Business Succession Planning - Your Children and Your Estate
BUSINESS SUCCESSION PLANNING - YOUR CHILDREN AND YOUR ESTATE
By David M. Kauppi President Mid Market Capital, Inc.
As Penn State professor William Rothwell ominously points out in the forward to Exit Right: A Guided Tour of Succession Planning for Families in Business Together, more than 40% of the people who run the closely held operations that comprise 80% of the North American economy will retire by 2007. Those businesses will either be sold to a third party or management team, closed down, or passed on to the next generation. In this article I will focus on passing the business on to the next generation.
Tax laws still favor home ownership with mortgage interest as a tax-deductible expense. The government has also encouraged the passing of a business from one generation to the next with several favorable estate and gift tax rulings. Estate planning attorneys have utilized IRS ruling 5960 to minimize the estate and gift tax owed for a business either gifted to or inherited by the next generation. The business is often placed in one or more LLC's and divided up into minority pieces to take advantage of very substantial and legal minority discounts, often as high as 40%.
As is often the case, a business owner will have, for example, 4 children. Two sons will be actively involved in running the businesses and two daughters have built lives totally separate from the business. Because 85% of the value of the estate is tied up in the value of the business, to be "fair" the business is gifted and willed to the four siblings in almost equal proportion. Because the sons are running the business, they will get slightly more of the business and slightly less of the remaining estate. This gives them majority interest in the business. After dad leaves the business, the two sons will continue to run and grow the business without any input or participation from their two sisters.
Typically the business does not pay any dividends and the two sisters' portions are non-liquid because there is not a good market for selling minority stakes in a privately held business. Also, there is generally a very restrictive buy sell agreement that favors the majority holders. The sisters have no idea what the "fair value" of the business is and the only indication they have ever gotten is an official IRS gift tax or estate tax return with 40% discounts applied. If the enterprise value were, for example, $50 million and the two sisters owned a combined 40%, you would think that they had an asset worth $20 million.
The only document they have seen, however, is the gift or estate return, valuing their portion at only 60% of that number, or $12 million. The brothers feel entitled to the lions share because Ann and Julie had nothing to do with building this business. The brothers pay themselves big salaries and benefits and pay out little of no dividends. They may approach the sisters with gift tax return and restrictive buy sell agreement in hand and offer to generously buy out the sisters for a combined 8 million, because that is "all the company can afford to pay."
After this transaction takes place, let's look at the result of how dad's estate was fairly divided. Originally the brothers were left with 60% of the $50 million business, or $30 million and a minor portion of the remaining estate. The sisters were left with 40% of the business, or $20 million and the bulk of the remaining estate of $10 million. That appears to be fair. However, the buyout of the sisters for a combined $8 million results in an effective estate distribution of $42 million to the brothers and $18 million to the sisters. This is not what dad intended, but it happens all the time.
This is a very complex and emotional issue and there are no simple answers. Generally, dad had his identity tied up in the business and wants it to live on through his sons after he is gone. This is a noble, yet impractical thought if all the siblings are not actively involved in the business. The children often inherit the restrictive buy sell agreements that favor the brothers running the business and scare off investors that may have been interested in a minority stake in the business. Much of the value from a privately held business is derived from the benefits of working in the business. There is the very real concern that the integrity of the gift or estate tax business valuations will be compromised if the sisters are bought out at a price approaching a pro-rated division of total enterprise value.
Unfortunately, in most cases, nothing is done and as a result there are literally hundreds of billions of dollars of minority interests in privately held business that are providing little return or no return to their owners. We are working with estate planning attorneys, tax accountants and investors to come up with solutions. One of the keys to unlocking the liquidity in these minority interests is for the business owner to recognize this situation prior to building his estate plan. Unfortunately, we are often brought in after the fact and a fair outcome then is contingent upon the majority owners honoring dad's original intent of fairness and working toward that end.
Business Succession Planning - Should Your Children Run the Family Business?
BUSINESS SUCCESSION PLANNING – SHOULD YOUR CHILDREN RUN THE BUSINESS?
By David M. Kauppi, CBI, President Mid Market Capital
As Penn State professor William Rothwell ominously points out in the forward to Exit Right: A Guided Tour of Succession Planning for Families in Business Together, more than 40% of the people who run the closely held operations that comprise 80% of the North American economy will retire by 2007. It makes me wonder, what is going to happen to all of those businesses? Although it is a noble gesture, passing a business down to the next generation is more often than not, unsuccessful. In fact, statistics show that only one-third of all family businesses are successfully transferred to the next generation and only 13% are transferred onto the third generation.
Many family business consultants say the primary reason for this low survival rate is the failure to develop and effectively plan for the transfer of ownership and management of the closely held family business. I agree that this is a factor, but in my dealing with family businesses I find that there are some more fundamental reasons. The first is that the next generation has a lot different life style than the business founder and entrepreneur. They do not share the same drive and commitment that dad needed to build the business from scratch. They go to the good schools, get a taste of the good life and generally do not share the passion of the business founder. I recently was involved in selling a produce distributor. I found that most of the firms were in their second or third generation. I asked a third generation owner why this particular industry had such success with keeping the business in the family. He said, "When you are up and on the docks at 3 am and work 12 hour days, you don't have the time to spend the money."
The next generation may have a grand scheme to turn the traditional printing business into a media empire or a liquor business into an entertainment enterprise. A few years back the second generation of a well known Chicago area computer leasing and IT Services Firm tried to turn it into an Internet Venture Firm with disastrous results.
Before you just assume that your torch will be carried by the next generation, make sure that the next generation even wants to run the business. Imagine the loss in value that would have occurred if the real estate billionaire from the western suburbs had turned his empire over to his son who simply wanted to produce plays.
Are your heirs even capable of running your business? Have you held on to the reins so tightly that the kids involved in the business have not been able to develop their decision-making or leadership skills? Do they command company respect because of their personal strength and skills or are they grudgingly granted respect because they are the child of the owner? If that is the case, the odds are not good for them taking over when you retire.
Another big challenge is trying to balance fairness in employing many children or even grandchildren in a family business with various skill levels, compensation levels and ownership levels. The jealousy and in fighting can absolutely grind the company's progress to a halt.
The business owner must make some difficult decisions when he or she decides it is time for them to retire. Why did I create this business? Was it to keep this business in the family for generations or was it to provide for my family for generations? If the desire and the capability of the children are not evident and the company is large enough, it may be the right decision to first get outside board members actively involved as step one. Step two would be to hire professional management to run the business. A second alternative is to sell the company while you are still running it and it can command its highest value. If you have children that want to remain in the business for the immediate future, incorporate that into the sale agreement with employment contracts.
Another way to think of it is, while I am running the business, the best ROI is to keep the bulk of my net worth invested in this company. If I am no longer running the company what is the best risk reward profile for my net worth? Would my heirs be better off if the business was sold and the value converted to financial assets?
Growing Your Business Through Acquisitions
davekauppi@midmarkcap.com or visit our Web page www.midmarkcap.com.
Growing Your Business Through ACQUISITIONS
By David M. Kauppi CBI - Mid Market Capital
Successful growing companies usually grow through a combination of organic growth and strategic acquisitions. For purposes of this article, a strategic acquisition is defined as an acquisition where the result of the combination is far greater than the sum of the parts. For example, if Company A with revenues of $50 million Acquires Company SA with revenues of $10 million, the Newco mathematically would have revenues of $60 million. The anticipated performance of a well thought out strategic purchase might result in a combined revenue for Newco of $100 million within a 1 to 2 year period. A second category of strategic acquisition would focus on an improvement of the profit margins of Newco.
Let's use two companies that are recognized as among the best at making successful acquisitions, General Electric and Cisco Systems. As their stockholders will happily tell you, these companies have been star performers in growing shareholder value. General Electric is a giant conglomerate with business lines such as GE Capital, GE Plastics, GE Power Systems, GE Medical, and several others. Cisco Systems could be categorized as a high tech growth company primarily focusing on voice and data communications hardware, software, and services.
The first rule of strategic acquisition we learn from these two prolific and successful companies is that they do it on purpose. They have a well thought out defined approach. To quote GE, "We are allocating capital to businesses that can increase growth with higher returns, businesses requiring human capital as opposed to physical capital. We are disciplined and integrators and we grow the businesses we acquire. Over the past 10 years Cisco Systems has acquired 81 companies. If you track their stock price over the same period, it is up a remarkable 1300% over that same period. GE, starting with a much larger base, still outperformed the S&P 500 index over the same period 3 to 1.
If you study the acquisitions of these two companies as well as good middle market growth through acquisition companies, you find some common strategic themes. The core principal that runs through almost every example is INTEGRATION. With the exception of establishing the original platform, GE expanding from their original roots and establishing a presence in plastics, for example, all of these acquisitions focus on integration.
An example that I use to summarize strategic acquisitions for Cisco Systems is not a real acquisition, but a hypothetical company that should demonstrate a point. I have been a very happy stockholder for over a decade. It seems like every year they would announce an acquisition that looked like this – Today Cisco announced the acquisition of Optical Solutions Company for $30 million in stock. Optical Solutions Company manufactures the OptiFast Switch, the fastest optical networking switch on the market today. The Company was started two years ago by two Stanford Electrical Engineering Professors. Current sales are $1.5 million and last year they lost $700,000. My initial reaction was, "What the heck are they doing?" What they were really looking at was what this technology could become as it was integrated into the Cisco family. First, Cisco has 5,000 sales reps, 12,000 value added resellers and systems integrators that sell their solutions, and 600,000 customers that think Cisco walks on water. Cisco knows their market, their customers, and the first mover advantage in their market. With this backdrop, the OptiFast Switch achieves sales of $130 million in its second year of Cisco sales. That's what the heck they were doing – a classic strategic acquisition.
There are several categories of strategic acquisition that can produce some outstanding results with effective integration. Many acquisitions actually have elements from several categories.
1. ACQUIRE CUSTOMERS – this is almost always a factor in strategic acquisitions. Some companies buy another that is in the same business in a different geography. They get to integrate market presence, brand awareness, and market momentum. Another approach is to acquire a company that can establish a presence for you in a different market segment. For example, lets say that that Company A made fasteners for the automotive industry and felt that their expertise could be applied to the aerospace industry. A company that produced fasteners for the target industry could help jump-start this strategic initiative.
2. OPERATING LEVERAGE – the major focus in this type of acquisition is to improve profit margins through higher utilization rates for plant and equipment. A manufacturer of cardboard containers that is operating at 65% of capacity buys a smaller similar manufacturer. The acquired company's plant is sold, all but two machines are sold, the G&A staff are let go and the new customers are served more cost effectively. Adding new customers without increasing fixed expenses results in higher profit margins.
3. CAPITALIZE ON A COMPANY STRENGTH – this is why Cisco and GE have been so successful with their acquisitions. They are so strong in so many areas, that the acquired company gets the benefit of some, if not all of those strengths. A very powerful business accelerator is to acquire a company that has a complementary product that is used by your installed customer base. It is ten times easier to sell an add-on product to an installed account than to sell a product to a new account. Management depth and skill, production efficiency/capacity, large base of installed accounts, developed sales and distribution channels, and brand recognition are examples of strengths that can power post acquisition performance.
4. COVER A WEAKNESS – This requires a good deal of objectivity from the acquiring company in recognizing and chinks in the corporate armor. Let me help you with some suggestions – 1. Customer concentration: too much of your business is concentrated on a small group of customers 2. Product concentration: too much of your business is the result of one or two products 3. Weak product pipeline – in a business environment that is becoming more innovation focused, having a thin product pipeline could be fatal. Many of the acquisitions in the pharmaceutical industry are aimed at covering this weakness. 4. Management depth or technical expertise and 5. Great technology and products – poor sales and marketing.
5. BUY A LOW COST SUPPLIER – this integration strategy is typically aimed at improving profit margins rather than growing revenues. If your product is comprised of several manufactured components, one way to improve corporate profitability is to acquire one of those suppliers. You achieve greater control of overall costs, availability of supply, and greater value-add to your end product. Another variation of this theme some refer to as horizontal integration is to acquire a company supplying you distribution.
6. IMPROVING OR COMPLETING A PRODUCT LINE – this approach has several elements from other acquisition strategies. Successfully adding new products to a line improves profitability and revenue growth. Giving a sales force more "arrows in their quiver" is a powerful growth strategy. You take advantage of your existing sales and distribution channel (strength). You may be able to improve your competitive position by simplifying the buying process - providing your customers one stop shopping. You have already established momentum and credibility with your installed accounts and it is far easier and cost effective to sell them additional products than it is to win new customers.
7. TECHNOLOGY – BUILD OR BUY? This is a quandary for most companies, but is especially acute for technology companies. Acquiring technology through the acquisition of another company can be an excellent growth strategy for several reasons. First, the R&D costs are generally lower for these smaller, agile, more narrowly focused companies than their larger, higher overhead acquirers. Secondly, time to market, window of opportunity, first mover advantage can have a huge impact on the ultimate success of a product. It has been said that Alexander Graham Bell arrived four hours before another inventor at the patent office for essentially the same invention. If there is a good idea or a market opportunity, most likely it is being pursued independently and simultaneously on several fronts. First one to establish their product as the "standard" is the big winner. I sure would not want to try to displace Microsoft Windows as the operating system for PC's.
8. ACQUISITION TO PROVIDE SCALE AND ACCESS TO CAPITAL MARKETS – In this area, bigger is better. Larger companies can generally weather a storm better than smaller companies and are considered safer investments. Larger companies command larger valuation multiples. Some companies make acquisitions in order to get big enough to attract public capital in the form of an IPO or investments from Private Equity Groups. Many smart business owners have consolidated several smaller companies at lower multiples to create a larger company that the investment community valued at higher multiples. This can be a very effective grow to exit strategy.
9. PROTECT AND EXPAND MATURE PRODUCT LINES - I recently came across an outstanding example of the execution of this strategy. Johnson & Johnson, the multi-billion dollar pharmaceutical company in 2000 acquired Alza Corporation, the maker of drug delivery systems and devices for what appeared to be an unbelievably steep price of $13.7 billion, or 23 times year 2000 revenues. They are the inventors of the transdermal patch used in products such as NicoDerm CQ. They have developed time released pills that can, for example deliver Ritalin, the drug for attention deficit disorder in children, at prescribed times with one dose. They have developed an injectable titanium stint to deliver cancer medication over the course of a year. Why would J&J pay so much for this company? Here is the strategy. The latest price tag for getting a major new drug through the FDA and to market is a whopping $800 million. These delivery technologies can turn J&J's old drugs into new best sellers that are re-patentable at a far lower price than new drug development. An added benefit is that they can do the same for off patent drugs from other competitors.
10. PROTECT CUSTOMER BASE FROM COMPETITION – The telephone companies have done studies that show that with each additional product or service that a customer uses, the likelihood of the customer defecting to a competitor drops exponentially. In other words, get your customers to use local, long distance, cellular, cable, broadband, etc and you will not lose them. Multiple products and services provided to the same customer dramatically improve retention rates. At the risk of repeating myself, it costs ten times more to get a new customer than it does to keep one.
11. ACQUISITION TO REMOVE BARRIERS TO ENTRY – An example of execution of this strategy is a large commercial information technology consulting firm acquiring a technology consulting firm that specializes in the Federal Government. The larger IT Consulting firm had valuable expertise and best practices that were easily transferable to government business if they could only break the code of the vendor approval process. After many fits and starts to do it themselves, they simply acquired a firm that had an established presence. They were able to then bring their full capabilities from the commercial side to effectively increase their newly acquired government business.
12. OPPORTUNISTIC ACQUISITION FOR WHEN THE MARKET TURNS – as they taught me in business school: buy low and sell high. Well-run businesses often will buy competitors that bring many of the benefits from above at very favorable prices when times are tough. They buy customers, new geographies, technology, management talent, etc. at less than strategic prices because they have the staying power to last through a market downturn. Buying a company that doesn't fit at a bargain is ultimately not a bargain if you are unable to integrate to make your core business more powerful.
Larger firms with lots of resources have established business development offices to execute corporate growth strategies through acquisition. These experienced buyers search for companies that fit their well-defined acquisition criteria. In most cases they are attempting to buy companies that are not actively for sale. If a strategic company is for sale and is being represented by an M&A firm, the M&A firm's job is to sell that strategic value to the marketplace. If properly done, the buyers are competing with several other buyers that recognize the strategic value and the price tends to be bid way up. The win for the successful corporate acquirer is to target several candidates that have many of the characteristics from above, buy them at financial valuation multiples (traditional valuation techniques like discounted cash flow or EBITDA multiples), integrate to strength and achieve strategic performance.
By David M. Kauppi President Mid Market Capital, Inc.
As Penn State professor William Rothwell ominously points out in the forward to Exit Right: A Guided Tour of Succession Planning for Families in Business Together, more than 40% of the people who run the closely held operations that comprise 80% of the North American economy will retire by 2007. Those businesses will either be sold to a third party or management team, closed down, or passed on to the next generation. In this article I will focus on passing the business on to the next generation.
Tax laws still favor home ownership with mortgage interest as a tax-deductible expense. The government has also encouraged the passing of a business from one generation to the next with several favorable estate and gift tax rulings. Estate planning attorneys have utilized IRS ruling 5960 to minimize the estate and gift tax owed for a business either gifted to or inherited by the next generation. The business is often placed in one or more LLC's and divided up into minority pieces to take advantage of very substantial and legal minority discounts, often as high as 40%.
As is often the case, a business owner will have, for example, 4 children. Two sons will be actively involved in running the businesses and two daughters have built lives totally separate from the business. Because 85% of the value of the estate is tied up in the value of the business, to be "fair" the business is gifted and willed to the four siblings in almost equal proportion. Because the sons are running the business, they will get slightly more of the business and slightly less of the remaining estate. This gives them majority interest in the business. After dad leaves the business, the two sons will continue to run and grow the business without any input or participation from their two sisters.
Typically the business does not pay any dividends and the two sisters' portions are non-liquid because there is not a good market for selling minority stakes in a privately held business. Also, there is generally a very restrictive buy sell agreement that favors the majority holders. The sisters have no idea what the "fair value" of the business is and the only indication they have ever gotten is an official IRS gift tax or estate tax return with 40% discounts applied. If the enterprise value were, for example, $50 million and the two sisters owned a combined 40%, you would think that they had an asset worth $20 million.
The only document they have seen, however, is the gift or estate return, valuing their portion at only 60% of that number, or $12 million. The brothers feel entitled to the lions share because Ann and Julie had nothing to do with building this business. The brothers pay themselves big salaries and benefits and pay out little of no dividends. They may approach the sisters with gift tax return and restrictive buy sell agreement in hand and offer to generously buy out the sisters for a combined 8 million, because that is "all the company can afford to pay."
After this transaction takes place, let's look at the result of how dad's estate was fairly divided. Originally the brothers were left with 60% of the $50 million business, or $30 million and a minor portion of the remaining estate. The sisters were left with 40% of the business, or $20 million and the bulk of the remaining estate of $10 million. That appears to be fair. However, the buyout of the sisters for a combined $8 million results in an effective estate distribution of $42 million to the brothers and $18 million to the sisters. This is not what dad intended, but it happens all the time.
This is a very complex and emotional issue and there are no simple answers. Generally, dad had his identity tied up in the business and wants it to live on through his sons after he is gone. This is a noble, yet impractical thought if all the siblings are not actively involved in the business. The children often inherit the restrictive buy sell agreements that favor the brothers running the business and scare off investors that may have been interested in a minority stake in the business. Much of the value from a privately held business is derived from the benefits of working in the business. There is the very real concern that the integrity of the gift or estate tax business valuations will be compromised if the sisters are bought out at a price approaching a pro-rated division of total enterprise value.
Unfortunately, in most cases, nothing is done and as a result there are literally hundreds of billions of dollars of minority interests in privately held business that are providing little return or no return to their owners. We are working with estate planning attorneys, tax accountants and investors to come up with solutions. One of the keys to unlocking the liquidity in these minority interests is for the business owner to recognize this situation prior to building his estate plan. Unfortunately, we are often brought in after the fact and a fair outcome then is contingent upon the majority owners honoring dad's original intent of fairness and working toward that end.
Business Succession Planning - Should Your Children Run the Family Business?
BUSINESS SUCCESSION PLANNING – SHOULD YOUR CHILDREN RUN THE BUSINESS?
By David M. Kauppi, CBI, President Mid Market Capital
As Penn State professor William Rothwell ominously points out in the forward to Exit Right: A Guided Tour of Succession Planning for Families in Business Together, more than 40% of the people who run the closely held operations that comprise 80% of the North American economy will retire by 2007. It makes me wonder, what is going to happen to all of those businesses? Although it is a noble gesture, passing a business down to the next generation is more often than not, unsuccessful. In fact, statistics show that only one-third of all family businesses are successfully transferred to the next generation and only 13% are transferred onto the third generation.
Many family business consultants say the primary reason for this low survival rate is the failure to develop and effectively plan for the transfer of ownership and management of the closely held family business. I agree that this is a factor, but in my dealing with family businesses I find that there are some more fundamental reasons. The first is that the next generation has a lot different life style than the business founder and entrepreneur. They do not share the same drive and commitment that dad needed to build the business from scratch. They go to the good schools, get a taste of the good life and generally do not share the passion of the business founder. I recently was involved in selling a produce distributor. I found that most of the firms were in their second or third generation. I asked a third generation owner why this particular industry had such success with keeping the business in the family. He said, "When you are up and on the docks at 3 am and work 12 hour days, you don't have the time to spend the money."
The next generation may have a grand scheme to turn the traditional printing business into a media empire or a liquor business into an entertainment enterprise. A few years back the second generation of a well known Chicago area computer leasing and IT Services Firm tried to turn it into an Internet Venture Firm with disastrous results.
Before you just assume that your torch will be carried by the next generation, make sure that the next generation even wants to run the business. Imagine the loss in value that would have occurred if the real estate billionaire from the western suburbs had turned his empire over to his son who simply wanted to produce plays.
Are your heirs even capable of running your business? Have you held on to the reins so tightly that the kids involved in the business have not been able to develop their decision-making or leadership skills? Do they command company respect because of their personal strength and skills or are they grudgingly granted respect because they are the child of the owner? If that is the case, the odds are not good for them taking over when you retire.
Another big challenge is trying to balance fairness in employing many children or even grandchildren in a family business with various skill levels, compensation levels and ownership levels. The jealousy and in fighting can absolutely grind the company's progress to a halt.
The business owner must make some difficult decisions when he or she decides it is time for them to retire. Why did I create this business? Was it to keep this business in the family for generations or was it to provide for my family for generations? If the desire and the capability of the children are not evident and the company is large enough, it may be the right decision to first get outside board members actively involved as step one. Step two would be to hire professional management to run the business. A second alternative is to sell the company while you are still running it and it can command its highest value. If you have children that want to remain in the business for the immediate future, incorporate that into the sale agreement with employment contracts.
Another way to think of it is, while I am running the business, the best ROI is to keep the bulk of my net worth invested in this company. If I am no longer running the company what is the best risk reward profile for my net worth? Would my heirs be better off if the business was sold and the value converted to financial assets?
Growing Your Business Through Acquisitions
davekauppi@midmarkcap.com or visit our Web page www.midmarkcap.com.
Growing Your Business Through ACQUISITIONS
By David M. Kauppi CBI - Mid Market Capital
Successful growing companies usually grow through a combination of organic growth and strategic acquisitions. For purposes of this article, a strategic acquisition is defined as an acquisition where the result of the combination is far greater than the sum of the parts. For example, if Company A with revenues of $50 million Acquires Company SA with revenues of $10 million, the Newco mathematically would have revenues of $60 million. The anticipated performance of a well thought out strategic purchase might result in a combined revenue for Newco of $100 million within a 1 to 2 year period. A second category of strategic acquisition would focus on an improvement of the profit margins of Newco.
Let's use two companies that are recognized as among the best at making successful acquisitions, General Electric and Cisco Systems. As their stockholders will happily tell you, these companies have been star performers in growing shareholder value. General Electric is a giant conglomerate with business lines such as GE Capital, GE Plastics, GE Power Systems, GE Medical, and several others. Cisco Systems could be categorized as a high tech growth company primarily focusing on voice and data communications hardware, software, and services.
The first rule of strategic acquisition we learn from these two prolific and successful companies is that they do it on purpose. They have a well thought out defined approach. To quote GE, "We are allocating capital to businesses that can increase growth with higher returns, businesses requiring human capital as opposed to physical capital. We are disciplined and integrators and we grow the businesses we acquire. Over the past 10 years Cisco Systems has acquired 81 companies. If you track their stock price over the same period, it is up a remarkable 1300% over that same period. GE, starting with a much larger base, still outperformed the S&P 500 index over the same period 3 to 1.
If you study the acquisitions of these two companies as well as good middle market growth through acquisition companies, you find some common strategic themes. The core principal that runs through almost every example is INTEGRATION. With the exception of establishing the original platform, GE expanding from their original roots and establishing a presence in plastics, for example, all of these acquisitions focus on integration.
An example that I use to summarize strategic acquisitions for Cisco Systems is not a real acquisition, but a hypothetical company that should demonstrate a point. I have been a very happy stockholder for over a decade. It seems like every year they would announce an acquisition that looked like this – Today Cisco announced the acquisition of Optical Solutions Company for $30 million in stock. Optical Solutions Company manufactures the OptiFast Switch, the fastest optical networking switch on the market today. The Company was started two years ago by two Stanford Electrical Engineering Professors. Current sales are $1.5 million and last year they lost $700,000. My initial reaction was, "What the heck are they doing?" What they were really looking at was what this technology could become as it was integrated into the Cisco family. First, Cisco has 5,000 sales reps, 12,000 value added resellers and systems integrators that sell their solutions, and 600,000 customers that think Cisco walks on water. Cisco knows their market, their customers, and the first mover advantage in their market. With this backdrop, the OptiFast Switch achieves sales of $130 million in its second year of Cisco sales. That's what the heck they were doing – a classic strategic acquisition.
There are several categories of strategic acquisition that can produce some outstanding results with effective integration. Many acquisitions actually have elements from several categories.
1. ACQUIRE CUSTOMERS – this is almost always a factor in strategic acquisitions. Some companies buy another that is in the same business in a different geography. They get to integrate market presence, brand awareness, and market momentum. Another approach is to acquire a company that can establish a presence for you in a different market segment. For example, lets say that that Company A made fasteners for the automotive industry and felt that their expertise could be applied to the aerospace industry. A company that produced fasteners for the target industry could help jump-start this strategic initiative.
2. OPERATING LEVERAGE – the major focus in this type of acquisition is to improve profit margins through higher utilization rates for plant and equipment. A manufacturer of cardboard containers that is operating at 65% of capacity buys a smaller similar manufacturer. The acquired company's plant is sold, all but two machines are sold, the G&A staff are let go and the new customers are served more cost effectively. Adding new customers without increasing fixed expenses results in higher profit margins.
3. CAPITALIZE ON A COMPANY STRENGTH – this is why Cisco and GE have been so successful with their acquisitions. They are so strong in so many areas, that the acquired company gets the benefit of some, if not all of those strengths. A very powerful business accelerator is to acquire a company that has a complementary product that is used by your installed customer base. It is ten times easier to sell an add-on product to an installed account than to sell a product to a new account. Management depth and skill, production efficiency/capacity, large base of installed accounts, developed sales and distribution channels, and brand recognition are examples of strengths that can power post acquisition performance.
4. COVER A WEAKNESS – This requires a good deal of objectivity from the acquiring company in recognizing and chinks in the corporate armor. Let me help you with some suggestions – 1. Customer concentration: too much of your business is concentrated on a small group of customers 2. Product concentration: too much of your business is the result of one or two products 3. Weak product pipeline – in a business environment that is becoming more innovation focused, having a thin product pipeline could be fatal. Many of the acquisitions in the pharmaceutical industry are aimed at covering this weakness. 4. Management depth or technical expertise and 5. Great technology and products – poor sales and marketing.
5. BUY A LOW COST SUPPLIER – this integration strategy is typically aimed at improving profit margins rather than growing revenues. If your product is comprised of several manufactured components, one way to improve corporate profitability is to acquire one of those suppliers. You achieve greater control of overall costs, availability of supply, and greater value-add to your end product. Another variation of this theme some refer to as horizontal integration is to acquire a company supplying you distribution.
6. IMPROVING OR COMPLETING A PRODUCT LINE – this approach has several elements from other acquisition strategies. Successfully adding new products to a line improves profitability and revenue growth. Giving a sales force more "arrows in their quiver" is a powerful growth strategy. You take advantage of your existing sales and distribution channel (strength). You may be able to improve your competitive position by simplifying the buying process - providing your customers one stop shopping. You have already established momentum and credibility with your installed accounts and it is far easier and cost effective to sell them additional products than it is to win new customers.
7. TECHNOLOGY – BUILD OR BUY? This is a quandary for most companies, but is especially acute for technology companies. Acquiring technology through the acquisition of another company can be an excellent growth strategy for several reasons. First, the R&D costs are generally lower for these smaller, agile, more narrowly focused companies than their larger, higher overhead acquirers. Secondly, time to market, window of opportunity, first mover advantage can have a huge impact on the ultimate success of a product. It has been said that Alexander Graham Bell arrived four hours before another inventor at the patent office for essentially the same invention. If there is a good idea or a market opportunity, most likely it is being pursued independently and simultaneously on several fronts. First one to establish their product as the "standard" is the big winner. I sure would not want to try to displace Microsoft Windows as the operating system for PC's.
8. ACQUISITION TO PROVIDE SCALE AND ACCESS TO CAPITAL MARKETS – In this area, bigger is better. Larger companies can generally weather a storm better than smaller companies and are considered safer investments. Larger companies command larger valuation multiples. Some companies make acquisitions in order to get big enough to attract public capital in the form of an IPO or investments from Private Equity Groups. Many smart business owners have consolidated several smaller companies at lower multiples to create a larger company that the investment community valued at higher multiples. This can be a very effective grow to exit strategy.
9. PROTECT AND EXPAND MATURE PRODUCT LINES - I recently came across an outstanding example of the execution of this strategy. Johnson & Johnson, the multi-billion dollar pharmaceutical company in 2000 acquired Alza Corporation, the maker of drug delivery systems and devices for what appeared to be an unbelievably steep price of $13.7 billion, or 23 times year 2000 revenues. They are the inventors of the transdermal patch used in products such as NicoDerm CQ. They have developed time released pills that can, for example deliver Ritalin, the drug for attention deficit disorder in children, at prescribed times with one dose. They have developed an injectable titanium stint to deliver cancer medication over the course of a year. Why would J&J pay so much for this company? Here is the strategy. The latest price tag for getting a major new drug through the FDA and to market is a whopping $800 million. These delivery technologies can turn J&J's old drugs into new best sellers that are re-patentable at a far lower price than new drug development. An added benefit is that they can do the same for off patent drugs from other competitors.
10. PROTECT CUSTOMER BASE FROM COMPETITION – The telephone companies have done studies that show that with each additional product or service that a customer uses, the likelihood of the customer defecting to a competitor drops exponentially. In other words, get your customers to use local, long distance, cellular, cable, broadband, etc and you will not lose them. Multiple products and services provided to the same customer dramatically improve retention rates. At the risk of repeating myself, it costs ten times more to get a new customer than it does to keep one.
11. ACQUISITION TO REMOVE BARRIERS TO ENTRY – An example of execution of this strategy is a large commercial information technology consulting firm acquiring a technology consulting firm that specializes in the Federal Government. The larger IT Consulting firm had valuable expertise and best practices that were easily transferable to government business if they could only break the code of the vendor approval process. After many fits and starts to do it themselves, they simply acquired a firm that had an established presence. They were able to then bring their full capabilities from the commercial side to effectively increase their newly acquired government business.
12. OPPORTUNISTIC ACQUISITION FOR WHEN THE MARKET TURNS – as they taught me in business school: buy low and sell high. Well-run businesses often will buy competitors that bring many of the benefits from above at very favorable prices when times are tough. They buy customers, new geographies, technology, management talent, etc. at less than strategic prices because they have the staying power to last through a market downturn. Buying a company that doesn't fit at a bargain is ultimately not a bargain if you are unable to integrate to make your core business more powerful.
Larger firms with lots of resources have established business development offices to execute corporate growth strategies through acquisition. These experienced buyers search for companies that fit their well-defined acquisition criteria. In most cases they are attempting to buy companies that are not actively for sale. If a strategic company is for sale and is being represented by an M&A firm, the M&A firm's job is to sell that strategic value to the marketplace. If properly done, the buyers are competing with several other buyers that recognize the strategic value and the price tends to be bid way up. The win for the successful corporate acquirer is to target several candidates that have many of the characteristics from above, buy them at financial valuation multiples (traditional valuation techniques like discounted cash flow or EBITDA multiples), integrate to strength and achieve strategic performance.