Analyze an Acquisition

If you are considering buying a business, then you need to carefully analyze the risks and potential benefits of the acquisition. In particular, you should closely study the target company’s finances, assets, and liabilities. Try to find a business that has a reasonable price tag and isn’t saddled with debt or lawsuits. You should also analyze how the acquisition will benefit your business.

Steps

Checking the Target’s Finances

1. Ask for audited financial statements. The target should be willing to hand over audited financial statements for the past five years. If the company is publicly traded, it should file financial statements with the Securities and Exchange Commission (SEC). They file 10-K statements each year and 10-Q statements quarterly, which you can obtain online at the EDGAR website.
   • If the company is private, you still want their audited financial statements.
   • You’ll want to use five years’ worth of statements to create a trend line comparison. This allows you to see whether the company’s finances are improving or deteriorating.
   • The financial statements should also include a cash flow analysis. This report shows the sources of cash and why it is used.
2. Check if you can Read an Annual Report. Confusing financial statements are a red flag. You should probably avoid buying a target whose statements you can’t understand. Instead, look for clean and clear financial statements.
   • You might need help reading the financial statements. If so, you should hire an accountant.
   • You can find an accountant by asking another business or contacting your state’s accounting society and asking for a referral.
3. Ask whether the company has been up for sale before. If it has, you’ll want to know about these earlier sales efforts. Ask the target why the sale fell through.
   • It’s also a good idea to ask why they are selling in the first place. For example, the owners might want to start a new business in a different industry, or they may want to retire. Those are good reasons.
   • However, the business might be losing money. If so, then the owners could be trying to get out before going bankrupt. You’ll want to avoid a company that’s losing money unless you know how to turn things around.
4. Research a public company’s purchase price. If the company is publicly traded, you can find this information on the stock exchange. This is the amount it costs to buy a share of the company. If you want to buy all of the shares, multiply the total number of shares by the share price. If you want to buy only a majority stake, then multiply a majority of shares by the share price.
   • However, you should assess whether you think the market is over- or under-valuing the company based on your analysis of its financials and other fundamentals.
   • Also check the share price over time and consider whether the share price has been recently inflated. It’s not unusual for a target to try and inflate the price when it anticipates being bought.
5. Ask a private company for its purchase price. If you are buying a private company, then there is no purchase price on the market. Instead, the purchase price will be whatever the owners want to sell for, so be sure to ask.
   • You’ll still need to analyze the price based on the company’s assets and liabilities, which is discussed below.

Analyzing a Target’s Assets

1. Value the target company’s fixed assets. The company will record the net book value for fixed assets in its accounting records. However, you’ll need to value what these assets are worth on the open market. Try to estimate their value by checking how much comparable assets have recent sold for. Fixed assets include the following:
   • buildings
   • land
   • furniture
   • computer equipment and software
   • vehicles
   • machinery or other equipment
2. Study the company’s accounts receivable. Accounts receivable are the amount the target company can collect from another business because it sold them goods or services on credit. You’ll want to see how much your target can collect. Also analyze how successful it has been collecting on accounts payable.
   • Request an “aging” report. Many clients don’t pay their bills when due. You should check to see if there are any accounts receivable that are long overdue. If so, try to find out why.
3. Don’t forget about intellectual property (IP). Even smaller companies might have IP that is worth a considerable sum. Intellectual property includes things like patents, trademarks, copyrights, trade secrets, and any income from licensing IP.
   • Also check whether the target licenses intellectual property from a third party. For example, the target might pay for the right to use another company’s patent. If so, you’ll want to see copies of the licensing agreements.

Studying the Target’s Liabilities

1. Request information on employees. Employee salaries make up a large fraction of a company’s costs. You should request information from the target about the following:
   • List of key employees.
   • Total compensation paid to employees.
   • Explanation of employee benefits. Benefits make up a large percentage of total compensation.
   • Copies of employment contracts, if any. Check if the contract provides for severance packages if you lay off any employees.
   • Pay history. Check to see how much the company has generally given in raises each year. The current employees will probably expect a comparable amount once you buy the target.
2. Analyze the target company’s debt. You should calculate the company’s debt-to-equity ratio. This is the amount of debt divided by the amount of shareholder equity. If the company has a high debt load, you might not want to acquire it.
   • A healthy debt-to-equity ratio will depend on the industry, so research what is typical. For example, technology companies with a lot of research and development have ratios of 2 or lower. However, in the financial industry, ratios can be 10 or higher.
   • Also check the interest rates on the company’s loans. The company might have a moderate debt load but at a high interest rate. If you buy the company, you can refinance the debt for a lower rate and save money. This type of company is an attractive target.
   • Some debt agreements contain a clause that accelerates debt repayment when a business is sold. Check all debt agreements for these clauses.
3. Analyze the target’s accounts payable. Accounts payable are the amount the target company owes other businesses for buying goods or services on credit. For example, a company might owe its suppliers for two months of supplies.
   • Check that the target pays its accounts payable in a timely fashion. If not, try to identify why. Is it experiencing a cash flow problem?
4. Collect information on contractual obligations. A target company might have signed contracts for materials, supplies, or commercial space. Make sure you get a copy of each and fully understand the terms of the company’s obligations.
   • Also consider whether you can negotiate a better deal with the third party. If so, then the target company might be an attractive option.
5. Investigate whether the company is being sued. It’s normal for large companies to be sued. However, your target shouldn’t have more lawsuits than is typical for a company of its size in its particular industry.
   • The company should disclose its pending or anticipated lawsuits. Also ask for information about any lawsuit within the past five years. If the suits settled, then ask to see copies of the settlement agreements.
   • You can find information about lawsuits by searching online. Also check with your state’s Attorney General’s office.
6. Identify any potential environmental issues. Environmental costs can be much larger than you anticipated. Accordingly, you’ll want to perform an environmental review of the target business. Consider the following:
   • The company’s environmental permits and licenses.
   • Any correspondence with regulatory environmental agencies.
   • The hazardous substances the company uses in its daily operations, e.g., petroleum or asbestos.
   • Environmental lawsuits or investigations.
7. Review the company’s taxes. You’ll want to confirm that the target company is paying its taxes. Make sure to double check the calculations to confirm the company has paid the correct amount over the past few years.
   • Also look for suspicious business deductions. A business deduction should be ordinary and necessary for a business of its type.
   • Business deductions shouldn’t be too large for the business, either. For example, a mom-and-pop business shouldn’t be deducting jet travel expenses for meeting with suppliers one state away.

Identifying Benefits to Your Own Business

1. Analyze the strategic fit. You shouldn’t buy a company just because you’re bored. Instead, you want the acquisition of the target business to benefit your own business. You should consider how it will fit into your larger organization.
   • Have you done business with the target before? If so, you should have a good idea of how the target’s business benefits you.
   • Does the target provide services or goods you need? If so, you can get those goods and services cheaper by buying the company.
   • Does the target company have a good reputation? How is it viewed by the marketplace? Does the target’s brand perception align with yours?
2. Consider the complexity of integrating the companies. Some businesses can be folded seamlessly into your own. However, integration might be more complex. For example, you might not be located near each other geographically, or you might have very different supply chains.
   • Do some research on the target’s organizational culture. A company with a culture that values trust and recognition could be a great acquisition. However, a company with a cutthroat culture might not. Make sure each company’s cultural values align.
   • Try to estimate the costs of integration. If the costs are prohibitive, then you might not want to go ahead with the acquisition.
3. Estimate the increase in your revenue. Ideally, your revenue will be enhanced by the acquisition. Try to project how much you can expect revenue to increase or decrease. Use your accountant if necessary to help you with these projections.
4. Check the legality of the merger. Federal antitrust laws prohibit some mergers. You should meet with legal counsel to discuss any issues that might arise if you choose to buy the target company. Also talk about regulatory issues with your lawyer.
   • You may have to draft certain filings, depending on your business, if you need approval from the Department of Justice or Federal Trade Commission. You should begin talking about these requirements early with your lawyer.
5. Identify how you will pay for the purchase. You might buy the company with excess cash, shares, or with debt. If you are taking on debt, then you need to analyze how the additional debt will affect your company.
   • You also might buy only a majority stake in the target company. If so, then the minority interest is entered as a liability on your balance sheet.
   • Also consider how you feel about having minority stakeholders. They will still have rights, such as the right to inspect the books and to vote.

Tips

• You will probably have to sign a confidentiality agreement before the target company hands over information about finances, assets, and liabilities. Read this agreement with your lawyer so that you fully understand your obligations. You can be sued if you violate it.

Related Articles

• Make Acquisitions in a Down Economy
• Write an Acquisition Proposal
• Become a Mergers and Acquisitions Lawyer
• Account for Negative Goodwill
• Finance a Business Purchase
• Form a Board of Directors
• Use Investment Banking

Sources and Citations

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