small business management mgmt5601 workshop 5 part a ...€¦ · considerations in acquisition...

© Mazzarol 2018 all rights reserved

Small Business Management MGMT5601

Workshop 5 Part A: Acquisition

or Exit

Professor Tim Mazzarol – UWA Business School

UWA Business School MBA Program [email protected] MGMTG5601

©Mazzarol 2018 all rights reserved


• Examine options for growth.

• Understanding the concept of business

valuation.

• Overview and assess different business

valuation methods.

• Understand the nature of goodwill and

how to measure it.

• Examine the advantages and

disadvantages of buying an established

firm.

• Understand the process of preparing a

business for sale.

Workshop Overview


In this workshop we aim to:


Three “Generic” strategic options

Growth

• FOCUS:

• Market opportunity

• Innovation

• Profitability

• NEEDS:

• Visionary leadership

• Strategic thinking

Exit

• FOCUS:

• Preparation for sale

• Succession planning

• Wealth creation

• NEEDS:

• Operational management

Stasis

• FOCUS:

• Consolidation & Efficiency

• Low stress & Profitability

• NEEDS:

• Operational management

Source: Mazzarol & Reboud (2009)


D

E

G

R

E

E

O

F

C

H

A

N

G

E

T

I

M

E

Where

The BusinessCould

GoThe Outcomes

Key Internal

Influences

On the

Development

Process

Vehicle for

Growth

(Product

or Market

Development)

Key External

Influences

On the

Development

Process

POTENTIAL

FOR GROWTH

CURRENT

PERFORMANCE

A MODEL OF GROWTH THROUGH PRODUCT/MARKET

DEVELOPMENT IN THE SMALL FIRM

Source: Gibb & Davies (1992)


Growth cycle of small firms


Stage 1 Stage 2 Stage 3 Stage 4 Stage 5

Start-up Survival Growth Expansion Maturity

Size

Age of BusinessYoung Mature

Decline

Contained

Contained

Decline

Fold

FoldCrisis

Crisis

Crisis

Crisis

Source: (Scott and Bruce, 1987)

Source: Scott & Bruce (1987)


Product lifecycle growth


Strategies for growth

Organic

Maintained within firm’s existing

resources.

Funding by retained profits

and debt financing.

New product and market

combinations internally

generated.

Slow and sustainable.

Inorganic

Facilitated by the merger and acquisition.

Funding by equity capital

raising.

New product and market

combinations externally generated.

Fast but higher risk.


Product-Market Growth


Growth by New Product Development

Growth by Diversification

ConsolidationGrowth by

New Market Development

New Product

Existing Product

New MarketExisting

Market

Source: Ansoff (1965)

RISK


Diversification

• Diversification:

– Encourages efficient capital allocation.

– Trains general managers.

– Spreads risk.

• And:

– Diversified corporations have more strategic options than single businesses.

– Good diversified corporations have good control systems.

• Australian research evidence suggests:

– Diversification alone will not create value.

– Managing diversified firms is difficult.

– Corporate strategies should adapt and change.

– Performance measurements need careful thought.

Source: Hubbard (1999)


Considerations in acquisition strategy

• Business strategy of the acquiring firm

– Dominant, Related, Unrelated

• The industry relationship of the target to

the acquirer

– Same industry, related or unrelated

• Pre-Takeover competence of the acquirer

– Competence = ROSF¹

– Aggressive versus defensive motivations

• Pre-takeover competence of the target

– Competence = ROSF

– Investment versus Turnaround

Source: Hubbard, 1999

¹ Return on shareholder funds (ROSF)


Buying a business – Key Questions

• Why is this business being sold?

• What are the intentions of the existing owners?

• What is the outlook for the market?

• What is the current physical condition of the business?

• What is the condition of the inventory?

• What is the state of the company’s other assets?

• How many of the staff will remain?

• What type of competition does it face?

• What does the firm’s financial picture look like?

• How much additional investment is needed?

• What is the return on this investment?

• How secure is the tenancy?

• Are there any government regulations likely to change?


Value a business

• Establishing value is not the same

as setting a price for the business.

– Value = assessed worth of business

– Price = negotiated value agreed by

buyer and seller

• Value rarely equals Price, but it

offers a starting point.

• Key elements within the small firm

that comprise its value are:

– Tangible assets (e.g. fixtures &

fittings)

– Property (e.g. buildings & land)

– Work in progress & inventory

– Intangibles (e.g. Intellectual Property)

– Goodwill (e.g. future earnings & brand

reputation)

Source: Carland & White (1980)


Valuing the business


Methods of valuation

• Book Value– Based on the firm’s balance sheet

(should be audited)

– Key considerations:• Original purchase price less

depreciation

• Replacement value of assets

• Liquidation value of assets

• Gross Income Multiplier Method– Assumes gross profit is most

important

– Gross profit margin is key measure

– Past earnings are a major indicator of future performance, but take care

• Discounted Cash Flow Method– Focus is on cash flow not profit

margin

– Uses Net Present Value (NPV)

– Not common in small firm sales due to its complexity and difficulty in forecasting sales

Source: Mazzarol (2006)


Book value method

Assets to be transferred $ $

Inventory at replacement cost 87,500

Accounts receivable at cost 650

Equipment at replacement cost 17,000

Fixtures at cost 6,000

TOTAL 111,150

Debt to be assumed

Accounts payable 42,000

7.5% current

4.1% 30 days

88.4% 60 days and over

Bank loan balance 48,000

67 pmts @ $818.55 (9%) secured by

loan

TOTAL 90,800

Estimated Business Value 20,350

• Example illustrated here is a general

retail hardware business.

• The aim is to assess the value of

“salable assets”.

• It needs access to the firm’s current

balance sheet to review all assets and

liabilities. Ideally this should be

audited.

• Of particular interest are inventories.

• Key points to note:

– Substantial appreciation has occurred

in inventory and equipment.

– Bank approval of the loan assumption

will be required.

– Additional requirements for sale will be

the agreement to liquidate accounts

payable on terms satisfactory to

suppliers.



Gross income multiplier method


• Example is for a retail hardware store.

• Assumes:– Business has little control over prices.

– Gross profit margins are constant.

– Inventory is the largest and most important asset.

• Historical sales trends for past 2-3 years are used to forecast future sales.

• Gross profit margins are determined using industry averages or historical trends within the business.

– GP margins higher than industry average are rare.

• Estimated Business Value– 2.7 x $45,000 gross profit

• Established fixed costs (rent, wages etc)

Gross Sales $ $

Year 1 – actual 166,000

Year 2 – actual 171,000

Current Year – annualized 160,000

Future year expected sales forecast 167,000

Gross Profit Margin

Industry average 27%

Year 2 – average 28%

Current Year – actual 27%

Future year expected gross margin 27%

Stock turnover – industry average (2.7)

Estimated Business Value 121,700

Established Fixed Costs 28,400

Rent 8,200

Insurance 2,200

Wages (1½ @ $8M) 12,000

Fringes 1,200

Utilities 4,800

Pro-Forma Contribution Margin¹ 16,600


Discounted cash flow method


• Assumes cash flow is the key value within a business.

• Future returns on the purchase price will be generated from future cash flows.

• There are four steps:

– Estimate the expected cash flows.

– Determine an ‘appropriate’ discount rate.

– Determine a ‘reasonable’ life expectancy for the business.

– Calculate the value of the business by discounting the estimated cash flows by the ‘appropriate’ discount rate over the expected life of the business.


Problems in small business valuation

Sources: Mazzarol (2006); Winter (2006)

• The valuation of a small firm can be complicated by:

– A lack of reliable financial reporting and record keeping.

– Lack of third party audits.

– Lack of reliable benchmarks.

• Study of 267 small businesses sold in South Australia found most valuations were inaccurate and unreliable.

• Most common valuation method used was future maintainable income multiple.

– Future estimated income is multiplied by a given multiple (e.g. 2, 2.5, 3 or 4), plus the value of the tangible assets.

– Size of multiple relates to the perceived risk associated with the business. Higher risk = lower multiple.

– Criticized because it fixes risk.

Example:

Value = (FMI x 3) + tangibles

$975,000 = ($300,000 x 3) + $75,000


The Goodwill factor


• Much of the final sale price of a small

firm will be found in its ‘goodwill’.

• Goodwill is one of the more complex

issues to deal with in accounting.

• Generally defined as:

– Intangible assets not otherwise covered

within the assets of the balance sheet.

– The capitalized value of its established

reputation and profits potential.

– The future benefits from unidentifiable

assets.

• Can include such things as:

– Clients or contracts sold with the

business.

– Intellectual property assets.

– Brand name (if formally valued).

– Trading history and forecast future

earnings.



Business in Australia by size


Source: Gomes (1988)


Goodwill and valuation


• Pragmatically goodwill is about the firm’s

ability to generate future sales.

• When deciding on paying for goodwill ask:

– How long would it take to set up a similar

business and the expense and risk associated

with such a venture?

– How much additional income is likely to be

generated by purchasing the established business

as opposed to setting up a new business?

– Does the goodwill value reflect what other similar

businesses might charge for their goodwill?

• What are the firm’s most valuable assets?

– Are they included in the goodwill price?

• Is the business system or people dependent?

– How much goodwill is associated with the existing

owners?



Valuing intellectual property


• If the firm has IP assets they

should be kept in a register.

• Define and classify the IP assets.

• Make sure IP assets can be:

– Readily identified and capable of

being separated from other assets

employed in the business.

– Non-physical in nature.

– Capable of producing future

economic benefits.

– Protected legally or through a de

facto right.

• If these conditions are not met

the IP assets cannot be valued.

Sources: Bertolotti (1995)


Prior to settlement


• Obtain independent professional

valuation

• Sight original tax returns, accounts

• Obtain “restraint of trade” clause

• Talk to customers, suppliers,

competitors

• Discuss with existing staff

• Work in the business

• Compare figures with Business

Benchmarks


General summary

• Well run, profitable businesses with

solid client base are excellent

investments but will be expensive to

buy and are rarely advertised.

• Good businesses are sold via

business brokers or accountants who

have existing lists of waiting

purchasers.

• Conduct a careful SWOT analysis.

• Assess ‘Goodwill’

• Buy in haste, repent at leisure.

End of Presentation

small business management mgmt5601 workshop 5 part a ...€¦ · considerations in acquisition...

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