An aggressive acquisition strategy can be a way to scale a well-financed business quickly, but it also comes with a multitude of risks, that need to be carefully addressed.  All too often, acquisition strategies are simply, “we will look at opportunities as they are presented to us”.  The wrong acquisition can be a drain on resources and can weaken a strong company.  On the other hand, a well-thought-out, clearly defined acquisition strategy will not only improve the likelihood of closing a deal but can also strengthen your company’s competitive position, drive enterprise value, and formulate the basis for the post-acquisition integration process.

Strategy-First
One way to start thinking about the best acquisition strategy is to think of a hub and spoke, where your business is the hub, and each spoke represents a different segment of business types that may fit.  The first decision is to determine which spoke represents the best opportunities.  Each spoke can represent various opportunities up and down the supply chain (backward or forward vertical integration) or horizontal integration opportunities to consolidate and scale the business by expanding into new regions or adjacent product lines. What does the seller universe look like along each spoke?  Are there enough potential targets to warrant an all-out acquisition effort in a particular business segment?

Perhaps more importantly, which spoke represents the best opportunity to strengthen your weaknesses or enhance your current strengths in the market.

Vertical integration acquisition strategies can sometimes represent a higher risk than horizontal strategies if the acquirer moves outside their comfort zone and core competencies.  However, there are situations when capturing a bigger slice of the margins up and down the supply chain can be highly rewarding.

Synergies
Part of the decision on the best strategy to pursue should also be based on where the biggest potential synergies lie.  In low-margin, low-growth, red ocean markets, cost synergies are often a major driver for M&A.  Be careful, however, since it is common for acquirers to end up with significantly fewer savings than originally anticipated, post-acquisition.  It is best to be conservative in estimating the savings that will materialize.

More often, focusing on opportunities with synergies that will grow the topline or improve margins is a better approach.  Using M&A to expand capabilities and/or product lines, grow into new markets, acquire talent, cross-sell products, etc. can also be difficult, but the potential upside is often much larger than when cost synergies are the primary driver.

Financing and Deal Size
It is important to clearly define how any acquisition would be financed before going out and soliciting targets.  Your risk appetite, balance sheet, and access to additional debt or equity capital will determine the maximum size of any acquisition.  If the use of outside capital is planned, it is best to have those strategic conversations with your sources well in advance of going out in the market.

Small deals can also be a problem, in that they can often take as much time to negotiate and close as larger deals.  Smaller deals need to have elevated strategic importance.

Assemble the Team
We addressed this topic in greater detail in a previous blog article, however, the M&A team is typically made up of both internal and external resources.  At a minimum you will need a corporate lawyer with deep experience in M&A.  You may also be well advised to hire an intermediary to act as an outsourced corporate development team to help ensure your success and to assist you in completing any due diligence, negotiate a favourable deal, and to help you navigate through the complex process.

Generate the Target List
An effective acquisition strategy requires upfront research to generate a viable list of potential candidates with the right contacts, target ownership structure, and estimated size.  Keep in mind that it can be a numbers game.  Many candidates will have little interest in even exploring a dialogue if it is not part of their plan or it’s not the right time, and as such, may ignore your inquiry.  To be successful, the list should be robust and categorized from highest to lowest priorities.

We have found that it is better to be specific and targeted, rather than broad and general.

Articulate your Value Proposition
Don’t assume a potential target will immediately see the benefits of opening a dialogue with you to discuss the sale of their business. They will need to understand the value proposition from their perspective and/or you will have to be able to provide a solution to a problem they have.  As such, the value proposition will need to be clearly articulated and presented in a way that will allow them to quickly assess the opportunity.  It is always best to be flexible in how any deal would be structured to get the dialogue started.

It is also important to get your strategy and value proposition in front of Investment Bankers, M&A Advisors, and other intermediaries that participate in your industry.  Otherwise, you may miss out on an attractive and active opportunity that is already in the market.  Many business owners will simply forward your inquiry to their representative when they get approached, but it may be remiss to count on it. There also may be potential candidates that are not on your list or that you are not aware of.
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Successful acquisition strategies take an immense amount of planning and resources.  Acquisitions can be game-changers or they can become a fatal drag on a well-run company.  For most companies, simply exploring opportunities as they present themselves is not a viable approach if growing through acquisitions is a priority.

In our “Business Valuation Mythology 101 – Part I” blog article, we outlined some common misconceptions often held by sellers on how potential buyers view and value their businesses.  Myths one to four included 1) asset quality, 2) industry-standard multiples, 3) enterprise value equals equity value, and 4) the working capital assumed in the transaction.  In Part II we outline three additional common myths often held by sellers, including owner benefit add-backs, growth projections, and potential synergies.

Myth #5 – Owner-benefit add-backs
It is not uncommon for closely-held businesses to accrue some benefits to their owner(s) as business expenses, to minimize taxes.  After all, no one likes to pay more taxes than necessary.  Legitimate owner-related expenses such as a company car, travel, meals, etc., should not be added back to earnings when the financials are presented to a potential buyer unless they are “above market” or it can be demonstrated that they will disappear under new ownership.

While personal items such as the family cottage renovation expenses or the country club membership should be added back, it forces buyers to distinguish between a legitimate future business operating expense and those that will be non-recurring.  This can create uncertainty and can impact a buyer’s perception of value as well as their appetite for completing a deal.  It rarely is as simple as identifying and adding back the personal historical expenses.

It is always best to have clean financials, (or even audited statements), purged of any unjustifiable personal expenses, for at least a few years before the sale of the business.  This may mean the business will pay more in taxes but it will help bridge any gap between taxable income from the company’s tax filings and the financial statements.  Most professional buyers will value the business based on GAAP (Generally Accepted Accounting Principles) or some other accounting standard such as IRFS (International Financial Reporting Standards) rather than OAAP (Owner Accepted Accounting Principles).

Myth #6 – Growth projections - The buyer will pay for the business's growth potential 
While this is partially true, the proverbial “hockey stick” projections presented by an overly optimistic seller is usually highly discounted by a buyer, especially if it is based on a strategy that the seller has little experience in executing.  Buyers will make some assumptions on growth as they build their valuation models, however, those assumptions will be mostly based on historical trends.  Anything above this trend will be treated more as “ideas” rather than viable projections.

While ideas create optimism on what may be possible for a new owner, any tie-in to the financial projections should be layered-in and presented more as speculative potential, rather than true projections.  It is important to separate what is doable based on track record and what is possible based on new ideas, wherever possible.

Myth #7 – The buyer will pay the seller for potential post-acquisition synergies
Synergies can be cost savings, such as when redundant personnel are eliminated post-acquisition, or revenue synergies, such as cross-selling opportunities.  While the magnitude of synergies varies by each potential buyer, their value may not be reflected in an offer to the seller, since there is a risk that the synergies will not materialize.  Of course, there are always exceptions.  For example, where a big industry player makes a highly strategic acquisition and pays an outsized multiple for a scarce asset.  But in normal M&A transactions, the buyer will tend to pay the least amount they can or at least no more than fair market value (FMV).  They will often only make offers that exceed FMV when they are pushed via a competitive marketing process.  Even then, many strategic buyers exercise discipline and will not pay more than their perception of FMV, particularly if have a robust pipeline of potential acquisition targets and can simply “move on” to the next target.

There can be situations when there is a strong case for a buyer to use some of the future expected synergies to sweeten an offer beyond FMV to knock out other competitors from acquiring a target.  However, in most cases, both cost and revenue synergies are used primarily to justify the acquisition with internal stakeholders, such as lenders, outside shareholders, or investors.

There are several other myths out there that we will address in future blog articles.