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Every owner or chief executive of a growing company eventually
faces the make versus buy decision. Should a company develop a new product
inside, with its own people and resources, or should it acquire another
company that already has the ability to design, manufacture and distribute
the product?
If you make the product internally, how fast should you
go? How much money should you spend to get the product to market quickly?
It is always possible to accelerate the development effort by applying
a little green lubricant in the right places. You can add temporary
capacity where you have bottlenecks, subcontract parts of the work with
long lead times, or offer premium payments to outside vendors to reduce
lead times for tooling, materials and sub-assemblies. Does spending
money in this way make the company more valuable?
These questions came up last week in one of our companies.
Here is how we made the decisions.
First, let me tell you how we got to this point. The
board and management worked together to develop a strategic plan for
the company's long-term growth. We decided that, in order to become
the dominant company in the industry, we needed to expand out product
line to include all the products our customers buy. We agreed that it
was essential to do this in a way that would enhance our already top
brand name in the industry, which stands for engineering, durability,
service in the minds of the customer. We agreed that product X would
the first piece of the puzzle to go after.
We could make the product ourselves in our current engineering
group, but we knew that would take time. An acquisition of a company
already making product X would speed things up. After a thorough review
of the market, we concluded there were a small number of companies whose
products were good enough to wear our brand name. We approached them
directly, found one that was interesting, with people we respect, where
the company was available for purchase at a fair price.
Should we buy, or should we make it ourselves? Like everything
else in business, it boils down to a careful look at the cash flow implications
of either course. Our objective is to realize the full potential of
developing the brand, and thereby create the most equity value for the
owners and managers.
The way to make this decision is to compare the equity
value creates by the two alternative strategies. The simplest one is
the buy decision. View the acquisition as a new subsidiary, and create
a financial model of the resulting company. The initial purchase price
- we'll use the figure here of twelve million dollars - is a cash outflow
in the initial period.
Here is the first big mistake most people make. Since
this exercise requires extensive financial modeling, many companies
assign the analysis to finance people. This won't work. You have to
spend enough time with both the managers of your company and the company
you are considering acquiring to make a business plan for the new subsidiary,
quarter by quarter, over the next five years. The plan should include
every opportunity to do things better after the acquisition, including
saving money on materials, production costs and overhead, and a conservative
estimate of new sales due to any new sales channels acquired with the
new company. The more detail and the more conversation among the managers
the better. They must take ownership over the numbers. After all, if
you make the acquisition, these numbers will become their business plan
and they will be accountable for results, and will be used in evaluating
managers' performance for bonus and other long-term compensation decisions
later.
Once your team has produced a plan, it is time to evaluate
it. The first check on the plan is whether it creates value for the
overall company. We calculate the intrinsic value of the new subsidiary
by taking the present value of the cash flow numbers from the plan.
In this case the plan showed the new subsidiary would be worth $46 million
in five years, giving a present value would of about $17 million today.
Since we could buy the company $12 million today, the net result of
the acquisition is to increase the intrinsic value of the overall company
by $5 million. Not a bad day at the office.
We confirmed this result by measuring the internal rate
of return (IRR) on the equity used to finance the acquisition, in this
case a hefty 67%. Even at a high cost of capital of 40%, appropriate
to a new venture, this one made sense.
Finance professionals - the ones with the calculator
in their pocket -- can argue about what is the right number to use for
the cost of capital, i.e., the opportunity cost of the investors' funds,
through lunch and dinner and long into the night. This is a waste of
time. Nobody knows the right answer, it is up to the investor anyway.
I have always found that if you have to worry too much about what is
the right hurdle rate to make the decision you are looking at the wrong
project.
This project makes sense on its own. But before you get
out your checkbook we need to look at the second choice, making the
product internally. You can't do both, because two different product
X's in the market with your name on them would confuse your customers.
The in-house effort should be evaluated as a venture
capital project owned by the mother Company. There will be development,
engineering, and tooling costs, rather than a purchase price to consider.
It will likely take longer to bring to market than the buy analysis.
There will be competitive issues to work through - not the least of
which is there will be one additional company in the market, yours,
which could affect pricing. Again, sit with your managers and work up
a business plan for five years and evaluate the resulting cash flows.
In our case the present value of the cash flows from
developing product X internally turned out to be $19 million. Less the
$4 million spent in the early days on bringing the new product to market
this resulted in an increase in the intrinsic value of the overall company
of $15 million, triple the increase we would enjoy by buying. The IRR
of the funds invested here is huge, almost 300%.
Based upon these results we decided to continue internal
development efforts and halt efforts to buy a company with product X
capabilities.
The largest risk we face is that internal development
is slower. We attacked that risk by trying to squeeze the air out of
the development timetable. Using a similar analysis we concluded that
the present value of accelerating the product introduction by just one-quarter
was over $2 million. This means that judicious spending to accelerate
the program by hiring additional people or working with outside vendors
can be worth a lot to the company. And performance payments to key people
in the company for extra efforts are worth thinking about.
I love it when a plan comes together.
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