Acquisition Analysis

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Overview of Acquisition Analysis

A buyer performs due diligence on the target company in order to assess the benefits and liabilities of the proposed acquisition. The buyer does this by investigating all relevant aspects of the target that could present risks or opportunities to it.

For a full acquisition of the target’s legal entity, involving the assumption of all financial, environmental, and legal liabilities, as well as all assets, there are a great many sub-sets of analysis to perform. However, for a lesser acquisition, such as the purchase of all or specific assets, the number of analyses is substantially less. In this discussion, the types of acquisition analysis are broken down into a wide range of categories, which makes it easier to select only those needed for a specific type of acquisition.

Acquisition Analysis - Team Staffing

Performing due diligence on a potential acquisition is like no other type of financial analysis – not because the analysis itself is different, but because of the logistics of the situation. Typically, a potential acquisition situation arises suddenly, requires the fullest attention of the buyer for a short time, and then subsides, either because the buyer elects not to pursue the acquisition, or because the deal is completed, and an integration team takes over the activities of melding the organizations together.

Because of the suddenness of an acquisition evaluation, a company must be fully prepared to switch into a full-bore analysis mode. However, due diligence team members have other duties, and cannot leave them in order to conduct an investigation. Accordingly, the capacity of the various buyer departments to complete a potentially massive analysis chore may not be possible, if they are to operate in anything close to a normal and efficient manner. Accordingly, a company must make one of three choices. First, if there are very few acquisition evaluations to make and the potential acquirees are small ones, then it may be possible to accept some degree of disruption within the company and perform all the work with the existing staff. A second alternative is to form an acquisition analysis group that does nothing but evaluate potential candidates on a full-time basis. This is an excellent approach if the buyer grows primarily by acquisition. The third alternative is to hire an outside auditing firm to conduct the financial analysis on behalf of the company. This is a good alternative if the in-house staff does not have sufficient time or training, and if there are not enough acquisitions to justify hiring a full-time team of analysts. However, using outside auditors can be an expensive proposition, and the audit staff used must be of a high enough level of training and experience to conduct a thorough review. Thus, the number of potential acquisitions and the ability of the internal staff to complete acquisition analysis work will dictate the method used to conduct a due diligence analysis.

Where possible, some members of the team should come from the managers and their staffs who will eventually run the target company. These employees will exercise the most care in making inquiries, because they know that, once the acquisition is completed, they will be responsible for cleaning up any messes that are not uncovered. They also realize that the target’s performance will factor into the calculation of their bonuses. Though this group will not have all of the expertise needed for the entire due diligence program, they are invaluable for investigating operational issues.

Acquisition Analysis - Key Areas

With the acquisition analysis team in place, a buyer can then compile a list of due diligence questions that are tailored to the precise circumstances of the target company. The main analysis areas are as follows:

Market. If the buyer is new to the industry in which the target is located, it should inquire about a variety of fundamental competition issues, such as the ease of entry into the market, any excess capacity that may drive down prices, and the general size and growth rate of the market.
Culture. The buyer must understand how the target operates. Corporate culture involves the integration of numerous elements, such as its organizational structure, sense of community, and decision-making systems. The mark of an experienced buyer is one that spends considerable time investigating this area, because it knows that some cultures are strongly resistant to subsequent integration.
Personnel. If a potential acquiree has one or more departments that are justly famous for their work, then buying the company may be worthwhile in order to obtain those specific departments. The main analysis needed here is to determine the current compensation levels of the people being acquired, as well as how these pay levels compare to both internal and industry pay standards, and the presence and cost of any long-term compensation agreements.
Intellectual property. A target company may possess one or more valuable patents, especially ones that can be used to enhance the value of the buyer’s products. The primary analysis focuses on the number of years remaining prior to patent expiration and (especially) the expected cash flows to be obtained from them prior to expiration.
Brands. A brand name is immensely valuable if it has been carefully maintained for many years, has been strongly supported with proper marketing, and represents excellent products. This is a good reason to acquire a target company, and is most common in the consumer goods field. The investigation focuses on the incremental profits to be gained by use of the brand name in relation to the cost of acquiring and maintaining the brand.
Risk management. A well-run target will have systems in place for evaluating and mitigating those areas in which it is most at risk of loss. A target with an excellent risk management program is more valuable to the buyer, because the buyer is less likely to incur unexpected losses following the acquisition transaction.
Capacity. If a company is faced with a long lead time or technological challenges to acquire greater production capacity, it may be worthwhile to purchase a production facility from another company. The analysis focuses on the age and usefulness of the machinery and facility purchased.
Assets and liabilities. When an entire company is purchased, the acquiring organization is taking over virtually all assets and liabilities. In this instance, a comprehensive review of all balance sheet line items is mandatory.
Equity. Buyers tend to focus the bulk of their efforts on asset and liability investigation, and are then surprised when they realize that a key shareholder has super voting rights, and must be appeased in order to approve the acquisition. This can be avoided by investigating a short list of ownership topics.
Profitability. The bottom line on any acquisition is the bottom line – the buyer must expect to increase its earnings per share as a result of the transaction. This requires a detailed review of the target’s income statement, broken down by subsidiary, customer, and product.
Cash flow. If a company has a large store of cash or continuing cash flows, it is a prime target for purchase by companies that need the cash, possibly to fund further acquisitions. For this type of acquisition, an intensive review of the balance sheet, income statement, and statement of cash flows are necessary.
Customers. The relationship that a target has with its customers is a key concern to the buyer, but is frequently not investigated in detail. The buyer should review the length of relationships, profitability by key customer, complaint records, contracts, and related issues.
Product development. A target with a long-term commitment to product development is quite valuable. Relevant topics of investigation are the size and quality of the target’s product pipeline, as well as the presence of any failed products, target costing, and an effective development plan.
Production process. A target’s production process can hide considerable synergies. The buyer should examine its work flows, throughput philosophy, and industrial engineering capabilities.
Information technology. A target’s information technology systems can be a barren wasteland of ancient legacy systems and overburdened infrastructure. The buyer should be willing to conduct an in-depth investigation of this area to root out the worst problems.
Legal issues. The buyer’s attorneys are an important part of the due diligence team, because they protect it from a broad range of legal hazards. They are among the first to begin due diligence work and the last to leave, and can be expected to spot numerous legal problems in such areas as contracts, licensing deals, liens, and pending litigation.

All of these areas are described in more detail below.

Acquisition Analysis – Market Overview

In most cases, the buyer is located within the same market as the target, and so is already extremely knowledgeable about the structure and level of competition within the target’s market. However, if the target is located within a different market, the buyer should conduct a high-level overview of how the market operates. Here are some issues to consider:

Ease of entry
Excess capacity
Level of expertise
Market growth trend
Pricing sensitivity
Total market size

The topics noted here are extremely broad issues – so broad that many buyers ignore them completely, preferring instead to focus on the specific attributes of individual target companies. Nonetheless, these factors have a considerable impact on the long-term profitability of any company. Thus, the buyer should consider these issues for its target markets at least once a year, to see if it should continue or change its existing acquisition strategy.

Acquisition Analysis - Culture

One of the most important due diligence areas is the target’s culture, since this is the fundamental basis upon which the target operates. However, very few buyers investigate culture to any extent, on the grounds that culture is not quantifiable. What they miss is that integration of the target into the buyer’s organization will be extraordinarily difficult unless the buyer works within the restrictions of the buyer’s culture while making changes. In some cases, the cultures of the two companies are so incompatible that a successful integration is almost impossible. Thus, a due diligence review of culture should be one of the first and most important items completed, so that the team can quickly determine if it should recommend immediately abandoning the acquisition. Here are several core culture areas in which conflicts can lead to acquisition failure:

Organizational structure
Bureaucracy
Innovation
Employee focus

While it is entirely possible to work around one of these conflicts, having multiple ones will likely cause the acquisition to fail. Though the buyer can conduct a massive management purge in order to eliminate the existing culture, this also destroys a great deal of value, and so is rarely worth the effort. Consequently, the due diligence team should pay a great deal of attention to the differences between the buyer’s and target’s cultures, and how they will impact the acquisition.

Acquisition Analysis - Personnel

The core asset of many companies is its employees, so the due diligence team should focus a considerable proportion of its time in this area. Here are the key review topics:

Compare employee pay levels to industry and internal averages
Compile pay histories
Review bonus and commission plans
Investigate special pay situations
Review long-term compensation agreements
Determine the current turnover rate
Review benefits
Investigate principal employees
Verify collective bargaining arrangements
Review grievance records
Investigate employee names listed on patents
Interview customers and suppliers about employees

Acquisition Analysis – Intellectual Property

Due diligence for intellectual property largely focuses on the existing costs and revenues currently experienced by target’s patent and copyright holdings. The buyer should review the estimated additional revenues and costs that will subsequently be incurred by its use of the patent, which may vary from the use to which it has been put by the current patent owner. The primary analyses are as follows (references are to patents, but by inference include copyrights):

Determine annual patent renewal costs
Determine current patent-related revenue stream
Ascertain extent of current litigation to support patents
Verify the patent application process

Acquisition analysis should also encompass patent risks. Some problems may not be immediately obvious. For example, have other companies in the same industry experienced problems enforcing their patent rights? If so, how likely is it that the target will eventually confront the same issues? Also, are any key patents held by entities or individuals other than the target? If so, verify that the documents giving the target access to the patents will not terminate in the near future, and give the target rights to obtain usage extensions.

Acquisition Analysis - Brands

A brand name can be immensely valuable, but its true value can be subject to a broad range of interpretation. Use the following steps to arrive at a more quantitative view of brand value:

Determine the amount of annual trademark fees
Determine clear title to the brand name
Ascertain the amount and trend of any current cash inflows from the brand name
Note the amount and trend of any legal fees needed to stop encroachment

Acquisition Analysis – Risk Management

The risk management policies of the target company can be of significant concern to the buyer, because inadequate risk management leaves it open to possibly enormous additional expenditures. While a buyer will rarely find an environment where the target completely ignores all forms of risk, there are some areas in which risk coverage is likely to be inadequate. Here are some areas to investigate:

Claim terms
Deductibles
Penetrated aggregates
Premium adjustments
Self-insurance
Site security
Uninsured risks

While the above points will reveal areas of significant risk, the due diligence team should also make note of the target’s overall commitment to a risk management program. This is evidenced by a high-level officer who is charged with risk management, strong management support of the program, and extensive employee training in those aspects of risk management over which they have an impact.

Acquisition Analysis - Capacity

When a buyer purchases a manufacturing facility from another company, it is usually doing so to increase its capacity. With this end in mind, the key analyses revolve around the condition and cost of the facility, to determine the amount of replacement machinery to install, as well as the actual production capacity percentage, the cost per percent of capacity, and the facility’s overhead cost. For many of the analyses, the information assembled must be for three activity levels – minimum, normal, and maximum capacity levels. The reason for the three-fold format is that management may not use the facility as much as it anticipates, in which case it must be aware of the minimum costs that will still be incurred, as well as the extra costs that must be covered if the facility runs at the highest possible rate of production. The primary analyses are as follows:

Determine the facility overhead cost required for minimum, standard, and maximum capacity
Ascertain the amount of capital replacements needed
Find out the periodic maintenance cost of existing equipment
Determine the maximum production capacity
Investigate any environmental liabilities
Determine the cost of modifications needed to increase the capacity of the facility

Acquisition Analysis - Assets

A company will sometimes acquire just the assets of another organization. This is most common when there is some risk associated with the liabilities of the target, such as lawsuits, environmental problems, or an excessive amount of debt. When assets are purchased, the buyer can be quite selective in buying only those assets that are of the most value, such as patents, brands, or personnel (which have been covered in previous sections). At this point, we note only the following additional analyses needed to ensure that all other assets are properly reviewed prior to an acquisition:

Conduct a fixed asset audit
Appraise the value of fixed assets
Ascertain the existence of liens against assets
Determine the collectibility of accounts receivable
Verify the bank reconciliation for all bank accounts
Review existing product line
Investigate inventory
Audit the existence and valuation of remaining assets
Determine the value of any tax loss carry-forward

Acquisition Analysis - Liabilities

If the buyer decides to purchase a target as a complete legal entity, rather than buying pieces of it, then it must also review the target’s liabilities. The main liability analyses are as follows:

Reconcile unpaid debt to lender balances
Look for unrecorded debt
Review debt terms
Audit accounts payable
Audit accrued liabilities

Acquisition Analysis - Equity

At a minimal level, a due diligence team can simply request the target’s current shareholder list, and assume that it will pay the people itemized on that list. While this may be sufficient for a very small target company having a simple capital structure, a great deal more investigation is needed for larger firms that have issued special classes of voting stock, options, registration rights, and more. Here are additional areas to investigate:

Calculate exercisable options and warrants
Investigate registration rights agreements
Obtain the shareholder list
Investigate special voting rights

In brief, the due diligence team must determine who needs to vote for the acquisition, how many shares it must purchase, and whether the buyer will inherit any registration obligations as part of the acquisition.

Acquisition Analysis - Profitability

There are several ways to review the profitability of a target company. One is to track the trends in several key variables, since these will indicate worsening profit situations. Also, it is important to segment costs and profits by customer, to see if certain customers soak up an inordinate proportion of total expenses. Further, it may be possible to determine the head count associated with each major transaction, to determine the possibility of reducing expenses by imposing transaction-related efficiencies. The intent of these analyses is to quickly determine the current state and trend of a target’s profits, as well as to pinpoint those customers and costs that are associated with the majority of profits and losses. The main analyses are as follows:

Review a trend line of revenues
Review a trend line of bad debt expense
Review a trend line of sales discounts
Review a trend line of direct costs
Review a trend line of gross margins
Ascertain the gross profit by product
Review a trend line of overhead personnel per major customer
Review a trend line of overhead personnel per transaction
Look for delayed expenses

Acquisition Analysis – Cash Flow

The analysis of a target’s historical and projected cash flows is of major importance, since the buyer must know if the purchase transaction will result in a new source or use of corporate cash. The key cash flow analyses to focus on are as follows:

Review trend line of net cash flow before debt and interest payments
Review trend line of working capital
Segment working capital investment by customer and product
Review trend line of capital purchases

Acquisition Analysis - Customers

Some buyers focus only on the existence of a sales history and outstanding receivables, without conducting any significant investigation of the underlying customer base. This is a serious mistake, since some types of customers may not yield continuing revenues once the acquisition has been completed. Here are some issues to investigate:

Concentration analysis
Customer markets
Customer relationship duration
Maintenance revenues
Customer complaints
Personal relationships
Profitability analysis
Customer contracts

In essence, the best scenario is to have a broadly distributed group of customers with a long history of purchases from the target, who appear to be well taken care of, and are not especially price sensitive.

Acquisition Analysis – Product Development

In industries where competition is based primarily on innovation, the true driver of profitability is the target’s product development process. It requires a special skill set to evaluate a target’s development efforts, so the due diligence tram should bring in the buyer’s product development manager or an outside specialist to conduct an investigation. Some of the key items to investigate are:

Product pipeline
Hanging products
Key development personnel
Incremental product launches
Funding
Product flaws
Development plan
Target costing

In short, the buyer is looking for a few key success factors when reviewing a target’s product development efforts: an ongoing funding commitment, a development strategy, a strong team to carry out that strategy, and a record of consistently bringing new products to market in a timely manner and within budget.

Acquisition Analysis – Production Process

In industries where competition is based primarily on cost, a strong driver of profitability is the target’s production process. If so, the due diligence team should spend a considerable amount of time here, delving into the following issues:

Work flow
Throughput philosophy
Industrial engineering
Engineering change orders
Safety
Shipping delays
Cost estimating procedures
Pricing procedures

The review of a production system will very likely yield a number of problem areas. However, this is not necessarily bad, and should certainly not be grounds for terminating an acquisition. On the contrary, the buyer may be able to achieve massive profit improvements in the production area. If anything, the presence of significant problems in the production area may be the key determining factor in deciding to acquire a target.

Acquisition Analysis – Information Technology

The information technology (IT) systems of a target company are likely to play a pivotal role in its operations, so they represent a significant risk that bears in-depth investigation. Given the complexity of IT systems and the time required to properly evaluate them, IT due diligence will likely span the entire length of the due diligence effort.

Many smaller buyers do not have sufficient IT expertise to properly evaluate the systems of a target company. An unusual result, and a common one, is for them to ignore the target’s IT systems entirely, and deal with them after the deal is closed. This introduces significant risks, since the buyer will be completely unaware of the real state of the target’s IT systems, which may be at the point of failure.

The best alternative is to bring in an IT consulting firm to conduct a complete review of the target’s IT infrastructure, software applications, network, policies, and procedures. This review can be extremely expensive, since it must be completed on a rush basis and requires the services of high-end IT experts. However, it can mitigate a considerable amount of risk.

Once the due diligence is complete, it may also make sense to retain the consulting firm to assist in integrating the target’s systems into those of the buyer. There is some efficiency to be gained by doing so, since they are already familiar with the target’s systems.

Acquisition Analysis – Legal Issues

There are a wide array of legal issues that the buyer must review. In most cases, the analysis issues noted here are related to various kinds of contracts. When these arise, a key analysis point is to see if they can be dissolved in the event of a corporate change of control. Key legal reviews are as follows:

Articles of incorporation and bylaws
Board minutes
Certificate of incorporation, including name changes
Certificate of good standing
Employment contracts
Engineering reports
Environmental exposure
Expiring contracts
Insurance policies
Labor union agreements
Leases
Licenses
Liens
Litigation
Marketing materials
Pension plans
Product warranty agreements
Related party transactions
Sponsorship agreements
Supplier or customer contracts
Trade secrets

Acquisition Analysis - Forecasts

It is extremely unwise for a buyer to evaluate a target company based solely on a forecast provided to it regarding future results. Any target company attempting to maximize its valuation will dream up every possible revenue increase for the next year, which inevitably yields a “hockey stick” jump in revenues. Needless to say, these gains rarely materialize.

However, the due diligence team should make some estimation of what the target’s results may be over the next few years, and the target’s forecasts are at least a starting point for making this determination. To do so, the due diligence team needs some investigative tools to verify how the forecasts were constructed. Here are some useful tips:

Backup for revenue changes
Capacity changes
Competitive reactions
Estimate participation
Working capital

Of the greatest importance in evaluating a forecast is the target’s historical ability to meet forecasts. If it has set unrealistic expectations in the past and failed, then the due diligence team should rightfully assume that the target will fail again with the current forecast.

Acquisition Analysis – Missing Information

In a hostile takeover attempt, the target company may be quite diligent in blocking attempts at obtaining information about it. This results in a significant loss of information, so that the buyer cannot complete a full analysis of the situation. If so, it is very useful to make a list of what information has not been obtained, and what the risk may be of not obtaining it. For example, if there is no information available about a company’s gross margin, then there is a risk of making too large an offer for a company that does not have the margins to support the price. Once all these risks are assembled into a list, determine the level of risk the company is willing to bear by not having the information, or in deciding to invest the time and money to obtain it. This will be an iterative process, as the number of open questions gradually decreases, and the cost and time needed to find the answers to the remaining questions goes up. At some point, the buyer will decide that enough information is available to proceed with making an offer, or that the risk is too great to do so.

Acquisition Analysis - Complexity

The primary objective of complexity analysis is to determine if it will be too difficult to integrate a target company, with a secondary objective of determining the level of risk posed by its general level of complexity.

One area to consider is the sources of the target’s revenue. The level of complexity and risk is increased when revenue is derived from multiple businesses, since the buyer must devote additional levels of management resources to each of those businesses. Complexity and risk also increase when a significant percentage of revenue is derived from a small number of large transactions that are custom-tailored to individual customers. These transactions tend to be highly volatile in their amount and frequency, making it difficult to estimate future revenue levels and attendant cash flows.

The tax rate can also contribute to complexity and risk. This is especially true if the target company has located its headquarters in a tax haven, since this indicates a strong interest in tax avoidance that has likely led to the use of a variety of complicated tax avoidance schemes. A further indicator of tax complexity is a substantial difference between the reported level of book and tax income. Finally, a volatile effective tax rate indicates that the target company is engaged in a variety of one-time tax dodges. While all of these issues may be caused by completely legal transactions, it clearly indicates that the company has altered its operations in a variety of ways to take maximum advantage of the tax laws, and this will require considerable ongoing effort to maintain.

Another indicator of complexity is the presence of off-balance sheet assets and liabilities, such as variable-interest entities, research and development partnerships, and operating leases. While the intent of these transactions may have little to do with dressing up the balance sheet and may be based on solid operational reasons, they are still more likely to cause sudden changes in the reported condition of the company if underlying accounting rules are altered to require their full presentation.

Acquisition Analysis – Red Flags

When conducting a due diligence review, the review team will inevitably find some items that will be of concern to the buyer. However, some concerns are more significant than others, and are indicative of a lax control environment that may pose major risks to the buyer. Some of the most important issues are as follows:

Auditor resignation
Change in accounting methods
Complex business arrangements
Covenant problems
Criminal records
Insider stock sales
Internal audit scope restrictions
Minimal operational reports
Month-end shipping surge
Non-standard accounting practices
Previous failed sale attempts
Regulatory warnings
Reserve changes

The presence of red flags in one or two of these areas may not be cause of overwhelming concern. However, if problems crop up in many areas, the due diligence manager should consider a strongly-worded recommendation to walk away from the deal. This may call for a detailed analysis of the reasons behind the recommendation, since the buyer may have already agreed to a breakup fee that requires it to pay the seller if it backs out of the purchase transaction.

Acquisition Analysis - Summary

The purpose of due diligence is to give the buyer some degree of exposure to the target company’s operations, and to thereby gain an understanding of the risks to which it will be exposed. Based on this information, the buyer will also likely adjust the proposed purchase price based on any excessive risks it may find, or at least attempt to shift some risks to the buyer. Further, the buyer may uncover possible synergies that it was not previously aware of, and which may increase its enthusiasm for the deal. For these reasons, due diligence is an absolutely mandatory part of the acquisition process. Though there is usually a tight timeline within which due diligence is conducted, the buyer should be willing to expand that timeline to ensure that all required review activities are completed to the satisfaction of the due diligence team. Only after the buyer has thoroughly investigated all key areas of concern should it proceed to the next step in the acquisition process, which is the purchase agreement.