By Eric Furlow, President, Furlow Consulting
Pursuing a merger or acquisition can be a very effective way to grow revenue, acquire a customer base to cross sell into, add new product and service lines, acquire specific assets (or permits, licenses, etc.), expand into new geographic markets, acquire talent (“acqui-hire”), or acquire intellectual property. Some CEOs have M&A experience and some don’t. For those who don’t, this doesn’t mean M&A should be avoided, rather just pursued in a slower gear. The following are a few suggestions I have.
Channel Target Company or Companies?
Just because a reseller or service provider CEO hears that a specific company is for sale doesn’t mean the CEO cannot look for additional sellers to compare the original target company to. I have seen too many CEOs try to force a deal with a single target company which suddenly came up for sale. Just like CEOs who are selling their companies should find the broadest pool of prospective buyers to auction the company to, CEOs who are in the acquisition mode should find the broadest pool of prospective sellers to choose from.
Is the target company superior or inferior to yours?
A CEO shouldn’t be afraid to acquire a company which is superior to theirs in almost every regard. Meaning their profit margins are higher, they are growing faster, their engineers, developers or service desk technicians are more qualified, their utilization of assets is more impressive, their vendor relationships are more attractive etc. Sure, this deal might be more expensive but it is usually better to pay full price for a high quality company than it is to “get a great deal” on a distressed company.
While it is flattering for CEOs to look at inferior target companies knowing they can improve almost every process of the target company, they should not lose sight of the goal which is to make their company more profitable and superior in almost every regard especially in the eyes of present and prospective customers. Following an acquisition of an inferior company, the combined company can actually take a few steps back in the short run. On the lower end of the market, below the inferior companies, are “distressed situations”. Warning: “Distressed M&A” is its own unique environment with a lot of bad things happening behind the scenes. The old expressions such as “90% of an iceberg is underwater” and “skeletons in the closet” start to make perfect sense to the buyer … or they will shortly after closing. In addition, it is during a distressed sale when honest and ethical selling shareholders sometimes turn shady for a short period of time.
Channel Assets, Engineering and IP
This is obviously a very lengthy topic, however let me point out just one biggie with regards to M&A risk. Proprietary software can absolutely be a diamond in the rough … a path to save recurring license costs, improve an operational process, sell a new provided service etc. or it can be a future shareholder value destroying component of the acquisition. The problem with proprietary software is the possible ongoing dependence upon its developers. Are these developers full time employees of the target company or third-party developers outside the target company? Was the software developed by one person who is a flight risk post-closing, or by an in-house team of 15 where if any 3-4 of them left the company there would still be a qualified base of developers to support and innovate the software?
It is not just the employees at the target company which warrant a bit of analysis; it is also the buyer’s employees which need to be considered. The level of talent within MSPs and VARs can be all over the scale from company to company in the IT space. If the buyer’s engineering team is clearly inferior to the target companies engineering team, there could be big trouble ahead if the target’s engineers are few in number and a flight risk. However, the target’s superior team can also be the motivation for the deal. To partially mitigate this risk, the engineering due diligence phase should be upgraded from a technical review to a ferocious educational phase. Obviously, the larger the company the less risky the difference in talent level is as a component of the deal.
Also, beware if part of the attraction of the deal is bringing on the target company CEO, who was one of the original founders. The reason is, original founders rarely stay with the buying company for very long post-closing. Many of them cannot stand the way buyers run their company post-closing, so they soon depart physically if there is no financial incentive structure in place to keep them there, or depart mentally if there is one in place. Make sure that if the main attraction of the deal is talent, it is a group of talent being acquired not just a couple of individuals in a single department.
Don’t believe everything you hear or read. The problems or some of what you hear is simply not true and some of what you hear is just the total deal value. The total deal value alone can be very misleading, it doesn’t tell you how much of the deal was paid at closing (it could be 90% in cash or just 20%), if the compensation component of the deal was cash vs. illiquid private stock, or the cash component was paid over many years (maybe 5+ years). Regarding public company valuations, this is a good source of info but can be a little tricky as well. Many companies within the same IT industry have vastly different product and service mixes and have different debt loads, hence their valuation multiples can vary widely. Of course, there are many other reasons for higher and lower valuation multiples. Finally, small private companies can sometimes sell for greater valuation multiples than their public counterparts because there are simply so many buyers bidding up small sub $20mm private company deals. In conclusion, inquire with a few trusted advisors, former sellers you know and trust, and compile the public company information.
Eric Furlow, is the president of Furlow Consulting and since 1996 has been assisting corporations & individuals acquire, divest and value Internet service companies such as: MSPs, web hosting, cloud services, IaaS, SaaS, eCommerce, VAR’s, VoIP.