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Growth through acquisition should not be considered an option
reserved solely for large or Public Companies. Small and mid-size businesses that opt to grow by acquiring
other companies, rather than growing one new customer at a time, can gain
benefits in addition to increased sales and profits.
Timing
is Right
Two elements have combined making growth through acquisition an attractive
option for small and middle market companies.
Demographics
- The maturing of the Baby Boom generation, many of whom own their own
businesses, will increase the number of owners willing to consider selling to
an historic high.
Financing
- Money is available to finance small and middle market acquisitions.
Banks and non-traditional lenders are aggressively pursuing acquisition
lending at a level we have not seen in twenty years.
Cash required to do a deal is at an all time low.
Profit
Pays the Bills
Profit and Value are two main financial components of every business.
Profits are essential and therefore on every businessperson's front
burner. Value, on the other hand, is an elusive and intangible issue.
Unlike Public company presidents,
whose effectiveness is measured daily in their firm's share price, private and
family business presidents need not be concerned with their company's value as
their shareholders, if any, typically focus upon profit only.
Value
Measures the Size of Your Pile
Shareholders of Public Companies measure their wealth (or the size of their
pile) using share value not earnings per share. Successful CEOs, therefore,
develop strategic plans for growth and profit that maximize shareholder's
value. Mergers and Acquisitions
is a fundamental element of most strategic plans to grow profits and value
simultaneously.
What follows is an overview of Public
Company strategies to grow profits and value through acquisitions and how to
adapt these strategies to private and family businesses.
Although the topic may seem technical and complex it is really quite
basic and straightforward.
An
Overview
Adding earnings or profits is self-explanatory.
We will, therefore, focus primarily on the value component of growth
through acquisitions.
We know a Public Company's
Price/Earnings Ratio measures the amount investors are willing to pay for $1
of company earnings and that a P/E ratio of 15 for a well-run company is not
unusual. Consequently, company
BIG with 100 million dollars of earnings and a P/E Ratio of 15 has a value of
1.5 billion dollars. We also know
private company P/E Ratios are much lower than those of Public Companies.
Strategy
#1 - Acquire
companies with a smaller P/E ratio than yours
Example:
The Transaction -- Company BIG with a P/E Ratio of 15 acquires company
SMALLER and pays 10 times earnings (P/E ratio = 10). Company SMALLER's 10 million dollar of earnings are added to
those of company BIG.
Increases
in Value Calculation -- SMALLER's earnings are now worth 15X
instead of 10 times earnings resulting in an immediate increase in
value of 5X earnings or $50,000,000 (5 times $10,000,000) over and above the
value paid by company BIG.
Strategy
#2 - Reduce
expenses through economies of scale
The picture gets even better if eliminating duplications and other economies
of scale will reduce company SMALLER's expenses.
Every dollar reduction in expenses translates into $15 of value (P/E
Ratio of 15 X $1).
Increases
in Value Calculation -- Company BIG is able to eliminate 1 million dollars of
redundant expense - $1,000,000 X 15 = $15 million dollar increase in value.
Strategy
#3 - Acquire
according to a strategic plan
BIGs acquisition of a company in order to gain specific benefits such as:
proprietary products, technology, channels of distribution or talent base for
example, can result in an improved outlook for company BIG.
Whereas the P/E ratio usually reflects expectations of future profits,
a strategic acquisition often produces a P/E ratio increase.
In this example company BIG's P/E ratio increases by a dollar from 15X
to 16 times earnings after the acquisition was announced.
Increases
in Value Calculation -- Every point increase in company
BIG's P/E ratio equates to 111 million dollars of added value (original $100
million in earnings plus addition of SMALLER's $10 million plus $1 million in
reduced expenses times 1).
Calculation
of Increased Value to Shareholders:
In the above example, company BIG's
acquisition of company SMALLER not only has increased earnings by $10 million
but has increase company BIG's value as follows.
-
Increased
value of $10 million in earnings
$ 50,000,000
-
Reduced
SMALLER's expenses by $1 million
15,000,000
-
Increase
of BIG's P/E Ratio from 15 to 16
111,000,000
-
Total
Increase in SIZE of PILE (VALUE)
$176,000,000
This CEO has made the kind of a deal
that makes shareholders happy.
No wonder there is so much M&A
activity in the marketplace. A
well conceived acquisition should produce wondrous results.
These dynamics are not reserved exclusively for Public Companies.
Private and family businesses can and should take advantage of the
opportunities presented by growth through acquisitions.
We will now apply these principles to smaller businesses and analyze
the results.
Value
Building Strategies for
Small and Middle Market Businesses
Private companies can employ the same
three strategies used in the above Public Company example given an
understanding of a few basic principles.
General
Principles:
Financial
Small companies generally have small P/E ratios.
P/E ratios increase as companies grow and develop structure.
P/E ratios increase as dependency upon owner decrease.
Valuation
Principles
Two major value determiners are:
Businesses
with essentially identical earnings, therefore, can have widely diverse values
"Round
Ball" Principle - Non Financial
None of us are equally talented in all directions.
We are not round balls, footballs or Frisbees perhaps, but no one can
"do it all" well. Company
strengths and weaknesses will therefore generally mirror those of its owner.
Armed
with a basic understanding of the
ground rules we can begin to formulate a strategic plan to grow and build
wealth through acquisitions. Table
A summarizes P/E ratios, level of earnings, definition of earnings and
management style by company size. We
can use Table A as reference as we develop our plan.
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