Introduction

This month's Hot Topics departs from the usual discussion involving current tax law issues. Instead, it is based on my 20 years experience representing small companies involved in acquisitions and sales. Many small companies miss the opportunity to grow their businesses by acquiring other companies in their field. This technique is relatively easy and inexpensive, compared to traditional approach of incremental growth through marketing methods.

Expanding your business through acquisitions requires four steps: (1) identifying opportunities; (2) evaluating the target company; (3) negotiating the purchase price; and (4) maximizing the tax benefits.

I.  Identify Opportunities

Develop a list of businesses to acquire. Sources for potential acquisitions include conventions, association boards, and the Yellow Pages. The main reason for selling is usually that the owner is tired of running the company.

Remember: A business owner who has nurtured and grown his business considers the company part of the family. At all times, treat the company with the respect you would show the owner’s child. It is not a "numbers" transaction as much as an emotional one for the seller. Convince the seller that his company will be in good hands and that it will continue to prosper and grow, and the seller will work with you on the price and terms of sale.

II.  Evaluating the Target Company

After identifying likely targets, you need to evaluate them. What does the target offer your’s? Identify specific assets such as inventory, equipment, work force, location, administrative, sales, or marketing synergy and intangibles.

There are six steps in the evaluation process:

1. Look for the intangible assets (goodwill): To paraphrase the Clinton campaign slogan: "It’s the intangibles - stupid!." Go behind the balance sheet and find the intangibles that make the company special. A small company’s value invariably resides in this intangibles -- those assets which do not exist in physical form such as: customers lists, yellow page advertisements and telephone numbers, location, name recognition, longevity in the marketplace, commission salesmen, estimators. In contrast, tangible assets are physical assets (one you can see or touch) such as land and buildings, inventory, raw materials and equipment. Tangible assets are usually commonplace and do not represent the value of a business, although they may be prominent on the balance sheet.

Remember, with customer and vendor information in a computer database the issue becomes whether that database is compatible with your current database. Examples of intangibles, include:

(1) A heating company's stickers on all those heaters and air conditioners they have installed or serviced amounts to tremendous goodwill, but you’ll never spot it on the balance sheet.

Remember: New business opportunities are primarily generated from existing customers. An old-line heating company may have stickers on their heaters and air conditioning units throughout your business territory for many years.

(2) An eye doctor looking to expand may evaluate a target which as compatible HMO’s and pricing structure, or a convenient location.

(3) A real estate agent, however, might focus on location and reputation of a real estate broker in a stable, mature neighborhood.

Key Point: Money is no longer the sole medium of exchange. Today, time is as valuable as money. People look to save time by using someone they know or have worked with in the past. Customers seek quick and convenient information such as stickers on appliances, a familiar Yellow Page ad, a card in a Rolodex or database, a newsletter or labeled file. Any association or connection to cut down the time it takes to hire you is a plus to a busy customer. Under the time verses money concept, people do not want to waste time hassling over which company to hire. If they know you and you have performed well, they will hire you out of convenience. The price you charge is secondary to the service (read "convenience") you provide.

2. Remember the 80/20 rule: Invariably, 80% of business comes from 20% of the customers. Learn to identify those customers and ask what type of services do they require? How long have they been with the company? What is their payment history? Will the customers stay if you buy the company? The goal is to buy only the 20% of the customer-base that produces the 80% of the business.

Note: The same holds true with the sales force. Make sure the key people will remain with you.

Example of the 80/20 rule in reverse: A successful auctioneer once explained to me that he will not auction a case of wine containing only the top wines every one wants. He will only include 3-4 top wines and place other hard-to-sell wines in the case as well. Given a choice, the bidders will only buy the top 20% of the merchandise. However, it is the auctioneer's job to sell as much wine as he can.

This example illustrates the power of the 20% rule – use it to your advantage.

3. Does the target complement your business? Is the pricing structure similar?

Example: An accountant or attorney who charges $250 an hour should consider acquiring a practice where the seller's hourly rates are $275 or higher, but should not buy a business where the hourly rates are $150 or lower.

The message: In a service business based on hourly rates, always trade up or even, never trade down. Be wary, however, if the rates are too much higher than yours. This is an indication that the seller is in a different market or has a specialized knowledge that might not be transferable to your business.

Other valuable complementary characteristics include: diversification into compatible markets (residential vs. business); location (different counties); business cycle diversification (flattening the boom and bust business cycles); and risk diversification (hourly rates vs. contingency fee business).

Example: An attorney with a practice that uses flat rates might consider acquiring a law practice with contingent fees to broaden the risk/reward aspect of his practice. For a contingency fee attorney, the opposite (acquiring an hourly rate practice) will bring income stability.

4. Timing: Go "bottom-fishing."

Buy at the bottom of the market, when you think you can least afford it. Your competitors will be on the brink of insolvency and most likely will be anxious to make a deal to save their company.

Example: Desperate for additional sales needed to keep his company afloat (yellow pages, fliers, and newspaper ads didn’t work), a company bought a competitor, paying 10% of gross sales for 2 years. The result, the company increased his gross sales by 25%. Next, it bought a company roughly its size and immediately doubled its gross sales. The combination of these two purchases tripled the company’s gross sales in 18 months --something that never could have occurred by traditional marketing and promotion methods.

Remember: In a down market, for every buyer there are 5-10 sellers. Choose the best of the lot and drive a hard (but fair) bargain.

5. After examining the target, examine your business:

Determine whether you have excess capacity, plant, equipment, inventory, labor, or whether you need to increase sales. Be sure to estimate cost the of acquiring a new client through your traditional marketing and advertising efforts verses acquiring clients through a merger or acquisition. Usually, acquisitions should be 50% cheaper.

Ascertain how the target will fit into your existing structure. Will you need additional labor and equipment (computers, trucks, production machinery), or to expand your plant or warehouse facililties? Will the increase volume give you leverage with your vendors for better deals (pricing or credit terms)? Will there be savings in administrative and accountings costs?

6. Inspect the target’s financials (Crunch the numbers)

Look at cash receipts on a monthly basis and the company’s rate structure. Does the target have a seasoned list of customers? Review the financial statements. Examine the cash receipts and balance sheets on a monthly basis for at least the past 12 months, looking for 4 to 6 months of stable cash receipts. Determine cash receipts from tax returns (usually Schedule "C" for a sole proprietor) and review bank statements (deposits and cancelled checks) for substantiation. Obtain a credit report and generally do "due diligence" on the company.

Note: If the company’s balance sheets and tax returns are not accurate, walk away from the deal. You absolutely need financial information you can trust. Once you have come to terms with the seller (a signed letter of intent is usually a good idea) involve your attorney and CPA in the transaction. Also, use a business escrow to insure that all proper procedures have been used and that tax clearances have been obtained.

Key Point: You decide to acquire a company based on its off-balance sheet items (the intangibles), but you structure your purchase based on the balance sheet (either the income statement or the asset and debt statement).

III.  How to Pay for the Business:

Suppose in your industry it is customary to calculate the purchase price on 6 months of cash receipts. If the receipts average $20,000 per month and you discount the total by 25%, you'll pay $90,000. Further discount the purchase price if the cash receipts are volatile or if the customer list is not seasoned within your industry standards.

Once you have decided on the purchase price, analyze your after tax return on the additional monthly cash receipts. If you assume that $20,000 of additional cash receipts will provide you with an after-tax profit of $3,000, then structure your purchase as follows: $3,000 per month for 30 months ($90,000 in total), then add in the interest payments. With interest added, the purchase might be $3,000 a month for 3 years.

Alternative to cash purchase: After you have determined the price, you might decide to structure the acquisition by setting a percentage of gross income as the actual payment.

For example, if you determined that the price would be $3,000 a month for 3 years and that 15% of the gross receipts generated from the target would be the equivalent of $3,000 a month, then offer 15% of the gross receipts generated from the customer list for 3 years.

Under this method, you have less risk if customers leave, although you'll wind up paying more if the customers generate more in revenues.

IV. Tax Angles

Allocation of the purchase price over the various items purchased is critical from your tax standpoint.  See the May, 1999 Hot Topics for a through discussion of this topic.

Conclusion

Growing your business through acquisition presents an excellent opportunity neglected by most small companies. Know your cost per new customer. Look to achieve 50% savings through acquisition of existing customers. Learn the potential sources for businesses. Create a template regarding your costs and potential profit; study a company’s balance sheet and tax returns (looking for stable monthly receipts and seasoned customers). Go behind the balance sheet and discover the tangible assets that represent the company’s true value. Structure the deal using the new business generated to pay the purchase price. Be sensitive to the tax allocations and maximize your tax results. Good luck!