Archive for the ‘valuation methodology’ Category

Costs that are Often Overlooked in the Costs to Create Methodology

Wednesday, March 26th, 2008

Often when a buyer is purchasing a business to get into a new geographic area or expand his product offerings, the buyer uses the cost to create or a buy versus build methodology to evaluate the price that the buyer should pay. The cost to create methodology is explained in detail on our Guide To Selling a Business website, so I won’t repeat it here, but I’d like to point out a pitfall in the methodology.

Unlike in a previous post, where I discussed the problem of the buy vs. build methodology producing a value that is too low because the probability of failure is underestimated, I want to talk about a problem with the buy vs. build methodology that results in overpayment for the acquired company.

Often a buyer will calculate the value of an acquisition by just totaling up the costs that would be incurred to create the new product and/or services or to expand into the new geographic area. Then, they assume that they are done with the valuation.

However, there are a number of costs associated with acquiring a business that you need to put into the equation:

Acquisition Costs

There is a cost to acquire the target company. These costs may include fees and commissions to business brokers, attorneys, can accountants. Costs of taking physical inventory. Due diligence can also be expensive to perform.

Opportunity Costs of Acquisition

An acquisition takes time of senior management, which may be better used for other purposes.

Potential Failure to Close

No closing is ever assured. You may decide that there was misrepresentation as you perform due diligence or the owner may decide to keep the company for reasons that have nothing to do with the deal.

Integration Costs

There are potential expenses related to integrating two companies. For example, you will probably rename one of the companies to have a single brand. Doing so requires marketing, printing, and communication expense. You may also want to standardize on a single pension, health insurance, or other benefit plan, a single accounting system, and so on. To do so you may incur legal, accounting, or IT costs.

You may also need to integrate your products and services with those of the acquired company. This is especially true when acquiring software companies. Seamlessly integrating software packages that were not designed to work together can be extremely difficult.

Being Stuck with Past Decisions

When you start something on your own, you can tailor your decisions to your target market and/or to the needs of your existing customers. In acquiring a company you need to accept the decisions that they have made in the past or pay to undo them.

So, if you are the president of a software company and your VP of business development comes to you and says “We think it would take $10 million to develop an ERP package, but I’ve identified three ERP companies that we could probably buy for $8,000,000″ you need to determine the costs of acquisition that are discussed above and add them to the price. You may find that the $2,000,000 savings disappears when you’re done.

Why The Value of Your Business Isn’t Based on your Efforts

Tuesday, October 30th, 2007

Many small business people believe that their business an unrealistically high price. Here is one of the arguments that I have heard to justify excessive valuations and the problems with that argument.

A very emotional reason is that the business owner has put his heart and soul into the business. When I asked one owner why he thought his business was worth $1,000,0000 he answered “I’ve put 19 years of my life into this business. That’s the minimum that 19 years of sweat is worth.”

As delicately as I could, I pointed out that a buyer is going to look at the business as an investment. The buyer wants a reasonable return on his investment, regardless of how much effort has been put into the business,

Imagine yourself in a buyer’s shoes for a moment. You are considering buying two businesses. Business A has a dedicated owner who works dawn to dusk. Over the last five years it has been running at break even. Business B has an owner that works 5 hours/day, and throws off $100,000 in profits every month. Which business is worth more to you?

Since buyers are interested in profits, as an owner charge your clients enough to make a fair return for your time today. Don’t count on a future buyer to make up for your lack of profits today when you sell your company. If anything, taking unprofitable clients to increase your volume of business today will decrease the price of your business when you sell it, because of the decreased margins.

There are a few exceptions that prove the rule. In certain industries, such as payroll or web hosting, the cost structure of the acquired business generally goes away almost completely post acquisition. When a large payroll company acquires a small processor they value based primarily on the gross revenues, because the largest costs, such as software, marketing, and labor, are not relevant. If a small payroll service spends 25% of revenue on software it doesn’t mean that the acquirer will incur a 25% cost for payroll software.

Another exception is in the rare instance where a company has put a lot of money into R&D that is not yet producing revenue. For example, if you own a software company that is about to release a completely new line of software, you can make an adjustment. If, however, your company produces Sudoku Software, the fact that you have a new version of Sudoku software in the works would probably not make a difference in the valuation, because a buyer will view the cost of producing a new version as part of the cost of doing business. However, if you have a new vertical market application for finance companies in which you’ve invested a substantial sum of money, that may merit an adjustment. R&D that produces intellectual property that is defensible (patents, for example) may produce larger adjustments.