One way of quantifying a business’ strategic value, at least to some degree, is to consider the ‘buy versus build’ scenario.
Ask yourself: ‘If I was to buy this business, what additional value over and above the fair market value would I get and could I achieve that same value simply by growing my own business?’
Often as business valuers we will determine a fair market value for a client’s business and then, under a separate and subsequent engagement, be involved in selling that business.
In general we find that for every 10 people – businesses or investors – who are interested in purchasing the business, about three of those 10 are already operating in the same market.
Quite often those three will be very conservative in terms of the price they offer for the business – invariably they will offer below what we might determine is fair market value.
Why is that?
Because they are weighing up the argument of ‘buy versus build’.
They know they want to get bigger, pull in more customers, deliver to different geographic areas, add on additional products and so on, but what they’re thinking is ‘why don’t I just grow organically and develop that offering myself?’
How much will the market pay?
If they do decide buying is the better option – perhaps because it will get them where they want to be more quickly – then how much will they pay?
Given they’re already operating in the same industry, chances are they won’t consider the alternative – starting the business from scratch – as risky.
So if the risk is not high, why pay more than necessary to avoid it?
Here’s an example:
I run a food distribution business based in northern NSW and I want to expand into regional Queensland.
What are the advantages of buying a food distribution business located in Warwick (in regional Queensland, about three hours west of Brisbane)?
Am I better to buy this business or just grow incrementally by sending a couple of trucks and a few key sales staff to regional Queensland, renting a short-term load dock premises and starting from scratch?
The strategic benefit of buying is that I’m not operating in that geographic location now and I don’t have a customer base there, so there is complementarity and critical mass of customer orders.
I have expertise in food distribution and the systems and processes. I probably have supply contracts already in place and can leverage those.
What to do?
The answer comes down to a judgement on value:
- Do you start from scratch with no customers and go through a hockey stick investment cycle to build a customer base in order to have enough activity to supply a different geography?
or
- Do you buy the business and its customer base of 400 customers already in place in the new geography?
There is a point at which you make a decision depending on the value assessment and equation, and you may benefit from seeking independent valuation advice to assist in pressure testing your thinking.
Quantifying strategic value
Let’s keep using the food distribution business in Queensland as an example:
The business’ fair market value (FMV) is 3.5 times its business maintainable earnings (BME).
BME = $575,000
FMV = approximately $2 million
Note, this FMV includes all the assets to run the business as a going concern.
In addition to the FMV, as a potential buyer you would look at things like:
- geographic expansion opportunities
- people and systems
- economies of scale.
For instance, all your supply, sales management and product support services are located in one place right now. The same services currently cost the Queensland business $350,000 per annum. By consolidating those services, when and if you take over the business, you are likely to save $350,000 immediately or in the very short term.
However, given you may be absentee to the business in Queensland, you may decide to add an additional $100,000 for on-ground sales and business management there.
So we have the positive synergies ($350,000) and negative synergies ($100,000) of buying this business.
Net synergies in Year 1 = $250,000.
That synergy is a quantified calculation of strategic value for you, in buying that business.
Importantly, from a vendor’s perspective in looking to sell the business, it is not the strategic value for the entire market – just for this particular potential purchaser.
If another potential purchaser was a food distribution business located just down the road in Toowoomba (about 60 minutes’ drive away), those synergies would be different.
Facts and figures versus emotions
By using the synergy example I’ve tried to put some level of quantitative analysis to strategic value, but we must always remember the qualitative angle: there is often an emotional reaction by one business owner to another’s value proposition because of their individual circumstances.
If you are considering buying a business and would like to obtain a valuation or market appraisal, contact the team at JPAbusiness on 02 6360 0360 for a confidential, obligation-free discussion.
James Price has over 30 years' experience in providing strategic, commercial and financial advice to Australian and international business clients. James' blogs provide business advice for aspiring and current small to mid-sized business owners, operators and managers.