Planning: Developing Business and Acquisition Plans—Phases 1 and 2 of the Acquisition Process
Abstract
This chapter focuses on the first two phases of the acquisition process—building the business and acquisition plans—and on tools commonly used to evaluate, display, and communicate information to key constituencies both inside (e.g., board of directors, management, and employees) and outside (e.g., customers, stockholders, lenders) of the corporation. Business strategies drive investment by identifying where the firm's board and management want to take the firm and why. M&As are not viewed as a business strategy but as a one means of implementing business strategies. The chapter discusses how to select the appropriate means of strategy execution from a range of reasonable options including reinvesting in the firm, partnering, or through acquisition. If an acquisition is viewed as the best means of executing a firm's strategy, an intelligent acquisition plan is required to define the necessary tactics, a realistic time line, and the roles and responsibilities of those charged with getting the deal done.
Keywords
Business plans; Business models; Acquisition planning; Merger planning; Building business plans; Building acquisition plans; Deal closing; Porter framework; 5 forces model; Mission statement; Business strategy; Business plan objectives; Corporate strategy; Cost leadership; Product differentiation; Mergers and acquisitions; External analysis; Internal analysis; Vision statements; Functional strategies; Strategic controls; Implementation strategies
If you don’t know where you are going, any road will get you there.
Lewis Carroll, Alice’s Adventures in Wonderland
Inside Mergers and Acquisitions: Home Shopping Feels the Heat From Amazon
The concept of shopping from one’s own home has been around for years. Sears, Roebuck & Company started as a mail order catalog company in 1888 allowing people to order items from catalogs using mail delivery, with the products often shipped directly to the customer. In 1977, the Home Shopping Network (HSN) began airing television programming promoting products that could be ordered via landline. The industry has evolved from home shopping channels to electronic retailing dominated by the likes of Amazon.com. The three types of home shopping include mail or telephone ordering from catalogs; responding via telephone to advertisements in print, TV and radio media; and online shopping.
Amazon’s increasing dominance of retailing has not only impacted brick and mortar stores but also television, radio and catalog sales. In the wake of the explosion in e-commerce, most brick and mortar retailers have been left struggling with a growing number of retailers from American Apparel to Radio Shack having filed for bankruptcy. Leaders in TV home shopping such as HSN and QVC have seen their sales decline in line with the growth of e-commerce, despite their efforts to shift more of their business online. According to eMarketer, sales in the TV home shopping industry have fallen 2.9% in the US and 2.3% globally between 2011 and 2016. Amazon, which has been growing aggressively, dominates the online shopping space.
The QVC and HSN business model relies on the premise that their customers engage with them over TV or digital platforms in a different way than they do with e-commerce firms. QVC and HSN customers tend to form a connection with the hosts on the TV shows and are encouraged to make impulse buys as they tune in throughout the day. In contrast, people who shop on Amazon tend to be transaction driven in that they are looking for a specific product to buy when they go to the website.
While QVC and HSN both found loyal followings among early cable television viewers in the 1980s, they have faced challenges adapting to the online age. Increasingly, they must appeal to “cord-cutters” who have given up their cable television subscriptions in favor of watching videos on tablets, computers and smartphones and have seen an erosion of their customers to the likes of online retailers Amazon and also Wal-Mart, with its rapidly growing online presence. For the period ending in June 2017, QVC’s US sales have declined in each of the last three quarters; revenue at HSN has declined for six consecutive quarters.
HSN’s earliest programming in the late 1970s featured investors, entrepreneurs, and designers promoting their products. Early success enabled the firm to expand its broadcast audience to 95 million households in the US via both cable and online streaming. It sells home and apparel brands through its Cornerstone business, which markets products through catalogs, branded e-commerce sites, and 14 retail and outlet stores. Well-known Cornerstone brands include Frontgate and Ballard Designs. The company had sales of $3.6 billion in 2016 and employs about 6900 people.
Starting in 1986, QVC focused on fashion and beauty products. Today the firm has annual sales of about $9 billion with broadcast operations in the US, Japan, Germany, UK, Italy, France and a joint venture in China. The firm operates 15 TV channels reaching more than 360 million households and 7 websites garnering more than 1 billion unique visitors in 2016. International revenue accounts for about one-third of total annual revenue. The majority of QVC customers are women who on average make 25 purchases a year.
Liberty Interactive, QVC’s parent, had been interested in buying HSN for years, but HSN’s shares sold at a premium making a share exchange dilutive for Liberty Interactive. Declining sales and eroding profit margins pushed Liberty Interactive into approaching HSN about combining their respective businesses. HSN seeing few alternatives proved receptive. In early July 2017, Liberty Interactive announced that it had reached an agreement with HSN to merge in a deal that valued the firm at $2.1 billion. Already a minority shareholder, Liberty Interactive is buying the 62% of HSN that it does not already own. Investors drove HSN shares up by 26% just after the announcement, while Liberty Interactive shares dropped by more than one percent.
The rationale for the merger seems to have been based more on necessity rather than on a change in the long-term vision for the firms. The immediate benefits of the merger will be the access to a much larger combined global customer base and significant cost cutting opportunities. Together, the two firms have 23 million global customers, including about 2 million that shop on both QVC and HSN, and ship more than 320 million packages annually. With aggregate annual revenue of about $13 billion, the combined firms can negotiate better pricing with suppliers, improved shipping costs, and realize certain cost synergies by eliminating duplicate overhead. The combined firms expect annual cost savings of $75 to $110 million for the next three to five years.
The business strategy for the combined firms is to become less reliant on cable TV by generating more revenue from online and mobile phone ordering. The companies also intend to accelerate investment in e-commerce and mobile operations to make it easier for viewers to order from their mobile devices. With more than one-half of annual revenue already coming from e-commerce, the combined company will become the third largest e-commerce company behind Amazon and Wal-Mart.
The new QVC’s business strategy is simply one in which it is playing catchup by accelerating efforts to derive a larger share of total revenue from e-commerce while cutting costs to improve margins. The fatal flaw may be that their primary market continues to be an aging and shrinking customer base that has a connection to their program hosts. While the firm may improve operating performance in the near term, its customer base could shrink significantly in the longer-term as younger customers shift to Amazon and Wal-Mart and their traditional older customers decline in number. Without changing their programming format and product offering or introducing clever loyalty programs similar to Amazon Prime, the future is likely to prove challenging for the new QVC.
Chapter Overview
Most successful acquirers view M&As not as a growth strategy but rather as a means of implementing business strategies.1 While firms may accelerate overall growth in the short run through acquisition, the higher growth rate often is not sustainable without a business plan——which serves as a road map for identifying additional acquisitions to fuel future growth. For example, Verizon’s acquisitions of AOL in 2015 and Yahoo in 2016 were driven by its announced strategy of augmenting its online business advertising revenue. In an effort to own both content and distribution, AT&T reached an agreement to acquire Time Warner in late 2016.
This chapter focuses on the first two phases of the acquisition process—building the business and acquisition plans—and on the tools commonly used to evaluate, display, and communicate information to key constituencies both inside the corporation (e.g., board of directors, management, and employees) and outside (e.g., customers, stockholders, and lenders). Phases 3–10 are discussed in Chapter 5. Subsequent chapters detail the remaining phases of the M&A process. A review of this chapter (including practice questions and answers) is available in the file folder entitled Student Study Guide and a listing of Common Industry Information Sources is contained on the companion site to this book (https://www.elsevier.com/books-and-journals/book-companion/9780128150757).
The Role of Planning in Mergers and Acquisitions
The acquisition process envisioned here can be separated into two stages: planning and implementation. The planning stage comprises developing business and acquisition plans. The implementation stage (discussed in Chapter 5) includes the search, screening, contacting the target, negotiation, integration planning, closing, integration, and evaluation activities.
Key Business Planning Concepts
A planning-based M&A process starts with a business plan (or business model) and a merger/acquisition plan, which drive all subsequent phases of the acquisition process. The business plan articulates a mission or vision for the firm and a business strategy for realizing that mission for all of the firm’s stakeholders. Stakeholders are constituent groups, such as customers, shareholders, employees, suppliers, lenders, regulators, and communities. While the objective of the firm is to maximize shareholder value, this is most likely achieved when the interests of all major stakeholder groups are considered. Overlooking the interests of one group can easily derail the most well thought out strategies. The business strategy is oriented to the long term and usually cuts across organizational lines to affect many different functional areas. Typically, it is broadly defined and provides relatively little detail.
With respect to business strategy, it is important to distinguish between corporate-level and business-level strategies. Corporate-level strategies are set by the management of a diversified or multiproduct firm and generally cross business unit organizational lines. They entail decisions about financing the growth of certain businesses, operating others to generate cash, divesting some units, and pursuing diversification. Business-level strategies are set by the management of a specific operating unit within the corporate organizational structure. They may involve a unit’s attempting to achieve a low-cost position in the markets it serves, differentiating its product offering, or narrowing its focus to a specific market niche.
The implementation strategy refers to the way in which the firm chooses to execute the business strategy. It is usually far more detailed than the business strategy. The merger/acquisition plan is a specific type of implementation strategy and describes in detail the motivation for the acquisition and how and when it will be achieved. For example, social media firm Twitter’s revenue generating business strategy is to attract advertisers by providing granular data to achieve more effective target marketing. Its merger/acquisition plan would include identifying, contacting, negotiating and completing deals enabling the implementation of its business strategy. For example, the firm acquired a five-person artificial intelligence startup called Whetlab in late 2015 to accelerate its own internal “machine learning” efforts. The acquisition enabled Twitter to obtain the team’s talent and patent pending software. This acquisition followed a similar acquisition in late 2014 of startup Madbits. Machine learning focuses on the development of software allowing computer programs to teach themselves to change when exposed to new data. Such computer programs could be used to identify emerging trends among the millions of comments made on Twitter before they are readily observable by marketing analysts.
Functional strategies describe in detail how each major function within the firm (e.g., manufacturing, marketing, and human resources) will support the business strategy. Contingency plans are actions that are taken as an alternative to the firm’s current business strategy. The selection of which alternative action to pursue may be contingent on the occurrence of certain events called trigger points (e.g., failure to realize revenue targets or cost savings). When the trigger points are reached, the firm faces a number of alternatives, sometimes referred to as real options. These include abandoning, delaying, or accelerating an investment strategy. Unlike the strategic options discussed later in this chapter, real options are decisions that can be made after an investment has been made.
The Merger and Acquisition Process
Some individuals shudder at following a structured process because they believe it may delay responding to opportunities, both anticipated and unanticipated. Anticipated opportunities are those identified as a result of the business planning process: understanding the firm’s external operating environment, assessing internal resources, reviewing a range of options, and articulating a clear vision of the future for the business and a realistic strategy for achieving that vision. Unanticipated opportunities may emerge as new information becomes available. Having a well-designed business plan does not delay pursuing opportunities; rather, it provides a way to evaluate the opportunity, rapidly and substantively, by determining the extent it supports realization of the business plan.
Fig. 4.1 illustrates the 10 phases of the M&A process described in this and subsequent chapters. These phases fall into two distinct sets of activities: pre- and postpurchase decision activities. Negotiation, with its four largely concurrent and interrelated activities, is the crucial phase of the acquisition process. The decision to purchase or walk away is determined as a result of continuous iteration through the four activities comprising the negotiation phase.
The phases of the M&A process are summarized as follows:
- Phase 1: Business Plan—Develop a strategic plan for the entire business
- Phase 2: Acquisitions Plan—Develop the acquisition plan supporting the business plan
- Phase 3: Search—Search actively for acquisition candidates
- Phase 4: Screen—Screen and prioritize potential candidates
- Phase 5: First Contact—Initiate contact with the target
- Phase 6: Negotiation—Refine valuation, structure the deal, perform due diligence, and develop the financing plan
- Phase 7: Integration Plan—Develop a plan for integrating the acquired business
- Phase 8: Closing—Obtain the necessary approvals, resolve postclosing issues, and execute the closing
- Phase 9: Integration—Implement the postclosing integration
- Phase 10: Evaluation—Conduct the postclosing evaluation of acquisition.
Prepurchase activities involve “getting to yes” with the target’s board and management. Postpurchase activities for strategic M&As involve combining the businesses to realize anticipated synergies. Decisions made at each phase of the M&A process involve certain trade-offs. To identify these, we must focus on the context in which the deal occurs and the deal’s stakeholders.2
How fast (slow) the acquirer should go depends on the context of the deal? What are industry conditions? Is the deal friendly or hostile? Is the target’s business related or unrelated to the acquirer. For example, industries undergoing rapid change require more time to perform due diligence. However, too much time spent analysing the industry can mean that others will have time to formulate competing bids for the target firm. Friendly deals can result in smoother postmerger integration but often result in the acquirer paying a higher premium to “buy” the target’s cooperation. Hostile deals may result in a faster takeover but may result in a disruptive postmerger integration. Related deals often result in larger potential synergies but may entail a lengthy regulatory review process.
Acquisition stakeholders include shareholders, board members and top managers, advisors (investment bankers, accountants, and lawyers), customers, employees, and lenders. The interests of any one stakeholder group must be carefully balanced against those of other groups. In theory, acquisitions should only be done if they increase firm value; in practice, agency problems can create motives for doing deals that are not necessarily in the best interests of shareholders. Board members and top managers must be committed to making the deal happen so as to provide the necessary resources. However, hubris and excessive emotional attachment to the target can result in overpayment. Advisors assist in making better, faster decisions but they add significantly to total deal costs. Communicating intentions to customers and employees may reduce attrition but it invites leakage of key information to competitors. Lenders must be convinced that the deal makes sense so they are willing to finance the transaction.
Answers to the above questions and the sometimes conflicting interests of stakeholder groups come from the board’s and senior management’s commitment to premerger planning. Long-range planning to anticipate issues that might arise and developing contingency plans to resolve such issues means that decisions can be made more rapidly as circumstances change. Senior managers must remain engaged throughout the deal process so that they are aware of the benefits and costs of available options and be willing to make the difficult decisions when the need arises.
Phase 1: Building the Business Plan/Model
A well-designed business plan results from eight key activities, summarized next. The process of developing a business plan requires addressing a number of detailed questions corresponding to each of these activities.3
The first activity is the external analysis undertaken to determine where a firm might compete—i.e., which industry or market(s) appear to be most attractive in terms of potential growth and profitability—and how to compete —i.e., what does it take to earn competitive financial returns in the markets the firm finds attractive. This is followed by the internal analysis, or self-assessment, of the firm’s strengths and weaknesses relative to competitors in these markets. The combination of these two activities—the external and internal analyses—is often called SWOT analysis because it determines the strengths, weaknesses, opportunities, and threats associated with a business. Once this analysis is completed, management has a clearer understanding of emerging opportunities and threats to the firm and of the firm’s primary internal strengths and weaknesses. Information gleaned from the external and internal analyses drives the development of business, implementation, and functional strategies.
The third activity is to define a mission or vision statement that summarizes where and how the firm has chosen to compete, based on the external analysis, as well as management’s operating experience and values. Fourth, objectives are set, and quantitative measures of financial and nonfinancial performance are developed. Having completed these steps, the firm is ready to select a business strategy likely to achieve the objectives in an acceptable period of time, subject to constraints identified in the self-assessment. The business strategy defines, in general terms, how the business intends to compete (i.e., through cost leadership, differentiation, or increased focus).
Next, an implementation strategy is selected that articulates how to implement the business strategy from among a range of reasonable options. The firm may choose to act independently, partner with others, or acquire/merge with another firm. This is followed by development of a functional strategy that defines the roles, responsibilities, and resource requirements of each major functional area within the firm needed to support the business strategy.
The final activity is to establish strategic controls to monitor actual performance to plan, implement incentive systems, and take corrective actions as necessary. Bonus plans and other incentive mechanisms to motivate all employees to achieve their individual objectives on or ahead of schedule are put in place. When significant deviations from the implementation plan occur, the firm may take corrective actions (e.g., cutting output or costs, etc.) included in certain contingency plans. Let’s look at each of these eight activities in greater detail.
External Analysis
What makes a market attractive? And what does a firm in that market have to do to earn the rate of return required by its shareholders? Answers to these questions can be obtained by modifying Michael Porter’s well-known “Five Forces” model. The basic model suggests that profit is determined in an industry/market by the relative bargaining power/influence of a firm’s customers, suppliers, current competitors, the potential for new entrants, and the availability of close product substitutes.4 The basic model can be modified to include other considerations such as of labor, government regulation, and global exposure.
The intensity of competition determines the potential to earn abnormal profits (i.e., those in excess of what would be expected for the degree of assumed risk). In general, competition among firms is likely to be more intense when entry barriers are low, exit barriers are high, competitors use a common technology, switching costs are low, there are many substitutes, there are many competitors who are comparable in size, and market growth is slowing. More intense rivalry often puts downward pressure on selling prices as firms compete for market share, add to marketing expenses, and boost prices for inputs. Firms are further constrained in their ability to raise selling prices when there are close product substitutes. The end result is that greater competition will squeeze firm profit margins potentially eliminating a firm’s ability to earn “abnormal financial“ returns. See the End of Chapter Case Study in Chapter 9 for an illustration of how the “Five Forces” model can be used to understand an industry’s or market’s competitive dynamics.
How a firm selects target industries/markets depends on the firm’s selection criteria and how it ranks the relative importance of each criterion as well as the risk tolerance and imagination of a firm’s board and management. Examples of selection criteria include market size and growth rate, profitability, cyclicality, price sensitivity of customers, amount of regulation, degree of unionization, and existence of entry and exit barriers.
An industry may be defined as a collection of markets and markets as a series of customers (either individuals or businesses) exhibiting common needs and characteristics. Markets can be subdivided into a series of sub-segments by applying a process called market segmentation. For example, a firm may segment markets until it finds customers whose buying decisions are based primarily on price, quality, or service.
Viewing the automotive industry as consisting of the new and used car markets as well as the after-market for replacement parts is an example of market segmentation. Markets may be further subdivided by examining cars by makes and model years. The automotive industry could also be defined regionally (e.g., New England, North America, Europe) or by country. Each subdivision, whether by product or geographic area, defines a new market within the automotive industry.
Another example is the cloud computing industry which consists of firms providing customers remote access in three discrete markets: software, infrastructure, and platform services. The software services market consists of such firms as Salesforce and Workday providing customers on demand licensing of their software applications for a fee. The infrastructure services market allows companies to rent on demand operating systems, servers, and storage services from such competitors as Microsoft, Google, and Amazon.com. The platform market, consisting of the likes of Google, Amazon.com and Salesforce, offers templates for customers to create software to meet their specific needs.
The factors affecting each component of the modified 5 Forces Model and how they may impact profit (and cash flow) are discussed in more detail next.
Bargaining Power of Customers
The relative bargaining power of customers depends on their primary buying criteria (i.e., quality/reliability, service, convenience, or some combination), price sensitivity or elasticity, switching costs, their number and average size, and availability of substitutes. A customer whose primary buying criterion is product quality and reliability may be willing to pay a premium for a BMW because it is perceived to have higher relative quality. Customers are more likely to be highly price sensitive in industries characterized by largely undifferentiated products and low switching costs. Customers are likely to have considerable bargaining power when they are relatively large compared to the size of suppliers. Switching costs are highest when customers must pay penalties to exit long-term supply contracts or when buyers would have to undergo an intensive learning process to buy from a different supplier. Customers having substantial bargaining power can force selling prices down, negotiate favorable credit terms, and squeeze supplier margins.
Bargaining Power of Suppliers
Suppliers in this context include material, services, and capital. Their bargaining power is impacted by switching costs, differentiation, their number and average size compared to the customer, and the availability of substitutes. When the cost of changing suppliers is high, their products are highly differentiated, they are few in number and large relative to their customers, and there are few substitutes, suppliers are able to boost their selling prices, impose more stringent credit terms, and lengthen delivery schedules. Other things unchanged, suppliers realize improved profit margins at the expense of their customers.
Degree of Competitive Rivalry
The intensity of competition among current competitors is largely determined by the industry growth rate, industry concentration, degree of differentiation and switching costs, scale and scope economies, excess capacity, and exit barriers. If an industry is growing rapidly, existing firms have less need to compete for market share based on aggressive pricing. If an industry is highly concentrated, firms can more easily coordinate their pricing activities; in contrast, coordination is more difficult in a highly fragmented industry where price competition is likely to be very intense.
In some instances, intense competition can arise even when the industry is highly concentrated. Even when there are only a few competitors, firms may compete largely on the basis of price when their product/service offerings are largely undifferentiated to gain market share. Such a market structure is called an oligopoly.
If the cost of switching from one supplier to another is minimal because of low perceived differentiation, customers are likely to switch based on relatively small differences in price. In industries in which production volume is important, companies may compete aggressively for market share to realize economies of scale. Moreover, firms in industries exhibiting substantial excess capacity often reduce prices to fill unused capacity. Finally, competition may be intensified in industries in which it is difficult for firms to exit due to barriers such as large unfunded pension liabilities and single purpose assets.
Potential New Entrants
The likelihood of new entrants is affected by scale/scope economies, first mover advantage, legal barriers (e.g., patents), limited access to distribution channels, product differentiation, and potential for retaliation from current competitors. Competitors within an industry characterized by low barriers to entry have limited pricing power. Attempts to raise prices resulting in abnormally large profits will attract new competitors, thereby adding to the industry’s productive capacity. In contrast, high entry barriers may give existing competitors significant pricing power. Barriers to new entrants include situations in which the large-scale operations of existing competitors give them a potential cost advantage due to economies of scale. The “first-mover advantage”—i.e., being an early competitor in an industry—may also create entry barriers because first movers achieve widespread brand recognition, establish industry standards, develop exclusive relationships with key suppliers and distributors, create large installed user bases, and amass huge customer databases. Finally, legal constraints, such as copyrights and patents, may inhibit the entry of new firms.
Availability of Substitute Products
The potential for substitute products is affected by relative prices, performance, quality, and service, as well as the willingness of customers to switch. The selling price of one product compared to a close substitute—called the relative price—determines the threat of substitution, along with the performance of competing products, perceived quality, and perceived switching costs. Potential substitutes could come from current or potential competitors and include those that are substantially similar to existing products and those performing the same function—for example, a tablet computer rather than a hardcover book. In general, when substitutes are close to existing products, switching costs are low, and customers are willing to switch, the introduction of substitutes limit price increases for current products by reducing the demand for product and service offerings of existing industry competitors and potentially their profit margins.
Bargaining Power of the Labor Force
The bargaining power of the labor force is affected by the degree of unionization, management/labor harmony, and availability of critical skills. Labor’s share of total operating expenses can range from very low in automated manufacturing industries to very high in nonmanufacturing industries. Work stoppages create opportunities for competitors to gain market share. Customers are forced to satisfy their product and service needs elsewhere. Although the loss of customers may be temporary, it may become permanent if the customer finds that another firm’s product or service is superior. Frequent work stoppages also may have long-term impacts on productivity and production costs as a result of a less motivated labor force and increased labor turnover.
The Degree of Government Regulation
Governments may choose to regulate industries that are heavily concentrated, are natural monopolies (e.g., electric utilities), or provide a potential risk to the public. Regulatory compliance adds significantly to an industry’s operating costs. Regulations also create barriers to both entering and exiting an industry. However, incumbent competitors can benefit from the creation of entry barriers due to regulation because it can limit the number of new entrants.
Global Exposure
Global exposure refers to the extent to which an industry/market is affected by export and import competition. The automotive industry is widely viewed as a global industry in which participation requires having assembly plants and distribution networks in major markets worldwide. Global exposure introduces the firm to the impact of currency risk on profit repatriation and political risk such as the confiscation of the firm’s properties. An industry exposure to foreign competition also can restrain their ability to pass on cost increases to customers by raising selling prices.
Internal Analysis
The primary output of internal analysis is to determine the firm’s strengths and weaknesses. What are they compared to the competition? Can the firm’s critical strengths be easily duplicated and surpassed by the competition? Can they be used to gain advantage in the firm’s chosen market? Can competitors exploit the firm’s key weaknesses? These questions must be answered as objectively as possible for the information to be useful in formulating a viable strategy.
Ultimately, competing successfully means doing a better job than competitors of satisfying the needs of the firm’s targeted customers. A self-assessment identifies those strengths or competencies—so-called success factors—necessary to compete successfully in the firm’s chosen or targeted market. These may include high market share compared to the competition, product line breadth, cost-effective sales distribution channels, age and geographic location of production facilities, relative product quality, price competitiveness, R&D effectiveness, customer service effectiveness, corporate culture, and profitability.
Recall that the combination of the external and internal analyses just detailed can be summarized as a SWOT analysis to determine the strengths and weaknesses of a business as well as the opportunities and threats confronting a business. The results of a SWOT analysis can be displayed on a SWOT matrix. Based on the results of this analysis, firms can select how to prioritize opportunities and threats and how to focus corporate resources to exploit selected opportunities or to reduce their vulnerability to perceived threats. This information helps management set a direction in terms of where and how the firm intends to compete, which is then communicated to the firm’s stakeholders in the form of a mission/statement and a set of quantifiable financial and nonfinancial objectives.
Table 4.1 illustrates a hypothetical SWOT analysis for Facebook. It is not intended to be a comprehensive list of perceived strengths, weaknesses, opportunities, and threats. Rather, it is provided only for illustrative purposes. Facebook’s management using similar information may have opted to acquire mobile message service WhatsApp for an eye-popping $21.8 billion in early 2014 to adapt to the shift of internet users to mobile devices and to preclude competitors such as Google from acquiring this explosively growing mobile messaging firm.
Table 4.1
| Strengths | Weaknesses |
|---|---|
|
2. Global scale with 2.23 billion monthly active users as of 12/31/17 3. User engagement (time spent online) 4. Extensive user database attractive to advertisers 5. Integrated website and applications widens user appeal 6. Ability to monetize increasing mobile traffic through Instagram |
2. Dependence on display ads which have lower user “click-through” rate 3. Dependence on advertising for more than 80% of revenue 4. Aging user demographics 5. Lack of website customization limits user personalization 6. Poor protection of user information |
| Opportunities | Threats |
|
1. Increasing use of Facebook through mobile devices 2. Expansion in emerging nations 3. Diversify revenue sources 4. Continuing shift of traditional to online advertising 5. Adding new features and functions to enable customization 6. Expanded “graph search” advertisinga |
1. Increasing user privacy concerns 2. Accelerating shift toward accessing internet through mobile devices, including wearable technology such as Google Glass 3. Alterative social networks (e.g., Twitter, Tumblir, LinkedIn, Pinterest, and Google +) compete for users and advertisers 4. Lack of website customization 5. Highly competitive ad market putting downward pressure on ad rates 6. Increased frequency of identity theft |
a Graph Search is a search engine that allows Facebook users to look up anything shared with them throughout their history on Facebook. This expands the firm’s user database to enable advertisers’ to track changes in buying patterns and personal interests.
Mark Zuckerberg has stated his vision for Facebook is to make the world more open and connected.5 How? By giving people the power to share whatever they want and to be connected to whatever they want no matter where they are. While Facebook dominates the social network space in which users are able to share everything they want others to know, Facebook also wants to dominate how people communicate. The opportunity is to build the best and most ubiquitous mobile product, a platform where every app that is created can support social interaction and enable people to share, and to build Facebook into one of the world’s most valuable companies. The threat is that others such as Google may acquire the business propelling them to the forefront of the mobile communications space.
The acquisition of WhatsApp in early 2014 illustrates Mark Zuckerberg’s understanding that people want to communicate in different ways: sometimes broadly through Facebook and sometimes narrowly through WhatsApp’s mobile messaging capability. However, Facebook’s efforts in recent years to penetrate the mobile messaging market have largely failed. Facebook sorely needed a platform to make inroads in the mobile messaging market. Enter WhatsApp with its frenetic growth.
With the WhatsApp acquisition not yet closed, Facebook acquired startup Oculus VR, the maker of virtual reality headsets, in mid-2014 for $2 billion. In an effort to increase user engagement or time spent online (a current Facebook strength), the deal represents a bet that virtual reality can eventually turn social networking into an immersive, 3D experience. Perhaps as a response to Google Glass that enables access to the internet through high-tech eyewear (a potential threat to Facebook), the Oculus acquisition represents an investment for Facebook in wearable hardware that “reimagines” how people will one day interact with information and other types of content.
Defining the Mission/Vision Statement
In 2009, Apple Computer’s board and management changed the way they wished to be perceived by the world by changing their company name to Apple Inc. The change was intended to be transformative, reflecting the firm’s desire to change from being a computer hardware and software company to a higher margin, faster growing consumer electronics firm characterized by iPod- and IPhone-like products. In other words, the firm was establishing a new corporate mission. In 2011, Starbucks dropped the word coffee from its logo and acquired upscale juice maker Evolution Fresh in an effort to transform itself from a chain of coffee shops into a consumer products firm selling products outside of its stores.
A mission/vision statement describes the corporation’s purpose for being, what business it is in, and where it hopes to go. The mission statement should not be so general as to provide little practical direction. A good mission statement should include references to the firm’s targeted markets, reflecting the fit between the corporation’s primary strengths and competencies and its ability to satisfy customer needs better than the competition. It should define the product offering relatively broadly to allow for the introduction of new products that might be derived from the firm’s core competencies. Distribution channels—how the firm chooses to distribute its products—should be identified, as should the customers targeted by the firm’s products and services. The mission statement should state management beliefs with respect to the firm’s primary stakeholders; these establish the underpinnings of how the firm intends to behave toward those stakeholders.
Too narrow a definition could be disastrous as it becomes difficult to ascertain opportunities and threats to the core business that do not fall neatly within the firm’s mission. A mission statement should not be tied to a specific product or service the firm currently produces. If railroads had defined their missions more broadly as establishing a strong market share in the transportation industry rather than limiting their positions to the rail business, they may have retained the preeminent position in the transportation industry they once enjoyed. That is, by defining their positions narrowly around existing products and services, railroads failed to see alternative forms of transportation emerging in time to be proactive.
To further illustrate, consider Alphabet Inc. (Google) which defines its mission/vision as organizing the world’s information and making it universally accessible and useful. The mission statement is powerful in that it focuses on satisfying consumers’ and businesses’ desire for access to timely, accurate information from anywhere at any time. It also highlights the firm’s core competence of organizing data to facilitate accessibility to useful information. However, its breadth is problematic since most things can be viewed as embodied information; as such, the mission does not restrict the firm from investigating any perceived opportunity. This contributes to the firm’s diffuse investments which seem to lack significant commonality with other investments.
Defining a firm’s mission too broadly creates a range of possible outcomes that is too large to analyze effectively. Consequently, much time in the planning process can be spent analyzing outcomes that may have little relevance to what firm wants to ultimately become. Defining the mission more narrowly results in putting boundaries on the range of possible opportunities the firm may choose to pursue. For example, the firm could prioritize so-called adjacent markets6 that might enable Google to leverage its core search and data organizational skills. Examples include increasing the firm’s database depth, breadth and detail in specific slices of the global economy such as healthcare, financial services, etc.
For a mission/vision statement to energize a firm’s employees it must be widely understood and accepted. Senior management must continually communicate the mission statement so that everyone clearly understands. In turnaround situations, employees should be given an opportunity to commit to the desired behaviors communicated by top management. When CEO Marissa Mayer of Yahoo required employees working from remote locations to work onsite, she was asking for more effective employee engagement and communication. She understood that some disaffected employees would leave but that the firm’s culture would be better off without those unwilling to conform to the culture she was attempting to create. Management also must be receptive to, not dismissive of, new ideas. Finally, management must be willing to celebrate successes by acknowledging what the firm has done well. But this does not mean lessening pressure to achieve the vision.
Setting Strategic or Long-Term Business Objectives
A business objective is what must be accomplished within a specific period. Good business objectives are measurable and have a set time frame in which to be realized. They include revenue growth rates, minimum acceptable financial returns, and market share; these and others are discussed in more detail later. A good business objective might state that the firm seeks to increase revenue from the current $1 billion to $5 billion by a given year. A poorly written objective would simply state the firm seeks to increase revenue substantially.
Common Business Objectives
Corporations typically adopt a number of common business objectives. For instance, the firm may seek to achieve a rate of return that will equal or exceed the return required by its shareholders, lenders, or the combination of the two (cost of capital) by a given year. The firm may set a size objective, seeking to achieve some critical mass, defined in terms of sales volume, to realize economies of scale by a given year.
Several common objectives relate to growth. Accounting-related growth objectives include seeking to grow earnings per share (EPS), revenue, or assets at a specific rate of growth per year. Valuation-related growth objectives may be expressed in terms of the firm’s price-to-earnings ratio, book value, cash flow, or revenue. Diversification objectives are those where the firm desires to sell current products in new markets, new products in current markets, or new products in new markets. For example, the firm may set an objective to derive 25% of its revenue from new products by a given year. It is also common for firms to set flexibility objectives, aiming to possess production facilities and distribution capabilities that can be shifted rapidly to exploit new opportunities as they arise. For example, major automotive companies have increasingly standardized parts across car and truck platforms to reduce the time required to introduce new products, giving them greater flexibility to facilitate a shift in production from one region to another. Technology objectives may reflect a firm’s desire to possess capabilities in core technologies. Microchip and software manufacturers as well as defense contractors are good examples of industries in which keeping current with, and even getting ahead of, new technologies is a prerequisite for survival.
Selecting the Corporate and Business Level Strategies
Each level of strategy serves a specific purpose. Implementation (also known as investment) strategies are necessarily more detailed than corporate-level strategies and provide specific guidance for a firm’s business units.
The different levels of strategy can be illustrated by looking at Alphabet, the holding company containing Google and other businesses. Alphabet determines the firm’s corporate strategy and allocates available funds to its various business units. Google, by far the largest and most profitable business unit, gets the majority of corporate resources. Google’s business strategy involves making investments necessary to drive more people to use the Internet more frequently and in more diverse ways. The Google brand has become a household name, associated with high quality search and innovative excellence. Consequently, by investing in diverse activities ranging from search to driverless cars and residential thermostats to smartphones, the firm is seeking to bolster sales and profits in new markets by promoting the association of their brand with quality and innovation. Furthermore, increased penetration of additional markets increases the amount of information they collect on users of their services, enhancing their marketing data base(s) used to improve the effectiveness of firms advertising on Google websites.
The strategy is driven by a combination of factors external and internal to Google. The inherent utility of the internet for both consumers and business will continue to drive usage worldwide (factors external to Google). However, the usefulness of the internet is enhanced by improved search techniques proprietary to Google (factors internal to Google). Google has implemented this strategy by internally developing new products and services (e.g., the driverless car technology which requires constant communication with cloud servers via the internet) or through acquisition (e.g., Motorola for its smartphone software and intellectual property patents and Nest for its innovative presence in the residential and commercial heating and cooling niche).
Corporate and business unit level strategies as well as implementation strategies are discussed in more detail below.
Corporate-Level Strategies
Corporate-level strategies may include all or some of the business units that are either wholly or partially owned by the corporation. A growth strategy focuses on accelerating the firm’s consolidated revenue, profit, and cash flow growth and may be implemented in many different ways. For example, CEO Satya Nadella’s corporate-level growth strategy for Microsoft is oriented around cloud computing, mobile platforms, content, and productivity software. In addition, the firm is increasingly interested in selling its software as a subscription, even if it is not used on the Windows operating system. The firm’s 2014 acquisition of Mojang, the video game developer that created Minecraft, for $2.5 billion illustrates how a single acquisition can contribute to multiple aspects of the firm’s corporate growth strategy. The acquisition enabled Microsoft to own the top game on Xbox (making this valuable content proprietary to Microsoft) and also the leading paid app on iOS and Android in the United States (selling such content on different mobile operating systems). The acquisition ensures that Minecraft will also run on Microsoft’s Windows Phone mobile operating system (making the firm’s own mobile operating system more competitive).
A diversification strategy involves a decision at the corporate level to enter new businesses. These businesses may be related to the corporation’s existing businesses or completely unrelated. Relatedness may be defined in terms of the degree to which a target firm’s products and served markets are similar to those of the acquiring firm. An operational restructuring strategy, sometimes called a turnaround or defensive strategy, usually refers to the outright or partial sale of companies or product lines, downsizing by closing unprofitable or nonstrategic facilities, obtaining protection from creditors in bankruptcy court, or liquidation. A financial restructuring strategy describes actions by the firm to change its total debt and equity structure. The motivation for this strategy may be better utilization of excess corporate cash balances through share-repurchase programs, reducing the firm’s cost of capital by increasing leverage or increasing management’s control by acquiring a company’s shares through a management buyout.
Business-Level Strategies
A firm should choose the business strategy from among the range of reasonable options that enables it to achieve its stated objectives in an acceptable period, subject to resource constraints. These include limitations on the availability of management talent and funds. Business strategies fall into one of four basic categories: price or cost leadership; product differentiation; focus or niche strategies; and hybrid strategies.
Price or Cost Leadership
The price or cost leadership strategy reflects the influence of a series of tools, including the experience curve and product life cycle, introduced and popularized by the Boston Consulting Group (BCG). This strategy is designed to make a firm the cost leader in its market by constructing efficient production facilities, controlling overhead expenses tightly, and eliminating marginally profitable customer accounts.
The experience curve states that as the cumulative historical volume of a firm’s output increases, cost per unit of output decreases geometrically as the firm becomes more efficient in producing that product. The firm with the largest historical output should also be the lowest cost producer, so this theory suggests. This implies that the firm should enter markets as early as possible and reduce product prices aggressively to maximize market share. The experience curve seems to work best for largely commodity-type industries, in which scale economies can lead to reductions in per-unit production costs, such as PC or cellphone handset manufacturing. The strategy of continuously driving down production costs makes most sense for the existing industry market share leader, since it may be able to improve its cost advantage by pursuing market share more aggressively through price-cutting.
BCG’s second major contribution is the product life cycle, which characterizes a product’s evolution in four stages: embryonic, growth, maturity, and decline. Strong sales growth and low barriers to entry characterize the first two stages. Over time, however, entry becomes more costly as early entrants into the market accumulate market share and experience lower per-unit production costs as a result of experience curve effects. New entrants have poorer cost positions thanks to their small market shares compared with earlier entrants, and they cannot catch up to the market leaders as overall market growth slows. During the later phases, characterized by slow market growth, falling product prices force marginal firms and unprofitable firms out of the market or force them to consolidate with other firms. Knowing the firm’s stage of the product life cycle can help project future cash flow growth, which is necessary for valuation purposes. During the high growth phase, firms in the industry normally have high investment requirements and operating cash flow is normally negative. During the mature and declining growth phases, investment requirements are lower, and cash flow becomes positive.
Product Differentiation
Differentiation encompasses a range of strategies in which the product offered is perceived by customers to be slightly different from other product offerings in the marketplace. Brand image is one way to accomplish differentiation. Another is to offer customers a range of features or functions. For example, many banks issue MasterCard or Visa credit cards, but each bank tries to differentiate its card by offering a higher credit line or a lower interest rate or annual fee or with awards programs. Apple Computer has used innovative technology to stay ahead of competitors selling MP3 players, most recently with cutting-edge capabilities of its newer iPads and iPhones.
Focus or Niche Strategies
Firms adopting focus or niche strategies tend to concentrate their efforts by selling a few products or services to a single market, and they compete primarily by understanding their customers’ needs better than the competition. In this strategy, the firm seeks to carve out a specific niche with respect to a certain group of customers, a narrow geographic area, or a particular use of a product. Examples include regional airlines, airplane manufacturers (e.g., Boeing), and major defense contractors (e.g., Lockheed-Martin).
Hybrid Strategies
Hybrid strategies involve some combination of the three strategies just discussed (Table 4.2). For example, Coca Cola pursues both a differentiated and highly market-focused strategy. The company derives the bulk of its revenues by focusing on the worldwide soft drink market, and its main product is differentiated, in that consumers perceive it to have a distinctly refreshing taste. Fast-food industry giant McDonald’s pursues a differentiated strategy, competing on the basis of providing fast food of a consistent quality in a clean, comfortable environment, at a reasonable price.
Blue Ocean Strategy
Proponents of this strategy argue that instead of competing with others in your own industry, a firm should strive to create unique products for new markets and to profit from these new markets or “blue oceans.”7 Apple Inc.’s record of introducing highly innovative and popular products is perhaps the best example of this strategy. The firm has a record of innovating new products that consumers did not even know they wanted but who learned to find them “cool” and indispensable. Firms that compete in conventional or traditional markets are said to work in “red ocean” conditions, where businesses fight for a share of an existing market. In contrast, “blue ocean” opportunities offer the prospect of a market free of competitors. Why? They are unique.
Platform Strategies
Platform business strategies are those that connect independent parties with the objective of expediting transactions. Such strategies are not new. They include firms ranging from telephone services to computer operating systems. The objective is to garner as many users as possible such that a firm can supply multiple products and services to its user base. For instance, the Microsoft Windows operating system served as a “platform” to support sales of additional products such as Microsoft Office that worked best on the firm’s proprietary operating system to its huge user base. Similarly, mobile phone companies compete in part of the basis of geographic network coverage. Those offering national (rather than simply regional) coverage could acquire more customers to whom they could sell other services and content. The sheer size of Microsoft’s user base and Verizon’s network coverage created huge barriers for potential competitors wanting to enter these businesses. Moreover, these barriers could be sustained as growing user bases would drive down the cost of attracting and retaining users.
Platform strategies are most effective when they are readily scalable to accommodate ever larger numbers of users. Platforms can create “communities” in which users can communicate and make transactions. Amazon.com, Google, Facebook, Uber,8 Airbnb, Pinterest, and Alibaba are examples of highly scalable platform companies. The key to their success is the ability to attract users cost effectively, connect buyers and sellers, and to provide the payment systems to consummate transactions.
Platform strategies do not involve owning production operations but rather they provide value in connecting consumers and businesses. This contrasts with the more traditional businesses which have a clearly delineated supply chain consisting of suppliers, production, distribution, and customer service. Supply chain driven companies create value by producing and delivering goods and services which they sell through owned or independent distributors. Examples include manufacturers such as auto and farm equipment makers General Motors and John Deere, subscription businesses like Netflix and HBO which create or license their content, and resellers such as Walmart, Costco, and Target.
Choosing an Implementation Strategy
Once a firm has determined the appropriate business strategy, it must decide the best means of implementation. Typically, a firm has five choices: implement the strategy based solely on internal resources (the solo venture, go it alone, or build approach), partner with others, invest, acquire, or swap assets. There is little evidence that one strategy is consistently superior to another. In fact, failure rates among alternative strategies tend to be remarkably similar to those documented for M&As9; this should not be surprising in that if one strategy consistently outperformed alternative approaches all firms would adopt a similar growth strategy. Table 4.3 compares the advantages and disadvantages of these options.
Table 4.3
| Basic options | Advantages | Disadvantages |
|---|---|---|
| Solo venture or build (organic growth) |
• Capital/expensea requirements • Speed | |
| Partner (shared growth/shared control) • Marketing/distribution alliance • Joint venture • License • Franchise |
• Limits capital and expense investment requirements • May be precursor to acquisition |
• Potential for diverging objectives • Potential for creating a competitor |
| Invest (e.g., minority investments in other firms) |
• Lack of control • Time | |
| Acquire or merge |
• Control |
• Capital/expense requirements • Potential earnings dilution |
| Swap assets |
• No earnings dilution • Limits tax liability if basis in assets swapped remains unchanged |
• Reaching agreement on assets to be exchanged |
a Expense investment refers to expenditures made on such things as application software development, database construction, research and development, training, and advertising to build brand recognition, which (unlike capital expenditures) usually are expensed in the year in which the monies are spent.
In theory, choosing among alternative options should be based on discounting projected cash flows to the firm resulting from each option. In practice, many other considerations are at work such as intangible factors and the plausibility of underlying assumptions.
The Role of Intangible Factors
Although financial analyses are conducted to evaluate the various strategy implementation options, the ultimate choice may depend on a firm’s board and management desire, risk profile, and hubris. The degree of control offered by the various alternatives is often the central issue senior management must confront as this choice is made. Although the solo venture and acquisition options offer the highest degree of control, they can be the most expensive and perceived to be the most risky, although for very different reasons. Typically, a build strategy will take considerably longer to realize key strategic objectives, and it may have a significantly lower current value than the alternatives—depending on the magnitude and timing of cash flows generated from the investments. Gaining control through acquisition can also be very expensive because of the substantial premium the acquirer normally has to pay to gain a controlling interest in another company. The joint venture may be a practical alternative to either a build or acquire strategy; it gives a firm access to skills, product distribution channels, proprietary processes, and patents at a lower initial expense than might otherwise be required. Asset swaps may be an attractive alternative to the other options, but in most industries they are generally very difficult to establish unless the physical characteristics and use of the assets are substantially similar and the prospects for realizing economies of scale and scope are attractive.10
Analyzing Assumptions
Financial theory suggests that the option with the highest net present value is generally the preferred strategy. However, this may be problematic if the premise on which the strategy is based is questionable. Therefore, it is critical to understand the key assumptions underlying the chosen strategy as well as those underlying alternative strategies. This forces senior management to make choices based on a discussion of the reasonableness of the assumptions associated with each option rather than simply the numerical output of computer models.
Functional Strategies
Functional strategies focus on short-term results and generally are developed by functional areas. These strategies result in concrete actions for each function or business group, depending on the company’s organization. It is common to see separate plans with specific goals and actions for the marketing, manufacturing, R&D, engineering, and financial and human resources functions. Functional strategies should include clearly defined objectives, actions, timetables for achieving those actions, resources required, and identifying the individual responsible for ensuring that the actions are completed on time and within budget.
Specific functional strategies might read as follows:
- • Set up a product distribution network in the northeastern United States that is capable of handling a minimum of 1 million units of product annually by 12/31/20XX. (Individual responsible: Oliver Tran; estimated budget: $5 million.)
- • Develop and execute an advertising campaign to support the sales effort in the northeastern United States by 10/31/20XX. (Individual responsible: Maria Gomez; estimated budget: $0.5 million.)
- • Hire a logistics manager to administer the distribution network by 9/15/20XX. (Individual responsible: Patrick Petty; estimated budget: $250,000.)
- • Acquire a manufacturing company with sufficient capacity to meet the projected demand for the next 3 years by 6/30/20XX at a purchase price not to exceed $250 million. (Individual responsible: Chang Lee.)
Perhaps an application software company is targeting the credit card industry. Here is an example of how the company’s business mission, business strategy, implementation strategy, and functional strategies are related.
- • Mission: To be recognized by our customers as the leader in providing accurate, high-speed, high-volume transactional software for processing credit card remittances by 20XX.
- • Business Strategy: Upgrade our current software by adding the necessary features and functions to differentiate our product and service offering from our primary competitors and satisfy projected customer requirements through 20XX.
- • Implementation Strategy: Purchase a software company at a price not to exceed $400 million that is capable of developing “state-of-the-art” remittance processing software by 12/31/20XX. (Individual responsible: Daniel Stuckee.)
- • Functional Strategies to Support the Implementation Strategy (Note each requires a completion date, budget, and individual responsible for implementation.)
- • Research and Development: Identify and develop new applications for remittance processing software.
- • Marketing and Sales: Assess the impact of new product offerings on revenue generated from current and new customers.
- • Human Resources: Determine appropriate staffing requirements.
- • Finance: Identify and quantify potential cost savings generated from improved productivity as a result of replacing existing software with the newly acquired software and from the elimination of duplicate personnel in our combined companies. Evaluate the impact of the acquisition on our combined companies’ financial statements.
- • Legal: Ensure that all target company customers have valid contracts and that these contracts are transferable without penalty. Also, ensure that we will have exclusive and unlimited rights to use the remittance processing software.
- • Tax: Assess the tax impact of the acquisition on our cash flow.
Strategic Controls
Strategic controls include both incentive and monitoring systems. Incentive systems include bonus, profit sharing, or other performance-based payments made to motivate both acquirer and target company employees to work to implement the business strategy for the combined firms. Typically, these would have been agreed to during negotiation. Incentives often include retention bonuses for key employees of the target firm if they remain with the combined companies for a specific period following completion of the transaction. Monitoring systems are implemented to track the actual performance of the combined firms against the business plan. They may be accounting based and monitor financial measures such as revenue, profits, and cash flow, or they may be activity based and monitor variables that drive financial performance such as customer retention, average revenue per customer, employee turnover, and revenue per employee.
The Business Plan as a Communication Document
The business plan is an effective means of communicating with key decision makers and stakeholders. There is evidence that external communication of a firm’s business plan when it is different from the industry norm can improve the firm’s share price by enabling investors to better understand what the firm is trying to do and to minimize confusion among industry analysts.11
A good business plan should be short, focused, and supported with the appropriate financial data. There are many ways to develop such a document. Exhibit 4.1 outlines the key features that should be addressed in a good business plan—one that is so well reasoned and compelling that decision makers accept its recommendations. The executive summary may be the most important and difficult piece of the business plan to write. It must communicate succinctly and compellingly what is being proposed, why it is being proposed, how it is to be achieved, and by when. It must also identify the major resource requirements and risks associated with the critical assumptions underlying the plan. The executive summary is often the first and only portion of the business plan that is read by a time-constrained CEO, lender, or venture capitalist. As such, it may represent the first and last chance to catch the attention of the key decision maker. Supporting documentation should be referred to in the business plan text but presented in the appendices.
Phase 2: Building the Merger-Acquisition Implementation Plan
If a firm decides to execute its business strategy through an acquisition, it will need an acquisition plan. Here, the steps of the acquisition planning process are discussed, including detailed components of an acquisition plan.12 The acquisition plan is a specific type of implementation strategy that focuses on tactical or short-term issues rather than strategic or longer term issues. It includes management objectives, a resource assessment, a market analysis, senior management’s guidance regarding management of the acquisition process, a timetable, and the name of the individual responsible for making it all happen. These and the criteria to use when searching acquisition targets are codified in the first part of the planning process; once a target has been identified, several additional steps must be taken, including contacting the target, developing a negotiation strategy, determining the initial offer price, and developing both financing and integration plans. These activities are discussed in detail in Chapter 5.
Development of the acquisition plan should be directed by the “deal owner”—typically a high-performing manager. Senior management should, early in the process, appoint the deal owner to this full- or part-time position. It can be someone in the firm’s business development unit, for example, or a member of the firm’s business development team with substantial deal-making experience. Often, it is the individual who will be responsible for the operation and integration of the target, with an experienced deal maker playing a supporting role. The first steps in the acquisition planning process are undertaken prior to selecting the target firm and involve documenting the necessary plan elements before the search for an acquisition target can begin.
Not surprisingly, observing the outcome of previous deals in the same industry can be highly useful in planning an acquisition. Researchers have identified a strong positive relationship between premerger planning involving an analysis of past M&As in the same industry and postmerger performance. The correlation is particularly strong in cross-border deals where cultural differences are the greatest.13
Plan Objectives
The acquisition plan’s objectives should be consistent with the firm’s strategic objectives. Financial and nonfinancial objectives alike should support realization of the business plan objectives. Moreover, as is true with business plan objectives, the acquisition plan objectives should be quantified and include a date when such objectives are expected to be realized.
Financial objectives could include a minimum rate of return or operating profit, revenue, and cash flow targets to be achieved within a specified period. Minimum required rates of return targets may be substantially higher than those specified in the business plan, which relate to the required return to shareholders or to total capital. The required return for the acquisition may reflect a substantially higher level of risk as a result of the perceived variability of the amount and timing of the expected cash flows resulting from the acquisition.
Nonfinancial objectives address the motivations for making the acquisition that support achieving the financial returns stipulated in the business plan. They could include obtaining rights to specific products, patents, copyrights, or brand names; providing growth opportunities in the same or related markets; developing new distribution channels in the same or related markets; obtaining additional production capacity in strategically located facilities; adding R&D capabilities; and acquiring access to proprietary technologies, processes, and skills.14 Because these objectives identify the factors that ultimately determine whether a firm will achieve its desired financial returns, they may provide more guidance than financial targets.
There is evidence that acquirers relying on key nonfinancial objectives that drive firm value are more likely to realize larger announcement date financial returns than those that do not.15 Why? Firms whose managers are focused on financial returns can lose sight of the factors that drive returns. Firms employing so-called “value based management” measure their performance against value drivers and are more likely to realize desired financial returns. Table 4.4 illustrates how acquisition plan objectives can be linked with business plan objectives.
Table 4.4
| Business plan objective | Acquisition plan objective |
|---|---|
| Financial: The firm will • Achieve rates of return that will equal or exceed its cost of equity or capital by 20XX • Maintain a debt/total capital ratio of x% | Financial returns: The target firm should have • A minimum return on assets of x% • A debt/total capital ratio ≤ y% • Unencumbered assetsa of $z million • Cash flow in excess of operating requirements of $x million |
| Size: The firm will be the number one or two market share leader by 20XX | Size: The target firm should be at least $x million in revenue |
| Growth: The firm will achieve through 20XX annual average • Earnings per share growth of y% • Operating cash flow growth of z% | Growth: The target firm should • Have annual revenue, earnings, and operating cash flow growth of at least x%, y%, and z%, respectively • Provide new products and markets resulting in $z by 20XX • Possess excess annual production capacity of x million units |
| Diversification: The firm will reduce earnings variability by x% | Diversification: The target firm’s earnings should be largely uncorrelated with the acquirer’s earnings |
| Flexibility: The firm will achieve flexibility in manufacturing and design | Flexibility: The target firm should use flexible manufacturing techniques |
| Technology: The firm will be recognized by its customers as the industry’s technology leader | Technology: The target firm should own important patents, copyrights, and other forms of intellectual property |
| Quality: The firm will be recognized by its customers as the industry’s quality leader | Quality: The target firm’s product defects must be less than x per million units manufactured |
| Service: The firm will be recognized by its customers as the industry’s service leader | Warranty record: The target firm’s customer claims per million units sold should be not greater than x |
| Cost: The firm will be recognized by its customers as the industry’s low-cost provider | Labor costs: The target firm should be nonunion and not subject to significant government regulation |
| Innovation: The firm will be recognized by its customers as the industry’s innovation leader | R&D capabilities: The target firm should have introduced new products accounting for at least x% of total revenue in the last 2 years |
a Unencumbered assets are those that are not being used as collateral underlying current loans. As such, they may be used to collateralize additional borrowing to finance an acquisition.
Resource/Capability Evaluation
Early in the acquisition process, it is important to determine the maximum amount of the firm’s available resources senior management will commit to a deal. This information is used when the firm develops target selection criteria before undertaking a search for target firms. Financial resources that are potentially available to the acquirer include those provided by internally generated cash flow in excess of normal operating requirements plus funds from the equity and debt markets. In cases where the target firm is known, the potential financing pool includes funds provided by the internal cash flow of the combined companies in excess of normal operating requirements, the capacity of the combined firms to issue equity or increase leverage, and proceeds from selling assets not required to execute the acquirer’s business plan. Financial theory suggests that an acquiring firm will always be able to attract sufficient funding for an acquisition if it can demonstrate that it can earn its cost of capital. In practice, senior management’s risk tolerance plays an important role in determining what the acquirer believes it can afford to spend on a merger or acquisition.
Three basic types of risk confront senior management who are considering an acquisition. How these risks are perceived will determine how much of potential available resources management will be willing to commit to making an acquisition. Operating risk addresses the ability of the buyer to manage the acquired company. Generally, it is perceived to be higher for M&As in markets unrelated to the acquirer’s core business. Financial risk refers to the buyer’s willingness and ability to leverage a transaction as well as the willingness of shareholders to accept dilution of near-term EPS. To retain a specific credit rating, the acquiring company must maintain certain levels of financial ratios, such as debt-to-total capital and interest coverage. A firm’s incremental debt capacity can be approximated by comparing the relevant financial ratios to those of comparable firms in the same industry that are rated by the credit rating agencies. The difference represents the amount the firm, in theory, could borrow without jeopardizing its current credit rating.16 Senior management could also gain insight into how much EPS dilution equity investors may be willing to tolerate through informal discussions with Wall Street analysts and an examination of comparable deals financed by issuing stock. Overpayment risk involves the dilution of EPS or a reduction in its earnings growth rate resulting from paying significantly more than the economic value of the acquired company. The effects of overpayment on earnings dilution can last for years.17
Management Guidance
To ensure that the process is consistent with management’s risk tolerance, management must provide guidance to those responsible for finding and valuing the target as well as negotiating the deal. Upfront participation by management will help dramatically in the successful implementation of the acquisition process. Senior management frequently avoids providing input early in the process, inevitably leading to miscommunication, confusion, and poor execution later in the process. Exhibit 4.2 provides examples of the more common types of management guidance that might be found in an acquisition plan.
Timetable
A properly constructed timetable recognizes all of the key events that must take place in the acquisition process. Each event should have beginning and ending dates and performance to plan milestones along the way and should identify who is responsible for ensuring that each milestone is achieved. The timetable of events should be aggressive but realistic. The timetable should be sufficiently aggressive to motivate all involved to work as expeditiously as possible to meet the plan’s management objectives, while also avoiding over optimism that may demotivate individuals if uncontrollable circumstances delay reaching certain milestones. Exhibit 4.3 recaps the components of a typical acquisition planning process. The first two elements were discussed in detail in this chapter; the remaining items will be the subject of the next chapter.
Some Things to Remember
The success of an acquisition depends greatly on the focus, understanding, and discipline inherent in a thorough and viable business planning process. An acquisition is only one of many options available for implementing a business strategy. The decision to pursue an acquisition often rests on the desire to achieve control and a perception that the acquisition will result in achieving the desired objectives more rapidly than other options. Once a firm has decided that an acquisition is critical to realizing the strategic direction defined in the business plan, a merger/acquisition plan should be developed.
Chapter Discussion Questions
- 4.1 How does planning facilitate the acquisition process?
- 4.2 What is the difference between a business plan and an acquisition plan?
- 4.3 What are the advantages and disadvantages of using an acquisition to implement a business strategy compared with a joint venture?
- 4.4 Why is it important to understand the assumptions underlying a business plan or an acquisition plan?
- 4.5 Why is it important to get senior management involved early in the acquisition process?
- 4.6 In your judgment, which of the elements of the acquisition plan discussed in this chapter are the most important, and why?
- 4.7 After having acquired the OfficeMax superstore chain, Boise Cascade announced the sale of its paper and timber products operations to reduce its dependence on this cyclical business. Reflecting its new emphasis on distribution, the company changed its name to OfficeMax, Inc. How would you describe the OfficeMax mission and business strategy implicit in these actions?
- 4.8 Dell Computer is one of the best known global technology companies. In your opinion, who are Dell’s primary customers? Current and potential competitors? Suppliers? How would you assess Dell’s bargaining power with respect to its customers and suppliers? What are Dell’s strengths and weaknesses versus those of its current competitors?
- 4.9 Discuss the types of analyses inside General Electric that may have preceded its announcement that it would spin off its consumer and industrial business to its shareholders.
- 4.10 Ashland Chemical, the largest US chemical distributor, acquired chemical manufacturer Hercules Inc. for $3.3 billion. This move followed Dow Chemical Company’s purchase of Rohm & Haas. The justification for both acquisitions was to diversify earnings and offset higher oil costs. How will this business combination offset escalating oil costs?
Answers to these discussion questions are found on the online instructors’ site available for this book (https://textbooks.elsevier.com/web/Manuals.aspx?isbn=9780128150757).
The so-called “Amazon effect” describes the shift in recent years in how people shop moving away from traditional brick and mortar retail stores to online purchases. Traditional retailers aren’t the only businesses feeling the squeeze from Amazon.com Inc. Vendors all along the retail value chain are impacted from the accelerating shift to consumer online purchases.18 What follows is a discussion of how this trend is sparking a consolidation not only among retailers but also among their suppliers. The focus in this case study is on merchant acquirers. Fig. 4.2 illustrates the value chain for credit and debit card processing industry.19
Key participants in this value chain include the cardholder, merchant, merchant acquirer (merchant bank),20 issuing bank (cardholder bank), and card association (Visa and MasterCard). A cardholder obtains a bankcard (credit or debit) from an issuing bank and subsequently presents the card to merchants as payment for goods or services. A merchant is the business providing the good or service willing to accept the credit card as payment. Merchant acquirers provide merchants with equipment to accept cards and customer service involved in card acceptance. The issuing or cardholder bank issues cards to consumers. Card associations like Visa and MasterCard act as a clearinghouse for their cards to effect authorization and settlement.
For merchant acquirers revenue is driven by the volume of transactions processed and fees per transaction. The latter is a percent of the sale amount (merchant discount rate) or a fixed fee per transaction. Due in part to the “Amazon effect” merchant acquirers are under substantial pressure to combine to reduce costs in the wake of declining in-store transactions at traditional retailers. The challenges facing merchant acquirers are compounded by rising competition from technology startups which squeeze the fees merchants pay to merchant acquirers. The combination of downward pressure on fees and lethargic growth in the number of in-store transactions has constrained revenue and profit improvement.
To reinvigorate growth, merchant acquirers have been pursuing ways to reduce costs and grow revenue. But with the market changing rapidly, they had to move quickly. That meant mergers and acquisitions. The number of M&As has been running at a fever pitch in recent years. Global Payments Inc. acquired Heartland Payment Systems Inc. for $4.3 billion in December 2015, combining two of the largest US merchant acquirers. In January 2016, Total System Services announced it would pay $2.35 billion for TransFirst. In April 2017, Mastercard Inc. received regulatory approval to acquire payments technology company VocalLink Holdings Ltd. for $920 million. First Data Corp agreed to buy CardConnect Corp for $750 million in May 2017, two months before industry leader Vantiv announced on July 5, 2017 that they had reached an agreement to merge with Worldpay.
Vantiv’s share price fell by about 2% while Worldpay’s rose by 15% immediately following the announcement on July 5, 2017. Valued at $9.94 billion, the stock and cash offer represented a 19% premium to Worldpay’s closing price on July 3, 2017. At closing, Worldpay shareholders owned 41% of the outstanding shares of the combined companies.
The Vantiv deal to acquire Worldpay is one of the most significant in the payment processing industry since the 2008 financial crisis. Payment processing has become increasingly important for financial institutions as more people shop online and move money using cellphones or other digital devices such as tablets. They need accurate systems to minimize fraud and networks robust enough to handle the growing volume of online transactions. Vantiv became the largest merchant acquirer with 20% share in the US in 2016, knocking First Data from the top spot for the first time in 20 years, according to Nilson.
Totally focused in the US, four-fifths of Vantiv’s 2016 revenue of $1.9 billion came from merchant services. The remainder was attributable to financial institution services. Merchant services consist of processing electronic payments at point-of-sale or online, security and fraud services for small to mid-sized merchants and top tier regional and national retailers. Revenue per transaction was $.074 for each of 21 billion transactions processed in 2016. Financial institution services consist of managing payment and security services, as well as card production, acceptance and transaction processing for PIN debit and ATM cards for large and regional financial institutions, community banks and credit unions. Revenue per transaction was $.089 for 4 billion transactions processed in 2016. Despite efforts to do more online transaction processing, the bulk of Vantiv’s business is the offline (i.e., in-store) market in the US.
Worldpay is an international merchant acquirer, processing digital and in-store payments in 146 countries. By buying Worldpay, Vantiv acquires a huge international footprint, especially in Europe. Worldpay will also help Vantiv out of the rut that large US retailers are in because of Amazon. Currently only 15% of Vantiv’s business is with online retailers, the rest is with brick and mortar stores. In contrast, Worldpay has 34% of its revenue from online businesses.
By acquiring Worldpay, Vantiv will be able to help its big retail clients looking to develop global ecommerce capabilities. Vantiv is attractive to Worldpay because of Worldpay’s small market share in the US. Both firms see many opportunities for cutting costs by sharing overhead administrative overhead and technology development and revenue growth opportunities. For example, the acquisition of Worldpay gives Vantiv international ecommerce capabilities that they would be able to cross sell to their US “off line” (in store) client base.
Vantiv intends to become a leading global payment processor by differentiating itself from its competitors through a comprehensive offering of traditional and innovative payment processing solutions from a single vendor to merchants and financial institutions. The firm has moved into such high growth markets as integrated payments systems, ecommerce, and merchant banking through acquisition. In 2016, Vantiv acquired the US subsidiary of Canadian payments company Moneris for $425 million; and, in early 2017, it acquired enterprise payments firm Paymetric for an undisclosed amount. And most recently it acquired Worldpay.
Discussion Questions
- 1. Who are Vantiv’s customers and what are their needs?
- 2. How would you describe Vantiv’s corporate vision, business strategy, and implementation strategy?
- 3. What external and internal factors are driving the merger between Vantiv and Worldpay?
- 4. In the context of M&A, synergy represents the incremental cash flows generated by combining two businesses. Identify the potential synergies you believe could be realized in combining Vantiv and Worldpay? Speculate as to what might be some of the challenges limiting the timely realization of these synergies?
- 5. How would the combined firms be able to better satisfy their customer needs than the competition?
- 6. Why did Vantiv shares fall and Worldpay’s rise immediately following the announcement? Speculate as to why Worldpay’s share price did not rise by the full amount of the premium.
- 7. What alternative implementation strategies could Vantiv have pursued? Speculate as to why they may have chosen to acquire rather than an alternative implementation strategy? What are the key risks involved in the takeover of Worldpay?
Answers to these questions are found in the Online Instructor’s Manual available for instructors using this book (https://textbooks.elsevier.com/web/Manuals.aspx?isbn=9780128150757).