As featured in our Q2 2013 Capital Ideas Newsletter. An article by Terry Fick, Managing Director of our Dallas, Texas office.
Most small companies never think about acquisition as a viable strategy, and many that do dismiss it as unfeasible. However, in some instances, a lower middle market privately held firm can reap huge benefits from acquiring one or more smaller companies or a company of equal size. That strategy is easier today than ever due to the availability, flexibility and cost of debt. Let’s take a look at one such success story implemented by a CFA client.
A B2B service company earning $5 million of EBITDA on $20 million of revenue saw acquisition as a strategy to address three issues that raised their risk profile and lowered their market value:
- They had a significant customer concentration issue.
- Their fortunes were tied to a less than stable industry.
- The company had likely reached capacity within their geographic market.
On paper, the solution was simple. Find a company or two in their industry that (a) sold nothing to the currently large customer, (b) sold its services into a different industry, and (c) was in a different geographic market. Assuming that it may well take more than one acquisition to solve all of these issues, only two small hurdles remained. First, was such a company (or companies) available for sale? Next, how to finance the acquisition(s)? Let’s take a generic look at the process that was applied and can be applied to any such company.
First, examine your industry. Is it fragmented enough to find good targets to acquire? If not, this may not work for you. If so, you need to analyze your own strengths and weaknesses. Are your management team, systems and infrastructure ready to handle this strategy? Do you recognize your own weaknesses so as to avoid an acquisition with the same weaknesses?
- Check your risk tolerance. Not only ask if the resulting debt is within the company’s comfort zone, but more importantly, is it within the owner’s comfort zone?
- Do the self-analysis outlined above (under “The Process”).
- Engage an Investment Banker to research the current debt markets so you have a clear picture of just what is feasible.
- Next, have that Banker research the industry and approach potential targets. Most will not be open to a reasonable sale, some will be too small to move the needle, and some will be too large (defined as larger than you). Keep running your own business and let the banker sort through the first two or three levels of information on multiple opportunities before getting engaged in the process.
- Avoid taking a run at the first target that comes to the surface. There may be better targets, or you may find multiple targets that better fit your strategy. Just as you should when selling a company, get all of the viable options on the table before making a commitment.
- Now you are ready to begin conference calls and visits with the best targets. Keep your initial strategies in mind at all times. Even if one is “pretty”, but doesn’t solve a specific problem or meet a specific need, move on. Unlike the big boys, your capital and infrastructure is limited. And do not let your energy outrun your wallet. If you have to overpay, move on.
- Get your target(s) under letter of intent (LOI) and charge ahead to secure the financing you have researched.
How did this work out for the CFA client mentioned above?
The client put two targets under LOI at the same time. One was a smaller target in a different geography with a different customer base that served a different industry. This was closed with current cash and their current line of credit at their bank. The second was the same size as the acquirer, in a different location with a unique customer base and provided even more industry diversity.
The larger acquisition took a little longer as it was the same size as their company and required a combination of a new revolver, a “Term B” unsecured element and mezzanine financing. Sound scary? Not really. In addition to a seller note for 25% of the price, they only borrowed less than 2x the combined EBITDA of the three companies. The flexibility of the revolver and the mezzanine financing enabled them to pay the Term B in less than two years, while generating substantial cash for both growth and debt retirement.
The result was a company with fairly low customer concentration and good market and geographic diversity. The debt can easily be repaid in three years. With only 10% annual growth, a value of over $100 million in five years is entirely feasible, whereas it was previously just $20 million before acquisitions.
Would you like to be two or even five times your current value within five years? With a little boldness, a sound strategy and careful implementation, it can happen.