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March 18th, 2010 When Growth Decreases Value |
I have frequently been heard to say to an entrepreneurial team ‘Don’t grow!’ This is normally received with a chorus of exclamations and some strong objections. It is only as I set out how their value is created through strategic value rather than growth that they see the logic of putting their efforts into creating more strategic value rather than simply growing the business. In fact, further growth can sometimes decrease value.
Our traditional model of business value creation is all based on the ‘proof of business concept’ paradigm. That is, value is created through generating ever higher levels of revenue and net profit. Of course, this is certainly true for the vast majority of businesses but it is seriously sub-optimal for strategic value ventures. Increasing value in a strategic value venture is achieved by increasing the value to the strategic buyer not in generating higher profits in the business.
In a strategic sale, we create value by providing a product or service which the buyer can exploit, usually over a large customer base or extensive distribution channel. What we are doing is plugging our product or process into their business concept rather than developing our own. A global corporation hardly needs us to show them how to generate more customers or support products through a distribution channel. What they are looking for are ways to exploit the infrastructure they already have.
However, the strategic buyer needs proof that the product or process can be readily exploited through their business. This evidence may vary from situation to situation but can normally be expected to encompass things like evidence that the product or process works, the competitive advantages are strong and sustainable, scalability is able to be achieved, sales will be profitable and so on.
The strategic buyer’s due diligence will focus on whether they can rapidly scale up operations around your product or process not whether you have been able to do so. This being the case, your level or sales or profit may be quite irrelevant to their assessment.
Once you have a proven product or process and can show that a limited number of customers want it, use it and are satisfied with the price and performance, you may have sufficient evidence to prove demand. A large corporation will soon establish whether their existing and prospective customers will buy it in large numbers. At this point, you will create greater exit value by concentrating on aspects of scalability and making the integration into the buyer’s business easier.
My last business, Atlanta based Distinction Software, was sold to Peoplesoft for 6 times revenue. Peoplesoft was really only interested in the software modules. They had over 2 thousand customers at the time of acquisition, many of whom would be targets customers for our products. They were not interested in our customer base of 20, especially as most did not use Peoplesoft applications. They terminated all our distributor arrangements and made most of our administration and senior executive staff redundant. It was the scalability of the product suite in their hands which was attractive to them not our small customer base or distribution arrangements.
If the buyer has to unwind parts of the business, dispose of segments of the operations and terminate distributor and supplier arrangements, this can cost them money and time. Any distraction from moving the business forward to exploiting the underlying asset or process is at the cost of the vendor.
In setting up a strategic sale, we need to work backwards from the exit to ensure we are doing those things which contribute to higher strategic value. If we have additional funds or resources, these should be directed towards increasing our strategic value rather than generating higher levels of revenue and profits for ourselves, especially if this has little or negative impact on our exit value.
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