Value Driver #9: Barriers to Competitive Entry (Business Moat)

Circumstances that give a business an advantage over its competitors, strengthen its strategic position, or can be leveraged for future gain boosts business value. Why? Because it increases the probability of the continued future profitability of the business and decreases perceived risk by prospective buyers.

As with all value drivers, it’s all about risk. Lower risk achieves higher value. Buyers will pay a premium price for a business that has barriers to competitive entry.

One way to describe this Barrier Value Driver is to use Warren Buffet's term, "Business Moat." Buffet compares a castle's moat to the protection that a business needs to ward off encroaching competitors. For instance, the wider the moat, the more easily a castle can be defended. A narrow moat does not offer much protection and allows a castle to be breached. To Buffett, the castle is the business and the moat is the barrier that protects its competitive edge. The wider the moat, the longer you can protect your profits.

Understanding a company's competitive position is an important process in determining business value. Therefore, a business owner who is considering a sale should understand what can be characterized as moat.

The following are example barriers that widen moat and hinder competitors from breaching a company’s castle.

Intangible Assets

• Trade Secrets
• Developed Processes
• Proprietary Designs / Proprietary Know-How
• Patents / Trademarks / Copyrights
• Government Approvals
• Brand Names / Trade Names
• Hard-to-get Licenses (zoning, permits, regulatory approvals)
• Accreditations
• Engineering Drawings
• Customized Software Programs
• Step-by-Step Training Systems / Operations Manuals
• Customized or Proprietary Databases
• Published Articles or Industry Press
• Exclusive Contracts/Agreements with Suppliers, Distributors, etc.
• Contracts with difficult-to-penetrate entities (government, for example)

Customer Goodwill

• Is your product or service so much better than anyone else’s that your customers feel compelled to talk about it with others?
• Do you get a lot of word-of-mouth business and referrals?
• Do you provide guaranteed on-time delivery that makes you more reliable than anyone else and put money on that guarantee?
• Do you offer same-day service that makes you faster than anyone else in your market?
• Do you have a 99% success rate or other signifier that makes you better than anyone else in your market at getting the job done?
• Do you have 24/7 on-call service or other such practice that gives customers confidence that you go the extra mile?

Cost Advantages

1) An Efficient Business Model - The firm that can achieve the highest efficiency for the same service or product can widen profit margins over its competitors. Not only is the business model important, in some cases innovation rests not in the product or service but in the business model itself. Having the ability to transform with the market is key to staying on top.

2) Economies of Scale - When a company can effectively cut costs on a per-unit basis, this often gives it the flexibility to drop its prices (thereby attracting more customers), charge the same amount and pocket a higher profit, or some combination of the two. Spreading fixed costs over a larger production base is one way to generate operational efficiencies. Other ways include specialization of labor, reorganization of key processes, implementation of new technology, or the purchase of materials at bulk prices.

3) Niche Market Domination - “The big fish in a little pond.” Usually, the niche is only large enough to support one entrant profitability so it makes little sense for competitors to spend the capital necessary to displace the incumbent.

4) High Switching Costs - Switching costs are those one-time inconveniences or expenses a customer incurs in order to switch over from one product to another. If you've ever moved your account from one bank to another, you know what a hassle it can be--so there would have to be a really good reason for you to consider switching. We use Quickbooks and it would be a headache to migrate all our data and learn a new software product. Quick Books is so entangled in the day to day business operations of many small and midsize companies that it is impossible to easily change. The power of switching costs is evident in the annual licensing and maintenance fees. This brings the #1 Value Driver into play---Recurring Revenues!

5) The Network Effect - The network effect is one of the most powerful competitive advantages, and it is also one of the easiest to spot. The network effect occurs when the value of a particular good or service increases for both new and existing users as more people use that good or service. For example, the fact that there are literally millions of people using eBay makes the company's service incredibly valuable and all but impossible for another company to duplicate. For anyone wanting to sell something online via an auction, eBay provides the most potential buyers. For buyers, eBay has the widest selection. A company with a network advantage controls more territory than its competitors and the cost to displace it is prohibitive.

Got Moat? To determine whether or not your business has moat, follow these four steps:

1. Evaluate the firm's historical profitability. Has the firm been able to generate a solid return on its assets? This is probably the most important component to identifying whether or not a company has a moat.
2. Assuming that the firm has solid returns and is consistently profitable, try to identify the source of those profits. Is the source an advantage that only this company has, or is it one that other companies can easily imitate? The harder it is for a rival to imitate an advantage, the more likely the company has a barrier in its industry.
3. Estimate how long the company will be able to keep competitors at bay --it can be as short as several months or as long as several decades. The longer the competitive advantage period, the wider the moat.
4. Is the company in a highly competitive industry or is it in one that has only a few companies vying for customer dollars? Highly competitive industries will likely offer less attractive profit growth over the long haul.

AN OVERVIEW OF THE OTHER TOP VALUE DRIVERS:
Ten Value Drivers That Increase Sale Price of a Business

How Much Cash Does a Buyer Need to Purchase a Business?

There are two cash requirements to think about when you start thinking about buying a business.

1. How much cash do you have to use as a down payment on a business.
2. How much cash is required to close the sale and start out on a sound financial footing.

These are two different things. In addition to the cash you will pay the seller for the business, there will be a host of additional demands for cash. These issues should be taken into consideration when assessing your financial capacity. It will help you determine the price range of the businesses to target as realistic acquisition candidates. This is a general list and is not meant to be all-inclusive and not all may apply.

• Closing costs & escrow fees
• Legal filings & recording fees
• Attorney's fees
• Accountant's fees
• Appraisal fees
• Inventory counting service fees
• Sales tax on equipment purchased
• Vehicle registration & licensing fees
• City, County, & State Business licenses & permits
• Franchise license agreement transfer fee
• Franchise training fee
• Travel expenses associated with franchisor training
• Maintenance expenses
• Correction of code violation(s)
• Landlord lease deposit
• Utility deposit(s)
• Property liability premiums
• Workers compensation insurance premiums
• Operating cash / working capital
• Cash to fund credit sales

Earnouts - How and Why are They Used in a Business Acquisition?

An earnout is a type of payment agreement which is sometimes used in a business acquisition. Under an earnout agreement, the seller receives part of the purchase price up front, and additional funds over time. The terms of the earnout are written into the sales contract.

An earnout can be used for different reasons:

To tie the acquisition payout to future performance

An earnout, in a business acquisition context, is an arrangement in which the buyer doesn't pay the entire purchase price up front but agrees to pay a certain amount now and more later depending on how well the business performs in the future.

To bridge the pricing gap

If there is a valuation gap between the buyer and seller, and there always is, it is a way to bridge the gap. The seller may be placing a heavier emphasis on the company's projections, and the buyer placing most of the company's value on its present and past performance. An earnout agreement is a useful tool to get the deal done. In an uncertain economic climate, there may be more willingness to take the wait-and-see option offered by an earnout-structured acquisition.

To mitigate risk factors

A form of escrow account can be established to mitigate certain risk factors inherent in the business, such as customer or product concentration issues or a down revenue trend. Funds will be paid out conditioned upon meeting certain thresholds over a defined time frame.

PROS

From the buyer's perspective, earnouts obviously reduce the initial cash payment and provide a level of insurance by minimizing the risk of overpaying for future revenues and profits.

From the seller's perspective, they are able to structure the transaction to realize the level of value that they think is in the business if it performs as they believe it will. It allows the seller to feel that they aren't leaving any upside on the table. Earnouts can also provide a vehicle to defer taxes.

CONS

From the buyer's perspective, integration issues are of paramount concern. Earnouts don't work if the buyer plans to significantly change or meddle with the operation after the acquisition.

From the seller's perspective, the seller is delaying their receipt of full payment and is dependent on the financial health of the buyer. They also run the risk of unforeseen circumstances and disputes surrounding the earnout if operational changes are made that interfere with the ability to achieve earnout targets.