The Maximum Competitive Advantage

This page introduces the concept of maximum competitive advantage.

If we accept the idea that a buyer should only compensate a seller for customers, clients, or patients (CCPs) that “transfer in”, and only for as long as they continue to patronize the buyer, then we must agree that from the buyer’s point of view there is a maximum competitive advantage (MCA) to buying the seller’s firm to access their CCP base. Both the seller and the buyer realize that only a certain fixed number of the seller’s CCP base will heed the recommendation to continue patronizing the firm under new ownership. They also know that only a certain amount of discretionary earnings (DE) can be extracted from each transferred CCP. Finally, both seller and buyer realize that of those CCPs who heed the departing owner’s recommendation, virtually all will at some point stop being a CCP of the firm. This inevitable attrition will be due to dissatisfaction with the new ownership or more “normal” factors such as death and relocation. So the seller and the buyer realize that the total amount of DE that can be extracted from the transferred CCP base has a theoretical upper limit.

The Maximum Competitive Advantage Depends on the Buyer

The MCA,  this upper limit of DE, will not be the same for every potential buyer. Some buyers will prove more capable of extracting DE from the customer base than others. The degree to which a buyer can retain CCPs and their efficiency in extracting DE will certainly vary. In any given local market there will always be one type of buyer who is capable of extracting more DE from a CCP base than any other and this buyer is the optimal buyer.  Click here for more on optimal buyers. From the seller’s point of view this is the buyer that should be able to supply the highest bid for the firm.

Example: Suppose a small plumbing company has 450 customers. Assume the optimal buyer is a long term skilled employee of the firm. This employee expects that 400 of the customers will accept the selling owner’s recommendation to continue utilizing the firm. Based on past history the buyer can expect an attrition rate of about 5% per year. Further assume that based on past history the DE per customer per year will be $500. A 4% time value discount factor is utilized to convert all future DE to a present value.  Click here for more on present values. Here is the computation of the MCA for this buyer:

Thus the MCA is about $1.2 million. However, a few points need to be stressed. First and foremost the MCA is not the rational and fair price that the buyer should be expected to offer. The MCA represents the total expected DE that might be extracted over the life of the CCP base given realistic transfer, DE and attrition rates for this particular buyer. The MCA is computed before taking into account the amount that the buyer will have to be paid to the seller. In other words the computation assumes that no amount will have to be paid to the seller. This is of course not going to be the case so that the MCA computation should be looked upon as a starting point for the negotiation of a fair equity price. The MCA should be viewed  as determining the size of the pie that would be divided up between the buyer and seller in the negotiation leading to an equity exchange price. At one extreme if the buyer offered nothing to the seller they would keep the entire MCA. At the other extreme, if the buyer offered the exact MCA value, nothing would be available to them in DE. The MCA is simply a starting point for negotiation of a fair equity price.

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