Why do Big Companies Buy Small Companies?

I’m on a plane right now for a quick client meeting. We’re helping this particular client in the sale of his business to a much larger company. In fact, we’re in discussions with multiple companies at present, all of them very large and very interested in acquiring my client’s business. In preparation for the meeting, it got me thinking – why do big companies buy small companies?

The story of industry consolidation is generally one of larger companies acquiring smaller companies, especially in the earlier stages of industry consolidation. I’ve found that some business owners are surprised when big companies buy small companies in their industry. Some of the comments I hear include: “The industry has become so competitive, why would this big company be interested in my business?” or “It is difficult to find good talent – how is this big company going to find talent across hundreds of locations if I can’t find talent for only a few?” or “My company is so small compared to a multi-billion dollar company – why would they even bother?”

But there are actually several very attractive reasons big companies buy small companies

Low Risk 

When helping companies on the buy-side, I often comment that the first one is the hardest. Successfully acquiring a competitor demands a solid business case, and a thorough understanding of what can go wrong. In other words, understanding both the rewards and the risks present. A bad acquisition can destroy a company.

A way to mitigate the risk of a failed acquisition is when big companies buy small companies. When a large company acquires a smaller company, downside risk can be limited due the size of the target and the relative financial impact on the larger company.

When a company acquires multiple smaller targets, risk can be further mitigated through diversification. Similar to holding a diversified portfolio of stocks, a diversified acquisition strategy allows a company to spread risk of a catastrophic acquisition failure across a portfolio of targets.

The strategy of acquiring multiple smaller companies is often referred to as a “roll up” or “buy and build: strategy. Roll ups are common in fragmented industries, where there are many smaller players. Roll up strategies present very attractive opportunities for larger companies and investors to grow aggressively, take advantage of multiple arbitrage, while managing and diversifying risk.

Exponential Growth

When big companies buy small companies the growth can be exponential. While small acquisitions can limit risk, the flip side of the coin is that small acquisitions also offer the potential of significant upside growth.

For any company, increasing sales by 40% or 50% can be challenging in the best of environments. For larger companies, the law of large numbers comes into play, and doubling the size of a multi-billion dollar company can be more challenging than doubling the size of a smaller organization.

When big companies buy small companies, the upside is twofold. First, the acquiring company benefits from the existing sales and profits it acquired. Second, there is often a significant increase in revenues/profit post close. In the past I’ve written about revenue and cost synergies as an important factor in driving M&A. Acquisitions make the most sense in the context of the buyer’s ability to improve revenues and decrease costs post close.

When big companies buy small companies, the acquirer brings the resources of a larger company to bear. New customer relationships, established sales processes, improved buying power, additional management resources, etc. all tools designed to improve the financial position of the newly acquired business.  The result can be a double-digit increase (or more) in sales and/or profitability. Doing multiple small deals avails a larger organization the opportunity to significantly increase sales and/or profitability at acquired locations in a way that may be considerably more challenging at existing same store locations.

Absolute Risk vs Relative Risk

Relative risk can be mitigated by pursuing smaller deals. But as anyone familiar with portfolio diversification knows, a diversified basket of equally bad stocks does little to improve outcomes, and can hurt more than it helps. The same holds true in acquisitions. Pursuing multiple bad deals does not diversify risk. Proper due diligence, an experienced deal team, and strong post deal integration planning are the only ways to mitigate absolute risk. Doing the right deals is more important than doing lots of deals.

If you are interested in taking advantage of these trends – whether you are a buyer or a seller – please use my contact page to get in touch (subscribers, hit simply hit REPLY). The great part of my job is that I work with businesses both on the buy-side as well as the sell-side. There is no “one size fits all” strategy, but understanding both sides of the coin allows us to effectively design a strategy that best suits your needs. As always, our conversations are always confidential.

Until next week.