Thinking of buying a company? Whether you’ve identified a target or are still exploring your options, careful planning is key to a successful acquisition. From understanding your motivation to carrying out detailed due diligence and calculating a fair price, every step matters.
In this guide, we walk you through the company acquisition process, helping you reduce risk, ask the right questions, and approach the deal with confidence.
Looking to acquire a company? Our experienced M&A lawyers can help you navigate the legal process and assess risk with confidence.
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Identifying your acquisition goals
According to McKinsey, entrepreneurs typically acquire companies to boost profits, whether by increasing revenue, cutting costs, accessing new technology, or expanding sales channels. Other common reasons include achieving economies of scale, reducing competition, or developing early-stage businesses, often favoured by VC and private equity firms. Being clear on why you want to make an acquisition, and why this one in particular, will focus your research and put you in a stronger position to negotiate the right deal.
Our top tip is to nail your reasons for wanting an acquisition in general, and this acquisition in particular. If you’re sure why you’re investing, your research will be more efficient and targeted. You’ll also be in a better position to negotiate the best price.
The importance of due diligence
Due diligence is the term used to describe the investigation the buyer makes into the target company. It’s carried out by the buyer’s team and their lawyers.
Here are the principal areas the team will look at, and the main factors that impact the company valuation:
Background checks on the company and management team.
These checks include:
- Establishing the company’s credit history to see if they pay on time, and the amount of debt
- Identity checks on key individuals
- Finding out if there are existing or threatened court actions or judgments or criminal convictions
- Assessing credit scores
Another area to explore, with the help of your legal advisor, is long-term legal obligations like leases and contracts and any issues with regulators.
As part of the due diligence process, your target will set up a data room in which it will place key documents for you to explore.
You can also use your network to make informal enquiries about the company’s reputation with investors, and mine the internet for relevant news stories featuring your target or key management figures. Job listings are helpful too.
Carry out market research
The scope of your market research will depend on your motivation for investing. Even if you’re already operating in the target’s market sector, you view the sector differently from the target. Here are some factors to consider:
- Is the sector local or global, and can you clearly define it?
- Who are the principal suppliers in that sector, and what do they sell?
- Who are the actual and potential customers? Has this changed over time?
- How is the market performing, and how is the target company performing in the market? Is it competitive, or have you found a good niche?
Be prepared to walk away if your research reveals that you have made wrong assumptions about the market, or your target, in which the case price may be too high.
Explore company culture and values
If you’re buying a company to supplement your existing business, you’ll do better if the target company’s culture closely aligns with your own. A company’s culture can be defined as ‘the way we do things around here’. It includes factors such as management style, speed of decision-making (entrepreneurial or bureaucratic), and ability to implement new ideas quickly.
Do a gap analysis to see what will need to be addressed if the acquisition goes ahead,
You can get a good idea of a company’s culture when you visit their offices by chatting to staff (dress codes can reveal company culture) and reviewing its HR policies and incentive programmes. If you will be relying on your target’s staff to drive value out of the acquisition, then imposing your own culture, or requiring a major change of values, can be counterproductive.
Evaluate brand awareness.
It can be costly to create brand awareness where none exists, or to revive brand awareness if a company’s popularity has slumped. Companies with good brand awareness will start generating new revenue sooner and will be cheaper to turn around if that’s a factor.
How transferable is the current model – is the seller’s knowledge vital to the business for example?
How transferable is the current operating model? If the seller or their team needs to stay on, ensure they’re motivated and cooperative, or that all key IPR, data, and know-how are fully transferred. Also consider factors like lease agreements, customer data quality, and whether any rights or assets are non-transferable.
Regarding due diligence activities that will help you assess risk and company value generally, we’ve compiled a comprehensive pre-acquisition due diligence checklist to guide you.
How to value a company for acquisition
A clear company valuation is key to avoiding overpayment and setting an accurate share price if new shares are issued. Review at least five years of financial records, audited if possible, to assess performance, assets, and liabilities. If records are poor, treat it as a risk. You can also run a discounted cash flow analysis to project future earnings and factor in the time value of money.
Here’s a checklist of things to consider:
- How much debt do they have? Is it short- or long-term, secured or unsecured?
- How organised is their finance team/processes? Are their records in good order?
- What are current operating profits and revenues, what are the recurring revenue drivers and are these stable, and how is cash flow?
- Are their accounts audited, and if not, how will you evaluate them using a third party?
- How do they plan to grow, and based on your view of the market, are these plans realistic and sustainable? How will this business scale, and how much will this cost? Will you need to inject capital (for example, building a new IT platform)?
- What, if any, risks have you identified, and how will you value these?
How to calculate the acquisition price
There’s no one-size-fits-all method for valuing a business, ultimately, the price comes down to your judgment. Use common valuation techniques, then fine-tune based on factors like the seller’s motivation, the company’s maturity, asset base, and financial performance.
Check if the business owns valuable assets like property, machinery or IPR, and review the balance sheet, poor records signal higher risk. Look at sales, earnings and cash flow to assess revenue potential, and apply discounted cash flow (DCF) or Net Present Value (NPV) to account for future earnings.
Finally, adjust your valuation based on risks or red flags uncovered during due diligence.
Common valuation methods
Here are some of the most popular methods used by buyers to arrive at a price they’re prepared to pay for a business:
Price to earnings ratio (P/E ratio)
The P/E method is where you take the business’s current share price and divide it by the earnings per share. This is a much easier process if the company is listed on a stock exchange. Most P/E values for quoted companies vary between 10 and 25, and the P/E ratio of a smaller, unlisted company is likely to be about 50% lower than a comparable quoted company.
If you’re planning to use the P/E method, you need to factor in:
- Comparing the seller’s stated profits with the figure in the accounts
- Possible cost reductions and the potential drag on future profits post-sale because of the integration into your existing business
- Recalculating the profit figure in the accounts using your own accounting methods
Entry cost valuation
Another way of valuing a business is to work out what it would cost you to start a similar business yourself. You’d need to factor in:
- The cost to buy assets such as equipment
- Product or service development cost
- Talent acquisition and training costs
- Sales and marketing costs
- Loan servicing and costs of financing
You’ll then discount it based on improvements and cost savings you could make.
Asset valuation
If the target is asset-rich (it’s a property company or manufacturer), then your starting point for a valuation is the value of the assets in its accounts (its Net Book Value or NBV) minus its liabilities.
You may need to tweak this number to take account of certain factors, for example, bad debts and changes in property values over time. In addition, if you’re planning to sell assets, you need to factor in a realistic sale price.
Discounted cash flow
This is a technical accounting method for valuing a company with a relatively stable cash flow. You need to forecast this over a certain period and then discount it.
Sector-specific valuation
In some sectors, businesses are bought and sold often such as franchises. Rather than profits, you come up with a valuation based on turnover, customer numbers and the number of outlets for sales.
Issues that can affect a company’s valuation
Sometimes, either during initial due diligence or part-way through negotiation of the sale agreement (the disclosure process), a buyer discovers a factor that might affect the company value. Read our article to explore the role of disclosure in acquisitions, including how it protects sellers, informs buyers, and helps manage risk during the transaction process.
Here are some common factors that can affect a company’s value that that don’t necessarily appear in the company’s accounts.
- The target holds exclusive rights to produce or distribute a product or service. If you think these rights are valuable because the product will be successful, the price you offer will increase
- Whether you will be able to hold onto key members of staff, and if there are restrictive covenants in their contracts that would stop them competing with you if they leave
- Any risks you’ve identified in due diligence that you may not be able to mitigate
How to approach a company for acquisition
Once you’ve found a suitable target company and made initial approaches, the next step is to put together an acquisition team. Ideally you, or a senior member of your team, would direct activities. You’ll need:
- An investment banker to investigate finances
- An acquisitions lawyer to undertake legal due diligence
- An HR expert to deal with staffing issues
- An IT person to evaluate technology issues
- A PR/comms individual to liaise with third parties and handle any necessary publicity
After initial research, the next step in the acquisition process is due diligence, gathering key information from public sources and verifying the target’s operations, finances, and risks.
To move things forward, you’ll typically sign a non-disclosure agreement (NDA), followed by a letter or memorandum of intent. As talks progress, a heads of terms will outline the key deal points before finalising everything in a purchase agreement.
Once you’re satisfied with the due diligence, you can make an offer. Aim for a fair starting point, too low could damage negotiations. Stay firm but constructive, working toward a balanced deal before signing contracts and completing the acquisition.
For more answers to commonly asked questions and company acquisition advice, read our Mergers and Acquisitions FAQs.
