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Mergers and acquisitions are an appealing strategy for channel partners looking to expand their businesses. Although there are many reasons for buying, the M&A process is not without complexity and requires time and resources during the initial negotiation and planning phases.
Below, Tom Donahue, managing director at Atlanta-based investment bank Bowstring Advisors, and Eran Gil, CEO of cloud consultancy and Israel-based provider AllCloud, give some tips for engaging an acquisition target and putting the M&A process into motion. They also offer advice on how to avoid common pitfalls and red flags that can crop up at the eleventh hour.
What are the first steps of engaging acquisition targets and putting the M&A process into motion?
Tom Donahue: It is estimated that there are 40,000 MSPs [managed services providers] in the U.S., and the vast majority [make less than] $5 million in revenues. Consolidation is happening. Valuations depend on scale, growth, margin profile and churn [rate].
If I'm a buyer engaging with a target, I first determine if the target is interested in selling. If yes, I try to learn more details and put a preliminary valuation on the table.
Eran Gil: The first real step is understanding why you're actually going after an acquisition target of any sort. For cloud, for instance, we had a strategy in 2017 for 2018 to enter the North American region, and that was the foundation for us going out to market on our own, without … any assistance from an investment banker or bank to acquire an organization. We operate predominantly in two ecosystems: One is AWS and one is Salesforce.
To get into the North American region, we focused on either consultancies or implementations. We approached both vendors' channel organizations, and we solicited assistance to identify potential prospects for acquisitions. It's not the only way to do it, but for us it was because, as we partner with either [AWS or Salesforce], a critical factor remains the relationships with the vendors and, as such, their recommendation goes a long way. If they say, 'They bring a slew of skilled people and geographic reach, etc., and are well-liked by us,' that's a leading indicator of a good prospect.
We spoke to a half-dozen to a dozen partners [of both vendors], and we ended up acquiring one in the San Francisco ecosystem -- namely, Figur8 at the time, and now they're called AllCloud North America.
M&As can be lengthy negotiations, and a lot can go wrong. What are some of the common pitfalls?
Donahue: They can take a long time. The most common challenge is that sellers [and] entrepreneurs focus too much time and energy on the [M&A] process and not enough on running their businesses. Buyers and sellers also spend several months exchanging information and meeting with one another before reaching alignment on valuation.
Gil: It is a lengthy process, which, on its own, is one of the pitfalls. Specifically, no matter whether it is a large or small organization, it creates some sort of distraction, and you're taking away from [the acquisition target's] focus on their business … and also their customers and internally. … Figur8 had approximately 40 employees and two founders working on the [M&A process] with us and, obviously, it took them away from the business a little bit. Business continuity is something you need to focus on.
We learn a lot before we put a letter of intent before a prospect. … The things that could derail [the M&A process] would be learning that the business was depicted slightly differently than it [is in reality]. Our people are our most valuable resource, so learning the team you actually expected to acquire isn't in fact [the team] you're acquiring will derail the opportunity.
Also, when in the courtship phase prior to the due diligence process, where a lot of details are found out, you're all very cordial. When it comes down to … getting deeper into the actual business and understanding it and the details around it, this could cause some strain. And it will on the people who are selling more so than the people who are buying, and you want to make sure they continue to be excited and driven.
Stress can bring behavior you didn't expect that could cause one of the sides to derail the [M&A] process. The buyer could say, 'OK, well, this is a stressful time and we're learning things we may not have been excited about, so … this isn't the right business to acquire.'
How can channel partners tell if they are ready to acquire?
Donahue: Buyers who have processes and systems in place, some organic growth, and strong retention and customer satisfaction are in a good position. Access to capital and financial strength are also important.
Gil: For us, it was pretty straightforward. As a company coming from Europe looking to enter the North American region … it required [looking] for an acquisition rather than making an organic entrance. For others, it has to align with [their] strategy. Whether that business is looking to acquire a company to extend into another geography or ecosystem or buy it for simply creating a critical mass [of employees and customers], employees are what we service customers with, so you want certified consultants and then a critical mass of customers. Those are the main reasons a company would look to acquire.
Eran GilCEO, AllCloud
For a partner looking to be acquired, that varies. There are many businesses that realize in order to achieve scale they either have to be acquired and be part of a broader platform, or they need to attract investors to raise capital. In a larger-scale business, when you reach a certain size but want to broaden your reach and grow … you probably want to find some strategic buyer that would enable that.
What are some of the red flags partners should look for in the acquisition target?
Donahue: High churn rates, meaning, is the seller also the best or only sales person at the target and does the seller own the client relationship? If yes, then the buyer may want to use an earnout or retention mechanism to keep the seller around for a bit.
Gil: A red flag could be … if a business doesn't have a strong foothold in its ecosystem as a channel partner.
Another would have been if we found out the relationships in their customer base isn't strong, because obviously we're just as good as our customer relationships. In an acquisition, typically toward the end, you would want to talk to a few reference customers.
You definitely also want to speak to the team by the end of the M&A process so you know you will retain them after the acquisition. A red flag would be if you identify concerns from employees about being acquired, such as some who don't want to be part of a larger company.
What problems can emerge at the eleventh hour? And how can partners nip these problems in the bud?
Donahue: Revenue performance can be a problem [i.e. not hitting forecasts]. Expectations about roles, responsibilities, titles and salaries for the acquisition target. Understanding the cash at close versus some later date. And concepts like working capital. The best way [to identify these] is to hire a lawyer or banker who has experience in these transactions.
Gil: First and foremost, a company could be in a financial state you weren't aware of that through due diligence wasn't identified, and you may be buying a business that is in dire circumstances. Proactively, you'd approach that early on.
One other one would be other constituents -- meaning customers and employees -- so there will be key employees you want to make sure you're keeping. Many times, you leave the discussion of the key employees until the end because you don't want to rock the boat if you don't know that the deal will definitely be closing.
The way you approach these employees is critical. Proactively, you would prepare a compensation plan … to ensure they want to be part of the [acquired] business. So proactively reach out to the key employees with the leaders you've been negotiating with a little earlier than the eleventh hour to make sure that, one, they are feeling part of the process, and, two, they understand their importance to the acquired business.