NEW VENTURE EXPANSION STRATEGIES AND ISSUES (Continued….):DETERMINING THE PRICE FOR AN ACQUISITION

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Entrepreneurship MGT602

Lesson 44

NEW VENTURE EXPANSION STRATEGIES AND ISSUES (Continued....)

LEARNING OBJECTIVES

To explain the methods for expanding the venture.

To discuss the types of joint ventures and their uses.

To discuss the concepts of acquisitions and mergers.

To discuss the appropriateness and uses of leveraged buyouts.

To discuss the different types of franchises.

To identify the steps in evaluating a franchise opportunity.

DISADVANTAGES OF AN ACQUISITION

Marginal success record

Most ventures for sale have an erratic, or even unprofitable, record. It is important to review

the records and meet important constituents to assess the future potential.

Overconfidence in ability-Even though the entrepreneur brings new ideas, the venture may never

be successful for reasons not possible to resolve

Key employee loss

Often when a business changes hands key employees also leave. In a service business, it is

difficult to separate the actual service from the person who performs it. Incentives can

sometimes be used to assure that key employees will remain with the business.

Overvalued

If the entrepreneur has to pay too much for a business, the return on investment will not be

acceptable. The entrepreneur will need to establish a reasonable payback to justify the in-

vestment.

DETERMINING THE PRICE FOR AN ACQUISITION

Some of the key factors used in determining price for an acquisition are assets, owner's equity, earnings,

stock value, customer base, personnel and image. The price paid should provide the opportunity to get a

reasonable payback and good return on the investment.

Valuation Approaches

Ratios measuring profitability, activity, and liquidity can also be helpful in evaluation. Using the

asset valuation method, the entrepreneur values the underlying worth of the business based on its

assets.

The figure obtained using book value should be only a starting point, as it

reflects the accounting practices of the company.

In adjusted book value the stated book value is adjusted to reflect the actual

market value.

Another method is to determine the amount that could be realized if the

assets were sold or liquidated.

The final method is the replacement value-the current cost of replacing the

tangible assets.

Another way of evaluating a firm is to calculate the prospective cash flow from the business.

Positive cash flow is cash received from the operation of the business.

A negative cash flow, signifying the company is losing money, can have tax

advantages.

Final cash flow value, the terminal value, is a source of cash when the

entrepreneur sells the business.

Earnings valuation capitalizes earnings of a company by multiplying earnings by the appropriate

factor (the price earnings multiple.)

The question of earnings involves determining the appropriate earnings

period as well as the type of earnings.

The earnings period can be either historical earnings or future earnings.

Entrepreneurship MGT602

Earnings before interest and taxes (EBIT) are the most frequently used.

It is appropriate to select a price earnings multiple of a publicly traded stock

similar to the company being evaluated.

The valuation of a business is important in determining the feasibility of the acquisition.

SYNERGY

Synergy is "the whole is greater than the sum of the parts." With reference to the venture synergy refers to

the phenomenon in which two or more discrete influences or organizations acting together create

an effect greater than that predicted by knowing only the separate effects of the individual

organizations.

An acquisition should positively impact the bottom line.

Lack of synergy is a frequent cause of the acquisition failing to meet goals. Evaluation should

consider the upside potential, downside risks, and vulnerability to changes in markets and

technology. Some of the warning signs include poor corporate communications, poorly

prepared financial statements, and few new products.

The evaluation process begins with financial analysis.

Past operating results indicate the potential for future performance. Areas of weakness, such as

too much leverage, should be carefully evaluated.

In considering a firm's product lines study the past, present, and future.

The life cycle and present market share of each of the present products should be evaluated.

Also consider the compatibility of the firm's product lines. A method for evaluating the

product line is the S or life-cycle curve plotting sales and margins for each product over time.

The future of the firm's products and market position is affected by its research and

development.

In addition to the absolute dollar amount of R&D spending, it is important to determine

whether expenditures are directed by the firm's long-range plans. The output and success of

new products developed should be compared with the expenditures.

The entrepreneur should evaluate the firm's entire marketing program and capabilities.

Care should be taken in evaluating the established distribution system, sales force, and

manufacturer's representatives. The entrepreneur can also gain insight by look at the

company's marketing research efforts.

The nature of the manufacturing process is important in deciding whether to acquire a

particular firm.

The entrepreneur should rate the management and key personnel of the candidate firm.

Specific Valuation Method

Step 1: Compound the current revenue level forward to yield a revenue level at time of liquidity.

Step 2: Multiply the future revenue level times the expected after-tax profit margin to produce an

expected earnings level.

Step 3: Multiply the estimated earnings level at time of liquidity times the expected price/earnings

ratio to give a future market valuation.

Step 4: Calculate the present value factor.

Step 5: Divide the future company value by the present value factor to give a present value.

Step 6: Divide the required capital by the present company value to obtain a minimum ownership

for the investment required.

Structuring the Deal

The deal structure involves the parties, the assets, the payment form, and the timing of the payment.

There are two means of acquisitions.

The entrepreneur may directly purchase the firm's entire stock using funds from an outside lender.

Another option is a bootstrap purchase, acquiring a small amount of the firm for cash then pur-

chasing the remainder by a long-term note.

Locating Acquisition Candidates

There are professional business brokers, operating similarly to a real estate broker that represents the seller.

Accountants, attorneys, bankers, business associates, and consultants may be aware of good candidates.

It is also possible to find opportunities in the classified sections of the newspaper or trade magazine.

Entrepreneurship MGT602

Analyzing Candidates

The entrepreneur should gather as much information as possible, read it carefully, consult with advisors,

consider the situation, and then make a constructive decision. A profile containing acquisition criteria and

prospect data can guide initial screening. Once the prospect passes the initial checklist, more rigorous

analysis can evaluate the acquisition.

MERGERS

A merger is a transaction involving two or more companies in which only one company survives.

Acquisitions are so similar to mergers, that the terms are often used interchangeably. A key concern in any

merger or acquisition is the legality of the purchase. The Department of Justice frequently issues guidelines

for horizontal, vertical, and conglomerate mergers. Merger motivations range from survival to protection to

diversification to growth. A merger requires sound planning by the entrepreneur. Merger objectives must

be spelled out with the resulting gains for the owners of both companies delineated.

The entrepreneur must evaluate the other company's management and resources to ensure that the weak-

nesses of one do not compound those of the other. The entrepreneur should establish a climate of mutual

trust. The same methods for valuing the entrepreneur's company can be used to determine the value of a

merger candidate. The process involves looking at the synergistic product/market position, the new market

position, and undervalued financial strength. A common procedure is to estimate the present value of

discounted cash flows and the expected after-tax earnings attributable to the merger.

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