Acquisitions -- Why Buy when You Can Build?

In a recent meeting of Chief Executive Boards International, a member brought up a failed acquisition attempt. This member is in a pure advisory service type of business, and had attempted to acquire another practice in his same market space.

After hearing some details of the failed deal, the Board gave him a completely different perspective on the acquisition, a regular occurrence in these meetings. Turns out the member was looking a business, represented by a broker, at a valuation of roughly 3 times gross revenue. The member was proposing $1 million cash, and $3 million owner financing over 7 years. A handsome price to buy only a client list. The deal failed due to the buyer's inability to obtain financing on the $1 million.

The Board questioned not only the lofty valuation, but also the buyer's likely "conversion ratio" of the existing clients. In any personal service business, there's a degree of chemistry between the client and the provider, and that might be tough to transition to a new organization. At any rate, the existing clients have a reason to shop around as a result of the change of ownership.

Then came the paradigm-shifting difference in perspective. The question was asked, "If you were willing to fork over $1 million in cash to buy this business, what would happen if you invested $1 million, say $250,000/year, in stepped-up marketing and sales activity in your existing business?" "Why", the member said, "I could explode my growth with that amount of sales & marketing effort." And then, of course, he wouldn't owe the other $3 million on the back side, either.

A strange thing happens when we use our taxable income, rather than cash flow analysis, in considering an acquisition opportunity. IRS allows Goodwill (most of the purchase price of a service-based acquisition) to be amortized over 15 years, straight line. Thus, the first $1 million of the purchase price looks like only a $67,000 annual hit to earnings, despite the fact that you're either $1 million poorer or $1 million more in debt. Somehow, in the mind of the business owner, that's "less bad" than four years of $250,000 in additional sales and marketing expenses, making the income statement look $183,000 worse (in all four years).

What's that reason? I think it's ego. We get our sense of accomplishment and self-worth all tangled around our income statements and tax returns. We forget about our long-term strategy, the long-term value of growing our businesses, and the ultimate "end game". We just say, "That's going to cost me $250,000 in profit -- I'd never want to sacrifice that." In fact, $183,000 less taxable income actually saves most business owners at least and additional $80,000. So, the Government is helping you defray the cost of that additional sales & marketing expense. Not to mention that it's fun to say on the golf course, "I acquired a business." Lots more sex appeal than "I grew my business with money I saved by not acquiring one."

We've completely ignored interest in this simple analysis, both of which tilt it further in the direction of "grow your own" vs. "buy". To be more rigorous in comparing cash flows, one could look at the loan amortization cash flow of the $1 million over, say, 7 years at, say, 6%, and do this example on that basis -- $175,000/year in growth funding vs. debt service.

Now that you think about it, what would benefit your business more -- a $1 million acquisition or $250,000 "invested" in a pure growth strategy for each of 4 years running?

So, you never want to acquire a business, right? Of course there are exceptions -- I'm not arguing that acquisitions are never a good idea. Here are some of the litmus tests that could be applied to an acquisition that might make it worth a serious investment:

• A platform company -- It's surely easier to build a business from an established brand, organization, facility, customer base, etc. than to start one from scratch. Even then, you need to have a clear-cut vision for how you're going to transform the acquired business into something far more successful than the one you're paying for.
  
  
• A new platform for your own company -- An acquisition in a new product/service segment that would be expensive to break into from scratch. An expansion into a geography where the seller has facilities, customers, brand recognition, etc. that would cost you a lot to establish.
  
  
• Intellectual property -- The seller has specific know-how, whether patent or trade secret protected, that you can't figure out any other way to acquire (or can't acquire separately from the business).
  
  
• Human Capital -- This one is dicey, and assumes you can win the hearts and minds of key players the seller has groomed over time, to fill holes and gaps in your own management team.
  
  
• Eliminating a Competitor -- If you're in a narrow niche, and you can take a meaningful competitor out of action, there may be some benefit to your base business, as well as the acquired portion.
  
  
• It's really cheap -- Some businesses sell in distress. If you come across a real distress sale that you're completely convinced you can turn around in MONTHS, not years, you may have a bargain on your hands.
  
  
• Leverage -- You don't use your own money, and your return is many times the cost of the money you do use.

Bob Pritchett, author of one of my favorite business books of all time, Fire Someone Today, says, "In acquisitions, the buyer is the loser." If you're thinking about an acquisition, order the book and read only Chapter 18. Pritchett makes the case that the seller always knows more than the buyer will ever learn in due diligence, and there's a litany of things that you won't see, including the difficulty of integrating newly-acquired entities (and people) into your company.

So, Pritchett suggests, "Ask crazy questions", like, "If I am considering buying customers or employees, what would happen if I took the acquisition cost and offered it directly to the customers or employees in cash instead of paying it to the business they are associated with?"
Which is very close to the question this Board posed to the member -- "What would happen if you took the acquisition cost and spent it on growing your own (already successful) business?"

If you've experienced an acquisition that either validates or disputes these ideas, please click "Comments" below, and share your experience with others.

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Terry Weaver


CEO
Chief Executive Boards International
http://www.chiefexecutiveboards.com/
TerryWeaver@ChiefExecutiveBoards.com