How to Value Your Distributorship

Distributor A had $2 million in annual sales as did Distributor B*. Both were located in the same area of the country and employed two sales reps in addition to the company principal. They used the same software system, both owned a small warehouse and had virtually identical product lines with approximately the same gross margins. But when it came time for the owners to sell their companies, Distributor A was offered $100,000 more than Distributor B. What accounted for the difference?

First, 60 percent of Distributor B's sales were to just one account. The buyer got nervous that the account could disappear tomorrow and adjusted the price accordingly. Next, one of distributor B's salespeople did not want to work for the new owner, and she had never signed a non-compete agreement. Finally, Distributor A's buyer used the same software as Distributor A and was looking forward to transferring all company records quickly and easily. Distributor B's buyer faced the time-consuming process of re-entering data and would never be able to use Distributor B's software or computer system.

Valuing a business is a long and complicated process. It can take several months for a broker or appraiser to value your firm and more than a year to reach a final purchase price and sell it to a willing buyer. Business appraisers say most sellers believe their businesses are worth more than they truly are because of the emotional investment they've made. "They think it's worth many times what it really is because of their blood, sweat and tears." says James Rabe, a senior associate with Willamette Management Associates, a financial consulting firm headquartered in Portland, Ore. At the same time, buyers want to pay as little as possible to maximize their returns, making valuation and subsequent negotiations tricky, complex and time-consuming.

The valuation process is especially difficult for forms distributorships because so much of the business' worth--the customer list--is an intangible asset and thus difficult to value. Unlike revenue at the corner drugstore or bookstore, revenue of a distributorship could swing wildly after such a deal because sales are so dependent on personal relationships. Without the company owner or key salespeople in place, customers may look elsewhere for products.

In small distributorships where the company principal generates most of the sales, the structure of the purchase agreement will have a major impact on the selling price of the firm. For example, a company owner who plans to retire immediately will not usually receive as much for his firm as one who works out an employment contract with the buyer. Even worse, the value of a small, closely held distributorship would decrease substantially if negotiated after the owner's death.

In larger companies, owners may no longer be responsible for selling. Buyers will be less concerned about the owner's impact on sales when a competent sales force exists. Instead, they will fear that under new ownership, salespeople may decide to work for a competing firm instead of joining the buyer. Therefore, the presence (or absence) of enforceable non-compete agreements can result in fluctuations in the value of the company. Buyers also must analyze the owner's role in corporate management and how he could be replaced.

Some methods attempt to value the entire company, including goodwill, by adding together the discounted future cash flow, net earnings or pre-tax earnings for the next five years to present dollars. There are many ways to derive the discount rate, and the appraiser must conduct a thorough analysis of the industry and the company being valued to do so. This may involve studying ratios, such as the price/earnings ratios of publicly traded companies in the industry. This can be misleading when used in the valuation of forms distributorships, since the publicly traded companies in the industry are manufacturers. The discounting method includes valuation of goodwill because projections are predicated on such intangible items as non-compete agreements, transferability of accounts and licensing agreements.

Other methods attempt to assign a separate value to tangible and intangible assets. Appraisers say they can place a value on intangible assets such as non-compete agreements and licensing agreements. They assign a value to these items by comparing current and predicted sales with the agreements in place to current and predicted sales if the agreements did not exist. Future sales are discounted back to present day dollars, and the difference between the figures multiplied by the probability that the contracts will be honored gives an estimate of the worth of these contracts, according to Peter Schaefer, an associate with Compass Capital Advisors in Radnor, Pa.

In some cases, appraisers look at a firm's customer list, mailing list or proprietary software and attempt to estimate what it would cost to recreate these items from scratch, thus placing a value on this aspect of the business.

Most often the seller and the buyer's appraiser will expect to see 5-year pro formas. A seller can increase the credibility of his predictions by making them a few years prior to the sale. Then, show their accuracy by comparing estimated and actual statements. Appraisers may also take last year's earnings or an average of several years' earnings and use an appropriate multiple they have developed as a rough guideline of value.

Valuation is imprecise and highly subjective, in part because it often relies on predictions of future sales, a subjective matter that buyer and seller may dispute. Always consult advisers when buying or selling a company.

Business appraisers caution against using industry rules of thumb because they often result in under- or over-valuation. At most, they should be used as a rough guideline. They may rely on last year's sales or profit margins, which often are not an adequate prediction of future sales or margins. Also, at best, they describe on average, what similar firms fetch in the marketplace. "If you want to sell your business for an average price, OK," says Donald D. Kent, president of The Geneva Companies' Geneva Marketing Services. Geneva, of Irvine, Calif., is a business broker representing sellers in the middle market--those with annual sales up to $100 million.

For those looking for a starting point, Consultant Bob Rosen of R.H. Rosen Associates Inc. in New York, has found that many transactions of forms distributorships result in the buyer paying approximately one year's gross profits--more or less--over some period of time. In DMIA's handbook, "Mergers, Acquisitions & Business Combinations," Rosen says that variations lie in the length of time over which the payment is made and whether or not some portion of the payout is guaranteed. In addition to that payment, the owner often gets the value of the business' assets--whether the buyer purchases them or the owner liquidates them.

When using any rule of thumb related to gross margin, whether as a buyer or seller, make sure that gross margin is being defined and calculated the same way. Also, remember that rules of thumb change over time depending on what the market will bear. Sometimes distributors active in mergers and acquisitions develop their own rules of thumb--at least minimum and maximum values--based on their experience. This may be effective if the distributor buys similar types of distributorships frequently.

No matter which valuation method is used, the appraiser will need to conduct a thorough analysis of the company, its product and customer mix and the marketplace. Both buyers and sellers should be prepared to answer a series of questions about the company's strengths and weaknesses, account base and key salespeople.

Katherine L. House is managing editor of FORM magazine.

* This is a fictional example based on a variety of real-life circumstances.

Accountants--Your accountant may be able to provide limited assistance. As a seller, have him assist in the preparation of past and present financial documents. A buyer may have the accountant review the books of a possible seller. It is unlikely that accountants will have adequate valuation experience. They may value a company according to book value or adjusted book value, which does not account for goodwill and should be used as a minimum selling price only.

Appraisers--They may work for financial consulting firms and investment banking groups. They are generally paid a flat fee so there is little incentive to overvalue the firm. Brokers, however, point out that appraisers may not be as knowledgeable about realistic selling prices because they do not put deals together. For names of people in your area, contact the American Society of Appraisers, Herndon, Va., (703) 478-2228 or (800) ASA-VALU (U.S. and Canada).

Attorneys--Hire an attorney specializing in mergers and acquisitions. Your attorney may be able to provide referrals. If not, ask other business owners for names and check references.

Brokers--Business brokers, sometimes called intermediaries, represent the seller. They can set the value, provide information about the seller to prospective buyers, even close a deal. They are paid a commission based on total sale price. Appraisers at financial consulting firms warn that brokers who appraise firms may give an unrealistically inflated value. For a list of the business brokers in your area, contact the International Business Brokers Association, Reston, Va., (703) 437-7464.

One of the key steps in valuation, especially for small, privately held companies, is adjusting financial statements. Because closely held corporations are usually set up to minimize taxes instead of maximizing profits, the balance sheets and income statements may be misleading.

Typically, the seller adjusts the financials before talking to a prospective buyer. That's because his salary and benefits may be in excess of what a prospective buyer would pay for someone in the same position. By restating the financials, he is able to show what is known as the EBITD number, earnings before interest, taxes and depreciation. In a forms distributorship, it may not be useful for the seller to restate the balance sheet because few line items--if any--would increase in value.

Buyers, on the other hand, often cannot adequately assess the financials until the due diligence process when they probably will adjust both the income statement and the balance sheet. Below is a list of some line items that require close scrutiny. Your accountant, valuation expert or attorney should be able to help.

• Executive Salaries. Often the compensation of the principal is inflated to reduce corporate taxes. A new owner may be able to eliminate the bloated salary or hire a replacement for much less. The buyer likely would want to restate the salary accordingly, increasing earnings on the income statement. This also will be necessary if a spouse is listed on the payroll for an excessive salary compared to the duties performed.

• Expenses. Those that include perks for the company principal, including lavish business trips and an expensive car, often can be reduced. The seller should show increased earnings accordingly. Club dues and membership fees for the owner often can be added back in since the owner's replacement, such as a sales manager, will not be afforded these luxuries. Car insurance for an expensive car will be excessive too, so the seller can adjust the category that includes insurance expenses accordingly.
  Also, the buyer may anticipate that some expenses will be reduced after consolidation. This will increase the value of the company to the buyer, depending on economies that could be realized.

• Rent. If the owner of the company owns the building and leases it to the corporation, the books may reflect a higher rent than true market value. This could artificially decrease earnings on the income statement. At the same time, examine the real estate assets listed on the balance sheet. The stated amount may not reflect true market value, which could increase or decrease total assets based on changes in market conditions. The buyer should determine where warehouse space expenses have been included to make sure selling costs and real estate costs are valued properly.
  Business appraisers recommend that buyers keep the real estate valuation process separate from business valuation because the two processes are so different. Inaccurate valuation of real estate or the structure of a real estate transaction could adversely affect the value of the business.

• Inventories. Inventory for most distributorships is minor unless the company warehouses a lot of stock products, including forms and office supplies. The seller may want to restate inventory using whichever accounting method more accurately reflects current inventory. During due diligence, a buyer should examine the appropriateness of the accounting method used as well as the seller's inventory carefully. If it is outdated or unsalable for any reason, such as poor condition, the value of inventories on the balance sheet may need to be reduced substantially. Determine if excess inventory on the balance sheet could be lowered with tighter controls.

• Artwork. The savvy buyer would eliminate this from the balance sheet if it's listed, thus reducing assets. Artwork is technically owned by customers. Additionally, it may be outdated or unusable, making it of no use to the buyer.

• Equipment. This is not a large factor for most distributorships, and sellers usually do not need to adjust this. During the negotiation process, however, buyers may realize they have no use for office equipment, including telephones and computer hardware, and may want to lower the purchase price. Because there is usually little equipment involved, most sellers need not adjust depreciation on the income statement.

• Goodwill. The seller may have previously purchased another firm and be carrying goodwill on the books and amortizing it. When the buyer analyzes the balance sheets, he would want to eliminate any allowance for goodwill since the cash flow generated from that goodwill would be accounted for when income statement projections are made.

• Accounts Receivable. During due diligence, the buyer should examine the receivables and determine how likely it is that they will be collected. The buyer may adjust the assets on the balance sheet downward for uncollectibles. Often in deals involving distributorships, the seller is responsible for all receivables and payables up to a certain date, leaving the seller responsible for collections.

Buyers also should examine expenses and income carefully for any hidden rebates the seller might have with manufacturers or freight companies. For example, one company owner does not want his sales reps to know the true cost of products, so he worked out an arrangement with a manufacturer who agrees to bill him the true cost plus 10 percent. At the end of each month, the company owner receives a 10 percent rebate that is not reported. Therefore, factory costs are listed as higher than they should be, undervaluing gross margin. Such an arrangement may also raise a red flag in the buyer's mind about company management and the presence of other similar arrangements.

As a buyer or seller, be prepared to answer the following questions about the company being valued. The buyer or the appraiser for either party likely will need to interview the owner and key personnel. Also, see the list at the end of the article for 10 reasons why your business may be worth less than you think.

Are there two or three large customers that represent more than 50 percent of sales? Again, this could decrease the value since the buyer may not be able to retain the sales. Does any customer represent more than 10 percent of sales?

How dependent is the company on a certain industry? Ask the same questions as above. What are the experts' predictions for growth in these industries? While a solid niche market is very desirable, it does bring certain risks, which could decrease the value. Conversely, the buyer may be committed to entering such a market, which he could not do easily on his own. Thus, the value may increase.

What kind of relationship does the company have with key customers? Are some, many or all of them price buyers with little loyalty? Or, are they loyal to the company and recognize the value of the services it provides? Is the company well known and respected in the marketplace? Get insights by talking with the owner and salespeople. Analyze the results of customer surveys, if available.

Increasingly, potential buyers are paying to have customer surveys done to analyze these relationships, then sharing the results with the seller, says Dick Gorelick, president of Gorelick & Associates Inc., a West Chester, Pa., consulting firm that conducts the surveys. Surveys have kept potential buyers from making disastrous purchases by revealing that client relationships were not very deep and were largely dependent on price, he says.

Does the company have signed contracts or verbal agreements with customers that will help ensure the transfer of business? The presence of forms management accounts will enhance the value, says Gorelick, because it is difficult for forms management buyers to switch vendors. Examine the percentage of repeat business to determine if every sale is a new one or repeats are prevalent.

Does the company have any patents, copyrights, trademarks, exclusive territory agreements with vendors or licensing agreements in place?

What type of operating data does the company maintain? This extends beyond financial data to information about vendor performance, job tracking and accounts receivable. This could significantly enhance a firm's value because it illustrates managers are not operating by the seat of their pants, according to Gorelick. Also, buyers can benefit from the data when integrating the companies.

Does the firm have extensive customer files? Data on each customer detailing such things as the buyer's birthday, his preferred freight line, shipping addresses and tolerances for overruns and underruns can increase the value because they help provide for continuity without the company principal, says Gorelick.

What type of banking relationship does the company have? What about the line of credit? "A poor or non-existent banking relationship might lower the purchase price," says Gorelick. "A good relationship with a good line of credit will enhance it."

What is the stability of the top 20 accounts in the last five years? Look to see if those that were in the top 20 five years ago are still there. Have there been significant increases or decreases in sales?

How stable has the employee base been during the last few years? Focus on anyone with direct customer contact.

How effective and well-balanced is the sales effort with or without the owner? Does the owner or one salesperson account for all or the majority of sales?

Are enforceable non-compete agreements in place? Are the owner, key salespeople and key managers likely to stay in place after the merger or acquisition? If not, how will this affect sales and earnings? Some buyers say the negotiation process would have stopped if key personnel had not agreed to join their firms.

How desirable is the product mix? Is it heavily reliant on certain products? What are the predicted growth rates for key products? What type of competition does the company face for sales of these products? Reliance on products with little or no growth rates could lower the value of a firm. Conversely, an edge in a market with projected higher than average growth or little competition could increase it.

Is most of the business done locally or nationwide? If local, what is the economic outlook for the region? A business in a depressed area likely will not bring as high a price as one in a booming market.

Who are the company's main competitors? What are their strengths and weaknesses?

Many intangible items, such as the personality of buyer and seller, may affect the way the deal is structured, the ultimate purchase price, even whether the deal is consummated. Because business agreements of this type have major tax ramifications for buyers and sellers, plan accordingly. Sellers also will want to find a way to protect themselves if the buyer dies before the end of the payout period. Always consult an attorney specializing in mergers and acquisitions.

Katherine L. House is managing editor of FORM Magazine.