When it comes to figuring out what a pallet company is worth, the answer is more complicated than a simple multiplier of sales or profits — or the amount a competitor sold for last year.
The time to think about your company’s value is not when you want to sell it but while you are building it.
According to the Internal Revenue Service, the value of a business is determined by what it will sell for when the seller and buyer are both fully informed, and when neither is pressured to make the transaction. Planning ahead and determining the worth of your business now should help maximize its value when the time comes to sell.
"Valuation is subjective," said Jim Schwab of Crimstone Partners, a special purpose private equity firm. Crimstone made headlines in the pallet industry in 2005 when it purchased AAA Pallet, which has operations in Texas and Oklahoma. Based in Dallas, Crimstone focuses on middle market manufacturing and services companies, acquiring those where it sees long-term growth opportunities. In addition, Crimstone takes a hands-on management approach.
"I use a very simple analogy," Jim said. "Buying a company is no different than buying a treasury bond — you are investing with an expectation of return. But unlike treasuries, companies have a range of risks that affect the certainty of that return. Therefore, buyers expect more upside for taking that risk. That risk tolerance is different, depending on the buyer."
Jim has experience as a management consultant and also ran logistics for a major telecommunications carrier. His partner in Crimstone is Robert Sullivan, who is an experienced operations manager and investment banker. The two met while students at Harvard business school.
The Crimstone partners did a financial analysis and valuation of AAA Pallet. "They use things such as interest rates, taxes, earnings history, earnings forecast, hurdle rates and comparisons to alternative investments, and sophisticated tools such as discounted cash flow," said Jim Crowe, the previous owner. "In other words, they have it down to a science."
Jim Crowe hired RSM EquiCo to perform a similar analysis. RSM EquiCo is an investment banking firm that specializes in mergers and acquisitions, divestitures and corporate finance for the private, mid-size business market.
"They (RSM EquiCo) examined the current state of the mergers and acquisitions market as it pertained to transactions involving wood pallet manufacturers and recyclers," Jim Crowe explained. "They evaluated AAA Pallet in terms of its customer base, its suppliers, employees, systems, earnings history and projections."
After the analysis was complete, RSM put a value on AAA — what they thought the company was worth in the merger and acquisition market at that time. "After going to market, it became clear that buyers were agreeing with our enterprise value," said Jim Crowe.
A key consideration in determining the value of a business is risk tolerance. "For example," said Jim Schwab, "if a private equity firm is the potential buyer and half the customer base is a single customer, there is a degree of risk. But if a major forest products company is the potential buyer, perhaps its existing relationship with the large customer is only strengthened by the acquisition." In other words, a business may have a different value to different potential buyers.
"In building value you have to be conscious of what your exit strategy is," said Jim Schwab. "In any case, the best way to build value is to show a history of strong performance relative to peers and to have market leadership in your region." A company that wants to appeal to investors should possess a diverse customer base, strong business systems and a management team that is capable of growing the business.
"Value is based on growth and profitability," he added. "I’m much more comfortable with a strong, defensible market position."
Because business value is based strongly on such factors as financial performance, business systems and management, which need to develop over time, many valuation experts warn that the time to start thinking about a company’s worth is when you buy it or start it – not when you want to sell.
"Understanding the factors that determine the value of any business will pay tangible dividends by focusing you on ways to increase your firm’s short and long-run profitability," wrote Dr. Stanley J. Feldman, co-founder and chairman of Axiom Valuation Solutions, in a 2002 article published on Axiom’s Web site (www.axiomvaluation.com). "Therefore, there is no time like the present to begin to understand what a business valuation is, under what circumstances a valuation is customarily completed, and the critical issues to for when events dictate that you undertake a business valuation."
Dr. Feldman noted that if a business is to exist beyond its current owners through business and estate planning, then a regular valuation of the business is required.
Several other factors can impact a company’s valuation, including interest rates, mergers and acquisition market exuberance, and others, Jim Schwab observed. "Within the context of your business, those will ratchet the value up or down," he said. "I want to buy a great business at a fair price rather than a fair business at a great price," he said, quoting investor Warren Buffett.
People will use tricks to favorably affect the valuation process. "Ultimately the process of due diligence will wash them away," said Jim Schwab.
"I would caution potential pallet company sellers to be aware that interest rates, taxes and trends in the mergers and acquisitions market change," said Jim Crowe. "All of these variables have an impact on valuations. All companies are unique in terms of their strengths and weakness. These variables will also have an impact on value."
Sellers should do research or seek credible advice, suggested Jim Schwab. He advised against relying on an agent or broker to perform the valuation process, particularly one who promises he can sell your business for a high price. For example, he noted that a realtor may offer an inflated opinion of a home’s value in order to obtain the property’s listing from the owner. Over-pricing a home or business can result in it sitting on the market far too long.
"The tendency for many is to go with the highest appraisal," said Jim Schwab, "although selling it at the highest price might prove to be problematic because of unrealistic expectations. People need to look realistically at the value of their business. The more informed you are, the better. You can do a good analysis yourself or with a third party."
While it may be difficult to identify other similar pallet businesses in your region for comparison purposes, Jim Schwab suggested it may be possible to find other comparable businesses, such as other low-tech industrial or manufacturing companies, wood products businesses, machine shops or others. "To the extent that you can get direct industry comparables, great, but they may be misleading if data is not comparable to your operation," he said.
"Take a mix of a variety of companies in and about your geography," Jim Schwab added. "And if it sounds too good to be true, it probably is."
He prefers not to use a simple multiplier of sales or profits in determining a company’s value. When pressed, however, he offered a rough range. "It is all about cash flow. A range of three to five times earnings is a common range for smaller companies. Usually, the larger the company, the larger the multiplier." Most experts caution against this method of valuing a business because even with an accepted range of multipliers the valuation may vary widely.
Dr. Feldman emphasized to both buyers and sellers to look beyond the bottom line if a privately owned business is losing money on paper, a situation that is fairly common. It can be deceiving if cash is "masquerading as legitimate expenses," such as lucrative salaries and bonuses for owners or managers. A good ‘test’ for determining excessive compensation: would the owner pay a stranger the same amount for the job? Any excess is cash the business generates, and identifying cash positively impacts a company’s value. Sellers can increase buyer confidence – and ultimately the value of their company — by keeping track of discretionary expenses and sharing that information with a prospective buyer.
Before Crimstone decided on AAA Pallet for its first acquisition, the partners looked closely at a number of other companies. They considered tooling businesses, metal shops, cabinet manufacturing plants, and rubber operations, among others.
When asked if he thought that there was anything in particular buyers or sellers should consider in valuing a pallet company versus another type of business, Jim Crowe said, "I don’t think there is anything unique about the pallet industry. It is a mature industry growing at four percent a year."
Jim Schwab summarized the valuation process. "Everybody’s journey is going to be different," he said. The key for business owners is to begin the valuation journey earlier – not later.
