Chapter 2
Get ting Ready to Buy or Sell a Company
In This Chapter
Knowing why companies often sell or buy other companies
Preparing your company to engage in M&A
On Seller’s side, the conversation begins with any one of numerous comments: “I think it’s time to retire,” or “I’ve taken this company as far as I can take it,” or maybe even, “This company is about to crater; I want to get out.”
On Buyer’s side, the conversation also begins with any one of numerous comments, but comments of a slightly different variety: “Organic growth isn’t enough. We need to consider growth through acquisitions,” or “I think buying that product line might be easier and less expensive than building one from scratch,” or maybe even, “Those guys are killing us; let’s see if we can buy them out.”
These conversations are often held with advisors — lawyers, accountants, wealth managers — or other executives. Most often, a set of questions follows: “How do we do this?”, “What’s the first step?”, and finally, “Do you know anyone who can help us?”
The decision to sell a business or to make an acquisition is often confusing, frustrating, time consuming, and expensive. But never fear; in this chapter, I break down the early considerations for selling or buying a company so that they feel less intimidating.
Considering Common Reasons to Sell
Many people, including many business owners, think the cash flow from a business is the only source of wealth creation. They overlook the (quite often stunning) wealth that company ownership can create. This section explores the reasons an owner may want to sell his business.
Trying to time the market — that is to say, trying to set your transaction to close when the economy is roaring — rarely works. Instead of trying to guess when Buyers are going to pay high prices, Sellers should focus on running the business, increasing sales, controlling costs, and improving profits. The best time to sell a company is at the intersection of salability and the need/want to sell the business and not necessarily when the market is booming.
Retirement
Retirement is one of the top reasons business owners decide to sell their businesses. The older some people get, the more they hear the siren call of Florida or Arizona. Or the Carolinas. Or . . . well, any place that doesn’t involve work sounds enticing. When an owner is considering moving on to the next phase of life, that phase of life often is fueled by the proceeds from selling his business.
So the question then becomes, “How do I know when it’s time to retire?” Here are some typical issues business owners consider when deciding whether to head off into the sunset:
Family: Where are the kids? At home? In college? On their own? Are you still supporting them, or are they financially independent?
Lifestyle: What do you want to do? Get involved with charities? Golf? Boat? Travel? Spend time with the grandkids? How much vacation time are you taking each year? If you’re spending increasing amounts of time away from the business and the business can operate without you (a good thing if you want to sell it), retirement time may be nigh.
Finances: Do you have enough saved to fund the lifestyle you want? Have you actually figured out that number with a professional planner, or are you just guessing?
As far as funding retirement, business owners usually have a rough, back-of-the-envelope number in their heads. Many times, that number is little more than a guess, and that guess often is a gross overstatement of what the owner really needs to fund his retirement. Sit down with a qualified wealth manager and talk about exactly what you want to do in retirement. That wealth manager should be able to determine what you’ll need to retire and live exactly as you want to live.
Your personal drive: Be honest: How’s your energy and drive? Yeah, I know, that sounds like one of those pharmaceutical commercials, but in all seriousness, are you still the go-getter who originally built the business? Admitting that your drive isn’t what it once was and that you’re putting aside your ego to think about what’s best for the business and your employees is no cause for shame.
If your position is no longer necessary to support the family, you have enough to retire, your lifestyle interests are increasingly outside the confines of work, and you’ve simply lost your mojo and desire for work, perhaps you’re ready to think about selling the business and retiring.
Buyer, you can ask a reluctant Seller if she has planned her retirement with a qualified professional. Getting an owner to create a concrete retirement plan with an advisor can be a way to bridge a valuation gap (see Chapters 12 and 21 for more on valuation and bridging valuation gaps).
Let someone else take the company to the next level
Some owners choose to sell because they’ve determined that they’ve taken the business as far as they can take it. They may not want to retire, but they also may not want to run the same company anymore. This situation happens for a few reasons:
Capital needs: A growing company, even a highly profitable company, usually requires more capital than the business generates from operating cash flow. Why is that? For most companies, cash flow lags behind revenue recognition, and revenue recognition lags behind expenditures required to support that revenue. A growth company that constantly needs to reinvest in the business (new employees, equipment and supplies, and so on) essentially has the capital needs of a much larger enterprise. Owners often decide they’re no longer willing to put their money at risk, and as such, they’re ready for another owner, perhaps a larger and better-capitalized entity, to swoop in and take the company to the next level.
The segue: I’m not talking about those fancy two-wheeled scooters here. The segue refers to a natural phase during the life cycle of a company: the gradual shift from a entrepreneurial company to professional company.
As a company grows, it needs more people to manage, oversee, and support the company’s new, larger size. With each new hire, the dynamic of the company changes; the entrepreneur/owner’s influence on the corporate culture is diminished. This move isn’t a bad thing; it’s normal. The company, by necessity, has to shift from a centralized, seat-of-the-pants, CEO-is-in-on-every-decision organism into a diverse, decentralized, and highly structured entity.
Many successful entrepreneurs simply don’t have the ability (or interest) to design, implement, and run a highly structured company and thus begin to pine for the days of yore. At this point, bringing in a larger, professionally run entity may be the best way for the company to continue its upward growth.
Chairman of the bored: The major battles are won, the company is on a great footing, and everyone knows his job and does it well. So where’s the problem? Believe it or not, many business owners, especially those of the entrepreneurial stripe, grow exceedingly bored with a well-run company. In this situation, both the company and the owner may be better off if another, more-engaged entity takes over.
An owner selling his business so that someone else can take it to the next level isn’t indicating that he can’t run the business; he may be setting his sights on his next business venture. He may be one of the vaunted serial entrepreneurs you’ve undoubtedly heard about. The world of M&A is rife with them, and everyone is better off as a result because entrepreneurs create jobs, new products, and better services.
Divesting a division or product line
An owner doesn’t have to sell the entire company; selling a division or a product line is a very common M&A activity. Some of the reasons to divest a division or product line include
A bad acquisition: Here’s a bit of irony for a book about M&A: Bad acquisitions are often the reason companies sell businesses, thus fueling a less-than-virtuous cycle (for Buyer’s shareholders) of making acquisitions at high prices and then selling them off at low prices, over and over and over. Sometimes Buyer is too large and the acquired company gets lost in the shuffle and declines from lack of focus and support from the parent. Other times, the acquired company suffers as a result of bad decisions by Buyer. I’ve seen far too many acquired companies go downhill because Buyer decided to cut costs by firing the sales staff! Getting rid of the sales staff often has the effect of — surprise, surprise — reducing revenue. As the acquired company declines because of these bad decisions, it may start to lose money to the extent that Buyer eventually seeks to cut its losses by divesting the acquisition.
An overleveraged Buyer: Sometimes Buyer borrows too much money to finance the acquisition, and the slightest hiccup in the economy can impair the acquired firm, thus forcing Buyer to sell off the acquired company. Actually, Buyer’s lending sources most often force the issue when Buyer is unable to service the debt incurred to finance the acquisition. Buyer has to sell the acquisition (often at a bargain- basement price), or worse, the creditors may end up taking over the acquired business, resulting in a total loss for Buyer.
A money-losing division: The decision to sell a weak division is often very easy and straightforward, especially if the rest of the company is strong. Losses can drag down an otherwise-strong company, so instead of throwing good money after bad, a company may simply spin off a money-losing division to get rid of it and its offending losses.
A lack of synergy: Sometimes one plus one equals three. Many other times the grand plan of combining two entities doesn’t pan out. For example, say a marketing services company starts up a janitorial services division. Most likely, the parent company will discover two divisions in disparate markets are spreading the company too thin. The best course of action may be to sell off one of the offending divisions and focus on the core strengths of the company.
In the hands of the correct owner, divested divisions often rebound quickly. Far from being the bad gift that just keeps on giving, selling off a division or product line that doesn’t fit with Company A may be a perfect fit in the hands of Company B.
The industry is changing
The decision to sell a company in the face of a changing competitive landscape is often a very smart move. But it’s a difficult move because forecasting the future is so darn difficult. When people wanted to forecast the future in days of old, they would observe the flight patterns of birds . . . and then make up something. Today, folks read newspapers and the Internet, follow their gut instincts, and try to guess what’s going to happen next.
Timing the market can be a dangerous pursuit, but if a business owner believes the future involves technology developments that will render his company a has-been, or worse, obsolete, he may be ready to exit the industry by selling the business.
For Buyers, changes in the industry are always a risk. Just ask any newspaper about how the Internet changed the way news is disseminated.
I’ve got troubles, troubles, troubles
In the “How did I get here?” file, you find the troubled children of the M&A world, often known as troubled companies, special situations, challenged companies, and turnaround opportunities.
Troubled companies run the gamut from handyman’s specials that just need a little TLC to those that should be in bankruptcy. A company that is suffering from poor management decisions but remains a going concern (liquidation is not on the horizon) may make a suitable acquisition for an acquirer well versed in turnaround work. On the other end of the spectrum, a company that is no longer a viable going concern should probably be liquidated by an orderly bankruptcy.
Although the reasons a company becomes troubled are virtually limitless, you can pool them into three distinct buckets:
Changes in the macro-economy: A general downturn in the economy, much like the one experienced in the latter years of the first decade of the new millennium, often has a chilling effect on many companies, including those that are fundamentally sound. An otherwise healthy company that has been beaten up by the market (suffered declining revenues and profits) is often a great acquisition for a savvy acquirer.
Managerial mistakes: Companies can suffer a downturn at the hands of poor management. Bad managerial decisions may or may not be tied to the general economy, and include overextending the company’s operations by opening too many new locations (often, the second location constitutes “too many”), making bad hires, neglecting to reinvest in the company, throwing company resources after a bad idea, and failing to participate in a new trend in the industry.
Is this company worth the trouble?
In addition to considering the nature of the target’s downturn (macro-economic, managerial, or changes in customer preferences — see the nearby section), a wise Buyer also looks at a few other key considerations when determining the value, if any, of a troubled company:
Is the target still profitable? If profits are down (perhaps even greatly down) but the target is still break-even or better, a Buyer will be able to ride out the storm (because the acquisition is not burning cash) and wait for the economy to pick up. After the economy turns around, the acquired company’s bottom line will be in position to snap back to its previous higher levels.
What are the target’s trends? Is the target continuing on a downward slope, or does it appear to be on the rebound? If the worst is behind the company, a Buyer will be in good position to pick up a bargain.
What’s the target’s top line revenue? Even if a target is suffering losses, that company may still have a great deal of value if revenues are large enough. What’s “large enough” depends, of course, but in a general sense, a $40 million revenue company has far greater residual value than a $3 million revenue company. A Buyer may be able to move the target’s operations to a new facility and/or eliminate duplicate positions, thus rapidly improving the bottom line of the acquired company.
Does the company have a recognizable brand name or other intangible qualities? These factors are notoriously difficult assets to value, but if a company has a recognizable name within in an industry or has done a good job of differentiating itself from the pack, that intangible may have value for the right Buyer. On the flip side, a company that’s essentially a faceless name in a sea of interchangeable companies probably doesn’t have much intangible value.
The good news is a company that has made managerial errors similar to those listed here may make a great pickup for the smart acquirer. The bad news is a company suffering through a series of near-fatal managerial mistakes may have burned bridges with its customers or suppliers. Consider yourself warned!
Changes in customer preferences: In the world of troubled companies, those affected by this situation are the most troubled of them all. Think of the proverbial story about buggy whip manufacturers in the wake of the advent of the automobile. Sometimes, technology passes by a product; regardless of the product’s quality, companies can’t do much to regain market share when customers move on to new and better products. The word for this phenomenon is disintermediation.
If you own a troubled company, speak to your attorney and an M&A advisor about how to proceed with a potential M&A transaction. You may need to consider accepting a deal below your dream price because holding out for a better, future deal is risky. That better deal may never materialize, and the clock is ticking on the longevity of a troubled company.
Selling a piece of the company
Business owners don’t need to sell the business and then retire or move on to other pursuits. The following sections explore some of the common reasons a business owner may want to sell a piece of the company.
Needing capital for growth
A growing company often needs more cash than it can generate from operations. If the owner doesn’t want to put her own money into the company or sign a personal guarantee for a bank loan, she can raise money from an outside investor. Outside investors come in two basic flavors, control and non-control:
Control investment: A control investment simply means the investor has control of the company. This situation occurs when an investor, often a venture capital or private equity fund, invests money in exchange for stock in the company. (Well, maybe stock, maybe something else. See the nearby sidebar “Structuring equity investments.”) In most cases, this investment is in the form of a majority equity investment — that is, the new investor owns more than 50 percent of the equity in the company, or the bylaws of the entity are amended to grant effective control to the investor.
Non-control investment: A non-control investment, often called a minority equity investment, is similar to a control investment, except the investor doesn’t have control of the company.
As you may guess, Sellers tend to prefer the non-control investments, while Buyers prefer control investments. The control investor has greater recourse to change management and affect the direction of the company. The non-control investor simply goes along for the ride, with little or no recourse to exit the investment.
Diversifying assets: Take some chips off the table
Many business owners have nearly all their wealth tied up in their companies, so their finances are in serious jeopardy if the company fails. Selling a piece of the company to an investor allows an owner to create liquidity in an otherwise illiquid holding. This maneuver is called a recap (short for recapitalization).
With the right investor, an owner who has recapped her business also has a capital source for further investment in the business and/or for acquisitions. In other words, the investor may also be willing to pony up more money to invest in the business or pay for acquisitions. One of the many challenges for most business owners is the age-old question, “Do I pay myself a big fat dividend or reinvest that dough back in the company?” By selling off a piece of the company, the owner is essentially able to pay herself that big fat dividend and have a source of capital for growth.
Lastly, a recap sets up the owner to get a “second bite of the apple,” that is to say, to generate a second liquidity event (realizing a gain from an investment by selling shares for cash) when the company is sold to another acquirer. For an owner who’s looking to retire in five to ten years, the recap can be a great way to lock in a certain amount of wealth and allow herself some additional time to continue to run and grow the company, setting up a potential second payday when she sells off her remaining shares and retires or goes off to another venture.
Bringing in an outside investor to buy out a partner
Partners are a great way to build a business: One person deals with one area, such as sales, and the other handles another (say, the back-office administration and accounting). That’s a good coupling. The downside to having partners is that they sometimes stop seeing eye to eye, and one of them needs to leave the business.
For a closely held business, this situation can be a problem; the partner who wants to stay may not have the money to buy out the partner who wants to leave. Bringing in an outside investor is a way to solve this problem.
Planning Ahead to Ensure a Smooth Sale
If you’re thinking about selling your company, a division, or a product line, you can take a few steps to make your asset more attractive to potential Buyers. This section tips you off to some areas to look at before you sell (or even decide to sell) so that you can avoid common pitfalls.
If Seller is unable to institute operational improvements prior to a sale process, she should inform Buyer where he can make additional improvements. Getting Buyer to pay for the improvements he’s bringing to the table is often a difficult proposition, but it’s usually worth a try. At a minimum, Buyer will view the suggested list of improvements as a sign of goodwill, thus increasing the odds of a successful closing.
Clean up the balance sheet
One of the biggest obstacles to getting a deal done is a messy balance sheet. Now, don’t freak out about the accounting. Repeat after me: Accounting is your friend.
One of the key figures on a balance sheet is the current ratio, or the difference between current assets and current liabilities. Anything labeled current on the balance sheet is essentially the same thing as cash. So what are these cash or almost-cash items?
Assets: Cash, accounts receivable, inventory, deposits, and prepaid expenses
Liabilities: Accounts payable, accrued expenses (those not yet paid), and the current portion of any loans (interest, and perhaps some principal)
The current ratio measurement is important because if the current liabilities exceed current assets, the company is considered illiquid, which means that if all the current creditors demand immediate payment, the company doesn’t have enough current assets to pay those demands. And if you’re trying to sell a company, that’s not going to endear you to most Buyers.
To fix up your balance sheet in preparation for a sale, follow these steps:
1. Collect your receivables.
Buyers check to see whether Sellers are diligent about this collection (at least, they should). If the terms are net 30 (that is, money is due within 30 days), as a Seller you should be collecting those receivables within that time frame. If customers are taking longer to pay, that’s effectively a use of cash.
Slow collections on receivables may mean Buyer has to obtain a revolver loan, a loan designed to help companies with fluctuations in cash flow. Loans aren’t free; therefore Buyer may demand to reduce the purchase price to help defray the cost of that loan.
Buyer will likely assume your working capital, namely receivables and payables, as part of a transaction. Buyer will probably want all the receivables but may make you grant a discount on overdue accounts. Buyer will also only assume payables if they’re current or within terms. For example, if a vendor gives you net 30 days terms but you’ve been paying net 45 days for years without complaint from the vendor, you can make a case that the actual (or de facto) terms are 45 days.
2. Make sure inventory is all saleable.
If you have obsolete or slow-moving inventory, talk to your accountant about how best to write off this inventory. Writing off inventory decreases the company’s earnings, so you want to get this step out of the way before you go through a sale process. If you write off any inventory prior to a sale process, you should be able to discuss the rationale you used for those write-offs as well as the steps you’ve taken to prevent future build-ups of excess or obsolete inventory.
You put yourself in a precarious position as Seller if, during the due diligence phase, Buyer discovers a boatload of obsolete inventory that isn’t reflected on the valuation. In this scenario, Buyer will likely attempt to renegotiate (that is, argue for a different deal, probably with a lower price) because earnings are now effectively lower in light of the inventory the company needs to write off.
If you want more information about the wonderful world of accounting, check out Accounting For Dummies, 4th Edition, by John A. Tracy, CPA (Wiley). Or you can talk to your accountant.
Pay off debt
Another hurdle in selling a company is taking care of your long-term debt. Many Sellers either “conveniently” forget about the debt or hope/assume that Buyer will simply assume the debt no questions asked. Here’s a little bit of expert advice: That ain’t gonna work! The long-term debt of the business is Seller’s obligation.
Don’t despair if your business has unattractive long-term debt; you have some options: Retire that debt now, make a plan to retire that debt before closing, or retire that debt at closing. Although Buyer can assume the long-term debt of an acquired company, Buyer will probably simply deduct the amount of debt from the proceeds of the sale. For all practical purposes, if Buyer assumes the debt, Seller is retiring that debt at closing.
If you’re worried that your company’s long-term debt may block a sale, here’s a tip for negotiating with the lending source. Call the lender, explain that a deal to sell the company is on the table but may be in jeopardy because of the company’s debt load. Ask whether the lender would accept a percentage of the amount owed (60, 70, 80, or whatever) within a certain time period (such as 45 days) and then consider the debt paid in full if you meet those new terms. Tell the lender that if you fail to meet the terms of this new agreement, your deal reverts to the original 100 percent. The lender, if it accepts the deal, gets the benefit of getting part of its money repaid right away (or in the near future), and if that immediate repayment doesn’t materialize, the lender hasn’t lost anything. It’s an offer some lenders won’t be able to refuse. If the lender agrees to this gambit, be sure to memorialize the agreement in writing.
Address legal issues
A wise business owner settles any outstanding lawsuits before a sale and is prepared to talk about those lawsuits and their outcomes. Planning to gloss over or omit mention of lawsuits, or simply expecting Buyer to uncover a lawsuit (or criminal investigation) by itself, isn’t smart. These actions indicate that you’re negotiating in bad faith, which means you’ve just kneecapped your credibility. Ideally, you want to be able to honestly say, “We are not aware of any pending lawsuits or investigations.”
The other major legal issue for many deals is the legal organization of the company. In other words, is it an LLC or a corporation (and if it’s a corporation, is it an S-corporation or a C-corporation?). These distinctions are important because they affect the taxation of the business.
An LLC and an S-corporation allow for a single layer of taxation, which means the government taxes a sale of assets once, most likely at the prevailing capital gains rate.
The Seller of a C-corporation, on the other hand, gets hit with two layers of taxation. First, she pays on the proceeds of the sale at the corporation level, and then when the remainder of those proceeds is distributed to the shareholders, the shareholders also pay tax, most likely at the capital gains rate. This double-whammy means the shareholders of a C-corporation many be looking at receiving less than 50 percent of the gross proceeds. Ouch.
Sellers should speak with their tax advisors prior to pursuing a business sale and set a plan well in advance of the decision to sell. Depending on the company’s legal organization, converting to a different legal entity may make sense tax-wise. But starting early enough is key: When converting from a C-corporation to an S-corporation, you may need a full decade before the full benefit accrues. And don’t forget to talk to a wealth manager before the decision to go through a sale process. An able advisor can provide you with a structure for a deal that minimizes your tax burden. Don’t wait until after the deal closes to talk with a wealth advisor, or you may be unhappily surprised.
Trim staff and cut dead weight
If you want to maximize the company’s valuation, you need to maximize the company’s profits. One way is to reduce and eliminate wasteful expenditures, and because the largest expense of most businesses is personnel, you may have to make some difficult decisions.
Please don’t read this suggestion as a license to be capricious or cruel. Don’t start firing staffers simply for the sake of cutting positions. Make a determination of what personnel you need to run the business and simply execute on that decision.
Don’t be afraid to be tough. No one likes to let people go; it’s difficult. But if certain employees aren’t pulling their weight or aren’t performing up to expectations, you need to lay them off. If an otherwise-good employee is in a low/no value position, either move that employee into a productive role or bite the bullet and let him go.
If some staffers are on the edge, give them a chance to improve. Set realistic goals and give them the tools to succeed. My experience has been people respond to this challenge in one of two ways: Either they step up and improve their performance to a tolerable level or they quit. Either option is a suitable outcome.
Increase sales
The other side — and happy side — of the “improve profits” coin is higher revenue. The profitability of your company improves when revenues increase and expenses stay the same. It’s simple math, of course, but you can’t follow the road to higher revenues until you push your salespeople and perhaps provide a different (that is, more lucrative) commission plan.
Don’t settle for short-term fixes that will likely go away when the new owner takes over. That’s why permanent plans, as opposed to a one-time, short-term stimulus plan, pay better dividends over time. Set the stage for long-term success. A savvy Buyer sees a short-term gimmick for what it’s worth and argues for a lower transaction price.
Quantify owner’s expenses and other add backs
Most business owners and executives are familiar with the term generally accepted accounting principles, or GAAP. Closely held businesses often utilize a different version, colloquially called FAAP, or family accepted accounting principles. Owners of closely held businesses often run personal expenses, such as car, country and other clubs, travel, cellphone, meals, and any other expense that isn’t really a business-related expense, through the company. If you’re one of those owners, talk with your accountant about how best to quantify and present those expenses.
These owner expenses are add backs to the all important EBITDA calculation. Providing these add backs, or a “roadmap of value” as I like to call it, helps provide Buyer with the ability to see the true value in the business and helps improve his willingness to pay for that value.
Although this section shows an owner or executive how to treat owner expenses prior to a sale, I don’t actually advocate running personal expenses through a business. If the business is audited by the IRS, those expenses may be disallowed and the owners may face penalties.
In addition to owner expenses, you may have other add backs to account for, including one-time expenses such as severance, a lawsuit settlement, or a once-in-a-lifetime capital investment (for example, buying equipment with an extremely long useful life). The proverbial “acts of God” also fall into this category.
The rule of thumb when analyzing whether an expense is one time is simple: What are the odds of this expense happening again? The higher the odds, the less the ability you’ll be able to claim it as one time. If the so-called one-time expense happens year after year, it’s not a one-time expense, and you’ll have a difficult time arguing for that add back.
Owner, make thyself expendable
Companies with the greatest value to Buyers are those companies where ownership is completely, totally, and utterly replaceable. Not surprisingly, that’s a spiky pill for many owners to swallow. Heck, the thought of being utterly replaceable is spiky for almost anybody! But ego aside, think of the issue this way: How can you expect to get top dollar for selling your company if the company can’t operate without you?
Here are a couple ways you can make yourself replaceable as an owner:
Train other managers to run the company without you. Empower them to make decisions, and trust them to work independently and make their own decisions.
Design and implement systems that remove any ad hoc decision- making systems. You’re not trying to cripple the decision-making of others; instead, you’re providing a framework for employees to make decisions so that they can do so without constantly running to you.
Exploring Typical Reasons to Acquire
Since time immemorial, mankind has grown through acquisitions. Granted, those early acquisitions were really conquests, but in recent years, empire-building has focused on acquiring companies.
As I note in Chapter 1, an acquisition allows a company to skip the growth stage and buy existing sales and profits. For this reason and those in the following sections, a company may choose to buy other companies instead of relying on organic growth.
Make more money
Make no mistake: The pursuit of money is a main reason for making acquisitions. Although it may be the most base and crass of reasons, it’s an extremely valid one. Making more money is a noble pursuit. Profits make shareholders happy and therefore keep the vultures from descending upon high-flying executives’ careers.
Gain access to new products and new markets
Acquiring a company with a similar product allows the acquirer to increase its share of the market. Being a larger player in an industry can have benefits, such as the ability to negotiate better prices or terms from suppliers and vendors, increase awareness to customers (larger companies typically are better known than small companies), and raise prices.
Buying a company may also allow the acquirer to introduce its products into new markets, as well as introduce the acquired company’s products into Buyer’s markets.
Implement vertical integration
Vertical integration means buying a supplier or an end user of your product. An ice cream manufacturer that buys a dairy farm is vertically integrated. The benefits may include better pricing (the ice cream manufacturer doesn’t have to pay the dairy farm’s markup) and control of raw materials.
The downside is that the acquired company may service other competitors. If that dairy farm also supplies other ice cream manufacturers, those competitors may balk at buying from their rival. This situation is a channel conflict. (And you thought that was when you and your spouse argue over what program to watch!)
Take advantage of economies of scale
You’re likely to hear this term countless times. Economies of scale simply means that as a company grows larger, the fixed expenses stay the same (or increase far more slowly than the top line revenue). Therefore, the larger the company becomes, the more profitable it becomes.
Buy out a competitor
If you can’t beat ’em, buy ’em! If Company A is killing a Company B in the marketplace, Company B may determine simply buying Company A is the best way to make the competition go away.
Prepping before an Acquisition
A company thinking about making acquisitions just doesn’t wake up one day and close a deal. Successfully acquiring other companies takes some planning and preparation; I cover the vital considerations in this section.
Determine the appropriate type of acquisition
How much revenue does the target need to have? Does the target need to have a minimum profitability level, and if so, what is it? Are you willing to consider acquiring a money-losing operation? Should the acquired company be a product extension or a new product? Should the acquisition allow you to vertically integrate? (See “Gain access to new products and new markets” and “Implement vertical integration” sections earlier in the chapter for more on these topics.) These are only a few of the possible questions to consider when choosing a potential acquisition.
Unless you have a clear idea of what you want to buy, you probably won’t successfully close a deal. Many strategic and financial Buyers often take a “show me everything” approach when looking for acquisitions. The odds of finding the right fit are exceedingly low when you haven’t defined the parameters of a right fit.
Get your company’s balance sheet in order
How’s your balance sheet? No, really, be honest. How is it? If your balance sheet is a mess, your company isn’t ready to do deals. Companies able to successfully do deals have strong cash positions and little or no debt. Working capital should be positive, and the current ration should be at or above the industry norm. (The “Clean up the balance sheet” section earlier in the chapter gives you some balance sheet basics.)
Have the money lined up
Have your sources of cash ready to go before you begin the acquisition process. Sure, a strong balance sheet with lots of cash is very helpful, but an acquirer doesn’t necessarily have to use its own money to fund 100 percent of a deal. Depending on the acquirer’s situation, a line of credit from a bank, a mezzanine fund (a lender subordinate to the bank loan), and/or a private equity fund may be able to help with the financing.
Although you don’t have to have a private equity fund or mezzanine fund as a financial partner to make an acquisition, failure to line up your sources of financing ahead of time may mean you’re unable to close a deal, resulting in wasted time for both you and Seller. Also, reputations travel because people talk. A Buyer unable to close a deal because of a lack of forethought sullies its reputation.
Set up an acquisition chain of command
In order to successfully complete acquisitions, you need to determine who’s taking what role. If you’re handling the acquisition internally, give team members specific jobs: compiling the target list, making the calls, negotiating and structuring the deals, and so on. If you’re bringing in an outside firm to perform some or all of these tasks, appoint an internal person to be the main interface with the intermediary. Following this chain of command at all times helps the acquisition process go smoothly and efficiently by eliminating poor communication and duplicate steps.
Designate a specific individual as the deal point-person to have all of the interaction with Seller or Seller’s representative. All requests and questions go through this one person to prevent poor communication, duplicated steps, and a frustrated Seller.
Buying a Company from a PE Firm
In some situations, you may consider acquiring a company from a private equity (PE) firm, a pool of money that buys companies with the intention of reselling them later for a sizable profit. PE firms can be very motivated Sellers. But be warned: They’re also extremely crafty deal-makers. After all, buying and selling companies is their industry. They’re experts. (Head to Chapter 4 for the lowdown on PE firms.) The following sections offer some considerations to keep in mind as you look at dealing with a PE firm.
Understanding why PE firms sell
Because PE firms are in the game to make money (and who isn’t?), a PE firm will eventually be looking to exit its investment (which may now include some add-on acquisitions).
PE firms also hear the constant ticking of the internal rate of return (IRR), one of the key metrics they like to flaunt when raising capital. In a nutshell, the longer a PE firm holds an investment, the greater the chance the IRR will be lower than the PE firm prefers.
Evaluating a PE firm’s portfolio company
I provide plenty of factors to consider in acquisitions throughout this book, but here are a few specific suggestions to look at for a PE firm’s portfolio companies.
Does the company fit with your goals? This question is pretty basic, of course, but as Buyer, take care when evaluating the fit of a portfolio company with your company. Despite the great case the PE firm may make for the portfolio company, a company that doesn’t fit your goals isn’t that great a deal.
How will the company’s earnings affect your earnings? If the acquired company’s earnings increase your earnings, they’re accretive; if they decrease your company’s earnings, they’re dilutive. Decide whether a potential earnings hit matters to your company. Consider also whether the acquired company will eventually be able to generate higher earnings for the entire firm if earnings take an initial hit.
Is the company actually an integrated set of other companies? PE firms often cobble together multiple companies into one integrated firm. This setup is perfectly fine, and PE firms often do a wonderful job of integrating, but you need to be wary of just how well organized formerly disparate companies have been integrated.
How long has an integrated company been operating (since the last acquisition)? If the acquired company is actually a group of formerly independent companies, don’t make an acquisition too quickly. Waiting awhile (at least a year) to make sure these formerly independent companies are operating as a cohesive unit is a good idea.