Acquisitions: An Avenue for Growth – February 2015

This topic involves both strategy and valuation.

A vibrant small business continually seeks growth opportunities. Such opportunities can present themselves as new products, new markets, product-enhancing technologies, or cost saving technologies. Another attractive source of growth, particularly for mature industries, is acquisitions.

In examining this topic we consider such matters as: objectives; due diligence; valuation; and structure. The latter includes financing.

The overriding objective for the buyer is profitable deployment of capital. This objective can be achieved in many different combinations of objectives relevant to the acquirer. Among the more common are to:
• Eliminate a competitor
• Attain economies of scale through cost efficiencies and/or market coverage
• Expand into adjacent markets – product or geographic.
• Expand into an adjacent customer vertical
• Leverage resources through acquisition of a complementary business

Two elements are essential in achieving any or all of these objectives. One is due diligence. The other is valuation.

Due diligence entails investigation of the target company to be acquired to make sure there are no hidden problems; minimize the risks inherent in making a material investment; and verification that undertaking the acquisition is a sound business decision. An exhaustive list of due diligence efforts is very long. Some of the major components are:
• Review of business processes
• Review of historical financial statements
• Review of the business plan, budgets, and forecasts
• Review of internal controls
• Review of tax records
• Review of litigation in process, threatened litigation, and unrecorded claims
• Review of regulatory issues

Due diligence provides confidence the buyer is getting the company it seeks. Valuation is important to avoid paying too much and ensure the capital is deployed in an optimally profitable manner. Thus, the computation of the price the buyer pays is critical to determine that the expected return compensates the buyer for the risks it undertakes in the purchase. For small businesses, this often means an annual rate of return in excess of 20%; sometimes well in excess of 20%. The means of valuation can take several forms including:
• Discounted Cash Flow
• Multiple of after tax earnings
• Multiple of EBITDA
• Multiple of Revenue
• Price Paid per employee of the target

The smartest buyers do all of the above and reconcile the findings. The multiples are compared to industry standards and recent transactions in the same or similar businesses.

There are two key components of structure. One is whether the buyer is purchasing the assets of the target company or whether they are purchasing the company’s stock from its owners. Often tax issues drive this variable. The other component of structuring is financing. For small companies this will entail variables such as down payment, source of financing (bank; investors; stock issuance; seller note), and the terms of the financing. Key terms include interest rate, maturity date, and bonus payments.

A vibrant small business can find an attractive source of growth in acquisitions. This is particularly true for mature industries. Important matters to consider include: objectives; due diligence; valuation; and structure.

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