Experienced and professional acquirers often have the advantage in dealing with many inexperienced corporate sellers who are selling their business for the first time. On the other hand, buyers have a very formidable task in acquiring a company, because the facts need to be uncovered through careful, pragmatic analysis. The following ten items are matters that some buyers might overlook.
1. The industry As part of an acquirer’s assessment of the target company, he should review the industries in which the potential seller’s customers and suppliers operate. This method of due diligence is frequently called a SWOT analysis in which the buyer reviews the Strengths, Weaknesses, Opportunities, and Threats of the potential acquisition candidate’s competitors. For example, with the consolidation in retailing and the concurrent rise of Wal-Mart, Home Depot, Staples, and others, power has clearly passed from the manufacturers to the retailers. When Rubbermaid with annual sales of $2.2 billion tried to pass on a much needed price increase to partially cover the higher resin costs, Wal-Mart with an annual sales of $83 million balked.
2. The compensation
An acquirer should assess the target company’s compensation of personnel at comparable levels of responsibility. For example, a high-tech public company from Boston made an offer on a smaller company with a proprietary product. Part of the reason the target company was so profitable was the owner paid his employees minimum wages with virtually no benefits in a facility with minimum overhead. If the acquirer absorbed the target into its own system, it would be compelled to equalize the compensation of the seller’s employees thus vastly reducing the stated profitability of the target. Conversely, if the target’s management and employees had a much higher compensation than the acquirer, it will be difficult to merge the two companies without having personnel problems.
3. Capital expenditures An acquirer should determine to what extent the machinery and equipment of the target company needs to be replaced in order to be up to date with the competition, thus adding a further cost to the acquisition price. Or, rapidly growing companies may require annual capital expenditures which exceed the normal depreciation expense thus modifying projections and ultimately affecting the transaction price.
4. Internal controls
An acquirer, especially a public company, is often far more sophisticated in financial controls, systems and reporting than the target companies. Some companies grow so fast they do not have time to put proper controls in place, but these companies are often out of control. For example, an $11 million retail chain came very close to selling a minority interest to raise essential working capital. The potential investors ultimately lost confidence because the financials were not audited and the five stores did not control their inventory through a Point of Purchase (POP) perpetual inventory control system at the check out counters.
5. Inventory obsolescence
An acquirer should pay particular attention to the target company’s product life cycle, particularly in the high tech industry. The buyer should question the seller’s inventory reserve policy to be sure it is adequate to cover the inevitable write downs.
6. Cash flow statements For buyers, evaluating cash flow statements is more important than evaluating the target’s balance sheet and income statement. The acquirer should verify that the seller will continue generating positive cash flow after the acquisition when the extraordinary and non-recurring items have been eliminated and the new debt service has increased.
7. Discretionary costs
An acquirer should be aware that some sellers prepare the company for sale by maximizing profits through a reduction of managed costs such as advertising, promotion expenditures, research and development expenses, maintenance, etc. These cuts will eventually hurt the company’s long-term prospects.
8. Financial covenants If a buyer plans to exercise a stock transaction, one of his major concerns should be the covenants which will be assumed with the bank notes, leases and rentals. The lenders, leasors and landlords will have enforceable covenants such as balance sheet ratios, debt coverage percentages, etc. If an asset transaction is to occur, then the buyer should not be rushed into agreements without proper time to negotiate the covenants.
A buyer does not have to be a Fortune 1000 company to be immune from having to notify the Federal Trade Commission when two competitors merge. The Hart-Scott-Rodino Anti-Trust Act requires the commission be notified if the buyer intends to acquire a middle market company of considerable size. The buyer should consult with their transaction attorney on the various requirements.
10. Tender offer
If a buyer is thwarted when approaching the management of the target company, the buyer should determine whether the controlling stockholders are outside of management. If so, a friendly tender offer can be made directly to them on the assumption that the actual owners would be more receptive than the president who could well be a minority shareholder and who would be particularly concerned about losing his job.