The conversation usually starts like this: “It’s getting hard to get our monthly loan payments covered. What can I do?” Then comes the idea: “I’d like to buy that smaller firm. I think they’d be a good fit for us. We could have a higher chance to cover our loan payments.” “But why?” we ask. “Why would buying that firm help?” Because more business means more loan payments we can cover! You hear it all the time. You see it in the headlines every day. Buying other companies to grow your business is like rocket fuel on the path to success. Yes, mergers and acquisitions are a way to grow your business. They can also be one of the riskiest things a business owner can do.
For a business carrying debt, what’s the best type of growth: vertical or horizontal? Start with the terms. Horizontal growth is expansion on the same level of the supply chain. In simple terms, it is a merger or acquisition with a competitor. Vertical growth is expansion up or down the supply chain. Say a manufacturing company buys a company that provides raw materials for the product it makes. This is backward vertical integration because the buying company is moving backward up the supply chain towards the source of the raw materials. Or the same manufacturing company buys a retail store, selling directly to consumers. This is forward vertical integration because the buying company is moving forward down the supply chain towards the end consumer.
Both have real upside. Buying a competitor can bring in revenue sooner than launching a new product yourself, and it can expand a company’s reach in a new market or niche. Meanwhile, vertical integration can shrink input costs, improve quality and protect against supplier volatility. Each path opens a different window of opportunity, and owners choose based on where that window is widest. But when you already owe money, the downside matters more than the upside.
A Risk for a Leveraged Business
Horizontal expansion comes with a risk for a leveraged business: The businesses of the companies that are acquired or merged with are likely very similar. If your industry hits a downturn, both halves of the company take the losses at the same time. Add to that a bigger team and the needs and concerns of a bigger company. The new business will require more management and governance. An already-problematic business will become even more problematic. A merger increases the risk of corporate culture clashes and a resulting decline in productivity and/or employee morale. This too is a greater burden on a struggling business.
Vertical expansion also carries a risk for a leveraged business: For example, the manufacturing business buying a raw materials supplier may, in theory, save costs by buying the raw materials it needs directly from the supplier, but those savings may never materialize. The benefits of vertical expansion are more like long-term bets than guarantees, and those benefits take time to show up, even if they do. A company with this level of debt may not have the cash flow to support the new growth strategy. Vertical mergers or acquisitions may trigger antitrust issues and other regulatory hurdles.
Large companies learn this the hard way too. In 2022 JetBlue Airways agreed to buy Spirit Airlines for $3.8 billion, a horizontal deal. JetBlue would not give up on the merger without a fight, and ultimately lost. A judge sided with the Justice Department and blocked the deal as anti-competitive. The deal was abandoned in March 2024, and JetBlue owed Spirit $69 million under the merger agreement. On the vertical side, Lockheed Martin terminated its deal to acquire Aerojet Rocketdyne after the US Federal Trade Commission (FTC) challenged it in 2022. Aerojet was a supplier, and the FTC argued that owning it would let Lockheed cut off its competitors’ access to critical parts.
Both vertical and horizontal expansion carry a risk for a leveraged business. Which is worse? Which is safer for a business that has debt? On one hand, horizontal expansion carries a greater risk of problems due to cultural and labor strife. It also carries a greater risk of losses if the industry turns down. A vertical deal mostly risks savings that never arrive. The risk in both cases is often driven by the amount of debt it takes to finance the growth.
Borrow Money to Make a Purchase
A deal can be paid for with an all-cash transaction, a stock deal, or a combination of the two. And of course, a business may borrow money to make a purchase, which is an issue when that business is carrying debt. Buying the company you want to buy with more debt will aggravate the existing debt issue. Ultimately, the riskiest thing a business with debt can do is add more debt. There is one structure worth knowing about, though. In an asset purchase paid for in cash, the buyer assumes no debt or other liabilities; it assumes ownership of only the assets being bought. The idea is to have a “clean” company at the end of the deal.
If the deal will be financed with a lot of borrowed money, due diligence has to start with cash flow and liquidity. Look at the acid-test ratio, aka the quick ratio. This ratio measures a company’s ability to meet short-term obligations with cash or cash equivalents. Check that working capital and the timing of cash coming in can actually service the new debt. The goal is to make sure the deal is worth doing on the front end, or that the business will be able to afford it. Liquidity is important. Don’t make a deal that makes it harder for you to make loan payments.
No Single Answer
So, back to the owner who wants to buy that smaller firm. Which is safer, horizontal or vertical? There is no single answer. It depends on the business, the level of debt, and the situation. Maybe a cash purchase to take over an asset-only company is the safest answer. But for a business that is struggling to make loan payments, perhaps the safest thing is simply to take care of the debt problem first.
