Archive for March, 2008

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.

Three New Websites

Tuesday, March 18th, 2008

We have added three new websites to our growing family of mergers and acquisitions websites. The first stie, our Business Broker Locator which allows you to locate a business broker based on the location, size, industry and other specific characteristics of your company. The second site, Ownership Transitions showcases services available to either buy or sell a business, at either an affordable hourly rate or at a fixed fee. The third site, is a companion to our Guide To Selling a Business. This site, a Guide to Buying a Business is written from a buyer’s perspective and has a plethora of information on how to purchase a company.

More About Comparables

Thursday, March 6th, 2008

In my last real post I talked about some of the problems with using comparables, namely that there is not enough information in most datasets to determine how comparable the data really is. It’s a bit like trying to value an orange by knowing the price of 30 small round fruits.

Comparable values often can give you a range of multiples that is so broad as to be meaningless. In a comparables report that I ran for Mfg. – Fabricated Metal Products with sales between $1,500,000 and $2,500,000 I got an average cash flow multiplier of 3.21, and the median was 3.52. “Great,” you say, “so my metal fabrication business with cash flow of $1,000,000 is worth about $3,333,000.” “Not so fast,” I reply, “the range of multiples in the report was from 0.16 to 5.27, so your business is worth between $160,000 and $5,270,000 – quite a range.”

Further complicating the use of multiples is that unlike in real estate deals where comparables are often used, in small to mid-sized business transactions the deal is seldom all cash. When a comparable is reported it may not be clear what the true value of seller provided notes, earn-outs, restricted stock, contingent payments, and so on really is.

There is, however, one big advantage to using comparables. Comparables represent real world transactions. So, if you are going to use comparables, how do you go about doing so in a way that minimizes the problems that we’ve discussed? The answer has two pieces. First, use comparables as only one method of valuing your business among several. Second, select a good source of multiples data. The best source is a business broker that can use past transactions of his own as a source of data. The broker will be aware of how the deal was structured and how similar your business is to the comparable. If you don’t have access to an experienced professional to help with the valuation, has data that is more comprehensive than most. For example, the data includes a field for the percentage of the deal paid in cash at closing. Alternatively, if you’re considering selling perhaps it makes sense to talk to a broker. You can use our website (shameless promotion here) to get up to four proposals from pre-screened business brokers. Ask them how they’ll help you determine an appropriate asking price.