Evaluating and Acquiring a Game Company
Overview
Tom Sloper
<tomster@sloperama.com>
The information in this article is based on the steps taken in evaluating a potential acquisition that did not come to fruition. By reading this article, you will learn about the various processes involved in evaluating and
eventually acquiring a company.
The Target Company and You
The process begins when you find a company you think you would like to buy (or when the company's current owner thinks he would like to sell it to you). A preliminary conversation sets things in motion. You and the company's owner discuss whether a deal can occur, including a range for the acquisition price. In our case, the business' owner initiated negotiations. An initial meeting revealed that the seller's target price was twice what the buyer had in mind, but the parties did agree that they would probably be able to negotiate a deal in that range.
The Emotion Factor
The first thing to keep in mind as you begin the acquisition process is that emotions play an important role in acquiring a business, both for the buyer and for the seller. The buyer is buying a job, a new career, almost a new persona. The seller is selling the product of many years' hard work, and he wants to see the business go to someone who will work equally hard at keeping it successful.
It's important, though, that you not allow your emotions to win over your better judgment. If the deal is going to cost too much or otherwise turn problematic, you need to be prepared to walk away from it.
The Business Plan
The first step once you've decided to acquire a company is to work on your business plan. As explained in Article 4.2, "Managing the Development Process," you have to make a plan.
The business plan is not only a document that you will use to define what you will do with the company. It is also a plan used to get capital for acquiring the business. Your business plan also helps you set priorities and define, in concrete terms, the reasons for (or against) acquiring this particular business.
Without a solid plan, life usually conspires to prevent you from getting where you are trying to go. The very act of planning, though, lays the groundwork for a flexible approach to a process. Almost assuredly, things will work out somewhat differently from your well-laid plan, but you absolutely must have a solid plan before proceeding.
The process of developing the initial plan helps later on, when the plan has to be adapted to deal with changing circumstances.
Outlining the Plan
In the first section of the plan you should describe your plan for the business itself.
Describe the company, its products and services, its focus.
Accomplishments of the company under the current ownership.
Growth opportunities under your ownership after acquisition.
Marketing aspects:
Who the company's customers or clients are.
Your plan to step in and take over those relationships—how you will keep them and strengthen them.
What steps you will take to get more clients.
How you will maintain the balance, not taking on more than you can handle.
The competition:
What other companies are doing what this company does.
Strengths and weaknesses of the competition. What lessons can be learned from those competitive operations.
Your plan to make your company successful and unique in that competitive environment.
Analyze current trends, and their implications for your venture.
Operating procedures:
Location: Where you will operate the business, and why.
Space: What kind of space the business needs.
Accessibility: For employees, for clients, for courier services, etc.
Hours of operation.
Building security.
Personnel and staffing:
Job descriptions and job titles: Number of employees in each. Name the employees if possible.
Salaries, benefits.
Staffing schedule.
What is the "business personality?"
Transition plan: When the acquisition occurs, will you be suddenly replacing the current president, or will there be a gradual transition?
Goals and objectives.
Future opportunities.
Risks: You have to be brutally honest in considering what kinds of things could go wrong, the likelihood of them happening, and what some contingency plans might be in case they do happen.
The preceding is a very brief description of what goes into Part I of your business plan. It is recommended that you get a good book on business plans; see this article's References section for suggestions.
Financial Data
Part I is written in prose style, but Part II of your business plan is presented in spreadsheets, charts, and graphs. Here you get into the real nuts and bolts: how much it costs to run the business, and how much money is to be made.
First, analyze and show the financial history of the company under current ownership. Banks want to see at least three years' history, and they want to see a pattern of profitability. If the company has not been profitable, then they'll see it as a bad risk. If you have a plan for turning that around, it had better be a really good
one—and very convincing. You'll have to overcome skepticism and (worse) entrenched bank policies.
Analyze what it costs to run the business per month, per quarter, and per year.
Personnel costs: Salaries, benefits, raises Office rent or building purchase payments
Utilities and ongoing expenses: Electricity, gas, water, trash removal, cleaning service, telephone, internet access, Web hosting
Capital expenses:
Computers, printers, scanners
Telephones, faxes, answering machines
Teleconferencing equipment, projectors for presentations Desks, chairs, filing cabinets, credenzas
Conference tables, chairs
Coffeemaker, refrigerator, microwave, toaster Supplies:
Printer ink, printer paper Pens, pencils, erasers, staples Batteries
Coffee, sweetener, creamer, filters Cleaning supplies
Analyze where the money comes from: development milestone payments, royalties, direct sales How much
How often Break-even
Desired profit margin Profit & Loss analysis
Year One—per month
Year Two—per quarter Year Three—per quarter
Evaluating the Company
A company evaluation might or might not be part of the business plan document itself, but you need to evaluate the business. This can be a difficult part of the process, because no two companies are alike, and standard guidelines you might find won't necessarily apply. Each bank uses its own valuation methods, and nobody wants to tell you what his or her method is.
In this case, three different valuation methods were used and then averaged together. The three methods were as follows:
Thirty percent of annual sales (Source: [BizStats02]).
Five times EBIT (Earnings Before Interest and Taxes). (Source: [Robb95]) Earnings (EBIT) times two, plus inventory. (Source: [SCORE02])
The desired and maximum purchase prices were set based on the average of the valuations yielded by these three different methods.
Adapting Valuation
The target company is a retail game business, so the valuation methods that were used were based on factors such as sales and inventory. Different valuation methods should be used for a game development company.
The concept of EBIT (Earnings Before Interest and Taxes) applies to any business. Put succinctly, EBIT represents all profits (income minus deductible expenses) before interest and income taxes are deducted.
You will also need an asset breakdown: what exactly are you buying, and how much is every piece of that puzzle worth. A little creativity might be needed here, because it is likely that some of the price that will be paid will be above and beyond the tangible assets. That "above and beyond" money is usually called "goodwill."
However, if your loan goes through the U.S. Small Business Administration (SBA), there cannot be any goodwill built into the purchase price. Therefore, you have to find other reasonable assets and assign them value. An example of such a valuable but intangible asset is a Non Compete Agreement, which states that the current owner or president cannot start a new game company (taking the most valuable employees with him) and compete against your new enterprise for at least two or three years. Determine how much such an agreement might be worth, and add that to the asset breakdown. Or perhaps the current owner will agree to consult exclusively for you for the first two years after the acquisition.
Figure out your capital spending plan. How much money do you need to buy furniture, equipment, business licenses, office lease deposits?
What is your "startup nut?" How much money do you need to buy the business and run it until you're past the transition period and the company is making a profit?
These figures tell you how much of a loan you need. You will be expected to inject some of your own capital into the acquisition. Expect this to be at least 25 to maybe 30% or more, depending on bank policy.
Figure in the loan payments into your Profits & Losses and Cash Flow statements. The interest payments go into the P&L, while the principal payments go into the Cash Flow.
Completing the Picture
Part III of your business plan is all about the current owner and you. The business plan needs to paint a complete picture of both parties of the deal—the buyer and the seller—and why the banks should want to loan the money for the deal to happen.
The banks want to see that you are stable, capable, reliable, and responsible. You have to have an up-to-date credit report and FICO score. A FICO score is a number that rates the individual's likelihood to repay a loan. A high number means you are a good credit risk. Use myfico.com, equifax.com or one of several other Web sites to obtain this data. Each bank will also have its own Personal Financial Statement forms they'll want you to fill out. They're taking a big risk on you, and they want to feel comfortable about taking that risk.
Other supporting documents that will need to be attached to the business plan are your résumé and the company résumé of the acquisition target. Specifically, you will need to include the past three years' corporate tax returns for the acquisition target, as well as your own personal tax returns.
Putting the Plan to Work
Your business plan is finally done. It's a masterpiece, and it was hard work to write. Still, in the end, the business plan is just a tool. Once you have written the plan, it's not like everything else will fall into place.
However, completing the plan is an extremely important step in the process, and you should give it your best effort.
Getting the Loan
There are various sources for obtaining business loans, including the Small Business Development Center (SBDC) and your local bank. The SBDC program is administered by the U.S. SBA. Their mission is to provide management help to small business owners (those who currently own or are working to own small businesses).
However, going through the SBA is usually very slow, and it seems that the program is geared primarily to aid minorities and veterans.
As mentioned before, one of the major documents required by the banks is tax returns for the company you are purchasing. Companies need to have at least three years' worth of tax returns in order to be considered stable, and our target company only had two years of returns. You need to check with your bank or financial institution to determine exactly what paperwork they require, but keep in mind that it's a long process that requires a lot of follow-up.
Contracts and Due Diligence
Another major part of the purchasing process is the contract and due diligence review. There must be a Buy- Sell Agreement between the buyer and seller. This agreement should cover all the rights and obligations of both parties, including delivery of intangible assets covered in the Asset Breakdown as mentioned previously. It's a truism that the seller is the one who controls the price, but it's the buyer who controls the terms. Although a particular business is offered for sale, there won't be a sale if the buyer doesn't come up with the seller's desired price. Once the seller agrees to an offer, though, it's the buyer who holds the position of strength; the money won't be changing hands if the seller doesn't agree to the buyer's terms.
"Due diligence" means that the buyer has accountants and other experts in the area review all business
documents to ensure that they are factual and reflect the actual costs and revenues of the company. If anything is found to be false during this phase, the deal can be canceled, or the seller might be given time to remedy the problem. Do not underestimate its importance; many high-profile corporate mergers collapse at this point.
Advisors
Typically, you should have a CPA, a lawyer, and a businessperson as your advisors.
You should seek a CPA who is familiar with business acquisitions. The same goes for your lawyer. You probably don't need the lawyer until you are ready to write the contract, but you should at least get him lined up in advance. The CPA you will want even earlier in the process—you'll want his feedback on your business plan, before sending it out to banks.
SCORE stands for "Service Corps Of Retired Executives." These are folks who have learned a lot about business and volunteer their time to help neophytes in any way they can. A SCORE counselor can help you evaluate the target business, for example.
Good advisors are tremendously important. When the result of an action comes back, you have to make a decision, and quickly. The thinking of others will be extremely valuable in this process. Each advisor adds his perspective on the matter. These different points of view will help you arrive at a better-informed decision than if you just proceed based on your gut reaction. In our case, although the buyer very much wanted to buy this business, there was group consensus that this deal was not going well. Intellect wound up winning over heart.
Conclusion
Buying a business is a good way to become a business owner. However, emotions can get in the way of making the best decisions, both for the seller and for the buyer. As with any important venture, planning is vital.
You'll need money to buy a company, and if you're not a minority or a veteran, perhaps the conventional bank business loan might be better than trying to go through the SBA.
References
[McKeever99] McKeever, Mike, How To Write A Business Plan, Nolo Press, 1999.
[Bischof&Pucket96] Bischoff, William R. and Pucket, G. Douglas, Guide To Buying And Selling A Business, Practitioners Publishing Co., 1996.
[Yegge96] Yegge, Wilbur M., A Basic Guide For Buying And Selling A Company, John Wiley & Sons, 1996.
[Robb95] Robb, Russell, Buying Your Own Business, Adams Media Corporation, 1995.
[BizStats02] BizStats.com, "Rules Of Thumb For Valuing Small Businesses," available online at www.bizstats.com/rulesofthumb.htm, 2002.
[SCORE02] Service Corps of Retired Executives, available online at www.score.org, 2002.