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Financing an Acquisition

No matter what your reason for buying another business, these smart tips can help make the deal a success.
July 31, 2006
URL: http://www.entrepreneur.com/article/159512

Why do some entrepreneurs seem to get so hung up on making their original idea work that they rarely consider growth by acquisition? I remember a pharmaceutical company back in the 80's that had raised more than $75 million in venture capital funding and was down to its last $10 million. Everything was banked on the FDA approving the single drug entity they'd been working on for years--if the FDA didn't approve it, all would be lost. Recently, the company had experienced one setback after another and, in desperation, had just hired their third CEO to try and turn things around. Within just a few months of being hired, this new CEO presented a radical and explosive idea to the board: Use the companies last $10 milliion, not to secure FDA approval but to buy another company.

Clearly, such an outrageous suggestion would put the company at substantial risk if the CEO was wrong. He was, in essence, saying that the $65 million already invested was lost and the only way to save the company was to take it in another direction. That, in itself, was a gutsy move. What was even more gutsy and imaginative was to even consider buying another company as a solution to saving the existing company and/or growing it. Acquisition strategies just don't seem to be a favorite alternative to building a growing business. Too often, companies get fixated on the idea that "If we didn't think of it, it can't be any good, so all products must be developed internally and grown from within. Besides, buying a company is just too complicated, time consuming and, from what we've heard, few work out."

Well, let me tell you what happened with our risk-taking pharmaceutical company CEO. The FDA ultimately rejected the company's drug. If the last $10 million had been spent on it, the company would have failed and all investor money would have been lost. Instead, they ended up buying another company with the money, and from that acquisition, they built the company into a multimillion dollar company that became extremely profitable, went public, and was later sold to a larger pharmaceutical company. Needless to say, their investors were extremely pleased.

So what's the secret to acquiring another business? How can you avoid the failures that can follow an acquisition? Here are a few tips I've learned that are critical to making this process work:

1. Hire a professional. There are some things in life that should never be done without the help of a professional, and buying another business is one of them. A good investment banker or mergers & acquisitions professional is worth every penny you'll spend. They'll help you research the industry, find appropriate candidates, qualify the best options and structure the final deal. A good one will guide you through all the nuances of the tips given in this article that only they will truly understand.

2. Line up the money. One of the worst things you can do when looking to buy a business is to find one you really like and then, during the beginning of the mating dance, have to admit that you don't yet have the money to make this deal work. Nothing will kill a deal faster. So where do you get the money? There are three great sources for financing the acquisition of a qualified business:

3. Focus on keeping the players involved. I cannot emphasize this step enough! Are you buying a product that can be easily and simply integrated into your existing distribution channel? Or are you buying relationships that are delicately balanced on the shoulders of two to three key players in the company, hopefully, one of whom is the owner? If it's the former, your deal could be simply and straightforward. But if it's the later, beware! When it's the performance of people that will define the future success or failure of a deal, the deal must focus on how to best keep these key players motivated and contributing. Here are a few rules to consider:

4. Always structure an earn-out. This isn't like buying a car, where you pay the full price and then drive it off the lot. No matter how you structure a deal, it should follow a logical path to the final structuring. The first step is to agree on a valuation. This, in essence, is the fair market price all parties feel the company would be worth if it sold today. Each side will probably have their own set of experts crunching numbers to justify their position. The first step is to find some common ground and agree on a compromise.

The next thing you have to do is agree on an earn-out. This is often the hardest part because, to do this effectively, both sides must agree on several points. The first is the amount of the down payment, or how much cash will be paid on the date of sale.

The second is the parameters that will define how much of the remaining payment will be made and when. The reason deals are done this way is because the factors that determine the valuation may change if the company fails to perform to par after it's acquired. Let's say you buy a company that says it's doing $5 million per year in sales with a $2 million profit line, but in the first year after you acquire it, the company only does $3 million and has a loss? That's why earn-outs are important. They protect the buyer and, if structured properly, give the seller a chance to get a higher price if they can meet or exceed certain goals.

Finally, you need to establish a timeframe that will define the earn-out period. Generally, earn-outs that are structured for any longer than three years don't work because, as I've pointed out, key players won't stay that long.

5. Clearly define your targets. When you're looking to acquire a company, don't do it just because it sounds like a good idea. Instead, decide on what objectives an acquisition will help your company achieve. Are you looking to acquire a company to expand your product or service offering? To fill in management gaps, such as to find a strong selling team? Or do you want to expand your geographic reach? Or maybe your goal is to get closer to a specific strategic partner by buying a business that already has an established relationship with a partner you want to do business with? Knowing what the acquired company is supposed to accomplish will help you set measurable objectives that management can use to define its worth.

As you can see, acquiring a business is a complex exercise. However, when done properly, few things can accelerate the growth of a company more.

Jim Casparie is the "Raising Money" coach at Entrepreneur.com and the founder and CEO of The Venture Alliance,a national firm based in Irvine, California, that's dedicated to getting companies funded.