Want To Grow? Think Merger

A key consideration is why the merger is taking place rather than how a merger is taking place.

Al stood peering out his office window. His daughter had just graduated from the MBA program at a prestigious Texas university and now wanted to join him in the family business. The family business, originally formed by Al in the early 1970s, is located in the highlands of western North Carolina and manufactures quality upholstered furniture. The business had been good to Al and his family, and he was content operating the business at the status quo. Al knew his daughter had the education and, having grown up in the furniture business, the experience to join the company and become productive within a short period of time. The problem, as Al saw it, was there was no room for his daughter, or her salary requirements, at the company. Al decided to call his daughter and break the bad news to her.

Kim was sitting in a chair on her patio and she felt great! With her MBA program now complete, she was ready to take on the world. When the phone rang, it was her dad on the other end of the line. After some pleasantries, her dad broke the news. “Honey, you know I would love to have you come back and help, but right now the business cannot support the additional overhead and our marketing efforts are in place,” said Al.

“Dad, what if we expanded our product offerings, found new markets and/or went global,” asked Kim.

Al thought this might be a solution, but was not sure how he would be able implement this idea without putting a financial strain on the company.

“Sounds like something we should look into,” said Al. “How do we pull this off ?”

Kim’s reply was somewhat shocking to her dad.

“Well Dad, you know my MBA concentration was in marketing so I am sure that if we can find a way to make it work from an operational and financial standpoint, I can make it work from a marketing standpoint,” said Kim. “Let me talk to my friend as her MBA concentration was in finance—maybe she will have some ideas.”

Exchanges similar to this take place every day in the world of business. Owners of small to mid-sized businesses are feeling the effects of a phenomenon referred to as “globalization.” Financial-minded individuals use the term “flattening” since trade between countries is increasingly easier. Knowledge communication, via transoceanic cables or satellite by means of the Internet, occurs in a matter of minutes. Products can be shipped anywhere in the world in days as opposed to weeks or months. Gone are the days when business owners need only to worry about local, or regional, market conditions. Gone are the days when the status quo was enough to keep pace with the economy and assure business owners, like Al, the success achieved in the past.

Many business owners forced to solve these riddles are confused where to turn. Some believe that if they could simply borrow additional money, and put that money into production, they would be able to remain competitive. However, greater production simply means the business owner is tying up more money in inventory. Some business owners will also try to utilize increased production as a means to produce greater profit. Producing more profit may be appealing to a financial neophyte, but it will not make a sound business. It is cash flow—in particular, operational cash flow—that assures the future success of the business.

When looking at cash flow, business owners should focus on methodologies that reduce, not increase, the debt position of the company. In closely held companies, the business owners should consider converting closely held loans to equity, restructuring the debt and seek new equity investors. They should also explore avenues to increase profit margin. The most commonly used benchmark for determining a company’s performance is profit margin, and unfortunately, many business owners equate this with profit; however, they are not the same. To increase profit margin and positively affect cash flow, be sure to focus on sales, direct cost and overhead.

Obviously, increasing sales while controlling the direct cost will have a positive impact on cash flow, but it begs the question: how can sales be increased? If Al knew the answer to that question, he would have gladly welcomed Kim into the family business. Increasing sales is accomplished by expansion—that is, expansion through various methods such as adding products, adding channels to deliver the products, increasing the geographical area where the products are delivered (i.e., take advantage of the globalization phenomenon), implementing advertising strategies and much more. However, increasing sales without controlling the direct cost is counter productive. This situation is similar to a car stuck in the sand. More pressure can be applied to the accelerator causing the wheels to spin faster. The wheels continue to spin faster; however, the car remains stuck. Real control of direct cost means that labor cost, production cost and efficiency cost, among others, are controlled.

Kim’s friend provided an additional twist that Kim and Al had not taken into consideration. Instead of building from scratch, they should consider the possibility of merging with another company. The reason why major M&A deals grab headlines is because there are millions of dollars at stake. The chemistry behind mergers is that the value of two companies combined into a third company is greater than the sum of the two companies standing alone. An important factor to consider regarding mergers is that companies will come together to gain by adding products, increasing the geographic area where the products are sold and so forth.

Known in financial arenas as an improvement in market reach and industry visibility, mergers quite often expand opportunities for new distribution channels thereby allowing revenues and earnings to increase. Mergers also help in controlling and often reducing direct cost. For example, mergers tend to lead to job losses. After all, this new company will not need twice as many staff members in accounting, marketing, sales and other departments. In Al and Kim’s hypothetical situation, a merger could mean the marketing departments of both organizations are scratched and Kim is placed in a position of building a dynamic marketing department while, at the same time, saddled with the responsibility of controlling direct cost (labor burden for the marketing department and advertising expense).

When properly structured, mergers can also help control direct cost through economies of scale. In the corporate world, purchasing power equates to greater ability to negotiate pricing with key suppliers. A merger that is well conceived should produce greater purchasing power. In essence, the big dog gets to eat first! Another direct cost savings can be found in the incremental cost associated with producing one more widget. For example, if Al could locate and strike a deal with another upholstery manufacturer, the cut and sew operation could be consolidated. This consolidation could lead to a reduction in the overhead expense associated with production as well as a reduction in labor cost. The reduction in overhead stems from the fact that utility expense, salaries for management, etc. will not be doubled.

So, exactly what is a merger? Ask a lawyer and he or she will most likely say it is typically referred to as a statutory merger and is driven by state law. Ask a tax accountant and he or she will most likely say, “this appears to be a statutory merger, but there may be specifics required by state law and when looking at Federal taxation we should look at section 368(a)(1) (A) of the Internal Revenue Code.” Ask a finance professional and he or she will say that it is an opportunity to enhance shareholder and enterprise value if the appropriate synergies exist. After all, synergy is the secret ingredient that allows for revenue enhancement (sales increase) while, at the same time, producing cost savings (reduction of direct expense). It is this synergistic effect that truly allows merging companies to see dramatic and positive results practically overnight.

From a transactional perspective, there are a variety of ways mergers can be constructed. Typically, mergers fall into three categories: straight mergers, reverse triangular mergers or forward triangular mergers. However, it is important to consider why the merger is occurring as opposed to how a merger is occurring. Al’s company manufactures high-end upholstered furniture in the highlands of western North Carolina and ships products to the continental United States. Let us assume that Kim is able to locate an upholstered furniture manufacturer in El Paso, Texas, which has manufacturing facilities in El Paso as well as Mexico. Let us also assume that the majority of the furniture manufactured in these facilities is distributed in Mexico and South America. It would appear that these two companies manufacture and sell essentially the same product in very different markets. From a transactional standpoint, a merger between these two hypothetical companies can be accomplished using a straight merger, reverse triangular merger or forward triangular merger.

From a financial perspective, mergers are more appropriately defined by the premerger relationship of the companies.

In addition to defining mergers based on the pre-merger relationship, the finance perspective also considers financial obligations associated with a merger. From this perspective, a merger is classified as a purchase merger or a consolidation merger. A purchase merger is distinguishable from a consolidation merger in that a purchase merger involves one company buying another. If the consideration used in the purchase is the stock of the acquiring company, this will typically be a tax-free transaction. On the other hand, if the consideration paid is cash, or some form of debt instrument, the transaction will be viewed as a taxable sale. With a consolidation merger, a new company is formed, and two or more companies are then brought into this new company. Many involved in investment banking will refer to consolidation mergers as “roll ups.” From a tax perspective, consolidation mergers are taxed depending on the consideration received, similar to purchase mergers.

As fortune had it, Kim’s friend was able to provide some valuable insight into mergers as a growth option. Al and Kim were able to locate an upscale retail home furnishings company headquartered in Dallas, Texas. The retail outlets were located in the southwestern area of the United States and in Mexico. Coincidentally, the owners of this home furnishings company were in retirement mode, but wanted to stay somewhat active in the business. A deal was struck, and Kim was put in charge of the retail aspects while Al was re-energized. As for Kim’s friend, she is working diligently to find the next opportunity for Al and Kim.