This post originally appeared in in The Journal of Free Enterprise
…if you want an immediate increase in net cash flows, with a low cost of capital, a strategic acquisition may be the best solution…
“The conventional wisdom says, ‘The more rapidly you want to grow, the bigger the risks you must take.’ Now risk is a part of business, and every entrepreneur understands that. However, that doesn’t mean huge risks are necessary on a regular basis and it doesn’t mean there is anything wrong with minimizing risk to the extent possible. A lot of growth can indeed come from taking risks in the hope of a sizable return. A lot of growth can also come from the lower risk route of acquisition.” David Annis and Gary Schine.
Strategic Acquisitions Make for Good Risk Management
To many business owners, the most risky step they might think of is the prospect of buying another company. It feels like the great unknown. You don’t know what the previous owner has done that could make it hard to establish a new relationship with good customers, how loyal the management team is and if they will want to stay after a transition, what undiscoverable financial issues are waiting just on the other side of closing, etc.
But this can be very short sighted thinking. Creative middle markets commercial banks are often willing to make growth-acquisition loans with lower down payments, and sometimes none at all, for acquisitions by companies that already operate in the same business segment as the company they are buying. There’s a reason they’re willing to do this. Banks know repayment risk better than their clientele. They know that a company that has a good record of cash flow isn’t likely to lose its footing just because it’s acquired by another company, especially when the buyer also has a history of profitability.
The bottom line then, is if you want an immediate increase in net cash flows, with a low cost of capital, a strategic acquisition may be the best way to get there. Think about it. This statement, by itself, sounds highly risk averse. Of course, the decision doesn’t come with no risk at all, but the key to making a good, sound acquisition lies in the process. A quality valuation and thorough due diligence following the submission of a letter of intent, will tell you what you should know in order to move forward to closing an acquisition.
Accomplishing Growth Goals via Acquisition
How can a business achieve growth through acquisitions? Let us count the ways.
- Acquisition helps the small business in securing a larger market share and more revenue.
- Acquisition enables a small business to establish a dominant position in the market, made possible by market consolidation.
- Acquisition empowers smaller companies to break geographical and even political boundaries, and bring their operations to the world.
Market share, greater revenue and cash flow, dominance, geographic expansion…these are the common goals of every small business owner. Yet, all of these are typically accomplished much more readily in the wake of acquisitions than they are via organic, internal growth.
So what do you need in order to be prepared to go into the market for an acquisition?
Building on Current Success
There are four key prerequisites for growing your business through acquisition:
- Current profitability
- Sound business model
- Strong management team
- Access to capital
The biggest thing you need to have in order to go into the acquisition market is positive cash flow. You don’t necessarily need consistent taxable income (although it helps in the underwriting process for a loan), but without having at least a couple consecutive years of positive cash flow, obtaining the leverage to make an acquisition can be very difficult. It does happen that a struggling company buys a more successful one and makes more out of both than they were apart, i.e. 2+2=5, but it’s tough to get there if you’re not in the black at the outset.
And 20 or 30 years of continuous, positive and increasing cash flow doesn’t hurt. The most common buyer in the market today has a long history of organic growth and has pretty well peaked at what it can accomplish without buying another company. That same company has just never stepped out and taken the chance to buy a competitor, a “bolt on” business or expanded its geographic footprint through an acquisition.
The business model you have today needs to be able to reflect where it can go if you make an acquisition tomorrow. Years of positive earnings demonstrate the success of your model, but you do need the sense and confidence to be able to transfer the template that works for you to the next company you own.
The management team needs to be stable, strong, professional and with a good reputation in the marketplace. It may go without saying that this is even more important for the selling company, but the acquiring company is the one that will be calling the shots, post-acquisition and thus needs to do what is necessary to make things work. In fact, it’s good to think the way a VC or private equity shop does when you make an acquisition. That is, the most important thing we will bring to the table is our ability to manage the bottom line of a combined enterprise for even greater profitability than the two separate companies could achieve.
Access to Capital
While cash acquisitions do occur, they are very rare in the lower middle market space in particular. Nearly every deal comes with financing. Quite often, SBA financing, which is good, but with certain deals there may be even better alternatives.
Lisa Forrest of Live Oaks Bank points out that “when seeking strategic acquisition debt, the cash flow and equity of the existing company could potentially help garner more creative bank loan terms” for the acquiring company.
Live Oaks is one of many players in the closely held acquisitions lending space that are willing to put together terms that make a deal more attractive than a buyer ever may have thought it could be when it decided to test the waters.
Back to where we started: if you want to generate immediately increasing cash flow with an efficient cost of capital for little or nothing down, a strategic acquisition may be the ideal move for your business.