In Part 2 of this series, we started to look at how to Do the Right Deal - the process of identifying potential acquisition targets, and deciding which potential targets to pursue further:
In this article, we're going to take the next step - making contact with the target and the process of agreeing an deal.
Engaging with and Understanding the target
OK - now you’re ready to speak to the target company. Your goal here is to get all the information to make a formal offer for the business, which is both acceptable to them, and which lets you meet your Strategic Rationale goals.
Remember that right up until the end of this phase, you are not committed to anything. Once you gather more information about the target business, you may realise that they are not suitable to achieve your strategic rationale, and you may choose to withdraw from the deal.
There are three parts of this phase:
- Making initial contact with a confidentiality agreement
- Making a non-binding offer with a letter of intent
- Making a final binding offer once you have all the available information
Making Initial Contact
The objective for this phase is the ‘sound out’ the target. Are they open to be acquired, and do they have realistic expectations of how this may play out? You may want to position the offer as a merger to make it more palatable to the owners of the business, but as we discussed in the first of these articles, there’s really no such thing as a merger.
Only limited information will be shared by both parties at this stage, but a confidentiality or Non-Disclosure Agreement (NDA) should be put in place up-front. This will set the scene for the remainder of this phase and protect both companies from accidental or deliberate release of information.
An NDA is a relatively simple agreement, but should still be drafted by your legal advisor to ensure that it is reasonable and will hold-up if needed. The target will probably want their legal advisors to review it as well.
What sort of information will be shared at this point that needs to be protected?
- First, you may not want your approach to be public knowledge. This both shares your strategy with your competition, and may open the deal up to other bidders, potentially increasing the price. There’s nothing stopping the target using this as an opportunity to start shopping themselves around, but your details should remain secret until formally announced later in the deal.
- Secondly, you will want the target to share as much information as possible with you. They will only do this where they are comfortable that this will not be mis-used or protected. This will include information on financials, business structure, technology, customers, growth projections, strategy and plans, etc.
Clearly, the target will never share all the details about their business, so you will not be able to make an offer with all the information you would like. However, when the time comes to make a binding offer, you can protect yourself with warranties and guarantees from the seller, so that if they have lied in order to get a better price, you will be able to take action to recover some of the value of the deal.
- Finally, you will want to include provisions for what should happen with confidential information if the deal does not proceed. Any information shared should either be returned or destroyed. There should be protection for both parties in the event that confidential information shared is used for purposes that were not intended, e.g. to interfere with day-to-day business, such as using sensitive information on competitive bids.
If the target has indicated that they are willing to discuss being acquired, then you will be able to move to the next phase. If they are not, then it’s back to the drawing board and the next of the companies on your list of prospects.
Our example from Part 2, The Tartan Toffee Company, has decided to approach Scottish Shortbread Limited about a potential acquisition.
The legal advisor for The Tartan Toffee Company has modified their standard NDA to be specific for this deal. This is now taken by their Managing Director to the initial meeting with Scottish Shortbread Limited.
Scottish Shortbread Limited's directors are willing to consider the potential acquisition, so they sign the NDA enabling the next steps to proceed.
The Non-Binding Offer
For the smaller business, this phase might be quite quick. You can use the initial information that you prepared for your deal profile to build up the initial Non-Binding Offer that you will give to the target.
The Non-Binding Offer is the next level of detail from the initial conversations around willingness to sell. You will set out a Term Sheet, which details the ‘agreement to agree’ around the deal. This term sheet is not legally binding, but does set out the initial proposals and commitments on both parties to proceed with the deal. These might include:
- Transaction Structure, e.g. full purchase, majority share purchase, share swap, creation of a new entity, etc.
- Purchase Price - The initial valuation view, subject to finalisation through due diligence.
- Due Diligence - A commitment to participate in due diligence in good faith, sharing all information that can be reasonably requested about financials and the operation of the business.
- Confidentiality - Extending the term of the non-disclosure agreement
- Deal Exclusivity - Committing to engage only with you through ther duration of the negotations.
- Representations and Warranties - Commitments expected from the seller about accuracy of information, business risks such as outstanding litigation, intellectual property ownership, etc.
- Additional Conditions e.g. closure of key deals which have a material impact on the financials of the target business.
If the target agrees to the basics on the Term Sheet, then you can issue a Letter of Intent (LOI). The LOI will incorporate the details set-out in the term sheet, and may go into more detail on these. It will also set out some specific terms which will be legally binding such as a reiteration or further refinement of the NDA, and an agreement of exclusivity for a period of time.
Agreeing exclusivity is particularly useful for a buyer, as this removes the risk of a deal becoming competitive, which can significantly increase the price.
The Tartan Toffee Comapny has prepared their Term Sheet based on the research they have performed earlier. They are proposing:
- Transaction Structure - A purchase of 100% of the shares of Scottish Shortbread Limited.
- Purchase Price - Subject to further assessment in Due Diligence, The Tartan Toffee Company will offer a total price of £0.75m. This price is based on the discounted cashflow of Scottish Shortbread Limited, plus a consideration of the value which the buyer expects to achieve. The underlying detail around valuation, the value drivers for the deal, and expected synergies is not revealed to Scottish Shortbread.
- Due Diligence - Due Diligence will be performed over the following two weeks, and will cover:
- Additional details around the financials of the business
- Operations including details of the manufacuring facilities
- Supplier relationships
- Distribution relationships
- Addtional questions around the current operations of the business
- Confidentiality - The term of the NDA is extended until the deal is agreed. If the deal does not complete, the approach will remain confidential.
- Deal Exclusivity - Scottish Shortbread Limited will not engage with any other potential purchasers for the next two months.
- Representations and Warranties - Scottish Shortbread Limited guarantees that all information provided is accurate, and that they will disclose any material factors which may have an adverse impact on the valuation of the business.
There is no commitment at this stage by either party, but this Term Sheet sets out the approach and next steps that will be taken as part of the acquisition process.
Again, as these documents might be legally actionable, it’s worthwhile having your legal advisor prepare or review these.If the target is still in agreement, you can progress to making a binding offer.
The Binding Offer & Due Diligence
By now, things are starting to get serious. You’ve made indicative statements to the target and both of you have committed to develop the deal further.
You’ve set out a price you may be willing to pay in the Term Sheet and LOI, but this price was subject to a lot of assumptions. Now your objective is to validate as many of your assumptions as possible, to finalise your financial model and understand the risks you face.
The way you will do this is the undertake Due Diligence (DD) on the target. This is the process of requesting additional information on all relevant parts of the business to update your plans and models.
When large companies do this, they may have teams of tens of people crawling all over the target business, asking for hundreds of pieces of data. You are unlikely to have the team or the capacity to absorb all of this information, so your DD activity must be a lot more focused.
We recommend that you focus your data requests around 4 main areas:
- Understanding the Business - What commercial information do you need? For example - how many customers, details on products such as profit margins and sales volumes, marketing approaches, etc.
- Understanding the Risks - You will have identified a number of risks for the deal in your early planning. For example, you may be concerned about supplier pricing or software versions. Ask the target to provide any information that would let you mitigate these and any other risks that come up during DD.
- Paying the Right Price - Your financial model is based on assumptions from publicly available information and the synergies you think you can achieve. More up-to-date financial information may be available, confirming or changing growth assumptions. For the synergies, the outline business case can be refined based on the additional information you request.
- Understanding the Changes Required - The way the business works can be clarified. We recommend that you consider seven dimensions of the operating model in comparison to how your business currently runs, and your plans to integrate the target. These dimensions are - Processes, Organisation, People and Skills, Technology, Assets and Locations, Performance Metrics and KPIs, Sourcing and Alliances. All of these add up to the customer value proposition the target currently offers.
How should you carry out Due Diligence? While a large company will have a central team coordinating multiple functional DD teams, you will not have this luxury. Slimming this approach down for the smaller company, we recommend that you plan in advance the questions that you want to ask, and give these to the target.
Bear in mind that the target will also have limited resources and don’t want to distract from the ongoing business, so it’s likely to take some time for them to respond. As such, while a large company might make 1,500 specific data requests, you may want to limit this to 50 - 100.
Ask the target to provide the information as quickly as possible, and to send it over as it becomes available. If possible, you or your team should spend time with the people providing the information - direct interviews are the most time effective way to get the information, and you may get more than you expected.
As you receive the information, review it and apply it to your deal information. Update your risks, assumptions and financial models. If new questions come out of the the information you receive as part of DD, then send these over as supplementary questions. Also, keep in close contact with the person in the target leading DD from their side. It’s easier to request more information when you have a good relationship.
You should try to complete DD as quickly as possible. It’s always tempting to keep asking for more information, but at some point you have to draw a line and work with what you have. By using a structured DD approach, you will get a feeling for when you have as much as you think you’re going to get.
Once you reach this point, formally put an end to the DD process by informing the target. As part of the LOI, you may even have stated timescales that you are working towards, so try to stick to these if this is the case.
The Tartan Toffee Company provide their list of Due Diligence questions to Scottish Shortbread Limited to let them assess the request and prepare their response.
It is in both parties interest to provide as much information as reasonable. The Tartan Toffee Company needs as much information as possible to revise their planning and valuation models, and to understand the risks of the acquisition. On the other side, if Scottish Shortbread Limited can show that Tartan Toffee can obtain additional benefits from the deal, they may be able to negotiate a higher price.
Once Scottish Shortbread Limited have provided their initial response, the team from The Tartan Toffee company arrange to visit the Scottish Shotbread Limited offices. There they meet with key members of the Scottish Shortbread Limited management team and other subject matter experts as required, to gain further information and clarify their understanding. They feed back any concerns or missining information to the main Scottish Shortbread Company contact, to see if their concerns are valid, and whether these can be resolved.
Once these meetings are completed, The Tartan Toffee Company team will consolidate their notes, update their models, and produce the Binding Offer for final negotiation.
You will not get all the information you ask for. It’s still possible for the deal to fall apart at this stage, and no-one has made any firm commitments. As such, the target is right to be wary about giving too much information for competitive reasons. You must make your final decision and offer based on the information that is available to you. You will have some protections from the warranties and representations described in the LOI above, and finalised in the binding offer, but there will always be a degree of uncertainty.
Once you have absorbed all of the information from DD, and revised your deal models, you will be in a position to make the final Binding Offer, sometimes known as the Definitive Agreement.
Assuming that neither you or the target pulls out at this point, the Binding Offer will essentially be an updated version of the LOI with additional information about the transaction specifics.
When you’ve handed over the Binding Offer, it’s now out of your hands. Though there will be negotiation on the deal, and you may choose to change some of the terms or accept a higher price, ultimately, it’s the target’s decision as to whether they accept. If they do, then you will quickly move through to the next phase of the deal - Integration.
Though a lot of work has gone into the deal so far - ultimately you’ve made no changes to your business as yet. Integration will take a lot longer and will have a much greater impact, so it’s worth putting the effort into planning this.
We’ll cover integration planning in the next of these articles.