growth by acquisition

Last month, we looked at the pros and cons of merging with or acquiring another business as part of a strategic growth plan. In particular, pending federal legislation could make an acquisition growth strategy more attractive for many businesses looking to complete an M&A this year.

Here, we dig deeper into the M&A process, starting with a discussion of how to find good acquisition candidates. We also describe the M&A due diligence process and how to structure an offer for a business that you decide you want to acquire.

A Long and Complex Process

Finding the right business to acquire can be a long and complex process that takes from one to two years or longer. During this time, you might look at 100 or more different candidates before finding the right business fit and proceeding to closing. Integral to the right fit is the realization of synergies between the merged businesses and a plan for how the two different corporate cultures are going to mesh together.

The Internet is usually the best place to start your business search, as there are many different websites designed to connect business buyers and sellers. In addition, it may also be helpful to work with a business broker. But first, do some planning and legwork to start narrowing down the type of business you think you want to buy.

For example, do you want to buy a service, manufacturing, wholesale or retail business? Are you looking in the B2B or B2C universe? Do you want to make a horizontal or vertical acquisition? And are you focused on a particular type of business or industry, or do you just want to find the right opportunity where the numbers make add up?

Once you start to zero in on a good acquisition candidate, you’ll begin the process of performing due diligence on the company you’ve targeted. Your primary due diligence objective is to confirm any representations the seller has made about the company. Or in other words, you want to make sure you’re buying what you think you’re buying. Pay especially close attention to any synergies you identified and try to confirm that they are, in fact, going to materialize.

The Due Diligence Focus

During due diligence, you should focus primarily on three key areas of the candidate company:

  1. The business’ financial condition - This will involve a close examination of the financial statements, which consist of the balance sheet, income statement and statement of cash flows. Your goal here is to confirm any statements of financial fact made by the company’s leadership, as well as to understand the assumptions behind any financial projections and decide whether or not you agree with them. This is critical, because when you buy another business, you are essentially buying a future steam of cash flow and earnings. If projections are based on faulty or unrealistic assumptions, the anticipated cash flow and earnings are not likely to materialize — and neither is your expected ROI from the acquisition.
  2. Its client base and existing contracts - Future earnings and cash flow will be heavily dependant on the company’s existing client base and contracts, so you’ll want to examine these carefully. In particular, what is the term of contracts, and will they hold up in a court of law? Ask your attorney for expert guidance here. The client base should be scrutinized from two perspectives: the quality of the customers, and the degree of customer concentration. Do most customers buy regularly and pay promptly? And are they relatively low-maintenance, or do they require lots of hand-holding? Meanwhile, high customer concentrations may be a red flag. If a higher percentage of sales and/or profits is concentrated among a handful of large customers, this could pose a serious financial risk if one of these large customers is lost.
  3. The employees and management team - It might sound cliché, but it’s true: A business is only as good as its people. So look carefully at the level of skills, knowledge and experience possessed by the employees — especially the managers and key executives. Try to gauge their level of buy-in to the merger and their commitment to remaining with the company after the deal finalizes. You might even consider offering key employees a piece of the business pie in the form of ownership shares in exchange for their commitment to remain on board for a certain number of years after the merger is complete.

Structuring the Offer

If everything checks out to your satisfaction during due diligence, it’s time to start thinking about making an offer to purchase the business. But this isn’t the time to relax: The structure, terms and conditions of the offer could make or break a deal that has been in the works for months, if not longer.

The structure of your offer will incorporate such variables as contingencies, earn-outs, non-compete agreements, real estate and equipment included with the business and, of course, the purchase price itself. Not surprisingly, owners and buyers often have very different ideas about what a business is worth. A professional business valuation performed by a trained business appraiser is often a good starting point for negotiation.

As always you should consult with your legal, accounting and other advisors.

City National, as a matter of policy, does not give tax, accounting, regulatory or legal advice. The effectiveness of the strategies presented in this document will depend on the unique characteristics of your situation and on a number of complex factors. Rules in the areas of law, tax and accounting are subject to change and open to varying interpretations. The strategies presented in this document were not intended to be used, and cannot be used for the purpose of avoiding any tax penalties that may be imposed. The strategies were not written to support the promotion or marketing to another person any transaction or matter addressed. Before implementation, you should consult with your other advisors on the tax, accounting and legal implications of the proposed strategies based on your particular circumstances.