Let’s use two companies that are recognized as among best at making successful acquisitions, General Electric and Cisco Systems. As their stockholders will happily tell you, these companies have been star performers in growing shareholder value. General Electric is a giant conglomerate with business lines such as GE Capital, GE Plastics, GE Power Systems, GE Medical, and several others. Cisco Systems could be categorized as a high tech growth company primarily focusing on voice and data communications hardware, software, and services.

The first rule of strategic acquisition we learn from these two prolific and successful companies is that they do it on purpose. They have a well thought out defined approach. To quote GE, “We are allocating capital to businesses that can increase growth with higher returns, businesses requiring human capital as opposed to physical capital. We are disciplined and integrators and we grow businesses we acquire. Over past 10 years Cisco Systems has acquired 81 companies. If you track their stock price over same period, it is up a remarkable 1300% over that same period. GE, starting with a much larger base, still outperformed S&P 500 index over same period 3 to 1.

If you study acquisitions of these two companies as well as good middle market growth through acquisition companies, you find some common strategic themes. The core principal that runs through almost every example is INTEGRATION. With exception of establishing original platform, GE expanding from their original roots and establishing a presence in plastics, for example, all of these acquisitions focus on integration.

An example that I use to summarize strategic acquisitions for Cisco Systems is not a real acquisition, but a hypothetical company that should demonstrate a point. I have been a very happy stockholder for over a decade. It seems like every year they would announce an acquisition that looked like this – Today Cisco announced acquisition of Optical Solutions Company for $30 million in stock. Optical Solutions Company manufactures OptiFast Switch, fastest optical networking switch on market today. The Company was started two years ago by two Stanford Electrical Engineering Professors. Current sales are $1.5 million and last year they lost $700,000. My initial reaction was, “What heck are they doing?” What they were really looking at was what this technology could become as it was integrated into Cisco family. First, Cisco has 5,000 sales reps, 12,000 value added resellers and systems integrators that sell their solutions, and 600,000 customers that think Cisco walks on water. Cisco knows their market, their customers, and first mover advantage in their market. With this backdrop, OptiFast Switch achieves sales of $130 million in its second year of Cisco sales. That’s what heck they were doing – a classic strategic acquisition.

There are several categories of strategic acquisition that can produce some outstanding results with effective integration. Many acquisitions actually have elements from several categories.

1.ACQUIRE CUSTOMERS – this is almost always a factor in strategic acquisitions. Some companies buy another that is in same business in a different geography. They get to integrate market presence, brand awareness, and market momentum. Another approach is to acquire a company that can establish a presence for you in a different market segment. For example, lets say that that Company A made fasteners for automotive industry and felt that their expertise could be applied to aerospace industry. A company that produced fasteners for target industry could help jump-start this strategic initiative.

2.OPERATING LEVERAGE – major focus in this type of acquisition is to improve profit margins through higher utilization rates for plant and equipment. A manufacturer of cardboard containers that is operating at 65% of capacity buys a smaller similar manufacturer. The acquired company’s plant is sold, all but two machines are sold, G&A staff are let go and new customers are served more cost effectively. Adding new customers without increasing fixed expenses results in higher profit margins.

3.CAPITALIZE ON A COMPANY STRENGTH – this is why Cisco and GE have been so successful with their acquisitions. They are so strong in so many areas, that acquired company gets benefit of some, if not all of those strengths. A very powerful business accelerator is to acquire a company that has a complementary product that is used by your installed customer base. It is ten times easier to sell an add-on product to an installed account than to sell a product to a new account. Management depth and skill, production efficiency/capacity, large base of installed accounts, developed sales and distribution channels, and brand recognition are examples of strengths that can power post acquisition performance.

4.COVER A WEAKNESS – This requires a good deal of objectivity from acquiring company in recognizing and chinks in corporate armor. Let me help you with some suggestions – 1. Customer concentration: too much of your business is concentrated on a small group of customers 2. Product concentration: too much of your business is result of one or two products 3. Weak product pipeline – in a business environment that is becoming more innovation focused, having a thin product pipeline could be fatal. Many of acquisitions in pharmaceutical industry are aimed at covering this weakness. 4. Management depth or technical expertise and 5. Great technology and products – poor sales and marketing.

As a general rule, buyers of businesses have already completed several transactions. They have a process and are surrounded by a team of experienced mergers and acquisitions professionals. Sellers on other hand, sell a business only one time. Their “team” consists of their outside counsel who does general business law and their accountant who does their books and tax filings. It is important to note that seller’s team may have little or no experience in a business sale transaction.

Another general rule is that a deal structure that favors a buyer from tax perspective normally is detrimental to seller’s tax situation and vice versa. For example, in allocating purchase price in an asset sale, buyer wants fastest write-off possible. From a tax standpoint he would want to allocate as much of transaction value to a consulting contract for seller and equipment with a short depreciation period. A consulting contract is taxed to seller as earned income, generally highest possible tax rate. The difference between depreciated tax basis of equipment and amount of purchase price allocated is taxed to seller at seller’s ordinary income tax rate. This is generally second highest tax rate (no FICA due on this vs. earned income). The seller would prefer to have more of purchase price allocated to goodwill, personal goodwill, and going concern value. The seller would be taxed at more favorable individual capital gains rates for gains in these categories. An individual that was in 40% income tax bracket would pay capital gains at a 20% rate. Note: an asset sale of a business will normally put a seller into highest income tax bracket.

The buyer’s write-off period for goodwill, personal goodwill, and going concern value is fifteen years. This is far less desirable than one or two years of expense “write-off” for a consulting agreement.

Another very important issue for tax purposes is whether sale is a stock sale or an asset sale. Buyers generally prefer asset sales and sellers generally prefer stock sales. In an asset sale buyer gets to take a step-up in basis for machinery and equipment. Let’s say that seller’s depreciated value for machinery and equipment were $600,000. FMV and purchase price allocation were $1.25 million. Under a stock sale buyer inherits historical depreciation structure for write-off. In an asset sale buyer establishes $1.25 million (stepped up value) as his basis for depreciation and gets advantage of bigger write-offs for tax purposes.