What's It Worth?

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."

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