How one plus one can equal three

By Mark Zweig, Chairman & Founder, Zweig Group

From The Zweig Letter

This is the math that firm owners who pursue mergers and acquisitions use to create a lot of value in their businesses.

People talk about “synergy” in mergers and acquisitions of AEC firms, and for some, the word sounds like a cliche. Cynicism keeps many firm owners out of the business of pursuing M&A as a strategy, but they are missing out.

Aside from the client and talent sharing that can and should occur between the buying and selling companies – which certainly can be real as long as earnouts or internal accounting or reward systems don’t work against it – the real synergy shows up in the valuation of the combined entities.

Consider this example: Firm “A” is a $20 million revenue company that makes a 10 percent profit and is growing by 10 percent a year. They want to buy or merge with Firm “B,” which is a $4 million revenue company that also makes a 10 percent profit and is growing by 10 percent a year.

One might think combining these two companies that are essentially both performing at the same level – although Firm “A” is larger – would result in a company with similar valuation multiples. If each of these firms had a proper appraisal done using the generally accepted principle of discounted future cash flows based on their historic EBIT (earnings before interest and taxes) that resulted in a valuation of one times revenue, then the combined company would also be worth one times revenue, right?

But that answer would be wrong. Here is why. When we combine the two companies (and let’s say for simplicity in our example that it happens on the last day of the year), the acquiring firm (or larger firm in a merger) would have its normal 10 percent growth PLUS the growth of the revenue from the acquired company. Now in this case – a greatly simplified example to make my point – that means that instead of growing from $18.18 million to $20 million in revenue for the year, they would grow to a $24 million company.

Let me explain that. The $20 million company that was growing by 10 percent a year consistently would have its normal 10 percent growth that it achieved throughout the year, plus another 20 percent from the acquired company. So it would have gone from roughly $18.18 million to $24 million in a single year. Now the company had a $5.818 million increase in revenue for the year, or 32.3 percent growth rate.

When the new combined firm is valued, it will suddenly not be a company with just a 10 percent growth rate. It will be a company with a 30 percent plus growth rate. That will impact all predictions of EBIT growth going forward, even if it is not assumed to be the future growth rate going forward it will achieve the greatest weight in any appraisal because it is the most recent performance. Now the combined firm could end up with a valuation of 1.5 times revenue or some other number.

Keep doing these deals every year and you can imagine how the firm will be valued. It transformed from a steady-state, plodding, consistent performer into a high-growth company. Hence, one plus one equals three, or at least something greater than two. And this doesn’t even consider the client and personnel sharing that will hopefully occur, plus the redundant overhead between the two companies and resulting overhead reduction that should lead to better profitability.

Does this make sense now? This is the math people in the know use to create a lot of value in their businesses. THAT is the difference in small business ownership versus entrepreneurship.

Let me know your thoughts at mzweig@zweiggroup.com. 

Mark Zweig is Zweig Group’s chairman and founder. Contact him at mzweig@zweiggroup.com.