The Strategic Logic Behind Various Types of Acquisitions

Before you search for a company to acquire, you must address why and how the acquisition will benefit you – and any other companies you own.

Understanding how different types of acquisitions can be advantageous is essential. Being prepared for the unique challenges associated with each acquisition type is mandatory for the entrepreneur.

This guide will help you understand:

  • The logic behind acquisitions
  • The goals and features of each method
  • How to match an acquisition type to your needs as an entrepreneur

Here’s what you need to know.

The Logic of Acquisitions for the Entrepreneur

An acquisition entrepreneur aims to create a strong portfolio by acquiring and growing businesses. Successive purchases and exits generate personal wealth, while a well-managed portfolio will include businesses that synergize to promote growth across your portfolio.

Depending on your goals as an entrepreneur and how you like to manage your portfolio, you may prefer different methods. Before we examine the logic and motivations behind acquisition types, let’s consider why ETA (entrepreneurship through acquisition) is a critical part of building a successful portfolio.

Acquiring a Business vs. Creating a Startup

Building and growing startups remains the most popular type of entrepreneurship – but it comes at a price. That price is an incredibly high failure rate.

This is especially true if you have limited experience managing a business. Acquiring companies that already have solid internal structures can present a safer, more structured route into entrepreneurship.

It can also give you the resources to fund startups in the future. Many acquisition entrepreneurs’ portfolios are a combination of burgeoning startups and stable, successful acquired companies.

Acquisition vs. Organic Growth

The somewhat romantic (and very American) notion of the individual who starts a business from scratch, grows it slowly, achieves profitability, and finally retires with a nice nest egg is still appealing. However, it relies almost exclusively on organic growth.

Organic growth is always desirable. But relying too much on a company’s inherent, long-term viability is risky – today more than ever.

Diversifying and growing your portfolio and promoting organic growth within multiple companies isn’t just safer than putting all your eggs in one basket. It lets you exploit synergies within different businesses, unlocking growth potential you’d struggle to achieve otherwise.

Finding a Balance

Achieving organic growth is fantastic. Creating viable startups should always be a goal if you’re someone with a head full of ideas. Making sensible, informed acquisitions following the tried-and-tested PATHS framework is the cornerstone of finding a balance that lets you achieve all your goals as an entrepreneur.

This is why an expert knowledge of acquisition types and strategies is non-negotiable as an entrepreneur. Let’s get into the details.

Complementary vs. Supplementary Acquisitions

There’s some gray area between complementary and supplementary acquisitions, as a merger may meet both definitions. However, all acquisitions are either complementary or supplementary to some degree.

(And if they’re not, they’re not a good idea…!)

  • Complementary acquisitions address a weakness or gap in the acquiring company. The target may have access to skills, intellectual property, or a market that the acquiring company would struggle to take advantage of otherwise.
  • Supplementary acquisitions reinforce the acquiring company’s existing strengths. This may include a merger that consolidates market share or allows for improved economies of scale and scope.

The 3 Main Types of Acquisitions

Acquisitions may be divided into 3 general types – horizontal, vertical, and conglomerate. I’ll outline the defining features and goals of each type below.

Horizontal Acquisitions

How it Works

The acquiring company purchases a business in its own field or a very closely related field. The target may or may not be a competitor – horizontal acquisitions also include mergers between companies in the same industry but with distinct markets (e.g. a roofing company in Florida acquiring a roofing company in North Carolina).

Key Goals

  • Increasing market share
  • Acquiring new talent that may augment current operations
  • Growing the customer base
  • Reaching new markets
  • Acquiring intellectual property
  • Protecting against takeovers by other firms in the same industry (especially in local or ultra-competitive markets)

Advantages

Horizontal acquisitions are often desirable for creating short-term synergies that help complementary businesses grow rapidly before a successful exit.

They can also boost a company’s long-term growth prospects by increasing its customer base and gaining access to fixed assets that may be essential for scaling the company. This could include machinery and plants, plus skilled individuals to manage and operate these assets.

Challenges

Especially in highly competitive markets, horizontal acquisitions are frequently treated as hostile mergers. This makes negotiations difficult for the acquiring company and may result in having to pay above the target’s realistic valuation.

Careful post-acquisition management of both employees and the target’s existing customer base is also essential. Taking advantage of synergies must not come at the expense of the target’s brand identity and core services if these are its main selling points.

Larger horizontal acquisitions may also fall foul of antitrust laws.

Vertical Acquisitions

How it Works

The acquiring company targets a business at a different stage of the supply chain. For example, an oil refinery may purchase a chain of gas stations to reduce distribution costs.

The opposite may also happen (so, in this case, the owner of a chain of gas stations could purchase a refinery).

Key Goals

  • Increasing efficiency in moving and distributing goods or services
  • Reducing operational & production costs
  • Safeguarding the supply chain
  • Diversifying income streams
  • Supporting future acquisitions of businesses that work with the target company

Advantages

Vertical acquisitions are often advantageous when you’re looking to manage a business in the longer term, as they can generate long-term benefits like greater control over your supply chain.

They can also bring significant short-term benefits. Especially when acquiring a company that currently supplies your business, being able to streamline logistics and cut out purchasing costs is incredibly helpful.

Challenges

Entrepreneurs should be aware that just because two businesses operate in the same supply chain, there are still numerous challenges for the acquiring company. The acquired company may require a new and very different skill set to manage successfully.

For example, the skills required to successfully manage textile factories aren’t directly applicable to managing a clothing store chain, even though the businesses are on the same supply chain. Experts in the target industry should be brought on board before even considering the acquisition – and kept on to oversee a smooth transition.

Larger vertical acquisitions can also be jeopardized by antitrust regulators, as in the case of the Microsoft/Activision merger.

Conglomerate Acquisitions

How it Works

In a conglomerate acquisition, the acquiring company targets a business that operates in a completely separate market or industry.

This doesn’t mean that synergies don’t exist between these businesses – e.g. marketing expertise or ownership of intellectual property that may be advantageous to future acquisitions or operations.

Key Goals

  • Diversifying the owner’s portfolio
  • Moving into new or high-growth markets
  • Building funds for future acquisitions
  • Boosting assets, especially when the acquiring company currently has a high ratio of earnings to net assets

Advantages

Conglomerate acquisitions are an incredibly useful tool in ETA. As an entrepreneur, they allow you to diversify your portfolio and protect against having all your owned companies in one vulnerable industry (this is especially true for tech-focused entrepreneurs).

Conglomerates represent an opportunity to tap into high-growth markets, which can be a great way of quickly raising funds for potential future acquisitions. Conversely, for entrepreneurs who typically operate in risky markets, conglomerate acquisitions allow movements into sectors with more stable income prospects.

Challenges

Lack of knowledge about the target industry is the main reason conglomerate acquisitions fail.

You could end up paying more than the target business’s realistic valuation, acquire a business with limited growth potential, or fail to communicate your vision to the target company’s existing management infrastructure, resulting in key losses.

The Strategic Logic Behind an Acquisition – Finding the Solution

Here’s the million-dollar question (often literally!) – what’s your reason for identifying and acquiring a business? What are your goals?

By understanding this, you’ll get a much better idea of which acquisition type makes strategic sense.

Let’s walk through the most common reasons and identify what to do in each scenario.

Growth Through Synergy

The most frequently identified reason behind an acquisition is to achieve growth by synergizing two companies’ strengths. This may include:

  • Expanding your customer base
  • Combining knowledge & expertise
  • Having control of complementary products
  • Reducing production costs

Synergetic growth is most achievable in companies that operate in the same industry but aren’t necessarily like-for-like competitors. Growth opportunities should be identified both in the acquiring and acquired companies; the acquisition should be mutually beneficial.

What To Do

A horizontal acquisition is usually the best option to expand your offering and tap into a larger customer base. In some highly competitive markets, it may be beneficial to acquire a direct competitor simply to secure a larger market share.

A vertical acquisition is an excellent choice for identifying long-term synergies and enabling further acquisitions.

Acquiring Fixed Assets or Expertise

This is a common goal for entrepreneurs who find, after a successful start, that their owned companies’ growth is slowing or plateauing. Scaling upward may require specialist expertise or access to plants, machinery, etc., which may be prohibitively expensive and represent a risky investment.

Identifying a target company that already has access to these resources and is experienced in managing them may be preferable. This is especially true if the target company is underperforming in other areas that you specialize in, as you’ll be able to present an offer with a clear growth plan.

What To Do

Horizontal acquisitions are typically the best option here – it’s often worth looking further afield than your local competitors.

A similar company in a neighboring state, for example, may have access to infrastructure and expertise that your business needs, but the acquisition process may be easier than taking over a direct competitor.

A vertical acquisition may also be viable, though this depends heavily on the type of infrastructure you need to accelerate growth.

Acquiring Intellectual Property Rights

This reasoning is a hallmark of acquisitions by large companies. If you identify a startup that has developed intellectual property that would be extremely beneficial to your company, moving quickly to acquire the rights can be advantageous.

An entrepreneur with a proven track record as a business manager and a portfolio that could support the target’s operations will be well-placed to make an approach.

What To Do

These are usually horizontal acquisitions. The acquiring company tends to be a larger business with a well-developed corporate structure and significant management expertise.

The target is often a smaller company in the same field with exciting assets but limited industry experience.

Entering a New Market or Industry

You may wish to diversify your portfolio if you perceive your current market or industry as volatile. Having access to stable revenue streams from several sources is advantageous – however, it also comes with unique challenges, as you’re less likely to be a specialist in the target industry.

You may also have identified an industry with extremely high growth prospects in the near future. Acquiring a business in such an industry early can yield huge rewards.

What To Do

Conglomerate acquisitions are the preferred diversification choice for many entrepreneurs. Banks are also more likely to finance moves into industries with stable demand (e.g. home services, healthcare), so if you’re struggling to raise funds for an acquisition in your current industry, a conglomerate acquisition can make it easier to expand your portfolio.

Vertical acquisitions may also help to diversify your revenue streams. If you’re looking to acquire a business further up the supply chain (e.g. an electronic goods manufacturer purchasing a microchip developer), you may find that the acquired business has more stable growth prospects.

Improving Supply Chains

Slow, inefficient, or expensive supply is a common headache for business owners. Taking greater control of the supply chain may allow you to offer better deadlines and lower prices for your customers.

If your competitors rely on a common supplier, it can also give you a strategic advantage for future horizontal acquisitions.

What To Do

This reasoning almost always calls for a vertical acquisition. These can be difficult to negotiate, not least because antitrust regulators scrutinize these mergers very closely. However, if you can successfully acquire and manage another company in your supply chain, the rewards can be far-reaching.

Raising Capital to Finance New Acquisitions

Managing cash flow is a constant challenge for acquisition entrepreneurs – even those with a portfolio of successful businesses. Growth often comes at the expense of well-developed cash reserves.

It’s easier to finance new acquisitions if your portfolio includes businesses with substantial liquid assets. For this reason, you may wish to acquire a business that already has solid cash reserves and that can generate income consistently with a limited need for investment into growth.

What To Do

This is a common reason that entrepreneurs consider conglomerate acquisitions. Strengthening your portfolio with a stable, cash-rich business that can help finance new acquisitions is a great move – but the acquired business should never be viewed as a “cash cow.”

Every company in your portfolio requires careful management, and whatever industry the target company operates in, you should have a clear growth plan to ensure its profitability from the start.

Otherwise, you’ll struggle to make a successful exit.

Boosting Assets

The companies in your portfolio may yield impressive earnings but lack assets. Substantial assets are invaluable to acquisition entrepreneurs, as they make it much easier to acquire funding for future ventures – banks like to build on solid ground.

What To Do

All acquisition types are viable here.

A horizontal acquisition may give you access to key fixed assets that your owned companies can also benefit from – plus the expertise to manage them.

A vertical acquisition can be directed toward a business in your supply chain that has tangible assets.

A conglomerate acquisition may let you acquire an unrelated business with strong tangible assets if these are relatively rare in your industry (e.g. software development).

Defense Against Predator Companies

This isn’t the reason any entrepreneur wants to consider a merger, but sometimes, acquiring another company can help prevent a hostile takeover by a larger competitor. This is especially common in hyper-competitive markets.

Even if you’re under pressure, this should never be a rushed decision – all the usual due diligence must be performed, as there’s no point in acquiring a company if there’s no realistic prospect of growth or making a successful exit.

What To Do

A horizontal acquisition may give both your companies the resources necessary to compete with the business that was previously looking to take you over.

Horizontal mergers are also often the best way to generate rapid growth – this may increase your company’s valuation to a level that the predator company can’t afford.

Key Takeaways

ETA is based on logical, strategic decisions that consistently grow an entrepreneur’s portfolio and allow their businesses to synergize. Selecting the right acquisition type helps to identify targets that will allow you to achieve your short-term and long-term goals and open up future opportunities.

If you can retain focus on your goals and keep abreast of opportunities for any type of merger, you already have the pieces to the jigsaw.

ETAInsider is your #1 resource for discovering these opportunities, with a wealth of information from seasoned industry insiders to help you put together a successful portfolio.

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