Unearthing Potential: The Art of Identifying Underperforming Businesses for Acquisition

Imagine this addition to your portfolio.

A business with clear growth potential, a well-established management structure, solid cash reserves, reliable demand, and a developed customer base. It operates at a profit, and the market carries relatively little risk. The owner is amenable to the idea of selling.

Now stop imagining that business.

I’ve trained myself to act as if it doesn’t exist. People can waste years looking for it.

You’ll know it if you find it – but until then, most of the companies you’ll consider acquiring won’t meet this description.

“Underperforming” doesn’t mean “defunct.” It just means that there’s work to do, and nobody is currently doing it.

Making that happen is your job. Why should you bother? Because acquiring an underperforming business and fixing it can be significantly more profitable than playing it safe.

Identifying underperforming businesses and understanding how to turn them around is a critical skill in the acquisition entrepreneur’s toolkit.

Here’s how to make it work.

Why Acquire an Underperforming Business?

Any business worth buying must align with your long-term goals as an acquisition entrepreneur. So what should you look for when choosing a target?

Growth Potential

Inefficiencies, lack of direction, and inexperienced or poor management are common features of businesses that aren’t living up to their potential. That doesn’t mean the potential isn’t there.

An acquiring entrepreneur with industry experience and know-how can unlock transformative growth potential. This may be achieved through:

  • Operational improvements
  • New marketing strategies
  • Leveraging synergies with other businesses in your portfolio

Opportunity for Increased Profitability

Underperforming companies often display poor profit margins – they may even be operating at a loss. While this is an immediate cause for concern, it may also help you acquire a business for a lower price than you’d typically be asked to pay.

An acquiring entrepreneur with a sound turnaround strategy might cut costs, improve operations, and optimize pricing strategies to increase profitability. As the acquired company becomes more efficient and profitable, you’ll benefit from a higher return on investment when you make a strategic exit.

Diversification

Acquiring underperforming businesses offers a significant opportunity to diversify your portfolio. You have a great chance to enter new markets or add complementary products or services to your range of owned companies without having to pay over the odds.

This reduces your reliance on limited or narrow revenue sources and mitigates risks associated with market volatility or changing industry trends. Diversification also provides new opportunities for growth and may solidify and improve your overall market position.

Competitive Advantage

Acquiring underperforming businesses can give you a competitive edge, especially when making a horizontal acquisition of a direct competitor. You may:

  • Gain access to valuable intellectual property or technologies
  • Leverage the acquired company’s market presence and customer base
  • Acquire key talent and personnel
  • Unlock new synergetic sales opportunities (e.g. by being able to sell complementary services as a package)

So we know why we’re interested. Now, what type of company fits the mold?

Characteristics of an Underperforming Business

The first step in identifying underperforming businesses is to conduct comprehensive market research and analysis. You’ll need to:

  • Study industry trends
  • Analyze competitor performance
  • Evaluate general market dynamics
  • Understand customer preferences

These can be weighed against the business’s performance to understand whether its issues are purely internal or partly due to market forces. Here’s what to focus on.

Financial Struggles

Declining revenue, low profit margins, high debt levels, and poor cash flow are common red flags indicating underperformance.

A thorough review of financial statements is essential to assess the financial health of potential targets and identify businesses with turnaround potential.

Operational Issues

You must evaluate potential targets for issues such as:

  • High operating costs
  • Low productivity
  • Poor supply chain management
  • Outdated technology

Identifying and addressing operational challenges can lead to significant improvements in the business’s performance.

Low Customer Satisfaction

One of the most attractive prospects for any acquisition entrepreneur is a company that already has an established customer base that is invested in its product. Declining customer retention rates, poor customer reviews, or a decreasing market share indicate that you won’t benefit from this.

You’ll need to evaluate the reasons behind low customer satisfaction rates and understand how to engage with the existing customer base to turn dissatisfied customers into repeat business.

Inefficient Management

Ineffective or inefficient leadership and management is a leading cause of underperformance. Assess potential targets to identify any shortcomings or misalignment with the company’s strategic goals.

What Causes a Business to Underperform?

Along with understanding how a business is underperforming, we need to examine why it’s struggling. The analysis should include:

Industry Trends

A decline in overall industry demand, the emergence of new competitors, shifts in customer preferences, or regulatory changes can all contribute to underperformance.

Companies in industries with high levels of risk may be harder to turn around than those with limited industry-wide risk but substantial internal issues.

Economic Factors

Macroeconomic conditions, such as economic downturns, changes in interest rates, inflation, or currency fluctuations, can impact a business’s performance. A business that is sensitive to economic cycles may experience underperformance during periods of economic slowdown.

Identifying these vulnerabilities early can help the acquirer develop a growth plan that diversifies the target business’s offering and offsets economic risk factors.

Internal Issues

Poor management, operational inefficiencies, outdated technology, lack of innovation, and weak customer relationships are often difficult to identify and address from within.

Businesses that are struggling due to unidentified internal issues may benefit the most from intervention through an acquisition. However, they can also present unique challenges for the acquisition entrepreneur, such as a demoralized or unreceptive workforce.

Competitive Pressures

Companies in ultra-competitive industries are prone to being priced out of the market by larger players. You’ll need to assess the competitive landscape and consider strategies to differentiate the business from its competitors, such as:

  • Improving product quality
  • Enhancing customer service
  • Developing unique value propositions

Supply Chain Challenges

Disruptions or inefficiencies in the supply chain can lead to higher costs, delays, or inventory issues, affecting the business’s performance. This may present an opportunity for a successful vertical acquisition if one or more of your owned companies can help address these issues.

Negotiating better terms with suppliers, improving inventory management, and implementing more efficient logistics processes are all essential steps.

How to Identify an Underperforming Business – A Step-by-Step Guide

Based on the analysis above, here’s a step-by-step guide to identifying a business that may be underperforming but has significant potential for growth.

1. Analyze the Target’s Financial Statements

Start by reviewing the income statement, balance sheet, and cash flow statement to understand the business’s financial position, profitability, and liquidity.

You’ll get a clearer picture of the business’s financial health and current performance levels by considering metrics such as its:

  • Gross margin
  • Operating margin
  • Return on assets
  • Debt-to-equity ratio

This information alone often highlights glaring issues with a business’s current operating model.

2. Weigh the Target’s Assets and Liabilities

The business’s balance sheet provides valuable insights into its assets and liabilities.

Your assessment should include both

  1. Tangible assets (property, plant, equipment)
  2. Intangible assets (patents, trademarks, customer relationships)

The business’s liabilities, including debt and other obligations, should also be evaluated to understand its financial obligations and assess the impact on the business’s value.

3. Estimate Future Cash Flows

The business’s historical cash flows, trends, and growth rates must be assessed to estimate future cash flow projections.

Key factors in determining future cash flows include:

  • Revenue growth
  • Cost structure
  • Capital expenditures
  • Working capital requirements

Armed with an accurate assessment of future cash flows, you’ll be able to value the company more accurately and potentially acquire it for a lower price.

4. Identify & Plan Around Undervalued Assets

Underperforming businesses may possess undervalued assets that are not fully reflected in their financial statements. These need to be identified and considered during the valuation process.

These may include:

  • Real estate
  • Intellectual property
  • Proprietary technology

This is one of the best ways to identify growth potential that isn’t currently being utilized – don’t take what you’re presented with at face value. Keep digging.

5. Assess Management and Workforce Quality

Conduct an independent review of the skills, experience, and performance of the management team, as well as the quality and morale of the workforce.

Strong leadership and a motivated workforce can be valuable assets in driving a successful turnaround, while hostile employees or inexperienced management can present a significant challenge for the acquisition entrepreneur.

6. Perform a Sensitivity Analysis

A sensitivity analysis involves testing the impact of different assumptions on the business’s estimated value, such as changes in revenue growth, cost structure, or discount rate.

This analysis provides a range of potential valuations and helps assess the risks and uncertainties associated with the acquisition.

Due Diligence for Underperforming Businesses

By the time you’ve prepared a LOI, you’ll have a sound understanding of the target’s key vulnerabilities, weaknesses, and potential areas for growth.

However, there’s much to be learned about a company after you’ve made your initial approach. You must conduct systematic due diligence checks to ensure nothing has been left out.

Here’s what you’ll need to cover in-depth.

Financials

You’ll need to analyze financial trends, profitability, liquidity, and debt levels to understand why the business is performing poorly. Any off-balance-sheet liabilities or contingent liabilities should be identified.

You should also be able to verify the accuracy of the financial statements and assess the quality of the business’s earnings – poor record-keeping can be a reason for underperformance in itself, but it’s also a red flag about how the company is currently being run.

Operations

Operational factors requiring due diligence checks include:

  • Production processes
  • Supply chain management
  • Inventory management
  • Use & maintenance of technology systems

You’re looking both for risks and areas that could be improved for greater profitability. The business’s capacity utilization, cost structure, and quality control measures are key metrics for both these assessments.

Market Position and Competitive Landscape

What’s the company’s current market position? Does it have a developed customer base? Can it perform in the current competitive landscape?

You’ll need to identify whether the business is well-placed to capture market opportunities and whether it can maintain and increase its current customer base. If it’s fallen behind industry trends in a hyper-competitive market, it may struggle to catch up without significant investment.

Legal Issues

With the support of a legal acquisitions expert, you’ll need to review any outstanding litigation, contractual obligations, or regulatory issues that may impact the business’s value or operations.

This means reviewing contracts with customers, suppliers, and employees, as well as verifying compliance with national or local laws and regulations.

Workforce

How did the management team arrive in their current positions? What key skills and competencies do they have? Are they effective communicators? What’s motivating management to work with either the current or new ownership?

The skills and morale of employees, as well as the company’s staff retention rate, should be evaluated. You’ll also need to review employee contracts, compensation plans, and any labor-related issues.

Environmental and Social Factors

The target business’s environmental and social impacts must be assessed, including compliance with environmental regulations, waste management, and social responsibility practices.

It’s your responsibility as the acquiring entrepreneur to identify environmental risks or liabilities. You should also investigate the business’s reputation and community relations, as these may need to be improved for your growth plan to be workable.

Synergies and Integration

The question of how the target business fits into their existing operations is always central for acquisition entrepreneurs.

The potential for cost savings, revenue enhancements, or other synergies should be identified as early as possible. Furthermore, integration challenges such as differences in corporate culture or technology systems should be identified and planned for.

Developing a Turnaround Strategy

Before the deal is finalized, you’ll need a well-developed turnaround strategy in place based on comprehensive due diligence.

Being prepared from the start will help you during negotiations and also show the company’s existing management and employees that you’re serious about growing the business. Communicating this – and how you’ll achieve it – is essential for the acquisition entrepreneur.

Set Clear Objectives

Your due diligence will have uncovered the root causes behind the company’s underperformance. You’ll want to address these on a realistic timescale and know how and when each objective may be achieved.

These objectives should be aligned with your strategic goals and reflect the desired outcomes of the turnaround. This provides a roadmap (both for you and for the company’s existing workforce) for the turnaround and helps measure progress.

Develop and Implement Targeted Actions

You should develop targeted actions for the acquired company based on a SWOT analysis. These will typically include but are not limited to:

  • Operational improvements, including optimizing the supply chain, reducing costs, improving productivity, and enhancing quality control.
  • Financial restructuring, which may mean renegotiating debt terms, reducing liabilities, or optimizing the business’s capital structure.
  • Market strategies, such as targeting new customer segments, expanding into new markets, or launching new products or services.
  • Management and organizational changes typically involve enhancing leadership skills, improving employee morale, and aligning the organizational structure with strategic goals.

Monitor and Adjust

It’s so important to monitor the progress of the turnaround and assess the impact of the interventions.

Key performance indicators (KPIs) should be established to measure progress against the set objectives. Regular reviews and adjustments may be necessary to fine-tune the turnaround strategy and ensure its success.

Communicate and Engage

Effective communication and engagement with stakeholders, including employees, customers, suppliers, and investors, are critical during a turnaround.

Transparency and open communication will build trust, gain support, and facilitate the successful execution of the turnaround strategy.

Acquiring the Business

Negotiations with underperforming businesses can be tricky, depending on the reasons behind the company’s poor performance.

The best route to demonstrating to the target’s current ownership why your valuation is fair is to take a methodical, rigorous approach that:

  • Shows respect for the business
  • Clearly outlines its current limitations
  • Communicates an actionable growth plan

Here’s how to achieve this.

Determine a Fair Purchase Price

The purchase price should reflect the fair value of the business, taking into account its assets, liabilities, future cash flow potential, and risks.

The price should also consider the acquirer’s strategic goals, potential synergies, and expected return on investment – do you have a reasonable chance for a successful exit?

The valuation methods used in the due diligence process can serve as a basis for determining the purchase price.

Agree on Payment Terms

Payment terms may include a combination of cash, stock, or debt financing. In some cases, earn-outs or contingent payments may be used to align the interests of the seller and the acquirer.

Assess and Allocate Risks

All potential risks should be assessed and allocated between the seller and the acquirer through negotiation.

This may involve indemnities, warranties, or escrow arrangements to protect against specific risks, ensuring an equitable deal for both parties.

Establish a Plan for Synergies and Integration

You must be able to show how the target business fits into your existing business operations. Demonstrating the potential for cost savings, revenue enhancements, and other synergies is fundamental to a successful turnaround.

The deal structure may include provisions for post-acquisition integration, such as employee retention, technology transfer, or customer onboarding.

Structure the Deal

The optimal structure for the deal depends on your goals, but it will typically be either an asset or stock purchase.

  • In an asset purchase, you buy specific assets and liabilities of the business. This method is often preferred because it can secure attractive tax advantages for the buyer.
  • In a stock purchase, you buy shares of the business, acquiring the entire business along with its assets and liabilities. This process tends to be more straightforward than an asset purchase.

Finalize and Close the Deal

After the terms are reviewed by your legal and financial advisors, it’s time to finalize the deal.

The final agreement will include:

  • Purchase price
  • Payment terms
  • Risk allocation
  • Other unique conditions of the acquisition

Implementing the Turnaround Strategy: Post-Acquisition Management

Buying an underperforming company generally means you’ll have paid less than you would for a more stable, secure business – the great challenge is transforming it into a profitable enterprise.

Following the PATHS framework, the final stage of this guide outlines how to achieve this so you can guarantee a successful exit.

1. Communicate and Implement Your Objectives

You must communicate your growth plan to the existing management and employees of the acquired business. This means outlining your strategic direction, letting staff know what role they’ll play, and highlighting key benefits.

Listening and encouraging feedback is essential – staff may have further insights to help you understand why the business was underperforming previously. You’ll need to address any concerns or resistance to build a cohesive and motivated team.

2. Monitor Performance and Adapt

You must establish KPIs to measure progress against the objectives of the turnaround strategy.

Remember that strategies that seem watertight on paper may run into unforeseen challenges in practice – you’ll need to keep a close eye on performance and potentially adapt your plan. Continuous improvement and flexibility are critical to achieving sustainable success.

3. Engage with Stakeholders

Maintain open and transparent communication with stakeholders, including employees, customers, suppliers, and investors. Consistent engagement can provide insights, build relationships, and keep all parties on board with your strategic goals.

Effective stakeholder engagement can also enhance the brand’s reputation, drive loyalty, and facilitate the long-term success of the turnaround.

4. Leverage Synergies

Take advantage of synergies between the acquired business and other companies in your portfolio.

You may have identified opportunities for cost savings, revenue enhancements, cross-selling opportunities, or shared resources during the acquisition process. It’s time to make these work for you.

Transforming a Business With ETA – The Final Word

Identifying and acquiring an underperforming business with untapped potential can be an incredibly profitable venture for an acquisition entrepreneur.

Likewise, a business that has never reached its true potential may be crying out for the vision, experience, and wisdom of a seasoned M&A professional.

If a business’s weaknesses match your strengths, it’s worth looking twice at. It’s worth looking at three times.

It’s worth investigating in microscopic detail – because it may be your next great success story.

If you’re interested in acquiring and transforming businesses, you’ve come to the right place. Keep an eye on businesses with unrealized potential, stay updated on market trends, and engage with a rich community of M&A professionals.

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