8 Home Truths About M&A for SMEs – you’re not too small

Many tech companies think they’re too small for ‘Mergers & Acquisitions’ (‘M&A’). They ‘put it in the too-hard basket,’ ignore it, or just wait for the proverbial ‘knock on the door’ from potential partners. This overlooks a powerful strategy for growth and reduces your business’ value if that knock does finally come.

‘Inorganic growth’ from a single transaction can create as much value in 6 months as years of hard work growing organically. Once you get past the start-up stage (nobody buys start-ups – they invest in them and recover from them) you don’t have to be huge or ‘cashed-up’ for a good transaction to take your business to the next level.

M&A is certainly high-risk, but running a small business is already risky, isn’t it? Keep an open mind, get some expert help (shameless self-promotion, but still good advice) and you might be surprised at what you can achieve.

A few guiding principles to start you thinking:

1.      There are no ‘mergers’ (the rule of control)

Equitable mergers of equals are vanishingly rare and seldom successful. Someone always ‘buys’ someone else, though the ‘buyer’ may not actually spend any money (more on that later). Ultimately, someone must be in control to guide integration after the deal is done.

The one in control after a transaction is not always the biggest, richest or largest player. It’s usually the one who’s driving the transaction – that’s why you need a strategy of your own, rather than waiting to respond to someone else’s.

2.      Small companies do not get bought by industry giants (the rule of 10)

In the tech industry, small owners dream of buy-out offers from huge multinationals: Microsoft, Google, Apple, Cisco, or IBM. That almost never happens and when it does, it’s usually a disaster – especially for the smaller company. Acquisitions beyond a 10x scale difference seldom work.

Unless you’ve got something amazing – cold fusion amazing – your company isn’t going to make the slightest bit of difference to the annual results of a huge multinational. They pay M&A guys lots of money to find targets that will – businesses with scale or the that might just have invented cold fusion (no, you have not, and usually, neither have they). Those M&A guys won’t get promoted to making lots and lots of money by spending time on little guys – even good ones.

A company 10 times your size will swamp whatever made your firm special with their ‘corporate culture’ – for better or worse. Even when they want to ‘keep your entrepreneurial spirit,’ they just can’t help themselves. Within 6 months, the requests will inevitably come: ‘we want you to stay nimble, but we just need you to use hour HR/ERP/CRM/compliance/whatever system to fit in with the group’ – and then you’re on the slippery slope.

3.      SMEs get more valuation ‘bang for the buck’ (the multiple boost)

Combining SMEs can create significant additional value just because of the way they’re valued. This is part of what drives ‘industry consolidation’ in the tech industry.

Ignoring start-ups (whose valuations are based on the quality of sunshine) and larger listed businesses (see ‘greater fool theory’ on Wikipedia or Investopedia) valuation for ordinary tech SMEs often boils down to ‘EBIT multiples’ or something similar (read, read, read, read, and yes, this is actually lots more complicated, with charts and graphs and everything, for $600/hr).

A nice little business with $1-3M revenue might be ‘worth’ 3X EBIT, while a firm with $4-9M revenue might get 5X EBIT, and once they get over $10M they might get 7-10X EBIT. That makes sense because that $1M business could go belly-up from a big raid on the stationery cupboard, but the $10M firm might even survive a decent sexual harassment claim.

What happens when you combine two of these firms together? Obviously, there’s lots of work, risk and costs involved, but to grossly oversimplify, two $2M revenue firms with 15% EBIT at 3X might be worth $1.8M, but combined they’re potentially worth 5X, or $3M – a 67% uplift.

Two similar $6M business might be worth about $9M separately but $12.6M combined – only a 40% uplift – and two $10M businesses might not get any uplift at all from this simple ‘scale effect.’ PowerPoints about ‘synergy’ and ‘strategy frameworks’ might get that deal over the line, but smaller businesses have much more to gain from good deals – if they pull them off successfully.

4.      SMEs can jump, not climb to the next level (creating a crisis)

SMEs are notorious for ‘hockey stick’ forecasts with flat revenues until ‘lift-off’ when it climbs like a frightened fighter jet. That’s one thing for a start-up, but a business that’s bounced around in a stable revenue range for years is another story – stability is a mixed blessing, if you want to grow.

It’s hard for a new marketing campaign, product version or salesperson to trigger a whole new growth trajectory. Change in an SME seldom has a sweeping effect on outcomes unless it impacts the whole business dramatically – including the proprietor.

Equity transactions create just the kind of sweeping change that makes the difference, and the challenge to your sole authority is exactly what can make it work.

5.      The biggest obstacle is you (the proprietor principle)

If you’re not willing to make a big change, you’re not likely to see a big result. That kind of change is notoriously hard for independent-minded SME operators – and if you weren’t a go-it-alone kind of person, you wouldn’t be running a small business in the first place.

The smaller your business is, the more it depends directly on you. The principal is usually the driving force behind a small business, and if the business is stable or stagnant, that’s likely to be because of you, too. It can take a lot of soul searching to realise this when you’re in the middle of the battle. Step back from the business and get some outside perspective to understand your role.

The right person to start a business and get to $1M revenue is often not the same kind of person to take it to $5M, and getting from $5M to $10M can require a different mind-set and skill-set as well. M&A is one way of bringing in ‘new blood,’ though of course there are others, once you decide that you want to reach the next level and that a change is necessary.

6.      You don’t need lots of cash (equity swaps)

Often, not having a ‘war chest’ of cash stops most SME owners from looking at M&A, but lots of cash is not necessarily a problem. Combining businesses adds value to the equity in both, creating a currency you can use to benefit both parties.

Swapping shares in your company for the shares in a target company can make a deal happen with little or no cash changing hands. The increased valuation of the combined entity can mean that both parties own a greater equity value than they did before the transaction.

It’s critical, however, that there be clarity around everyone’s roles after the transaction. Someone needs to be in charge to take the business forward. This is generally more important than the details of the transaction, and both are things a good advisor should help with.

7.      Who dares, wins (be the driver)

There are lots of keys to making an M&A strategy work, but the biggest is being in control, and whoever initiates a transaction is most often the biggest winner. You get that control by having a clear M&A strategy and acting on it at the right time.

This may mean assembling a ‘hit list’ of potential counterparties, targets, or potential buyers and feeling them out early for suitability and willingness. You’ll be surprised by what you hear, and may find some unexpected opportunities.

  • Active Strategy: have an acquisition/merger plan, identify counterparties that might work for you, and engage to find out what’s possible – then evaluate your options and act.
  • Passive Strategy: position to be a strong target by understanding what partnes want. Build an understanding of valuations and deal structures in your sector. Ask potential counterparties what they’re after and be prepared to act when the opportunity arises.

Being on the front foot will reveal all your options at the same time and allow an informed choice. Passive targets usually see only a single offer, with limited ability and time to identify other options. Asking an advisor ‘can I get a better deal than this?’ without reasonable time for research will leave you asking, ‘is a bird in hand worth two in the bush?

8.      Get help – expert 3rd party advisors are worthwhile

More shameless self-promotion, but we’re worth it. You’re better at your business than we’ll ever be, and we’re better at ours. The earlier you establish a relationship with an expert, the more time you’ll have to prepare, whether you’re driving the transaction or not.

Good advisors who specialise in your area (like we specialise in technology) will help set your business up to maximise the outcome of a transaction, and there’s more to it than just valuation. You should consider your saleability, deal structure, personal aspirations, the ongoing role you might or might not want, focus, organisation structure, staffing, financial structure and other factors, too.

Your advisor will also maintain an understanding of the market and let you know when it’s a good time to act, whether you want to buy or sell. Timing can make a very significant difference to valuations, just like the stock market.

This process can last 3-5 years but will be time well spent. A good advisor can bring forward an exit by years, if that’s what you want, and easily double your personal yield from a deal, or more.

When you do choose to act, 3rd party advisors can talk to others in the market without revealing whom they’re working, building market intelligence without letting it be known that you’re looking for a deal. Many SMEs worry that customers, suppliers and partners will react badly to such news, though often they’re happy to see you become a larger, more stable and capable partner. The real risk is usually among your staff, where a prospective transaction can cause uncertainty; also something a good advisor can help you with.

9.      If you’re in tech in Australia, talk to us now

We’ve been doing this for years and can provide informal advice to set you on the road to success. We take advisory or coaching in the months or years ahead of a potential transaction as well as being able to run the deal process from start to finish (there’s lots of information on our website about how that works). We’re flexible to provide the expert input you need, in a form that you can use.

Contact me in Sydney:

Dr Paul D Hauck, Principal, ICT Strategic Consulting
+61 0414 35 35 03 (mobile)
PaulDHauck on LinkedIn, Twitter or Facebook

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