|Super-premium value combinations are not the product of luck or timing. Rather, they are the result of a strategic planning process that is rooted in an understanding of the motivations and behaviors of buyers, as well as in the process of creating value to meet their expectations.
The five major harvest options are merger; IPO (going public); ESOP; sale; and management buy-out. Of the five listed, I have been involved in the sale and acquisition of a number of companies and in one major management buy-out (LBO), in addition to numerous transactions with venture capital companies as an investor and as a recipient of venture capital.
I could easily devote pages to a discussion and review of the issues facing middle- and upper-management in companies that may or may not be acquired, depending on due-diligence, timing, and other variables, such as loyalty, honesty, the squeeze-play between buyer and seller, stock options, and golden parachutes. Some of these issues, however, fall outside the parameters of this discussion, so we will set them aside for another time. Let me turn now to the concept of exit strategies, key elements in any strategic planning process.
Developing a Harvest Strategy
The first piece of the strategy, and a very important one, is for the selling company to continue operating. In other words, business as usual. After all, there might not be a closing, and buyers of companies like this kind of selling environment.
Once the directors and owners of a business decide to sell, a "harvest strategy" must be developed or refined. A well-organized company will already have a harvest strategy in place, though perhaps called by a different name. The owners of the business to be sold must be educated about how the market measures value.
The principals and owners of the selling company may be moving forward with the sale of their company under the assumption of many myths, which may over- or under-value the worth of their company, one that they have likely worked very hard to develop. Later I will review some of these myths and the truth of each subject.
Buyers Want Specifics
In developing a harvest strategy, it's important to remember that buyers want easily to understand the specifics of a seller's business, including who its customers are and why they buy; its qualitative and quantitative market share positions; its explicit strategies for growth; how to measure the business risk; how to validate the financial assumptions; the culture and the style of the business; and its core competences. In the words of Peter Drucker, "Ounce for ounce, a mouse may be larger than an elephant."
Previously I stated that a well-organized company will already have an exit strategy at the time it is being considered for acquisition. A seller's strategy, which can function as a harvest strategy or exit blueprint and which was developed for the acquisition of companies, product lines, and new and expanded ideas for the seller's ongoing business (i.e. "business as usual"), can also be used to demonstrate the company's potential to employees, customers, investors, and prospective buyers. Theoretically, almost every acquisition candidate for the seller may also be a candidate for the buyer; the seller's acquisition plan will be rooted similarly to that of the potential buyer.
Consolidation and Functionalization
The valuation tree has its roots in confidence. In addition, a seller's company benefits from consolidation and functionalization, particularly in the areas of market strategy, sales, and service. The greatest bottom line impact to a buyer after acquisition is derived from the sales and service segments of the business. Consolidation and functionalization of sales and service segments lead to enhanced benefits from joint advertising; increased efficiencies of sales personnel; shared exhibition activities; more products offered to similar customers by fewer sales and service personnel and distribution outlets; decreased travel and entertainment costs; increased regional sales responsibilities; heightened satisfaction of more customers through "one-stop shopping," total system concept, and potential cost savings; and greater efficiency through the elimination of duplication, keeping only the best from both companies.
What are buyers looking for in a strategic acquisition? The valuation tree has many branches. These branches of ROI, NPV, cash flow, DCF, ebit, growth, and sales are important and must be healthy, but are not the real source for realizing and creating value. The process to realize premium value starts when one looks at the roots, including trends, diversification, sourcing, elimination of competition, timing, and market share. If the roots make sense to the buyer, he will make the branches (e.g. the ebit's ROI) work and will place a premium value on the seller's business.
Manufacturing Products, Selling Hope
"In the factory we manufacture lipstick, but in the marketplace we sell hope." (Charles Revson Founder, Revlon Company.) Buyers who happily paid a premium for hope bought: high sales predictability (United Asset Management); a product line extension (Bausch & Lomb); a solid brand name (Colgate); geographic distribution (Melville Shoe); immediate access to customers (AT & T); access to technology (Hewlitt Packard); market consolidation potential (Waste Management); industry trends (K-Mart); a competitor (Computer Associates); access to low-cost sourcing (The Limited); and diversification (Xerox Corporation.)
More specifically, United Asset Management (UAM) pays an average 2.5 times sales for service firms with contractually recurring revenue. Bausch & Lomb paid 18 times earnings for Tropic-Cal Sunglasses in order to extend its product line in Europe and Asia. Colgate Palmolive paid 30 times earnings and 1.5 times sales for the Mennen Products brand name. Melville Shoe paid 20 times earnings and one times revenue for Foot Action Stores and K & K Toy Stores so as to continue its geographic extension of specialty retailers. Hewlitt Packard paid 25 times earnings to Apollo to gain access to work-station technology. Computer Associates acquired Software International, Integrated Software, UCCE, ADR, and Cullinet for average values of 1.5 times sales, in part to eliminate potential competitors and in part to prevent others from acquiring those companies. Xerox paid an average one times revenues and 25 times earnings for the Crum & Forster insurance firm and for Van Kampen Merritt Mutual Funds because they needed diversification.
Each of these buyers was looking for something different in its acquisition candidate. The endgame is to make resource allocation decisions throughout the building of the business, so that upon exit there is a clear and easy match to the buyer's needs and hopes.
Who is telling the truth?
"Actual knowledge of the future was never lower, but hope was never higher. Confidence will beat predictions anytime." (Will Rogers, September 1933). The buyer has no reason to believe what the seller tells him; and yet the buyer needs to be convinced to pay twenty dollars for one dollar's worth of earnings. How can buyer confidence be built?
In the strategic planning process, try to imagine how confident the next investor in the business will be about the value of the intangibles, and then vigorously allocate resources to that end.
Strength in sales and marketing may be more valuable than strength in financial management. Why? Because most buyers feel confident about finances but less confident about sales and marketing. As a result, they will value the seller's strengths more. CML paid 8 times earnings for Nordic Trak and within two years eliminated the wholesale distribution channel and went direct. Result? Sales went from 14 million and one million dollars in net income in 1986 (the time of acquisition) to 230 million dollars in sales and 30 million dollars in net profit in 1992. The seller may have left a lot on the table.
There are many myths surrounding the issue of how the market measures value: that DCF and NPV drive the valuation (they don't); that IRR and ROI are measures (yes, but the wrong ones); that the EBIT multiple drives the value (that's an HBS invention); and that the EBITDA multiple drives the value (that's an I-Bank invention.)
Roots of the Valuation Tree
Getting back to the roots of the valuation tree--technology is one of them. Everyone is looking for the next breakthrough in technology--a better mousetrap, an improved service, ideas and inventions to better serve the public. Market share also is extremely important; significant market share is the key to obtaining above-industry margins. However, sometimes being number two or three in numerous niche markets may make buyers more confident than being number one in just a few markets.
Timing is another root. In the cyclical nature of businesses, both the buyer and the seller are important, but a healthy financial market may be essential; bell curves in technology and products can be crucial. So can the elimination of competitors. The elimination of even one competitor may allow for increased prices and market-share gains resulting in increased profits. It can also put you to sleep if you're not careful.
Sourcing is important because a company that has its own access to sourcing can be important to a buyer weak in that area. Diversification can add stability to a company by offering a variety of products to the public, while the selling company that has good market intelligence and is close to its market, brings significant value to the buyer.
In developing a so-called harvest strategy, value for the seller can also be affected by the type of sale. A tax-free reorganization occurs when a seller receives stock; when a seller sells stock, it's taxable. It's taxable when a seller receives cash. Generally, one should stay away from earn-outs and the infamous post-closing adjustments.
One can think of the harvest strategy as defining the team that will deliver for the seller, with the investment banker as coach, the major principal as quarterback, and attorneys, accounting, key employees, and the board of directors as the other players. The harvest strategy should be established early on, so that a company can answer questions from investors, bankers, and key employees regarding how and when they will get their return. This strategy should be incorporated into the yearly business plan.
Going Public: Pros and Cons
Another form of harvesting is to go public. Going public, instead of selling, is usually the best option for healthy, growing companies that frequently find themselves in a position where retained earnings and/or short-term loans do not meet their capital requirements.
The advantages of going public, to both a company and its stockholders, are less dilution (if a company is at the stage where it is ready to go public, it may command a higher price for its securities through a public offering than through a private placement or other form of equity financing, giving up less of itself for the same amount of funding); enhanced ability to borrow (when stock is sold, it increases a company's net worth and improves the debt-to-equity ratio, likely allowing the company to borrow money on more favorable terms in the future); enhanced ability to raise equity (if a company continues to grow, it will eventually need additional permanent financing, and if a stock performs well in the market, the company will be able to sell additional stock on favorable terms); stock options (stock options offered by emerging public companies have much appeal and can help in recruiting and/or retaining well-qualified executives and in motivating employee-shareholders); prestige (a company's founders gain enormous personal prestige from being associated with a company that goes public); and personal wealth (stories abound of millionaires and multi-millionaires created through public offerings.)
There are also some very significant disadvantages to going public, however, that should be weighed against the many advantages. For one thing, there is the expense. The initial costs, the underwriters' commission, can run as high as ten percent or more of the total offering. And there is the disclosure of information; a publicly-held corporation's operations and financial situation are open to public scrutiny. Along with this comes the pressure to maintain a growth pattern. A company that goes public will be subject to considerable internal and external pressure to maintain the growth rate it has established; if sales or earnings deviate from the established trend, stockholders may become apprehensive and sell their stock, driving down its price. Also, if a sufficiently large proportion of a company's shares is sold to the public, the owners or executives of the company may be threatened with loss of control.
Alternatives to IPOs exist. A company can simply borrow money. Funds may also be raised through limited partnerships, venture capital financing, and other private placements of stock.
In summary, the valuation tree has many branches, each of which may lead to the wrong conclusion or decisions. In order to realize value, the process starts by looking for or establishing strategic roots for a business. Owners should incorporate a strategic plan as soon as possible, using it as a guide for growth and for creating value in the company.