The Forgotten M in M&A
A Creative Approach to Deal-Making for Small
and Mid-Sized Government Contractors
By Senior Managing Director, Robert Rubin
Current market conditions are having a profound impact on the value of small and mid-sized government contractors. The macro factors impacting the industry present major challenges to sustaining growth, maintaining profitability and enhancing enterprise value.
When forced to confront the reality of survival, a sale at currently depressed prices, though unappealing, may seem to be the only viable option available to produce any value for shareholders. However, is this the only option? We believe that there are other options for small and mid-sized government contractors (revenues up to $50 million) to not only survive, but thrive, and position themselves for a significant enhancement in shareholder value.
Though the fundamentals of government contracting may still be more attractive than many other sectors of the economy, continuing to do business the same way increases the risk of becoming marginalized and experiencing a potentially slow and possibly long decline.
The Forgotten M in M&A
Historically there has been a much greater volume of “A” acquisition than “M” merger activity. For purposes of this article, the term merger is being used in the strategic and business context. A discussion of some of the legal issues that arise will also be examined later in this article. Acquisitions tend to be more straightforward as the parties agree on a purchase price and terms and at the closing the buyer assumes authority over management, decision making and issues impacting the corporate culture. In contrast, a merger is a “union of two or more entities into one” – where integrating the operating and cultural needs of the parties into a workable environment becomes a more collaborative effort.
Resolving the most basic elements of a transaction, such as valuation and ownership control, can be significantly more difficult and time consuming in a merger. In spite of these additional complications, we are seeing increased activity in merger transactions for small and mid-sized government contractors as a practical response to current market conditions where valuations have experienced a significant decline.
Recent Merger Activity
Let’s look at a real life example to understand how a merger works.
ABC is a $50 million government contractor providing high end engineering services including simulation and training to customers throughout the Department of Defense (DoD). The majority of their business is in the intelligence community. Until recently, ABC experienced double digit revenue growth and profit margins. Beginning in 2016, however, as customer budgets declined, the movement toward larger contract awards and schedules and increased pressure to become a subcontractor, ABC experienced a significant slowdown in new business awards resulting in flat revenue growth and a 33% decline in profit margins. In the near term the Company implemented actions to stabilize profit margins by selectively reducing their fixed cost structure. To be able to compete for larger contract awards and return to historical levels of growth and profitability, senior management identified the need to achieve greater critical mass-- $100 million revenue. To reach this target in the next 3-5 years, will likely require a combination of organic growth supplemented by multiple strategic acquisitions. While ABC had excess cash and the availability of bank debt to complete these transactions, they were concerned that taking on the leverage necessary to complete these transactions could have a significant negative impact on their financial flexibility.
In their search, ABC met Company XYZ which had $10 million in revenues. Much of their business was concentrated in the intel space and most of their people had high level clearances. Both parties saw a strong business case as there was little overlap of customers and skills and identified opportunities to leverage a wider range of skills across a large customer base. Just as importantly, the senior management of both companies hit it off and shared many of the same basic beliefs and culture. In addition, there was little redundancy and opportunities to rationalize the back office. Owner of XYZ wanted to stay on for some time after a transaction.
Great chemistry, great business case, ABC did not want to take on the debt that was going to be required to complete this transaction—what to do? A transaction structured with some cash to seller at closing and the remainder of the purchase consideration of stock in ABC provided the seller with a nice amount of cash at closing and the incentive to continue to work hard for the combined entity.
What this created:
More critical mass—a 20% increase in revenues and increased level of profitability
Greater opportunity for the combined entity—identified numerous opportunities that they could not have gone after on their own
The opportunity to come up with a more competitive cost structure—while there were few headcount reductions, spreading ABC’s G&A and OH structure across a wider revenue base resulted in a more competitive cost structure. Immediately becoming more competitive
Expansion of management team to include owner of XYZ.
Articulation of common goals and exit strategy which reduces a lot of the risk associated with a transaction
The ability to complete the transaction without crippling the balance sheet with debt
Keys for Success
An important factor for success in a merger is the development of detailed strategic and operating plans which incorporate clearly identified and measurable financial goals and milestones, specific management responsibilities, and an agreed upon exit strategy. While the keys to a successful merger entail many of the same strategic considerations as an acquisition, other considerations which require serious examination include:
Compatibility of corporate cultures
Alignment of management structure and style
Agreement on long term shareholder goals and expectations
Initial valuation of both enterprises
Structuring of corporate governance
Mechanism for resolving major issues that arise
Agreement on exit horizon
The importance of these issues and the time required to reach agreement should not be minimized, and can be even more complicated where a private equity firm or financial owner is involved. If done correctly, however, the success of any transaction is greatly enhanced.
M&A the same old way? Not likely! With continued pressure on growth and profit margins, small and mid-sized government contractors are going to have to be more flexible and creative in accumulating the resources to realize their full potential. Companies and investors with the financial resources and fresh approaches to creating value will may be handsomely rewarded with transformational opportunities at prices not seen in the market for years.
Completing a merger requires a broad skill set to address the many challenges that a straight acquisition does not. The principles of Boustead Securities, LLC have the unique combination of M&A, financial and operational skills to accomplish these transactions.
If you would like to discuss how a merger or an acquisition can impact your company, please contact me at:
About Robert N. Rubin
Robert Rubin joined Boustead as Senior Managing Director in 2020 and has over 35 years of experience in Mergers and Acquisitions, the last 25 of which have been specifically focused on the technical services marketplace including Aerospace, Defense and Government contracting in the Washington DC Metropolitan area. In addition to his background in M&A, he has extensive experience in corporate finance and development with public and privately held companies. He has been involved in more than 40 transactions worldwide, and served as President of the National Capital Chapter and on the International Board of Directors for ACG. Robert is a FINRA registered representative and holds series 7, 24, 63, 79 and 99 licenses. For more information on M&A's contact: Robert Rubin (301) 537-8221 Robert.Rubin@boustead1828.com
About Boustead Securities, LLC
Boustead Securities, LLC (“Boustead”) is an investment banking firm that executes and advises on IPOs, mergers and acquisitions, capital raises and restructuring assignments in a wide array of industries, geographies and transactions, for a broad client base. Boustead’s core value proposition is the ability to create opportunity through innovative solutions and tenacious execution. With experienced professionals in the United States, Boustead’s team moves quickly and provides a broad spectrum of sophisticated financial advice and services. Boustead is a majority owned subsidiary of Boustead & Company Limited, a diversified non-bank financial institution. For more information, please visit www.boustead1828.com.
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