Profits and pitfalls - what you need to know about business acquisition

Article Type: General

Provided By Abu Dhabi Commercial Bank (ADCB), Strategic Partner for the SME Knowledge UAE


Buying a business can be a powerfully effective strategy for strengthening your market position, bringing a competitor ‘on-side’ and building scale and critical mass. Yet it can also be an expensive undertaking, with wasteful trial runs, legal costs and a good deal of time-consuming detail. Here is our guide to the pros and cons of becoming an acquisition specialist in the SME space…

 

Undoubtedly at the beginning of 2013, you were determined to increase sales and operating margins. So you considered - and perhaps implemented – a strategic plan. It may have included ideas such as expanding into new territories, innovating or adding to your products and services, or expanding your team to facilitate better service to your market segment.

Yet of course there is another option that you may not have considered. There is a powerful way to potentially do all three of these things at once; buying another business that complements your own.

Buying a business can be a great opportunity to strengthen your market position, diversify into new markets and accelerate growth. But it can also be a high-risk step, investing substantial amounts of money into a business that could produce any number of hidden surprises. There are really three key steps to keep uppermost in mind before embarking on the acquisitions trail:

• Find out as much as you can about the business you want to buy

• Be sure to protect yourself against the main risks

• Convince the vendor to sell it to you for a good price

Yet all these conditions only apply if you’ve decided categorically that buying a business is the right next step. How do you decide if an acquisition is the right way to grow your business?

 

Sorry to be negative, but…

The path to acquisition can be long and hard. The end result may be disappointing too. According to the UK’s Federation of Small Businesses - the largest SME organization in the world, with more than 240,000 members – about 48 per cent of all acquisitions end in failure or resale within three years. Here’s a key point list of some of the major risk factors:

 

Buying a business takes time

Identifying a potential business to buy (or putting together a viable shortlist) and then evaluating to see if there is a good ’fit’ can take months. This will also require a quite different skillset from that needed to manage your own business, since you will need at least a basic knowledge of valuation techniques such as Multiple of Profits, Asset Valuation, Entry Valuation and Discounted Cash flow. Without doing the basic financial evaluation, you won’t be in a position to know if you can afford to make a positive move on the business, or whether you can achieve the level of borrowings it may involve.

 

• Does it make sense from a financial and strategic standpoint?

Will the potential financial gains be worthwhile? You will have to do a full profit forecast based on your understanding of the company’s performance (which will only be approximate at this stage, since no confidentiality agreements have been signed). Is the business proposition strong enough to enable you to manage increased debt with peace of mind? Does the company really represent a fresh market opportunity, or is it simply a bigger, better version of your own? In which case, it may be far more cost-effective to build your business organically, using this template as your guide.

 

Do you have enough cash?

A classic mistake by businesses on the acquisition trail is that they forget the mounting costs commanded by the professional services agencies who will assist in brokering the deal, including lawyers and accountants. This means that you’ll need a fair amount more than the sum needed to buy the business itself. Professional services fees can mount, especially if the deal is complex or entails any cross-border negotiations.

 

• Do you have a cultural ‘fit’?

The biggest single reason for the failure of an acquisition is not necessarily due to financial issues, but more generally as a consequence of cultural mismatch. This makes integration difficult, because the mindset and behavior of the staff are so different. Perhaps the business has a very different style of personnel from those you would employ in your company, there is not the same kind of nimble, ‘can-do’ culture, or starts mistreating the customers you’ve taken years to win over? Perhaps it simply has different values, and you did not audit those before you went ahead with the purchase? All of which means that in the fullness of time the acquired business is likely to be ‘dropped’ and spun-off again because it is simply more trouble than the gains in scale are worth.

 

So you want to go ahead?

The reality is that the acquisition path, while not for the faint-hearted, is one of the key routes to leveraging incremental growth in scale. Statistically, over 84 per cent of all Fortune 500 companies have made at least one acquisition in their commercial history. While the purchase of another business is in any case a very detailed process, it pays to approach it in a highly structured way, taking the following key steps:

 

• Research your target - align markets, affordability and values

Before making any offer to buy a business, you will need to undertake a considerable range of preliminary research. The more you know about the business and the market it operates in, the easier it will be to identify how it fits with your existing business, what the main weaknesses and risks are, and how much it is worth to you.

You will need to work with advisers to establish a valuation and plan your offer for the business you are acquiring. Advisory teams typically include an accountant, lawyer and corporate finance specialist. You may also find that your bank can offer a valuable ‘one-stop’ service, giving you access to SME finance professionals and working as part of your team throughout the approach, funding and acquisition steps.

The research process should include:

• A clear understanding of what you want the acquisition to achieve

• In-depth analysis of the target’s markets, and client base. What percentage of client relationships are bound by signed contract?

• A review of the target’s values, HR policies and ‘modus operandi’

• An investigation into the target’s reputation and standing in the sector - you want to buy a respected firm, not start firefighting the moment the deal is done

• A full approximate P&L analysis, costing in your repayments on any fresh borrowings that the acquisition has involved

 

• Assert your credibility

At the same time as gathering data on the target business, you will need to consolidate information on your own company, building as much credibility as possible (it’s no accident that larger, publicly-listed businesses employ a PR agency at this stage in the process). You will need to ensure that your audited accounts are available in presentable hard copy format, along with a full business plan giving a detailed vision of where you will take the new unified business. Establishing your credibility from the outset is important. The vendor may be reluctant to provide information unless they feel that you have a plan for taking their business forward and can access finance. At the same time, the more you can find out about the vendor’s position and objectives, the stronger your negotiating position will be.

 

• Heads of Terms agreement

Your initial offer will be based on factors such as:

• Your own forecasts, taking into account any cost savings you expect to make

• The vendor’s position

• Interest from other potential purchasers, and so on

Your formal offer sets out the key points of your purchase offer (subject to detailed negotiation) and why the vendor should find it attractive.

Once you have reached agreement in principle, both parties should sign a document called a ‘Heads of Terms’ agreement setting out the main terms. Ideally this should state an exclusivity period during which you can work to finalize the deal, without the vendor approaching other potential purchasers.

The Heads of Terms agreement sets out what you are offering to buy, for example, will you be buying the whole company or just certain assets? Buying assets can be an easier option (as you do not take on the company’s liabilities) if the vendor is willing to accept this. The agreement should also set out any key conditions such as whether the owner is expected to continue to run the business.

The agreement will spell out price and payment terms, for example, whether the price is tied to future profits and whether any part of the payment will be deferred or paid in shares rather than cash.

 

• Due diligence

Once you have signed the Heads of Terms agreement, you will be able to carry out detailed due diligence. This involves examining the business, talking to its customers and suppliers, and taking a close look at the financial records and outlook. At the same time, you will want to develop a comprehensive action plan that will be implemented once the business purchase is completed. This plan should be detailed and include items such as timings and phase-in events, to name but a few.

At this stage, your lawyer will need to make detailed checks on issues such as ownership of assets and potential liabilities. To help reduce the risks, the business purchase agreement will include extensive warranties from the vendor confirming information that you cannot independently verify. Your lawyer will also negotiate indemnities setting out any conditions when the vendor would be required to reimburse you.

Your advisers, such as your bank, will help you through what are often complex and stressful negotiations, continuing until the deal is completed.

 

• Part-purchase agreements

You may decide - perhaps as a result of the due diligence process - that while purchasing the whole business is not financially viable, you nonetheless want to purchase part of its product range or an aspect of its intellectual property. (For example, perhaps you are a publisher and want to take over the Science or Current Affairs publishing portfolio, but not the rest of the business; or you’re a software manufacturer and want to take exclusive rights to three of the prospect’s highly successful combat games). You should now undertake a separate research process, culminating in a new and revised Heads of Terms agreement. Note that this should specify a clear ‘switch-over’ date, so that there can be no misunderstandings amongst customers as to where the product-line is coming from - and similarly, no confusion over payments.

 

Smooth and steady – but aim high

It is vitally important that no aspect of the acquisition should disrupt the normal working patterns of either the vendor or purchaser, or that adverse rumors are allowed to circulate in the marketplace. Clearly, undermining the productivity and reputation of either business is hugely self-defeating, and a trusted professional advisor can play a key role in minimizing the risk of ‘stormy seas’ or any interruption in normal trading activities.

One final point: according to a 2010 report by ratings agency Standard & Poor’s - Global Trends in the Acquisition Landscape - a common mistake among businesses is that they aim too low when choosing an acquisition target. The result is a lot of time and trouble spent acquiring a company that simply can’t deliver the kind of quantum leap that first inspired the decision to buy. Stephen White, Standard & Poor’s Head of Markets & Companies, Asian Market Sector, comments that: “A larger target prospect can seem a more daunting goal, but in fact may not require significantly greater financing; a well-funded smaller business can therefore acquire a more diffuse, larger entity which may only require a modest overhaul and can leverage significant market share and advantage.”

 

 

This article is extracted from SME Advisor Middle East, issue 94, September 2013.

ADCB has partnered with SME Advisor to jointly inform, educate, empower and connect business decision-makers to advice that facilitates a positive business environment. Their aim is to help develop business best practice, and also encourage dialogue between the banking sector and SMEs.