One way to grow a business, especially during uncertain economic times, is by acquiring companies and merging them with your existing business. When executed correctly, an acquisition or merger strategy can grow your revenues, increase your market penetration and provide economies of scale. However, acquisitions are also challenging to execute and can backfire. They can lead to serious losses. In this article, we discuss some of the basic concepts to keep in mind if you choose this strategy.
Consider these important questions as you evaluate an acquisition target, develop a strategy and prepare for financing.
6 strategic questions
1. Is it a horizontal or vertical acquisition?
The first step in your acquisition strategy is to determine if you will expand horizontally or vertically. Both expansion strategies have advantages and disadvantages. In our experience, horizontal integration is more common and simpler to execute.
A horizontal acquisition is when you acquire companies that are similar to your company. They work with the same type of customers and are in the same position in the value chain as yours. A vertical acquisition is when you acquire a company below or above you in the value chain. Examples include acquiring suppliers or customers.
2. Can the target companies be merged?
As you evaluate targets, determine if the company can be merged with your existing business. Combining the companies into a single entity allows you to gain some efficiencies of scale. However, integrating the businesses is also the most challenging post-acquisition task. Most transactions fail because the merger is not well-executed. When evaluating acquisition targets, consider the following:
Company culture. A merger will work only if the company cultures are compatible. Buyers often overlook this important consideration. Companies with very different cultures make bad acquisition candidates and often lead to disasters. Ultimately, key employees and clients become dissatisfied and leave.
Redundancies. Mergers often lead to redundancies. Redundancies are functions that both businesses perform but don’t need to be duplicated. Eliminating redundancies can lead to savings, which boosts profitability. A straightforward example is rent. The company may not need to pay rent for two locations when a single location works fine. This is an obvious benefit of eliminating redundancies.
Unfortunately, you will also have to deal with personnel redundancies. These are handled through layoffs. This is one of the hardest parts of a merger. Additionally, implementing layoffs right after an acquisition is a sure way to destroy company morale.
If possible, avoid layoffs by retraining and reassigning staff. If you have no alternatives, consider using a kind and generous approach with the laid-off employees. It’s the right thing to do and the best strategy for the company.
Client base. Good acquisition targets have a client base that complements yours. This point is extremely important if you plan to merge the target with your business. Acquiring a company whose client base is not complementary to yours is often a recipe for problems.
For example, if you are currently set up to handle large commercial projects, acquiring a company that focuses on small residential projects could create problems in some environments. They are two very different customer bases with no overlap. The customer base, scale, sales process, billing, customer management and overhead are all different.
3. Will the acquisition be profitable?
Your main objective is to increase your profits of the combined businesses. Determining whether an acquisition will be successful is difficult and very time-consuming. It involves building and testing financial models. You don’t want to skimp on this effort.
Test your business model against different market conditions. Don’t assume things will always be rosy, as many first-time buyers often do. Shock the business model with recessions and other problems to see how it performs.
4. How will you pay for the acquisition?
Every acquisition requires that the buyer contribute funds to the transaction, whether the acquisition is paid for solely in cash (a rarity) or via financing (most common). This financial contribution is called an equity injection. The amount of cash you need for the purchase is determined by the size of the equity injection.
At a minimum, most loans require that the buyer contribute 10 percent of the total project cost. The total project cost is calculated by adding the following:
- Cost of the business
- Capital expense additions (e.g., machinery, equipment)
- Cash flow additions (i.e., funds to operate the business)
- Transaction costs
Note that 10 percent is usually the absolute minimum. Some transactions may require a higher contribution.
5. Can you afford the acquisition?
The equity injection must come from your current company, your own funds or a combination of both. Even if you have the funds, you must determine if you can afford to spend them in the transaction.
Investing funds in the acquisition reduces your liquidity, which affects your ability to weather future problems. Make sure your remaining funds are sufficient to handle small or moderately sized issues.
6. How will you finance the acquisition?
Acquisitions up to $5 million are usually financed using SBA-backed financing. Transactions that don’t meet SBA eligibility or are larger than $5 million are usually financed through conventional lenders.
Not every lender is comfortable with companies in construction-related industries. Look for a lender that is comfortable with the glass and fenestration industries. It may take some effort, but this strategy will ensure you get the best financing terms.
Your acquisition will have a better chance of getting funded if you prepare ahead of time. Do the following things before you look for financing.
- Fix your company’s accounting system and financial statements. You will likely want to pay for part of the equity injection or collateralize the acquisition using your existing company’s assets. And, in most cases, you will likely merge the acquisition with your current company. Consequently, lenders will want to review your company in detail.
Address any accounting issues before you look for financing. Work with a CPA to ensure your financial reports are pristine. This effort shows lenders that you operate a well-managed company. Be prepared to show two or three years’ worth of financial statements.
- Get your taxes in order. Lenders will examine your business and personal tax returns. Personal and business taxes must be in order and up to date. If you have tax issues, fix them before you look for financing. Seek the help of a CPA if necessary.
- Organize personal financial statements. All business acquisition loans, SBA-backed or not, require a personal guaranty from the buyers. Consequently, the lender will examine your personal financial statements and assets. Get ahead of the process by organizing your finances and assets before you look for funding.Obviously, offering a personal guaranty for an acquisition can impact your personal assets. For this reason, I consider growing through acquisitions to be a risky strategy. Consider this strategy only if you are very certain that the transaction will succeed.
- Additionally, review your personal credit, which lenders will review as part of their decision-making process. They consider the credit score to be a proxy (albeit imperfect) for financial responsibility. SBA-backed loans require a minimum credit score of 650 to 680. Other lenders have higher requirements. If your credit does not meet these criteria, consider addressing those situations before seeking a loan.