Determining Your Company’s Value May Be an Adventure
Proceed with caution when it comes to spending your hard earned money on a valuation of your business.
By Rick LeBlanc
Date Posted: 3/1/2002
(Editor’s Note: This is the first of a two-part series on business valuation for pallet companies; part two will be published in the April issue.)
When Jeff Baggett received a mailing last summer from Great Western Business Services Inc., he was a little suspicious. The amount of money it suggested that his Ozark, Missouri-based pallet business was worth seemed a little far fetched.
Great Western, a Dallas based co-operative business marketing company, implied that it had significant expertise about his kind of business, Jeff recalled. Having been around the industry for many years, though, the numbers did not add up. "They were kidding themselves," he said. "You get all kinds of scams in the mail." Jeff threw the letter away.
Proceed with caution when it comes to spending your hard earned money on a valuation of your business or accepting an offer for a ‘free’ evaluation that has up-front fees for marketing services. One scam that has been reported recently is the practice of offering a free initial valuation, a tantalizing hook that suggests that your business is worth a lot more than you thought possible. Great Western Business Services, the company that solicited Jeff by mail, was the topic of such a story in INC Magazine a few months ago.
The scam goes something like this. The business owner may not have a good idea of his company’s real value. Not surprisingly, he spends most or all of his time running his business. He started it or built it up by himself, so he has nothing to compare the value to -- as he would if he had bought the business recently. He is contacted by a co-op marketing company by phone call or through the mail and is offered a free valuation. A representative of the company determines a value for his business that seems too good to be true -- and it most likely is just that. After getting his ‘free’ but inflated valuation, the entrepreneur suddenly has visions of selling his business and retiring to Florida. Blinded by the dollar signs, he agrees to pay an up-front fee to the same company to market his business to prospective buyers.
In the case of the INC Magazine article, the up-front fees amounted to $8,975 for a fence installation company and $10,205 for a small storage company. Neither was sold as a result of the marketing services, and they received only a few, inconsequential leads from prospective buyers. Both companies felt that they had been severely misled.
The best protection against this type of scam is to come already armed with a basic grasp of your company’s value. In Jeff’s case, he had sold his business to PRANA several years earlier and bought it back, so he was only too aware that the figure suggested by the ‘free’ valuation was too high.
A related pitfall is paying a business broker a large up-front fee for a valuation. Patrick Seitz, a pallet broker at Sunbelt Business Brokers in Chattanooga, Tenn., warned most pallet companies not to get involved with brokers that charge up-front for valuation services. "This could introduce an element of bias," he said. "They may charge $10,000 to $20,000 to do the valuation and have zero interest in doing a deal." In other words, the broker may be more interested in the fee he collects for the valuation than actually helping you sell your business. If the broker already has collected his fee for a valuation, he may not be particularly motivated to complete a deal. (In mergers and acquisitions involving large companies, Pat noted, there typically is a non-refundable fee paid up-front to the investment banker.) Others also caution that for businesses of modest size, typically only one of three listed with a broker actually sells. Many brokers will look for some kind of up-front fee to cover their expenses of marketing a business. If you don’t want to pay fees up-front, they will urge you to shop around for another broker.
What Is a Pallet Business Worth?
Valuing a business is a back-burner issue most of the time, pointed out Lawrence Tuller, author of "The Small Business Valuation Book." However, when it becomes time to sell, take on new investors, end a partnership, or make some other major organizational or ownership change, knowing the value of the business is crucial to such critical decisions. Understanding the valuation processes can also help business owners make decisions more likely to enhance the value of their companies.
Valuation of a business is important for many reasons, including -- but not limited to -- its potential sale. These include:
CSell your business at the fair market value
CProvide a lender with fair market value information for a business loan
CPlan for a merger, acquisition or stock offering
CDevelop an estate plan or tax plan to protect your wealth
CTransfer of the business into a trust or create a succession plan
CDetermine the value of assets and liabilities for a divorce settlement
CAssist attorneys in litigation
CSettlement of an insurance claim
CSet up an employee stock ownership plan (ESOP)
(Source: Ross, Wendler & Steen)
Just as there are many reasons for wanting to know what a business is worth, there are many methods to determine its value. Experts agree that determining the worth of a pallet business is both art and science. It goes beyond the application of basic cash flow or sales multiples, although these will provide a useful launching point. "Ultimately, a pallet business, as any business, is worth what a reasonable buyer will pay for it and what the seller will reasonably sell if for," Pat observed.
The most commonly used rules of thumb for determining the value of a pallet business are multiples of sales or cash flow, such as three to five times net operating cash flow (or EBITDA, earnings before interest, tax, depreciation and amortization.)
We used the Pallet Board, an Internet bulletin board at the Pallet Enterprise Web site (www.palletenterise.com), to ask others in the pallet industry about this issue. "I purchased at four times cash flow (i.e. EBITDA) in 1995," said one Pallet Board visitor. "I have heard people shoot values as low as three times cash flow. This seems ridiculously low. Especially for a capital intensive business (in new manufacturing) which, if the equipment has been well maintained over the years, would give any buyer additional security. I would think four and a half or even five times cash flow would be more reasonable."
Others believe that a multiple of four would sound pretty tempting. Jeff, who owns Industrial Wood Products, is one. "In my experience," he said, "in a flat-out cash deal, if someone is willing to pay four times the cash flow, you would be able to buy pallet companies by the hundreds. People would be jumping all over it." Like other business veterans, Jeff hopes to sell his company one day and retire.
Jeff, who has been in business for 18 years, has hands-on experience in selling his company. He sold his company several years ago to PRANA during a time when pallet businesses were valued at about seven times their cash flow. Now, even values based on lower multiples should be attractive, according to Jeff. "From my experiences, with three of four times cash flow you could buy as many pallet companies as you wanted."
Some people argue that basing a company’s value on a multiple of cash flow can be overly simplistic; the method looks only at historical performance and does not take into account prospects for the future. "It is pretty simple to say three times $300,000 is $900,000, but there may be more important things involved," said Andrew Davies, president of Iroquois Enterprises in Iroquois Ontario. "I don’t like that particular approach because we are working off history."
More complex valuation methods rely on forecasting models and discounting future cash flows; they involve best guesses about future economic, market and operating conditions.
While forecasting and discounting future cash flows may be more scientific, history is also important in determining what a company is worth. "If a person is already established, they probably already have an excellent banking relationship," Pat said. "Do we have the cash flow to service the debt and establish a reserve account? The best way to judge the future is the past."
Of particular interest to Iroquois when it bought Thomco Pallet & Box was the potential for efficiencies and savings when combining the acquisition with existing operations. "Synergies – that was a big player," Andrew stated. "If it is the first pallet plant you are buying, then there are no synergies. We felt we had some major ones." Iroquois was able to reduce some costs by pooling resources among multiple facilities.
The presence of synergies to cut costs may help explain why IFCO sought to sell its pallet manufacturing plants as a single unit; presumably the synergies among its plants increased their aggregate value. (IFCO ultimately sold its plants in two groups; it sold off three Western plants together and later sold the remaining dozen facilities to PalletOne.)
Synergies may exist between the same kind of business in a different geographic market or a complementary business in the same geographic area. The latter was the case for Bernie Kamps of Michigan-based Kamps Pallets Inc., when he was looking to acquire a landscaping mulch business. "When we bought a landscaping mulch business, we did it because we were moving into that business," Bernie recalled.
"We had been in pallet recycling and new pallet manufacturing, and that was back in the early 90s, and we were creating a tremendous amount of landscaping mulch," said Bernie. "We thought, ‘Why don’t we purchase a landscaping mulch company -- one that already had as its clients the people we want to sell to?’ Instantly, we had customers throughout the whole state of Michigan. It was a way to integrate our business. We were looking at that as a way to push our business."
When Iroquois began talking with Thomco owner Bill Thomlinson, Bill came up with a price and was pretty firm about it. After analyzing Thomco’s numbers, Iroquois agreed his price was fair and struck a deal.
Even if a company has been doing well, no one can predict future performance, of course. As a precaution, Iroquois scrutinized possible ‘what if’ scenarios for worst-case consequences. For example, would they be alright if they lost some of their biggest customer accounts? The answers to those kind of questions were yes.
If the owner still enjoys running the business, it may take a higher price to "knock him out of the seat," said Ross Beverley of Kenleigh Wood Products in Acton, Ontario. Sometimes an owner will price his business high to scare away potential buyers.
Terms of a sale can play a big part in determining the value of a business. "Terms can have a big impact on how it is valued," Andrew said. "Some guys want to sell and stay on under contract. In this case, the buyer may be able to keep the purchase price down by offering the owner a larger salary over an extended contract period." Deferred payments and interest-free loans are other options. Income tax and capital gains tax considerations may factor into how a sale may be structured.
An advantage of retaining the owner as an employee, at least during transition, is better access to more favorable bank terms. Lending institutions are more comfortable if the previous owner of a successful business stays on during a transition period -- especially if the new owner does not have direct experience in the same kind of business or industry. According to Pat, the worst thing that could happen is for the seller to say, ‘Here are the keys, see you later.’ A smooth transition is vital for the new owner to become properly orientated with employees, vendors and suppliers – and even competitors. "There needs to be a proper handing of the baton from old to new," Pat said. A common practice is to sign the owner to a management contract for three to six months after the business changes hands.
There are many different ways to try to pin down the value of a going concern. Stuart Knotts, owner of The Pallet Express in Nimpco, Calif., advertised his company for sale in Pallet Enterprise. He got calls from potential buyers, but then Stuart got busy and did not have the time to follow up with them. His valuation method was straightforward. "I just added up all my equipment, and an average of what I had sold over the last eight or nine years, and said it will take a guy ‘x’ amount of years to pay off his debt from buying it,"Stuart said.
(Next month: Pros and Cons of Third-Party Valuation.)
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