Business Transitions - Part III

In our last newsletter we discussed the selling side of the business transition process. We left off where the selling business has engaged an intermediary to assist in the sales process. Typically engagement letters or letters of understanding are prepared by the intermediaries. This document describes the services to be provided and related fees. In the course of working with an intermediary a confidential information memorandum will be prepared by the intermediary. A confidential information memorandum contains the following:

Executive summary with key financial data.

Description of company operations.

Organizational chart

Market and competitive analysis.

Normalized financial statements

Property and facility descriptions.

Ownership information.

Appendices: Accountant’s financials, commitments, major leases, etc.

Reasons for selling, etc.

The confidential offering memorandum serves as a sales document. Buyers can also perform preliminary due diligence from this document. It can also expedite the selling process. From this document a sales agenda can be set and requests for preliminary bids can be made.

Initial buyer meetings consist of both sides sizing each other up. The specific circumstances dictate whether the buyer and intermediary should attend or only the intermediary. Favorable outcomes might be both parties approving each other and additional due diligence being performed.
 
There are three cardinal rules from the sales side in going through the due diligence process.
Disclose all weaknesses to the buyer prior to the letter of intent (LOI).
 
Allow no due diligence uncertainties prior to the LOI.
 
Some weaknesses may be turned to opportunities if controlled and initially disclosed.
The next step is letter of intent (LOI). This is a very important step. There are a couple of LOIs-preliminary LOI and the final letter of intent. The seller should keep one important point in mind. After the letter of intent is signed, any negotiation advantage will swing to the seller. A preliminary letter of intent can be used as a formal auction process by the seller. The preliminary LOI will cover all major points and also will weed out non serious parties.

The informal LOI is not a formal agreement. A final LOI can serve the following purpose:

Binding for a couple of matters such as exclusivity and confidentiality.
 
Allows an offer to be made.
 
All major points such as price, terms, timing are negotiated.
Final steps prior to drafting the final sales document and closing would be final due diligence procedures. Adjustments are usually allowed in the price for any unknown

financial items discovered by the buyer’s auditors. From LOI to closing usually takes forty five to sixty days.

Let’s now look at the business transition from the buyer’s side. Buyers usually search for target acquisition companies using the following methods:

Industry analysis of available databases, trade associations, analysis reports, web sites etc.

Competitors, suppliers, customers.

Supply chain analysis

Reaction to third party solicitation.
The buyer usually includes five main steps for initial due diligence;

Plausibility of data from target company.

Strategic fit with plan.

Strengths and weaknesses; particularly with management, financial, revenue stability, competitive position, limiting contractual obligations and culture.

Likelihood of integration.

Preliminary valuation.

 
Analysis of value to the buyer really comes down to the buyer’s investment value. Fair market value (stand alone value) is looked at, but really the value to the buyer is the investment value. 

More specific buyer due diligence steps can be broken down into three categories; Marketing, Financial and Operational.

Marketing due diligence steps consist of reviewing the target company’s marketing plan/strategies, customer base, key customers, market share, market growth potential, sales force, distribution channels, pricing, pricing elasticity, competition, competition developments, substitutes and complimentary products. 

Financial due diligence steps consist non operating assets of the target company, a review of detailed projections and underlying assumptions, a detailed review of historical financials including non-reoccurring/discretionary items, the identification of synergy opportunities, and a look at contingent liabilities, legal claims, commitments, risky accounts, reserves, debt agreements, covenants, working capital requirements, capital expenditures, capital expenditure history and foreign exchange exposure. 

Operational due diligence consists of reviewing the status of technology (developments, R & D, etc.), and looking at government regulations, company compliance, capacity utilization, age/condition of fixed assets/facilities, information systems, quality control, suppliers, contracts, key inputs, seasonality, cyclical assessment and key operating indicators.

The buyer should look for five key indicators when evaluating the acquisition of a target company.

Emphasis should be placed on drivers of prospective revenue/free cash flows and associated risks.
 
Hidden costs such as representations and warranties should be scrutinized.
 
Consistency in facts and assumptions.
Be alert for window dressing; pre-sale reduction of expenses such as
marketing, R & D, repairs and maintenance, staffing etc. 

Be very detailed with the company evaluation; details are important.

In asking a number of merger and acquisition professionals the question of why do merger companies fail, the predominant response is employee integration issues. Ways of reducing this risk are to go in with a detailed plan. The plan should include an appointed champion, someone who can act as a go between for both sides.

This article and the previous two articles offer a thumb nail view of the business selling process from both sides—the sellers and the buyers. Please feel free to contact me with your specific questions covering this process.
 
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