Value Gen: Transitioning the Core Business
In search of higher multiples, investors and their advisors are increasingly pressuring companies to transition their core business to match “themes” that earn higher valuations. For instance, businesses that would rightly be described as professional services with just a hintof a technology base – such as a staffing service with a proprietary database – become “technology enabled business services.” A transition can be extraordinarily valuable if completed successfully. The question for prospective acquirers is how you can tell when a company is transitioning its core business.
We start by defining three different types of businesses:
- Core businesses involve three factors:
- It is not dependent on other revenue-generating activities to grow
- It is what customers, distributors or other partners will tell you the company “stands for”
- It is nearly always the area in the business that generates the highest cumulative per-customer profit (defined as Customer Lifetime Value minus Customer Acquisition Cost)
- Non-core businesses will never scale relative to the core business, either because they are dependent on the core business or because they are otherwise growth-constrained
- Prospective new-core businesses may not yet have scaled to rival the core business, but there is no good reason why they cannot
Of course, companies can grow to have multiple core businesses so not all discussions involve transitions; we are focusing on those cases where “old core” has truly become old and that a current management team is seeking to transition to a new-core business.
Successful transitions from core to new-core – IBM’s transition into focusing on a professional services offering is a classic example – often take years of effort. Companies that shortcut the process tend to pay a price. To illustrate, take Netflix’s decisions to split its rental-by-mail business from its burgeoning new-core streaming business in 2012. While CEO Reed Hastings clearly believed that the core business could be transformed overnight, enough customers still believed that Netflix = DVDs that their revolt caused Netflix to halt the split. It would essentially complete the split years later (to become dvd.netflix.com), but the core business first had to be slowly displaced by the new-core.
In advising prospective investors, we ask two questions:
- Is this an attractive new-core business?
Here are five determinants of core business value (as outlined in our 2018 Diligence Matters™ toolkit):
- How significant of a problem does the business solve?
- What gives the company the authority to solve the problem successfully?
- Is there anything that threatens the problem?
- Is there anything that threatens the solution?
- Is there anything that threatens the economics?
- How quickly can the company transition to the new-core business?
Multiple factors can increase the speed with which a company makes the transition:
- High demand and low adoption hurdles for the new business as it addresses a significant challenge
- The new-core business enjoying weak competition or high differentiation in its market segment
- High overlap in customer segments between offerings
- High ability for the new core to be “sold into” the same situations as the old core and therefore ultimately displace the old core – for example, when customers or distributors place the products in the same consideration set or budget
- Well-conceived and aggressive transition plans for the old core
Whenever we evaluate a business in transition, we always challenge ourselves to carefully define the core business today, and the new-core that is targeted. We ask ourselves, how quickly is the business prepared to make that transition? And, can a new owner and management team increase the speed as part of the value gen plan?
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