Provided by My Own Business, Content Partner for the SME Toolkit
Objective:
Buying an existing business can offer advantages over organic expansion. In this session you will learn how to evaluate the opportunities and risks associated with expansion through acquisition.
- Advantages of buying companies in your own business
- You know the business
- Achieve economies of scale
- Profit centers are already in place
- Expand geographically
- Better position to evaluate intrinsic value
- Vertically integrate
- Complement or fill out your product line
- Risks
- Branding mistakes
- Integrating the businesses
- Failure to clear up seller’s potential liabilities
- Inadequate evaluation of retaining the management
- Seller’s suppliers may not want to sell to you
- Over leveraging
- Inadequate accounting controls
- The Berkshire Hathaway acquisition model
- Description of the model
- Acquisition criteria
- Management roles
- Warning label
- Your acquisition team
- Evaluation methods
- Establishing the price
- Sales
- Earnings
- Return on Capital
- Intrinsic value
- Growth potential
- Leverage with seller financing
- Advantages of your being publicly owned
- Due diligence checklist
- Top ten Do’s and Don’ts
- Session Feedback and Quiz
You know the business
In many ways buying an existing business can offer advantages over internal expansion. You already know where the pitfalls and opportunities lie. You can “ad on” a business without any learning process and can make improvements based on your own operations.
Economies of scale
Acquisitions of companies in your own business will strengthen your buying power and spread your fixed costs over a high level of sales. Waste Management is a good example of successful growth through acquisitions. This multi billion dollar enterprise was built by acquiring hundreds of companies in the waste business.
Profit centers are already in place
Acquiring businesses is inherently less risk than starting from scratch. Everything is already in place: the sales, earnings and organization. All these are uncertainties when starting an operation from scratch.
Expand geographically
Geographic expansion increases your customer base and therefore sales. It also opens up potential for more potential advertising media that would be inefficient in a limited area.
Better positioned to evaluate intrinsic value
Placing an accurate value on an acquisition will be crucial when investing your retained earnings. We recommended that calculating intrinsic value be used as the basic tool. Operating companies with a history of earnings plus good prospects of future earnings will make the calculation of its intrinsic value more accurate. See “evaluation methods” later in this session.
Vertically integrate
On the supply side, vertical integration includes acquiring sources of supply in order to lower your costs and insure quality standards. On the operating side it might mean acquiring an IT firm to establish your own Internet technology department. On the marketing side it may mean acquiring a distributor in your marketing chain. Vertical Integration article will furnish complete information on the advantages, risks and how to evaluate vertical integration.
If you are manufacturing golf clubs, would it be appropriate to also sell golf bags and other golf equipment? Here are two examples of “add on” acquisitions:
- Quaker Oats’ acquisition of Snapple in 1994 became a textbook example of what can go wrong in an “ad on” merger. The corporate cultures were altogether different. Quaker Oats upset the distribution network, let go the sales force, redesigned packaging and advertising campaigns, all with disastrous results. Quaker Oats sold Snapple three years later at a loss of approximately 400 million dollars.
- Proctor and Gamble’s acquisition of Natura Pet Products in 2010 is an example of a positive “ad on” acquisition where P and G’s existing lines of pet foods will be broadened to include the holistic and natural segment of the market. The localized business of Natura will also be scaled up to world-wide marketing opportunities.
Maureen Costello
Wholesale Distributor
Is buying a business easier than starting one from scratch?
Personally I think that buying a business is a lot easier than starting a business from scratch. When you start a business from scratch you have to do everything. You have to have to reinvent the wheel in many instances. When you purchase a business it’s already operating. There are already pieces in place and then you can improve upon them and move them around. So I believe it’s easier to purchase an existing business. You know more about it, there’s more information, more history and the best business to buy is one that you’re already operating. I purchased a business I was already operating. I knew everything about it, I didn’t have any surprises. And a lot of people get into a business and don’t get into owning a business by purchasing the business they are already working for.
Lincoln Watase
President, Yum Yum Donut Shops, Inc.
What were the ingredients that made Yum Yum Donut’s acquisition of Winchell’s a success?
Yum Yum’s acquisition of Winchell’s was unique in that Yum-Yum and Winchell were so similar; the same types of products the same general locations of stores. As far as advice, in looking back I know the VP of Operations and I personally went and visited every store, took the time to meet with and take to each manager. We thought that was important because we wanted to let the folks in the stores know we cared about them and appreciated and knew how much work it was to manage a store so we wanted to send that message. In addition we deliberately minimized changes if possible to allow for a smother transfer of the acquisition. If there was something we have to change we erred on the side of not having to make that change. Just the sear fact that we were doing this acquisition that was plenty of changes for the employees of Winchell’s to be dealing with. So as a general rule we did try and minimize changes and we also in for the planning of the acquisition we tried to think of any and every possible thing that could go wrong so we would be prepared for just about every contingency in the hopes there would never be any surprises given to us. And lastly we used experts. We know how to run donut shops but in doing a large acquisition by all means attorneys that deal with these things on a regular basis as well as consultants, tax attorneys, you know we weren’t hesitant to recognize where we really didn’t have the expertise and go out and get expert advice.
Branding mistakes
Purchasing a company whose product is highly regarded poses the question: “Should we change their branding to our own?” Most acquiring firms take great pride in their own brand names and generally will change an acquired name to their own. This can be either a good or bad idea depending on the circumstances. Here are examples:
- Do you think an acquirer of Hershey Chocolate would change the name from Hershey to their own brand? Probably not…an easy decision.
- Building a brand name is expensive and takes a lot of time.
- In 2004 Yum Yum Donuts acquired Winchell’s Donuts, a famous name in doughnuts. Yum Yum’s management resisted the temptation to change the name to Yum Yum. Why discard a great reputation and name that had taken generations to build?
Integrating the business
There will always be challenges when integrating an acquired business. For example labor issues may need to be resolved or operating cultures, spending disciplines, and lines of authority. In your due-diligence process, make a check-list of all issues in which the cultures and business practices of you and the acquirer differ and work out all potential problems before closing.
Failure to clear seller’s potential liabilities
Any company you acquire will have some problems and possibly unrecorded liabilities. Usually the seller will be anxious to disclose undocumented problems because if they don’t, non-disclosure could expose them to potential of later litigation. So whenever the seller discloses any unrecorded liabilities or problems, slow down and be careful to take the time to have them fully resolved.
Inadequate evaluation of retaining the management
It would be a mistake not to carefully analyze whether or not to retain the management of the acquired firm. Here are some considerations:
Retain the management
- In some businesses that are relationship-driven, retaining managers and their client networks would be crucial to the success of the business.
- You may not be able to, or desire to, supply management. You will need to have a clear agreement that management will stay on.
- In some cases the seller may be a great manager and getting great satisfaction from the challenges of the job.
Install your own management
- You may be able to install your own managers with no loss to the business.
- Enhancement of the business by replacing poor management could become part of your acquisition strategy.
- A review of “Getting Your Team in Place” can provide a business plan outline for operation of an acquired business.
The seller’s suppliers may not want to sell to you
Let’s assume you are purchasing a competitor. Part of the reason is your wish to add their highly desirable “widget” line of goods to your own line. You will need to get assurance from the company making “widgets” that they will continue to sell to you. If you close your purchase without this assurance and “widget’ company declines to sell to you, you have wasted what you paid to get the line.
Over leveraging
The biggest risk in expanding or making acquisitions is incurring too much debt, either from the seller or other sources of financing. Business leverage refers to the use of borrowed funds to accelerate growth and increase the rate of return on an investment such as purchasing a business. For example, if an acquired business can generate a 20% annul return and the cost of the borrowing is 5%, the potential earnings are magnified.
But leverage is a double-edged sword that is a powerful tool during good times but can quickly become your worst enemy during bad times. The world-wide financial collapse of 2008 was squarely due to leverage. You may encounter temptations to over-leverage when purchasing a business. If you are offered favorable financing from a seller, keep in mind he may not be too concerned with your risk because if you can’t make the payments he will put you in default and take the business back.
Whenever you hear about companies going into bankruptcy, there will almost always be the same reason cited: “Our revenues dropped because of the bad economy.” But if you investigate closely you will probably find that the company had launched a capital project or acquisition by borrowing money and were unable to pay it back….nothing to do with a bad economy. In bad times companies without debt can simply continue to reduce cost to maintain a balanced cash flow.
The worst part of incurring a high level of borrowing lies in the fact that if for any reasons, including unexpected business downturns, you are unable to service, replace or renew the debt, you will run the risk of losing your company. You could be betting the company that unforeseen external or internal adversities will not occur.
So as you grow, you have choices:
- Don’t borrow at all. Build through the use of retained earnings.
- Restrict borrowing within two very conservative limits:
- Restrict the annual debt service to a small fraction of your conservative annual cash flow.
- Borrow long-term and pay off short term. If you plan to repay in 3 years borrow for 6 years (but pay off in 3 years).
Inadequate accounting controls
It is possible that your existing accounting system and internal controls are not adequate to manage the larger organization. Review the overall needs with your accountant before closing and have necessary systems and people in place.
Your acquisition program should include having your annual financial statements audited. This highest level of accounting scrutiny is expensive but can be invaluable in an acquisition program:
- To secure financing from your bank who will most likely require it.
- To gain your seller’s confidence in providing seller financing.
- To give assurances to any other involved parties.
Maureen Costello
Wholesale Distributor
Is buying a business easier than starting one from scratch?
Personally I think that buying a business is a lot easier than starting a business from scratch. When you start a business from scratch you have to do everything. You have to have to reinvent the wheel in many instances. When you purchase a business it’s already operating. There are already pieces in place and then you can improve upon them and move them around. So I believe it’s easier to purchase an existing business. You know more about it, there’s more information, more history and the best business to buy is one that you’re already operating. I purchased a business I was already operating. I knew everything about it, I didn’t have any surprises. And a lot of people get into a business and don’t get into owning a business by purchasing the business they are already working for.
Stan Henslee
President, Yum Yum Donut Shops, Inc.
What experiences have you had when acquiring an accounting practice?
Yes, I was part of a team that worked on the acquisition of accounting practices to merg them into our firm. And there were several factors that we looked at in trying to make a decision or to make an offer for an acquisition. The first one, we looked at the customer’s target base. Were their clients the type of client that the new firm or our firm would be able to serve and retain? Were the employees properly trained and skilled and would they fit into our model of accounting practice? Would we be able to keep the owner involved in the targeted practice for at least a short time to help with the transition into the new firm? Fourthly, what type of management requirements would it make on our parent firm? Would we be able to manage the transition of the target? And then just as a general rule, you’d want to look at how the deal was structured. Would it create a debt service that the target company would not be able to generate enough cash to meet some type of a return on our investment and be able to meet the debt service to the seller.
Description of the model
Warren Buffett’s remarkable success as chairman of Berkshire Hathaway provides a potential acquisition strategy for some entrepreneurs. It requires expert judgment in evaluating acquired management and the intrinsic value of potential acquisitions. The overall strategy is to acquire businesses with high intrinsic values at attractive prices where the sellers wish to stay on as operating managers.
Acquisition criteria
Some important considerations:
- You, as the acquiring firm, will control all capital allocations including use of the acquired company’s retained earnings to purchase other companies.
Management roles
Your firm must be very good at two distinctly different management skills:
- The oversight and nurturing of the acquired companies.
- Making wise decisions in the allocation of capital.
Warning label
Warren Buffett is one of the most brilliant businessmen in history. In other words, be warned that this is a difficult growth model to emulate. It requires uncommon abilities in the evaluation of businesses and their managers.
Stan Henslee
President, Yum Yum Donut Shops, Inc.
What mistakes have you seen people make when buying a business?
There are two basic mistakes; the first is a lack of doing the proper due diligence in looking at the business before negotiating the purchase. You want to find out the true reason the seller wants to sell his business. You want to find out what type of customers he has and try and estimate how many of those customers you will be able to serve. You want to find out what the labor situation is for that business and the technical qualities the employees must have and how readily available are such employees. You want to find out what the situation is for the facilities, are they leased? How long a lease will you be able to get and how favorable will the terms be? The second big mistake is not having adequate capital going into the business. Many times it can take up to two years before the business starts to generate enough money to support you. So you’ve got to have to have about two years of savings that you can live out of. Many times I have seen people buy a business and the debt service is so high that it takes a lot more than two years to get the business turned around to where it will support you.
Establishing the price
In any purchase transaction (and buying a business will be a big one) you will need to establish that the price you pay is justified. If you are already in the business that you are acquiring, your evaluations should be better qualified than the estimates of outsiders.
To follow the desirable rule “buy low sell high” you should buy a business for less than its valuation and sell it for more than its valuation…but you must know how to establish “valuation!” There are three guidelines to keep in mind:
- It is better to buy a great business at a fair price than a fair business at a great price.
- It is better to be approximately right than absolutely wrong in your pricing evaluation.
- It is better to buy a great business with bad management than a bad business with great management.
Placing a value on a business can be determined in a number of ways. In order to lessen the risk if being absolutely wrong in pricing, we recommend that you establish valuation by more than one or two methods. Here are methods available to you:
Sales
The standard valuation of a donut shop is weekly sales. As weekly sales increase, the bottom line earnings increase more rapidly because fixed costs are already covered. For example once a fixed cost such as rent is paid for, higher sales will produce an even higher percentage of profit. Earnings of a PKR20,000 per week shop will be more than twice that of the PKR20,000 store and experienced buyers will pay more than twice as much for the PKR10,000 store.
Earnings
The earnings of a business can sometimes be hard to determine. This could result from inadequate accounting records. Accounting transactions might be erroneously booked as earnings. Or some cash sales (and therefore earnings) may not be recorded at all. It may be necessary to stand by the cash register for an extended period of time to determine real sales and make an estimate of earnings.
Return on capital
Return on capital is sometimes referred to as return on investment or ROI. This is a mathematical equation: net earnings divided by the rate of return establishes the valuation. If you are buying a business earning PKR100,000 per year after taxes and expect to receive 20 percent return, your purchase price could be around PKR500,000. ROI will vary widely in different industries. So it will be helpful to learn what the norm is for the business you are interested in.
Intrinsic value
When you buy a business, what you are really paying for is the present value of the sum of all of its future earnings. Intrinsic value is a mathematical calculation which converts all future earnings into their present value. One method is to create a ten year spreadsheet of the estimated future year-by-year earnings and convert each of these, along with a residual long-term value, to an overall present value. This becomes the “intrinsic value” of the business. Search engines may offer programmed solutions to determining intrinsic value and we strongly recommended you become familiar with this important tool. Here’s a free resource that makes the calculations for you: http://www.moneychimp.com/articles/valuation/buffett_calc.htm
Growth potential
The measurement of a growth potential situation can be numerically measured by the intrinsic valuation calculation because your future projections will include your estimates of growth. Of course the result will be a reflection of your accuracy in projecting future numbers.
- Outline to your seller exactly how you plan to repay his loan including your anticipated debt-to earnings ratio.
- Sometimes sellers will look for a personal guarantee or additional security based on assets outside your business.
- If you secure financing from both your bank and the seller, the seller’s financing will most likely be subordinated to the bank loan.
- Your lawyer and accountant can strategize with you to design the overall financing package.
- You are in a much better position to raise money for acquisitions through the sale of your securities.
- Your higher profile as a public company will put you at an advantage over other bidders for a company you would like to acquire.
- Participation in ownership of stock or stock options can be a strong incentive for the management of your acquired company.
- Unless you are also buying the property, the lease is probably the most important document you will evaluate. Review “Location and Leasing” session. The following are the most relevant lease items:
- The term or length of the base lease.
- Options to the base lease term.
- A rent that is affordable and competitive.
- How often and how much are the adjustments to the base rent?
- NNN charges.
- Assignment provisions.
- The Landlord’s contributions to the improvements, if a new business.
- What is the quality of the improvements and fixtures: will they need replacement?
- What is the quality and size of the inventory: is it overstocked with obsolete items?
- What is the condition and amount of the receivables: are they collectable?
- If I am to buy the payables, how current are they and what is the accurate total?
- Is there an order backlog?
- How strong are customer relationships: the goodwill you will pay for?
- Is the primary marketplace stable or changing?
- Does the business have, or can it obtain, all necessary government approvals and licenses? Are there any exorbitant fees?
- Is the seller motivated or anxious?
Screening of franchisees
A franchised company is only as good as the quality of their franchisees. It is a good investment to retain the service of a professional to assess potential franchisees. They can be found under the heading “franchisee employee assessment” in search engines.
Don’t be misled into zealous growth because you find a lot of potential franchisees clamoring for your offering. There are lots of entrepreneurially minded people seeking to operate franchised businesses. Your challenge will be to install filters when interviewing potential franchisees so that selected candidates all demonstrate integrity, intelligence and energy as well as the intention to become active operators. As Warren Buffett has said, “People with integrity are predisposed to perform; people without integrity are predisposed not to perform. It is best not to get the two confused.”
Real estate development
Real estate development plays a key role in franchising. These functions include:
- Creation of the design and working drawings of stores including equipment and fixtures.
- Negotiation of store leases in shopping centers or other appropriate locations Normally the franchisor will be the lessee and the franchisee the sub-lessee.
- Securing building and occupancy permits.
- Build-out of store premises including fixtures and equipment.
- Participate in store opening process.
Site selection is a key factor in the success of a franchised chain. Each business has its own individual site criteria. For example a donut shop should be on the side of the street going to work and a liquor store should be on the side going home. Through research and experience you need to create a “Site Model” that will provide a measurable, non-emotional, objective way to evaluate potential locations.
You can create your own “Site Model” by assigning different values to the factors that are most important for your particular business. Then each location can be numerically evaluated and compared against these measurements. The following example form will give you a methodical approach for evaluating the strengths and weaknesses of each potential location. Here are the steps:
- Evaluate your site location for each factor on a scale of 1 to 10, Number 10 being the highest.
- Decide the importance of each factor to your particular business on a scale of 1 to 5, number 5 being the most important.
- Multiply the grade by the weight to determine the points for each factor. Add up the points to get a total score. Repeat this process for each site to gain an objective, comparative analysis.
| Site Criteria Table | |||
|---|---|---|---|
| Factors | Grade 1-10 | Weight 1-5 | Points |
| Traffic count: Cars or pedestrians | |||
| Visibility access | |||
| Proximity to competition | |||
| Zoning | |||
| Parking (include off-street parking) | |||
| Condition of premises | |||
| Proximity to customer generators | |||
| Income level of neighborhood | |||
| Population density | |||
| Ethnic make up of neighborhood | |||
| Age factor | |||
| Directional growth of area | |||
| Area improving or deteriorating | |||
| Crime/shoplifting rates | |||
| Availability of qualified employees | |||
| Labor rates of pay | |||
| Supplier proximity | |||
| Terms and rental rates | |||
| Adequacy of utilities, gas, & water | |||
| Transportation accessibility | |||
| Total Points | |||
Some things to keep in mind in site selection:
- There’s no such thing as the “last good location.”
- Copycatting your most successful competitor’s site criteria can help you avoid making mistakes.
- If you are building a chain of stores, never sign a lease on your second location until your first location is profitable and proven.
- It is better to pay fair rent on a great location than pay great rent on a fair location.
- Don’t rely on leasing agents to make your site decisions.
- Driving streets and walking neighborhoods is a good way to scout for locations.
You will need to decide whether to build an in-house store development department which will be responsible for all aspects of site location and leasing or to outsource to commercial real estate brokers. A drawback to using brokers is the risk of conflict of interest issues.
Specialized legal council
Your legal council will be responsible for approval and compliance with all documentation including the offering circular, the franchise agreement and the sublease agreement. It is important that your legal council be experienced in corporate work and experienced in franchising law. If you are interested in an international franchising program, global expansion will require special skills. Please visit International Franchising in the Global expansion session in Business Planning section.
Training and operations management
You will need franchisees that are well trained, well motivated and well supervised. Your mission should be to emphasize consistent operations procedures, service, quality and cleanliness.
Area supervision
Ongoing oversight will be required to maintain consistency in quality and adherence to procedures. In the food service business it is correctly stated that “you are only as good as your last meal served”. Area supervisors also provide valuable feedback.
Do’s
- Create an acquisition team including outside professionals.
- Create a due diligence checklist.
- Consider vertical integration prospects.
- Acquire businesses that you understand.
- Compliment your existing product line.
- Evaluate whether or not to keep the seller’s management.
- Resolve all disclosed and undisclosed potential problems before closing.
- Learn the basics of how to calculate intrinsic value.
- Use intrinsic value and ROI to establish valuation.
- Gain economies of scale such as purchasing power.
Don’ts
- Over leverage by borrowing too much.
- Combine different corporate or labor cultures.
- Dismiss the value of acquired brand names.
- Make optimistic assumptions.
- Forego assurances that seller’s suppliers will continue to sell to you.
- Fail to have additional accounting controls in place.
- Fail to evaluate receivables.
- Buy a business that will take more money to keep competitive.
- Be afraid to walk-away
- Overlook your consultants when structuring financing.
