Frequently Asked Questions About Acquiring a Company
How do we identify potential acquisitions?
50% of buyers find a suitable business to buy from a referral or through an intermediary. 25% find a business through a web search or newspaper ad.
Identifying an appropriate acquisition can be very time consuming: 50% of buyers spend between 10 to 20 hours a week searching for 6 months to a year to find a suitable business. About 30% are able to locate one in less than 6 months usually by spending more than 20 hours a week on the acquisition process.
What should we expect from the initial discussions with prospective targets?
Opening up discussions with potential targets takes time. You’re likely speaking with a possible competitor and a certain level of trust and credibility must be established before they are prepared to open up to you.
In fact, a thorough acquisition search means that the majority of companies that you approach are not “for sale” – but might be. That’s why companies who are serious about growing through acquisitions will often work with outside professionals whose credentials lend credibility to you and the your process.
Once you have the trust of your target acquisition, a legal document know as a Non-Disclosure Agreement will be signed by you and the target company – this agreement gives the target company the comfort level they need to provide you with their financial information. At this stage the amount of financial information provided varies widely. We find that many SMEs are surprisingly open to providing full historical financial information, while others provide only high level numbers and wait to see what a potential deal could look like before providing more detailed disclosure.
Until a Letter of Intent is signed, which outlines the key points of the deal, don’t expect to get specific information such as individual customers, suppliers, product mix or SKU profitability. You should be able to get enough information to decide if you’re interested in proceeding to the next level while providing very broad and non-committal parameters of a deal.
How do we figure out what the target company is worth?
This is where you may need some outside professional help.
It’s not just a question of what is the target company’s worth – it’s also a question of how the deal is to be structured, that is to say, how much cash is given to the owner at the closing and what is the amount, and the nature, of payments made to the owner afterwards.
Typically, companies are valued based on the expected cash flows that the company will generate in the future. To do this, the company’s historical performance is used as an indicator of future performance. So that’s why you’ll hear that a company was valued at, say, a 4 or 5 times multiple – meaning it was valued at 4 to 5 times the company’s current annual cash flows or EBITDA (earnings before Interest, Taxes, Depreciation and Amortization).
But you will also need to know what your incremental EBITDA will be when you acquire the target company. This requires understanding the synergies (cost savings and / or enhanced margins derived from a stronger purchasing position) that occur when bringing your two organizations together. Many people say that you should never “pay for synergies”. However in some cases these synergies are so compelling that you might decide to pay more than would a buyer who didn’t have these synergies.
Will we have to pay 100% cash on the closing?
Not necessarily, particularly when buying smaller private companies. Acquiring companies in the SME market has its unique challenges, including large “valuation gaps” (the difference between what you are prepared to pay at closing and what the seller thinks their company is worth), and the risk that the owner is possibly the key ingredient to the success of their company.
A significant “valuation gap” can be dealt with by agreeing to future additional payments to the seller should certain milestones be met such as meeting certain sales levels. Vendor financing can be structured in a manner that’s appealing to the seller which can often bridge the “valuation” gap. Other forms of capital also exist, as discussed in How do we finance the acquisition?, that could provide the necessary cash at closing.
In structuring any transaction, your need to ensure that, post-acquisition, your relationship with your banker won’t be harmed if your acquisition does not go 100% as planned. This means not relying too heavily on the bank to fund the initial cash payment to the seller at closing.
How do we finance the acquisition?
The “value” of the deal is different than the amount of cash that is paid to the owner when the deal closes. Deals are financed by a combination of the following sources:
- Traditional banks
- Subordinated debt
- Payments to the Seller post-closing
- Private Equity
Traditional banks: If you already have a banking relationship you should first turn to your banker for financing. You’ll present your banker a scenario that shows what your company will be like once you’ve acquired, and integrated, your acquisition. Your bank will then make their decision on how much to lend you for this acquisition based on the combined companies pro forma balance sheet security and cash flows.
Subordinated debt: Subordinated debt, sometimes called mezzanine debt, is a loan that has no tangible asset security and relies solely on the strength of the company’s future cash flows. It ranks behind the bank, so is “subordinated” to the bank’s first claim on the assets and cash flows of the company. Interest rates range as high as 18% and are normally tax deductible. This may appear to be very expensive debt but should be looked at as cheap equity.
Payments to the Seller post-closing: This is where creativity comes into play when structuring the deal. These payments bridge the gap between what the owner wants for their business and what you want to pay at closing. These payments come in the form of a vendor note (VTB), royalty payments, performance related payments, or minority equity interest in your company.
Private Equity: Private equity (PE) can come from PE Funds, Crown Corporations, and private individuals. These investors are you “partners”, not your bankers. And they each have their unique cultures and methods of dealing with you. They typically look at exiting their investments within 5 years and look for Internal Rates of Return of 30%+.
Regardless of who your financial partners are, you need to do your “due diligence” on them. These will be your “partners” for a long time so getting the right fit – working with people who you like and respect and who are experienced in helping private companies grow – is very important for the future success of your company.
How long it will take?
Some of the best deals are the ones that take the longest to do. Why? Because most sellers want 100% cash at closing while you want to get them to provide some vendor financing. Through spending time with them – creating a trusting bond, getting them to buy into your vision, and demonstrating that they could possibly make more money if they “stay in for bit” – can often result in a “win – win” deal for you and the target’s owner.
What will buying a company cost us in fees?
Beware of the hidden costs of an acquisition!!
It’s important to all know the costs that are associated with an acquisition. These can be quite significant, and must be factored into your decision to pursue any acquisitions, and include:
- Due diligence costs – accounting & others’ due diligence fees, appraisal reports, environmental reports
- Closing costs – lawyers’ fees, bankers’ fees, financial advisors’ fees
- Integration costs – severance costs, moving costs, new promotional costs (website, stationary), IT costs
But some of the most damaging costs are the ones you don’t reach into your pocket for at closing, including (i) the risk that your existing business suffers as you chase an acquisition or (ii) not properly integrating your acquisition and putting at risk both the company you’ve acquired as well as your own.
In Their Words
The MBO Group provided our members with excellent insights into opportunities for C-level executives to buy into smaller businesses as part of a transaction where management buys out the owner of a private business or buys a division of a larger company; takes the business to the next level; and then exits generating a handsome return to the shareholders. [read full testimonial]
Phoenix Executive Network Member