Does Your Company Have an Inorganic Growth Strategy?

Recently, I’ve been connecting with my inner child by playing Super Mario Bros. on the Nintendo Switch with my daughter. The music, graphics, and my muscle memory recalling where the hidden mushrooms and passageways are after 30 years of hiatus, all congeal to form a distilled dose of nostalgia. 

As any respectable 80s gamer can tell you, one of those secrets is the famed “Warp Zone,” a hidden passageway that enables the player to skip levels. 

Purists will elect to conquer the game in its entirety, but the Warp Zone presents a fun hack if you want to access certain levels that are more challenging or interesting. 

Organic vs Inorganic Growth

Inorganic growth (aka Mergers and Acquisitions) is the business version of the Warp Zone. 

The difference between organic growth and inorganic growth is that the former requires you to play all the levels, whereas inorganic allows you to “level up” with another company. With just a stroke of the pen, you can increase the value of your company severalfold. 

However, if you jump to a level that your company isn’t ready for, you can experience serious growing pains. And, unlike Nintendo, when you die, you can’t just blow on the game cartridge and start over. 

In this article, we will explore the benefits and tradeoffs of inorganic growth. In short, we’ll cover:

1. What it is
2. Why you might want it for your business and
3. How to grow a business via acquisition
   

Types of Growth: Types of M&A

Inorganic growth is when a company acquires the assets or stock of another going concern. 

Rather than the relatively slow process of growing by selling more products every year, a company can acquire another company and immediately add revenue through the incorporation of the target company. 

This type of growth can happen via merger (combining the assets or stock of two or more companies) or via acquisition (when one company buys another). An acquisition can have several flavors. Here are a few:

Example: Kroger (Ralph’s) acquires Safeway (Vons). 

Example: Kroger acquires United Natural Foods (a food distributor)

Example: Kroger acquires Philz Coffee 

Sometimes a business sells a portion of the business, known as a “spin-off” or divestiture. A business can also buy a company for the company’s intellectual property or human resources. 

In short, the motivation for acquisition and strategic growth planning can vary, but they all share the quality of helping a business jump several levels at once. 

Should you seek to acquire another business? 

If you own a small business, you might think that a business acquisition is out of reach financially. However, the Small Business Administration has loan programs that can lend up to $5MM towards the acquisition of a business. This provides business owners with tremendous leverage to grow their company by acquiring the assets of another firm. 

Another reason to consider inorganic growth has to do with something called an Enterprise Value Multiple. This is a simple calculation where you divide the Enterprise Value (EV) by the company's EBITDA (profit). Most companies are valued based on the amount of money they can produce in profit multiplied by some number (the multiple). The more growth and demand in the industry of the business, the higher the multiple. But multiples are also higher for larger firms. For example, a consulting business producing $100k in EBITDA could have a market multiple of 4. This means multiplying 4 by the profit of the company ($100k) yields an EV of $400k. However, a company with $1MM in EBITDA might warrant a multiple of 6. So the second company is worth $6MM. 

Here they are side-by-side:

In this example, the medium-sized company is 15 times more valuable than the small company. However, the profit of the medium company is only 10 times larger than the small one. The discrepancy is because larger companies have more demand (buyers), making them more valuable. 

So if you are able to leapfrog into higher profitability via acquisition, you can also add value to your company that is incommensurate with your growth in profit. 1+1=2.5. 

Of course, there are several reasons NOT to pursue inorganic growth. 

One reason is culture. Will the new company operate like the one you now run? Will key people leave when they hear that you are buying their firm? 

Another challenge is what is called “cannibalization.” This strange word simply refers to the phenomenon when existing customers stop purchasing your product in favor of another one of your products. So, for example, if company X sells sandals and acquires company Y, which sells tennis shoes, the company could lose some sandals customers who decide to simply switch to tennis shoes. The combined sales of the new company might be less than the sum of the parts. 

In short, an M&A strategy should be thoughtful, and, ideally, executed with the help of an M&A advisor. 

How to Get Started

M&A largely goes through four stages:

The first stage is essentially a marketing exercise. Just like you would seek out new customers, you can begin the process of seeking out acquisition targets. You can create a robust outreach program using an agency like Kasvaa or simply reach out to people directly on LinkedIn. If this were dating, it would be the equivalent of setting up an account on an app and “swiping” at companies that interest you. 

Next is the “getting to know you” stage. Again, in online dating, this would be when you actually meet for an in-person date. Here, you might meet the potential seller and understand the company culture they have built (to mitigate the risk described above), and understand their goals and desires during the transition and exit. 

At some point, you make an offer and begin to deeply analyze the business. In a home-buying analogy, you are now getting the required inspections from contractors to test the roof, foundation, plumbing, etc. This is the most time-consuming part of the process and can lead to hundreds of hours of work for you or your M&A advisor. Obviously, this stage should not be entered into until you believe the target would be a good fit. 

Finally, if the acquisition goes through, you have the work of combining the two companies and getting the new teams to play along together in the sandbox. 

The first step is relatively easy to activate. You can simply put out the feelers and explore conversations. Should you be fortunate to find the right partner, you can easily begin to double the size of your company with compounding enterprise value to follow. 

Are you considering inorganic growth? 

Let’s talk today about how you can get started.

Best,

Stephen