07 Aug Building Value: Size Matters
In a prior article in this series we talked about the trade-offs related to the relative size of a company in comparison to its market position. However, if you look at a company’s size and compare it to its valuation, bigger is almost always better.
Organic growth through increased sales, revenue and profitability is always a good thing. Inorganic growth through a merger or acquisition can leapfrog your company into a different valuation tier.
What Acquirers Want
Most mergers and acquisitions are based on the idea that the value of two companies combined is higher than each company would be valued alone. This is true of small company mergers too, not just the large public deals that make the news. However, for smaller businesses, the source of their higher value may be different than for larger companies.
One source of value creation is the opportunity to build a better management team. For example, one of the companies may have a founder/owner who is strong on technology while the other may have a leader who is skilled in marketing and sales. One benefit of merging the companies would be enhancing the sales capabilities and the technical offerings of the combined entity.
Another way that value is created is by increasing the size of the entity. There is plenty of evidence that larger companies are valued at higher multiples, everything else being equal. For example, based on our experience and some market research:
- we see a 26% premium paid for IT managed service providers with revenue of $5M to $10M compared to those with less than $5M revenue
- we see a whopping 89% premium for companies with revenue over $10M vs. companies with less than $5M revenue.
Those numbers inspire some savvy small business owners to consider merging their companies to increase their valuations. This is a form of valuation arbitrage, because the merged companies are valued using the multiples of a larger business.
Value is also created in a small company merger as they move up the economy-of-scale ladder and become more efficient. That is one of the advantages of being larger: the overhead costs of marketing, sales people, R&D, and payroll expenses, can be spread across more revenue. As that happens, the profit margins increase, and valuation of businesses rises.
M&A activity is often based on companies that are looking to improve their financial performance and hoping to achieve synergy by acquiring or merging with another company. Here are a few more rationales for mergers and acquisitions that also apply to small companies:
- Enhanced geographic coverage
- Synergy – can take the form of cost saving, such as eliminating redundancies and improving purchasing discounts through greater volume. Another form of synergy is on the revenue side, which can come from cross-selling in which the merged companies have opportunities to sell their products and services to the customers of the other company.
- Resource sharing
While there are multiple sources of value in mergers of small companies, they are not always easy to achieve.
- Who will be the CEO?
- How will you agree on the respective valuations of the two entities?
- How will you integrate the boards, management teams, products, services, and operations?
Merging companies can be very challenging and business owners should be wary of embarking on a merger without experienced advisors.
Bottom Line for the Entrepreneur
Inorganic growth is a viable growth strategy for many companies, so you should:
- Consider a merger or acquisition if you find your growth trajectory plateauing
- Be very selective in picking a target. Don’t do a deal unless there is a good product/service and culture fit.
- Realize that 1+1 sometimes can be valued at >3
- Leverage experienced legal, financial, and M&A advisors who have done other transactions.
In this series of articles, the Austin Dale Group will distill some of the lessons learned from our many years as M&A and Strategic Growth Advisors to emerging and mid-market technology companies. We will review what acquirers want and how these key factors can have a dramatic impact on the value of a company to shareholders and acquirers.