In any business decision utilizing company resources, management must ascertain whether or not an asset purchase makes the most sense for its owners. This is true on a micro or macro level. A corner Laundromat, for example, may have $1,000 to spend on either a snack machine or another dryer. General Electric may, for example, have had the wherewithal to purchase a company like Telemundo, the Spanish-speaking network to complement its National Broadcast Company (NBC) investment (prior to selling NBC to Comcast). Or GE might instead invest in a power plant on a barge off the coast of Nigeria or develop a new health-care technology. No business has unlimited resources, and those managers who allocate company assets are to be held responsible for the decisions they make.
Each transaction directly affects individual shareholders. If you own 10 percent of a company that earns $1 million per year, your share of the business income will be $100,000 annually. If the management enters into an agreement that results in your $100,000 increasing to $150,000 each year, you as an owner will be thrilled! Such a transaction is considered “accretive”, because it increases earnings per share. On the other hand, if management makes a deal that reduces your income to $50,000 next year, you won’t be quite so pleased. A transaction that reduces earnings per share is considered “dilutive” to shareholders.
Imagine that the ABC Corporation is a publicly traded C corporation. ABC has one million shares outstanding that trade on the New York Stock Exchange at $20 each. ABC’s market capitalization is then said to be $20 million. This is calculated simply as 1,000,000 shares outstanding times the $20 price per share. ABC Corporation earns $1 million per year and therefore has earnings per share of $1.00. Again, the math is straightforward: $1,000,000 of profit divided by 1,000,000 shares outstanding equals $1.00 per share.
XYZ Company, a private company with no public float or shares available for purchase on a stock exchange, also earns $1 million per year. XYZ is for sale for $10 million. ABC Corporation agrees to buy XYZ for the full asking price of $10 million utilizing shares of ABC stock. In order to come up with the purchase price, ABC issues 500,000 shares of stock, worth $20 apiece, to the owners of XYZ Company. This is calculated as 500,000 shares times $20 per share equals the $10,000,000 sought by the XYZ shareholders. Was this a good decision by the managers of ABC Corporation? The answer lies in whether or not the transaction was accretive or dilutive to ABC shareholders.
Let’s look at the pro forma results (i.e., assuming that the transaction had already occurred). ABC Corporation’s earnings have now increased from $1 million prior to the transaction to $2 million annually due to XYZ’s additional $1 million of net income that now benefits ABC. ABC Corporation has more shares outstanding, though, and consequently has more hands to share in the increased earnings. ABC had one million shares prior to the deal getting consummated, but now it has another 500,000, with a new total of 1.5 million shares outstanding. Dividing the new total earnings of $2,000,000 by the revised shareholder base of 1,500,000 shares equals $1.33 per share. In short, the transaction has increased ABC’s earnings per share by one-third, from $1.00 to $1.33; it is therefore accretive and desirable. Good job, ABC management!
Different types of buyers may offer better value for equity holders of companies for sale. Obviously, if you own some or all of a business and you wish to liquidate your interests, you would like to get as much as possible for your investment. Consider the varying categories of business purchasers in the marketplace and their differing interests.
Next, let’s look at a local, singular grocery store for sale. It generates a certain amount of revenue and profit and seeks a reasonable asking price, as its owners are looking to move on to other ventures or to retire.
Clearly, any company buyer seeks to get more money in the future than it invests today. Financial investors that buy equity in businesses include individuals, pension funds, insurance companies, hedge funds, and mutual funds. These institutions make investments on their own behalf or for others. Their objective is to realize a profit through appreciation in the value of the shares or other assets they buy.
The financial investor may consider purchasing a small grocery store as an investment. In doing so, based on current income levels, the return on investment might be 20 percent. (The purchase price in this case is expected to be five times net income, so the return is one-fifth of the purchase price, or 20 percent.)
Strategic investors include vendors, customers, or competitors. Just like financial investors, strategic investors look to make a profit on investments on behalf of their owners. A strategic investor, a large grocery store chain, is also considering the acquisition of the small, private grocery store. The large chain has advantages over the financial investor, however. Because it already buys from suppliers a lot of similar inventory (e.g., fruit and vegetables, meat and poultry, paper products, dairy products, canned goods, and other stocked items), it is able to extract concessions from vendors that result in lower prices and better payment terms.
The grocery store chain also has another store in the area, so its existing advertising coverage will allow it to eliminate the advertising expense for the smaller store after purchase. The larger competitor has an existing accounting department that can handle this function for the acquired store going forward, eliminating salaries for bookkeepers at the small store. And because less competition will exist in the area, the large grocery store chain may be able to raise prices at both stores. This combination of beneficial factors in a purchase by a strategic investor is called “synergy.” Due to the synergies associated with the deal, the strategic investor in this case, the large grocery store chain, might realize a 40 percent return on its investment (through an effective doubling of net income) if the price were the same as that proposed by the financial investor.
Alternatively, the chain might pay a premium to the financial investor’s maximum purchase price and still derive a superior rate of return. For these reasons, companies are generally better off looking for strategic buyers when looking to sell their business so that their owners realize maximum benefit.
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