In the first article in this series, we explored the fundamentals of making your first acquisition. We discovered the two phases of the acquisition process:
- Do the Right Deal
- Do the Deal Right
We also looked at why you would consider acquiring, and what planning was needed to make the deal a success.
In this article, we’re going to dive more deeply into the first of these phases - Doing the Right Deal.
This phase is about making the right decisions about the acquisition you are considering. Specifically:
- Picking the right target
- Preparing to engage
- Engaging with and understanding the target
- Shaping the deal
- Setting the right price for you to pay
Alongside this, you’ll also start to work on 'Doing the Deal Right' by beginning to plan for the integration of the business.
This time, we're going to focus on the first part of this process. We're going to look at how you find potential targets and how you assess them against being the "Right Deal" to do.
For simplicity, in these articles, we’re working on the assumption that this is not a competitive deal - you are the only one talking to the target company. Similarly, as we’re looking at this from the perspective of smaller companies with relatively simple ownership models, we’ll assume that the acquisition process is relatively friendly - no hostile takeovers!
Picking the right target
In the first of these articles, we described the Strategic Rationale - the reason that acquisition has been chosen as a strategic direction.
That Strategic Rationale is one of the key inputs into the choice of the acquisition target. It will help you to set the criteria you will use to identify potential candidates, screen them for consideration, and prioritise the ones you might pursue.
The Tartan Toffee Company has decided that it wants to diversify from its standard sticky business. They want to add new products to their line-up, but don't want to take the risk of building new facilities for new lines that they are not sure will succeed.
They've decided that the best option is to look at acquiring a direct or indirect competitor, though they are open to other options too if the right opportunity comes up.
You can think of this process as a funnel, where you may start with a large number of potential targets, and gradually whittle these down to a small number which meet your requirements:
The first step in this process is the identification of potential prospects - where do you find your potential targets? There are two potential sources:
- Internal Sourcing - Where you have identified potential targets yourself, e.g. through research, networking, industry knowledge, etc.
- External Sourcing - Where potential targets are presented to you by brokers, investment banks, private equity companies or companies looking to be acquired.
Both options are valid sources, and feed into your target filtering process. If acquisition is going to be a major part of your future growth plans, you can provide feedback to external sources of opportunities so that they are likely to bring you better prospects in the future.
As soon as you receive a possible target, you can put this through a screening process to decide whether it’s one you want to consider further. The screening process will apply a number of filters to the target.
These filters are largely determined by the strategic rationale.
If the target fails to meet any of the filter criteria, it is immediately discarded from the process. There is no sense in wasting time assessing it further if it does not meet your requirements. However, it can be worth keeping a note of the prospect and the filter results - you may change your criteria in the future or the prospect might become more attractive later.
The Tartan Toffee Company has identified four potential targets they are going to investigate:
- Scottish Shortbread Limited
- Pitlochry Porridge PLC
- Treat Tin Technology
- Edinburgh Tablet Limited
They have decided on three criteria that they will use to evaluate these deals:
- Strategic Alignment - Does the target line up with the criteria specified in the strategic Rationale?
- Required Investment - As The Tartan Toffee Company is a relatively small business, they don't want to have to invest more than £25,000 above the purchase price.
- Availability - Based on the available information, how open is the target to a potential acquisition, e.g. can an acquisition offer a better return to the owners than ongoing ownership?
This is the result of their analysis:
The Tartan Toffee Company will take Scottish Shortbread Limited and Edinburgh Tablet Limited through to the next phase of the acquisition process.
Those prospects that pass through the filter can be considered at the next level of scrutiny - prioritisation. This is a similar process to filtering, but with a different set of criteria, targeted more towards relative attractiveness of different targets.
This is still a relatively high level assessment, as you will have only limited, publicly available information to work with. However, as you and your team become more experienced with assessments and acquisitions, you will develop rules of thumb and guidelines you can trust.
Prioritisation criteria may include items such as:
- Availability - Indicates the extent to which the identified target has communicated its availability and interest in agreeing to an acquisition.
- Estimated Synergy Potential - The estimated amount of value that can be created as a result of combining the two companies (i.e. net value created as a combined entity that would not have been realised had the two companies operated separately).
- Strategic Value - The extent to which the proposed target is aligned to your strategic priorities, i.e. the drivers which resulted in the strategic rationale for the acquisition.
- Execution Risk - The estimated level of uncertainty related to realising the deal objectives and synergy targets. Considerations for assessing execution risks include deal size (initial estimates of valuation and affordability), financing availability, geographic footprint of the deal, culture compatibility, and number of employees to be integrated.
The Tartan Toffee Company now needs to consider the deals that have made it through the filter. By prioritising them they can decide which, if either, they will progress first. The other deal may be considered at a later date if it is more attractive than other strategic options.
Three prioritisation criteria have been identified, each with a score which matches the relative attractiveness. For this deal, they are not weighting the factors as each are judged to be equally important:
Based on this assessment, it's a close-run thing, but Scottish Shortbread Limited wins out narrowly in this case. They will go onto the next stage of deal assessment.
Once this second round of assessments has been carried out, you will have a better understanding of the relative attractiveness of your remaining prospects. You may want to apply a cut-off value against the prioritisation score - some may just not be that attractive, but may be worth considering later if other factors change.
It is always worth remembering that no deal MUST be done, and it is infinitely better to do no deal at all rather than a bad deal for the sake of it. You can expect that only 5% to 10% of the deals that enter your funnel will make it to this stage.
The target screening process is a continual exercise rather than a one-off activity, identifying potential targets for action now or in the future. Once prospects have been qualified, it is then time to move forward to the next step of engaging with the target.
In larger companies, this will usually involve a formal presentation for approval from a deal board. For the smaller business, it’s still worth having some formal approval to proceed that clearly shows the justification for engaging with the target. Being clear what you’re doing and why you’re doing it is never a bad thing!
Do you want to improve your deal pipeline process? RitchieHogg can find, assess and select your next deal.
Preparing to Engage
You will want to go into the next stage as prepared as possible, though without going overboard. As you haven’t yet engaged with the target, you are still limited to publicly available information. This might include:
- Companies House information on published accounts, shareholdings and directors.
- The company website and social media accounts, which may provide information on operations, pricing, customers, etc.
- Google for news stories and other interesting facts, such as customer complaints, problems and so on.
With this information, you can start to build up your deal profile:
- A preliminary and basic valuation model using revenue, profit and balance sheet information. We’ll look at initial valuations in a later article.
- Your viewpoint on value drivers and preliminary synergies. Take a look back at the strategic rationale and think how these objectives will be achieved, with the numbers you think can be delivered. It's good to have an outline business case which can be further updated during Due Diligence.
- A plan for how the acquisition will be financed - from cash-flow, loans, additional investment, partners, etc. You should consider the relative cost of each option, including opportunity cost.
- Initial thoughts on risks and issues, for example, you may have concerns about customer retention under new ownership.
As well as a written summary of these, you can use some other tools to provide a simple overview of the deal. These are particularly useful if you are working with partners or banks to provide financing for the deal.
We mentioned the Deal-on-a-Page in the first of these articles, and you now have some more information to flesh this out. Your initial assessment of the synergy projects and changes needed will help to provide some initial values against these:
You can start to picture the overall financial value of the deal with a Waterfall Diagram. This shows the financial inputs and outputs for the deal, so you can understand the end value to your business, and the value gap you need to overcome:
Once you are ready to proceed, you can take the next step - making contact with the target to gain a better understanding of them.
In the next article, we will delve further into this process - approaching the target, due diligence, making an offer and finalising the deal.