How to Successfully Acquire a Business
By: Steve Seavecki
Whether you would like to leave Corporate America and purchase your first company or if you have an established company and are looking to expand, this article is meant to provide some helpful tips.
After 20 years as a senior manager in the software industry, I was tired of the travel and wanted to spend more time in Seattle. Over the last several years, I purchased my first business and subsequently acquired 7 other companies. The first company I acquired had been in business for 12 years when I purchased them. The following tips are from lessons learned during various acquisitions. Each acquisition definitely provided new experiences and unique issues. From my first to the seventh acquisition, I learned how to reduce my risk by 70% and increased my net profits by 40%.
Since each industry is different, you really can’t find a perfect boiler-plate ‘how to’ recipe in making a successful acquisition. However, 75% of the questions and processes are the same across industries and that is what I would like to share with you. The 25% that is unique from industry to industry is related to such issues as - what is a good margin for each product line - what are the most difficult aspects of running a company in that industry - how much of an issue is retaining the key employees - what is the most cost-effective way to generate leads, etc.
Step One: Financing
In order to save yourself a lot of time and help narrow your acquisition parameters, it is important to understand what your options are for financing which will dictate what your options are for structuring a deal.
First off is how much cash will you and/or the company be willing to invest in the acquisition? This often dictates how big of a loan you can get, regardless if you sign a personal guarantee or not.
Will you need a SBA (Small Business Administration 504) guaranteed loan? Based on your current company or personal debt, profitability and revenue growth, the only loan you may be able to obtain is a SBA guaranteed loan. For an SBA loan, 75-85% of the total loan amount is guaranteed by the US government, so that if you default on the loan, the bank can still recoup a majority of the amount it lent to you. Therefore, banks usually like to push you in the direction of a SBA loan if you don't have a large amount of unencumbered assets to collateralize.
The down side of a SBA loan is that you pay in upfront loan origination fee and you don’t have any say in the terms. In addition, the rate is a floating rate. The SBA does not typically allow for a fixed rate load for business acquisitions. Therefore, if the rates go from 5% in today’s market to 8% over the next two years, you will be stuck with a much higher monthly payment. You will need to factor this into the overall purchase price as a risk component.
The SBA requires a minimum of 10% down. Most banks want to see the seller also carry a note for 10-20% of the purchase price. This is also something you should push for as it gives you an opportunity to use as leverage if you discover issues after the deal is closed.
Let me describe an issue I experience related to the advantage of a seller note. During my due diligence on one deal I asked the seller how many multi-year contracts the company had and what is the total financial exposure of those contracts that customers would be looking for me to fulfill. The seller told me the total was $35,000. After I closed the deal, I found out that that number was not $35,000 but $260,000!!!! Since the seller had taken a 20% note from me on the purchase, I was able to negotiate a settlement where we agreed that the note was now deemed paid in full, even though I hadn’t made any loan payments yet.
It was still a pain and led to some ill will as I had to go back to some of the customers and renegotiate the contract and require a supplement to cover some of my costs until thier contract was up. Since I purchased the company’s assets and not company stock, I was able to explain to those companies with contracts that I was not legally obligated to fulfill those contracts at all. You do not want to purchase another company’s stock as you then are liable for any known or unknown issues connected to that company. You only want to purchase their assets.
Personal Guarantee. Unless you have a growing company with tons of cash and little or no debt, you will likely be asked to sign a personal guarantee. If you do your homework and follow the process, this should not scare you. But, if you just purchase a business because you ‘like’ the products or services they sell and don't ask the tough questions, you may be in for some financial surprises.
Cash. Cash is king. With the interest rates as low as they are, do everything possible to keep as much cash as you can. Put down as little cash as possible when making an acquisition. This gives you a war chest for future acquisitions. There is a reason Microsoft, Apple, etc. keep massive amounts of cash. It gives them flexibility to make deals when they need to. As long as you have the cash flow to cover your monthly debt payments, banks will still lend you more money. However, if you use up all you cash and run into cash flow issues, it doesn’t leave you many options as banks will not lend you more money easily. Also, interest on loans is an expense against your profits so instead of paying taxes on your excess profits you are getting, in affect, a discount on the loan rate.
Bank like deals with assets they can resell. They don’t like deals with large amounts of Goodwill. Therefore, if you are able include a building in the purchase of a business, you might receive more favorable terms on your loan and avoid a personal guarantee.
Step Two: Defining the Acquisition Parameters
The most important step is to create a really good definition of what you want and what you are willing to spend to purchase a business. When I started looking for my first business to purchase, my main parameters were; within 10 miles from downtown Seattle, selling of products to business (not consumers), not a services only company, not a high cost of assets for expensive machinery or inventory, a business with a wide base of potential customers and minimal travel outside the Seattle area. My parameters on subsequent acquisitions were much narrower as I was looking to acquire my competitors.
How much cash am I willing to invest in the purchase? This will somewhat dictate the revenue size of the target company.
Am I looking to purchase a company that will stay in the physical location they are at? If so, what is my geographic area for my search?
What types of products and/or services does the company sell? Are you willing to run a company with very complex products? Do you have the technical skills so you are not held hostage by the ‘smarter’ people in the company?
Do my target companies have a specific SIC industry code? This allow for a more targeted search.
Are you looking at a mature industry where there will be more interested sellers or a new industry where businesses are just getting started? A 10 to 15+ year old industry is a great target as Owners who started the business may be ready for a change or retirement.
Do you want to be selling products and/or services to businesses or consumers? Consumers are generally more high maintenance and require more customer service staff.
How capital intensive is the company? The higher the asset cost for machinery and/or inventory, the higher the loan amount needed and the higher the down payment required. If you go after a business with a million dollar piece of equipment, you just bumped the purchase price up a million dollars and your down payment up $100,000 to $200,000. Risk is increased as the machine needs to be utilized to pay for itself. If business slows down, you can't reduce the loan payment on that machine.Therefore your profits will suffer twice. Once from the lack of profit on the sale of goods produced by the machine and second on the machine loan itself.
Why do you want to acquire a business? For me it was to stop traveling so much. I also wanted to spend more time with family. Therefore, I didn’t want a business that was pure consulting where if I wasn’t billing hours, I wouldn’t make any money. The reason I continued to acquire companies was to increase the number of employees to ensure there were enough layers of experienced staff to cover for each other so senior management could be less tactical and more strategic.
Organic growth versus acquisition. If you are using the acquisition to accelerate growth, you need to compare the cost with acquiring customers through a business acquisition to the cost of acquiring them organically.
Reduced Cost of Goods. One purpose for acquiring a company in your same industry is to significantly increase how much you spend on goods. In some industries, this added buying power can dramatically reduce the cost of goods and increase profits for all goods sold. Through my series of acquisitions, I was able to negotiate a 20% discount on my cost of goods due to the increased purchasing volume with my suppliers.
Of course the majority of people would say “I want to make more money” or “retire sooner”. These were on my list as well. Therefore, I looked for scenarios that would accelerate profits. One such approach is to target companies that had their own offices but since they were not retail, I could shut the operation down and move it to my location. Now I get the financial advantage of not paying for everything twice; rent, accounting, legal, phone, internet, utilities, insurance, etc.
A quick note here on franchises. They are a great fit for some people and not for others. If your business experience is in a discipline that is very narrow, say human resources, you might be better served to seek a franchise where all the other areas of business such as marketing, sales, financial have been worked out and proven. The down side of franchises is that you pay royalties for that security. I personally had a broad base of experience that included growing up in a family owned chain of retail stores. Therefore, I preferred the freedom of taking a company in whatever direction I choose and that is pretty difficult when owning a franchise. Also, I didn’t find a big difference in the cash needed to purchase and start a franchise compared to purchasing an established small business.
Step Three: Creating a List of Target Companies
As you know, the best opportunities come when the competition is low. From my personal experience, the smaller the size of company you want to acquire, the fewer good opportunities are available via business brokers that list companies for sale. When brokers are involved, they get paid based on the final purchase price and are paid by the Seller. Therefore, it is in the best interest of the broker to secure the highest possible sale price. However, if you are not interested or don’t have the time to seek out a company to purchase, then enlisting a buyer’s broker is a great way to go. Also, a buyer’s broker is very useful in giving you a reality check on whether they believe the asking price for a business is realistic. Your accountant can also provide feedback on the health of a company you are looking at and a reasonable purchase price.
However, some industries have special circumstances that warrant a significantly higher or lower purchase price and only professionals with experience in that industry will be able to provide accurate numbers.
You will need to use the acquisition parameters to identify the industries or business segment that match your criteria. Again SIC codes are a great way to narrow down the industries. Once you have the SIC codes identified you can now create a list of target companies that fall within your geographic area.
I used a personal letter with a direct mail campaign to solicit interest from the target industries. In addition, your personal career network, accountants, attorneys, associations and alumni groups are great resources. Ultimately, it was an Alumnus from the Harvard Business School that I contacted and he knew of a company thinking about selling and we consummated that deal. There were no other people/companies bidding to buy their business. That's not to say I got a great deal...remember that was my first acquisition.
Step Four: Due Diligence
News Flash!!!…..Sellers will deceive you! They may not lie when you ask them a specific question, but they usually won’t volunteer negative information. Well, maybe this news flash doesn’t surprise you. However, assume that the seller is not telling you the whole story. Most sellers want to maximum the purchase price. Therefore any information that increases the purchase price they will share and anything that lowers the purchase price you will need to uncover with due diligence.
Once you find a seller willing to entertain a discussion about selling their company, you should offer to sign and send them a Mutual Non-Disclosure Agreement. If you email me I can send you a copy of what I use. My contact information is at the end of this article. This usually gives the seller enough comfort to give you revenue and profit figures so you can determine if you want to dig further.
One of the major disconnects when talking to a seller is about percentage of customers that will continue to purchase from you after you take over the company. Most sellers argue that 100% of the revenue will continue to flow. In reality, I have found that on average only 83% of the customers continue to purchase from the new company after the first year. We found a couple of reasons for this. One is that they liked or had a relationship with the principals of the company and now that they are gone they will buy from someone else they were holding at bay because of the relationship. Another reason is that since companies have to set up a new vendor they figure they may as well take this opportunity to shop other vendors.
The next interesting discussion is how the seller believes that you will be able to easily increase revenue by 20% by doing all the things they ‘just haven’t had time to do’ related to sales and marketing. Really? Then the other common comment is ‘we have a database of old customers for the last ten years. All you need to do is call them up and get them buying again.’ These are just more ways to get you to believe the company is worth more than it really is and increase you purchase price. Most companies have already picked any low hanging fruit and I would be skeptical of any significant, incremental revenue generation coming from the sellers suggestions.
Now starts the interesting part…digging into their financials to determine if you are going to pursue a deal. For the first round of information I ask for a current balance sheet and an income statement for the last 12 months. Sometimes it is easier to get an income statement for the last fiscal year and the current year-to-date numbers. It is important to also get from the seller a list of expenses that will disappear when the company is sold. These are items such as personal auto expenses, family compensation, insurance and other personal expenses. Your end goal is to determine the SDCF – Seller’s Discretionary Cash Flow.
If the financials look interesting, then you will want to start your more in-depth due diligence. Some of the questions I ask are; what were the revenues and profits for the last three years, how many customers account for over 5% of total annual revenue, do you own or lease the office space, when is the lease up, do your key employees have non-compete agreements, how is the total revenue broken down between product lines, what is the average sale price for the top three items and what are they (this will help you understand how much they are discounting their price), etc. I usually ask about 30 questions. The best approach is to send them an electronic document with the questions and ask them to fill them out before you meet face-to-face to discuss.
This is a good time to get an acquisition consultant, accountant or business attorney to look over the data you have gathered. Another set or two of eyes always uncovers questions you should be asking that you haven’t.
Step Five: Analyzing the Financial Data to Determine a Purchase Price
The first rule is…Ignore Revenues. Most sellers want to calculate the value of their business based on the total revenues. Revenues are just a data point. The only number that really matters is profits. Profits tell you how much you should pay for the business and how long it is going to take you to pay off the cost of the acquisition. There is a big difference between a ten million dollar company with low margin products and a profit of $100,000 and a ten million dollar company with high margin products and a profit of $1,000,000. Revenues give you an idea of how much wiggle room you are going to have to reallocate non-product related expenses to optimize revenue and profit growth.
The golden rule for me in determining a purchase price is not to allocate more than 50% of the anticipated profits towards the acquisition debt. For example, if my annual anticipated income is $1,000,000, then I don’t want my loan payments (principal and interest) to exceed $500,000 for the year. This allows me to weather any storms that might come up that affect profits and also some cushion if I overpaid for the company. So you are working a little backwards sometimes to determine what you can afford to pay for a company, while considering the financial risk. If you are financing the acquisition, the type, rate and term of the loan will make a big difference in what you annual debt payments will be. This is where an SBA loan with a floating rate can look great now at 5%, but not so great in 4 years at 9%.
The primary way I come up with a purchase price is as a multiple of the profits. If I pay four times the annual company profits, then it will take me four years to pay off the acquisition costs if I apply all profits to the cost. This assumes you don't use any of these profits to grow revenues or compensate yourself. Often reality says that it will take six to eight years to pay off a single acquisition. This multiple will vary a lot from industry to industry. An industry where the past and future revenues have been or are expected to be flat or declining carry a lot of risk and the multiple may be closer to 2 times profits. For an industry or company that is growing revenues at 20% higher, there really isn’t a ‘standard’ multiple you can go by. For these types of companies it comes down to can you work out a deal where both sides think it is a fair deal.
Other ratios of past acquisitions that I use as data points are; Purchase Price to Revenue, Net Income (profit) to Purchase Price, Net Income as a Percentage of Revenue and Net Income as a Percentage of Purchase Price. These can vary widely depending on how the deal is structured.
When you feel good about a purchase price then you should submit a signed “Letter of Intent’. This is not a legally binding document. However, it does declare how much you are willing to offer for the business. It also shows you are serious about making a deal happen. This is very short letter and should not go into any of the details of how the deal would be structured. You don’t want to scare them off, but you do want them to mentally commit and agree to a purchase price. (Contact me for a sample letter)
Sometimes the seller will have paid for a ‘business valuation’ to get an idea of what the company is worth. This usually is done by a financial type with no knowledge of the industry. This can present issues if the valuation is significantly higher than your offer. If you are financing a loan, the bank often does a third-party valuation to make sure the value of the company agrees with the loan and purchase price. If the bank valuation comes in low, you will need to help the bank/third-party increase the valuation based on industry specific data they didn’t consider. Also, you can use the low valuation as a negotiation tactic with the seller and get them to reduce the purchase price.
Step Six: Structuring a Deal
Biggest consideration is to be flexible. Don’t go into a deal having one price and one option. Don't give them a make it a "take-it or leave-it" offer. During your due diligence and casual conversations with the seller, you should be trying to get an understanding of what is really motivating the seller to sell. One red flag is the owner who says, “I'm ready to do something else.” Usually that translates into “I have tried everything possible to increase revenues and I’m out of bullets.” This isn’t necessarily a reason to walk away from the deal, but you need to use this information to dig deeper.
The most ideal structure is where you put very little cash into the deal and the seller carries a note for the rest. Most owners won’t do this because they are using this opportunity to get the big cash-out for all the long hours and risk they put in over the years. However, it is possible. In one deal, I was able to structure it so I only had to put down 15% cash and the seller carried a note for three years for the 85%. How this was accomplished was to give the seller two options; first option was 70% up front cash and 30% seller note over three years and the second option was for me to increase the purchase price by 40% but only put 15% cash down and the Seller carried the 85% note for three years. To protect myself from violating my ratios with such a high increase in the selling price, I wrote into the agreement that if the revenues from their book of business fell below certain revenue projections from those customers, then their note would be reduced dollar for dollar. A deal structure like this will really tell you how confident the seller is in believing their customers will continue to purchase from you. In this deal, my only risk was the 15% I put down. Pretty sweet deal. I wish I could find more of these!! If you are having problems getting bank financing, getting the seller to carry a large percentage of the purchase price may be a way to get a deal done.