Growth: Acquisition vs. Organic
The debate rages on regarding the merits of a business trying to achieve rapid growth via acquisition vs. growing organically (or internally within its existing infrastructure).
The debate rages on due to the fact that both avenues have their merits, pitfalls, drawbacks, and positive attributes….The true answer lies in the specific situation, the specific opportunity, the specific business, and the specific industry. In other words…..it depends.
The Acquisitionists Make Their Case
Let’s start with discussing growth through acquisition and its relative plusses and minuses. When one business acquires a competitor, a supplier, or a major customer, that business acquires a built-in, established sales and customer base. The single greatest advantage to taking this tack is speed. Once the acquisition or merger transaction is closed, there is an instant bump to consolidated sales for the organization. This bump could be 10% or 200% depending upon just how much the acquirer is willing to swallow in one transactional bite.
On top of the ego driven satisfier of being able to steer a bigger ship, there are organizational cost savings that can be achieved by eliminating redundancies. If both organizations have accounting and HR departments, personnel and space can be eliminated to immediately bake in organizational cost savings and increased profits. The acquirer may be able to immediately peddle its products or services to the customer base of the acquisition target, saving substantial dollars in marketing outreach and awareness campaigns. The increased total sales volumes of the combined companies may allow for the company to lower its product or service prices and thus increase market share. Larger companies also have the advantage of greater buying power for raw materials, advertising, and leasing costs which could ultimately lower the overall cost/unit of its products allowing for greater profit margins than its competitors. There are many other advantages to growth through acquisition but let’s now focus on the acquisition pitfalls and challenges.
The number one cost (and risk) to growth through acquisition is overpayment. Specifically, your target is not going to give away its hard earned business or customer base. Typically a multiple of cash flow from the target’s business is negotiated and paid for during the transaction. If the target’s 2019 cash flow was $1,000,000 and the acquirer agrees to pay a multiple of 5 times prior year cash flow, the purchase price for just the business cash flow would be $5,000,000. Real estate, fixed assets, and intangible property are typically tacked on to that price. Therefore, if nothing changed, it would take five years for the acquirer to achieve its return of capital under those acquisition terms. The $5M the acquirer used for the acquisition has to come from somewhere. It would either come from internal funds (which would mop up significant working capital), a lender (which comes with an interest rate and a security agreement), or an investor (which would require a significant portion of the annual $1M in cash flow to achieve its desired rate of return). All three of these funding scenarios have a cost which ultimately reduces the value of the acquisition. If the acquisition target’s customer base weakens or dries up after the acquisition, the acquirer may have just spent an enormous amount of money on a losing asset. Once again, depending upon the size of the target relative to the acquirer, that scenario could very well be fatal. If the acquirer went out and borrowed all $5M to make the acquisition, that company could be choking on debt and find itself running out of cash quickly.
There are numerous other acquisition pitfalls and mine fields including: fraudulent representations by the target (i.e. overstated sales or understated liabilities), major corporate culture clash causing damaged employee morale, loss of customer base, and even sabotage. When a smaller company acquires a larger company the management and ownership of the smaller company may lack necessary sophistication and experience to handle the larger volume and more complicated transactions. This scenario can result in unnecessary inefficiencies, errors, or lost sales.
Organics Strike Back!
An equally compelling argument can made for organic growth. What does “organic growth” mean? Simply put, it’s the process of a business growing its sales via its own internal resources. In other words allocating human and financial resources on advertising, direct sales, web and social media campaigns, trade shows, and other means and methods generated by its own staff and corporate resources. There are several advantages to this method over the acquisition strategy. First of all, an organization has much more control over the rollout and growth strategy when it pursues internal organic growth. The scale and speed of an internal sales growth campaign can be regulated much like a spigot regulating the volume and speed of water. If an advertising or e-commerce campaign is not realizing an adequate level of return via increased sales, that campaign strategy can be scaled down quickly and the corresponding costs can be significantly reduced. With an acquisition once the ink is dry on the purchase documents, there’s no going back. The acquirer is “all in” on the purchase and corresponding costs. The acquirer is basically making a bet on the acquisition target. If it turns out to be a bad bet, the costs for the acquirer can be enormous and cannot be reversed.
Another key advantage to internal/organic growth is larger potential margins on sales growth. With an acquisition, the buyer is paying for the “blue sky” or future profits of the target. That upfront cost is imputed into the future profit margins and sales inherited from the target via the acquisition. While sales volume may have been dramatically increased via the acquisition, the overall margins on those sales are significantly reduced due to the hefty blue sky cost of acquiring those sales. With organic sales growth once the customer is acquired via the internal sales campaign, there is no on-going blue sky premium reducing the profit margin on that particular customer. Continuity of company culture and personnel is another major benefit of going the organic growth route. The existing company’s brand, motto, sales approach, production methods, along with the collective personalities and tendencies of its management team can remain consistent throughout the growth process. This allows for a consistent message and aura to be projected to its current and future customer base. Oftentimes under the acquisition scenario, customers receive conflicting messages after an acquisition. If the acquirer does not properly finesse the transition and corporate message to the new customer base, customers can get confused, frustrated, and may choose to go elsewhere.
Organic Growth Drawbacks
Speed to growth is the most significant risk with growing sales internally. While there is always substantial risk acquiring a competitor, there is also risk with internally generated marketing strategies. In other words, those strategies may not be as successful as anticipated or they may be a total flop. In that instance, it’s back to the drawing board for management to regroup and come up with a more effective marketing strategy. In the meantime precious time, resources, and energy has been wasted with little to no substantial increase in sales or margins.
Lack of in-house strategic marketing expertise is another major impediment to internal growth. This can be overcome, somewhat, by hiring outside marketing and market research firms. However, it may take months for these firms to fully understand the company’s business model and there’s no guarantee that their sometimes pricey third party solutions will work. The biggest chance of success when using third party marketing firms is to go with an organization that specializes in the company’s specific industry. These firms typically bring proven strategies, techniques, and technologies to the engagement.
Organics vs. Acquisitionists…Who Won?
The answer is both and neither. As you can see, both strategies have their risks, rewards and limitations. In a perfect world, a company would use both strategies to grow, flourish, and dominate their markets. Most large successful companies that were once small (Microsoft, Apple…) used both paths. When choosing the acquisition path, one very important rule to implement is perform thorough and adequate due diligence of the target. This can be negotiated into the purchase documents and can ultimately give the acquirer an “out” if information or facts are discovered that don’t mesh with seller representations. When choosing the internal growth plan, I suggest hiring (even on a limited basis) a market research firm with industry specific knowledge to guide your company’s marketing strategy and rollout. A little money spent up front can save a ton of wasted dollars on the back end.