PPB April 2015

nity and industry, and ego. Here is a recurring

conversation we have with owners:

“We have been in business for 25 years …We’re the

best distributor… I was president of our regional

association …Our sales were $3 million a couple

of years ago. What is my company worth?”

Which of these elements contributes to

financial value? Actually, in and of them-

selves, none of them provide value. Value is

based solely on the qualities that can reason-

ably contribute to

future

earnings.

There are a variety of qualities and met-

rics used to estimate the likelihood of future

earnings. Here are some of the more com-

mon ones.

Historical Earnings

This is the most important metric.

Owners sometimes claim you can’t determine

the value of their companies by numbers. It’s

their people, their reputations and their cus-

tomers that make their companies valuable.

In some sense they are correct, but only to

the extent that these qualities contribute to

earnings. The best staff and reputation in the

world don’t matter much if the company

doesn’t make much money.

There are four primary elements of his-

torical earnings that are important. The first

overall cash flow

. This is sometimes called

free cash or EBITDA (Earnings Before

Interest, Taxes, Depreciation and

Amortization.) Strong historical cash flow is

a positive indicator for future cash flow.

The second element is

gross margin

Gross margin is the difference between what

you billed your customers and how much

you paid for the products and services. Total

gross margin rep-

resents the

amount of money

a company has

available to cover

operating

expenses and,

hopefully, con-

tribute to cash

flow (EBITDA).

Gross margin is

important both

in total and in

percentage terms.

For example, a

company that has

$1 million in

total gross margin that is 40 percent of sales

is going to be worth more than a company

that also has $1 million in total gross mar-

gin that is 20 percent of sales.

The third element is the

trend

of the

business. Are sales and gross margin trending

upward and, if so, at what rate? Or, are they

stagnant or headed downward? Without a

doubt, a company with $2 million in gross

margin last year following four years of dou-

ble-digit growth is worth more than a com-

pany with $2 million in gross margin every

year for the past four years, assuming all other

things are equal. Other trends to consider are

cash flow, operating expenses, days in receiv-

able, number of customers, etc.

The fourth element is

stability

. Investors

may enjoy roller coasters at the amusement

park, but not in ownership of companies.

Stability of historical EBITDA indicates reli-

ability and safety.

Customer Base

Many owners develop close, personal

relationships with their customers. They

nurture and grow key accounts that con-

tribute 25 percent of the total company’s

sales and are proud they have been selling to

them for the past 20 years. However, these

accounts don’t necessarily increase a compa-

ny’s value. First, if the relationship is tied

too closely to the distributor owner, that 25

percent of the sales may be at risk if the

owner sells, retires, goes elsewhere or dies.

This reduces the likelihood of future earn-

ings. In the process of focusing on and

growing key accounts, most likely margins

on those accounts have declined because of

the higher volume and the fact that the

owner hasn’t spent as much time acquiring

the new customers necessary for long-term

growth and stability. As a result, the value of

the distributor company may actually be

22 •

PPB

• APRIL 2015

INNOVATE

Four Qualities That May

Decrease

Value

Long-term leases.

Owners

lock into leases that are

fixed costs, which can con-

tribute to negative cash flow

during economic and busi-

ness slowdowns.

In-house decoration.

Most

distributors outsource

embroidery because it does

not provide a good return

on investment.

Customer industry concen-

tration (i.e., financial, real

estate, etc.).

Too much of a

concentration in one indus-

try creates risk if that indus-

try encounters difficulties.

Excessive commission plan.

When owners pay sales-

people too much, it sup-

presses profit and is difficult

to change to a more reason-

able plan.