BWSmallBiz -- Cover Story April 3, 2009, 5:00PM EST

How to Make Acquisitions in a Down Economy

(page 3 of 3)

R. Kent Farmer, CEO, Spectrum Lubricants John Chiasson

Sue Murray, President, EduCorp Matthew Mahon

Larry Browne, CEO, Diligent Delivery Systems

Look at three to five years of company financials, including working capital, inventory, receivables, capital expenditures, debt, and, crucially, cash flow, including customer diversity, stability, and payment histories. If any one customer comprises 5% or more of revenues, or a large share of profits, get on the phone with them and try to determine how strong the relationship, and the business, truly is. "If you only look at profits," says Petty, "you're going to miss the whole picture." Then there are legal issues. Sift through contracts, pending litigation, leases, trademarks, licensing, permits, and environmental documents. You should also find out if the company has ever filed for bankruptcy. "Any of this information can either be an opportunity or a liability," says Siegel. "You just need to know what they are."

The most important part of your due diligence may lie in assessing the other company's reputation. After all, you're staking your own business' name on this acquisition. "I'd want to know everything about how this company is perceived, because that is what you are buying, above all," says Joseph Birkofer, principal at Houston's Legacy Asset Management. Talk to industry experts who do not have direct relationships with the company, as well as your employees and customers.

Often forgotten is cultural due diligence. Can the management style of the company be adapted to yours? Diligent's Browne works with indepedent contractors and avoids companies whose employees need hand-holding. "Any company we acquire has to be at least 80% similar to ours," he says, "and the other 20% they have to be willing to change." An air delivery and trucking company he acquired in 2007 for $500,000, for example, used independent contractors and had few full-time employees, like his own business.

The role of the founder or CEO of the acquired company should be clear from the get-go. You can offer that person a transitional role, responsibility for overseeing a business unit, or a short-term contract as an interim executive. Avoid dueling chief executive positions in the new company. "Keeping a small business owner on board after an acquisition for the long term is a big mistake," says Timothy Galpin, associate professor of entrepreneurship at University of Dallas Graduate School of Management. "Entrepreneurs often struggle with somebody else taking over their business, and can become an obstacle."

CLOSE THE DEAL

Finally—time to make the offer. Your due diligence should have given you a solid feel for what the company is worth. The most advantageous deal structure is probably for you to purchase assets rather than shares. If you buy assets, you can depreciate them and reap the tax benefits. And you won't be responsible for any past liabilities—for example, if you're buying machinery, you won't be liable for accidents that occurred on it before the sale. If you were to buy shares, you would pick up the company's legal liabilities and add to your own tax obligations. Of course, it's the rare seller who is willing to give you the tax breaks and keep the legal risks. A common compromise is to do a stock purchase, so that the buyer inherits any liability, but to treat the deal as an asset purchase for tax purposes. The nuts and bolts of this are outlined in IRS section 338(h)(10).

Not every penny needs to be paid out immediately. "You can mitigate your risk by holding back payment" until the company has reached certain milestones, says Sandra Knowler, partner at law firm Lang Michener in Vancouver. You may withhold a certain percentage until several major customers are on board with the new company, for example. Talk to key employees, such as top salespeople and managers, and discuss new employment contracts. If you don't intend to keep anyone on board permanently, you might offer stay bonuses, so that the must-have employees will stick around throughout the transition period. This can run from 90 days to as long as a year, and should be based on the employee's monthly salary. The importance of this can't be overstated: Most deals that go south, says Siegel, do so because the acquirers lose key employees or key customers. Your attorneys can then create a purchase agreement and any employment and noncompete contracts that need to be signed. Count on 45 days for this at most.

Every deal, of course, is unique. Browne's Diligent has made each of its acquisitions in cash, and mandates that its acquired executives stick around for up to a year. This is key in a service business, where the deals are primarily about the customers, not hard assets. "It ensures that...the transition happens quickly," Browne says. "We do an up-front down payment, but the payout for the owner usually comes a year later."

The process is arduous. But for Browne, who hopes to buy at least two more businesses this year, it's been worth it. "Businesses are available, and I'm aggressively seeking them," he says. "The time to buy is now."

Return to the BusinessWeek SmallBiz April/May 2009 Table of Contents

Choi is a staff writer for BusinessWeek SmallBiz in New York.

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