The fifth in our series of articles for distributors that are contemplating a sale of their business focuses on the insight financials provide prospective buyers.

by Jane E. Baynard and Scott Benfield

As you move forward with the sale of your wholesale distribution business, prospective buyers will primarily focus on your financial documents throughout their decision-making and valuation process. In our last article, we concentrated on the importance of the “corporate scrub” to fully highlight the attractiveness and financial strengths of your business and command a favorable price. The “pre-sale positioning” successfully acted as the bait and buyers have started nibbling at your offer. The financials give them something to sink their teeth into so they will get hooked.

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Buyers will look toward your primary financial documents – your balance sheet, income statement, and financial performance ratios – to assess the meat of your company. These documents give buyers insight to your company, providing them with a snapshot of your financial standing and a tool to compare your performance relative to others in the business. Buyers will especially look for consistency, growth and comparative success within your financial documents.

We touched on the four types of value standards in the previous article. Fair market value, intrinsic value, investment value and fair value are all popular approaches to valuing businesses, and each valuation method emphasizes particular financial documents. 

Because each wholesale distribution business has unique strengths and competitive advantages, we recommend consulting an acquisitions specialist to develop a custom approach to value your business based on one of the approaches but using an appropriate combination of valuation methods to realize the most favorable value of your firm.

Asset-based method: Focusing on the balance sheet
The balance sheet represents the tangible assets a buyer will acquire and the liability obligations they will take on when they purchase your company. 

In particular, they look to the value of your net identifiable assets (NIA), which is the excess of the fair market value of your assets over your liabilities. The NIA figure helps buyers value your business as they identify the tangible value of your firm.

When determining the value of your firm’s NIA, you must distinguish between the book value and the market value of your assets and liabilities. 

Prospective buyers take interest in the market value of your net assets, which, with the exception of cash, will likely differ from the book value. 

For example, depending on your method of accounting for inventory, the market value of your inventory will likely differ from your book value. Similarly, the book value of a liability under a long-term lease contract will likely differ from its present market value. 

Moreover, if the prospective buyer does not wish to continue with that lease under the long-term contract, it could adversely affect their valuation of your company. With appropriate planning, business owners who anticipate selling their business should avoid extended contracts in the years prior to a divestiture. 

Business owners should also appreciate that the market value of their net assets will differ from their book value, and plan appropriately to present the market value of their net assets to prospective buyers.

In some cases where a business is losing money, the business is worth only the value of the NIA. In this case we term the valuation “as if in liquidation.” Sometimes other distributors can use your physical capital for their own purposes because they have a direct use for your plant and equipment and they can capitalize on your leasehold improvements. 

In such a case, termed “as a going concern,” the buyer may pay a premium over the value of your NIA to acquire the net asset package. The same is true when the buyer has a rational concern that the firm’s suppliers and customers will leave with the owner’s departure.

Any buyer willing to pay a premium is said to be a strategic buyer as opposed to a financial buyer. Strategic implies they can leverage your assets above their fair market value. 

Remember, the definition of fair market reflects the consensus opinion among all the buyers and sellers constituting the market for a company as to its worth, rather than the opinion of any individual investor. Strategic buyers are specific buyers, not hypothetical ones.

In the majority of cases where the business remains profitable, the balance sheet and NIA comprises a base for your business’s value. The market value of your company’s net assets serves as a starting point, and then appropriate adjustments modify that value to incorporate the value of expected earnings, intangible assets, business relationships and other factors.

When preparing for the sale of your business, as an owner you must keep in mind the importance of accurately reflecting the value of your net assets to prospective buyers. Buyers will look at the balance sheet as the foundation of your company and expect an accurate reflection of your net assets to serve as a basis of their valuation. 

However, as you already appreciate, the value of your business encompasses much more than just the building you work from and the money in the bank.

Income statement methods: Cash flow and income
Along with a company’s net assets, a buyer also needs an accurate estimate of your company’s future earnings as seen on your income statement.

In theory, the buyer should pay a premium equal to the present value of the company’s future earnings. Prospective buyers consider both the solidity and quality of earnings based on the information contained in your income statement.

When looking at your income statements, buyers want to see consistent earnings and revenue growth. They will pay close attention to earnings growth in recent years, and model earnings growth to predict future revenues. 

Therefore, business owners must take care to manage earnings and expenses, especially in the three to five years preceding a sale of a business. Consistent growth and solid earnings will give your prospective buyer confidence in your firm, and will likely reward you for that confidence. 

A simple numerical example explains how a prospective buyer would likely value your company’s future cash flows:

In the above example, the buyer would have first projected your firm's future cash flows based on information from your recent income statements.

Next, the buyer selects a reasonable rate of return they expect to realize from their investment, usually in the 20 percent to 50 percent range; in this case the buyer selected a 25 percent rate of return. The selected rate of return gives the buyer a standardized discount rate used by financial calculators or found in financial tables at your bookstore. 

You can think of the discount value as a percentage. One dollar a year from now is worth 80 percent of its value, or 80 cents, today based on the 25 percent rate of return discount rate used above. In the above example, a buyer that expects a 25 percent rate of return on their investment will pay $2.9 million today for the above $5.7 million of cash flows over the next five years.

Occasionally, the pressure to manage earnings in the years before an anticipated sale can lead managers to artificially inflate earnings under the assumption that higher earnings due to lower expenses will enhance the value of the business. Managers have been known to cut discretionary spending in functional areas of the business in the years preceding a transaction to make their earnings appear more attractive. 

However, savvy buyers actually penalize this short-term profitability if they believe it adversely affects the long-term success of the business. Buyers appreciate that advertising, research and development, equipment maintenance, quality control and other such expenses benefit the long-term success of a company. Buyers also pay careful attention to detrimental spending controls that artificially inflate earnings.

The income statement gives prospective buyers insight into your business’ success, and allows them to estimate the value of your firm’s future cash flows. 

Your recent income statements should clearly demonstrate your firm’s earnings consistency, accuracy and expense management. An acquisition specialist will look out for quality of earnings issues that could undermine buyer confidence. If your income statement builds up buyer confidence in your earnings, you should receive an appropriate premium when you sell your business.

Comps: Financial ratios
If you’re working with a mergers and acquisitions professional, chances are they will provide information about what firms in your industry trade for. 

This means either what other distributors have sold for in out-and-out acquisitions or it can mean a comparison with public companies. Either way, using comps, or industry comparables, is one method for giving prospective buyers a means for comparing not only what companies sell for, but often more importantly, performance among similar firms in your industry. 

Prospective buyers look for more that just your net assets and expected earnings. They want to see how well you stack up against the rest of the pack, so they often look at financial ratios. 

Financial ratios provide an unbiased, quantitative comparison to help buyers identify your strengths and weaknesses among your peer firms. It also helps prospective buyers within the same industry identify synergistic opportunities to capitalize on your firm's unique strengths, and benefit your firm with their own strengths.

Cross-company comparison through financial ratios gives buyers insight into your firm's unique strengths and weaknesses. A prospective buyer will want to compare your financials to industry averages and industry leaders. 

Often, distribution firms have carved out lucrative niche markets that give them market share leadership within a market segment. When selling your business, owners should seek to quantify your unique accomplishments with financial ratios highlighting your market share leadership, industry out-performance or whatever quantifies your unique strengths.

Financial ratios also faithfully represent your weaknesses relative to other firms in your industry, allowing prospective buyers to identify synergistic opportunities. You should use your financial ratios as a tool to find a good fit for your firm; you can match your firm up with an appropriate buyer, like piecing together a puzzle, to find a mutually beneficial fit. 

Buyers will look toward your firm’s financial ratios to identify opportunities for them to benefit from your unique strengths, and for your firm to benefit from theirs.

In summary, the financials of your distribution business serve as the primary evaluative source for your company. 

You attracted prospective buyers with your memorandum, now they will look toward your balance sheet, income statement and financial ratios to find the hard facts necessary to evaluate their potential for a successful acquisition of your firm. 

These financial documents give prospective buyers the tools to take the next step: pricing your firm. 

When deciding to sell your business, it is important to have your financial documents in order and ready for buyer scrutiny. 

Are your firm’s financials ready for buyer scrutiny? We have developed a worksheet that can help you estimate the readiness of your financials; just send us an e-mail request and we will forward it straightaway. In the next installment of our series, we will focus on pricing your firm and determining its value.

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