Golden rules for cash converters

Most people in the design industry are finely attuned to Maslow’s Hierarchy of Needs, chasing the illusive top tier of ‘self-actualisation’. We crave intellectual engagement with the world and the chance to shape this through creativity. At some point, this urge needs to be grounded in the need for ‘filthy lucre’. It kind of helps, my wife says.

Loewy has developed a model to bring together design and communications hot shops to create ‘something bigger’ – a collaborative space to explore bigger projects but also to spread the financial risks inherent in smaller businesses.

Design Week asked us to answer the question, ‘what is a design business worth?’, presumably so those in the Top 100 league tables might go totting up whether they can afford Aeron chairs for everyone in the studio or commission Marc Newson to design their bathrooms.

The thing is, it’s actually more useful to consider the question, ‘how do I get my hands on the money?’, which is a subtly different issue, given that a business is only worth what someone will pay for it.

The simple answer to the first question is people will pay a multiple of pre-tax profits from one times to six times (as in one-times-profits or six-times-profits etc), depending on size, spread of clients and length of relationships, age and experience of founders, spread of ownership, and discipline of the finances.

Confusingly, stock market-quoted profit multiples, known as p/e – or price-earnings – ratios, are quoted in post-tax multiples, so you need to add 40 per cent to the above sum in order to compare like with like (for example, instead of six times £1m pre-tax, we’re talking more than eight times £700 000 post-tax). If you look in the Financial Times, you’ll see that listed marketing, advertising and design groups in the sector are valued around multiples of ten to 15, justifying their higher valuation metrics in terms of the spread of business in much larger profit streams.

If your firm’s profits are below £300 000, you might anticipate valuing your business at four times, £1.2m. However, it’s not so simple. At this level, it’s tough to find buyers. The acquisitive groups know that the logistics of a merger is as much effort for this level as one ten times this size, but the risks are more obvious – the business is probably dependent on two or three key people inside the company, and three or four clients outside. A bit of moderate turbulence and the profits can slide to zero. So, there isn’t a huge number of potential buyers for your business.

Remember, your profit will be judged with the owners taking normal salaries/bonuses, so if you are over- or under-paid, take that into account. A buyer will.

No buyer will pay all cash upfront, either. They might pay something like a third of the valuation initially (£400 000 in my example), with the rest dependent on the business continuing to perform over the next three to five years. Happily, they will usually pay more on top if you can show that you can continue to grow your business’s profits in those following years too. (So, don’t see ‘earn out’ as a necessarily negative factor in your deal – it’s a chance for you to show how good your business is, or to make it better).

It is likely that most design businesses produce less than £300 000 in annual profits, given there are only 300 out of 15 000 UK marketing firms with more than £10m turnover.

So what can you do to create some cash value for your business?

We’d recommend you look at two different strategies. The first is to go for a management buy-in, selling some of your stake in the business to your colleagues. If you want to realise your money quickly, one of the best places to look for funds is from your own colleagues, by encouraging an MBI. Colleagues should know the business, see its potential and be even more committed to you and the business if they have a financial stake. In many businesses like law or accounting, it’s commonplace for a next generation of partners to buy out their seniors as part of the evolution of the business, so banks should be open to the idea of financing this activity and you might consider changing the business into a limited liability partnership format to facilitate this. If you think that other routes to financial liquidity will be transitional over a number of years, why not also let your colleagues buy you out over a number of years?

It’s also well worth mentioning here that outside buyers are not attracted to design businesses with only one or two owners, because the perception is that these owners exert a disproportionate influence over the business and might take fright in a bigger group. thereby damaging the profits. So an MBI could be a way to diversify ownership at the same time, making it more attractive for a future, bigger deal.

The second possible strategy is to opt for a ‘roll-up’. A quick way to break into profit levels which are attractive to bidders is to bring a number of profit streams together. This provides a portfolio effect, spreading the risk of a few founders and a few clients into creating your own ‘super’ group. By simply aggregating profit streams, you bequeath to shareholders a higher p/e ratio, but this alone is not enough. You need to consider the ‘shape’ of the new entity in terms of your offer to the market. You should also look at the synergies in terms of office space and accounting, as well as the potentially more tricky area of studio and account management efficiencies.

Find a few savings and you can add this to your business value – but here you get into the emotional areas of ‘sweating the asset’ and pushing harder business realities into a business that may pride itself on freewheeling culture. It’s always important to consider the rational issues and the emotional issues in any merger situation because these are the areas that can create disharmony across a team which can then unravel the whole beautiful idea. At Loewy, we spend a disproportionate amount of time considering these issues to try to create a business and a culture which is healthily competitive, rather than aggressively over-commercial.

A fine balancing act of give-and-take is always best – and a recognition that it’s important to listen to everyone from principals and founders, through key managers and right down the troops in the trenches. One solution we’ve explored at Loewy is to offer share options to all colleagues so they benefit from the potential value we create from mergers.

I’d reckon that many designers who have built up a thriving business will have contacts – former colleagues or college friends – who could join forces to create a complementary team. Think about the shape of the business you are creating because that is significant to the interest you will get from future potential buyers or merger partners. Do you want to create a group offering diverse services, or one focused around a particular design discipline or sector.

It’s par for the course in a people business that you will create strife, but the end game could also be greater security, more challenge and a financial ‘upside’. So, it’s important to get everyone focused on the shared goals, even if it can be painful along the way. I’m sure Quentin Crisp said something like, ‘A marriage should be considered for life, not just for financial engineering’. And another sage definitely said, ‘Marry in haste – repent at leisure.’ Do the courting process slowly and thoroughly.

While many people are highly focused on building up their design portfolio, mergers and acquisitions are a different way to grow a business and to create shareholder value. There’s nothing like dipping your toe into the water to see if you might like to follow the this path. But the golden rule is never to get distracted from your own business trading, because this can create a dip in your profits. It can be exciting to consider the deals, but if your profits slip, then you could have the double whammy of a partner who is put off, and no money to pay the bills.

Talk to as many people as you can about how you might do a deal, and put your house in order, because only if you take steps to realise some cash, are you on the way to achieving that. If you don’t make plans, it could be a long journey to financial security and the day when you can draw a pension.

Charlie Hoult is chief executive of Loewy

WAYS TO CREATE CASH VALUE
• Management buy-ins: Sell some of your stake in the business to colleagues. Banks will finance this activity and you could change the business into a limited liability partnership to facili-tate this. Why not also let your colleagues buy you out?
• Roll-ups: Bring a number of profit streams together. This prov-ides a portfolio effect, spreading the risk of having few founders and few clients. You bestow on shareholders a higher p/e ratio – but you need to consider the logistics of such a move