Optimal Buyers

This page discusses optimal buyers, a foundational element in the Fair Commission Model.

For a firm with goodwill to have any value there must be qualified, competent and willing buyers who will pay more than the value of the firm’s net tangible assets. In almost all sales of such firms the departing owner will no longer be active in the management of the firm or direct provision of services to customers, clients or patients (CCPs) beyond a usually short transition period. Not only do the buyers have to convince the seller’s transferred CCPs to keep patronizing the firm, they have to replace the labor and managerial hours previously provided by the owner manager. The replacement labor also has to be of sufficient skill and experience to provide the quality of services or products the prior departing owner provided. Buyers that are most capable of exploiting the value of goodwill of a firm are likely to be operating at either a larger or smaller scale rather than an equivalent scale to the seller.

Buyers operating at similar scales to the seller may be interested in merging with the seller under the assumption of continuing involvement of the owner, but they often are not in a good position to acquire the seller outright because they lack the additional skilled personnel to service the acquired CCPs. In all likelihood they would have to go out and hire a replacement for the departing owner/employee and this may prove challenging. A larger firm with excess labor capacity may be in a better position to exploit a seller’s goodwill because they often can service the acquired CCP’s base without having to go out and hire new employees.

A smaller buyer may be in an even better position to acquire a larger seller because the smaller buyer may have excess labor capacity to service CCPs. Often an optimal buyer is currently an employee of the seller or an outside employee seeking the opportunity to become a small firm owner.  

Financing Capacity

Buyer financing capacity looms large in determining the ultimate equity exchange price for a firm. In the end even if a buyer can gain significant competitive advantage by acquiring a firm, it matters little if they cannot afford to pay a fair price for the equity. This issue is particularly acute in the realm of small service sector firms, where the largest and most valuable asset is the intangible goodwill. Few third party lenders will recognize this intangible asset for purposes of collateralizing a loan to finance the equity acquisition of a small service firm. Some buyers will have more personal resources and better credit to obtain financing than others, and this will certainly be a factor in determining which buyers are in the best position to acquire a firm.

If the value of the goodwill is large and the best qualified and motivated buyer has insufficient personal resources to finance a reasonable equity purchase price, seller financing will be required. This is not an infrequent occurrence in service sector markets.

Buyer Motivations

It might seem axiomatic that every competitor firm in a local market seeks unlimited CCP growth. The reality is far different. Many successful small service firms are decidedly not interested in significantly growing their CCP base beyond current levels. The reasons for this are obvious. First, significant expansion is risky because it may not be sustainable. Second, CCP base expansion inevitably entails increased burdens on the owner. These burdens may include the need to hire and supervise more staff and/or provide more direct service labor themselves. This is also another reason why the most motivated buyers will either have smaller CCP bases than the firm or significantly larger CCP bases. A smaller buyer just starting out has the room to grow. A larger growth oriented firm already has excess labor capacity or can afford to invest in added resources with less risk from underutilization of new hires.

Even larger potential buyers may not be motivated to acquire immediate access to the entire available CCP base of a selling firm. Such firms often seek to cherry pick only those CCPs that would be willing to pay more for services than they presently do or those CCPs who utilize only the most profitable services offered.

The Optimal Buyer

Each potential buyer will have differing capacities and motivations to exploit the immediate access to CCPs that a firm with goodwill can provide. The value of goodwill must always be specified relative to the capacities and motivations of a specific buyer. In most local sector markets there are only a few potential buyers and they tend to have similar characteristics and motivations usually dictated by the scale of their operation. Usually it is not hard to identify which of the potential buyers are in the best position to fully exploit the competitive advantage from buying a firm with enterprise goodwill. The optimal buyer can:

  • Provide the level of service or product, convenience and price that will convince the greatest proportion of transferred CCPs to keep coming back despite the change in ownership.
  • Extract the most discretionary earnings from the future patronizations of these returning CCPs.

Exit Planning: Finding an Optimal Buyer before They are Needed 

Any current owner of a firm with goodwill should try to identify and lock in their optimal buyer well before they intend to sell. They should not count on finding the optimal buyer  when they decide to retire because the available buyers may not be that optimal from your point of view. Because of the challenges of finding a buyer with the right combination of competence and motivation to operate and exploit goodwill, such a buyer may be hard to find just when they are needed. In fact, among existing competitor firms it may be in their collective best interest when an owner retires to see that no one is there to buy the firm so that the cluster of CCPs will be available for the taking without having to pay for having immediate access to them.

In the service sectors there is a specialty field known as exit planning that assists owners of firms with enterprise goodwill to find an optimal buyer before one is actually needed. By far one of the most common recommendations of exit planners is to hire, train and motivate an employee or group of employees to acquire the equity of the firm when the current owner is ready to retire.

For more on exit planning click here.

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Copyright 2018 Michael Sack Elmaleh