EXIT STRATEGIES: Strategic vs financial exits

There are basically two types of ventures which attract acquirers. Financial ventures create value on exit via a financial trade sale or an IPO by assigning a value to the future profit generating power of the entity being sold.

Alternatively, a strategic venture creates exit value, not on the basis of what profit it could inherently generate, but on the basis of what future profit could be generated by the buyer exploiting the underlying assets or capabilities of the entity being acquired.

These are fundamentally different types of businesses and the entrepreneur has to ensure the business development process and the exit preparation align with the appropriate exit. In order to assess the potential exit value of any entity, we must first understand how the business creates value for its buyer (financial or strategic sale) or its future public shareholders (IPO).

Those businesses which deliver inherent profitability must create value for its future owners through enhanced profitability and future profit growth. By contrast, strategic value businesses create value by enabling a large corporation, the strategic buyer, to exploit a significant revenue opportunity created through the combination of the two companies.

The strategic seller builds value by developing strategic assets and capabilities which a large company will exploit. In the case of a strategic sale, it may not matter whether the selling business is making a profit, has revenue or is growing. This is in direct contrast to a financial exit which is entirely based on revenue and profit growth which the business itself must deliver to its new owners.

Because these outcomes are very different, the manner in which the entrepreneur should plan the exit for their business depends greatly on which type of exit is most appropriate. I have grouped financial trade sale and IPO under the financial exit as they both have the same basic value creating process, they both need to generate a future stream of positive earnings to create a successful exit event.

The IPO exit is an extreme situation of a financial venture where the projected revenue levels and the projected market capitalization is very high. While the IPO exit requires a more sophisticated organization to be successful, the fact is that both the financial sale and the IPO require a proven, high growth potential business concept to generate a successful exit value.

Smaller firms and firms with limited growth potential which create value through projected net earnings need to be directed towards a financial trade sale as they will not be able to meet the rather high threshold of revenue and potential growth requirements needed for a successful IPO.

Given that only a very small percentage of firms are able to achieve IPO status, the vast majority of firms need to be prepared for a financial sale. For the purposes of this discussion, I am going to refer to all financial exits as a ‘financial sale’ with the understanding that some exceptional firms will be able to achieve an IPO.

Also, for the purposes of this discussion, I am going to assume that all financial exits will be to an individual or corporation, that is a ‘financial buyer’, and that the buyer is setting the purchase price based on the anticipated future stream of earnings from the acquired firm alone.

That is, the buyer is not assigning any synergy or benefit to the acquisition based on what is happening, or could happen, in the rest of the buyer’s organization. The financial sale is very different from a strategic sale where value is created through the combination of the buyer and seller businesses.

We have all heard of businesses which were sold for many times revenue and staggering multiples of profit. These situations are all cases where the business being acquired had something which the large corporation needed to counter a major threat or to chase after a major new revenue opportunity.

Most of these acquired businesses had unique intellectual property, deep expertise or well established brands or rights (e.g. to exploit forests, minerals, fishing etc). The assets or capabilities being acquired were considered by the buyer to be too expensive to copy, build or develop, or would take the buyer too long to assemble or to create internally.

The delay in acquiring the asset or capability may also expose the acquiring corporation to an unacceptable level of risk. In a strategic acquisition, a small business can often provide the means by which a large corporation can quickly generate many times the purchase price by leveraging its own assets and capabilities alongside those being acquired.

Such acquisitions are bought, not on the basis of the profits of the acquired business, but on the value which can be generated within the combined entity. Few acquisitions, however, fit this profile. I will use the terms ‘strategic sale’ and ‘strategic buyer’ to describe a situation where a business is sold on the basis of its strategic value to the acquirer.

Businesses which are typically sold to a strategic buyer are those in biotechnology, information technology, research and development, designer fashions, mineral exploration, agricultural science, computer hardware and telecommunications. Also companies in consumer packaged goods with strong brands or with manufactured products which have global market potential can often secure significant premiums on sale.

Acquisitions which can deliver very significant synergies in operating costs through integration would also fit into this category. Probably about 95% of all private businesses which are sold are acquired by a financial buyer. In some, there will be synergies in the acquisition but these will be minimal and not sufficient to override the need for the acquired business to show its inherent profitability.

Most companies don’t have the type of assets or capabilities to leverage large scale opportunities for an acquirer. Instead, they build profits through their own inherent competitive advantages through a local customer base. A financial buyer seeking an acquisition will often have many choices of similar businesses, although sometimes geographically separate.

The buyer may be buying a business to own and manage or a corporation undertaking a consolidation strategy by acquiring many businesses of a similar type. What the financial buyer is acquiring is a profit stream and so the basis of the purchase is simply how much profit the firm makes now and is likely to make in the future.

Purchase value is calculated almost purely on the inherent profitability of the acquisition with little regard to the combination synergies in the acquisition. The seller to a financial buyer must put effort into increasing profit and profit potential. Businesses which would normally be sold to a financial buyer are professional services firms, marketing firms, management consultancies, distribution companies, trucking companies, most retail businesses, wholesalers, import/export companies, agricultural enterprises, printers, professional practices, builders, construction companies and so on.

Non complex manufacturing also attracts a high proportion of financial buyers. Basically, any business which does the same as many other businesses will fall into this group. Businesses acquired to be operated as a stand alone business will be purchased on the basis of their inherent profitability as there are no synergistic benefits in the deal for the acquirer.

Therefore, a business bought by an individual who wants to invest retirement or redundancy funds to buy a business to manage will be a financial sale. Similarly, a business purchased by a private equity fund which intends to increase its profitability through new management, increasing its debt level and refocusing the business will also be a financial sale.