The following is adapted from Buy Then Build: How Acquisition Entrepreneurs Outsmart the Startup Game

 

As a new acquisition entrepreneur, you’re ready to purchase a company and you understand that it could be one of the most important investments you ever make. You’re also faced with the challenge of determining the future potential of any company you’re interested in. Will it still look like a good investment in five years?

An excellent way to assess the company’s potential is to apply Porter’s Five Forces model.

Michael Porter is a revered economist and corporate strategist from Harvard University who literally wrote the books on Competitive Strategy and Competitive Advantage. He first introduced his Five Forces model in Harvard Business Review in 1979. Today, they represent a cornerstone of corporate strategy education in business schools and board rooms across the globe.

Porter’s Five Forces provide a framework for identifying where the power lies in the supply chain, where the threats exist in an existing business model, and where the strengths of a company’s value proposition can be found. For your purposes, Porter’s Five Forces can help you to understand the dynamics at play both within an industry and in a specific company.

Force #1: The Threat of New Entrants

How can you tell whether a company you’re interested in will still provide a valued service in a few years? In other words, does the company provide something that allows it to fend off new companies from entering the market and taking existing market share? Spend time identifying the barriers to entry that exist. If someone else wanted to start a similar business, what would keep them out?

The threat of new entrants is typically kept at bay with competitive tools such as differentiation, brand equity, economies of scale, switching costs, cost of starting up, access to distribution channels, geographic restrictions, or the new favorite, network effects. Does your target business hold any protection from this threat? How strong is it?

Force #2: The Threat of Substitutes

This force relates to the value the product or service delivers to the customer. Is there a potential easier way to accomplish the same or similar goal for the customer? This points not to direct competition over the same product, but rather to understanding the value being received by the customer and identifying what else may provide that benefit.

There are several ways to look at this force. It’s easy to think about new technologies moving in and eating market share, such as cell phones overtaking landlines or tablets eating away at laptops. Additionally, I try to consider the offering at the highest level; for example, television and books both provide home entertainment.

Force #3: Buyer Power

How likely is it that your customers will drive down your prices? This will depend on a number of factors. For example, imagine there are a few large buyers and many fragmented suppliers. In this scenario, buyers have a great deal of power to pit suppliers against each other in a race to the lowest price. This concept is typically thought of as commoditization.

The good news for you is that the industry in this situation might be ripe for either a disruptive technology or consolidation play—either of which could be executed by an acquisition entrepreneur with the right plan.

Force #4: Supplier Power

As the name suggests, supplier power is a similar risk to buyer power, coming from the other direction. This force describes how easy it is for the company’s suppliers to increase prices, which in turn increases the cost of goods sold and reduces gross margins.

To assess the power of suppliers to your prospective business, consider the following questions: How many suppliers are there? How unique is their product? How difficult is it to switch? Alternatively, could the supplier cut out your target business altogether and sell directly to buyers online? How strong is the distribution channel?

Force #5: Competition

The last of Porter’s Five Forces is competition. Who are your rivals in the industry and how strong are they? Understanding who the competitors are, how competitive the market is, the position of each of the competing entities, and what their value proposition is will lead you to an understanding of all the players.

Look for quantifiable data showing trends in the industry. Get industry reports and comparable company financials if you can. This will help you understand the performance in the industry as well as help identify new opportunities or differentiators.

How to Apply the Five Forces

 

To evaluate any business you’re interested in purchasing, make use of Porter’s Five Forces model as dispassionately as possible. You need good information about the likely strengths of the company you’re investigating, and any potential pitfalls that might lie ahead.

As you apply Porter’s Five Forces to the acquisition target and its industry, a picture will emerge that will enable you to understand clearly how attractive the business is in its current state. As you review, ask yourself what new management could do to leverage or change any threats or opportunities. Nonetheless, remember that acquiring any business comes with an inherent level of risk. Don’t be put off by moderate levels of risk if you think you can mitigate the challenges.

By applying the Five Forces, you should be able to clarify the risks of a specific business. You should also be in a position to understand whether you are comfortable with the level of risk involved in a specific purchase.

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For more advice on how to succeed in acquisition entrepreneurship, you can find Buy Then Build on Amazon.