Growing your Business Through Mergers and Acquisitions

by | Apr 29, 2022

ARTICLE | April 29, 2022

The business world is consolidating rapidly. Companies of all sizes are looking to increase their size, power, and efficiency through merger and acquisition (M&A) activity. It’s no surprise as they face fierce competitive pressures and increasing demands from investors for successful returns.  Through the second quarter of 2021, global M&A activity reached $2.4 trillion – surpassing the prior year’s record by 158%, according to a Refinitiv Deals Intelligence Report.

Well-designed and executed mergers and acquisitions, and the benefits they bring, are proven value creation levers.  Mergers and acquisitions can create synergies – a condition where the new business as a whole is greater than the sum of its parts. Two organizations combined can often increase their efficiency, reduce cost structure, improve competitiveness, open new sales channels for both entities, and combine complementary product and service offerings.

What’s the difference between a merger and an acquisition?

While mergers and acquisitions can bring similar benefits to the combined entities as a whole, they are separate and distinct processes. In an acquisition, one company takes over partial or complete ownership and control of the other company. The purchase typically goes one way: the acquiring owners pay compensation to the selling owners, buying more than 50% of voting shares. The sellers can stay on as employees of the new firm or walk away, retire, join other companies, or start new enterprises.

In a merger, on the other hand, there’s an exchange of equity. Each group of owners, and/or the companies themselves, receive shares in the new combined entity. There’s often a new brand established, and if the company is publicly traded, a new stock exchange listing.

When is a merger vs. an acquisition appropriate?

A merger may be more appropriate when the smaller company’s management team is capable and energetic, and where both sides can see the strategic benefits of combining. Mergers may also be appropriate if the smaller or weaker of the two entities can bring a lot to the table in terms of leadership, talent, personal and social capital, technology, or market connections. In the middle market, having a good match between the two organizational cultures is critical – often the determinative characteristic of the success of the deal.

An acquisition may be more appropriate if the owners and senior management teams of the acquired company are looking to exit or don’t want to be involved after the deal. It may also be appropriate if the purchaser has a much stronger brand than the selling company, and re-branding doesn’t make sense. 

Additionally, if the owners of the acquired company wish to stay involved in the combined company, there are often opportunities for them to roll over a portion of the sales price into equity in the acquiring company.  In the right circumstances, this allows the owners of the acquired company a chance to cash in on the growth of the larger, combined company down the road, often called a second bite of the apple. 

What are the strategic benefits of a merger or acquisition?

Where a merger or acquisition goes well, there can be many potential benefits:

Greater size

Larger companies tend to trade at a premium to smaller companies. Large companies have scarcity value – there are fewer of them – and with good management, they can usually operate more efficiently.

For example, a local grocery chain with 75 locations may sell at a multiple of 5 times EBITDA. But the owners notice that regional grocery chains with 100 locations or more typically sell at closer to 7 times EBITDA. The owners may look to acquire one or more local grocer chains to rapidly expand their footprint to more than 100 stores – and quickly expand their multiple from 5x to 7x, simply by virtue of the size premium.

Along that same line, a company commanding a valuation of 7 times EBITDA may be able to acquire smaller companies at 5 times EBITDA or less and thus take advantage of a valuation arbitrage.  Post-merger, that EBITDA purchased for 5X may instantly be valued at 7X as part of the larger company.

More customers, more quickly

Customer acquisition is expensive and takes time. It can cost a significant amount of money for marketing, advertising, and sales commissions to acquire a new customer, especially in more mature markets.  Sometimes, it’s much less expensive for a company to buy an established customer base with predictable long-term revenue than to incur the marketing costs to fight for it.

This becomes an increasingly vital consideration where growth through organic means has stagnated. Customer acquisition costs go through the roof in saturated markets, and even a large marketing spend can produce very limited results. In this case, it may be better to commit those resources to acquire an already active and established customer base, enjoy their recurring revenue, and upsell or cross-sell to them.

Finally, acquiring new customers simply takes time.  If a company wants or needs to quickly expand its market share, then a merger or acquisition may be the best strategy.

Increased purchasing power

Mergers increase purchasing power. Suppliers often provide better pricing for higher volume buyers, so combining two smaller companies into one larger company can even lead to cost savings. Contracting and acquisitions teams can have each company’s new vendors bid competitively for the rights to sell to the new larger company – a process called vendor consolidation. The result is significantly increased efficiency and a cost structure advantage over smaller competitors who are unable to get this favorable pricing.

Improved benefits design

The same logic can also apply to employee benefits. Companies with a larger workforce can expect better pricing on health insurance, disability insurance, voluntary benefits, pension, and 401(k) administration, and other benefits.  Not only are there cost savings, but the combined company may be able to improve the overall benefits offered to employees.

Optimized or diversified geographical footprint

Companies can diversify their exposure to local and regional economic risks. For example, a Florida company acquiring businesses outside of Florida can reduce its potential exposure to business interruption costs as a result of a hurricane.

Consider another example. Suppose a restaurant franchise owner has capital and would like to expand to an up-and-coming, fast-growing suburb. However, the franchise company won’t allow the expansion because the territory is held by another franchisor.  But the existing franchisor who has a restaurant in the up-and-coming community would also like to open another store – but just doesn’t have the capital. In this case, one side has the desired territory but doesn’t have the capital while the other side has the capital to build a new restaurant but doesn’t have the territory. The potential for synergy is obvious: The owner with the capital can buy or merge with the owner with the desirable territory. This is another example of territorial expansion through M&A.

Less competition

Acquiring a direct competitor not only provides the assets, intellectual property, talent, and goodwill of the acquired company, it also eliminates a competitor.  Competition tends to drive up the cost of acquisition and slows customer growth.  An acquisition or merger may reduce the premium cost of going toe to toe with the competitor.

Fewer gaps in product and service line

Mergers and acquisitions often offer opportunities to upsell/cross-sell existing customer bases. For example, a manufacturer may acquire a transportation company with a fleet of vehicles and experienced drivers – and charge both for manufacturing and delivery. This offers two opportunities for profits, provides a competitive advantage over competing manufacturers, or accomplishes both.

Alternatively, a retail bank that only offers traditional consumer banking services and small business loans may merge with a wealth management company or brokerage. Both provide an established market, and both can readily cross-sell services to the other.

Better talent and intellectual capital

Mergers and acquisitions can also bring much-needed talent and intellectual capital in-house. For example, an established guitar maker may possess a team of outstanding craftsmen, machinery, and a valuable inventory of aged wood – but have trouble selling through brick-and-mortar music stores struggling with pressures like the coronavirus pandemic and competition from online sellers.

The guitar manufacturer may merge with or acquire an established and successful online/e-commerce company. The e-commerce company gets to sell some of the best guitars in the market, while the manufacturer benefits by opening a brand new and powerful sales channel for itself. It would have had a difficult time building the e-commerce function from scratch and on its own. But a merger or acquisition allows the ramp up of combined operations immediately.

Greater efficiency and less redundancy

Mergers and acquisitions offer opportunities to reduce costs by eliminating or consolidating redundant positions and departments. Obviously, there’s no need for two different CEOs and CFOs. So, expenses can be reduced at the top. But the same can apply to all departments and functions up and down the organization – including for non-core functions like HR, accounts receivable, maintenance, and other non-revenue-generating functions.

Reduced real estate and physical plant costs

When two organizations combine, they may be able to reduce real estate and lease expenses substantially. There’s no need for two separate headquarters buildings, vehicle fleet maintenance yards and garages, separate sales offices in different cities, etc. Merging or acquiring allows companies to reduce real estate expenses, sell unneeded properties to raise cash or rent them out, or both.

Challenges to successful acquisitions and mergers

M&A isn’t easy. Both acquisitions and mergers usually require funding. Acquisitions frequently involve a large amount of leverage, which may be concerning to partners or shareholders. Increased debt means increased risks in the event of a setback. If funded with equity, existing owners may will be concerned about the dilutive effect of additional equity issuance. There are advantages and disadvantages to both.

Mergers and acquisitions also generate substantial costs of their own. Expect to pay significant sums to outside investment bankers, business brokers, and legal, tax and accounting advisors.

There are also internal costs to consider: You may need to pay severance packages to people being let go, or bonus packages to encourage people to stay on through the transition. You’ll need to retrain people and departments on new technologies, such as accounting and HR software.

Cultural fit is a major consideration. For example, when the old, traditional media company Time Warner merged with the young, high-tech, and dynamic America Online to create AOL Time Warner, there were a large number of cultural clashes at all levels of the company. One study from Bain & Company found that executives who managed through mergers reported that cultural differences between merged companies was the number one reason for merger failures.

In many cases, an acquiring company can let the selling company continue to operate, even under its former owner, relatively autonomously. Warren Buffett regularly does this with acquired companies in his holding company, Berkshire Hathaway, with great success. This is one way to minimize cultural clashes between combined organizations. But it’s not always practical – and, in the case of mergers rather than acquisitions, may be impossible.

Approaches to finding merger and acquisition targets

Make a list of direct competitors in your market and in adjacent markets – either geographically or conceptually. Many of these firms may have aging owner-managers who are looking to retire or otherwise make an exit. Some may be experiencing business or personal challenges that make them motivated sellers, willing to be acquired at a bargain price.

Even when the other companies are not having difficulties, they may still have access to critical assets, markets, distribution channels, intellectual property, favorable contracts, or other advantages that make them worth acquiring.

You can also look to acquire companies that operate up or down the production and distribution chain, bringing more capabilities in-house, and building out a vertical monopoly. For example, a manufacturer could purchase a raw materials company, a trucking company, and a warehouse operation, taking control of more and more of the production and distribution process.

You can work with an investment bank or business broker. Both of these will know companies and owners who are interested in selling. In many cases, such as with private equity and venture capital-owned companies, getting acquired was part of the business model all along.

Leverage your own personal contacts. You may be able to find a great candidate for an acquisition or merger through your own network – and save on broker fees and investment bank commission costs, which are substantial.

Navigating the merger and acquisition process

If you’re ready to merge or acquire (or be acquired), there are multiple ways to start the process. Consult with KHA’s management consulting team to help gauge whether or not you and your company are ready to consider a transaction.   This is especially important for sellers. Having excellent financial records and other documentation is important for maximizing your sales multiple. A company that is well-prepared for the diligence process will build confidence and command a higher multiple than companies whose records and plans are in disarray.  We can help you visualize the process, understand whether you and your company are ready, and, if you are not ready, help lay out a plan to get you ready to maximize the value of your company. 

When the time is right, we can help you engage the right team of advisors which can include a business broker or investment banker, an attorney, and a financial advisor.  Engaging the right team, especially ones who specialize in your industry can provide sellers with valuable advice about preparing themselves for sale, and buyers with advice about who is selling and which acquisitions might best satisfy the strategic objectives of the buyers.

Be prepared to manage the human side of mergers and acquisitions. There are almost always some winners and some losers. Even in the best of situations, conflicts can arise in and between departments and managers. It can be a very stressful process for employees uncertain of their future and potentially damaging for the organization.

Navigating a successful merger takes sensitivity, compassion, foresight, work, and expertise.  If you are considering growth through a merger or acquisition, or if you’re looking to be acquired, contact our office.  We’d be happy to discuss your unique situation and how we may be of service.

This article is provided solely for informational and educational purposes. KHA Accountants, PLLC, its partners and others do not provide any assurance as to the accuracy of this information or its fitfulness for any purpose. As such, KHA Accountants, PLLC cannot be held liable for any information derived from the article or from referenced sources. Consult your legal and business advisors prior to making financial decisions

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