Beyond the Obvious

“Obvious targets are exactly that… obvious.”
– A wise banker.
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In today’s climate of global economic and political insecurity, mergers and acquisitions (M&A) represent a key growth catalyst. Despite the uncertainty of volatile markets, rising interest rates, and regulatory concerns, excess corporate cash reserves are fueling acquisition demands. At the same time, the boom in M&A activity over the last few years has sparked a highly competitive landscape for quality assets – with fewer blue ribbon businesses in the market, the dollar value of deals is increasing. When weighing “build-versus-buy” growth options, CEOs are turning to external opportunities to expand into new markets, broaden their customer base, enhance workforce skillsets, procure valued intellectual property rights, and diversify their product and service pipelines. Whether you are positioned as a middle-market buyer or seller in this dealmaking environment, rest assured that strong, sustained M&A activity is projected to continue over the next year.

Despite this positive outlook, however, M&A transactions can still fall short of expected returns. Achieving your envisioned results rests on effective deal sourcing, pre-sale due diligence, trusted and objective business valuation, and well-executed post-sale integration. Whether you are a buyer or a seller, it remains critical to initiate disciplined tactical and strategic planning early in the dealmaking process to identify and prioritize your anticipated performance goals. Fundamental among these tasks is constructing a list of potential target assets – a task whose success rests on “digging deep,” looking beyond the obvious players for partnerships with the potential to catalyze significant growth.

Finding the right chemistry matters …

Building a robust portfolio of potential targets is often more of an art than a science. It requires researching a mix of directly and indirectly related companies to identify profitable alliances. Whether you are a buyer or a seller, you need to be clear about your objectives: are you searching for targets that recognize the intrinsic value and synergistic fit between each firm’s assets, or for targets interested mainly in cash flow and the return on their investment? Do you include immediate competitors in the business space?

Successful M&A transactions extend well beyond the immediate deal – they involve understanding your company’s long-term ability to create value. The more upfront rigor you dedicate to sourcing, evaluating, and performing due diligence on potential targets, the better your results. Investments of time and domain expertise can significantly enhance the competitive nature of the auction process. You will generally have a wider range of options, and you will improve your chances of closing the deal with optimal pricing outcomes.

First, Identify the Obvious Targets …

Target portfolios begin with lists of obvious potential targets – the high-quality firms with names you recognize. Take care to cautiously assess whether to include direct competitors who might view the M&A process as an opportunity to gain competitive intelligence. Consider adding the larger national and international players that dominate your sector, but understand that, in many cases, familiar firms do not end up as M&A auction finalists. While these are the companies you feel comfortable with, if you stop your research here, you may fail to discover alternative targets with strong motivations to engage in strategic partnerships.

Then, Look Beyond the Obvious …

Effectively expanding your target portfolio rests with framing your M&A objectives: Are you looking to merge with and/or acquire firms whose geographic location and/or products and services fit into your existing ecosystem – or for companies operating in adjacent industry sectors, who share similar customer bases, sell complementary products and services, hold valuable intellectual property assets, offer workforce talent, or provide technology advantages? What factors are important to you: firm size, business model, geographic or market footprint, competitive position, or economic stability? Where do you see post-deal integration occurring: in support areas only, or in core business administration and product development areas?

Identifying these contextual connections can be time-intensive, even for those with in-depth knowledge of products/services and economic geography. Finding potential targets with the best fit for your business is not easy. Publicly-available information may be scarce, market dynamics may be evolving – and overestimating potential corporate synergies and cost savings can easily lead to post-deal disappointments.

Experienced M&A advisors like White Falcon are well positioned to leverage their industry sector knowledge to help you efficiently flesh out your target portfolio. Their research teams have access to resources such as proprietary in-house and market intelligence databases; they have finely-honed networks with active national and international industry players; and they maintain established relationships in the well-capitalized private equity and family office space. Private equity funding can, for example, provide the motivation and financial capital necessary for a high-quality but otherwise “too small” company to aggressively compete in M&A auctions.

Making smart, data-driven decisions…

Responsible, smart M&A decisions are data-driven – yet every good assessor appreciates the fact that statistics must be more than numbers, they must recognize the stories behind the numbers. If your goal is to sell your business, acknowledge your motivations, then look at your company from a buyer’s perspective to gain a realistic, market-based viewpoint. Remember that buyers are investing in your future, not your past. If you are exploring potential companies to acquire, think about the unique advantages you would bring to the business – whether economies of scale, expansion into new markets or product/service pipelines, improved systems, or greater competitive advantage. Understand that your fiduciary responsibility to your shareholders, stakeholders, and investors begins with pre-sale due diligence and trusted, objective business valuations of your targets - but must also be followed by well-executed post-sale integration.

When identifying possible high-quality targets, weigh the following key macro- and microeconomic performance metrics carefully to define a realistic range of value expectations:

The Big Picture

Before delving into company-specific datapoints, take a minute to get a bird’s eye view of the sector lifecycle in which the business operates. What are the national and international economic trends driving both the firm’s operations and revenue sources and the sector within which it operates? Check out industry-wide forecasts from experts with sector-specific knowledge from services such as Standard and Poor or Value Line. What is the sector’s market size? How is the market changing? What technological trends impact the sector? What will the market sector look like in 5 years? 10 years?

Financial Aspects: Revenue Generation

With business worth often valued as a multiple of revenue, strong recurring company earnings are almost always viewed as a positive – as long as the business is profitable. If cash flows remain stable, generating high revenue streams can translate into increased dividends for investors or greater opportunities for sustained growth. For buyers, acquiring bigger operators “moves the needle” when it comes to the bottom line. Given that closing a large deal requires as much effort as closing a small one, it’s simply more efficient to target larger companies if buyers can afford them.

Financial Aspects: Profitability and Sustainability

In addition to revenue, the level of a business’ profitability or recast EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is considered a primary metric when valuing the financial performance of a business. As an approximate measure of operating cash flow, recast EBITDA includes a number of non-recurring and/or owner-related expenses that are usually stripped away when a company is acquired. A good general rule of thumb: if a company’s EBITDA as a percent of sales is less than 5%, the firm needs to look for ways to improve your bottom line; the higher the EBITDA performance ratio, the more stable the earnings. Taking into account the company’s business mix, an EBITDA track record of around 7.5% generally means it’s doing OK; 10% is good and what you should hope and expect to see, while anywhere close to 15% is great.

Recast EBITDA history and outlook indicates a target’s gross profit margins, which in turn are affected by pricing strategies. Industries with few entry barriers and large numbers of competitors make for a difficult operating environment and often lead to razor-thin profit margins. Inelastic demand, on the other hand, generates pricing power. Companies operating in sectors with few alternatives have more flexibility to increase prices and pass costs on to their customers. If a company has low margins, owners may consider testing price increases where viable. Can they improve purchasing strategies, extracting better vendor prices to lower the costs of inventory? Can they cut back on operating costs without impacting customer service and customer retention? Buyers want to see growing, sustainable profits with a plausible future upside.

Financial Aspects: Growth Trajectory and Growth Opportunities

While a target’s financials must be solid, the promise of future earnings – its growth potential – is critical to demonstrating value. A company’s internal and external growth prospects reflect the base revenues on which incremental enhancements can be built. Having a well-framed growth plan is paramount: What options are available to diversify or add to the mix of products and/or services? Are there are new geographic or demographic markets to tap into? Are there are new verticals or smaller add-on acquisitions to pursue? Without this piece of the puzzle, it’s difficult to optimize a valuation.

Financial Aspects: Quality of Financial Reporting

High-quality financials instill confidence in the reliability of company’s revenue, cash flow, and profitability disclosures. Financials should outline the working capital required for current and planned projects. They should show short and long term capital expenditure requirements, as well as the level and quality of a company’s inventory. Accurate, consistent, and transparent financial reporting reduces perceived risks for buyers and provides sellers with solid data for projecting future earnings.

Operations: Depth of Management and Staff Experience

In any company, boots-on-the-ground experience is irreplaceable. Does the company have the right people in right place to take business to next level? Does the corporate climate foster positive workforce interactions and job satisfaction? Are critical functional areas appropriately staffed? What leadership culture is embraced by company executives and directors? Effective organizations require high caliber workers, well-planned and managed projects, transparent communication, and coherent strategies.

Talented managers with the knowledge, motivation, and incentives to grow the business are a key intangible asset. As administrators who understand how to retain a productive and efficient workforce while ensuring day-to-day operations run profitably, they make sure loyal customers remain happy … a virtuous cycle that recognizes relationships matter. Strong service, merchandising, or manufacturing managers know that transitions can be difficult. To mitigate the disruption following corporate mergers and acquisitions, these individuals are often central to the success of post-sale integration processes.

Operations: Competitive Advantage – Product/Service Mix, Intellectual Property

Circumstances that give firms a leg up over their competitors – their competitive advantage – are fundamental to mitigating risk. Does the company draw its revenue from multiple products and services, or does it rely on one or more exclusive products and/or services? Are its materials sourced from diverse places? Do its products and services have brand recognition? Does it own valuable intellectual property – trademarks, copyrights, patents, or trade secrets – and are these properties properly protected? Intellectual property protection is especially important for smaller start-up companies in heavily technology-driven sectors, or firms where commercialization and licensing are commonplace.

Operations: Market Share

What percentage of the sector market does the company control? Market share speaks volumes about a company’s current position and growth prospects. A strong position in the market suggests that the company possesses a unique competitive advantage and likely can be ascribed qualities protect its current and future earnings. Firms with a healthy market share are often better positioned to weather environmental changes that may be detrimental to smaller firms or firms with a smaller piece of the pie.

Operations: Customer Diversity

The number and type of a company’s patrons provides important insight into the value propositions offered to customers. How diverse and loyal is the company’s customer base? What percentage of corporate revenues derives its top five customers? from its returning customers? Do they effectively fold demographic data such as population density, income levels, and cultural perspectives into their marketing plans? For firms with a physical plant, do they have an e-commerce platform? Many companies (especially those with homogenous or small clienteles) disclose revenue percentages by client population in their annual 10-K reports. Be wary if the top five customers account for more than 30% of revenue, a dependency can cause downstream problems if client-customer relationships sour.

Environmental Aspects: Regulatory Compliance

Regulatory, fiscal, and monetary policies materially impact the costs of doing business. Industries handling commodities such as pharmaceuticals, foodstuffs, chemicals, or petrochemicals, for example, are heavily regulated due to the critical human and environmental risks associated with sector products. Banking and financial services must meet national and international monetary and fiscal directives. Cybersecurity and secure digital transactions impact even the smallest firms.

Characterizing compliance as a simply a restraint on entrepreneurial activity, however, can lose sight of the positive benefits and opportunities. Take data privacy. Effectively protecting corporate and customer data can be a competitive differentiator. Data needed to meet regulatory requirements can also be harnessed to flag problems early, improve customer satisfaction, reduce insurance rates, or lead to fewer days lost through workplace illness.

Regulations generally exist for a reason: society has deemed it important to pass legislation ensuring that protective standards and procedures are in place. A company’s past violations will invariably be uncovered during M&A due diligence and, if unremediated, can slow down or even kill transactions. Whether you’re a buyer or a seller, good compliance track records can signal a clean, well-run business reliant on data-driven improvements and risk mitigation.

Environmental Aspects: Facilities and Equipment

Physical plants that are clean, well-organized, consistently branded, and technologically up-to-date contribute to corporate value. Conversely, outdated, poorly-maintained sites and equipment will be devalued. If a company has deferred investments in facility maintenance, technology upgrades, advertising, inventory stocks, or employee training, it will likely show. If equipment is leased, contracts need to be renewable at reasonable rates. When buyers believe that significant funds will be required for capital improvements after a sale, auction prices will be commensurately lowered.

Environmental Aspects: Geographic Location

Companies are also worth more if they are located in geographic areas with favorable infrastructure, good transportation networks, advantageous tax rates, friendly regulatory environments, and higher reimbursement rates. Value increases if companies have ample access to an educated and competitive work force. Many sectors also demand proximate access to universities and research institutions, to technology development corridors, and to high speed network connectivity.

When looking for potential partners, consider whether target businesses have a strong footprint in the marketplace or if they have a disciplined growth strategy for moving into new regions. Are “make vs. buy” decisions at play, and if so, how does geography impact the decision-making process? In the end, based on need, some locations will be preferable to others. Decisions will rest on whether the potential opportunities outweigh any geographic deficiencies.

Environmental Aspects: Corporate Structure

When entering M&A negotiations, focusing on transaction price alone can be shortsighted. Issues surrounding taxes, liability, and depreciation/amortization significantly affect deal outcomes. M&A transactions can be negotiated as asset or stock deals, each with different advantages for buyers and sellers. A significant decision-driver is the company’s organizational structure – is it an S-Corp, an LLC, a partnership, a C-Corp? An increasing number of firms are organized and taxed as pass-through entities (S-Corps, LLCs, partnerships) – structures that facilitate buyers’ preference for assets sales so they can markup assets for depreciation and do not have to assume past unknown liabilities (environmental, discrimination, etc.). C-Corps, on the other hand, require transactions based on the sale of stocks to avoid significant tax liabilities, a purchasing mechanism often preferred by sellers.

Environmental Aspects: Endgame Expectations

Time is money in M&A transactions. Understanding player motivations – the endgame that both buyers and sellers are trying to achieve – improves the likelihood that deals can be closed. When buyers or sellers take hardline stances based on unrealistic expectations of a business’ worth, interested partners frequently walk away or seek comparable opportunities where they have greater leverage. Remember that businesses are evaluated through a variety of filters. While finances matter, so do operational and environmental factors. Unless a company is dominant in its market, offers unique twists, or is simply large and profitable, the reality remains that what ultimately counts is what a buyer is willing to pay.

Putting it all together …

M&A processes for both buyers and sellers can be a minefield to navigate without the right advisory firm. Investment bankers are positioned to guide you through process inefficiencies. They help you manage the deal process, identify and reach out to potential targets, leverage your tangible and intangible assets, negotiate key terms and conditions, and find the right partner at the optimal price.

With more than two decades of collective experience, White Falcon continues to offer experienced advisory services to its middle-market clients. Specializing in M&A deals ranging from $5 million to $300 million, White Falcon’ analysis, research, and negotiation skills help our clients realistically accelerate their financial growth through strategic merger- or acquisition-driven partnerships. White Falcon bankers have experience starting and selling their own firms. They hold advanced degrees, teach in university business programs, and have their pulse on research trends in their fields. Backed by a savvy research team with access to a fine-tuned spectrum of in-house and commercially available database and social media tools, their contact lists reflect deep networks in the industry sectors they represent.

… In a word, White Falcon understands that successful M&A transactions depend on reaching “beyond the obvious.”

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