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.'s finance editor.


REASON FOR VALUATION: To value proposed merger of two business-equipment distributors


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

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

Jeff Jones, owner of five-person Certified Appraisers Inc., in Houston, with 25 years in the business of valuing private companies


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


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


HOTZE:"If Kent and I had known how much time would be involved in all this, we would have eloped."

WATTS:"I didn't know what to expect when it came to the final valuation number. I just didn't have the financial background."

When it comes to valuations, many entrepreneurs prefer to just say no. Here are some findings from a U.S. membership survey recently conducted by TEC Worldwide Inc., an international CEO-education and -development organization based in San Diego. The 258 respondents are chief executives of small to large companies.

Q: Have you ever hired an independent appraiser to conduct a valuation of your company?

Yes 57.4%
No 42.6%

Q: If you have hired an outside appraiser, please list all reasons that apply:

Estate planning 42.6%
Company merger or sale 41.3%
Curiosity about the value of the business 21.9%
Bank or investor financing 15.5%
Growth-management strategies 12.3%
ESOP 5.8%
Planning to go public 4.5%
Divorce 1.9%
Other 18.7%

Q: If you haven't hired an outside appraiser, why not?

Unnecessary 69.9%
Trust your own judgment 17.5%
Too expensive 8.7%
Other 20.4%

Source: Inc. magazine-Tec Business Valuation Survey, September 1998.