If you’re thinking about a company acquisition and have a potential target in mind, your next steps could increase your business success.
Just like buying any major asset you’ll need to do your homework, and if you need some pointers this guide is for you. We will walk you through the factors you need to consider in order to come up with the right valuation and ensure a successful deal.
- Identifying what you’re hoping to achieve from the deal
- The importance of due diligence
- How to value a company for acquisition
- How to calculate the acquisition price
- Common valuation methods
- How to approach a company for acquisition
Identifying what you’re hoping to achieve from the deal
According to global consultancy McKinsey, there are six main reasons entrepreneurs want to acquire a new company:
- They think they can improve its performance, for example by reducing its costs and thereby increasing revenues and improving margins. If they’re successful, the company will deliver increased profits and be worth more. This is often the aim of Venture Capital and Private Equity firms
- They want to shrink capacity in an industry sector – fewer suppliers means increased efficiency and higher margins
- They want to use their own sales force to sell the target’s products, or get access to the target’s sales force for their products
- They want to get their hands on the target’s 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 combine companies to make economies of scale (the combination of VW, Audi and Porsche) and therefore reduce their overall costs
- They’re looking for start-ups and early-stage businesses and use their skills to develop them. This is a popular strategy for investors and funders, particularly angel investors.
Our top tip is to identify your reasons for making an acquisition, and for acquiring this company in particular. If you’re crystal clear why you’re investing, your research will be much more efficient and targeted. What’s more, you’ll be in a better position to negotiate the best price.
The importance of due diligence
Due diligence is the term for the investigation a potential buyer carries out into a company they’re considering buying. It’s conducted by the buyer’s team in conjunction with their lawyers.
These are the most important areas that the team will look at during due diligence and the most important factors that can have an impact on the price paid for the business:
Background checks on the company and management team
These background checks include desktop research such as establishing the company’s credit history, identity checks on key individuals, finding out if there are existing or threatened court actions or judgments against the company and looking for criminal convictions and assessing credit scores. Credit histories can establish a company’s record for paying debts on time, as well as the amount of debt it holds.
As part of the due diligence process, your target will set up a real or virtual data room in which it will place key documents relevant to the company’s business. You and your legal team will be looking to explore these, for example, looking at the terms of key documents like contracts and leases, as well as spotting any potential legal or regulatory issues and problems.
Another way to conduct background checks on individuals and companies is to exploit your network to find out their reputation with existing investors and mine the internet for relevant news stories featuring your target or key management figures. It can also be helpful to review job listings.
Carry out careful 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 may not have the same perception of that sector as your target. Here are some factors to consider:
- What’s the target’s market sector? Is it local or global, and can you clearly define it?
- Who are the principal suppliers in that sector, and what are their products and services?
- 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 relation to the market as a whole? Is it competitive, or have you found a good niche?
It’s important to be prepared to walk away if your research reveals that you have made wrong assumptions about the market, or your target. The price for a company may be too high in relation to the state of the market, or the target’s position in that market.
Explore company culture and values
If you’re buying a company to help develop your own business or to increase its value, then you’ll do better if the target company’s culture closely aligns with your own. Getting an idea of your cultural compatibility will help you spot whether there are major gaps that will need to be addressed if the acquisition goes ahead,
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.
You can get a good idea of a company’s culture when you visit their offices by simply looking around, chatting to staff (dress codes can be very revealing of company culture), and reviewing its HR policies, incentive programmes, and the way it rewards good performance. 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.
When looking at your target’s products or services, consider how well consumers recognise them by name. It can be costly to create brand awareness where none exists or to revive brand awareness if a company’s popularity has slumped. Ideally, your target will be well known in its market, and consumers will be aware of its USP – the factors that distinguish it from its competition. Companies with good brand awareness will start generating new revenue sooner, and will be cheaper to turn around, if that’s a factor in your acquisition.
How transferable is the current model – is the seller’s knowledge vital to the business for example?
Another factor to bear in mind if you are acquiring a company to drive out value quickly is the transferability of the current operating model. If you need to retain the expertise of the seller to incorporate their business into your own or simply to transform the target and realise value, then you’ll need to ensure that either the seller is motivated to stick around and work with your team, or that you transfer all necessary IPR and data to you as part of the sale.
When doing due diligence and negotiating your deal terms, if you’re retaining the seller’s team it’s vital to ensure they’re on board with the acquisition (or at least not hostile to it) and that you understand the factors that might influence their decision-making and 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.
In terms of 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
How much you should offer or agree to pay for a company you want to acquire is a tricky issue. And, there’s more than one reason you’ll want to get this right. Not only will you want to avoid over-paying for the business, if you’ll be raising equity as part of the deal, the valuation will also help you set the price for any new shares being issued, if you’ll be issuing shares to employees, the price they’ll pay for those shares.
Understanding the valuation process can help you negotiate the best possible terms, and also ensure that the purchase goes through quickly since the price you offer will be evidence-based.
You’ll start the valuation process by looking at the company’s financial records for at least the last five years, or from when it started in business. If a company’s financial statements are audited, you will have an independent view of its performance. Normally, if a target’s financial records are in good order, you will be able to get a fair idea of its underlying value (its assets and liabilities). If recordkeeping is poor, then you’ll need to factor that in as a risk when calculating value.
You can also use a company’s financial data to give you a valuation based on a discounted cash flow analysis. This involves looking at the company’s revenues and profits and making projections as to how these will develop based on your market research, 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? What’s the nature of this debt – is it short- or long-term – and what kind of debt is it, 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 the company’s 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 it require a significant capital injection (for example, building a new IT platform)?
- What, if any, risks have you identified, and how will you value these?
Having understood your target’s market position and market forces, any legal or regulatory factors and liabilities, the company culture, the morale of the staff, brand awareness, distribution channels and customer factors, you’ll be able to fine-tune the company’s value fairly accurately.
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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 your evaluation of its worth using the factors you’ve identified at the start of your search. However, you can estimate a business’s worth using certain common factors, and then use your judgement to fine-tune your final number.
There are various factors that 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 have real potential).
You can look at the underlying value of a target by looking at its assets. Does it own land, buildings, equipment, machinery or valuable IPR? The balance sheet will tell you a lot about the value of a company’s assets and its profitability. If record-keeping isn’t good, then this is a major risk factor.
The other way to come up with a value 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 the course of due diligence such as market or cultural factors, and any risks you have identified.
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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)
Another technique for valuing a well-established and profitable business is to use the P/E method. 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, make sure you factor in issues that would affect the profit numbers, for example by:
- Comparing the seller’s stated profits with the figure in the accounts.
- Factor in any costs you could reduce, thereby increasing profits, and any potential drag on future profits post-sale because of the integration into your existing business.
- Recalculate 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
Once you’ve come up with a number, you’d then discount it based on improvements and cost savings you could make.
As we’ve seen, if the target is asset-rich (it’s a property company or manufacturer), then your starting point for a valuation is to look at the value of the assets in its accounts (its Net Book Value or NBV) and then subtract its liabilities to come up with the valuation.
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 will get rid of assets because you’re planning to make economies of scale, you’ll need to factor in the price you can realistically achieve for the properties, for example, at auction.
Discounted cash flow
This is a technical accounting method for valuing a company with a relatively stable cash flow. You come up with a price by forecasting the cash flow over a certain period, and then discounting it, taking into account the time value of money (cash in hand today is worth more than money received in the future).
In some sectors, businesses are bought and sold fairly 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
As we’ve seen, due diligence is one of the most important factors in a company acquisition. Due diligence is also a crucial part of the disclosure process in a company sale. It sometimes happens, either during initial due diligence or part-way through negotiation of the sale agreement, that a buyer discovers a factor that would affect the company value.
Here are some common factors that can affect a company’s value but 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 have identified, either yourself or via a broker, 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, and include:
- 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 team will work together to assemble information and documents that are essential to the acquisition and ensure that everything vital to the success of the deal is transferred to you.
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, and your expert advisors will conduct further due diligence. Make sure the company fits your desired strategy and that there are no issues that might derail the deal or impact value. You can use the information gleaned during this process during the negotiations around price later on in the transaction.
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 subject to contract. 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 and will be relying on the goodwill of management, staff and keep the value in the brand. 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.