Legal October 2010

Commercial Agency Valuation - don't ignore the positive factors

By Thom Vaughan of E.A.D. Solicitors L.L.P.and Adrian Pym of RSM Tenon

The valuation of an agency relies on more than the commission figures or the accounts of the agent. In our previous article we discussed the costs of running an agency and how taking these into account in the smaller agencies often led to a very low or negligible value. In this article we look at some of the positive

factors that impact upon the value of agencies.These factors are usually external to the agency but nonetheless are important in determining what a willing buyer might pay to acquire the agency.

In Lonsdale the court stated "if the market for the products in which the agent dealt was rising or declining, this would have affected what a hypothetical purchaser would have been willing to give. He would have paid fewer years' purchase for a declining agency than for one in an expanding market." So an assessment of the market is critical in assessing value.

AN EXPANDING MARKET

In the recent case of McQuillan -v- McCormick [2010] EWHC 1112 (QB) the Judge accepted our opinion that, in assessing the agency's maintainable earnings, it was reasonable to reflect the rising market for the product sold by applying a 'growth' multiple of 1.5 to the commission income prior to deduction of the attributable overheads and directors' salary. The agent

sold jewellery products manufactured in Denmark. The principal was the UK importer and distributor of the product. The sales were rising exponentially for the manufacturer and the agent was benefitting from the rising market for the product. It is perhaps useful to add a layer of detail and note that the Defendant acted as UK distributor for Pandora Jewelry, which retails popular

charm bracelets as its core product. Around 5 years ago the range could only be found in a small number of designer boutiques but is now a recognised name on the high street. It has enjoyed a stratospheric rise.

A willing buyer would recognise this positive factor and be willing to pay more for the agency. By applying a growth multiple to the commission income the rising trend was recognised in full rather then by applying a multiple to the profit of the agency. This was appropriate because the costs of operating the agency were not directly proportional to the commission income.

However, the court also recognised the risk that the principal's contract with the product manufacturer could be terminated within two years. If it was the agent would be out on his ear. The Judge concluded that "For my part I doubt if anyone would pay more than 1 years purchase..." Therefore in assessing value the parties must look at the stability of the agency - was it longstanding, durable and likely to continue for a number of years? The case also considered other relevant factors, such as exclusivity and its impact on value; as well as overheads and directors' salary.

EXPANDING MARKET - BUT FALLING COMMISSION?

In another unreported case the existence of a rising market did not result in an enhanced value for the agency. The factors specific to the case were that the principal was showing increasing turnover and profit year on year. Press releases and trade news were all positive about the future prospects of the business. In isolation these factors suggested an increasing value forthe agency. However, the agent's commission was falling year on year; the direct opposite of the principal's rising fortunes.

Detailed investigation highlighted a change in the way the principal conducted business. It had historically relied on a number of regional agents to source and manage customers, and to sell its product, thus giving national coverage. However, in the last two years it had secured national deals with two new key customers independently of its sales agents. The agents were still

required to manage the national accounts but were only paid a small commission on these "house accounts". The impact over time was to dilute the influence of the agents and their commission income fell as a greater proportion of sales were made at the lower commission rates.

HIDDEN POSITIVES IN CYCLICAL INDUSTRIES

Certain industries have defined cycles of activity which need to be understood to explain the changes in fortune of the principal and agent. For example, large capital intensive projects can last many years.

The water treatment industry operates a five year cycle of asset management projects ("AMP"). This involves significant investment in new infrastructure projects to improve, replace and maintain water treatment facilities. Sales of water treatment equipment will therefore follow closely the current AMP, typically starting low, rising to year 3 and then declining.

This allows for planning, procurement and then installation of equipment. Advising an agent in this industry would require detailed knowledge of the current AMP, which phase it had reached and what level of capital expenditure was planned for the next AMP. Reliance on the normal three to five years accounts of the agent and principal would not necessarily result in the correct assessment of value in this particular industry.

Agents in, say, the fashion or furniture industries will be acutely aware of the often cyclical nature of business

performance and the rapidly fluctuating fortunes of certain wares. One minute oak furniture is the rage and the next it cannot be shifted and sits on the shop floor gathering dust. Rimless sunglasses were cool when a certain Swede was managing the national football team and now they're yesterday's news.

SUMMARY

Understanding the agent's business and the wider industry in which the principal operates is therefore critical to the valuation of any agency. It may be that positive factors exist within the market that enhances the value of an agency beyond that suggested by the accounts of the agent alone.

 If these factors would arise as part of a notional purchaser's theoretical "due diligence" then they should be fed into the valuation process when compensation comes to be discussed.

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