Acquiring a new business entity is a major strategic decision for prospective buyers. It is one of those decisions in business where mistakes can be costly and detrimental to the future of the buyer company. This is why thoroughly evaluating a business before making an offer or closing a deal is not just a best practice; it’s an absolute necessity for successful business acquisitions.
But what does effective evaluation look like? Is looking at financial statements enough to evaluate a business for acquisition? What are the risks involved if an acquisition goes wrong? How do you assess the future business growth of the target company you want to acquire?
While seasoned investment professionals are not immune to making wrong acquisition decisions, these mistakes are more amplified if you are a business owner planning to take the inorganic growth route via M&A for the first time.
Some of the most common acquisition pitfalls that buyers face include overpaying for the target company, errors in forecasting future earnings and growth prospects of the target, overestimating synergy opportunities, and lack of cultural fit.
In this comprehensive guide, we use our real-world deal-making insights to help you understand how to properly evaluate a business for acquisition and decide whether the target company is the right fit for your business growth. We then take a glance at different methods to come up with a valuation if you decide to submit an offer and go ahead with the deal.
Table of Contents
- Should I make an acquisition offer?
- How to value the company?
- Which business valuation method to use?
- What factors determine the value of a company?
Two Aspects of Evaluating a Potential Business Acquisition
When evaluating a business for acquisition, you need to assess two key aspects:
- Financial evaluation (i.e., quantitative)
- Non-financial evaluation (i.e., qualitative)
Buyers are often so fixated on the target company’s financial performance that they forget the importance of non-financial factors such as the company culture, management background, and other vital qualitative factors that need to be analyzed for a successful acquisition.
In fact, we recommend buyers apply the same rigor to qualitative aspects as they do to quantitative when they are planning a deal.
Determine if the Acquisition is the Right Business Fit
If you are looking at potential business acquisition opportunities, we assume that you, as a buyer, already have your acquisition objectives and strategies jotted down. If not, this is the first thing you need to do.
Knowing why you want to acquire a business and what strategic objectives you want to achieve through M&A makes it easier to assess whether or not a potential target company is a good fit for your business.
Some questions that should be answered while evaluating the business and strategic fit of the target:
- Does the target company align with our long-term strategic goals and objectives?
- How does this acquisition fit into our overall business strategy? Do I understand the business model?
- What synergies can be achieved by integrating the target business into our operations?
Analyze Financial Results and Growth Expectations of the Business
It is not uncommon for a deal to be derailed or called off if the target company’s financial performance or growth forecasts do not meet the buyer’s expectations. Hence, giving special attention to financial due diligence is crucial to making well-informed acquisition decisions.
You should look at the target company’s financial records, aiming to validate the figures presented by the seller and uncover any discrepancies or red flags.
In particular, when doing the financial due diligence of the target company, typically analyzed metrics include:
- Historical sales growth: Is it growing, flat, or declining?
- Operating margins: How are margins performing? Can they be improved?
- EBITDA growth and margin: Crucial for profitability and debt-servicing analysis
- Growth forecast: This should be provided by the target company for at least the next two years with justifiable reasoning for the numbers and future profits (net income)
- Revenue concentration: Does a small number of customers constitute most of the revenue?
- Revenue Segmentation: If the target company has multiple products and services, how much revenue is being contributed by each segment?
- Total assets: Are the company’s assets on the balance sheet for business use only? In business terms, we say, “Is the balance sheet clean?” Founders may record their personal estate and other assets on the company’s balance sheet. This needs to be accounted for and adjusted for.
The process of detailed financial due diligence only starts after you have signed a confidentiality agreement (NDA) with the target company and submitted a term sheet (i.e., non-binding offer) to access such information from the seller to complete your evaluation.
How to Evaluate an M&A Term Sheet
Evaluating the Legal Business Structure of the Target Company
Undersanding the legal structure of the target company is when many skeletons come out of the closet. Typical legal structures, from lowest to highest simplicity, include:
- Multi-national conglomerates with subsidiaries and joint ventures
- Limited liability companies (LLCs)
- Joint stock companies (JSCs)
- Sole proprietorship
Legal structures tend to get highly sophisticated as companies grow bigger. A complex legal structure involving subsidiaries, joint ventures, or intricate ownership hierarchies adds complexity to the assessment process.
Family-owned businesses often have a complex ownership structure that must be evaluated thoroughly before proceeding further in your business acquisition journey.
Some questions that should be answered while evaluating the legal business structure of the target:
- What is the legal business structure of the target?
- Who are the primary shareholders, and what is the ownership distribution?
- Are there any restrictions on share transfers or changes in ownership?
- Are there any agreements among the founders regarding decision-making, equity vesting, or exit strategies?
Do Your Homework on the Management Team
The leadership team’s vision and effectiveness can profoundly influence the success of a business acquisition. Conducting background checks on the management team is a must-do activity for buyers. It can be a simple background check where you search for their LinkedIn account or do a quick Google search for their name to see what comes up.
While this part does not need a detailed report, sometimes, a quick search isn’t enough, and you will have to dive deeper to convince yourself about the competencies of the company’s management team.
Some questions that should be answered while evaluating the target’s management team:
- What is the past experience of the management team, and is it related to what they do now?
- How long have they been working with the target company? What is the average tenure of management?
- What are the management’s strategic goals and track record of delivering on them? Do they have a business plan for the upcoming months?
- What are the reporting relationships at the top level of management? Who reports to whom?
- Are there any past legal or ethical issues related to top leadership members?
Think About the Cultural Fit of the Target
A cultural clash and misfit with the target company is the last thing you want as a buyer. After spending weeks or sometimes even months evaluating a business acquisition opportunity, it is time wasted if the two companies’ cultures don’t fit.
A cultural clash between the buyer and the target company can disrupt workflows, demotivate employees, and erode the foundation upon which the deal was built.
One of the most notable examples of a failed acquisition due to cultural clash is the merger of Daimler-Benz and Chrysler in 1998. The companies had a contrast between the structured, hierarchical German culture and the informal, agile American approach, which led to a difficult collaboration and eventual separation.
You can ensure there is a cultural fit with the business by evaluating the HR policies of the target company, reviewing bonuses and other incentives for employees, understanding the employee attrition rate, conducting an employee morale survey, doing site visits, and even observing the dress code, communication styles, and surroundings at the company’s office when you go for a visit.
Some questions that should be answered while evaluating the cultural fit with the target:
- What is the leadership style of the top executives of the target company, and is it different from your company?
- Is there a culture of transparency and open dialogue?
- What is the company’s approach to employee learning and development? Are there opportunities for continuous education and skill enhancement?
- Are there strong interpersonal relationships among employees?
- How does the company support work-life balance? Are there initiatives or programs in place to promote employee well-being?
- Are there employee recognition programs in place? What is the employee attrition rate in the firm?
Evaluate the IT Infrastructure of the Business
Operational efficiency is largely a byproduct of the type of IT infrastructure that is being used in a company. While evaluating a business for acquisition, you need to understand its IT systems and how crucial they are to the business’s day-to-day operations. For a technology company, the IT infrastructure will be an indispensable part of the business, and any disruption will cause the business to come to a halt.
Some questions that should be answered while evaluating the IT infrastructure of the target:
- What is the current technology stack, including software, hardware, and databases?
- What cybersecurity measures are implemented to protect sensitive data and customer information?
- How is ongoing technical support and system maintenance managed?
- What intangible assets does the company own? Examples could be patents, trademarks, or copyrights, and are they up-to-date? Is there any past or ongoing IP-related litigations or disputes?
IT Services Valuation Multiples: 2015-2023
Know the Risks Involved
We advise buyers to perform a SWOT analysis (Strengths, Weaknesses, Opportunities, Threats) of the target company to understand what they are getting into clearly.
- Are there contingent liabilities that might surface after the deal closes? Do you have indemnity against such liabilities?
- Are business assets pledged for loans or mortgages?
- Is there risk involved related to key employees? What retention strategies are in place for key employees, and how will the acquisition impact the existing workforce?
- How will the acquisition affect the brand and reputation of the merged entity?
After you complete evaluating the business from a financial and non-financial lens, it is finally time for you to make a decision. This decision usually comes in the form of “How much am I willing to pay for this business, and should I make an acquisition offer or not?”
Should I make an acquisition offer or not?
Deciding whether to make an acquisition offer comes down to how confident you feel after completing the evaluation.
Making an offer is a good idea if you believe the acquisition will boost your business and if everything checks out during your evaluation.
However, it is better to walk away from the deal if you discover serious issues or hidden problems in the target company during your evaluation.
How to Value the Target Company for Acquisition?
Business valuations can be tricky and subjective, so we will now help you understand how to value the target company by answering the most common questions people face.
Which business valuation method should I use?
You need to decide from three commonly used business valuation methods to value the target company.
The income-based approach is also known as Discounted Cash Flow (DCF). It is the most sophisticated company valuation technique, mainly when the target company generates consistent cash flow. In the discounted cash flow method, the future cash flow is projected over a specific period, and the terminal value is calculated beyond the forecasted period and then discounted back to the present value.
If you choose to use the market-based approach, you have to look at similar public companies in the industry and find their valuation using multiples like EV/EBITDA or P/E. This approach is notably used in retail, consumer goods, and business services.
If you are looking to acquire a business in the manufacturing, construction, or real estate industry, such a business would likely have a lot of fixed tangible assets. This is when you can employ the asset-based valuation process to find the business’s value. You have to calculate the difference between the fair market value of a company’s assets and its liabilities.
How to Value a Private Company
What factors determine the value of a company?
There are various factors that influence the valuation of a business. The most common factors are:
- Revenue and Profitability: These are the fundamental indicators of a company’s financial health and performance. All valuation models are built on past, current, and expected future earnings.
- Cash flow: This is a vital factor in deciding the value of a business. Strong positive cash flow shows that a business can meet its financial obligations, invest in growth, and generate profits.
- Growth potential: Companies with a clear and scalable growth strategy, innovative products/services, or access to new markets are often valued higher due to their potential for increased revenue and profitability
- Market conditions: Understanding these factors is crucial for accurate valuation, as they provide insights into the business’s position relative to similar companies and the opportunities and challenges it might face in the future, thereby affecting the value of a business.
What is the final purchase price I should pay for the business?
While the valuation serves as a benchmark and a starting point for negotiations, the final price is the result of those negotiations and may differ from the initial valuation.
Both parties aim to find a mutually agreeable price that reflects the target company’s perceived value and the acquisition’s strategic benefits. Often, the purchase price is the market value of equity.
About Aventis Advisors
Aventis Advisors is an M&A advisor focusing on technology and growth companies. We believe the world would be better off with fewer (but better quality) M&A deals done at the right moment for the company and its owners. Our goal is to provide insight-driven advice, clearly laying out all the options for our clients – including the one to keep the status quo.
Get in touch with us to discuss how much your business could be worth and how the process looks.
Tell us about what you want to achieve; we can support you from start to close on your M&A journey.