Ashley Bancroft, a founding Partner of H&Hendricks LLP, discusses whether bigger really is better in the context of revenue and what red flags to watch out for if embarking on acquisitive growth.
With the annual Infologue Top 100 Security Companies by Revenue due to be published this week, the question whether bigger does really mean better will again be a hot topic for debate. The annual rankings have again increased this year and so has competition across the security industry. The quickest way to gauge how well you’re performing versus your peers is to see where your company features on the list.
If you have read my previous article Vanity or Value you will know that bigger revenues don’t necessarily equate to better companies. While growth is generally a good sign of prosperity, it is indeed possible to destroy value – and companies – in the pursuit of an ever-growing top line.
Grow or die?
The adage “grow or die” encapsulates a fundamental principle in business that emphasises the importance of continuous evolution and adaptation to survive in competitive markets. When focussing solely on revenue, to really appreciate whether ‘bigger is better’ it is necessary to dive deep into what factors are driving underlying revenue growth.
In a prosperous company you would typically expect to find that organic and acquisitive growth are complementary i.e. the latter isn’t solely used to compensate for the lack of the former. Whilst competitive advantage is often short lived, strong organic growth across new clients and markets is a positive sign that the company has a unique value proposition. Equally, the ability to increase prices/volumes with existing clients is also strong indicator of a sustainable business model built for growth.
However, as a company grows bigger, it becomes increasingly harder to deliver impressive, year-on-year top line growth. Focus often switches to acquisitive growth due to the lack of sizable organic opportunities. With this often comes challenges. In public companies the preoccupation with M&A can also be due for defensive reasons to prevent being muscled out or swallowed up by a competitor.
Even though it’s widely known that between 70-90% of M&A deals typically fail, they’re still all too easy to jump into headlong even when we know that although such opportunities will make you bigger, they are statistically unlikely to make the company any better.
2023 M&A activity
Deal volumes across all industries for the 12-month period to the end of October 2023 saw only a small reduction year-on-year (2.5%) despite the uncertainty resulting from global political tensions, interest rate rises and inflationary pressures. EBITDA multiples (EV/EBITDA) have also generally declined over 2023.
At an aggregate level, EBITDA multiples across Business Support Services – which includes the security industry – fell from 6.6x to 5.1x over the first half of 2023. Generally, larger transactions continued to attract higher multiples (and vice versa), so bigger can potentially be better at least from a seller’s perspective.
A few notable deals took place across the security industry this year which has seen some new faces join the Top 100 and some depart for good. Most notably, OCS and Atalian completed their long-anticipated merger in March 2023.
Further consolidation across the security industry can be expected which is likely to lead to an increase in M&A activity over the near-term, particularly amongst the Top 5 as they continue to battle for the top spot.
What do lemons and M&A have in common?
Whilst the bigger deals always get the most attention, M&A isn’t just reserved for the big players. No doubt you have probably received unsolicited emails trying to induce you into parting with a cheque?
The story is usually the same: the company is a hidden gem with great future potential; the seller wants a new challenge or wishes to retire, and they want to find a good home for what they have built – blah blah blah.
“Can I send the teaser/IM?” – You get the picture.
To keep your curiosity in check, think of lemons; not the citrus type, but of the used car variety. A ‘lemon’ is an American slang term used to describe a car that has many problems and defects – what would typically be called a ‘jalopy’ in the UK.
In a nutshell, as the seller often has more information about a used cars quality than the buyer, this can inadvertently force the sellers of premium-quality cars out of the market. The reason?
Well, as buyers are unable to distinguish between poor-quality and premium-quality cars they are typically only willing to pay an average market price in case the car they buy turns out to be a ‘lemon’. This leads to premium-car sellers – who are not willing to sell below a premium price – to withdraw from the market, resulting in only lemons being left on offer.
The same problem can also arise with company transactions. Using an average multiple as a proxy for fair market value also encourage premium-quality companies to withdraw because their true value is perceived higher than the average. They choose to wait until the market improves. This leaves the market flooded with lemons who are happy to sell for the average as their fair value is most often lower.
Keep this in mind next time that unsolicited offer lands in your inbox!
“Caveat Emptor” – Let the buyer beware!
However, if you are reading this too late and have already worked up a thirst to buy and build a new empire at least watch out for these 5 red flags to avoid being left with a sour taste in your mouth:
- The Hockey Stick > expected growth defies both industry logic and gravity;
- The Blue Chip Bonanza > you see the big names but no big contracts;
- The Margin Diet > the business is quickly shedding pounds in all of the wrong places;
- The Buy Now, Pay Whenever > DSO has exploded and customers aren’t complaining; and
- The New Normal > everything has been “normalised” apart from income.
As a word of advice, if acquisitive growth isn’t already embedded in your existing business plan it is probably wise to take a step back and put any proposal on ice for the time being. It’s far better to spend your time developing an M&A strategy (what’s that?) and target list before setting off to ‘kick some tyres’.
Bear in mind that when buying a company you are essentially making a bold statement that you can run the business better than anyone else. This may be true, but it could also be your ego talking. While it might be tempting, remember it’s not always possible to turn a lemon into lemonade.
Ashley Bancroft is a founding Partner of H&Hendricks LLP, a boutique firm of Chartered Accountants and Business Advisors that specialise in helping companies to transform in the ways that matter most to their value. The firm works with business owners to ensure they are best positioned to realise the maximum value for what they have built whenever that time may arise. Crucially, it is not a business broker.
A qualified Chartered Accountant, Ashley has considerable experience of successfully leading and transforming both small and large organisations, including as managing director of a UK top 10 security company. He holds an MBA from a world-renowned business school and specialises in finance, strategy and entrepreneurship, with particular expertise in value creation.