insurance was $1m each (cross-ownership), this will mean the business is potentially overinsured. In that scenario you might find it more cost-effective to have cross-ownership of $750k each, then if you really wanted maybe setup another policy externally (this can be tax-deductible if owned by a superannuation Trustee which essentially means that some insurance benefits can be paid in pre-tax dollars, significantly reducing the cost).
Happy to discuss/explain any of these points further, but suggest that getting an independent valuation is a very good starting point.
Good luck for Thursday.
I thought I might make a few additional comments regarding your options, but given everything that is going on I felt it might be better to use an alternative to your Pivot email address.
As mentioned, I am not familiar with valuing businesses in the construction sector, but my experience with businesses in healthcare, engineering and auto sectors is that EBIT is by far the most common (and sensible) approach for most businesses, with most trading anywhere from 2.5 x EBIT to 7 x EBIT.. Many people get a shock when it comes to selling their business as rates tend to be far below expectations.
One thing we need to keep in mind is that if you (or Matt) are being paid less than someone performing the same role then this will flow through to the valuation.
For example, let’s say we valued your company as 4 x EBIT average for last 3 years. An average EBIT of $400k (eg, $500k, $300k & $400k) would give us a valuation of $1.6m. However, if the market rate to employ you is $150k and you’re only paying yourself $80k p.a., we might have to adjust our EBIT to $330k, which reduces the valuation to $1,320k (reducing the value of your 50% share by $140k). This is just something to be aware of when thinking about valuations. It might pay to look around on Google and make some estimates of what you would be paid if you (and Matt) were employees.
Another option/example: if you bought Matt's shares
Though it sounds like Matt is more motivated to keep the business (or at least the business name) in the family, and therefore more likely to try to buy your shares, it's probably not a bad idea to consider how things might look if you made a bid to buy him out.
Using the example above, let's say we arrive at a valuation of the business at $1.32 m. If Matt was prepared to sell at this price, that would cost about $660k to buy his shares, following which you take claim to the full $400k EBIT.
The challenge would be financing this. With, say, $1m debt on Sep Creek etc, plus $660k to finance the purchase of Matt's shares you would probably need to look at a combination of increasing your (and Petrina’s) salary to satisfy the bank that you can afford Sep Creek, while also making some fairly aggressive repayments on the business loan.
Back of the envelope calculations:
(a) $660k business loan at 9% p.a., P&I over 10 years would cost about $103k p.a.;
(b) Sep Creek at 5% P&I over 20 years would cost another $80k.
So all up $185k give or take. Around $110k of this is tax deductible. If you’re current repayments on Separation Creek are around $50k (5% x $1m), the we are talking a difference of somewhere in the order of $135k p.a., $60k of which is tax deductible and around $75k that isn’t. To satisfy the additional repayments on Separation Creek (ignoring any rental income) you would need an extra $30k p.a. net, which would require additional income (a pay rise) of about $50k p.a. The business would be servicing the $660k; the $60k of interest is deductible, plus $43.4k that is not deductible which would be costing the business about $60k pre-tax. Therefore the business loan is costing $120k pre-tax.
The overall impact on our original $400k EBIT is a reduction of $50k due to additional wages for you & Petrina, and a further reduction of $120k within the business to service and repay the loan. This means our pre-tax profit is $230k, plus you are building equity in the business to the tune of $43k p.a. (principal repayments on business loan), plus building equity in your investment property at a rate of about $30k p.a. (principal repayments on investment property loan).
Therefore, overall position is $230k pre-tax profit + $43k net + $30k net = $303k p.a. On an after-tax basis, if profits are distributed to you and Petrina, the value of this comes in at roughly $200k.
This compares to $200k of EBIT (your 50% share of the $400k) if you only owned half the business; which (for the sake of a like-for-like comparison) is about $110k after tax. In other words, as full owner your after-tax profits and equity increase by about $90k in year one, increasing over time as the level of debt reduces. In fact, after 10 years the business loan would be fully repaid, the debt against Separation Creek would be about $620k, and business EBIT would be around $350k p.a. ($400k original EBIT less the extra $50k p.a. of wages paid to you).
Of course before any of this is even considered, you would want to have both an approximate value for the business and some indication from the bank as to how much of the purchase price they would be willing to lend. For businesses with good books, I've seen banks pretty happy to lend 50% of the enterprise value, which would just about get you over the line purchasing Matt's shares, but would probably mean a pretty harsh low doc rate on Separation Creek. You would likely get a better deal if instead of taking a $660k loan for the business you entered into an earn-out arrangement with Matt (actually this would probably be better for both of you).
Also consider whether $90k p.a. (approx. $160k equivalent pre-tax) leaves enough wiggle room in your working capital. Last thing you would want is a market downturn to reduce your sales in the first few years while at the same time reducing market value of Separation Creek; in this scenario a forced sale of Separation Creek could potentially eat your equity very quickly
Now to be clear, I’m not suggesting this is enough of a reason to making a bid for Matt’s shares, rather trying to make the point that you have options and to make the point that:
- If the market rate comes out much lower than you were expecting it should also mean that it's much cheaper to buy into an existing business down the track.
- It might also influence your thinking around distribution of profits and Pivot's capital structure: you might find it's a lower risk option for you (and Matt) to take more of the profit out of the business and help fund new projects with debt.
- Make sure you know what it would cost to replace you: this helps not only with the valuation, but also gives you some sense of what your alternatives (ex Pivot) might look like, and the cost of appointing your successor (if you were to buy Pivot, you should have an idea of the value of the business under new management or at sale).
Review of Valuation
A final note while I think of it. I think I noticed within the Buy/Sell proposal a recommendation to review business assets and valuation on an annual basis. Though I would agree it's nice to have a current valuation on hand, this could prove a very costly exercise. An alternative might be to use a professional valuation as your starting point, and from there agree on a valuation method.
For example, you might agree with Matt to value of the business like the following:
(1) Part A: from the P&L:
The mid-point between:
(a) 0.5 x average annual sales (or completions?) over last 24 months, and;
(b) 4.0 x average annual EBIT over last 3 full financial years (audited results)
(2) Part B: from the Balance Sheet
- Plus assets (ex cash) at 0.80 book value (prior year audited results)
- Plus cash
- Less liabilities
(3) Part C: Rounding
Sum of Part A and Part B rounded up to the nearest $25,000.
You might find that an approach like this provides a more independent and stable valuation of the business (not to mention much less expensive to review; with a rules-based approach like this anyone should be able to estimate the value very quickly).
Funding the Buy/Sell
I will leave this in the capable hand of your broker, but as he will explain the way that insurance benefits owned are taxed when owned by the business or a person other than the insured (ie, cross-ownership) is in most cases different to how they would be taxed if you were paying for your own insurance. The tax/legal side of this can be a little convoluted, so I won't get into it here, but if I was to make a suggestion: if you find that the prospective valuation of your shares in the business is substantially less than the level you are insured for... it might make sense to reduce cover. For example, if the business was valued at $1.5m ($750k each) but your insurance was $1m each (cross-ownership), this will mean the business is potentially overinsured. In that scenario you might find it more cost-effective to have cross-ownership of $750k each, then if you really wanted maybe setup another policy externally (this can be tax-deductible if owned by a superannuation Trustee which essentially means that some insurance benefits can be paid in pre-tax dollars, significantly reducing the cost).
Happy to discuss/explain any of these points further, but suggest that getting an independent valuation is a very good starting point.
Good luck for Thursday.