Valuation Expectations – Buyers vs. Sellers
We recently surveyed the Axial Investment Bank membership on the topic of exit preparation and will be sharing the results…
One of the most important ways mid-market business can ensure competitive advantage is by harnessing barriers to market entry. Defined as obstacles that make it difficult to enter a given market, these “barriers” may come in the form of intellectual property and patents, difficult-to-replicate products, or even economies of scale (potentially achieved by an aggressive acquisition strategy). Not only can barriers like these protect a company’s market share, but can potentially make them a more attractive prospect to buyers in the future.
Types of barriers
There are three distinct categories of barriers to entry — market barriers, legal or regulatory barriers, and capital barriers.
Market barriers involve exclusive agreements, geographic locations, brand or trade names, distribution channels, trade secrets, relationships with consumers and suppliers, and proprietary programs or industry knowledge. Primary examples of market barriers include proprietary assets that are not readily duplicated, like Starbucks’ Clover brewing system and Tesla Motor’s Powerwall.
Legal or regulatory barriers involve any agreements, contracts, patents, trademarks, copyrights, government approvals, accreditations, regulatory approvals, and licenses.
Capital barriers included significant investment in fixed assets, high costs for regulatory certification, extensive research and development etc. A few main examples of capital barriers are high investment-protected brands like Microsoft Windows and Disney.
Creating barriers to entry
CEOs who are keen to manufacture barriers for their own companies would be wise to study up on the Warren Buffett model of the economic moat. The theory states that every business is a castle, and the moat protects the castle and its assets, profits and customers from new entrants. So if the moat is too wide for new entrants, protection is sustainable. Buffett lists several factors that widen this moat, including intangible assets, customer goodwill, and cost advantages.
Understanding a company’s intangible assets is the first step to creating barriers to entry. These assets include trade secrets, patents and copyrights, government approvals, licenses, proprietary software databases, exclusive contracts and distribution channels. Examples of intangible assets are brands that have definable “must haves” like the Sleep Number Bed and Amazon Prime.
Customer goodwill is just as important as a company’s intangible assets because it determines the real value of the offering. The factors involved in creating goodwill can include word-of-mouth referrals, testing (and guaranteeing) the reliability of products and services, and customer services that exceed expectations and compel consumers to rave about the company. Brands that go above and beyond may have entire departments committed to community engagement or dedicated corporate social responsibility initiatives that help them establish authenticity with their consumers.
Finally, having clearly defined cost advantages can help establish barriers to entry. For example, the high switching costs and networking advantages for companies like Verizon keep customers loyal and competing brands at a disadvantage.
Beyond competitive advantage
While certainly crucial for growing companies, barriers to entry are particularly advantageous for companies approaching a sale. How a company is positioned in a market and the potential risks associated with such a transition are two of the key things a buyer will look at when considering an acquisition. If a CEO can demonstrate that he has created high barriers for his competitors, therefore lowering the risk of losing customers once he sells and proving the potential for continued growth, he can drive up demand and value from the buyer and better ensure a positive outcome for himself and his company.
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