Business Growth Through Acquisition

A Powerful Strategy

By: Richard J. Burke, CPA, CGMA, CM&AA,MBA

Traditional Growth Strategy:

The traditional way to grow a business is through increased sales and slowly adding operations and infrastructure support departments over time.  This strategy is commonly referred to as “Internal Growth” or “Organic Growth”.  Revenue growth is typically associated with more customers.  This requires not only maintaining your current customers, but at the same time adding new customers in excess of any lost customers so the net customer change is positive.  Churn is measured by:

Chart 1 – Customer Roll or “Churn”

 

Revenue growth can also be achieved through increasing revenue per customer via diversification strategies such as adding products or services.  A well-performing company with strong organic growth will achieve year-over-year growth of 8% to 10%.  However, maintaining a constant growth rate is extremely difficult, but achievable. 

Chart 2 – Incremental Growth Illustration

As shown in Chart 2, 10% growth on $5 million of revenue would require $500k in net additional sales.  When the business is at $12 million in annual revenue, it would need an additional $1.2 million of incremental sales in one year to achieve a 10% growth rate.  More than likely, this would require additional salespeople.  One of the key factors of achieving a net positive increase in sales is to minimize losing sales from existing customers.

Organic growth is a slow process that can take years to accomplish. To illustrate this, let’s assume your company earns $5 million of annual revenue.  If you grew 8% year-over-year, each year (called compound annual growth rate or “CAGR”), you would reach $15.8 million of revenue in 15 years. 

Chart 3 – Organic Growth

Acquisition Growth Strategy:

One of the fastest ways a company can grow enterprise value is through a well-defined acquisition growth strategy. This more aggressive strategy, if carefully planned, would accelerate the organic growth through acquiring several smaller companies.  The results could achieve 60% to 120% more growth in the same 15-year period.

Acquiring other businesses can help a company grow and benefit in multiple ways, such as:

 

  • Increasing market share: Acquisitions can help companies gain a competitive edge and market power quickly.

  • Expanding operations: Companies can acquire new products, services and operational efficiencies through an acquisition.

  • Accessing new markets: Acquisitions can help companies expand into new markets efficiently.

  • Acquiring skills and technology: Companies can improve human capital through an acquisition and improve technology capabilities such as research and development or innovative processes faster and less expensive than if it were developed in-house.

  • Diversifying the business: Acquisitions can open new customer segments and introduce new products or services.  This may compliment your existing offerings or simply expand them.

  • Increase Shareholder Value: M&A growth strategy can increase shareholder value by rapidly increasing earnings and achieving a higher exit multiple discussed below.

Acquisition Strategy Example:

Building a larger company would not only achieve greater revenue and earnings, it would also create greater value for an exit strategy.  Larger companies with diversified sales channels tend to be more attractive to a future buyer. 

To illustrate the impact of adding acquisitions to your growth strategy, let’s continue the 8% organic growth strategy from above.  Assume you could acquire up to $8 million in additional revenue through acquisition over the next 6 years.  The acquisition plan would look something like this:

Chart 4 – Sample Acquisition Scenario

If organic growth continues at 8%, while executing the acquisition strategy, the company will be earning over $35 million in revenue by year 15!  This is a 122% increase over the Organic Growth Only scenario! See chart 5 below.

Chart 5 – Growth Strategy Comparison

Impact on Exit Value:

Larger companies with higher revenue typically demand a premium in what is called a “Market Multiple”.  A market multiple is an easy method to determine a company’s approximate potential sale value.  By reviewing comparable company sales, we can determine a range of the company’s value (or Enterprise Value “EV”) as it relates to earnings.  The typical earnings measure is Earnings before Interest Tax Depreciation and Amortization or “EBITDA”.  For example, if a company sold for $9 million and in the year of sale the EBITDA was $3 million, the market multiple would be 3.0x (EV/EBITDA).  Applying sale data from other companies that are similar in size and industry and applying this “multiple” to your company’s earnings provides a good indication of what your company would sell for.  This is the same concept used in house sales.

To illustrate the higher multiple for larger deals, see the statistics below.   The smaller deals, under $4m only earned an EBITDA multiple of 4.2x and larger deals earned a multiple of 10.0x of EBITDA.  The difference in deal size multiples is referred to as arbitrage.

Chart 6 – Market Multiples by Deal Size

Applying this arbitrage concept to our growth strategy example, the total enterprise value would be higher by $8.45 million under the Acquisition Growth Strategy.  To walk through the math, refer to Chart 7 below.

Chart 7 – Exit Value Comparison

In both scenarios, we assume that EBITDA is 6% of Revenue.  For the organic growth strategy, Revenue is $15.8 million.  6% of revenue gives us $951.6k of EBITDA.  A deal at $16 million will earn a market multiple of 5.8x.  This gives an enterprise exit value of $5.5 million.

In the acquisition strategy, Revenue is $35.2 million.  6% of revenue gives us EBITDA of $2.1 million.  The higher deal earns a market multiple of 6.6x, providing a total enterprise exit value of $13.9 million

In this example, the acquisition growth strategy earned 145% ($8.45 million) more than the organic strategy.  Of the total $8.45 million increase, $1.69 million is due to the arbitrage in the market multiples (from 5.8x to 6.6x). 

Acquisition Growth Strategies are commonly used by large corporations, and it is also the basic model of how private equity (“PE”) funds operate.  While PE is primarily focused on the growth goal and achieving the market multiple arbitrage, large corporations like Google and Microsoft also focus heavily on revenue diversification and increasing innovation through acquisitions.  The private equity model is to buy up multiple companies in the same industry to form one large company.  This is called a “Platform”.  Their exit strategy is typically a 5-to-7-year horizon.

Key Components of a Good Acquisition Growth Strategy:

  1. Perform an evaluation of your industry’s market.

  2. Develop a target acquisition profile.

  3. Identify the synergies you’re looking to capture.

  4. Secure funding for acquisitions.

  5. Build a team of advisors.  Externally, you will need an experienced M&A advisor and M&A experienced attorney.  Internally, consider who should be on the team to assist with reviewing the various aspects of a target company.

  6. Develop a preliminary forward-looking financial forecast of your company with assumed acquisitions.

  7. Prepare a preliminary due diligence list.

  8. Plan for integration.

Conclusion:

When executed correctly, there is no better way to create long-term value creation.  The first step in exit planning is to know what the current value of your business is.  Often owners find that a gap exists between what they need for retirement and what the current value of their business is.  Having a 5-to-7-year runway prior to exiting will afford the time to execute this more aggressive growth strategy and close that value gap. M&A is a complicated project to execute.  Having the right advisors on your team will significantly increase your odds of Success!

At BFS, we provide all the experts you will need to execute your Growth by Acquisition Strategic Plan.

Previous
Previous

How Economic Business Cycles Influence Your Business Value