How To Evaluate A Company For Acquisition

Last updated: 24 February 2020

Estimated reading time: 10 minutes

Weighing up your options when it comes to a potential company acquisition? Deliberating every factor is undoubtedly complex. And when it comes to researching a company for acquisition, you’ll want to make sure that you’re getting all the information you need upfront. To help you feel more confident in your decision, here’s our guide on how to evaluate a company for acquisition.

Jump to:

  1. Factors to consider when acquiring a company
  2. How to value a company for acquisition
  3. How to calculate the acquisition price of a company
  4. How to approach a company for acquisition

Factors to consider when acquiring a company

If you’re thinking about buying a company, then you’ll know that preparation is the key to a successful deal. And when you’re considering a potential acquisition, understanding your underlying motivations for the purchase will direct your research. 

According to consultancy McKinsey, these are the six principal drivers for business acquisitions:

  • To improve the performance of the target company. A popular objective of VC and private equity firms, this strategy involves reducing the target’s costs in order to increase revenues and improve margins, providing the acquirers with an uplift in capital value
  • To reduce capacity in an industry sector in order to increase efficiency in that sector by reducing supply
  • To provide improved access for the target’s products via your own sales force (or acquire the benefit of the target’s own sales team for your products)
  • To get access to new technology or Intellectual Property Rights (IPR) faster or cheaper than developing it yourself (think Apple’s acquisition of Siri, the automated personal assistant)
  • To gain economies of scale (for example, the combination of VW, Audi and Porsche)
  • Spotting a winning businesses in its early stages and using your skills to help develop it. This is another popular strategy for investors and funders, particularly angel investors.

Once you’ve identified why you’re investing, this will help you focus on the factors that may impact on the value of your target.

Here are the most essential areas to explore when conducting due diligence in acquisitions that can impact on value:

Conduct background checks on the company and management team

These checks are normally carried out with the help of a credit rating agency, using publicly available information, and via the due diligence process. They can include verifying the identity of key individuals, finding out if there are existing or threatened court actions or judgements against them, verifying any 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. Another area to explore, with the help of your legal advisor, are long-term legal obligations like leases, 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. You may already be operating in a certain sector, but not view it through the same lens as your target for example, so research is key. Here are the main factors to consider:

  • What is the market sector you are considering, is it local or global, and can you clearly define it?
  • What products and services already exist in that market, and what are their characteristics?
  • Who are the present and future customers for the product or service, and 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 about 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 are buying a company to help develop your own business, or to increase its value, then understanding whether the target’s culture aligns with your own is an important consideration. 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 could 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 in order 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.

If you are retaining the seller’s team it’s vital to ensure they are on board with the acquisition (or at least not hostile to it) when doing due diligence and negotiating your deal terms. It’s important that you understand the factors that might influence their decision-making and willingness to help you grow the business.

You will 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

The valuation of a company for acquisition can be started by looking at its 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 in a position to fine-tune the company’s value fairly accurately. 

How to calculate the acquisition price of a company

There’s no single ‘right’ way to value a business, and ultimately the price you pay is down to your own 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 own judgement to fine-tune your final number.  

As a baseline, 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.

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 that is 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 acquisition solicitors 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 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.

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