This article, written by DefenseWeb Board member Joe Baker, a principal at M&A and business consulting firm Black Tusk Advisers, analyzes a recent Washington Technology piece on the rationale supporting acquisitions as a necessary component of increasing one’s footprint in the government services market.

Mergers and Acquisitions as the Lifeblood of the Government Services Market
By Joe C. Baker

In a June 2006 article in Washington Technology, Jerry Grossman, Managing Director at the Houlihan Lokey investment banking firm, sets out a three-part rationale for a targeted growth-through-acquisition program for large federal IT companies.

Grossman contrasts a large federal IT company pursuing an acquisition program against the alternative: a company with no acquisition program, one that instead relies solely on organic growth. The upshot of his piece is that the rewards of an acquisition program from the buying side outweigh the risks for the following three reasons:

• Organic growth in capabilities and customers is usually insufficient to sustain participation in priority federal markets. Political, economic and technological factors change federal market faster than can be met through organic development. By contrast, through acquisition a company can move fast enough to sustain its competitiveness and participation in key markets.
• Organic growth fails to provide the professional and technical challenges needed to attract and retain good staff. The fundamental growth engine for most companies is their people. As companies grow, they must provide professional development for staff and fill key personnel slots, commensurate with the business challenges at hand. Acquisitions can help meet these challenges.
• Companies in the federal IT services space generate considerably more cash flow than they consume, leading, over time, to diminishing returns on invested capital and slower value growth.

To illustrate his last point, Grossman describes a hypothetical target company. The company has $35 million in annual revenue, a growth rate equal to the larger company, and is as profitable as the buyer. He concludes that by buying one of these businesses each year for four years, the buyer would grow significantly faster than a similarly situated company relying only on organic growth.

Grossman does not discuss the motivation for the selling company. However, as with the rationale for the buyer side, there is a strong business case for the smaller IT company to sell to the buyer. This rationale also has three parts:

• Better access to key markets.
• Influx of capital and resources required for continued growth.
• Enhanced ability of a growing business to withstand the increased competitive pressure that results from a higher profile.

However, new opportunities can be limited in scale. They may be a result of short-term priorities, ones that can be addressed over the course of just a few years, rather than long-term needs that provide long-term growth opportunities. They also usually have smaller and less stable funding streams. In any event, they often can only support a company’s growth to a certain size.

To ensure continued growth, a company has to be able to enter into more established markets with large and stable funding commitments. The dynamics of these larger markets often favor the bigger dominant players, especially the entrenched incumbents.

A Federal IT company can only grow so far on small deals. In order to continue to grow and expand, a company has to increase its deal size. Larger deals have longer and more involved sales cycles, which require a greater allocation of personnel and other resources to respond to proposals and manage the sales process. The increased effort often requires a significant upfront investment that can be prohibitive for a smaller company, even if it eventually becomes profitable. The larger company also can provide the business with access to the capital and resources necessary for continued growth.

Finally, a smaller, rapidly growing company’s profile increases with each success, particularly with direct competitors. As the smaller business looks to break out of its niche to enter into larger markets with more stable funding streams, it more or less issues a direct challenge to larger competitors, and competition as a business risk becomes far more significant.

So, with Grossman’s buyer looking to purchase a smaller company, let’s take a closer look at what the hypothetical seller might look like.

For the purposes of this analysis, we’ll assume that this company is well managed and profitable and that it has been nimble and innovative enough to outmaneuver larger companies in its traditional niche. There is confidence that the business is fundamentally sound, so the motivation and objective for this hypothetical company is to pursue the best way to ensure continued growth.

One option is to do nothing; that is, continue to focus on its current niche. However, staying within its niche not only limits prospects for continued growth, but may actually lead to a decline in business. The emerging niche that sustained the company’s early growth was likely characterized by a larger number of smaller, shorter- term contracts which the company was able to win without a large investment of time and resources. Early sources of funding often level off and new federal priorities emerge causing projects to be consolidated and new contracts (although larger) become fewer in number. Even where the company has a long-standing relationship, costly competition becomes the norm and the investment may not yield offsetting revenue for some time, if ever, as larger competitors make substantial investments in their proposal responses.

An alternative to this option would be finding additional niche markets. However, one needs to keep in mind that a suitable expansion market may not exist. Although the company’s early niche may have ensured enough funding to enable the company to grow to its current size, the company was likely too small to be noticed by larger competitors. As the company moves into emerging markets, it becomes harder to play under the radar of its competition.

Looking for another emerging niche also doesn’t shield the company from the changing competitive landscape in its traditional market. In order to retain its business, the company is going to have to change its business practices to keep its position in its traditional niche regardless of whether it identifies a new one.

As long as the company is going to have to adopt new practices to protect its base of business, management may decide to pursue a third option: attempting to make entry into larger, more stable markets.

Bigger companies see bigger opportunities – and often have bigger, existing challenges to solve. By definition, smaller entrepreneurial companies survive only if they have developed creative, profitable solutions to existing problems. Adding that hard-won expertise to a larger organization’s solution set allows the larger company to not only gain new markets, but leverage the new expertise within its existing markets. By doing so, it not only solves existing challenges and fends off increasing competition with its own customer base, but it can also take that competition to the larger competitor’s markets – and win.

As it considers the best way to make the leap, the smaller company may well decide that trying to go it alone presents too much risk and would cost too much. At this point, combining with one of the larger companies, for all of the reasons discussed above, often is the best available option to hire the needed talent, invest in new technologies and lower costs. All of this is critical to continuing to offer the high level service required to retain current customers, open access to new markets and sustain growth for the future.

See: Washington Technology News Market Watch: M&A is Lifeblood of Government Services Market, J. Grossman, June 26, 2006

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Joe C. Baker is an outside Director with DefenseWeb Technologies, Inc. and is the principal of Black Tusk Advisers, an M&A and business development consulting practice based in Whistler, B.C. He can be reached at joe.baker@blacktuskadvisers.com.