Diversification (Part II)
3 QUESTIONS BEFORE DIVERSIFYING
“Asking the right questions takes as much skill as giving the right answers.” Robert Half
In 1995, I acquired a large landscape maintenance company that I sold in 2005. My
original plan was to buy it, fix it, grow it, and sell it in only five years for a handsome
profit. The company was unfocused, poorly managed by an absentee owner, and was
ripe for improvement. I already owned a commercial tree care company that had grown
well and was consistently profitable. It appeared that, in the meantime, it would be a
natural compliment to my present operation. This provided an interesting challenge and I
prided myself on my ability to establish a management team, create a sales force, and
manage a company profitably. It didn’t occur to me that what I knew, which was
sufficient to expand an existing business, might not be enough when diversifying into a
different business.
I wrote a plan, ran it by other businesspeople, and had no problem attracting investors. It
wasn’t clear, when things gradually went awry, if my management skills were less
impressive than I thought, or the fault was in my decision to diversify my company. In
reality, neither was true. When I was making the decision to diversify, I just did not
possess the correct criteria on which a good decision would be based.
My previous newsbrief, Four Strategies of Diversification, will help you decide what
kind of company your diversified enterprise should be based on your resources and
capabilities. This newsbrief focuses on whether a particular new business should be
started or acquired in the first place.
Business owners diversify their companies for many reasons. Some of these reasons are
to:
• Spread the risk
• Spread the company’s overhead among more profit centers
• Pursue a venture much more profitable than the existing company
• Even out seasonality
• Initiate a more aggressive growth plan
• Lower overall costs by acquiring a primary supplier
• Guarantee a market by acquiring a primary customer
• Increase sales per customer by introducing the customers of an acquired company
to the existing company’s service, and vice versa
• Share activities between entities (e.g., office staff) or to transfer skills (e.g.,
marketing) with the new business that will create a strategic advantage and higher
margins for the company
Although these are all reasonable rationales, the reasons you choose to diversify should
accomplish the purpose of owning your company in the first place – to increase its value.
This is covered thoroughly in my newsbrief The Purpose of Your Business.
If you own a business, invariably you will wish to diversify at some point in the future.
The following three questions determine whether a particular new business should be
acquired or started.
Question #1 – How desirable is the industry and business? The return on investment for
competing in a business depends on the industry structure. (Industry structure is
discussed in my newsbrief titled The 5 Forces.) A desirable business is desirable because
it can produce and sustain superior margins. But superior margins are only available
when there are entry barriers that keep competitors from flooding in and diluting your
profits. Also, too much control by customers will force your prices lower, and too much
control by suppliers will push your expenses higher.
Diversification can only be successful in adding and sustaining profits in your company if
the industry is favorable. It is common to mistake rapid growth potential for an attractive
industry. Rapid growth will not equate to superior and sustainable profits if the industry
structure is not favorable and stable.
Question #2 – How will you be better off? You could improve the value of your
company and be better off in a couple of ways. The business you acquire might benefit
from your existing operation. Likewise, your existing operation might benefit from the
acquired company. Either way, the advantage should be skillfully forecasted and
weighed by how the growth and profit performance of the combined entity will be
improved compared to the non-acquisition alternative. These added profits might come
from either entity, or both, due to contributing benefits such as developed distribution
channels, an existing sales network, more efficient operations, or marketing prowess.
When the benefit from an acquisition is a one-time (or short-lived) benefit due to
improvements like installing new management, overhauling the company, or
implementing a new strategy, it might be better to then sell the business to capture the
full short-term benefit and then free up corporate assets. Companies should be kept long
term only when they can sustain above average profits, because the parent company must
invest in additional overhead to support the acquired company.
Question #3 – Weigh the cost of entry. If acquiring a company is too costly, future
profits may not be sufficient to overcome the acquisition costs and still provide above
average margins. Market forces tend to create equilibrium over time where prices for
acquisitions are pushed up to the highest levels. One reason is multiple bidders.
My expansion from tree care into landscape maintenance can be evaluated as follows:
Question One: Was the market attractive? The landscape maintenance industry is
fragmented – there are many small companies, no one is in a position to grow much
larger than the pack, and competing on price is common. Since customers have so many
choices of who to use, they substantially control the prices that can be charged.
Furthermore, many significant costs such as equipment, landfill, fuel, and insurance are
beyond a company’s control and they rise steadily each year. This brief sampling
illustrates that the industry might not have been as attractive as other choices.
Question Two: Was I better off? The acquired company and my original company were
both immediately better off due to the acquisition. Many of the above reasons to
diversify applied and were exploited to the greatest extent possible due to our combined
resources and capabilities.
Question Three: Weighing the cost of entry. I bought the company at a low enough price
and we made the improvements necessary to earn an excellent profit, so the cost of entry
was not a burden.
If I had been given the knowledge of these three questions in advance, along with the
Four Strategies of Diversification from Part I, I would have approached the decision to
buy the company differently. Passing only two of the three questions might have offered
up a “no buy” conclusion. Since my interest was to only own the company for a few
years, my original strategy was to capture the value for a while, increase its value and sell
it (restructuring strategy). The problem was that I defaulted to a portfolio strategy when I
did not follow through and sell the company. But I did so in an industry that was not
ideal for a long-term return on investment. My opportunity for the best profits from the
acquisition and turnaround diminished each year because it became necessary for me to
invest heavily in an equipment-intensive business where margins were low due to the
industry’s fragmented nature. It also consumed resources from my core, the more
profitable tree company, which then limited its potential.
Entrepreneurs, as well as leaders of the Fortune 500, who don’t adhere to such an acid
test, have their acquisitions either under perform, or fail dismally. Given these strategic
insights, you can see from my example that I could have not only improved the return on
investment for me and my investors with a restructuring strategy, I could have chosen to
repeat the process several times in those ten years. My results rested on what I failed to
know about how to test a good acquisition candidate, and then how to align my
company’s resources and capabilities with one of the four strategies of diversification.