Business Valuation and Profitability | Spire Group, PC
It seems simple—too simple, perhaps…You acquire a business because you determine through careful due diligence that it’s profitable, and offers opportunities for expanded profitability through numerous growth avenues.
If only it were that simple. In reality, far too many investors – be they companies, partnerships or other entities – pull the trigger on an acquisition, only to learn soon after that the profitability they thought was baked into the business is actually fleeting, illusory, tenuous, or gone altogether.
In a perfect world, acquiring a company would be a straightforward proposition; determining its profitability in the early stages of that process would simply entail reviewing financials, interviewing key players, identifying assets and liabilities, then running the numbers and drawing logical conclusions.
In many situations, legal safeguards – in addition to practical realities – restrict what information is available for review, and who can be involved in the due diligence process. On the surface, that may seem burdensome; but there are good reasons behind it.
Consider competitive issues, for example. If proprietary or competitive information is disclosed in the course of due diligence, then the deal falls through, critical information has been disclosed, and the would-be acquired company may be at a competitive disadvantage as a result.
There are also people issues at play. If employees sense that an organization is selling and they perceive their jobs to be at risk, then valuable employees may leave before or after the transaction. Additionally, senior leaders, who represent intangible value within a business, may choose to leave following an acquisition. If they walk out the door, that value goes with them.
While businesses are bought for their revenue and profitability, understanding what drives revenue and profitability is what is truly critical. Is the value of a business under consideration in its contracts, its customer relationships, its intellectual property—even its processes and systems? What creates value in a manufacturing business is vastly different from what creates value in a health care/life sciences company or a high-tech/IT firm. Additionally, it’s critical to understand how that value of the target company is additive to the acquiring organization.
A key principle in the field of quantum mechanics is that when a particle is observed, the mere fact of observing it changes its properties. This is true in acquisitions as well. It is not uncommon when an acquisition is announced for vendors and customers to want to change contract terms due to the size and potential viability of the new organization. Similarly, critical employees have been known to leave in the wake of an acquisition announcement.
There are many other factors that combine to make profitability a veiled target, but the bottom line is that despite an acquirer’s best intentions and efforts on the front end, profitability remains largely a hypothesis. Smart organizations can work throughout the due diligence period to develop a really good hypothesis; but it isn’t until after the deal is officially completed that the acquiring interest gets a true picture of reality. The real value of any deal is realized through the hard work of integrating the organizations post-close.
Determining the way forward in business acquisitions
Knowing that profitability and revenue cannot be fully determined pre-acquisition, how do you as an acquiring business prepare for such uncertainties? Specifically, how can you develop a really good hypothesis? And assuming the deal goes through, what will it take to preserve the value that exists, and help ensure it doesn’t erode or evaporate post-close?
The answers to these questions are multifaceted; but at their core, they’re not difficult to understand. Some basic pointers include:
- Pinpoint the sources of value of the target business to your business and customers. Be clear on what benefits you expect to realize, and the anticipated benefits of that value. Ensure that you understand whether value comes from contracts, intellectual property, critical staff, and/or processes and systems, and stay laser-focused on realizing the benefits from those value sources.
- Identify the critical people in the acquired business—then work to ensure they remain in place. This includes everyone from corporate leaders and division heads on down to valued employees who possess key intellectual capital. This may require putting employment contracts and retention bonuses in place for key resources. Above all, make sure your leadership and management teams are established and ready to perform as soon as the deal is completed.
- Limit distractions post-close. Priority number-one is in fully integrating the business and ensuring you realize the full value of the integration. It is very easy to lose value as business issues start to dominate, or as the organization gets distracted with another possible acquisition.
- Prepare to hit the ground running seamlessly on day one—from internal considerations to all customer-touching activities. If the deal closes at midnight Sunday, and Monday morning rolls around, is the company ready to do business? The answer may seem obvious, but there are many details to consider ahead of time. Things like addressing all legal issues (prior to close); addressing branding and customer-touching issues; communicating to customers, vendors and the public at large; re-badging employees; and making sure benefit packages and payrolls are in place. These are but a few of the critical items that must be addressed before the deal closes. Full integration of operations, finance, HR, sales and marketing and IT systems can actually occur post-close. Failure to account for these (and all other relevant details) can significantly reduce – or even eliminate – the target value of the organization.
- Evaluate purchasing activities with an eye toward economizing where prudent. When two companies combine, it’s likely there are two sets of, well, lots of things—from vendor contracts, customer databases, direct material supply chains and more. In this regard, preserving value calls for leveraging economies of scale when appropriate and utilizing lower-cost products and services—again, when appropriate.
- Be very sensitive to how you manage accounting flows, and how you allocate overhead costs. If you as the acquiring company have a larger overhead cost structure than that of the company you just acquired, and you allocate your cost structure to the acquired company, even while lowering or eliminating their allocations, you could significantly erode its profitability. Make sure your accounting experts and trusted advisors design cost structures that make sense for all entities involved.
- Have a sound branding strategy in place, and roll with it when the deal closes. Your customers / clients should clearly understand what’s occurred – e.g., XYZ Company is now XYZ Company, a subsidiary of ABC Company. That message must be articulated throughout the chain of customer, prospect, vendor and public touchpoints.
- Finally, understand all potential cross-sell opportunities and pursue them to the extent possible. When two companies combine, through merger, acquisition or other means, opportunities may exist to sell new services (or put another way, services one company offers that the other doesn’t) to existing clients on both sides of the aisle. In doing so, your new enterprise may be viewed as more valuable to existing clients, given that you may now have the capability to address more business needs for your customers. There is significant value in creating a one-stop shop for your clients.
Do you have questions about business profitability or business acquisition strategy? Please contact us at 732-381-8887.