On paper, the concept looks attractive. You have built a successful company through hard work and smarts. You have established a sound competitive position in a solid market niche. But additional growth will be much more difficult to achieve, since you have exhausted all the obvious ways to increase sales and profits. Why not use your financial and management resources to buy another company?
A great deal is known about public company acquisitions, but how much is known about the buying and selling of private companies? Can anyone with a fund of cash and experience in business play the game, or is it so fraught with risk that it ought to be left to big public corporations that can invest much greater resources of money and management than private companies? How do you go about finding a company to buy?
Privately held companies are not required to report detailed financial information to shareholders and the SEC. Even the financial statements of privately held companies are subject to wide interpretation. Records of purchases and sales, selling prices, and terms are not generally available. Equally important, little information is available on how companies do with the private acquisitions they make—the acid test.
The result of this catch-as-catch-can environment gives rise to both the problems and the opportunities of the private-company acquisition market. The risk is much greater than it is in almost any other large-ticket market, but so is the opportunity for gain. The most successful acquirers have learned how to dig out and analyze essential information.
Information is not the only key to success in the acquisition game. Experienced acquisition experts, attorneys, CPAs, and others who are regularly in on the action will tell you that for every corporate acquisition that works out well there is a disaster. The triumphs are mostly by purchasers who stayed relatively close to the industries they understood, had well-defined strategic goals for the acquisition, did an enormous amount of homework before making decisions, and negotiated for price and terms that were justified by the short-term prospects (along with the long-term promise) of the target company.
More often than not, the successful acquirers looked at a large number of candidates before finding one that suited their needs. Failures, on the other hand, occurred most commonly when acquirers neglected the complex interactions of an unfamiliar market, or failed to uncover negative information through careful research and investigation.
Many corporate acquirers have suffered from management hubris, the overconfidence that often afflicts people who have defeated all odds and built a successful company. The experience leads easily to an attitude that if you can do it once you can do it again and again.
The importance of strategy
Given the hazards of the game, what does it take to make a successful acquisition of a privately held company?
The first essential is that an acquisition be a part of a broader, market-based strategy for growth. That strategy should be based on the things your company does better than others competing in the same market, or on specific reasons that will give your company an advantage over its competitors.
An example of such a strategy is the vertical acquisition, in which you buy one of your key suppliers—an “upstream acquisition”—or a distributor or retailer—a “downstream acquisition.” The first type should give you greater control or a price advantage over a critical source of supply. The downstream acquisition is designed to put you closer to the marketplace and give you greater control over how your products are sold. A horizontal acquisition involves purchasing a competitor, giving you access to greater market share and lower costs. Or it could mean acquiring a similar company with related products that can be distributed or sold through joint channels.
Less obvious are acquisitions that, in theory at least, create something called synergy. Perhaps you make a computer-peripheral product and determine that by acquiring a company that makes software for the same market, you can put them together into a system that broadens the applications for your product or makes it easier to use. Acquisition seekers are well advised to use the word “synergy” with caution. The hoped-for benefits have a way of evaporating somewhere between the planning and the execution. Nonetheless, it can be a powerful reality when expectations are limited to down-to-earth, measurable benefits.
Most successful growth strategies are developed and expressed in terms of marketplace needs. The mere desire to grow is not a sufficient justification for starting an acquisition program. What are your customers thinking about? How are they changing, and how can you best meet those changing needs in the future? Those are the first questions to ask.
Getting professional help
The acquisition business is sufficiently tricky that specially qualified professional assistance is a necessity. At every step of the way, questions arise that are highly technical. How professionally they are dealt with will have a lot to do with how successful and profitable an acquisition will be in the long run.
Many of these technical issues should be recognized early in the game, before commitments have been made that are irreversible. Some of them have to do with the structure of the acquisition rather than the size or type of company sought. For example, long-term profitability can be greatly influenced by whether an acquisition is structured as a pooling of interest, a purchase of stock, or an asset purchase; how purchase price is allocated among the various assets acquired; how payments are timed; and how money is paid to the seller for post-sale services. In the long run, professional assistance pays for itself many times over, particularly if the professionals are included from the planning stage.
Unless you are searching for a company in the $10–million–and–up range, your business will be too small to interest Wall Street investment banking firms, where fees for an acquisition frequently exceed $1 million. At the other end of the spectrum are business brokers, most of whom handle sales of very small businesses and few of whom are qualified to provide the strategy, research, analysis, valuation, and financial guidance that can be so important. That leaves a handful of acquisition consultants who work with companies in the range of $500,000 to $10 million in selling price, or $1 million to $20 million in sales volume.
Doing your homework
Since there are no standards or certifications for acquisition consultants, let the buyer beware. Check references carefully, determine the range of services provided, and talk with several clients the consultant has served. Insist on a full explanation of how the consultant will work and how fees will be determined. If you don’t, it is altogether possible to find yourself in a position where you legally owe the consultant a large fee even though you have acquired nothing. Also, in these days of instant lawsuits, it is more important than ever to know a lot about anyone who is going to represent you in a tricky marketplace.
The more vague and general the consultant is, the more he relies on unspecified “contacts,” the more cautious and skeptical you should be. Ask to see examples of reports and due-diligence studies he has done. Find out how acquirers have fared after the acquisitions he has worked on were consummated, which will say a lot about the quality of the businesses he has worked with.
Most professional acquisition consultants work on a combination of fee plus commission. You court disaster by retaining professionals on a commission-only basis, since all of their motivation will be to conclude a deal so they can get paid rather than call attention to potential problems. None of the professional acquisition firms will provide search services for commission only. One of the largest acquisition firms generally charges selling companies a one-time fee of approximately $20,000 for a detailed valuation plus commissions based on the Lehman formula when a company is sold. Purchasers are charged consulting fees to develop an initial strategy and to find a suitable number of acquisition candidates for consideration.
Finding the right candidates
Once you have devised an acquisition strategy, all you need to do is put the word out to your banking and financial advisers, look at the business opportunity ads in the major metropolitan areas, wait for candidates to contact you, and start the negotiations, right?
Wrong. Simply finding legitimate candidates to start with is one of the most difficult parts of this job. The reason? The best acquisition candidates are almost never officially on the block. The owner has been thinking about selling, but hasn’t gotten around to taking the right steps. The owner is past retirement age and has no successor. He (or she) is tiring of the grind, the increasingly competitive battle just to stay even. The trick is to find such companies before they take formal steps to sell. These are the best candidates, and they have to be ferreted out.
It is possible, from time to time, to find an acquisition through your legal, banking, or accounting advisors. If you’re a good client for them, they may review their client list to find candidates. If not, forget it.
Several financial institutions publish acquisition lists. Most of the major accounting firms also keep score on potential acquisition targets, and so do many banks. Some acquisition companies sell lists of companies that are (supposedly) on the block. Unfortunately, these lists rarely prove to have substance. By the time you track the companies down they have changed their minds, lost large sums of money, gone bankrupt, or simply disappeared. The truth is that an attractive acquisition candidate almost always finds a buyer before the casual inquirer finds out that it is for sale.
Once you have completed a list of possible target companies, you must contact them directly or through an intermediary to determine whether they would like to discuss acquisition. It’s slow, it’s tedious, it leads to a lot of wasted time, but it’s still one of the best ways known to find an attractive acquisition when there are no logical candidates on your doorstep.
The single most important step in the acquisition process takes place after you have found a candidate that appears promising. It is the due-diligence: the formal process of gathering facts, figures, and opinions about everything that has a bearing upon the future performance of a target company. Most successful acquirers approach the due-diligence process formally and in writing, so that the same data can be examined and challenged by everyone involved in making a decision.
A typical acquisition report, even for a company with only a few million dollars in sales, will cover the company’s history, management, financial performance for five years or more, markets, competition, products and services, facilities, and outlook. It will include adjusted earnings analysis, balance sheet and ratio analysis, determination of working capital needs, and a fairly explicit statement of problems to be addressed, opportunities to be exploited, and management priorities once the acquisition is completed.
Asset value is key
A professional valuation is essential. An appropriate method for valuing privately held companies will generally be based on fairly short-term prospects, since buyers of such companies can rarely wait five years or more for a return.
As a rule, the valuation of a typical private company will be set at a level that will yield the purchaser a 15 percent to 30 percent pre-tax return on cash invested in the first few years, with the lower end of the range for rapidly growing companies and the upper end for companies that have reached a plateau in sales and profits. This is a great generalization, however. It is not uncommon to find healthy prices paid for companies that have yet to earn a profit. If the promised market opportunity is attractive enough, and the purchasing company knows what it is doing, such an acquisition can show a greater return than other acquisitions.
In private company acquisitions, asset value will have a greater influence on selling price than it usually does in larger public company acquisitions, which are more likely to be pure earnings plays. This is because the private company acquisition is generally riskier, and it is correspondingly more important to have assets to sell off in the event of a complete failure. In addition, smaller companies need to rely on assets to secure borrowed funds, since lenders don’t like to make cash-flow loans to small companies.
What is a fair price?
The average prices paid for publicly held companies over the past several years have ranged from 10 to 16 times reported after-tax earnings. That sounds like a lot, since on the surface the return on funds invested at such prices would yield only 6.6 percent to 10 percent.
Here’s one of many cases where accounting and tax conventions enter into acquisition calculations. Since most of the money for an acquisition may be borrowed at a rate below the pre-tax earnings return, and since, within limits, much of the purchase-price payment can often be put into a form that makes it a deductible expense for the purchaser, pre-tax earnings rather than after-tax earnings are usually more relevant for the purchaser of a smaller company. Thus, the after-tax ratio of 10 to 16 times earnings translates into a pre-tax ratio of 5 to 8 (a return on investment of 12.5 percent to 20 percent). If a large portion of the purchase price can be borrowed at, say, 10 percent, the return on actual cash invested will be correspondingly higher.
In addition, if the acquisition strategy was well conceived and executed, there will generally be cost savings from combining operations or increased sales by exploiting market opportunities, leading to profits high enough to fund the acquisition plus a sizable sum left over to compensate for the risk of the venture.
This attractive arithmetic leads many acquirers to ask about leveraged buyouts—that is, using the assets of the acquired company by borrowing or capital sourcing to fund the acquisition and its cash flow to pay debt service. To set the record straight, most good acquisitions should meet this standard or, by definition, they aren’t good acquisitions. Most good acquisitions, in other words, will be self-funding.
Another way of judging historical purchase price trends is by the average ratio of purchase price to sales and net worth. According to data from W.T. Grimm in Chicago, prices paid for public company acquisitions have generally averaged 1.5 to 1.8 times the seller’s book value and one-half to two-thirds the seller’s annual sales. Bear in mind that book value, or reported net worth, can be very misleading. Many of the assets on the books may be carried at a fraction of true current market value. Conversely, in some instances book values may be inflated for a variety of reasons ranging from the legitimate to the highly questionable. Nonetheless, these ratios help to give you a fix when you assess a target company’s financial statements and asking price.
What are the real earnings?
A related issue is making an accurate estimate of the selling company’s true, as opposed to reported, earnings. Accounting conventions permit a wide variety of financial reporting options for privately held companies. For example, does the company record sales when the product reaches the shipping dock, when it reaches the distributor, when it is sold to an end user, or when payment is received? Have certain costs been “capitalized,” with the result that reported profits are inflated? On the other hand, it is not uncommon to find privately held companies that expense a great many capital costs in an attempt to reduce taxable earnings. Is there a lot of slow-moving, obsolete, or damaged inventory carried at full value on the books (or, a lot of valuable inventory not related on the books, a common indication that the owner has been hiding profits from the IRS)? How is work in process recorded—with or without overhead allocation and profits? How is inventory valued—LIFO, FIFO, or GUESSO?
Finally, how does one account for anomalies and what level of verification should you require for questionable issues? That all depends, and is one more instance of the need for experienced professional help.
The financing package
Assuming you have found a good candidate, thoroughly examined its background and prospects, and negotiated an agreement on price and terms, you’ll probably need to figure out how to pay for the transaction. If your company is closely held, the handy option of paying for the acquisition in stock probably won’t appeal to the seller, who wants only public company stock so that he has a way to cash out if desired. That leaves cash, externally borrowed funds, or funds lent by the seller in one form or another.
The typical private acquisition will be structured as an asset purchase. The stock of the selling company will be retired, and most of the liabilities will be settled by the seller out of the sale proceeds. You or your company will buy the assets only. Cash, securities, and other liquid assets will usually (though not always) be kept by the seller. You will buy inventory, land, buildings, machinery and equipment, furnishings, and such intangible assets as records, customer lists, advertising and promotional materials, mailing lists, patents, and goodwill. Accounts receivable and accounts payable may or may not be included in the sale, depending on circumstances and the financial dynamics of the company and its markets.
Only some of these assets are likely candidates for outside bank financing. Assuming everything else checks out, you will probably be able to borrow 75 percent or more against the current market value of land and buildings, 80 percent against qualified receivables if they are included, 50 percent to 80 percent of the auction value of machinery and furnishings, and 50 percent of the book value of inventory. You may also be able to negotiate a working capital loan, though don’t count on borrowing money against anything that can’t be liquidated by the borrower in the event of a disaster.
If a substantial part of the purchase price is allocated to intangible assets and goodwill, you are left with the problem of raising your own funds for this part of the acquisition. If the seller trusts you, he will frequently provide intangible-asset funding himself. In addition, most sellers will take a percentage of the purchase price (generally 10 percent to 20 percent) in the form of payments over the life of the non-competition agreement, a consulting contract for which not very much work will be done, or a salary contract if he or she is to stay on and provide services. The balance of the funding will usually have to come from you or your company.
Plain and fancy terms
That’s an oversimplification of what can get to be a very complicated production. Sometimes, for example, the seller will stay in for a percentage of ownership. Or a qualified pension fund can be flipped over as an ESOP for a percentage of the ownership. Sometimes past losses of the acquired company can be converted into tax savings to help fund the purchase, accounts receivable can be drastically reduced to generate cash, or excess inventory can be turned into cash. Under certain circumstances, outside investors can be lured in for a piece of the action, though as a rule they want a lot of bang for very little risk money.
Special forms of funding may come into play. If facilities are going to be consolidated and improved, there is a chance that a state or local development fund will provide low-cost financing. A creative bank, with ample help from your advisors, may be willing to help you completely restructure your own balance sheet to create new funds for the combined operation. If your company is beginning to look sexy, it may be possible to get a private fund placement from an underwriting firm to finance the purchase, with the expectation that, down the road a ways, they can help take your company public.
However, the plain kind of funding generally wins out over the fancy kind. The banks do their part, the seller does his part, you do your part, and somehow the deal comes together.
Making it pay
A great part—some would say most—of the success of an acquisition derives from what happens after the acquisition is made.
Considering the fact that there are almost infinite variables in the financial, business, and marketing character of any business, it might seem surprising that any acquisition works out well. Yet when the strategy has been well conceived and the rules have been followed, a great many acquisitions turn out even better than anticipated. Part of the reason is what small-company accountants and consultants call the “new owner effect.” A new owner brings new energy, a new perspective, and new human and financial resources to a situation that was stale. The surviving organization responds favorably when an agenda for growth is put into place. Morale improves, sales soar, and costs are beaten into line.
Needless to say, there are other scenarios, some of them disastrous. But a sound company that has suffered from tired management is an extremely fertile ground for improvement when the new management takes the right steps.
When it doesn’t work out that way, the reasons can usually be traced to something important that was not done. An important piece of information was overlooked. Financial needs were underestimated. Sensitivities among the acquired company’s managers and employees were bruised unnecessarily. The amount of time required to nourish the acquired company back into growth mode was underestimated.
What this says is that if you are prepared to observe all the dos and don’ts, the acquisition game can be exceptionally rewarding, but if you’re not prepared, you’d better stay close to home.
James S. Howard, co-chairman of Asset Growth Partners in New York City, has been involved in the purchase and sale of more than 300 businesses. Article reprinted with permission from D&B Reports, July/August 1986.The right fit for family companies
Only family companies that are currently profitable and reasonably well managed should embark on acquisitions — and never do it for the wrong reasons. Acquisitions should never be considered as a way to leapfrog a bad situation and turn around the company. They should never be done solely to create a separate domain for a family member who does not fit in well with the acquiring company.
The culture of the acquisition candidate can be as important as its balance sheet. Family companies usually pride themselves on having strong values, traditions, and customary ways of doing things. If the culture of the acquisition candidate appears to run counter to those values, forget it.
With these few caveats, it makes sense for owners of successful family businesses to consider acquisitions as part of their overall growth strategy. With due diligence and strong advisors, acquisitions can open up whole new avenues of growth for your company, and expand the horizons of every working member of your family.
– J.S.H.Traps for the unwary
Act in haste, repent at leisure. That’s a good admonition for lovers, gamblers, and corporate acquirers. Aside from that obvious trap, what are the reasons most acquisition programs fail, either before or after a deal is completed?
1. Management hubris. Gemstone Warbucks, chairman of Little Global Industries, has grown so rich by perpetuating the business his grandfather started that he has decided he can do no wrong. He has created the World’s Best Management Team, and they can conquer any market, manage any company just by issuing orders, having lunch with the banker, and making phone calls to the general manager. So Warbucks starts on the acquisition trail to fulfill his destiny as a giant of industry.
It doesn’t, never did, and never will work out that way. Most private-company acquirers find they have to build the acquired company brick by brick, just as they did their own companies, as they change it. They need to mediate all sorts of misunderstanding arising from the melding of two cultures. They have to find out from scratch about the demands of new customers and markets. All successful acquirers will tell you it is very hard work.
2. Undercapitalization. You underestimated the working capital demands of your new division. The general manager quit, and you had to pay more for a replacement. You lost two important customers when the sale was announced. The new product didn’t come on stream until twice the expected funds were spent. Result: disaster. You got in over your head. Now what?
3. Inadequate due diligence. Few companies (even large ones) go to the pains that are required to discover all key facts and establish priorities for building the company after it’s acquired. The result: surprises. And this is a business where all surprises are bad ones, like a deteriorating competitive situation, poor customer relations, the unexpected departure of a key staff person, inventory that is worth less than anticipated or any of a thousand other things that can go wrong and could have been foreseen if greater care had been taken.
4. Lack of strategic direction. The desire to grow may be an underlying motivation for hitting the acquisition trail, but it is not a satisfactory strategy. Smart acquirers begin with an analysis of their own business and markets to determine how they can strengthen their presence in the marketplace. If they decide to become the unquestioned high-quality producer among competitors, for example, an acquisition will only be made if it can contribute to that goal. If they are vulnerable to price increases from suppliers, they may acquire a source of supply. If they are too distant from end users, they may expand “downstream” by acquiring a distributor or retailer. As a rule, companies that expand into entirely new markets find that distant fields turn out to be browner.
5. Wasted time. Few newcomers to the acquisition scene appreciate how much time must go into consummating an acquisition—or worse, not consummating one. It is not uncommon for the owner of a business to spend months of time and thousands of dollars in professional fees and expenses, only to discover that the seller who was so certain he wanted to sell has now changed his mind. Many CEOs who become deeply involved in the acquisition pursuit find that they are spending over half their time chasing will–o’–the–wisps.
– J.S.H.