The acquisition process and
investors decision making:
A case study of Dutch SMEs
Master thesis September 2008
Author: R. ten Hag
Student number: 1570757
University: Rijksuniversiteit Groningen
Faculty: Economics and Business
Department: Finance
Management summary
To make sure to get a return on their investments, investors developed different techniques. The principal agent problem, described by Tirol (2006) uses the contracting theory to describe these techniques. This study focuses on the 5Cs of the investment decision making process. These are Character, Capacity, Capital Structure, Collateral and Coverage. The study focuses on the investment decisions of the bank, venture capital (VC) and informal investors (II), and on the acquisitions of SME. According to the literature the banks’ investment decision process is mostly dependent on the presence of collateral. The bank is using this collateral to cover the risks involved with the investment. In contrast the VC judges the capacities of the manager and puts great emphasis on the capital structure. Because of their expertise VCs are able to judge the capacities of the entrepreneur. Instead of capacity the II is judging the character of the entrepreneur when making his investment decision.
By applying an exploratory case study, this study focuses on the acquisition of SME’s and the investment decision making criteria of the bank, VC and II. The main question is:
´How can the process of acquisitions, considering Dutch small or medium sized enterprises, be described and which are the criteria used by investors to take investment decisions? ´
Interviewing is time consuming and it is difficult to find investors that give confidential information. Despite of this it was possible to apply four cases. Each case consists of two interviews. One interview is with an entrepreneur and one with an investor. There are two cases with a bank as investor, one case with a VC and one case with an II. The cases are about the acquisition process and the investment decision criteria of the investors.
Preface
I believe that writing this master thesis gave me a lot of experiences and new skills. Especially the interviews, with experienced entrepreneurs and investors, were very interesting and informative. Because of the confidential information they have to give, it was sometimes hard to find the proper candidates. Fortunate I found enough
entrepreneurs and investors who were prepared to have an interview. By this, I want to thank those people for the very intriguing conversations.
Furthermore, I want to thank Dr. Westerman for his help and expertise. He was critical and stimulating at the right moments, which helped me to write this study with pleasure.
I also want to thank Jessica, my father and brothers for their support. I especially want to mention and thank my mother, who was supporting me during the thesis and the overall education program.
A special gratitude is for my uncle Gerrit Huurneman who helped me with finishing the thesis.
Finally I want to thank all my friends for their support.
Rob ten Hag
Table of contents
Preface ... 3
Table of contents ... 4
1 Introduction ... 6
2 Literature review ... 7
2.1 Small and medium sized enterprises ...7
2.2 The process of taking-over a SME firm ...8
2.2.1 Phase one: Strategic consideration ...8
2.2.2 Phase two: Search for the candidate ...9
2.2.3 Phase three: The transaction ...9
2.2.4 Phase four: Post-acquisition... 10
2.3 Credit analysis: criteria...11
2.3.1 Character ... 13
2.3.2 Capacity ... 13
2.3.3 Capital Structure ... 14
2.3.4 Collateral... 15
2.3.5 Coverage... 16
2.4 Credit analysis: Investors perspective...16
2.4.1 The banks’ investment decision ... 17
2.4.2 The venture capitals investment decision... 17
2.4.3 The informal investors investment decision... 19
3 Research questions and methodology ... 21
3.1 Research objectives and research questions...21
3.2 Case study ...22 3.3 Case selection ...23 3.4 Conceptual framework...23 4 Case one ... 25 4.1 The process...25 4.1.1 Strategy ... 25
4.1.2 Search for the candidate ... 25
4.1.3 Transaction... 26
4.2 The investment decision ...27 4.2.1 Character ... 27 4.2.2 Capacity ... 27 4.2.3 Capital structure... 28 4.2.4 Collateral... 28 4.2.5 Coverage... 29 5 Case two... 30 5.1 The process...30
5.2 The investment decision ...31
6 Case three ... 35
6.1 The process...35
6.2 The investment decision ...36
7 Case four ... 40
7.1 The process...40
7.2 The investment decision ...41
8 Analyses of the investment decisions ... 44
8.1 Analysis of the banks’ investment decisions ...44
8.2 Analysis of the VCs’ investment decision ...45
8.3 Analysis of the IIs’ investment decision ...46
8.4 The banks compared to the VCs’ and IIs’ investment decision ...46
9 Conclusions and recommendations... 48
9.1 The choice of financer by the entrepreneur ...48
9.2 The investment decisions of the bank and Dutch regulations ...48
9.3 The cooperation between bank, VC and II ...49
9.4 Use of investment criteria...49
References... 51
Appendix I: Questions for the entrepreneur (in Dutch) ... 53
Appendix II: Questions for the investor (in Dutch) ... 54
1 Introduction
A lot of research about acquisitions is focussing on acquisitions by large companies. But, due to obsolescence, the acquisition market of small and medium sized enterprises (SMEs) is booming. Many SME companies are facing a takeover problem because they cannot find a successor. This study concentrates on the takeover decisions taken in four cases. A part is written from the perspective of the entrepreneur. Especially the choice of financer is explored.
From the perspective of the investor the emphasis is on the way they handle the agency problem. The 5Cs of credit analysis are used to find out what the literature describes about the investment decisions of the bank, venture capitalist (VC) and informal investors (IIs). Differences between the literature and practise are explored in four cases.
Chapter two begins with a definition of SMEs. After that, a description of the takeover process is given, followed by a detailed explanation of the 5Cs of credit analysis. Also the different methods to check managers’ character, capacity, capital structure, collateral and coverage is death with. And the usage of the 5Cs by banks, VCs and IIs is described. The emphasis, as described in the literature, of the investment decisions by the different investors is given.
The research questions and methodology are included in chapter three; were also the conceptual framework is introduced. Case studies are based on interviews, whereas the interview questions are listed in the appendixes. This study involves four cases.
In chapter four, five, six and seven the acquisition process and investment decision making, as found in the interviews, are described. In the first paragraph of these chapters the takeover process is given according to the four steps of a takeover: strategic consideration, search for a candidate, the transaction and the post-acquisition phase. The second paragraphs of these chapters give the investment decision making following the 5Cs of investment. These are: character, capacity, capital structure, collateral and coverage.
2 Literature review
An outline of relevant literature for this study is given in this chapter. This study discusses the process of takeovers within the group of SMEs and the financing criteria that can be applied during the acquisition phase.
In the first paragraph a description of SMEs is given. The second paragraph deals with the process of takeovers. The third paragraph concentrates on criteria for credit analysis. The way with how different investor’s judge on their investments, is highlighted in the fourth paragraph.
2.1 Small and medium sized enterprises
Acquisitions are a common way to grow for SMEs. The characteristics of Dutch SME firms are described in detail. Organisations are categorised by the European Union in the following way:
Big enterprises (>250 employees)
Medium enterprises (<250 employees)
Small enterprises (<50 employees)
Table 1 shows the categories known for of the Dutch SME with some more information. The more detailed description has four instead of three categories. This is in line with new regulations which allow the government to create different laws for the different categories.
Table 1: Definition of Dutch small and medium sized enterprises Enterprises
Category
Employees Turnover (in millions)
Yearly balance sheet total (in millions)
Large >250 > €50 > €43
Medium < 250 ≤ €50 ≤ €43
Small < 50 ≤ €10 ≤ €10
Micro < 10 ≤ €2 ≤ €2
About 99 percent of the Dutch companies belong to the group of small, medium and micro enterprises. The total turnover of SMEs in 2006 was €764.6 billion while the total turnover of all the business was €1,322.4 billion. So, Dutch SMEs have more than half of the total turnover of all the businesses together.
