The Business Creation Approach

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The Business Creation Approach

“Providing integrated solutions towards a company’s redundant assets”

University of Groningen Faculty of Economics and Business

Amsterdam, 15 June 2010 Author: Casper Spiers (s1400991)

Student Organizational Management & Control Thesis supervision

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Abstract

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Preface

This thesis has been written during (and after) a six months internship at Business Creation B.V. in Amsterdam. In this master thesis I conceptualized Business Creation’s business model. In order to do this, I analyzed the Business Creation approach in the market of divestments from financial investment perspective. The goal is to provide Business Creation a framework from where her business model could be further developed in the future.

I am very grateful I was able to do my graduation project at Business Creation B.V. It was great to experience the entrepreneurial spirit while working for a dynamic company like Business Creation. It was very interesting to combine my graduation project with certain redevelopment projects. Thus, I learned about the Business Creation approach from a practical point of view. The experiences on brainstorm sessions with business experts about implementation of new business and searching for potential leads in a redevelopment project have enlivened the Business Creation approach to me. I owe Business Creation and all the people I have worked with a big thank you for a very interesting and enjoyable time.

I also would like to thank some persons in particular. The first is my personal coach Andreas Ezinga. With his critical comments and suggestions, his motivating words and by offering his time, he really was of great help. I also would like to thank my supervisor from the University of Groningen, Dr. W. Westerman for his critical and quick comments and suggestions. I extend my thanks to all the business experts interviewed for their input, time and help with reviewing Business Creation’s business model.

Last but not least, I would like to thank my parents for their mental- and financial support during my extensive study career in Groningen and Amsterdam. Hopefully, I can give your grandchildren the same loving treatment in the future.

Casper Spiers

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Chapter 1 Research design

1.1 Introduction

Business Creation (1982) is a redevelopment company that assists organizations who are facing restructuring challenges. Business Creation (BC) provides solutions for complex divestments and business recovery, focusing on closure of multinational firms’ subsidiaries. BC is aimed to analyzing, designing and implementing solutions that bring back results while including the interests of employees and other stakeholders.

The goal of my master thesis is to conceptualize Business Creation’s approach from a financial investment perspective. I do this by examining whether the company acts more like an investor or as consultant in the field of divestments. To support this result, I will analyze Business Creation’s competitors and possible substitutes in the market of divestments as well as reviewing and updating the concepts divestment and restructuring by doing literature research. After conceptualizing Business Creation’s business model, I am going to compose a questionnaire. This questionnaire will be used to interview a panel of business experts, proposed by Business Creation’s managing director Andreas Ezinga. The results of this panel will be used to do analysis regarding Business Creation’s approach in the market of divestments.

During my internship at Business Creation I have been working on a real business case, as a business analyst. I am going to use this case for analyzing the current business approach and the identification of dilemmas in her approach.

1.2 Motivation for research

Customers of BC are large multinationals who are planning to close a subsidiary. Multinationals can divest a subsidiary either by selling it or closing it. Potential customers can also choose for a turnaround, changing the internal processes inside the company.

Managing director Andreas Ezinga is working in the divestment and restructuring business for over 10 years now. He is convinced that BC’s approach is unique in the market of divestments. BC is a combined consultant, as well as restructurer, and also an investment company. This combination is unique in the market of divestments according to Ezinga. It is this statement that forms the motivation for my research.

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1.3 Problem statement

1.3.1 Introduction

The idea behind this thesis is that a divestment and also a business closure, although an extra-ordinary decision is actually a normal investment decision with all of its normal aspects. In addition to the normal investment issues there is the social (or moral) aspect of laying-off people. But basically it is a normal investment decision.

According to the on-line dictionary investorwords.com the definition of a business model is: “A description of the operations of a business including the components of the business, the functions of the business and the revenues and expenses the business generate”. The purpose of a business model is to connect internal input(s) with economic output. In order to analyze BC’s business model, I do research on her business approach, market approach and earnings model.

This research needs a clear problem definition. Only this leads to a study that is relevant, achievable and functional. Such a problem definition consists of an objective, research question and restrictions (De Leeuw, 1996). These three issues need to be addressed before we start with the research framework.

1.3.2 Research objective

The objective of this study is stated below:

Conceptualizing the business model of Business Creation active in the field of divestments and composing a business approach analysis from financial investment perspective.

The word redevelopment, instead of development, will be used in this thesis to emphasize on the fact that out of an existing business a new business will be developed. To specify the research objective, specifications and restrictions that the framework must meet are formulated and discussed below.

1.3.3 Specifications and restrictions

The specifications the method must meet are summarized below and illustrated in Exhibit 1.1. Specifications should be effective and efficient in use, in addition experiences must be included. The quality of the business model is determined by the way the output of the model meets the model’s specifications (De Leeuw, 1996). The model must do what it should do, according to its specifications; conceptualizing BC’s business approach in the market of divestments from a financial investment perspective.

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9 The model must be efficient in use: BC can use her business model in developing her approach and attracting customers in the market of divestments. The concepts and their relationships must be obvious. Therefore the model should rather focus on broad concepts than on details.

BC’s experience must be included as much as possible: including BC’s current business approach and integrated knowledge on the market and action plan(s) will increases outcome effectiveness. By using the business model in practice, more knowledge will be integrated which increases the quality of the model. The restrictions that apply on the problem definition are summarized below and stated in Exhibit 1.1:

1. The concepts of the new business model can be difficult to identify in practical use.

2. Development of the business model should be consistent with the current approach of BC. 3. The business model is not complete since there is no focus on all strategy aspects.

4. There is a focus on business model evaluation instead of the development thereof. The restrictions the model must apply to are illustrated in Exhibit 1.1.

Problem Definition Situation SPECIFICATIONS 1. Effective 2. E fficient 3. E xperience

1. Conceptual model has

limitations in practical use

2. Consistent with current models used by BC.

RESTRICTIONS

Objective

Business model

3. Strategy aspects are not included.

4. Focus on evaluation instead of development of the model

Exhibit 1.1 Specifications and restrictions

1.3.4 Research questions

From the research objective the following research question is drawn:

Is there a fit between the position of BC in the market of divestments and her current business approach in this market from a financial investment perspective?

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10 1. What are the characteristics and trends of divestments from a financial investment

perspective?

2. What is BC’s current business approach towards a divestment case? A. What is BC’s corporate mission?

B. What is BC’s integrated approach?

C. What are BC’s financial valuation methods?

3. How is the divestment market defined in terms of competitors and substitutes? A. Which segments can be distinguished in the market of divestments?

B. What is the position of BC’s business approach in the market of divestments? 4. What is BC’s financial investment perspective in a redevelopment project?

A. What is the investment? B. What is the earnings model?

5. Which actions could be taken by BC to develop her approach from a financial investment perspective?

1.4 Theoretical concepts and research framework

This paragraph describes the way literature is consulted. This literature is embedded in the divestment framework, which is the backbone of this study. The basic approach shown in Exhibit 1.2 shows the basic concepts that will be used in this study.

Exhibit 1.2 Basic approach

The purpose of this concept is to describe the current business model and mission of BC. This part contains the BC approach; the components of the business and the actions taken by BC in operating a project. Another part of the business model I will discuss is BC’s earning model on her operations. By doing desk research, I will discuss all the concepts characterizing a divestment. In addition the trends of divestments in the market are added to the framework. Divestments currently done by multinationals are of special interest. The aspects of a bad-will transaction and the added value of

Divestment framework BC’s current business approach

Conclusions and recommendations on BC’s business model Market of divestments

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11 these for potential customers, based on a Discounted Cash Flow (DCF) analyis, are also included in the framework.

The purpose of identifying the market of divestments is to position BC in a market segment. The process of divestments can be placed in a playing field that consists of the following decisions: 1. Continue of current business: business as normal and no need for drastic changes.

2. Restructuring/turnaround: business needs drastic changes and there is a need for restructuring (or turnaround to use another word).

3. Sale: the company can also decide to sell its business.

4. Closure: if a sale is not feasible or desirable, the business can be closed.

5. Redevelopment: Business Creation positions itself as an alternative for closure.

These decisions are identified from a customer’s point of view. In addition, I composed a competitor’s analysis based on BC’s characteristics, presented in appendix A. The purpose of this analysis is to position Business Creation and her competitors in the defined playing field.

In Exhibit 1.3 the research framework is shown. This research framework shows the chapter structure based upon the research sub questions, and how this finally results into an answer to the central research question.

Exhibit 1.3 Research framework

Chapter 3: BC’s current

approach Integrated

approach

Chapter 1: Research design

Problem statement and theoretical concepts

Chapter 2: Divestment framework

Combining divestment theory and trends into a framework

Chapter 4: Financial investment perspective

BC’s financial investment perspective in redevelopment projects

Market of divestments

Chapter 5:Review business model

Business experts interviewed on BC’s current and future business approach

Chapter 6: Conclusions and recommendations

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1.5 Measurement and observing methods

Different types of measurement and observing methods are used. A multi-method approach (Saunders, 2003) enables triangulation. This means when using different data collection methods within this study in order to get a result similar to the ideas of the researcher. For this research a combination of desk research and field research will take place. Research methods are stated in Exhibit 1.4.

The data for the research has been provided by:

1. A literature study; updating all the characteristics of divestment theory and other relevant subjects as described in Exhibit 1.3.

2. Field research; wrap up of redevelopment cases to analyze BC’s current business approach.

3. Interviews with business experts; dilemma’s being submitted on BC’s current- and future approach in the market of divestments. These interviews will be structured by a questionnaire.

Exhibit 1.4 Research methods

Chapter 5-6: Analyzing BC’s business model Desk Research

Field research: Case divested transformer manufacturing subsidiary

Chapter 1-4:

Conceptualize business model Interviews:

Questioning a panel of business experts

Dilemma’s being submitted about BC’s current and future approach in the market of

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Chapter 2 Divestment framework

2.1 Introduction

This chapter describes the unique characteristics of divestment and closure. For a good understanding of BC’s business approach from a financial investment perspective, an understanding of these characteristics is necessary. The framework shows what the influence is of divestiture on a company’s wealth. The divestment and closure characteristics are important dimensions of a plant’s redevelopment potential.

Why would managers, widely known to pursue self interest and value control over large firms, be willingly given up control over certain assets by undertaking transactions of corporate divestitures? In the scenario described by the financing hypothesis, parent firms are capital constrained and divestitures are used by managers to relax such constraints. The efficiency explanation discusses that divestment will lead to operational improvement and according to the focus explanation lack of divestment strategy can lead to large differentiation. This can lead to agency problems and reduces shareholder value.

In paragraph 2.2, different characteristics and trends of corporate divestiture and the link with corporate strategy will be discussed. Paragraph 2.3 provides more inside into the reasons and effects of a (cold) closure decision by a divesting company. Thereafter, the comparison between investments and divestments will be made in paragraph 2.4. This divestment framework will end with an insight in the valuation of divestments in paragraph 2.5.

2.2 Divestments

2.2.1 Types of divestments

According to the “Dictionary of Finance and Investment” (Downes, 1997) the definition of divestment is: “disposition of an asset or investment by outright sale, employee purchase, liquidation and so on”. The process of selling an asset is also known as divestiture, it is made for either financial or social goals. Corporate divestiture is a major mechanism for firms to streamline and refocus their business (Chen and Guo, 2005). The cost associated with each outcome is a major determinant in corporate divestitures. Managers’ decision to divest could be analyzed in three divestiture mechanisms: asset selloffs, spinoffs, and equity carve-outs (Chen and Guo, 2005). Besides these three divestiture mechanisms, companies also have two other exit strategies that can be made regarding to a divestment case; no divestment and closure of the facility. First the three divestiture mechanisms mentioned will be discussed.

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14 companies are expected to be worth more as independent entities than as parts of the existing business of a company. In the case of a spin-off, the new firm is created as a deliberate act of the parent and the owners of the parent are the original owners of the new firm. Although these owners can normally sell their ownership stakes at market rates soon after the new entity is formed.

Sometimes known as a partial spinoff, a carve-out occurs when a parent company sells a minority (usually 20% or less) stake in a subsidiary for an IPO or rights offering. In most cases the parent company will spinoff the remaining interests to existing shareholders at a later date when the stock price is much higher.

A sell off occurs when a firm sells part of its assets to the buyer firm. The buying firm integrates the new assets into its structure and on his balance sheet (Gadad, 2009). A parent company can choose to directly sell off the assets, in which it privately negotiates the sale of the unit/subsidiary to a third party.

Chen and Guo (2005) provide new findings on choices of firms among the divestiture mechanisms described above, conditioned on the decision to divest; firms mainly use asset selloffs in divesting smaller units operating in the same industry. Firms with larger divested units are more likely to use spinoff or carve-out transactions. Parent firms having high revenue growth, high book-to market ratio, and who are divesting a unit when market sentiment is high are less likely to use spinoffs. The three divestiture mechanisms mentioned above are often preferred over a closure alternative, because they can create value (cash or increasing price of equity interest) for the divesting company. In fact, closure is very expensive and damaging for (the image of) the divesting company. However, it is the most reasonable option left when the unit has no potential economic value in a standalone scenario and no other party is interested to invest. From a strategic point of view closing can also be the only alternative, if the divesting company does not want to sell the unit to a current competitor or potential new competitor. Business Creation is especially interested in those divestment cases where closing seems to be the only alternative. This type of divestment will be discussed in paragraph 2.3.

When divestiture alternatives are not realistic and closure is disproportionately expensive or harmful to the image of a divesting company, an on-going concern strategy is another option. The company chooses to do no divestment. The effect of no divestment from a financial investment perspective will be discussed in paragraph 2.4.2. The rationale of divesting companies will be discussed next. 2.2.2 Reasons for divestments

According to Gadad and Thomas (2004) the finance literature has identified three main reasons for a divestiture:

1. The efficiency explanation; assets can be transferred to those who can operate them most productively (Maksimovic and Phillips, 2001).

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15 3. The financing explanation; divestitures can raise capital without recourse to the capital

market, which may be unwilling to supply capital (Lang et al., 1995).

Improving efficiency is often cited as a prime reason for corporate restructuring. Weston et al. (1998) found that the reasons for divestitures included changing strategies, reversing mistakes and learning. Haynes, Thompson and Wright (2002) studied divestment impacts on firm performance. They did an empirical analysis of 132 quoted UK companies over the period 1985-1993. The results of this study suggest that divestment has a positive effect on raising operational performance and thus the profitability of the divesting company. Highly diversified firms are more likely to divest units when suffering from low operating efficiency. Chen (2005) suggests that managers of parent companies may divest (unrelated) units in order to enhance their focus in operation. Other studies document a positive relation between stock returns and an increase in focus (Hillier et al., 2009).

Prior studies indicate that divesting firms have lower operating cash flows, lower capital expenditure, as well as higher leverages, higher dividend yields and higher market-to-book ratios compared to their industry- and size matched peers (Chen and Guo, 2005). Consistent with the prediction of a financing explanation, parent firms are capital constrained and divestitures are used by managers to relax such constraints. Firms are selling off assets to relax their credit constraints, as they exhibit signs of distress (e.g. higher leverage ratios/low cash flows) prior to divestitures (Chen and Guo, 2005).

Belderbos and Zou (2009) argue, in support for a real options perspective on divestments, that subsidiaries established in host countries with adverse environmental changes (worsening labor cost conditions) are more likely to be divested. This impact was enlarged the greater the macroeconomic uncertainty in the country. This supported the notion that the valuation of growth or divest options of foreign subsidiaries in uncertain circumstances can lead to investment ‘‘hysteresis’’. Belderbos and Zou conclude that this can lead to non-rational decisions like divestiture of manufacturing plants even under adverse (i.e. growth) circumstances.

The mechanism of environmental uncertainty can be interesting for Business Creation. For example, the Netherlands with its high cost structures is an expensive manufacturing location in comparison to Eastern-Europe or Asia. Foreign multinationals will be interested to replace the Dutch manufacturing side to low cost regions. Business Creation can use the redundant assets to redevelop the existing business.

2.2.4 Divestment as strategy

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Exhibit 2.1 The industry life cycle and the company life cycle

Source: Contemporary strategy analysis, Robert M. Grant, 1998

In the maturity stage, where consolidation and rationalization are key issues for managers, cost management is very important. Finally, every business will be divested when no further options to extend its lifecycle are to be identified. Therefore, it is interesting to identify the options left for a business at the end of her maturity life cycle when it starts to decline. As illustrated in the industry lifecycle figure (Exhibit 2.1), Porter (1980) recommends 4 strategic alternatives for this point in lifecycle: cold closure, harvest, niche-strategy and leadership. The first two strategies lead directly to divestment. If one of the other strategies is applied, the company’s decline is deferred because it may want to invest in strengthening its position in the declining market.

Exit barriers are economic, strategic, and emotional factors that keep companies competing in businesses even though they may be earning low or even negative returns on investment (Porter, 1980). High exit barriers cause a firm to remain in an industry, even when the business is not profitable. A common exit barrier is asset specificity. When the plant and equipment required for producing a product is highly dedicated, these assets cannot be sold to other companies in different industries. As a parent firm would like to restructure, divesting from a subsidiary is sometimes not feasible since a large and dedicated investment could not be sold easily. Because the firm faces exit barriers it may decide to keep competing in a declining market through implementing the leadership or niche strategy whereas divestment would have been preferable.

What a subsidiary needs from its parent company changes substantially over the three major phases of its industry lifecycle. It’s unrealistic to assume that a parent company can provide all the different capabilities needed for a subsidiary to thrive over the whole life cycle, especially in a non-core business activity (Dranikoff et al., 2002, p79). From Business Creation perspective these end-of-lifecycle issues are the core of her business model. Since every industry life cycle will come to an end, divestment is not a one-shot effort. It needs to become a company’s strategy (Dranikoff et al., 2002).

Investment

Introduction Growth Maturity Decline

Divestment Indu str y Sa les C ompa n y Sa les Time Niche / Leadership Cold closure Harvest / Phase out Investment

Divestment Indu str y Sa les C ompa n y Sa les Time Investment

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17 The final step in a proactive divestiture program is creation of new business. This is when BC comes into play; reinvest the funds, management time and support function capacities in attractive new growth opportunities. The future value of an end-off lifecycle business depends on the success of the business redevelopment.

2.2.5 Trends

In recent years, theoretical and empirical research has focused on how companies respond to poor performance. Corporate restructuring is the most common approach to stop a business lifecycle’s downturn or prevent from diminishing profits. Stock prices respond positively to asset sale announcements due to (expected) improvements in operational returns and a decline in financial leverage and corporate diversification (Hillier et al., 2009). John and Ofek (1995) suggest that firms sell assets to increase the focus of their business; potential costs of diversification include the use of increased resources to undertake value-decreasing investments, cross-subsidies that allow value reducing segments to drain resources from better-performing segments. Managers are better able to control a related group of assets rather than an unrelated group of operations; negative synergy has been removed from the portfolio. Another reason that shareholders (e.g. investors) positively reward corporate restructuring is the idea of decreasing agency cost between managers and shareholders as a result of some of managerial disciplinary (Hillier et al. 2009). For example, the stock-reaction to asset sales is only positive for those firms who pay out the proceeds. When investors expect the proceeds to be held within the firm, there is a negative influence from asset sale on stock price (Lang et al. 1995). According to the financing hypothesis, management does sale assets when other sources of financing are too expensive. On average, firms’ stock price benefit from announcing asset sales because a successful sale means the firm received the amount of money to make the sale worthwhile (compared to future discounted cash flows).

Increasing focus on the core business is an important motivation for divestitures. According to John and Ofek (1995) increasing focus seems to dominate other explanations for divestitures, such as the financing explanation. Shareholders prefer high returns on their specific company shares above diversification. Shareholders can add diversification on their portfolios themselves; it seems inefficient when corporate managers considering deciding about investor’s diversification within the company.

2.2 Closure

2.3.1 Reasons closure

In a single plant firm, plant closure is usually associated with business failure. While in a multi-plant firm, plant closure may be a route to business success (Kirkham et al, 1998). But how do multi-plant firms choose which plant/subsidiary to close in case of a divestment?

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18 Kirkham, Richbell and Watts (1998) explain a number of important factors affecting closure in multiplant manufacturing firms. In sequence of importance these are: plant size, site constraints, few activities/limited capability, labor productivity, building design, remoteness and grants elsewhere. Plant size and site constraints seem to be of most importance across most studies. In a smaller plant, relative to other company plants, the sunk costs are lower compared to larger sites. It is easier to absorb the work of a small plant in a larger one rather than the other way around. Site constraints are also important in a number of ways. Space is important for future possible expansion; the less constrained and more readily accessible site should be retained. All the factors mentioned are not independent of each other (Kirkham et al, 1998). These factors take on particular significance where profit information on each individual subsidiary is not available, where there is no clear distinction between potential closure candidates or in a situation where a quick decision is needed. When plants are treated as a single accounting unit, economic rationale is more important.

2.3.2 Consequences cold closure

Since BC’s customers are mostly large multinationals with diversified businesses and several divisions, evidence on profit and performance of individual subsidiaries are available. Cold closure is defined as “the immediate und unmanaged shutdown of a (line of) business” (Offringa, 2001). A cold closure budget is used to estimate the financial impact; it is used by BC as a benchmark on estimating their potential redevelopment budget for the project. According to Offringa (2001) cold-closure budgets merely contain cast items.

Exhibit 2.2 Cold closure budget multinational subsidiary

Source: Business Creation analysis, 2009

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19 usually the most important part in a closure budget. Here we come to the clue of the BC redevelopment plan; saving (part of) total employment by implementing new business lines. For Business Creation’s customers savings on full closure cost is the result. BC’s added value is most in countries with high severance costs, mainly Western Europe. BC also bears higher risk when high severances are paid to redundant workers. When the new business development fails, BC has to pay the upon agreed severance payments themselves.

In a closure budget the relevant cash flow is the incremental cash flow that will be caused by closure of the plant. An irrelevant cash flow is a cash flow that will occur regardless of whether the proposed course of action is taken (Grinblatt and Titman, 2002, p 307). Liabilities need to be deleted from the balance sheet, although debt should not be included in the closure budget. Debt needs to be repaid regardless the plant is to be closed or not, and should therefore be considered as an irrelevant cash flow. In case of a divestment, asset related items are sold at their market value and can be written of the balance sheet.

Assets and asset related items, liability related items, social related items and other items should also be included in the cold closure budget. Most of BC’s clients do not have a realistic perception what cold closure is about. They are often far too optimistic in their calculation of the financial impact of closure due to not including (i.e. forgetting) some important aspects of cold closure (Offringa, 2001).

Exhibit 2.3 Cold closure budget elements

In Exhibit 2.3 direct costs and benefits of a cold closure budget are shown. Closure means not only writing assets and liabilities of the balance sheet but also writing employees of the payroll. The divesting company needs to develop an appropriate social plan to meet the social requirements of local unions and local authorities. The social plan includes severance payments and training- and outplacement costs. In general, these social related items are the largest cost in a closure budget. Other direct cost includes (physical) relocation cost; this can also be a saving when the result of

Closure budget

Direct financial costs

1. Redundancy costs for employees

2. Relocation and travel expenses for staff the firm wishes to retain

3. Disruption of production if selected lines have to be transferred

4. “clean pavement” (e.g.polluted ground)

Direct financial benefits 1. Real estate proceeds 2. Redundant assets proceeds 3. Scrap value of other assets

Additional costs and benefits

• Adverse publicity

• Managerial hassle

• Effect on overhead costs

• Pay back subsidies

• Penalties on supply agreements

• Effect on share price

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20 relocation is increasing operational performance and efficiency. Additional costs and benefits include effects on share price and subsidies. Subsidies can cause additional outlays since they must be repaid to local authorities in case of local business abandonment. Other additional costs that should be considered are risk costs. Risk costs are cash outflows that do not necessarily occur, but there is a chance they do reasonably exist. The financial impact of adverse publicity, managerial hassle and penalties on supply agreements are examples of risk costs. To be conservative, these cash flows should be taken into account in the cold closure budget.

2.3 Comparison between divestment and investment

2.4.1 Divestment as investment

Both divestment and investment are value creating instruments. In Exhibit 2.3 Casson’s (1986) comparison between the use of investment- and divestment decisions as strategic instruments are shown. They both can be used to align the company with its strategy and to reduce the gap between intended and realized strategy.

Exhibit 2.4 Divestment is the reverse of an investment

Source: Casson, 1986

In fact, there are also differences between the two decisions; divestment decisions are among the most difficult and painful decisions an organization has to make (Boddewyn, 1983). Consideration of a divestment begins with the appearance of (structural) losses in a business- or product line. On the other hand, investment starts with the recognition of an opportunity.

The costs of divestment, for example the costs of closure, can be seen as the initial outlay in an investment decision. The savings a divestment generates are actually cash inflows that occur each year until infinity, therefore divestment is considered to be less risky than investment (Offringa, 2001). The cash inflows involved with divestment are more certain; the inflows are based on historical figures and the outflow occur at the moment of plant closure. In case of investment only the initial outflow, which occurs at the moment the investment is made, is certain. The operating expenses as well as the cash inflows are future cash flows. Therefore, these are considered to be more risky.

Investment Divestment

Greenfield operation

1. Greenfield operation

2. Acquisition from

• company with no previous connection

• facility of an existing rival • entire company of existing

rival 1. Closure 2. Sale to • company with no connection in future • existing rival

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21 Since these cash flows also occur over a period of time, they should be discounted at an appropriate discount rate. The application of the Discounted Cash Flow (DCF) method on closure situations is discussed below.

2.4.2 Valuation of divestments

Divesting companies are selling of their assets and are interesting in the amount of cash the sale generates. The initial outlay of cash that has to be paid in case of a closure must be determined to evaluate the present value of the divestment. Since investment and divestment both are value creating instruments the appropriate way to evaluate a divestment, on a cash basis, is by using the DCF method (Offringa, 2001). Since divestment certainly generates revenues (e.g. savings on future losses) and investment does not, a divestment could be discounted at a lower discount rate than an ordinary investment.

Most closure budgets that have been examined contain a savings element. These savings can be on operational costs or the prevention of further losses. The wealth created by a divestment project is equal to the net present value (NPV) of the project. In essence, the NPV method measures the arbitrage profits associated with an investment project and recommends projects for which arbitrage profits are positive (Grinblatt, Titman, 2002, p.330). Savings and the risk costs (see paragraph 2.3.2) should be included. However, risk costs are hard to estimate since the arguments that support the value of the risk costs are not very strong.

Based on the assumption the closing business unit was going concern in the future and producing negative cash flows, known as standard annuity. The present value of the savings can be calculated with the perpetuity formula (Wessels Boer, 2005):

(= annuity / required yearly rate of return)

The above formula can be used to calculate the net present value of the indirect savings on a cold closure based on P&L accounting. In case of the multinational subsidiary accompanied by BC, the return on capital employed in 2008 was 31 percent (source: annual report). Assume the subsidiary has a yearly negative cash flow of 10 million. NPV savings on closing the business line will be: 10 million / 0.31 = 32,26 million in total. The initial outlay of cash (Exhibit 2.2) is estimated between 17.6 million and 21.8 million on P&L accounting. So the indirect savings from divestment for the multinational are between (32,26-17,6) 14,66 million and (32,26-21,8) 10,46 million.

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2.4 Conclusion

Divesting a subsidiary is the most reasonable option left for a company when the autonomous business has no positive economic future value and a sell-off is not an option. Since every business cycle comes to an end, divestment needs to become part of a company’s strategy. BC focuses on redevelopment of end-of lifecycle businesses where closure seems to be the only option left.

By implementing new business development BC can offer multinationals an alternative to closing, in order to save on closing costs and additional costs of a divestiture. A cold closure budget is used by BC to estimate the financial impact; the new business development cost must be lower than cold closure cost. The severance payments are usually the most important part in a closure budget. BC can realise savings on closure costs by creating new business which absorbs the otherwise redundant employees.

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Chapter 3 Business approach

3.1 Introduction

In this chapter, BC’s current business approach towards a divestment case will be described. BC is active as Redevelopment Company in the market of divestments. The aim of BC is to help businesses facing continuity challenges by implementing viable alternatives to closure of non-core business units. Formulated in the following mission;“ensuring a sustainable future for all stakeholders involved in or affected by a corporate restructuring program, by balancing the interest of companies, employees and communities trough the redevelopment of human capital, technology and assets”. BC manages entire divesting processes of corporate subsidiaries and simultaneously, redevelops redundant assets. Continuity challenges can have a variety of causes: outdated technology, an overcapacity in the company or the market or a flawed cost structure. Transition is change and often difficult; change from a corporate subsidiary to an independent company. According to Andreas Ezinga, BC’s managing director, the unique strength of BC is her entrepreneurial approach. BC does not only consult, she also implements and invests in a redevelopment project.

BC’s integrated business approach towards each large restructuring- or divestment project will be discussed in paragraph 3.2. In paragraph 3.3, the market of divestments including BC’s target range will be described. In addition, BC’s competitors in the market of divestments will be identified. Paragraph 3.4 provides the conclusion on the BC business approach in the market of divestments.

3.2 Integrated approach

3.2.1 Historical perspective

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24 Between 1987 and 1992, the company broadened its activities to include the acquisition and redevelopment of industrial real estate. BC developed towards an investment company with a portfolio of companies that had been divested by multinationals like ABB, Sony and Philips. Anno 2010, BC has been focusing on a truly integrated approach for each large restructuring of a divestment project. BC offers business redevelopment services, outplacement services and job searches via her Job Creation program.

3.2.2 Track record

BC is involved in projects that represent restructuring budgets up to 50 million euro’s per annum. As a result of BC’s approach and concepts, new and adapted companies employing approximately over 60,000 people have been created and some two million square meters of industrial real estate has been (re)developed.

BC has a particular interest in manufacturing companies that are part of large multinational corporations with a turnover of 5 billion Euros or more. These large clients restructure continuously and their size and numerous business lines required them to do so in the future (see paragraph 2.4.2). Recent clients are among others Philips, ABB and Corus. BC prefers manufacturing companies because these companies are commonly very labour intensive. Because redundancy payments are a major part of the closure budget, such a company can save a lot on their closure cost by not firing employees as need to be done in case of closure. As a result the BC approach led to a limited negative impact for work force and local communities.

3.2.3 Redevelopment approach

BC has been exploring and defining viable alternatives to the closure of non-core business units and manufacturing facilities throughout Europe. As soon as the preliminary decision to divest or close a subsidiary has been made, BC helps her corporate client to develop the best alternative in terms of costs and employee interests. BC has adopted a three phased redevelopment approach for most of her projects:

1. Solution identification (Quick scan)

2. Solution roadmap (Renewed business plan for redundant assets) 3. Redevelopment implementation (100-day recovery plan)

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25 client. In the final phase, the redevelopment plan of the ongoing business will be implemented using the renewed business plan. If relevant, inward investors will be attracted to join BC in the new venture.

BC provides two constructions in case of a redevelopment; a spin-off and a sell-off. Investors can be attracted to absorb the available human resources and assets. In order to facilitate this absorption, BC develops new business activities and redevelops the real estate. The objective is maximization of a company’s assets while minimizing the expenses of restructuring. In a spin-off construction, BC acquires part(s) of the company’s redundant assets and bears the corresponding risks. The amount to be paid depends on the gains (savings) BC has realized on her client’s closure budget, a percentage of this money will be available to BC in a redevelopment fund.

Another way to deal with the restructuring of a client subsidiary is a sell-off. BC acquires the entire redundant business activity (i.e. assets) from her client. The acquired activity is going to be transformed into a new company using the existing production facility, human resources and technology. In this stand-alone scenario the production can be sized down and new business can be implemented. New business can be created in cooperation with one or more inward investors (i.e. business partners), who have knowledge and skills in the specific markets. BC provides capital, real estate and human resources within this construction. The sell-off and spin-off construction and characteristics of the redevelopment will be further discussed in paragraph 3.2.7.

In both scenarios, BC supports the whole restructuring project. BC has the experience and knowledge to make agreements (i.e. enlarge commitment) with employees and unions. This is a crucial part in her redevelopment approach. Related actions include: definition of the redundancy programme, negotiations with work councils and unions and implementation of Job Creation programmes.

3.2.4 Job Creation

In 1981/1982, Philips Data Systems Den Haag had to close a plant, resulting in a layoff of some hundreds of people. Philips wanted to be seen as a responsible employer, especially in the country’s centre of government. Conversations with the city council led to the attraction of Job Creation ltd. Job Creation established a Business Centre in the former plant in which new SMEs could be established. The redundant workers were (partly) absorbed by the attracted SMEs. The new companies could hire the workers against favourable economic conditions, subsidised by Philips. Philips in turn, saved on its closure cost and suffered no damaged on its reputation as a responsible employer.

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26 In a regional Job Creation program public and private partners can work together, this program can be constructed as stand-alone programme under responsibility of the owner of the subsidiary (i.e. BC’s client) or by BC herself in case of a spin-off or sell-off construction.

Exhibit 3.1 Example of potential partners in a regional Job Creation program

In Exhibit 3.1 the client is the formal establisher of the Job Creation program. All the public and private partners work together to the same objective: creating jobs in the subsidiary’s region. Establishing a Job Center on site will not interfere with current business but serves it when necessary. The implementation of the Job Creation program is flexible and can easily be transformed into a redevelopment. Such an initiative will provide positive exposure to the client; it can facilitate future negotiations with unions and other stakeholders in case of a divestment. This regional stand-alone Job Creation program could be implemented without many costs by involving more partners and increasing value of real estate.

3.2.5 Real Estate

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27 Besides developing a Business Centre BC can also attract an inward investor or business partner related or unrelated to the current technology of the business. In this redevelopment approach the objective is to use the available technology and human resources to extent or expand related product lines or establish an unrelated production line on site. Inward investors can benefit from the redevelopment fund provided by BC and the experienced technical workers available. The redevelopment fund can be used to invest in assets and redevelopment of property supporting the establishment of new business activities. The Job Centre, simultaneously established on site, can be supportive for training and educating the workers to fit smoothly into their new jobs or as a Job Search Centre in order to replace employees (i.e. outplacement) that cannot be absorbed by the business on site. The purpose of redeveloping real estate into a Business Centre is creating value; the higher occupancy level and rental income the higher the market value of the real estate.

3.2.6 New Business

By implementing new business, thus creating new jobs, BC can realize significant savings on her client’s closure budget. To arrive at solutions BC works closely with various other organizations like BC Wind Energy and BC Solar. These companies are spin-offs of BC and are operationally and financially independent entities. They both focus on investments and consultancy within the renewable energy sector.

Creating new business is the key factor within BC’s current redevelopment approach. Without new business BC can only consult on a phase-out strategy of the current business in combination with outplacement via her label Job Creation. These two activities can also be consulted by other specialist in the field or by the client on his own. By implementing new business, BC can create sustainable value into the redevelopment project. The available company’s assets are the starting point of implementing new business. Companies with related technology and products (i.e. potential leads) are being identified by BC. In the solution roadmap, a few ideas are being concretised into a business model. The most important parameters for measuring the potential of new business ideas are employee absorption, market attractiveness, value of investments, fit with technology and timing of implementation. Employee absorption is estimated as the number of employees that can be re-employed in the new business activity. These parameters are used by BC to compose a redevelopment fit test. The degree of fit with internal and external factors is ranked from scores one to five.

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28 In Exhibit 3.2 an example is given of a redevelopment fit test developed by BC for a multinational subsidiary. The new business idea was to establish a wind technology center on site; assemble wind turbines in co-operation with local developers and an external wind turbine manufacturer (i.e. business partner). The new corporation could supply fully integrated wind-energy solutions to wind parks on the mainland of Ireland. The redevelopment approach would be as follows; BC Wind Energy would be the lead partner for the set up of the wind company and BC manages the transition and provides another strategic business partner (third party) in the new corporation. The project could get monetary support from governmental agencies in the region in order to secure employment. The redevelopment project is forecasted to absorb redundant employees and create additional jobs in the long term. The redevelopment fit test in Exhibit 3.2 shows a low score (2 out of 5) on investments, this implies that high investments are needed to establish a wind technology center on site. The overall score of this business idea is ‘4’, status ‘continue’, in the solutions roadmap this idea will be developed into a business plan.

3.2.7 Redevelopment scenario’s

As an outcome of the consultancy phases, BC’s client would be relieved from its problem; a subsidiary which is a large liability and at the end of the business life cycle. By phasing out her client, BC acquires the activity and the client is relieved from its liability. In the actual redevelopment BC’s earnings depend on the redevelopment construction developed by BC and finally chosen by her client. There are three regular scenario’s available to BC’s client in case of a redevelopment: continue-as-is, spin-off and sell-off.

The most important difference between the three scenarios is the financial and legal construction in which the subsidiary will remain after restructuring; as stand-alone company or dependent on the parent company (i.e. client). The key factor is who will bear the risk on several activities, BC (with partners) or the parent company itself.

In a continue-as-is scenario the financial and legal structure of the subsidiary remains the same; dependent on the parent company. When a BC client chooses for this scenario, it remains responsible for the operation and bears the corresponding risks. The parent company can invest in the current business, usually as recommended by BC in the consulting phase. BC is out of play in this case. The parent company can also choose to phase out the current business and finally wind down. BC can support this scenario by redeveloping the real estate; creating new activities on site. BC can earn on real estate proceeds after redevelopment. BC can also support this scenario by establishing a Job Centre on site, providing outplacement services for her client. Mostly this occurs by establishing a public private partnership as stated in Exhibit 3.1.

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Exhibit 3.3 Spin off construction

In Exhibit 3.3, an example is given of a spin-off construction where BC acquires the subsidiary except the R&D and Sales & Marketing divisions. Specific knowledge is still available in the stand-alone company; in the form of employee skills and knowledge. The production activity of the company and the available knowledge are combined into a platform; this is a starting point for developing new technology and products. Inward investors can use this platform to develop new business on site while saving on their initial investment by using the redevelopment fund (i.e. subsidies) provided by BC. The shares in the new corporation can be divided by BC and her business partner.

The parent company can support the spin-off company by being a customer of their products (providing cash flows), this reduces the chance that the new corporation subsequently goes bankrupt. Such an agreement is called a supply- and service contract and can be included in the deal when BC acquires the subsidiary. In this contract, agreements are made between the seller and BC about delivering products from existing business lines to the seller’s customers. Supply can take place under the original sellers’ brand or BC brand. Advantage for the seller is not losing their market share in the local market. BC can use this supply contract for guaranteeing part of the employment during the length of the supply contract. Thus, generating guaranteed cash flow from the production facility. In a sell-off scenario all the subsidiary’s asset, liabilities and employees, including contracted obligations are transferred to BC or a third party. This is an alternative to redevelopment (turnaround) for the client. The sell-off can take place in different constructions: including or excluding real estate, with or without a supply contract and with a positive or negative transaction value. With this transaction BC is also receiving the redevelopment fund from the seller. The redevelopment fund equals the seller’s closure budget less savings realized by BC. When BC acquires a subsidiary from her client (seller) with a large liability, the only payment made is the transfer of the redevelopment fund to BC.

3.2.8 Phase out current business

When implementing new business, current business should be phased out in order to make human resources available. In Exhibit 3.4, a phase out strategy is illustrated with a case load of 180 employees, before redevelopment of the business.

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Exhibit 3.4 Example of employees becoming available from phasing-out the current business

In this phase-out scenario the current business is completely wind down in 2015. In the mean time the business is being sliced down. At the end of 2011, one (out of two) production facility is closed. Overhead and complexity in the factory are being reduced, worker shifts becoming longer and are partly being cut out at the end of 2011 and all ended in 2015. In this redevelopment plan the biggest case load of workers is being absorbed by new business activities and by the Job Creation program (i.e. outplacement). Approximately one third of the total employees have an early retirement arrangement at the end of 2015, the load ‘other’ contains merely natural outflow of employees.

Exhibit 3.5 Redevelopment approach

Source: Business Creation corporate presentation, 2010

The key element in this particular redevelopment case is establishing a Job Centre on site which re-employs workers on- and off-site. The construction of BC’s redevelopment approach is illustrated in Exhibit 3.5. The redevelopment fund is made available by the client. This redevelopment fund will be used by BC to invest in new business and realize outplacement and training in the Job Creation program. Potential upside for the client is further savings on its closure budget and the redevelopment of new business on site can create additional value to the real estate. There are also arising potential risks for the client by implementing this integrated redevelopment approach. Rumors in the market of the current business based on the re-employment program can cause a loss of current customers. This can damage the client’s reputation in the local market. This is undesirable, even for a global operating firm. Another risk is that the unions are heading for cash payments for the redundant employees and are against the uncertainty of re-employment programs and

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31 transition. BC can neutralize this risk by starting early discussions with the unions and create a sense of urgency and commitment for saving employment in the region. Followed by using the created momentum; starting the actual redevelopment.

3.3 Market of divestments

3.3.1 Corporate divestments

If a business activity does not generate positive cash flows, there are several strategies to deal with the situation before making a cold closure decision. For example, sale to management or a third party, exploit the activity (harvest), acquisition or merger, redevelopment of human capital and assets or a turnaround. Turnaround is a synonym for organisational restructuring.1 Bowman et al. (1999) explain and discuss different restructuring strategies in their article; they argue that the restructuring of firms can be divided into three categories. These are financial restructuring, portfolio restructuring and organisational restructuring. The last two will be discussed next; financial restructuring will be discussed in paragraph 3.3.2. In paragraph 3.3.3 the competitors of BC in the market of divestments will be discussed.

A portfolio restructuring implies that firms have to identify the called “cash cows” and the so-called “dogs” within the firm. Focusing too much on the dogs and not taking full advantage of the cash cows may be an explanation for disappointing results (Miles & Snow, 1994). In such an analysis management discovers where in the whole spectrum value is created and where value is destroyed. If the dogs have been identified management has a choice to sell the business line to parties better capable of managing the activity.

Exhibit 3.6 Alternatives to cold closure

1

Interview Andreas Ezinga (Managing Director BC) Core

Cash flow Positive

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32 In Exhibit 3.6 a strategic framework is given of different alternatives to a cold closure decision. ‘Plant 1’ is an example of a company’s cash cow. This business activity should be retained; the core business is of strategic importance and generates positive cash flow. When the cash flow of the business is positive and the product range is non-core business (‘plant 4’), the activity can be sold to a M&A investor. This can be a financial- or strategic buyer which is better capable of managing the activity. As a result for the seller, more resources are available to focus on (improving) core business activities.

When the business faces continuity issues and generates no positive cash flows there are less alternatives to cold closure. If the product range is a company’s core business, the activity is of great strategic importance to survive (‘plant 3’). In this situation a company will trigger a turnaround of the business activity.

Organizational restructuring (turnaround) actions aim to return the company back in business and have a major influence on the positions of the employees. In several restructuring plans, cuts in the workforce can be seen as the way to cut costs by management. However, it appeared that layoffs unaccompanied by other organizational changes tend to have a negative impact on the performance (Iqbal and Shetty, 1995).

BC provides an alternative to cold closure when a business activity is in distress and the product range is non-core business (plant 2 & 5). BC can reduce the negative impact associated with organizational restructuring by implementing new business into the plant; simultaneously the current business activity can be restructured operationally (i.e. turnaround).

3.3.2 M&A investors

Financial restructuring is mostly executed by M&A investors. There are several ways to restructure a business financially. According to Bowman (1999) financial restructuring is widely practised, many articles investigated the results of leveraged buy outs (LBO’s) and management buy outs (MBO’s). LBO’s involve private equity (PE) investors making acquisitions without committing all the capital required for the acquisition. Within the range of possibilities some firms discover that in changing the leverage of a firm, value can be created since the interest expenses on debt are tax deductible in most countries. However, a closer examination of the results suggests that many of the changes after financial restructuring tend to be operational. Leveraging the acquisition will lead to larger focus on operations, since larger operational cash flows are needed to meet debt obligations and not fall into bankruptcy.

In Exhibit 3.7, private equity-, strategic- and turnaround buyers are distinguished as M&A buyers. Private equity can be defined as money invested in companies that are not publicly traded on a stock exchange or invested as part of buyouts of publicly traded companies in order to make them private companies.2 The most common investment strategies include LBO’s and venture capital. Venture capital is a broad subcategory of private equity that refers to equity investments made. Mainly in less mature companies for the launch, early development or expansion of a business. Private equity buyers are not typically active shareholders. They do not interfere with management of the

2

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33 company. Most popular for the valuation of private equity is the multiplier method. Different multipliers can be used to value divestiture proceeds for a seller: EBIT, EBITDA, net profit and revenues. Guideline for divestiture proceeds to a PE investor is an EBITDA multiples with a range between 3 and 5 (Exhibit 3.7).

Exhibit 3.7 Divestiture proceeds, associated with different M&A buyers

Strategic buyers are active in the same or related market, as the acquired business. Strategic buyers can be interested in a business technology, market share of the business and/or synergy (i.e. cost) advantages between business activities. Compared to private equity, divestiture proceeds are generally higher when selling your business to a strategic buyer (Exhibit 3.7).

Turnaround buyers can finance their acquisition with private equity too; the biggest difference compared to PE investors is their active hands-on-approach. A turnaround buyer is focused on companies with strategic, financial, operational or organizational challenges. This usually refers to businesses with low profitability. Turnaround buyers can create value by addressing these challenges with their active hands-on-approach.

As can be drawn from Exhibit 3.7, BC is focused on divestment cases in the range between turnaround buyers and cold closure of a business activity. Acquiring businesses with continuity issues be feasible with implementing new business, as discussed in paragraph 3.2. A sell-off to a normal investor can also be undesirable for strategic reasons. As an alternative, BC can acquire all redundant assets and employees in a spin off construction without controlling the strategic production activity. With acquiring a business activity BC can save on company’s divestiture costs by providing a feasible alternative to cold closure; redevelopment of human capital and assets.

3.3.3 Competitors

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34 are interested in growth businesses, generating positive cash flows, where they can create value by improve operational efficiency and realize tax gains by leveraging the acquisition.

To identify BC’s competitors in the market of divestments, investors in end-of life cycle businesses should be identified. In addition, investors (not) implementing new business activities into the subsidiary should be identified. The framework in Exhibit 3.8 is composed based on competitor analysis, presented in Appendix A, and interviews with business experts. Turnaround buyers such as H2, Nimbus and Plain Vanilla are investors with an active hands-on-approach. These parties are implementing new business activities into a subsidiary, although they are focused on restructuring the business activities organizationally. This implies laying off employees to cut in the costs; a negative social impact.

Other competitors in the market of divestments are parties involved when companies make a turnaround decision to restructure their core business internally. Consultants usually come into play when the life cycle of the business is starting to decline. Strategic- and business consultants are hired to return to a profitable business. These companies are advisors on restructuring the subsidiary. Cutting workforce is often unavoidable to streamline the business activity within a company’s structure; this implies a negative social impact.

Exhibit 3.8 Business Creation and her competitors in the market of divestments

Real estate agents, auctioneers and outplacement advisors are competitors coming into play in case of a cold closure decision. Real estate agents and auctioneers are valuing and selling redundant assets instead of redeveloping them. Outplacement advisors are generating earnings from a closure by re-employing the redundant employees in other companies. These parties are coming into play when the life cycle of the business is at the end.

Always into play in the market of divestments is the strategic buyer, either when cash-flows from the business activity are negative. Strategic reasons can be decisive to acquire a business activity, such as

Positive Core Cash flow Negative Non-core P ro d u ct ra n ge M&A buyers Business Creation Retain Turnaround Positive Social impact (employment) Negative N e w b u si n e ss Consultants Real estate agents

The Business Creation Approach