Establishing the Framework of a Business Acquisition
Establishing the framework before you buy a business to ensure success.
Preparing to buy a business requires an objective and tactical approach on many levels. Proper planning starts with a straightforward appraisal of the financial health, wherewithal and capacity of your organization to absorb another company with minimal disruption to either ecosystems. A close evaluation of how the tangibles and notably the conventional and digital intangibles could affect the synergies of a combined entity must be scrutinized to devise a realistic acquisition strategy.
Justify the Purpose of Acquisition
Companies opting to buy a business must be able to justify why acquiring would be more beneficial than reinvesting back into the business. Acquisitions are generally pursued to either enhance the core operations or develop new verticals. Adopting a growth by acquisition strategy is generally reserved for organizations that have reached a level of maturity with established stable and predictable cash flow with consistent earnings transparency. This strategy targets businesses that can be immediate accretive to earnings.
Strike Through the Target
Just as a professional fighter is taught to strike through and beyond the target for maximum impact, an acquisition strategy entails planning through the purchase into the integration and growth phase. Focusing on the complete acquisition sequence ensures a panoramic perspective of the big picture and extends the momentum to ensure you don't get blindsided or bogged down along the way. The sequence starts with first establishing the framework for acquisition based on the financial capacity of your company.
Assess Whether Your Financial Situation Can Handle an Acquisition
The financial health of the acquiring company will determine the capacity for an acquisition. The acquirer should not only be profitable, but must remain profitable in the core business throughout the acquisition sequence. It's prudent to set the parameters to quantify what the company can afford and mitigate the risk of contagion should the acquisition turn sour.
Appraise Your Financial Capacity
Each industry and type of business has different standard metrics to measure financial health. Year-over-year (YOY) sales and profit growth is a given. Ideally your revenue growth rate and operating expenses should remain proportional. The business should have a history of improving free cash flow (FCF) building up cash reserves. Efficiently run businesses generate YOY FCF growth. A FCF to operating cash flow (OCF) ratio north of 50 percent and preferably closer to 70 percent demonstrates strong capacity for investments, as noted by Ready Ratios.
Your quick ratio (QR) and debt service coverage ratio (DSCR) should be above two to expand the range of financing options and curtail risks of a cash flow crunch, as Fundera notes. Cash reserves should exceed three quarters of operating expenses at a minimum. Boost credit lines and facilities to twice the cash reserve level ahead beforehand. This evaluation should be updated quarterly to keep your organization acquisition-ready.
Isolate the Tangible Benefits
Quantify the tangible benefits that can be gained more quickly and economically through purchase, rather than organically through reinvestment. Identify the differing and overlapping factors that can lend to extending revenue channels while streamlining expenses. For example, the combined company might generate a 25 percent cost savings from consolidating the operations including administrative and marketing departments, leases, platforms and warehouse space within the first year. A combined entity also has the capacity to refinance debt at lower rates to further grow efficiencies.
Other areas of expense reduction stem from improved pricing power with suppliers and vendors, consolidation of overlapping data, services, memberships and subscription contracts. Further efficiencies can be harvested from digitization, mobility enhancements, virtualization, automation and enterprise cloud migration.
Uncover the Value of Digital Intangibles
Intangibles are often overlooked but can have a dramatic impact on operations, as Chartered Global Management Accountant notes. Conventional intangibles include intellectual property (IP), trademarks, patents, copyrights, brand reputation and goodwill.
Digital assets are by nature intangibles since they aren't physical. These include websites, email lists, mobile apps, e-books, blogs and social media accounts including Google, Amazon, eBay, Facebook, Instagram and Twitter followers. Social media, digital traffic and data analytics can be augmented and leveraged into future growth drivers.
A Solid Foundation for Acquisition
Construct the general template for the ideal acquisition candidate based on the parameters set by your financial capacity. Candidates that exceed the aforementioned FCF and debt ratios will command a larger premium. To keep acquisitions manageable, they shouldn't exceed 20 percent of the acquirer's size, revenues and debt load. Of course, there will always be exceptions, but they should offset the 20 percent threshold overshoot in other areas (i.e., 30 percent revenues offset with a 10 percent smaller workforce). DSCR should preferably be above one, but refinancing debt will improve this ratio after the acquisition.
For example, your template for a model acquisition candidate could entail: same industry, different products and demographics, overlapping support platforms, supply chain and expense structures and established social media presence. Potential synergies can account for 20 percent reduction in costs and 40 percent boost in revenues and 10 percent boost to OCF.
Augment Your Framework With a Seasoned Financial Partner
Establish a relationship with a seasoned financial partner and engage preemptively to determine what type of financing options are available. A financial partner with expertise, capital and flexibility can accommodate your organization's lending, expansion and acquisition needs and help you navigate your financing needs to successfully acquire a business and grow your organization.
This material is presented for informational purposes only and should not be construed as individual tax or financial advice. KeyBank does not provide legal advice.