Home  Accounting Guide

Table of Contents

  1. Introduction
  2. The Basics
  3. Financials
  4. Financial Ratios
  5. Managing Growth
  6. Acquisitions

Growing your company by acquisition

What's in this chapter

You can grow your company by acquiring other companies. This company will help you think about how much you should be willing to pay for the company, how you account for it, and the general process you'll need to follow to make it happen. Acquiring another company is a complicated and involved process, so we'll need to limit the scope of the chapter so that we can keep the reading time reasonable. But we will try to cover some of the most important aspects of the process to get you started.

How much should you pay?

Before you buy a company, the first thing you need to ask yourself is "What am I acquiring?". This question is more complicated than you might think. This will become clear if we compare it to buying a house. When you buy a house, you get a place to live and know you have to pay the bills to maintain it. The bills might include electricity, lawn maintenance, repairs, etc. But the bills are usually pretty limited and a good house inspection should give you a sense of any potential surprises. You won't, for example, need to pay the last owner's utility bills. You won't need to pay their lawn person. You won't need to pay for repairs that they already completed. Acquiring a business, on the other hand, is more complicated. Sometimes you'll have to pay the old owner's liabilities? Sometimes you may not be able to list out all the assets you are acquiring. These parts of the deal are defined in the agreement between buyers and sellers, so we'll start with the types of agreements you'll see in the real world. Luckily, there aren't many — you'll really only run into two main types of agreements when you acquire a business:

Asset deals are typically better for the buyer. You can isolate the liabilities you will assume (so there is less risk of owing money to someone and only finding out after the deal closes) and you get a tax benefit (which we'll talk about shortly). Because asset deals are better for the buyer, and because I'm assuming you'll be the acquirer (i.e., you want to acquire a business to grow), we won't spend any time on stock deals in this article.

In an asset deal, you'll typically create a list of assets that you'll acquire as well as a list of liabilities you agree to assume. The assets will often comprise of items like:

Note that some of these items are valued on a company's balance sheet (e.g., accounts receivable), while others are not (e.g., customer relationships). Also note that cash is not on the list. Theoretically you could include cash in the list of assets you acquire, but people don't usually do that because: why would you pay for cash? You're not going to get it at a discount. And you're not going to pay a premium for it. So there is really no reason to include it in the deal.

Next up are the liabilities that you'll assume once the deal closes. Sometimes you won't assume any liabilities, but often times you will include (or will need to include) some liabilities such as:

You usually won't assume debt because 1) you may not be able to, and 2) you'll typically want to work with your own lenders rather than the seller's. In private equity deals, you'll often see deals labeled as "cash-free and debt-free." Now you'll know what that means and why. But back to the regularly scheduled program: the first thing you're acquiring are the "net assets" of the business (assets – liabilities). Usually you are going to pay "full price" for short-term assets and liabilities, which is typically referred to as net working capital. If you acquire $100 of AR and you assume $50 of AP, you'll typically end up paying $50 for these items. These items are kind of like cash since they will either turn into (or use up) cash in the very near future, but are slightly different than cash because there is still some work to do. For short-term assets, you need to turn the assets into cash (e.g., by selling inventory or collecting on AR). For short-term liabilities, you still need to pay for the liabilities and reconcile bank accounts after you've paid them, etc. This is why they're typically included in the deal: you can usually calculate their value easily, but sellers don't want to deal with the hassle after the deal closes.

Another reason you'll mostly pay full price for net working capital is because the seller could just shut the business down, collect or sell the assets, and pay off the liabilities at full price. It would take some work, but they would get very close to full value by putting in the work.

You may or may not pay full price for longer-term assets like equipment or buildings. It's more difficult to determine if long-term assets are valued correctly because they won't turn into cash anytime soon and they may have been purchased a long time ago. Regardless, you will value them on your balance sheet and they do represent part of the value that you are acquiring.

While you'll typically pay full-freight for net working capital (and may or may not pay full price for fixed assets), you would never buy a business just for the net assets. That would be pointless, especially if there is no discount on the net working capital (just keep your cash). Even if you could buy these assets at a discount and sell them off at full price, it would be a one-time event and probably not worth your time. What you really want are the capabilities these assets give you. In particular, you want the cash flow the assets will throw off in the future. This is how you'll actually price the deal. And why not? Virtually all of finance revolves around estimating and trying to maximize return on investment (ROI). Cash is how you'll pay your bills and is the ultimate arbiter of your true monetary worth.

The other major benefit you get by focusing on how much cash the business will generate is comparability (i.e., you can compare it to alternative uses of your cash). If you invest $1,000 to aquire a business and it will generate $10 in cash flow each year, you'll get a 1% return. Why not invest in treasuries where there is no risk (er, theoretically no risk) and you can get a 5% return (at least, you can in in 2023) instead? Or what if, instead, the business you're about to acquire will generate $250 in cash for a $1,000 investment. That's much better than US Treasuries, but what if you can acquire customers for $100, those customers will spend $100 on your products, and you generate 50% margins on your sales? In this scenario, you could acquire 10 customers for that same $1,000 investment ($1,000 ÷ $100 per customer) and generate $500 in gross profit ($100 x 50% x 10) in the first year. You'd be much better off investing in marketing than buying a company (it would take 50 years for the acquisition to throw off the same cash flow as the marketing would in year 1!). These are not realistic examples, but the point is that by focusing on cash, you can compare alternative uses of your money and compare the returns to figure out how to best use your money.

One thing you might be wondering about is "what does cash generation mean?" since that's not a line item on any financial statement. Here are a few ideas to consider:

Free Cash Flow Calculation

You'll need to determine whether you can go with the easiest (EBITDA) or the most comprehensive (FCF) depending on the deal and the information you have available to you. Regardless of which metric you use, though, you'll need to determine the multiple you're willing to pay. A multiple is just the "number of times" you are willing to pay for cash flow. For example, you may be willing to pay "three times" (3x) or "four times" (4x) cash flow. So if cash flows are $100 and you are willing to pay 4x, you'd offer the owners $400 for the business. To determine the multiple, there are a few things you need to consider:

You'll note that three of the bullets above (margins, buyers, and suppliers) can be analyzed using Porter's Five Forces. When you have a stronger strategic position, you should be willing to pay more for the asset. So now that you know a little bit about the theory, here are some rules of thumb:

The process of acquiring a company

TDB. Some items to consider:

Accounting for an acquisition