THE STORY
One day, Bob was sitting in his garage. Suddenly, his neighbor Joe was running towards the garage. Joe quickly looked around Bob’s garage and noticed a shovel.
Panting from being out of breath, Joe said to Bob, “I’ll give you $1000 dollars for that shovel.”
Bob replied, “Are you crazy? That shovel is hardly worth $10. Why you can get a brand new one at Home Depot for less than $30.”
Joe said, “I need a shovel right now. Will you sell me yours for $1000?”
Bob answered, “Sure, Joe, you can have it for $1000.”
Before Bob could finish his sentence, Joe had tossed $1000 at Bob, grabbed the shovel and ran.
At the time, Bob thought Joe was crazy for paying so much for his shovel. But he soon forgot about it.
A week later, Bob saw Joe driving a new expensive sports car. Bob asked Joe how he could afford such an expensive automobile. Joe replied, “I used that $1000 shovel to dig up a treasure chest that was full of millions of dollars of gold and jewels. If I hadn’t had a shovel at that exact moment, I would have missed the opportunity to dig up that treasure chest.”
Suddenly, the idea of paying $1000 for that shovel didn’t seem as crazy to Bob anymore.
THE ANALOGY
The value placed on an object can vary significantly between people. Bob thought his shovel was worth about $10. Joe gave it a value of 100 times that price.
Why such a big difference? Bob looked at his shovel as a standalone object. He knew that new shovels were worth about $30 and that he had an old shovel. Therefore, Bob figured that the worth of the object was about $10.
By contrast, Joe looked at the shovel as a capability tool. If used immediately, that tool would give him the capability to get a treasure chest worth millions. It was well worth paying $1000 to get access to millions.
Successful business acquisitions depend on an accurate assessment of value. And often times, the greatest value is not in the standalone business being acquired (the “shovel”), but rather the value of the capability it gives you (access to the “Treasure Chest”).
Therefore, if you want a great return on your acquisition investment, the best path can be to first have a strategy to locate treasure chests. Then acquire whatever tools are necessary to dig up that chest.
Otherwise, you can be like Bob. Sure, he paid a lot less than Joe for that shovel, but when Bob had the shovel all it did was sit in his garage. The return on that $30 investment for Bob was worse than the return Joe got with the same shovel for which he paid $1000.
THE PRINCIPLE
The principle here has to do with capability planning. I think this is an under-emphasized part of the strategic planning process. People love to spend time talking about financial targets or market positions. These are fun topics. However, unless you have the right capabilities in place, those financial targets and market positions will never become a reality—no matter how much you talk about them.
Capabilities can cover items such as technology, patents, expertise, distribution capacity, access to raw materials, access to scarce talent, access to real estate, access to legal rights, and so on. You could have everything you need except one of these items and fail miserably—because none of the rest of it works unless you also have that missing piece. It could be something small, like a shovel, but if that missing piece keeps you from the getting the treasure, then merely knowing where the treasure is can be worthless.
The Problem With the Standalone Approach
Most acquisitions are looked at primarily as standalone business opportunities. Sure, one factors in a few synergies, like reductions in overhead and overlap, but the vast majority of the value is typically from the business itself.
But here is the problem with that approach. First, you have to pay a premium to get the business. Depending on the industry and the time in the business cycle, that premium can be on the order of 30% or more.
Second, to make that acquisition worth doing, you need a return on investment which exceeds your cost of capital. In other words, if you pay 30% more and you earn 30% more, all you have done is break even. And that is an unacceptable return. Depending on your balance sheet and the time of the business cycle, your stakeholders may require an additional 10% improvement or more.
In the end, this means that the only way that a standalone business is worth acquiring is if you can get 40% more out of it than the so-called experts who are already running the business (I spoke about this in more detail here). Remember, if it were easy to make such a large improvement, why aren’t the current owners doing so?
A few reductions in overhead or overlap rarely are enough to fill this large of a gap. And the gap may even need to be larger than 40%, because most acquisitions have some built-in dis-synergies which also need to be overcome. An example could be customers who no longer want to buy from the company after it is acquired because they don’t want to do business with you. I spoke more about these dis-synergies here and here.
The only way to assure that you can cover a 40% gap is to look outside the standalone business. You probably need to create an entirely new business to supplement the old business to cover the gap. In other words, the only way you can afford to overpay for a shovel is if you can use the shovel to obtain new treasure.
As long as you focus on positions or profits, you will look for acquisition targets that have great positions and/or produce great profits. And those are the targets which will typically have the greatest premium prices and the lowest potential for you to come in and cover the 40% (or more) gap.
The Benefit of Capability Planning
Capability planning looks at acquisitions more as a means rather than an end in themselves. The prize is not the acquired business. No, the prize is the separate hidden treasure which can only be obtained if the acquired firm is used as a tool to reach it. It is the capability value, not the operational value which makes the acquisition worth doing.
Consider the Pringles potato chip business. Proctor & Gamble has been disappointed with this piece of their portfolio for a long time. They have tried to find ways to get rid of it for literally decades. The fact that P&G could not sell it for such a long period implies that there was not enough inherent in the standalone business to ever justify paying a premium. The gap could not be covered.
But then along comes Kellogg. They see a buried treasure—international growth for their Keebler snack business. Unfortunately, Kellogg is missing a key capability—access to powerful global snack distribution. Pringles has that capability. It is the shovel that will help Kellogg get to their buried treasure. There is probably more value in Pringles as a distribution capability for Kellogg than as a snack business. Therefore, Kellogg can afford to pay for Pringles when others could not. They can cover the gap, because they have an addition treasure beyond what Pringles offers as a standalone business.
Therefore, rather than developing “Business Acquisition Strategies” focus on “Capability Acquisition Strategies.” And don’t forget that many times you can obtain access to the capability without having to buy a company (and pay the huge premium). This opens up more options, like start-ups, aggressive hiring, strategic alliances, licensing, and so on.
Acquisition is just one way to get capabilities. As long as you see acquisitions as a means, rather than an end, you can compare it to alternative means for obtaining that end. This can lead to superior strategic moves.
SUMMARY
Most acquisitions destroy shareholder value. One of the reasons is because there is not enough of an opportunity within the core business to increase the value to cover the premium and the return on capital requirements. Therefore, if you want to create value with acquisitions, start first by looking for treasure beyond the core business. Then look for acquisitions which are a tool to get to that treasure.
FINAL THOUGHTS
There’s the old story that for the lack of a nail, a shoe was lost. For the lack of a shoe, a horse was lost. For the lack of a horse, a battle was lost. For the lack of a battle, a kingdom was lost. When you look at that big picture, it makes that nail appear pretty valuable. Strategists love planning out the big battles, but if the capability to put nails in the horseshoe is missing, it can all be for naught.
Often times the great leaps in value can come from these capability issues which at first appear minor or are often overlooked. Don’t overlook capability planning in your strategy work.
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