Wednesday, February 16, 2011


Successful growing companies usually grow through a combination of organic growthand strategic acquisitions. For purposes of this article, a strategic acquisition is defined as an acquisition where the result of the combination is far greater than the sum of the parts. For example, if Company A with revenues of $50 million Acquires Company SA with revenues of $10 million, the Newco mathematically would have revenues of $60 million. The anticipated performance of a well thought out strategic purchase might result in a combined revenue for Newco of $100 million within a 1 to 2 year period. A second category of strategic acquisition would focus on an improvement of the profit margins of Newco.

Let’s use two companies that are recognized as among the best at making successful acquisitions, General Electric and Cisco Systems. As their stockholders will happily tell you, these companies have been star performers in growing shareholder value. General Electric is a giant conglomerate with business lines such as GE Capital, GE Plastics, GE Power Systems, GE Medical, and several others. Cisco Systems could be categorized as a high tech growth company primarily focusing on voice and data communications hardware, software, and services.

The first rule of strategic acquisition we learn from these two prolific and successful companies is that they do it on purpose. They have a well thought out defined approach. To quote GE, “We are allocating capital to businesses that can increase growth with higher returns, businesses requiring human capital as opposed to physical capital. We are disciplined and integrators and we grow the businesses we acquire. Over the past 10 years Cisco Systems has acquired 81 companies. If you track their stock price over the same period, it is up a remarkable 1300% over that same period. GE, starting with a much larger base, still outperformed the S&P 500 index over the same period 3 to 1.

If you study the acquisitions of these two companies as well as good middle market growth through acquisition companies, you find some common strategic themes. The core principal that runs through almost every example is INTEGRATION. With the exception of establishing the original platform, GE expanding from their original roots and establishing a presence in plastics, for example, all of these acquisitions focus on integration.

An example that I use to summarize strategic acquisitions for Cisco Systems is not a real acquisition, but a hypothetical company that should demonstrate a point. I have been a very happy stockholder for over a decade. It seems like every year they would announce an acquisition that looked like this – Today Cisco announced the acquisition of Optical Solutions Company for $30 million in stock. Optical Solutions Company manufactures the OptiFast Switch, the fastest optical networking switch on the market today. The Company was started two years ago by two Stanford Electrical Engineering Professors. Current sales are $1.5 million and last year they lost $700,000. My initial reaction was, “What the heck are they doing?” What they were really looking at was what this technology could become as it was integrated into the Cisco family. First, Cisco has 5,000 sales reps, 12,000 value added resellers and systems integrators that sell their solutions, and 600,000 customers that think Cisco walks on water. Cisco knows their market, their customers, and the first mover advantage in their market. With this backdrop, the OptiFast Switch achieves sales of $130 million in its second year of Cisco sales. That’s what the heck they were doing – a classic strategic acquisition.

There are several categories of strategic acquisition that can produce some outstanding results with effective integration. Many acquisitions actually have elements from several categories.

1. ACQUIRE CUSTOMERS – this is almost always a factor in strategic acquisitions. Some companies buy another that is in the same business in a different geography. They get to integrate market presence, brand awareness, and market momentum. Another approach is to acquire a company that can establish a presence for you in a different market segment. For example, let's say that that Company A made fasteners for the automotive industry and felt that their expertise could be applied to the aerospace industry. A company that produced fasteners for the target industry could help jump-start this strategic initiative.

2. OPERATING LEVERAGE – the major focus in this type of acquisition is to improve profit margins through higher utilization rates for plant and equipment. A manufacturer of cardboard containers that is operating at 65% of capacity buys a smaller similar manufacturer. The acquired company’s plant is sold, all but two machines are sold, the G&A staff are let go and the new customers are served more cost effectively. Adding new customers without increasing fixed expenses results in higher profit margins.

3. VALUATION MULTIPLE EXPANSION – this is a subtle mathematical approach that the private equity groups understand very well and regularly capitalize upon. They establish a platform company, usually in the $30 million to $250 million in revenue range and then they go on a mission to acquire several "tuck in acquisitions". They buy several other companies that can add to the value of the platform company based on expanding the customer base, improving on their technology, broadening their product line, or other strategic point covered in this article. They also recognize that a small company will sell at a smaller valuation multiple than their larger platform company.

Below is an example of how that might work for a company looking to grow through acquisitions. Let's say that the acquiring company is $30 million in revenue and is looking to acquire a $10 million in revenue target. The $30 million company with $7.5 million in EBITDA has a valuation multiple of 6.5 X EBITDA while the $10 million company with $2.5 million in EBITDA has a multiple of 5.25 X EBITDA. Pre acquisition that would mean that the value of the acquirer was $48.75 million and the target was $13.125 million. Theoretically, if you combined the two companies, the new value should be $48.75 plus $13.125 or $61.875 million. However, post acquisition, the combined company takes on the EBITDA multiple of the acquiring company resulting in a valuation of ($2.5 + $7.5 million in EBITDA) or $10 million X 6.5 or $65 million. Wall Street refers to this phenomenon as an accretive acquisition

4. CAPITALIZE ON A COMPANY STRENGTH – this is why Cisco and GE have been so successful with their acquisitions. They are so strong in so many areas, that the acquired company gets the benefit of some, if not all of those strengths. A very powerful business accelerator is to acquire a company that has a complementary product that is used by your installed customer base. It is ten times easier to sell an add-on product to an installed account than to sell a product to a new account. Management depth and skill, production efficiency/capacity, large base of installed accounts, developed sales and distribution channels, and brand recognition are examples of strengths that can power post acquisition performance.

5. COVER A WEAKNESS – This requires a good deal of objectivity from the acquiring company in recognizing and chinks in the corporate armor. Let me help you with some suggestions – 1. Customer concentration: too much of your business is concentrated on a small group of customers 2. Product concentration: too much of your business is the result of one or two products 3. Weak product pipeline – in a business environment that is becoming more innovation focused, having a thin product pipeline could be fatal. Many of the acquisitions in the pharmaceutical industry are aimed at covering this weakness. 4. Management depth or technical expertise and 5. Great technology and products – poor sales and marketing.

6. BUY A LOW COST SUPPLIER – this integration strategy is typically aimed at improving profit margins rather than growing revenues. If your product is comprised of several manufactured components, one way to improve corporate profitability is to acquire one of those suppliers. You achieve greater control of overall costs, availability of supply, and greater value-add to your end product. Another variation of this theme some refer to as horizontal integration is to acquire a company supplying you distribution.

7. IMPROVING OR COMPLETING A PRODUCT LINE – this approach has several elements from other acquisition strategies. Successfully adding new products to a line improves profitability and revenue growth. Giving a sales force more “arrows in their quiver” is a powerful growth strategy. You take advantage of your existing sales and distribution channel (strength). You may be able to improve your competitive position by simplifying the buying process - providing your customers one stop shopping. You have already established momentum and credibility with your installed accounts and it is far easier and cost effective to sell them additional products than it is to win new customers.

8. TECHNOLOGY – BUILD OR BUY? This is a quandary for most companies, but is especially acute for technology companies. Acquiring technology through the acquisition of another company can be an excellent growth strategy for several reasons. First, the R&D costs are generally lower for these smaller, agile, more narrowly focused companies than their larger, higher overhead acquirers. Secondly, time to market, window of opportunity, first mover advantage can have a huge impact on the ultimate success of a product. It has been said that Alexander Graham Bell arrived four hours before another inventor at the patent office for essentially the same invention. If there is a good idea or a market opportunity, most likely it is being pursued independently and simultaneously on several fronts. First one to establish their product as the “standard” is the big winner. I sure would not want to try to displace Microsoft Windows as the operating system for PC’s.

9. ACQUISITION TO PROVIDE SCALE AND ACCESS TO CAPITAL MARKETS – In this area, bigger is better. Larger companies can generally weather a storm better than smaller companies and are considered safer investments. Larger companies command larger valuation multiples. Some companies make acquisitions in order to get big enough to attract public capital in the form of an IPO or investments from Private Equity Groups. Many smart business owners have consolidated several smaller companies at lower multiples to create a larger company that the investment community valued at higher multiples. This can be a very effective grow to exit strategy.

10. PROTECT AND EXPAND MATURE PRODUCT LINES - I recently came across an outstanding example of the execution of this strategy. Johnson & Johnson, the multi-billion dollar pharmaceutical company in 2000 acquired Alza Corporation, the maker of drug delivery systems and devices for what appeared to be an unbelievably steep price of $13.7 billion, or 23 times year 2000 revenues. They are the inventors of the transdermal patch used in products such as NicoDerm CQ. They have developed time released pills that can, for example, deliver Ritalin, the drug for attention deficit disorder in children, at prescribed times with one dose. They have developed an injectable titanium stint to deliver cancer medication over the course of a year. Why would J&J pay so much for this company? Here is the strategy. The latest price tag for getting a major new drug through the FDA and to market is a whopping $800 million. These delivery technologies can turn J&J’s old drugs into new best sellers that are re-patentable at a far lower price than new drug development. An added benefit is that they can do the same for off patent drugs from other competitors.

11. PROTECT CUSTOMER BASE FROM COMPETITION – The telephone companies have done studies that show that with each additional product or service that a customer uses, the likelihood of the customer defecting to a competitor drops exponentially. In other words, get your customers to use local, long distance, cellular, cable, broadband, etc and you will not lose them. Multiple products and services provided to the same customer dramatically improve retention rates. At the risk of repeating myself, it costs ten times more to get a new customer than it does to keep one.

12. ACQUISITION TO REMOVE BARRIERS TO ENTRY – An example of execution of this strategy is a large commercial information technology consulting firm acquiring a technology consulting firm that specializes in the Federal Government. The larger IT Consulting firm had valuable expertise and best practices that were easily transferable to government business if they could only break the code of the vendor approval process. After many fits and starts to do it themselves, they simply acquired a firm that had an established presence. They were able to then bring their full capabilities from the commercial side to effectively increase their newly acquired government business.

13. OPPORTUNISTIC ACQUISITION FOR WHEN THE MARKET TURNS – as they taught me in business school: buy low and sell high. Well-run businesses often will buy competitors that bring many of the benefits from above at very favorable prices when times are tough. They buy customers, new geographies, technology, management talent, etc. at less than strategic prices because they have the staying power to last through a market downturn. Buying a company that doesn’t fit at a bargain is ultimately not a bargain if you are unable to integrate to make your core business more powerful.

Larger firms with lots of resources have established business development offices to execute corporate growth strategies through acquisition. These experienced buyers search for companies that fit their well-defined acquisition criteria. In most cases they are attempting to buy companies that are not actively for sale. If a strategic company is for sale and is being represented by an M&A firm, the M&A firm’s job is to sell that strategic value to the marketplace. If properly done, the buyers are competing with several other buyers that recognize the strategic value and the price tends to be bid way up. The win for the successful corporate acquirer is to target several candidates that have many of the characteristics from above, buy them at financial valuation multiples (traditional valuation techniques like discounted cash flow or EBITDA multiples), integrate to strength and achieve strategic performance.

Dave Kauppi is a Merger and Acquisition Advisor and President of MidMarket Capital, providing business broker and investment banking services to owners in the sale of lower middle market companies. For more information about exit planning and selling a business, click to subscribe to our free newsletter The Exit Strategist

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