In the last article we discussed how it is common practice for sales reps in the North American C&I lighting market to earn generous overage commissions by selling products above the manufacturer’s list price.
In this article, we’ll discuss how overage affects a lighting company’s income statement, and hence valuation in the M&A market.
Imagine a lighting manufacturer that doesn’t offer overage with $20m annual revenue, a 50% gross margin, 10% commission expense and 10% operating income margin.Then consider a scenario in which the manufacturer offers a 90/10 overage policy, and reps funnel an additional $1m overage through the company.Obviously, the company has an additional $100k in operating income and EBITDA at the end of the year.
Other things being equal, a 5% increase in operating income or EBITDA should increase the value of the company by approximately 5%. Note that the overage superficially increases the gross margin percentage, which investors invariably prefer as an indicator of pricing power.
In this example, there is no effect on the operating income margin as a percent of sales since the manufacturer’s operating income margin before overage (10%) is the same as the manufacturer’s cut of the overage. Obviously, if the manufacturer has a higher operating margin before overage, then the 90/10 overage policy would dilute the operating income margin.
However, overage has a couple of disadvantages in a sale process:
Overage is generally unpredictable, so earnings management and forecasting is more challenging.
The sporadic nature of overage may be flagged as a concern in the buyer’s due diligence process.