If you’re thinking about a company acquisition and have a potential target in mind, this guide will help increase your chances of success.
As with any major purchase, the buyer should beware. We will walk you through the steps to investigate the target, value it accurately and proceed with the deal.
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Identifying your acquisition goals
According to global consultancy McKinsey, there are six main reasons entrepreneurs like you want to acquire a new company:
- They believe they can increase revenues or cut costs to improve margins. If this works, the company will deliver increased profits. This is often the aim of Venture Capital and Private Equity firms
- To shrink capacity in a business sector – fewer suppliers mean increased efficiency and higher margins
- They want to use their own sales force to sell the target’s products, or use the target’s sales force to sell their own products
- They want access to new technology (or IPR) – this can sometimes be cheaper than developing it themselves (think Apple’s acquisition of Siri, the automated personal assistant)
- They want to make economies of scale (the combination of VW, Audi and Porsche, for example)
- They’re looking for start-ups and early-stage businesses to develop. This is another popular strategy for investors and funders, particularly angel investors.
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 you need to keep the seller on, you’ll need to provide a good incentive for them to stay or transfer all necessary IPR and data to you as part of the sale.
If you’re keeping on the seller’s team, make sure they’re on board with the acquisition (or at least not hostile to it) and that you have evaluated their willingness to help you grow the business.
You’ll also need to assess other factors that might impact transferability, such as leases of valuable business locations, transferability of IPR, and the completeness and accuracy of customer lists, for example.
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
The company valuation is important because you don’t want to pay too much, and also an accurate valuation will help you set the price for any new shares being issued as part of the deal.
Start by looking at the company’s financial records for at least the last five years, or from when it started in business. If they’re audited, you’ll have an independent view of its performance. If they look fine, you’ll get a fair idea of its underlying value (its assets and liabilities). If recordkeeping is poor, factor that in as a risk when calculating value.
You can also use this data to create a discounted cash flow analysis. This involves looking at the company’s revenues and profits and making projections, applying a discount to those cash flows based on 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 single ‘right’ way to value a business, and ultimately the price you pay is down to you. You can estimate a business’s worth using certain common factors, and then use your judgement to fine-tune your final number.
Various factors can have a bearing on a target’s valuation, for example, the technique you choose to use for the valuation and the seller’s motivation for selling. If they want to get rid of the business quickly for personal reasons, this can have a major impact on the price.
Other factors include the underlying value of the company’s assets and how mature the company is (if it’s a start-up or early-stage business, it may be loss-making but has real potential).
In terms of assets, does it own land, buildings, equipment, machinery or valuable IPR? The balance sheet will tell you a lot. If record-keeping isn’t good, then this is a major risk factor.
Another way is by looking at sales, earnings and cash flows. If a company does £100,000 of business each year, this represents a £100K revenue stream that can be projected into the future, although you need to be careful that you understand the underlying market and whether you feel these earnings are stable.
If you use earnings figures to create a company value, these should be discounted so you understand the present value of these future earnings streams (also known as a Net Present Value or NPV calculation).
Finally, you should adjust your calculations to take account of other factors you have discovered in during due diligence, and any risks you have identified.
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.
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
The next part of the acquisition process is research and due diligence. As we’ve seen, there’s a lot of publicly available information available on companies, from job adverts to web pages and blog entries.
Essential documents for the next stage of the transaction are a non-disclosure agreement (NDA), letter or memorandum of intent confirming your intention to proceed with a deal. Later in the transaction, the details of the proposed acquisition will be written up in a heads of terms, and later in a purchase agreement.
If you are happy with the results of the due diligence and would like to proceed, the next step is to make an offer. You don’t need to offer the full price you’d be prepared to pay, but make sure the offer is not too low as you’ll want to maintain good faith negotiations, During the negotiations that follow, be firm and try to reach an agreement that feels fair to both sides. The final stage of the acquisition will be proceeding to contract and sealing the deal.
For more answers to commonly asked questions and company acquisition advice, read our Mergers and Acquisitions FAQs. For legal support with experienced acquisition solicitors, get in touch on 0800 689 1700, email us at enquiries@harperjames.co.uk, or fill out the short form below with your enquiry.
