Organic growth is making a comeback

Market Watch | Financial views of a competitive environment

The small-business recertification rule implemented
last year by the Small Business Administration is having
a profound effect on companies that depend heavily on
small-business set-aside contracts for growth and midtier
acquirers of such companies, forcing both to focus more on
organic growth.

Midtier federal information technology
companies ? $300 million to $800 million
in revenue ? have been heavily dependent
until now on the formerly target-rich smallbusiness
environment for growth by acquisition
and access to new customers and
employees with desirable skill sets and
clearances. Conversely, such acquirers have
been attractive buyers to small-business
sellers ? typically less than $75 million in
revenue ? as culturally more compatible
than larger defense primes and platform
companies.

For midtier buyers, the recertification rule
is causing a strategic shift in their growth
plans. Organic growth for most of these
companies has declined in recent years to 10
percent or less. The large supply of affordable
companies with small-business contracts
has offered the principal means for
these companies to reconcile their annual
organic growth of 10 percent or less with
Wall Street's expectation of 25 percent
per year. These smaller companies
are also easier to integrate
and pose less risk than larger acquisitions.

As a result of the rule, midtier companies
have renewed their focus on organic growth
and are looking at targets that have not used
small-business contracts to any great extent
or have migrated to mostly full-and-open
competitions.

Similarly, companies with small-business
contract revenue of 25 percent or
more are also paying more attention to
organic growth because of the negative
impact of the small-business recertification
rule on the universe of buyers and their
lower market valuations. Owners of small-business
contractors are planning to stay
the course until they become more marketable
and the small-business contract
risk has been substantially mitigated. Until
now, many of these companies had been
reaching a point where they hit the wall. At
$40 million to $50 million in revenue, a
company had to radically redo its infrastructure
and business strategy to handle
internal growth and position itself to be
more competitive in a full-and-open environment.

For many owners, this was too
daunting. It took them out of their comfort
zone, forcing them to consider selling.
The changes businesses needed to stimulate
and handle organic growth and consider
small acquisitions include:
  • Upgrading their accounting systems to
    Deltek Costpoint.
  • Adding a bid-and-proposal capability.
  • Upgrading internal accounting, finance
    reporting and human resources
    functions.
  • Adding an internal acquisition and
    integration capability.

Such investments should be made
before embarking on an acquisition track
because they will stimulate organic
growth and reduce the risk of making the
wrong acquisition. Organic growth is
ultimately less costly and risky. The
increase in earnings before interest, tax
and amortization or cash flow will also
increase their borrowing base to finance
acquisitions.

Buyers value organic growth more highly
than acquisition growth and seek target
companies with an organic growth rate of 15
percent or more. The 2007 acquisition of
Dimensions International Inc. by Honeywell
International Inc. and the recently
announced acquisition of Eagle Group
International by Lockheed Martin Corp. are
two deals that illustrate how sellers with a
lot of set-aside revenue can overcome inflection
points and enhance shareholder value
by successfully transitioning into a full-andopen
environment, reworking their infrastructure
and focusing on organic growth.

Rick Knop is senior managing director and
head of international investment banking at BB&T
Capital Markets, of Reston, Va.

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