Small Business Management MGMT5601 Workshop 5 Part A: Acquisition or Exit Professor Tim Mazzarol UWA Business School SBM MGMTG5601 UWA Business School MBA Program tim.mazzarol@uwa.edu.au Mazzarol 2018 all rights reserved
Workshop Overview In this workshop we aim to: 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.
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)
The Business Could D E G R E E O F Where Key Internal Influences On the Development Process The Outcomes Vehicle for Growth (Product or Market Development) Go Key External Influences On the Development Process T I M E C H A N G E 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 Crisis Crisis Contained Decline Contained Crisis Crisis Fold Fold Decline Young Age of Business Source: (Scott and Bruce, 1987) Mature Source: Scott & Bruce (1987) Mazzarol 2018 all rights reserved
Product lifecycle growth
Strategies for growth Organic Inorganic Maintained within firm s existing resources. Facilitated by the merger and acquisition. Funding by retained profits and debt financing. Funding by equity capital raising. New product and market combinations internally generated. New product and market combinations externally generated. Slow and sustainable. Fast but higher risk.
Product-Market Growth New Product RISK Growth by New Product Development Growth by Diversification Existing Market New Market Consolidation Growth by New Market Development Source: Ansoff (1965) Existing Product Mazzarol 2018 all rights reserved
Diversification Diversification: And: Encourages efficient capital allocation. Trains general managers. Spreads risk. 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 Source: Mazzarol (2006) 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
Book value method 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. 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 Source: Carland & White (1980)
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 Source: Carland & White (1980)
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. Source: Carland & White (1980)
Problems in small business valuation Example: Value = (FMI x 3) + tangibles $975,000 = ($300,000 x 3) + $75,000 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. Sources: Mazzarol (2006); Winter (2006)
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. Source: Mazzarol (2006) Mazzarol 2018 2018 all rights all rights reserved
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? Source: Mazzarol (2006)
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) Mazzarol 2018 all rights reserved
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 Mazzarol 2017 2018 all rights reserved
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.
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