| True Value Jim Hotze and Kent Watts decided to merge
their companies, but first they had to figure out what
each was worth
Jim Hotze and Kent Watts both owned
successful companies that distributed business equipment,
situated just blocks apart from each other in the Houston
area. The two men even shared the same bank. But until
their loan officers started talking about the two
entrepreneurs--and the growth strategies each man had
started to explore in response to rapidly changing
conditions within their shared industry--the pair had
never exchanged a word.
But as soon as his banker passed on
the lead last spring, Watts made a cold call to Hotze
and, hoping for some feedback and even contacts, broached
the idea of selling his company, Wallace Business
Technology Inc. As Hotze recalls it, he listened to
Watts, rapidly calculated the possibilities, and then
replied, "If I may be so bold, let's merge
instead." Within minutes the men were meeting
face-to-face over lunch. That was the first of a series
of conversations in which they swapped their visions for
future accelerated growth, their attitudes about family
and business values, and, finally, their key financial
numbers.
Two months later they were ready to
consummate what looked to be a perfect union. Hooking up
with Hotze's company, Patriot Group, which specialized in
selling upper-end office printers to the region's largest
corporations, offered Watts the chance to broaden the
customer base of his business. In turn, his company,
which sold a variety of business machines, serviced laser
printers, and provided computer-network support, would
provide Patriot with a servicing capability its customers
and suppliers wanted. Hotze and Watts were convinced that
together they could create a powerhouse that could ring
up as much as $30 million in sales over the next few
years.
One hurdle remained: figuring out
how to structure the deal. Whose company was worth what?
What Hotze and Watts wanted was a fair assessment of how
much their respective companies were worth. Those
valuations would allow them to weight their stock
holdings in the new combined venture.
"We didn't want to argue or to
turn this into a whole emotional thing," Hotze
recalls. "What if Kent had said to me, 'My company
is more valuable than yours because you need me,' and I
had argued, 'My company is more valuable because it's
bigger'? What we needed was a way to remove our egos from
the process and just get a fair answer to the
question." Sitting around his conference table just
days before their merger finally closed, in mid-October,
Watts agrees. "What we needed was a baseline,"
he says.
The way they got to square one was
by hiring an independent appraiser to perform valuations
on both companies. Those figures then provided the basis
for the new company's equity structure. Neither man had
ever paid for a valuation before. But despite the cost in
money and in time, both owners are now hooked.
In many ways Hotze and Watts were
stuck in the classic entrepreneurial bind. They knew they
had successful companies and believed they could make
them even better--but since the companies were private,
neither knew how much the businesses were worth.
Was it revenues that mattered most?
Since Hotze's company logged nearly $12 million in 1997
sales, compared with Watts's $1.6 million, was Patriot
worth 7.5 times as much as Wallace Business Technology?
(No.) How much did corporate history matter? After all,
Wallace had been founded 51 years earlier by Watts's
father-in-law. Did that make the company 2.7 times as
valuable as Patriot, which was only 19 years old?
(Hardly.) Then there were all those other ratios that
might have held the answer. With 26 employees, Patriot
logged about $461,500 in sales per staff member. With
only 12 employees, Wallace had a sales-per-employee
figure of $133,000. So could one assume that Patriot was
nearly 3.5 times more valuable than Wallace? (No.) No
wonder the would-be partners agreed to turn to an
experienced outsider for guidance.
The pair began by consulting
Watts's upscale, downtown law firm, which supplied them
with a list of names, including a large local appraisal
firm. "It was frustrating," Watts recalls.
"Here it was, the end of March, and we really wanted
to get someone here quickly so we could wrap everything
up. But no one would return our phone calls--which we
eventually learned was because the firm was so busy with
valuations tied to taxes and the April 15 deadline.
Finally, a guy came out and we tried to explain to him
what we wanted."
Watts emphasizes: "We tried
to explain to him what we needed. But he just told us it
was going to cost us $8,000 apiece. And we told him,
'Wait! You don't understand. This valuation isn't for our
bankers or the IRS. It's just for the two of us. All we
want is a couple of numbers.'"
Although Hotze and Watts nixed the
first appraiser, they did ask him for a referral. He
suggested Jeff Jones, a local business broker and
appraiser with 25 years' experience performing appraisals
on privately held companies. Jones talked to the pair and
realized their needs would be met by what is known in the
industry as a "limited" valuation. "The
best way to think of this is as a summary report,"
Jones explains. "It doesn't give a single number but
comes up with a range of fair market values. Meanwhile,
it doesn't regurgitate a lot of industry and business
information that you already know." Instead of the
70 or 80 pages that a full-scale valuation might run, a
limited appraisal comes in at 10 to 15 pages. Jones's
price: $2,500 for each of the companies, in return for
two separate appraisal documents.
Watts and Hotze agreed in advance
that they wouldn't be bound by any of Jones's conclusions
if they didn't like what he had to say. But they were
hoping the process would give them the blueprint they
needed. As Hotze says, "If someone was going to tell
me that I was ugly, I wanted it to be someone other than
the guy I was planning on partnering up with."
In all, the process took about
three months. That was longer than the pair had expected,
and, if anything, the rigor of the appraiser's
investigations surprised them both. Jones began with an
in-person interview of each entrepreneur that lasted
several hours apiece. He started by asking them 26 pages'
worth of questions. Some were relatively straightforward:
How and where is the company incorporated? Who are its
lawyers, accountants, and other advisers? How many shares
of common and preferred stock have been authorized and
issued, and who owns what? Meanwhile, other questions
required a level of analysis that sent Hotze and Watts
off to perform some homework (for example, "Describe
your company's pricing and profit margins, if relevant,
on a product-by-product basis"). Jones says that he
developed the list of questions based on his own
experience performing valuations--and he's always adding
to the list.
Unfortunately for the impatient
Hotze and Watts, those questions were just the beginning
of the process. Jones required various types of support
documentation, such as financial reports and five years'
worth of tax returns for each business owner. "I
needed that to give me a good sense of the way the
companies behave in a full business cycle," he
explains.
Neither Patriot Group nor Wallace
Business Technology could present audited financial
statements, which meant that Jones had to be extra
diligent to verify the accuracy of their claims about
assets, financial results, and the like. Along the way,
the appraiser toured each company's facilities, camera in
hand.
After researching the companies,
Jones investigated general industry trends, which he
analyzed through trade associations and journals, Web
sites, and other independent resources. "That can be
the most time-consuming part of the process, but risk
scenarios are an essential feature of any
valuation," he explains. "One of the ways that
an expert evaluates a company's worth is by comparing its
risk and reward with all other possible investments that
might exist."
The final documents seem, at first
glance, to be deceptively modest in scope. Each begins
with a short letter that outlines the goal of the
appraisal: to determine fair market value. The meat of
the report consists of several pages in which Jones
calculated the value of each company according to a
variety of different appraisal methods.
A careful reader of those methods
would quickly come to the conclusion that valuation is
indeed an art and not a science. Different methods yield
different numbers. Jones emphasized the inexactness of
the numbers by the way he listed them on the bottom line
of each page, using the word say, as in
"Let's say it's about somewhere in the range
of...."
For the Patriot Group, an
asset-based approach that used book-value numbers yielded
a "say" value of about $973,000. Relying on
market rules of thumb for companies in the distribution
business produced considerably higher numbers, although
those figures also varied widely. Such companies tend to
sell at 30% of gross sales. Factoring in such things as
tangible and intangible assets and long-term liabilities,
the appraiser came up with a $5.1-million valuation based
on pro forma 1998 revenues of $14.4 million. Relying on
current business-sale trends related to annual adjusted
earnings, the result was a range from $2.2 million to
$2.6 million.
It was Jones's job to make sense of
those various sets of numbers and come up with a
defensible fair market value range, based upon the
particulars of each company's situation (which included
its net working-capital position, long-term debt,
nonoperating asset profile, and other key details). In
Patriot Group's case, Jones's range was a value of $2.9
million to $3.2 million. Wallace Business Technology's
value range was $409,000 to $445,000. In each case, Jones
concluded that the business was worth more than the
marketable sum of its tangible assets (his acknowledgment
that the ongoing business operations were indeed valuable
in themselves).
When Hotze and Watts received the
reports, they shared a quick telephone call in which they
confirmed that they both felt good about the numbers.
Using the valuations as the basis for their equity split,
Patriot's original owners (Hotze; his wife, Cindy; and
their partner, Patty Brown) received 87% of the stock in
the new company, which kept Patriot's name; Watts and his
wife, Jo Ann, received the rest.
Of course, as with any corporate
merger, that was the beginning and not the end. The new
partners share a vision for accelerated growth, which
will include building up strong sales and service
operations in their home state's other major cities:
Dallas, San Antonio, and Austin. They intend to build a
business with roughly twice this year's current combined
sales of $16 million. Says Hotze: "Kent's instinct
is to start from scratch. I want to make certain that
nothing great already exists which we can buy or merge
with. But the one thing that our valuation experience
gives us is a blueprint for how to carry out another
merger, if that's the route we go. We're not going to
argue. We're not going to lowball other entrepreneurs.
We're not going to interject a whole lot of gamesmanship.
We're just going to build a really good business."
Jill Andresky Fraser is Inc. Magazine's Finance editor.
the HIGHLIGHTS
- REASON FOR VALUATION:
To value proposed merger of two
business-equipment distributors
the PLAYERS
- COMPANY ONE:
Patriot Group, in Houston, founded in 1979 * CEO,
Jim Hotze, age 45 * 1997 revenues, $12 million *
26 employees * specialty: selling highend
printers to corporate clients COMPANY TWO:
Wallace Business Technology, in Bellaire, Texas,
founded in 1947 by father-in-law of current
president, Kent Watts, age 55 * 1997 revenues,
$1.6 million * 12 employees * specialty: selling
business machines and computer-network support
primarily to small and midsize companies
APPRAISER:
Jeff Jones, owner of five-person Certified Appraisers Inc., in Houston, with
25 years in the business of valuing private
companies
the PROCESS
- TYPE of valuation: A
limited appraisal
TIME from contract to written valuation:
Three months
COST: $2,500 for each company
FINAL VALUATION: For Patriot Group, $2.9
million to $3.2 million; for Wallace Business
Technology, $409,000 to $445,000
the FUTURE
- THREE THINGS the merged
company could do to increase the value of the
business:
1.
Accelerate revenue growth
2. Add new sources
of income by broadening product and service lines
3. Diversify
customer base
the BIGGEST SURPRISE
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