M&A: What is the valuation?
According to the Institute for Mergers, Acquisitions and Alliances (IMAA), there were 13,424 transactions in North America in 2015 compared with 14,215 in 2014 for a decrease of 5.6%. However, the value of the average transaction went up by 15.7% from $160.4M USD to $185.6M USD. Similar numbers were experienced globally with a 16% overall increase in average value to $91.5M USD and a volume of 42,930 total transactions. Several notable increases in average acquisition value from 2014 to 2015 was the Middle East and Africa at 232.6% and Asia-Pacific with a 42.6% increase. Every transaction has a risk and potential reward. With transaction values rising for fewer opportunities, the inherent risks continue to rise.
All too often, due diligence can be relegated to a financial investigation to ensure margins, assets and liabilities are accounted for. In some cases, Lean or Six Sigma experts are enlisted to assess opportunities for improved operational performance. In yet fewer instances is adequate verification performed on the processes directly associated with growth. These include competitive landscape, market value of Intellectual Property (IP), viability of technology road map, robustness of product development processes, retention of key technical personnel and strength of customer relationships. For projects where this research is performed, relying on secondary information or macro-market reports is inadequate. This is especially true for high-technology companies that represented 19.5% of all transactions globally in 2015, the largest of any single industry. As due diligence is a risk management process, perhaps more…well…diligence is warranted.
There are infinite reasons businesses come up for sale; however, in few instances is it because the business is healthy, vibrant or competitive. In response to this statement, the example of the aging owner of a very profitable privately held company seeking a liquidity event is often quoted as a counter-argument. These opportunities do exist and represent low hanging fruit for private equity and corporations alike. But for the vast majority of cases where an organization is on the market, the lack of performance is driving divestiture of the company or business unit. Think about it, even non-core businesses that generate double-digit Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) growth year-over-year are hard for most owners to part with! Reading annual reports or listening to earnings calls, it would appear that the best leaders want to “shape the portfolio” or “refocus on the core business”. It sounds like they simply don’t prefer a business unit that plays in a different market – like a preference for mayonnaise instead of Miracle Whip. The unspoken truth is that to fix a struggling business that is non-core isn’t worth the time and energy. For those that have been through this culling process, reality is a bit different than official public statements.
In another counterpoint to the statement that most business for sale are poorly performing, some cite the start-up that will be the “next Google”. After all, the chance of a lifetime, by definition, can only come along once…and that time is now before the company goes big! If it were really going to be the “next ‘paste wildly successful company name here’ “, why are they trying to sell before it goes big? Wouldn’t it make a bit more sense to sell after it went big? Shouldn’t the founders be asking for funding instead of a purchase agreement? Maybe the founders are altruistic and simply want to make the prospective company rich…because that is just the kind of people they are. Learn more about them at #ReallySmartButExtremelyNaïveFoundersThatDon’tExist.
It is time to ask the critical question: why is the business for sale, really? Due diligence is the process of discerning if the seller’s answer to that question can be taken at face value. It is a general term for all activities requisite to establish a current value for the company based on the objectives of the acquiring party. The formula for valuation is not a one-size-fits-all recipe. Depending on the type of business, it can be very difficult to determine the starting point for purchase price negotiations, especially for technologies that are still in development. Agreeing on EBITDA is not the hard part, it is deciding the appropriate multiplier. Historical financial results are used to derive the former, but are less relevant to calculate the latter. The multiplier is based on estimated potential value post-acquisition, integration, operation under new management and launch of new products. It is the numerator in the Return on Investment (ROI) equation that must be well understood.
For private equity in the US, a 30% annual ROI in 3 to 5 years is the threshold for a feasible opportunity. This means EBITDA has to grow 200% to 300% from acquisition to liquidity. There are two variables required to calculate any type of margin in any country: Income and expenses. Due diligence always includes both elements. The most basic questions potential investors have to answer are:
1. Can costs be cut from the business making it more profitable while maintaining or improving quality?
2. Can more products or services be sold to increase revenue with equal or less fixed cost?
Businesses cannot depend on cost reduction alone to achieve private equity ROI expectations: Revenue has to increase dramatically. Therefore, the purpose of this article is to discuss best practices in forecasting future income. It is also a good reminder that most businesses are for sale because they aren’t currently performing or future viability is in question.
Three generalized functions of a business are critical to revenue generation. They are development, sales and delivery. The first role, development, understands the unmet market need and how the company can provide a unique, compelling solution to this problem. Then it develops a functional product that meets or exceeds market requirements. Typical departments and skills encompass market research, strategic planning, product management, R&D, engineering, and product development. These roles work together to ensure new technologies actually solve a problem instead of being a nifty idea looking for a problem.
The function of sales is to make consumers aware that the developed product is available and where it can be purchased. Departments of marketing communications, channel/distributor management, and direct sales are often lumped together in the same, “sales and marketing” group because they are so tightly coupled to complete this essential task.
Delivery is a broad term to describe the process of getting developed product to customers. This involves supply chain, manufacturing, customer service, sales and operations planning, logistics, and product service. Unfortunately, delivery is thought of as a cost center not a growth engine for the business. Manufacturing improvement is frequently viewed as a path to cost containment, inventory reduction and waste elimination. In a competitive global market, delivery can be a significant differentiator when supplying product or service to a consumer base with increasing demands for immediate gratification. Perhaps looking at the antithesis of delivery will assist in understanding why delivery is a contributor to the income side of the margin equation: A pattern of not shipping or shipping later than the competition can impact customer retention and future business growth.
As part of the due diligence process, all three roles of revenue generation (development, sales, delivery) must be validated. A business is only as profitable as it’s least effective and efficient function. Further complicating the acquisition process, both current and future performance must be quantified. This means the due diligence team must assess all processes associated with growth. Example questions include the following:
1. How well does the company develop products today?
2. Are best practices deployed uniformly?
3. Is there a history of performance in development and what is the roadmap for future products?
4. Does existing intellectual property have value based on trends in the market?
5. If there are areas of weakness in sales, what will it take to improve them?
6. Is delivery performance competitive relative to other providers in the target market?
7. Is the market segment becoming crowded with new entrants?
Not only are answers to these questions fundamental to negotiating a purchase price for the business, they will also shape the “100-day Plan” for the management team accountable to implement change in the company. The more relevant and detailed the pre-sale intelligence regarding growth-generating processes, people, and products, the less risk an investor assumes. Because so many acquisitions today are categorized as high technology, the front end functions require specialized skills to evaluate.
Functional expertise should be on every due diligence team to manage risk: Knowledge of the development processes required to sell to the target market including expertise in the technology roadmap, experience selling and marketing in the target market, and understanding of the competitive landscape for delivery. If the team lacks any of the three assets, additional advisors or consultants should be added to supplement the team. A company acquiring the average $185M USD high technology company cannot afford to miss pertinent details affecting the future revenue generation potential of the target company. Remember, past financial performance does not guarantee future competitiveness. Businesses are sold for a reason. New technologies don’t always satisfy unmet market needs, some are just great ideas that have little revenue potential.
A Lean System’s Approach to Growth
The pressure to grow top line sales and bottom-line margins is incessant. This stress is necessary in a free-market economy because demand for improved products and lower cost services is equally insatiable. Consumers typically have options in who they buy from, and the process of natural selection is as unbiased in business as it is in nature. All too often business leaders sub-optimize growth initiatives without applying a system’s approach to solving market problems: like pairing a supercharged V-8 engine with a single speed transmission. This post will present a broader perspective on front-end growth processes that include dynamic, interrelated parts of the business.
Looking back over the past several decades, businesses have aggressively applied Lean manufacturing and Six Sigma methodologies to improve quality and reduce cost. If you have participated in these efforts, it was quickly evident that addressing immediate bottlenecks or high failure rate items is a best practice to begin the journey. It should also have been equally clear that optimizing a specific process or product design may not actually get the final goods delivered faster or with better quality. In a manufacturing setting it becomes painfully obvious that if you reduce the process time of the final assembly cell by 90% (sounds impressive) nothing ships if you don’t get quality parts from your supplier to build with. This would be akin to the big block V-8 shackled by a mono-gear transmission.
To address this in a physical plant, successful companies focus on lineback logistics, Sales and Operations Planning (S&OP), and supply chain management to connect demand with supply from mining the ore to delivering finished product. This is because most businesses are made up of numerous interdependent departments, functional processes, suppliers, distributors and consumers. Refining a single part in the system rarely moves the needle on company-wide metrics or customer satisfaction. This realization should be prevalent today in the manufacturing sector.
Reducing costs and improving quality by eliminating waste in all forms is an imperative for today’s global economy. Perhaps less obvious is the need for a similar systems approach to the pre-sales, revenue generating activities in a business. It is the experience of the author that delivering value to consumers requires much more than cutting costs. After all, calculating margin of any type involves both income and expenses. This article will focus on the processes that drive the first half of the equation.
There are four general categories of growth-creating processes: Market Research, Strategic Planning, Product Management/Marketing and Product Development. Depending on the business, one or more of the functions may be part of the same department. For example, market research may be a subset of the strategic planning group; or product management may report into product development. Irrespective of the organizational structure, the role of each process is unique. If we learn anything from Lean manufacturing, it is that optimizing a single element of the business will likely not produce the desired results. A definition for each area of expertise will be described in some detail to better appreciate how they interrelate.
Market research is both a science and an art. In the age of information, there is much more data available than ever before; however, armed with this same information, the competition in a global economy can be fierce. This important role is to gain better insights into what is happening outside the company: What are consumers willing to pay for, what products and services do they choose from, how many customers share the same need, is demand trending up or down and in what regions of the world is there growth or attrition, how are products/services delivered to the end-user, and what are the unresolved problems? Analytics are a large part of market research as it drives so many downstream processes; however, the value of intuition cannot be underestimated. Business is dynamic and what was true last week is no longer valid. Today’s solutions will likely not satisfy tomorrow’s requirements. Market research is only valuable when it provides insight into the future.
Before the next topic is discussed in sincerity, it must be said that “strategy” is one of the most inflated and overused terms in business. In fact, if career advancement is desired, just add the word “strategic” to any title: “Strategic” project manager, “Strategic” procurement engineer, or “Strategic” custodian and it sounds like the person is too smart to actually work. Possessors of such coveted positions are paid to sit in an office and …well…think stuff up, full time…while someone feeds them grapes and fans them with palm boughs to keep the flies off. Now back to the subject.
Strategic planning is primarily an internally focused process. It has three components in its simplest form: an idea, a plan and execution. The idea is a response to market intelligence and describes what the company will do to differentiate from the competition while addressing unmet needs. The planning phase is necessary to understand the investment, resource priorities and timing of development. It uses market data to estimate revenues and compares this to expected costs to complete a business case. An essential facet of strategic planning is to ensure the idea is aligned with the objectives of the company. It is also an opportunity to confirm that the company direction accounts for the available market research. Finally, execution (yes, doing work) is part of any successful strategic initiative. Hopefully the connection between market research and strategic planning is becoming evident.
Product management is the intersection of a Venn diagram comprised of three circles: technology, business and consumers. It is a challenging overlap of often conflicting needs that must somehow be satisfied simultaneously. The role is a bridge function between market requirements, internal business needs and development capabilities. Product management is part of the execution team discussed in strategic planning and must distill the output from market research into concise, actionable conclusions. It also has the responsibility to articulate the go-to-market strategy: How will consumers know the product exists, why they will prefer it over competing options, how much they will pay for it, and who they will get the product from?
Although some use the terms interchangeably, product development is actually the internal customer of product management. Product development’s function is to use internal resources and processes to design, integrate, test and transition product to production. Research and Development (R&D) is often on the leading edge of product development creating technologies that solve market problems identified by market research and thoroughly described by product management. Product development receives requirements and delivers validated product.
This all seems pretty strait forward, so why is the topic worth 1500 words on a blog? Unfortunately, there are readers of this article that can recall examples of an executive team that spent months refining the most incredible idea in their strategic planning process only to realize there is no market for it. Worse yet, some companies have already invested in product development without factoring in distribution costs, rep margins or total cost of production and when completely understood reverse the financial conclusion of the business case. How many companies have great ideas and plans, but take too long getting product to market never to reach payback on their investment? Are there businesses that are unable to finalize product requirements and meander perpetually in an otherwise efficient product development process guessing what the customer will pay for? The answer to both questions is, Yes! Situations like these happen every day in small and large organizations.
Reading these definitions may have felt like going back to third grade for a lesson in arithmetic (please stop yawing!). The fact is growth-creating processes are similar to manufacturing: Everyone understands Lean concepts, yet few implement them well. One fundamental reason companies struggle with creating growth is because they treat the system of highly interdependent functions as loosely connected, or altogether disconnected processes. Conducting the most insightful market research, or worse paying for it, just to have product development flounder in overruns is another V8/transmission mismatch. Likewise, when the “ideas” from strategic planning lack a prioritized resource plan to pull it off it probably explains overruns in the aforementioned product development. The processes are as inextricably interrelated as the valves and crank shaft in an internal combustion engine.
So what do you do about it? The first step is to recognize that the current process isn’t working as well as it should. The second step is to begin thinking of all pre-sales and pre-production processes as a single critical subsystem of the business. This subsystem must also be tightly coupled with sales and manufacturing to be successful. Like Lean manufacturing or Six Sigma, you start with the biggest bottlenecks and worst quality issues; however, process improvement must be made only after system constraints and interactions are well understood. Growth is a process, not an event. All roles of growth generation must be present and work together to be successful – even if all roles are fulfilled by the founder of a start-up. Help is available for companies that want to begin their journey to system-wide growth.