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November 9th, 2009 When is a Trade Sale a Strategic Exit? |
Over the last few years I’ve written extensively on strategic exits and encouraged Angel investors to concentrate their investments where a strategic exit is highly likely. I have focused on strategic value investments as I have found convincing evidence to show that these have higher ROI, shorter investment periods and lower execution risks. I have observed that more Angels are now discussing strategic exits, but find that there’s some confusion as to exactly what is a strategic exit.
I don’t believe there’s any confusion that a strategic exit does not occur where a single individual buys a business to manage it themselves. There are no benefits which accrue to the buyer beyond the boundary of the firm. Any return the buyer receives on their investment must come from the revenues and profits generated by the assets and capabilities of the acquired business. However, we would anticipate that a smart buyer would bring additional knowledge, funding, networks and experience to the business thus improving the return on the investment. In fact, knowing they could generate higher profits from the business through their own contribution, they may be prepared to bid higher for the right to acquire it. This is clearly a financial acquisition rather than a strategic acquisition. Therefore, the sale is a financial exit.
On the other hand, a business which is bought solely for its IP by a corporation and which has no revenue history or sales capability and will never be managed as a stand alone entity is a strategic acquisition. The buyer anticipates bringing the acquired IP into their own organization and leveraging their extensive capabilities, funding and distribution channels to generate new revenue. This would be strategic sale.
It is the direction of the benefit that determines what type of sale occurs. If the benefits of the acquisition are to be generated from within the acquired firm, even if the buyer puts additional resources into it, this is a financial sale. So even if the buyer provides trademarks, IP, new processes, new management, additional funding or excess demand to improve the performance of the acquired firm, it still remains a financial acquisition. The return on their investment is received solely through the performance of the acquired firm.
We might also argue that costs which are outsourced to the buyer, such as head office and services costs, do make a difference to the profitability of the acquired firm but this hardly makes it strategic. The acquired business still operates substantially as a stand alone entity from a product/market interface and the ROI must be generated through its revenue stream.
Moving to a different scenario, I would classify any acquisition as generating strategic value for the buyer if the buyer’s revenue, separate from that generated by the acquisition itself, was either protected (threat mitigation) or enhanced (opportunity exploitation) by the acquisition. Any situation where assets or capabilities are passed to the buyer to exploit within the buyer’s organization and which changes the buyer’s future prospects should be considered as a strategic value acquisition.
There are situations where the acquired business continues in operation, improved or not, with assets and capabilities passed back to the buyer’s organization. This would still be a strategic acquisition as additional benefits are being derived by the buyer beyond those which can be generated within the acquired firm.
This classification is critical for preparing a business for sale. A business which achieves its highest value on sale through its own revenue and profit potential needs to be structured for a financial sale. The bulk of the sale preparation effort needs to be put into revenue and profit growth, risk reduction and identifying growth potential which the buyer can execute on within the business. Any marginal strategic value or buyer synergies enhances the potential sale price but the major thrust of the sale preparation strategy remains with revenue and profit growth.
Alternatively, a business which achieves its highest value on sale by providing a large corporation with a means of mitigating a significant revenue threat or exploiting a major revenue opportunity through the transfer of acquired assets or capabilities, should be prepared for a strategic sale. The value of the strategic acquisition to the buyer is mostly determined by the size of the threat or opportunity within the buyer’s organization and not by the revenue and profit generating power of the acquired firm. In this case, the existing or even potential revenue and profit/loss of the acquired firm may be entirely irrelevant in determining what the business is worth to the buyer. You would prepare a strategic sale by concentrating resources on ensuring that your strategic assets and capabilities are structured so that the buyer can rapidly exploit them within their own organization.
We should not confuse the source and size of the value generated with the price paid to the sellers. The sale price achieved often has much more to do with positioning, preparation, negotiation and competitive tension in the deal. Any high growth potential firm suited to a financial sale, if handled effectively, can easily achieve 3 to 5 times a conventional (EBIT multiple) sale value. On the other hand, a venture suited to a strategic sale can often achieve a sale price equal to 20 to 100 times their net asset or revenue values.
A premium on sale to a corporation may be due to the inherent potential in the acquired business rather than synergistic or strategic benefits accruing to the buyer. Just because a corporation buys a business at a premium over the industry norm EBIT multiple does not make it a strategic acquisition. Rather it is only where additional benefits are achieved outside the boundaries of the acquired firm which determines it is a strategic acquisition and thus a strategic exit for the sellers.
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