Statistically, manufacturing companies are among the most sought-after acquisitions in the United States. But how can a buyer really know if they’re looking at a quality acquisition? In this article, we’ll examine the top ten things to look for in a manufacturing acquisition.
Here’s the list, but below we’ll discuss what to look for in each category and why it’s important:
- Growing Sector, Not Likely To Be Disrupted By New Technology
- Customer Concentration & Strength of Relationships
- Sales In An Upward Trajectory
- Financial Documentation
- Company’s Lack of Dependence on the Seller
- Pipeline Of Skilled Workers
- Documented SOPs
- Pricing Room & Strong Margins.
- Low Capex
- Positive Company Culture
Let’s look at each of the top ten in detail:
1. Growing Sector, Not Likely to Be Disrupted By New Technology
If you’re seeking a manufacturing acquisition, you need to understand changes within the sector and whether or not there are developing technologies that have the potential to be industry disruptive. Think about how email changed the print industry and the postage machine industry or how online bill-paying changed the check printing industry. Think about how certain types of machining might be dramatically altered by 3-D printing. In addition to asking Sellers if they are aware of any new technologies that will affect their industry, you can keep up with the latest by using websites like https://www.technologyreview.com/ and https://disruptionhub.com/. Make sure you’re not acquiring a technology that will soon be wiped out by innovation.
2. Customer Concentration and Strength of Relationships
M&A experts will tell you to be careful on the subject of customer concentration. It is no doubt a risk factor. There are varying opinions on the ideal percentage. Conventional wisdom will provide a percentage above which acquisition is too risky. This is typically over 20%. However, we’ve sold businesses with a customer concentration as high as 65%. In that instance, the rules of engagement were different. While we don’t usually allow buyer access to the customers prior to closing, with that high of a concentration, it’s the only way to get the job done. Sellers see risk in this, but it can be done in such a way that the buyer receives the comfort level they need with the Seller/Customer relationship being protected and preserved.
The bottom line is that the strength and length of the customer relationship can mitigate some of the risks. However, if you’re a buyer without capital reserve, conventional wisdom should prevail. If you can’t weather the storm of losing a key customer, steer into less risky manufacturing acquisitions. In some industries like aerospace, it’s almost impossible not to have a customer concentration. There are so few key players in the industry that if you’re doing anything of significance, you’ll likely have a concentration. That was the case when we sold a company in the aerospace sector with a 65% customer concentration. If that scares you, an aerospace acquisition is likely not right for you. Those with industry experience don’t usually mind.
3. Sales In An Upward Trajectory
For most acquirers, the target company’s sales should be in an upward trajectory – or at least stable. Often in the sale of founder-led manufacturing companies, the owners coast to retirement without much effort toward sales and business development. This is typically an excellent opportunity for incoming ownership to increase sales easily. Simply reaching out to existing customers to highlight the company’s machining capabilities can yield excellent results.
However, if the Seller’s coast to retirement has reached the level of customer neglect, you may need to think twice. Sometimes the window of opportunity to build upon past relationships has passed. Alternatively, some Sellers have such a great relationship with their longtime customers that they are asked to take on a new project that will require capital investment. Often an aging Seller will decide to sell at that juncture because they’ve moved from investment risk to wealth protection. These ideal situations for buyers can lead to fast growth in a manufacturing acquisition.
4. Financial Documentation
As a qualified buyer, you should expect to get three years of both financial statements and tax returns. If a Seller or Broker is not providing this information, don’t waste your time; move on. That said, some intermediaries will seek to understand your financial qualification before sharing their client’s financials.
My own company operates in that manner. We are contractually obligated to understand a buyer’s financial capability before disclosing our client’s financials, name, and location. To gain access to the best manufacturing acquisitions, buyers should respect the M&A professional’s process and give them the information necessary to help them. Just because one company provides all information with a simple NDA doesn’t mean all do.
Small manufacturing companies typically don’t have their financials audited. That should not be a deal-breaker. Small companies usually don’t have a board of directors (BOD) to answer to, and there’s no reason for them to go through the expense. That doesn’t mean they aren’t quality companies. I’ve seen small manufacturing companies with more robust financial reporting than companies five times their size.
Here are some things to look for:
- Does the Company track sales by customer and sales by product?
- Is the company accurately tracking the cost of their products?
- Is employee time tracked on each job?
- Is manufacturing labor part of their COGS number?
- Have there been large swings in sales, COGS, EBITDA or capital expenditure – find out why.
- Can the internal financials be reconciled with the tax returns?
Look for the speed with which your questions are answered when considering a manufacturing acquisition. If you can’t get preliminary questions promptly answered, due diligence will be a nightmare, and the deal might not make it through bank underwriting. So many manufacturing business owners are not skilled in financial documents or terminology. If that’s the case, you should be allowed access to the Company’s CPA to get critical information and become comfortable around financial reporting.
5. Company’s Lack of Dependence on the Seller
The best manufacturing companies have a culture of training and continual improvement to eliminate their dependence on the owner for survival. If an owner can’t leave the business for several weeks without it blowing up, it won’t be easy to transition to new ownership. Even though a Seller might agree to an extended transition time to resolve this issue, if he or she becomes unable to continue working, your investment could be at risk. Acquisition lenders will look carefully at this issue because it puts their money at greater risk. This issue is one of the “top ten” that is difficult to overcome. Companies, where operations and customer relationships are not dependent on the Sellers, are safer bets and usually better investments. Clearly, strategic acquirers already working in the same industry don’t necessarily have the same concern as a new entrant into the sector.
6. Pipeline of Skilled Workers
There is no denying that there is a national skills gap, with manufacturers struggling throughout the USA to find qualified workers. This comes from several decades of students being steered into other types of careers as a massive amount of manufacturing left the USA for other countries. With the advent of COVID-19, it has become very apparent that manufacturing and its critical supply chain need to be homegrown to ensure our national security. With all of the above, manufacturers scramble for quality workers and compete to acquire them.
Traveling nationally while assisting sellers and buyers in manufacturing acquisitions, I can tell you that not all manufacturers struggle in the same way with this issue. Some are proactive in their approach to achieving a pipeline of skilled workers. This is accomplished through several initiatives, including but not limited to the following:
- Developing relationships with local trade schools and colleges
- Outreach to local high schools for work programs
- Hosting plant tours during Manufacturing Day
- Participating in regional Maker’s Fairs & Robotics contests
- Developing scholarship programs for those successfully completing high school work programs
- “Home growing” workers – hiring for character and training for skill
Those implementing initiatives described above are experiencing less of a skills gap than those who complain. When shopping for a manufacturing company, look for one that takes a proactive approach to solving the skills gap. You should also take a serious look at the remaining work life of the current key employees. If those with all the tribal knowledge are close to retirement, think carefully before acquiring.
7. Documented SOPs
Manufacturing companies with documented standard operating procedures are easier to transition and typically trade at higher multiples. Manufacturing companies that hold certifications like AS9100 or ISO-9001, have to have developed SOPs as part of the certification process. Some companies will have documented procedures even though they haven’t undergone the formal certification process. However, those that have are attractive because the acquirer won’t have the expense of getting certified and can immediately begin to capitalize on the certifications to gain new business.
8. Pricing Room & Strong Margins
When evaluating manufacturing acquisitions, look for a company whose parts or products are a small portion of the overall cost structure in their customer’s end product. This can dramatically decrease pricing pressure from the customer and provide room for price increases as an easy avenue for immediate growth. Founder-led companies often take a “don’t rock the boat” approach to pricing in the years leading to retirement. Acquirers can often institute an immediate price increase without any blowback. Conversely, as a buyer, you need to know if the Seller has recently raised prices and if they lost any customers as a result. This should be a standard question when shopping for a good acquisition target.
From a margin perspective, you want to aim for a company with higher margins that competes on more than just price. Here’s another area where conventional wisdom might not be correct. Many acquirers steer away from “job shops,” thinking they only compete on price. The truth is that many quality component manufacturers in various sectors are considered “job shops” with no core product of their own. Many compete on issues other than price. Their longtime customers keep buying from them based on their quality, on-time delivery, design input, and relationship. Some job shops are so embedded in their customer’s business that the customer can’t be pried away from them with the promise of a lower price – and THAT is what you need to look for.
9. Low Capex
Manufacturing companies often have higher capital expenditure requirements than other types of businesses. That isn’t necessarily a problem because they are often more enduringly profitable too. Buyers need to be concerned about the immediate need for capital expenditure post-acquisition. Has the owner not invested in his company on the approach to retirement? If so, you’ll need to ask yourself what upgrades are required to maintain competitiveness. Look for companies that have been run as though they are not for sale, with continual improvement in machining technologies. You want to be able to hit the ground running after you make the manufacturing acquisition.
10. Positive Company Culture
A target manufacturing acquisition should have a positive company culture. This is hard to vet during the initial process, but here are some things that you might consider looking for:
- The owner speaks positively about the staff
- Employees have the autonomy to do their jobs successfully
- Low employee turnover
- A pleasant work environment – clean and well organized
- The staff is adequately compensated and have received appropriate raises
If you follow “The Top Ten Things to Look For In a Manufacturing Acquisition,” you’ll weed out targets that will waste your time and money and end up with a quality manufacturing acquisition.
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