XChange 2014: Profits, Culture More Vital Than Ever As M&A Activity Increases

2014 is shaping up to be the busiest year ever for IT mergers and acquisitions, according to a speaker at XChange 2014 in San Antonio.

Reed Warren, vice president at Revenue Rocket Consulting Group in Bloomington, Minn., said this year is on pace to surpass 2001 as the busiest M&A year in history, thanks to a stable economic forecast for the next three to four years.

"There are massive consolidations going on in the whole IT space," Warren said. "There's a whole lot of money on the sidelines waiting to come in."

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Much of that activity has been spurred by the retirement of baby boomers, said Tom Hogue, CEO of Philadelphia-based Gibraltar IT, who listened to Warren's speech. Some 40 percent of IT business owners are between 55 and 65 years old, Hogue said, and he said an onslaught of willing sellers is likely to drive down acquisition price over the next half decade.

Much of the recent M&A action has involved small firms, Warren said, with the purchase price coming in below $40 million in 80 percent of recent deals, and below $5 million in 40 percent of recent deals. Nearly 90 percent of a company's value comes from its recent profitability, Warren said, with just a small portion based on revenue figures.

Warren said buyers looking to grow should seek firms that are considerably smaller than their own, offer a good cultural fit and are consistently profitable.

They should typically stay away from purchasing firms more than half their size, Warren said, because acquiring a firm more equivalent in size would put a strain on the buyer's balance sheet and often result in competition for leadership.

Companies with a history of double-digit growth will attract the most suitors, Warren said, with consistent growth valued far more than volatility. At least 30 percent of a firm's revenue should be recurring, he said, with more than 50 percent recurring revenue becoming increasingly common in purchased companies.

Companies interesting in selling should encourage specialization in a particular marketplace, segment or geography, Warren said.

"It's pretty tough to acquire a generalist," he said.

Buyers must get a full return on their initial purchase investment within five years, with the deal ideally paying for itself within three years, Warren said.

If a company seems a little too eager to exit the arena, there's probably a catch, Warren warned. There's usually a reason that a firm is being offered at bargain-basement prices or has struggled to turn a profit in recent years, he said.

"The lower the price, the more it's really going to cost you in the long run," Warren said.

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For better or for worse, he said the financial performance of an acquired firm will typically resemble that of the company as a whole within three years.

He also cautioned firms thinking of acquisition as an exit strategy to hold their horses. Buyers expect top executives from the firm being sold to stick around for at least three years -- and often as many as five -- to assist with the transition, Warren said.

At the same time, buyers want to make sure the company being acquired has a deep bench. Warren said firms looking to grow will stay away from companies where it appears the founder is indispensable or doesn't have a succession plan in place.

Finally, Warren instructed firms not to sweat the small stuff in negotiations.

Once the buyer and seller are within 5 percent on a valuation of the firm being acquired, Warren encouraged the buyer to split the difference or give into the seller's price. This gesture is likely to result in the seller entering the joint company happier and more willing to work.

Warren's push for buyers to focus on the cultural and strategic fit as well as financials resonated with Hogue. One of Gibraltar's earlier acquisitions was based solely on financial considerations, and within 14 months of the deal, nine of the acquired company's 11 workers had left the joint company.

"It's going to fail if the culture doesn't fit," Hogue said.

Jonathan Goetsch joined Newport Beach, Calif.-based US ProTech through an acquisition, after he had sold off two companies of his own. Goetsch said he found buyers were most interested when he showed his firms could consistently deliver profits of at least 10 percent.

"As a buyer, that [the profit] is what I'm able to use to maximize growth and benefit," Goetsch said.