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When we meet a client who is considering selling their business, a question/concern that is often raised is “I don’t have any formal contracts in place with my customers, does that mean my business is not worth anything?”
The impact of having or not having contracts on valuation is unique to each business. Sometimes contracts are critical and sometimes they mean nothing at all.
Quality of earnings
In simple terms, businesses that attract higher valuation multiples are businesses that have a high ‘quality of earnings’. Quality of earnings is a ‘banker’ term to describe how reliable and stable the profit of business will be over many future years. At the heart of this question is how do customer contracts impact the future reliability of a businesses’ earnings?
There are many scenarios where customer contracts in a business mean very little and do not impact value at all. For example, most companies that sell their own brand of products through retailers (such as Coles or Woolworths) do not have any formal contractual commitment from their customers. In theory, their products can be deleted on a moment’s notice and there is no guarantee of future sales. In reality, a contract with a retailer in this situation is of little value. This is because it is ultimately the end consumer (the customer of the retailer) that makes the purchasing decision, and it is in the retailer’s best interests to keep consumers happy.
A strong brand can attract a high valuation multiple without any formal contracts in place. Consumers make purchasing decisions based on their opinion of brand image, product quality, value etc. In the above scenario, consumers would make the decision to purchase a product thousands of times every day. That makes for very compelling data. It is ultimately the sales volume, market share and gross profit margins over time that indicate the ‘quality of earnings’ for the brand. In general, it is better to have thousands of customers decide to support a product every day, then having one customer decide on a contract once every three years.
Following on from the above example, there are many manufacturers that supply private label products to retailers under detailed, formal contracts which are typically for a fixed term. In this scenario, there are often minimum order quantities and agreed pricing so that the earnings from such a contract can be predictable over the contract term. However, these contracts are typically short term (1 – 3 years) and there is a real possibility that a competitor will win the next contract and the earnings will cease. The nature of such contracts means there can be significant volatility in earnings (less predictable) and hence they have a lower ‘quality of earnings’.
Clearly from the above scenario, a strong brand with no contracts, will attract higher valuation multiples that a private label contract-based business, even if the product they are supplying is identical. To improve quality of earnings, a contract based business should look to have low customer concentration to reduce volatility if a contract is lost.
Formal documentation
Contracts can be important to business value when important business decisions are reliant on the successful execution of projects. In construction or industrial sectors, starting new projects often requires a significant investment of resources and capital. If you are operating in these sectors on ‘verbal agreements’ this can create a significant issue during a sale process. Whilst a ‘handshake’ agreement may suffice for a private owner with a long standing relationship with their client, a buyer will see substantial risk if the contract is not legally enforceable. Buyer’s will seek the comfort of binding written contracts, as if the verbal contract were to ‘fall through’ the business may face immediate financial distress and any goodwill paid by the purchaser could be destroyed. During a sale process, it is also difficult to extract value from buyers for any new projects that are upcoming (and verbally agreed). It is important the Vendors formally document these agreements prior to starting a sale process.
In summary, this article outlines situations where contracts are and are not important to company valuation. In a general sense, clients should ask themselves, does the absence of a formal contract reasonably impact the reliability of my company’s earnings, in the eyes of a new owner.
