Valuation, It’s All Relative
“So Tim, what is a beer distributorship worth these days?”
For me, this is a recurring question; and I’m sure it’s a recurring question for others who determine the value of beer distributorships.
“It depends,” is the short and somewhat vague response I’ve provided in the past. Making that particular statement is not an attempt to be coy, unresponsive, or irksome. The “it depends” answer is provided because professional standards prohibit analysis-free valuations and, more importantly, because the “right” answer is, “It’s all relative.”
A cynic could suggest that valuation standards prohibit off-the-cuff valuations as a fee-mitigation defense, but that would be wrong. Professional standards prohibit such offerings simply because the old adage about what happens when you assume becomes horrendous when the assumptions profoundly affect someone’s generational enterprise and livelihood.
Simple answers to valuation questions appear compelling but they actually provide a potentially dangerous disservice. Valuation questions cannot be answered without context. The answer, “it depends” is not intended to avoid the question—it is intended to start a conversation.
Historically, I have followed the “it depends” answer with a series of my own questions. Are you talking about your entire business, or are you just asking about a particular brand? What are you contemplating selling, stock or selected assets? Are you asking, “What is the maximum amount that a strategic buyer might possibly pay, or could afford to pay?” If so, who is that buyer? What kind of synergies can be generated by the combination? How much equity can they bring to the table? What is their disposition towards acquisition? Is there a single strategic buyer with material synergies or are there multiple strategic buyers with material synergies? Or are you really asking me what you need to pay for an acquisition, but are doing it in an inverse manner?
This is a conversational dance I’ve performed so many times that I’ve worn a path on my speakerphone. There was a time when I could have the conversation waiting for a cab outside the Denver Convention Center after the Great American Beer Festival, but then came 2008. The gaps between buyers and sellers and risk and reward became chasms. The need for an augmented response hit me. Ultimately, the notion struck me, “it’s all relative.”
If you look up the definition of “relative” you’ll find that Webster’s lists nouns first. At the top of the list of definitions for “relative” is, “a person who is connected with another or others by blood or marriage.” Blood relations are good place to start when you consider the relative nature of valuation perspectives. You can encompass the entire value spectrum (a past DMGF seminar topic) while covering the range of issues a family business might have to deal with over the course of a generation.
At the low-end of the valuation spectrum is the tiny nonvoting stock interest that might be gifted or sold near the beginning of the succession process. The following is an exaggeration (almost a cartoon) of such a situation.
Joe Senior tells Joe Junior that he’s getting a tiny, insignificant stake in the family business for his 21st birthday. Joe Junior can get excited about that tiny, insignificant stake in the company because—for Junior—there is an implicit expectation of increasing interest and ultimately control. Joe Junior might even manage to retain that excitement when Joe Senior explains the details.
“Here’s the deal son. You’re getting one of the 1,000 nonvoting shares in the company. Your mom and I are going to keep the other 999 nonvoting shares and I’ll keep all 100 of the voting shares. I want you to come to the annual board meeting, even though you’re not going to be on the board and won’t be allowed to speak. I want you to see how the chairman of the board, the president, the director of HR, and the compensation committee (i.e., me, me, me, and me) make decisions. As a preview, I can tell you that your annual distribution will only cover your tax liability and your annual bonus will be based on my mood. This, my son, is going to be a great deal for you.” And for Joe Junior, if all goes as planned, in the end it will be.
As a relative of Joe Senior, Joe Junior can be comforted by the intimate knowledge that this first gifting of shares is just the beginning, and that there is a long-term plan to get Junior to a point of significant interest and, ultimately, to a position of control. So, that first control-free, zero-net-divided share he’s getting should have some significant personal value to Junior. If Junior loses sight of his future and decides to liquidate his interest in the family business, however, then he might find that the market value of that single insignificant share is rather disappointing.
One can imagine what might happen if Junior attempted to find a buyer for his single nonvoting share. Junior—knowing that it is a consolidating industry—might decide to reach out to someone he perceives to be a strategic buyer. Let’s call that hypothetical potential buyer John Doe. Further, assume that this John Doe character is known to be an eager beer consolidator. So, in Junior’s mind, John Doe could be a wonderful potential buyer for his single nonvoting share.
Outside of Junior’s mind and in the world of practical reality, however, Mr. Doe is not a relative of Joe Senior. Therefore, Mr. Doe has no expectation of benevolence from Joe Senior and there is no implied path by which Mr. Doe will garner a more significant stock position. John Doe sees Joe Junior’s single share as a nonvoting (discounted), noncontrolling (discounted), and illiquid (discounted) investment. Perhaps more importantly, a single share doesn’t garner the interest of a consolidator like John Doe. Mr. Doe buys whole businesses, not fractional interests. John Doe understands that a single nonvoting share could well be a zero-return investment until Joe Senior decides otherwise. John Doe sees three reasons to discount from what DMGF calls stand-alone fair market value and zero reasons to pay a premium. Relative to John Doe’s perspective, Junior’s single share is about as uncompelling as is possible.
Now let’s move from the low end of the spectrum to the middle of the spectrum, and go from cartoon to conflict.
Imagine that, simultaneous with his gift to Joe Junior, Joe Senior gifted an identical share of stock to Junior’s older sister Kathy. Thereafter, Kathy and Joe Junior work for the distributorship. They both perform well and contribute to the ongoing success of the family business. Ultimately, Joe Senior sees that Junior and Kathy are ready to take over. Through a long, well-planned effort involving gifts to and purchases by his children, Joe Senior liquidates his entire ownership interest in the family business and leaves Joe Junior and Kathy as equal 50-50 partners; each owning 50 voting shares and 500 nonvoting shares. Joe Senior now is free from day-to-day business distractions. He can turn his attention to reducing his golf handicap and improving his fly-tying skills.
Then tragedy strikes: One of the two 50-50 partners dies. Although Joe Senior did a good job taking care of his own estate, Joe Senior, Joe Junior, and Kathy did not concern themselves with the estates of the next generation. Now, a 50-50 partner’s surviving spouse—who has never worked in the business and doesn’t know the industry—wants to be bought out.
The shareholders’ agreement gives the company and existing shareholders a right to buy out the deceased shareholder’s interest at “fair market value.” Unfortunately, however, the shareholders’ agreement does not clearly define “fair market value.” Complicating matters, the shareholders’ agreement includes other language consistent with an investment value standard. Consequently, the intent of the buyout provision is both ambiguous and conflicted.
This is a potentially volatile situation. Especially if you inject some long-standing mistrust and bitterness. This is the type of circumstance that generates what I only half-jokingly call an “everybody hates me engagement.”
Consider a cynical construction of the dynamic. The buyer wants the absolute lowest price and seller wants the highest imaginable price. Both perspectives could have relevance and might well be considered by both parties, but neither might be what Joe Senior had envisioned or intended when he was in control and had the shareholders’ agreement drafted.
As the appraiser, I can assess the value of business and I conceivably could value it using a standard that is favorable to the buyer, a standard favorable to the seller, or some other standard of value. The ultimate question is which standard of value is appropriate (i.e., what Joe Senior had hoped for and intended). Unfortunately, in this case, that answer is unclear.
Sometimes contracts or statutes include terminology that—either by mistake, omission, or intent—is not clearly defined. An appraiser can put parameters on a valuation using potential interpretations, but an appraiser should not attempt to decide which interpretation is appropriate. The appropriate interpretation is a legal question with a valuation consequence. If, perhaps, you are an appraiser with a J.D. and a law license then you could “go there,” but otherwise it’s not the appraiser’s turf.
I’m not a lawyer, so I don’t go there. I can calculate values under multiple interpretations (i.e., using different standards of value), but I decline to opine on which interpretation is the correct legal (e.g., contractual or statutory) conclusion. Consequently, when I refuse to resolve the legal question in favor of either the low-value buyer or the high-value seller, sometimes both parties end up disappointed—even if they understand and accept my reasoning, methodologies, and separate value conclusions.
Family business owners should do their utmost to avoid this unpleasant circumstance. When drafting their buy-sell or shareholders’ agreements, they should have their lawyers seek valuation advice from a qualified appraiser. They also should consider the fundamental purposes of their buyout provisions. If the primary intent is the continuation of the family business via orderly share purchases, then maximizing shareholder value is an element that might need to be subordinated.
In a 50-50 scenario such as that described above, it can be difficult (or even impossible) for an owner to match the price that a strategic buyer might be willing pay for the family business. This is because strategic buyers typically don’t look at the company’s existing earnings stream. Instead, strategic buyers look at their own post-acquisition earnings streams. The acquirer’s post-acquisition earnings can be far greater than the earnings generated by the existing business. For a distributorship with average profitability, the synergistic buyer might be able to double profitability by reducing the seller’s current operating expenses by say 25%. An illustration of this scenario is provided by the table below.
The owner who wants to buy out an equal partner doesn’t possess the means by which reduce operating expenses by 25%. Relative to the synergistic acquirer’s earnings, the current owner’s potential earnings are a mere 50%. If the acquirer offers a price based on a profit of $1,500,000, it would be an extremely dubious financial proposition for an existing owner to attempt to match that offer when having only half these earnings. It could be a bankable transaction for the existing owner, given the existing equity stake, but the payback would be extended and the investment return would be correspondingly (or even absurdly) small.
It is the same at the top end of the value spectrum; valuation is a relative matter. Two eager potential synergistic buyers can price the same target company differently. One of the two companies might have greater synergies. For example, due to the proximity of existing operations one acquirer might be able to eliminate a warehouse. As a result, that buyer might be able to reduce the seller’s operating expense structure by a third. The other buyer might not be so advantageously situated. That second buyer might be able to reduce the seller’s operating expense structure by only 25%. Using the illustration above, that 33% versus 25% difference results in nearly a quarter million dollars a year more profit. This equates to more value for one acquirer relative to the other.
Alternatively, two competing acquirers could perceive a target’s purchase price differently even if their potential synergies are identical. The balance sheets of the two potential consolidators could be the factor that makes the difference. If one potential buyer is debt-free and the other is levered up from one or more recent acquisitions, then the later is going to see the acquisition as a relatively more risky proposition because that buyer has a notably smaller margin of safety. If things unexpectedly go bad, then the company with the tighter balance sheet trips their bank covenants and stumbles into financial difficulties that much sooner.
For sellers there also is a variety of issues relative to value. An often-discussed issue is the attractiveness of dollars in the bank versus the intangible pleasures of owning your own company and staying in a highly enjoyable business. Another long discussed issue for sellers is the “What Next” factor. Historically, this dilemma primarily has related to what a distributor plans do with his or her life after an exit from the business. Recently, however, the financial question of what to do with after-tax sales proceeds has become a more pressing problem. Compared to the beer industry, other investments have become relatively uncompelling.
Finally, I would like to illustrate the relative nature of multiples. The table below shows how three different companies might have different gross profit multiples even if they sold the same number of cases, generated the same amount of EBITDA, and were valued using the same EBITDA multiple. Assume that the three companies all sell a million cases, all generate slightly more than a million dollars worth of EBITDA, and (for illustration purposes) all were valued at 10 times EBITDA. Despite these commonalities Company A garners a higher GP multiple than Company B, and Company B’s GP intangible multiple is greater than that of Company C. This is illustrated in the table (below).
Why the different gross profit multiples? In the case of companies A and B, the difference is entirely attributable to the higher margins and higher operating expense levels of Company B. Company B generates just as much profit as Company A, but a smaller percentage of each gross profit dollar generated by Company B survives operating expenses to become profit. Relative to sales, Company A and Company B each have the same level of profitability. Relative to gross profit dollars, however, there is a notable difference. For Company B and Company C, the difference in intangibles gross profit multiples is entirely attributable to the tangible asset base. In short, Company C needs more tangible assets to generate the same million dollars of earnings (think: accounts receivable in a noncash state). Note that only Company B’s and Company C’s intangible gross profit multiples are different. In terms of the values of the entire companies, Company B and Company C have the same multiple of gross profit.
Answering valuation questions requires perspective; a frame of reference. Questions of value must be answered relative to the interest being sold and the valuation purpose. The relative perspectives and objectives of buyers and sellers need to be considered. Without accounting for these essential elements, a valuation conclusion could be relatively inaccurate and inappropriate.
