From the September 2008 issue of Entrepreneur
With all the talk going on about a recession, you might think that now would be a lousy time to buy another company. But when organic growth stagnates, companies typically find that strategic acquisition is a good way to grow. And small deals are up, according to data provider Dealogic, which reports that at the end of May, the number of smaller M&A deals was up 17 percent this year from the same period in 2007 while larger deals had declined. "The middle market is really where all the action is right now," says Andrew Apfelberg, a corporate M&A attorney and partner at Rutter Hobbs & Davidoff. But mergers are tricky even in the best of circumstances, and in a down economy, one bad buy can bring down an otherwise healthy company. That means you need to be extra careful inspecting under the hood to make sure you don't end up inheriting business challenges you can't easily solve.

Start by scrutinizing not just earnings, but the quality of earnings, says Dwight Jacobs, executive vice president of M&A for GW Equity, an M&A advisory firm for middle-market business owners. "Are those earnings being generated from a wide variety of clients or just one customer?" asks Jacobs. "Are they consistent and repeatable? And how historically predictable has the earnings stream been?" Look back three to five years, or longer if the company has lived through a previous recession, since that may give you a sense of how well it will perform in the current climate.
"But don't fall in love with the history of the company," warns Alan Scharfstein, president of boutique investment bank The DAK Group. Since markets can change quickly, use historical financial performance only to support your conclusions about what the business will do in the future.

Be inquisitive as you pore through the financials, advises John Burley, president of M&A firm Burley & Associates. "Ask, 'Why?' over and over. Often the explanation for how something happened is very different from why it happened." For example, negative cash flow isn't necessarily alarming if it's the result of an expansion or a one-time growth-related expenditure. But additional probing may reveal a systemic problem.

Gross revenue is nice, but pay attention to the bottom line. "It's always much more important to focus on net than gross," says Apfelberg. "You can have a $20 million revenue company that's got no net and a $10 million revenue company that has $7 million of net." Some of the most telling information can be found in the auditors' notes to the financials. "They've spent time on the ground," says Apfelberg.
When you do find that perfect buy, be creative about structuring the deal to offload some of your risk. Offer a combination of cash and stock rather than all cash, Apfelberg advises. Or use an earn-out structure, which sets up contingent payments for as much as 25 percent of the purchase price based on the acquired company's future performance. If your research (and your gut) tell you the seller's price is too high, don't cave.

Elie Ashery, the 33-year-old founder and CEO of Gaithersburg, Maryland-based e-mail marketing company Gold Lasso, set out to buy Widgix Software. But the two couldn't agree on a price or a deal. "So I did the next best thing," says Ashery. He bought Widgix's co-registration division and its popular Survey Gizmo software, which was what Gold Lasso stood to benefit from most. He expects to start realizing cash flow from the purchase as soon as this month. "Later down the road, it's going to be a lot more expensive to build than to buy," says Ashery, whose company projects 2008 sales of $1.6 million. "Things are definitely cheaper now, so if you have the cash or the means--and if it's going to add immediate value and get you ahead of the curve--buying is the best thing to do."

C.J. Prince is a writer specializing in business and finance. Reach her atcj@cjprincemedia.com.