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Assessing the strategic value of a business - By Tom McKaskill

To be investor attractive, an emerging company has to have an asset or capability which can drive high growth, either organically or in the hands of an acquiring corporation.

7 September 2009

To be investor attractive, an emerging company has to have an asset or capability which can drive high growth, either organically or in the hands of an acquiring corporation. If you look at the investment outcomes of the typical private investor you will see about half of the investments have lost money, thus the balance must make up the losses. This means that, going into the investment, the target rate of return needs to be in excess of 30%. Without high growth potential, this is almost impossible.

High growth eludes the vast majority of firms. The ABS statistics for 2007 show that only 10% of firms had more than 20 employees and only 6% achieved revenue in excess of $2 million. What we don’t know from this data is how long these larger firms took to get to the size they are. We do know from research into high growth firms that very few businesses exceed 10% growth for even a few years. Thus few firms offer an investor high growth potential from organic growth. But high growth potential in the hands of a large corporation is a different matter entirely. This is where strategic value investments really pay off.

Large corporations already have the market penetration, distribution channels, funding and organization structures to exploit an acquired product or capability which has the potential to negate a significant threat, reduce operating costs or offer an opportunity for new revenue. Not all products and services are able to create this outcome. To have strategic value, an asset or capability must provide a benefit to the acquirer which they could not easily buy, build or assemble. Basically, if they could do it themselves they wouldn’t need to acquire it. The value to the buyer comes from the cost savings, retained revenue or new revenue which can be secured only through the acquisition. The strategic value increases as the period of exploitation extends.

Strategic value is most often found in strong intellectual property such as patents, brands, trademarks, licenses and copyright. It can also be found in deep expertise which is hard to acquire or assemble. The strategic value is based in the uniqueness of the asset or capability and the capability and capacity of the acquirer to exploit it.

While we would normally focus on strong and sustainable competitive advantage, strategic value can still be found in very ordinary products and services which can be sold rapidly into a large customer base. It is the ability of the acquirer to exploit the asset or capability which is the main determinant of strategic value.

Significant strategic value can exist inside a small business even if that business does not have the capacity to exploit it themselves. It may not matter how many employees or customers it has or even if it is making a profit. The value is determined by projecting how the buyer will exploit the acquisition not how the business itself does. Finding the right buyer is therefore critical to leveraging a strategic value investment.

This view of enterprise value flies in the face of conventional valuation techniques. Instead of the firm valuation being based on their inherent profitability and growth rate, it is determined by how a large corporation will exploit their underlying asset or capability. A large corporation with 20,000 target customers does not need your small customer base of 20. If they have 200 salespersons, they really don’t need your two. In fact, what you have achieved in terms of revenue and profit may be quite irrelevant.

We all know that high growth is inherently risky and often elusive. But what if you don’t have to go down that path to generate a high ROI. As an investor, you could target those emerging firms which have assets or capabilities which have strategic value. Instead of building the business through the long hard slog of acquiring customers, you could focus instead on the tasks to bring the underlying asset or capability to a point where a large corporation can exploit it. You need to create an asset or capability which will have significant competitive advantage in the hands of the buyer, make it scalable and ensure it is ready to be exploited. Choose your prospective buyers carefully, those which can fully exploit the strategic value. At that point, put it into a competitive bid so that its value can be captured in the sale price.

As a crude estimate, strategic value is the discounted cost savings or gross margin on new revenue or retained revenue achieved by the buyer in the first two years after the acquisition. Thus rapid early deployment in the hands of the buyer is critical. A trade sale which returns 50 to 100 times the investment is not unusual in these types of deals.

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