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.