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KEY PLANNING REQUIRED to Successfully Integrate an Acquisition
Even though most mergers or acquisitions start out with the best of intentions, numerous studies have shown that the majority fail to increase enterprise value.
This is highlighted by the following statistics from The Wall Street Journal, Forbes, Fortune and CFO.com:
- 70% of M&A deals fail to achieve the anticipated synergie
- 50% report a drop-off in productivity in the first 6 months post closing
- 47% of acquired company executives leave in the first year, and 75% of executives leave within the first 3 years
- Management grade the financial performance of their acquisition as a C minus on average.
Create an Integration Plan
So, how can you make sure your business is on the right side of these statistics?
Owners and managers need to put substantial time and effort into an M&A integration plan. Closing the deal is just the beginning. Before closing, you should have clearly defined your deal drivers and put them in measurable and quantifiable terms. Integration efforts should focus on delivering these goals and give you the framework to identify the critical action plan to achieve these goals.
Additionally, you need to determine the key success factors from the newly acquired company, which you may want to adopt in the existing company. Ideally, you will have two companies which learn and adopt best practices from each other to add value to the company as a whole.
Early on, you need to determine the degree to which the new entity should be integrated with the existing entity. Do you want it to remain largely independent, share the same corporate culture, processes and technologies, or maybe somewhere in between?
In making that decision, you need to look deep inside both companies and consider how they may or may not fit together. And don't make that decision from the sanctity of your office. You need to go down to the shop floor, talk to your managers, employees, live and breathe the heart of the two companies.
Based on this understanding, you should try and customize your integration structure and approach, then develop a plan for the first 100 days post closing. And then constantly refer to that plan so as not to lose sight of important items during the frenetic first few months.
Don't be afraid to adjust the plan based upon new findings after closing. This should also allow you to increase input from both sets of employees as they see the ongoing implementation and impact of the integration plan.
Leadership
Key people should be identified to manage the integration process. They need to quarterback the process while you retain the coach's role. Clear leadership roles are critical to minimize uncertainty, assign accountability and define authority.
Make sure that you have leaders on your team who are trustworthy, communicate well in both organizations, and can handle the inevitable uncertainties and morale issues with care. Leaders should be able to respond to changing conditions while keeping the strategic vision of the deal in mind and need to act according to the culture that you want to instill in the entity.
Communication
According to Watson Wyatt Worldwide, 90% of acquirers agree that communication is important but only 43% deem that communication was effective and successful in their integration. Communication success depends on paying attention to all groups involved with adequate attention focused on senior management, while at the same time providing clear and consistent messages to all employees from day one. Unfortunately, many integration leaders fail to communicate early and often.
Delay = Uncertainty = More Disruption = Decrease in Morale
= Loss in Productivity and Increased costs
Culture
The set of norms, values and assumptions governing daily actions and interactions are another critical issue that many acquisition integrations overlook. Most often an acquirer hopes to maintain its own culture and hopes that the new entity's culture merges into its own. But that doesn't really make sense.
Before you closed the deal, you likely placed a high value on the people in the target company. If you don't observe, understand and respect their culture, you will not only erode their productivity, but will also lose many of their key people. You need to carefully consider how their culture works and carefully design and implement incentives, compensation and benefits to reward behaviors that you believe are critical to the success of the integration and work within their culture.
Speed of Integration
Despite the fact that many managers like to take their time in integrating firms post closing, a 2008 study by PricewaterhouseCoopers suggests that waiting is a mistake. According to PwC, people are most open to changes in work culture and processes during the first 100 days.
A timely integration leads to improved employee commitment, lower employee turnover, improved focus on customers and improved adoption of new technology.
Conversely, prolonged transitions slow growth, decrease profits, erode morale and reduce profitability.
If you take too long getting to work on the integration, your company could lose market share and miss the best opportunities to deliver the anticipated synergies of the acquisition.
Conclusion
Companies that adequately plan and deliver on M&A integration issues should significantly increase the likelihood that their acquisition works out as everyone had hoped. So, remember the following three steps:
1) Gain knowledge about both businesses
2) Apply knowledge with a clear plan of action and constantly refer back to the plan and intended goals
3) Deliver the integration plan in the first 100 days. Track, monitor and adjust to deliver integration goals.
Acquisitions Should Compliment, Not Substitute, Good Corporate Growth Strategy
If you own or manage a business and intend to use the current softness in your industry as a springboard to pick up market share in 2010 and 2011, you need to carefully consider your growth strategy.
Organic Growth
To what extent can you fund and develop growth internally? What are your risks and returns on any capital investment you make? What access do you have to different types of capital and what are the overall costs? And, perhaps most importantly, how will your growth strategy affect future cash flows?
Growth through Acquisition
Will 2010 and 2011 provide some exceptional acquisition opportunities for your business? More than likely, yes. But the most successful business owners will only use mergers and acquisitions as one tool in their overall growth strategy. Acquisitions should be used to gain access to new markets, products or intellectual property where organic growth would be a less effective alternative, but only if it also complements a company's strategic plan.
Challenge your assumptions
As you are considering an acquisition, you need to challenge every assumption you have about the market and the opportunity before proceeding. In times like this, there is a rebalancing of the market. The days of easy credit and pure financial engineering will likely be replaced with one where organic growth, operational strength, smart planning and business acumen are more important.
Acquisitions are often rationalized as a faster and more cost effective way of growing, but that typically doesn't take into account the planning, time, disruption, financial and organizational resources that are required to successfully integrate companies after an acquisition. Synergies on paper are not realized without a thorough integration plan with detailed and realistic profitability targets. We'll talk more about that in the coming weeks.
Does it add value?
An important rule to remember is accretion and dilution. After integrating the two companies, will the acquisition add incremental value to the combined companies? Will it increase the overall value of the group (accretion) or dilute the value of the combined companies? Accretion is good. Dilution is bad.
Go for Growth
A little over 2000 years ago, Virgil told our ancestors that
Fortune Favors the Bold.
However, if Virgil were a business owner today, maybe he would a few caveats to that statement:
Fortune Favors the Bold ... so long as you have scrubbed the numbers, appropriately analyzed the risk, developed the most cost effective capital structure and are confident that your growth and profitability strategy will add value to your company.
There are going to be some great acquisition opportunities next year and we are already seeing buyers setting up for the start of 2010. Our message today, however, is to make sure that any acquisition fits your overall growth strategy. Now is the time to plan that strategy and then find the acquisition opportunities before anyone else does.
Critical Pre-Sale Due Diligence - Maximize Business Sale Price and Terms
Due Diligence preparation is often overlooked, yet is critical to maximizing sale price and ensuring a smooth transaction. Now more than ever.
Credit markets are tight and despite a recent rebound, Mergers and Acquisitions activity is still down.
Buyers are targeting acquisitions - but now with a heightened degree of scrutiny.
Even if a buyer has plentiful cash available, they are still likely to leverage the acquisition to increase their percentage returns.
Leverage brings lenders to the table. Even if lenders are familiar with the deal, they need to provide detailed support for their loan.
With the tighter credit environment, tougher reporting requirements and more stringent data and due diligence requirements, you need to do more today to ensure a smooth sale process.
A report on your company's financial results from your accountant or even an independent auditor is not sufficient.
Your best option is to conduct in-depth analysis of your Company by an independent due diligence expert to identify areas that will have a direct impact on the sale price.
Firstly, a buyer needs a thorough review of your financial accounts and reported financials with supporting detail, consolidated data as well as data by location, product categories and other relevant categories for historical and forecasted periods.
They also need in depth analysis and a report on the quality of earnings, accounting systems, methodologies and compliance with or departures from GAAP. They need to see normalized sales, gross margin, and operating expenses, as well as feedback regarding compliance with debt instruments. They need analysis on AR, Inventory, CAPEX, working capital, debt and coverage, and profitability.
Buyers will also require due diligence on liabilities, operations, tax compliance, legal issues, reputation, industry analysis and forecasts, competition, customers, suppliers, people, PP&E, integration risks, environmental, health, internal controls, lease, zoning and permits, in addition to other business issues.
CLICK HERE for ClearRidge Capital's website section with expanded information on due diligence requirements.
This is not something that is easy to compile and typically requires strong financial modeling skills, trained analytical skills and specific acquisition due diligence and corporate finance experience.
Whether it is a midsized privately held company or a single division of a large public company, it is rare that this data is tracked routinely by the lean accounting staff that is focused on daily operations and normal reporting needs.
Take Action to Better Position your Company
This doesn't need to be an obstacle to a successful sale, but it does take planning and clear forethought. Most sellers proceed too quickly at the start of the process and skip critical steps, only to suffer later on while attempting to close the deal.
Unfortunately for many sellers, starting later in the sale process can reduce the sale price or cause the deal to fall apart.
Your best solution is to prepare a thorough due-diligence report before talking to buyers. Proactively offering answers to their likely information requests not only speeds up the process, but also inspires confidence in the acquisition opportunity.
If you want to secure the highest price and the best terms, you are going to need at least two buyers competing in a confidential auction process.
By providing a due diligence report in advance, you are saving time and also providing potential buyers and their lenders with sufficient information for them to submit an LOI (purchase offer) and close the deal in a timely manner.
Professional preparation also enhances the image of your company.
Acquisition Strategies in a Troubled Economy
All of the points below are expressly related to a Troubled Economy. Every situation and every company’s acquisition strategy is unique and the risks and rewards are different every time. The rules also change when acquiring companies in a troubled economy versus a stable or strong economy.
We are going to consider strategic acquisitions, strategic mergers and joint ventures, distressed investing, due diligence, scenario modeling and financing.
Let’s start off with a cautionary note. Over 75% of acquisitions fail to realize the potential that the acquirer anticipated prior to the acquisition. On a positive note, the valuation multiples of mid size companies are significantly lower than publicly traded companies trading at 15 or more times their earnings. So, you are going to get more bang for your buck.
One of the best times to consider an acquisition is when times are tough. There is less competition from other acquirers and you have a much higher chance of buying low and selling high. Through every downturn there will be one or more companies that emerges as a dominant market force, one reason is because they had the foresight to roll up competitors when valuations were lower.
1. Strategic Acquisition
In a troubled economy, many companies are going to see their revenues drop by 20% or more. Most companies are unable to reduce costs appropriately and quickly enough and thus, profits are reduced or eliminated.
Consider the scenario that 6 months from now, your revenues have dropped 25%. You are going to face a challenge to increase your sales or just stay profitable in a tough climate. If this happens, there are likely to be many other solid companies in your industry which are going to be either over-leveraged by carrying too much debt, or have been less pro-active in streamlining their business and cutting unnecessary costs. If you were able to acquire one of these companies, you could gain an immediate advantage.
You could bridge your 25% revenue drop by picking up a competitor’s revenue by acquiring their company for below normal market value. It is never an easy process and it is essential to gain synergies while spreading overhead costs across the two companies, otherwise you risk gaining revenue without benefiting from reduced costs or improving your margins. You also want to ensure that you benefit in other areas such as increased purchasing power, spreading sales force over a larger customer base, and selecting the best employees from a larger and more experienced talent pool.
If you can plan for a potential downturn in your industry in advance, you may be able to benefit from acquisition opportunities as they occur and ride the wave out of the troubled economy ahead of your competitors.
Horizontal Acquisitions
An example could be a NE Oklahoma Company that acquires a competitor in NW Arkansas or SE Kansas with a similar business model. You acquire a competitor and gain economies of scale. Your new acquisition is still operating in the same region, so there is a higher chance of reducing overall operating, sales and marketing costs. Acquiring a company in the same region increases the likelihood of long-term success, as they are close enough to enjoy local synergies and you are also able to micromanage problem areas that need additional management oversight.
You could look at companies with a similar customer profile that buy from similar suppliers, but sell different products. You may not even need to broaden your geographic reach, just expand along complimentary product lines. An example could be a company selling to a mass merchandiser, such as Wal-Mart or Home Depot, looking to acquire other companies which have similar drivers to their business model, selling to similar merchandisers. You could even realize these benefits without being in the same product category. You would reduce the acquisition risk through your understanding of the needs, processes and practices of your customer.
If your business model is to sell to a high volume distributor with highly diverse product lines at multiple locations, then you already have skills to handle the same business process and supply chain. Your first choice could be an acquisition target in the same broad industry, with similar customers, suppliers and business structure (e.g. centralized). Your second choice could be a similar customer base and sales strategy, where your challenge would be to provide support to the target’s multiple locations with your existing overhead and service their customer base with your sales force. Your team already knows how, it’s just more locations and slightly different products.
Wherever you can share your sales, marketing and administrative infrastructure to reduce costs and increase revenues, you stand to gain cost advantages through the acquisition. Ideally, each company should be able to cross-sell to each other’s customers. And, as a reminder, the acquisition does not need to be an exact competitor.
Vertical Acquisitions
Vertical acquisitions occur along the supply chain from manufacturer to wholesaler to distributor to retailer.
In a tough economy there are going to be acquisitions to clean up the supply chain and reduce the number of participants. Those companies that enjoyed an easy entry into the supply chain and are over-leveraged will be among the first to be forced to sell their company or go out of business when times get tough. Someone is going to take advantage of this situation.
Distributors buy wholesalers; wholesalers buy distributors and so on.
It substantially reduces the risk of a failed acquisition if you know the industry (i.e. understand the risks, customer profile, skill sets required, pricing strategy and sources of supply). If you acquire a company along your supply chain, the seller may be more inclined to accept financing or earn out as a higher proportion of the sale price, as they already know the strengths of your company. Their perception is that a potential earn out is more likely higher from someone they have done business with before.
2. Strategic Merger
In a troubled economy, you could see a scenario where two competing companies predict troubled times ahead and foresee a struggle to remain profitable. If we use the same example as last week, one company could be in NE Oklahoma and the other in NW Arkansas. They are very similar businesses, each with around $20 million in revenue and around $2 million in EBITDA. They share a similar customer profile, similar suppliers and both companies operate with separate expense structures, including fixed overheads, purchasing agents, sales managers, finance, accounting and administrative departments. One has too much debt and the other has fixed costs that are too high to cope with lower sales volume.
If one party is able to reach out to the other with a merger proposal, there could be benefits in joining the two companies together. In addition to combined revenues, improved purchasing power, improved economies, shared resources and a broader reach, merging the two companies could reduce costs and improve margins. In another merger scenario, there could be two non-competing businesses which sell to a similar customer profile in a different region. They would be able to realize significant revenue increases from cross-selling to each other’s customers, in addition to the benefits referenced above.
Both owners should start with some basic due diligence to determine a fit between the companies. Then the two owners need to agree on some valuation principles that apply to a company in their industry. They should then value both companies. Both parties need to be realistic in their valuation expectations when they start the process and more importantly be sensitive to each other’s ego in negotiations. Many great deals fall apart because of disagreements over the way to value each other’s business.
Consider the following dilemma. We have the two above companies with annual revenues around $20 million and EBITDA around $2 million. Company OK took 20 years to build up to this sales volume and OK’s owners feel they have a stable and solid company. Company AR took only five years to reach $20 million in sales and AR’s owners think they have a more valuable company, because of its faster growth trajectory.
Both parties are going to need to compromise on their valuation assumptions about their own company. It is sometimes beneficial to hire an independent appraiser to act as intermediary and conduct an independent appraisal to smooth negotiations.
If the two owners can agree on a valuation, they have the opportunity of either starting New Co, Inc. that they both roll up into, or sell each other portions of their existing companies. There are benefits and drawbacks to both.
If the benefits of a merged entity are strong enough, both parties should set aside their differences to reach the common goal of striking a merger agreement.
More often than not, however, what starts out as a merger discussion, ends up with one company acquiring the other. One of the parties could offend the other and both end up walking away from the deal, or it could be that it just seems too unlikely that both owners could collaborate and run the new company together. One of them often steps aside, takes a pay day and either sells his company completely or retains a minority stake in the new venture.
If you are considering a merger in order to ride out a tough market, you could also consider a joint venture and determine which is the best fit for you.
Joint Venture
There could be operational and financial reasons to create a Joint Venture (JV) with a company that has complementary capabilities and resources. These could include common distribution channels, suppliers or technology. JVs are becoming an increasingly common way for companies to form strategic alliances. In a downturn, a joint venture may provide one company with marketing, sales and distribution expertise, while the other benefits from low cost access to a better product line and spare capacity. The two companies could share investment in product development or share costs of developing a stronger sales force.
In a joint venture, two or more companies agree to share products, services, capital, technology or human resources in a new entity under shared control. Alternatively, they could agree to a collaborative service sharing agreement between the two existing companies.
On the positive side, joint ventures are less costly than a merger in both time and money to set them up. On the downside, cost savings are going to be less drastic than a merger, as the two companies continue to operate separately.
JVs tend to have a short life span of around 5 years, at which time the two companies wind it up. If a joint venture has worked well, one company may offer to acquire all or a portion of the other company. Not only have they both seen improvements from the two companies working together, but they have also benefited from a lower risk toe in the water, to determine if the two companies enjoy a real fit that could be expanded after the acquisition. While most acquisitions fail to deliver the potential that the acquirer anticipated prior to the acquisition, the chances of success are much higher if two companies have worked collaboratively for a number of years prior to the acquisition. Ways to improve the chances of a successful acquisition and develop a clear plan for integration after the acquisition is a topic for another day.
So, if you are in a position where you would like to exit your company in a few years, but are unwilling to sell at reduced prices in a troubled economy, a well-worked joint venture could not only earn you more money in the short-term, but also be the forerunner to a successful acquisition of your company in a few years when valuations are higher. If your partner in the joint venture is confident in the chances of a successful acquisition, they may also be willing to offer you a higher sale price with higher earn out, which you can be more confident will be delivered.
3. Distressed Investing in a Troubled Economy
Within the context of this article, we are considering those investors who acquire troubled companies in a troubled economy. While some would consider distressed investing to be predatory, in many situations, a distressed acquisition is the most positive outcome, not only for the company itself, customers and vendors, but also the many employees who have served the company well and value their job security.
If employees are aware that the company is in trouble, new owners can quickly earn loyalty if they invest time and money in turning the company around and securing the financial future of the employees. A distressed acquisition is not the same deal as corporate raiders. For the most part, distressed investors typically see value in fixing the problems and building the company back up, rather than buying cheap assets and splitting up the company.
Investors who are looking to risk their money by acquiring a troubled company are doing so because they perceive future value beyond the acquisition purchase price. It tends to be a pure decision looking for a return on their investment. Typically, this investment will have a time horizon of 5 to 7 years, at the end of which, if all goes well, the company will have grown, increased its margins, will have improved processes and efficiencies, as well as having a much more secure future.
The buyers will likely have industry operating expertise, which focuses their efforts on finding companies in a particular industry, but their objective remains to buy low and sell high. They are typically prepared to risk millions of dollars in excess of their initial investment to grow the company and acquire other add-on companies to create a larger group. They want to buy a company for $20 million, make additional investments for inventory, equipment and technology, or additional acquisitions to rollup for $30 million and sell it for $100 million in 5 to 7 years. It sounds ambitious, but it often happens that way.
Across the US, if your industry is suffering from the economic woes effecting most industry sectors, the value of your company is likely going to be lower than it was a year ago. As a group, buyers have tighter access to debt, so they have to put more capital down, which can be as much as 50% of the acquisition value to finance the deal. Many buyers cannot afford and are unwilling to pay as high a price if the economic outlook and industry outlook is uncertain, and also because they can’t get the leverage to support a higher price tag.
So, who are the candidates for a distressed investor?
There are companies in every industry that borrowed in good times to fuel further growth, or were acquired with too much debt. Excessive debt obligations and rising interest payments cut into profit margins and cash liquidity, as well as drawing pressure from shareholders and creditors to either restructure the company or sell.
In terms of riding out the storm and getting back to positive growth, it could cost a midsize company many millions of dollars to restructure. So the better alternative now for many creditors and shareholders is to cash out for a reduced price, rather than fund the company’s survival through tough times ahead. As with any investment, stakeholders are going to consider the risk, reward and time horizons for a return on capital they invest. If they undertake a full restructuring or turnaround, stakeholders are going to have to commit significant dollar amounts to get through the next couple of years.
If a buyer offers a fair value price, it may be the best opportunity, all things considered, for the owners to sell and take cash today. A new and well-capitalized owner may also be able to relieve many of the company’s problems through a new capital structure.
Distressed investing is not for the faint hearted, however. Buyers need very thorough due diligence to deeply understand all the problems that exist within the company, not just those that are evident after a little digging. Uncovering many problems does not mean the acquisition fail to be viable, but it is much better to discover these problems before writing the check and taking ownership of the company. It is important to create financial models for every different scenario you can think of and add some scenarios for further problems you are yet to discover in order to determine how much capital is required and what timeline is realistic to turn the company around.
Points to consider
a) First of all, clearly identify why the company is in a distressed situation. If it’s just too much debt, capital cures that problem. If there is a downturn in the industry (e.g. housing), how long will it take to stabilize and what impact will that have on other competitors in industry.
If all the competitors are weakened, then the opportunity can be even better, so long as you have sufficient capital. Most of the competitors likely do not have sufficient capital. Overall weakness creates opportunities to buy a solid core company in a weak industry and pick up other companies that are performing poorly for discounted prices. If most companies in a cyclical industry are weak and you have enough capital to be a significant player, then there is a strong opportunity to roll up a good portion of these companies and become the power in the industry.
b) Pricing strategy – if a company’s volume is based on discounting and they only compete on price, there is a good chance that you would need to raise prices to make the new business model successful. If most or all of the sales volume is at risk by increasing prices, then you should probably walk away from the deal.
c) Quality management. Are there at least 2 or 3 existing managers who are willing to commit their future to the company? If the answer is no, the risk of failure is higher.
d) Net Operating Losses. If the target company is over-leveraged and carrying too much debt, then it should have significant interest deductions cutting into earnings. As long as the deal is structured properly with a second similar company, then the new owner can eliminate income tax expenses for the second company by carrying forward the net operating losses.
The rules for carrying forward Net Operating Losses vary from State to State and you should seek expert advice on how NOLs could apply to your company. Federal law allows NOLs to be carried back 2 years and forward 20 years (with proposals to extend carry back to 5 years), but each State has their own rules, requirements and stipulations for what proportion and how far forward and back a NOL may be applied.
e) Time horizons – If the economy stabilizes and the industry stabilizes, what could be a 5 to 7 year exit plan could turn into a 3 to 4 year horizon. Chances are the buyers have bought a troubled company for a lower price and a lower valuation multiple. When the industry turns around and prospects improve, the company valuation will not only be based on the existing performance of the company, but also the positive growth trajectory and potential.
4) Due Diligence in a Troubled Economy
In a troubled economy, the opportunity costs are higher. You can get a better deal than you were ever able to secure in a strong economy, but the odds of the acquisition failing are higher. For this reason, many private investors and equity groups that were acquiring 5 companies a year may now only be closing on 1 or 2.
For some investors, however, a troubled economy is the perfect storm. They have significant capital available and they are waiting for the right opportunities. One thing the most successful investors will make sure of is that they have spent considerable time evaluating all the risks of the opportunities before investing any capital.
Think about it. If the deal goes wrong, you will not only deplete your capital in a market where there are higher risks to increasing your capital, but you will also expend considerable man hours on fixing the company post closing. Other portfolio companies are going to demand more care and attention in a troubled economy and the last thing you need is a new acquisition to turn into a troubled restructuring project or turnaround situation, which will divert your attention from more lucrative opportunities.
In a troubled economy all problems become exaggerated. As a result, you have to look through all the issues and be more thorough than normal. The buyer should take their own people and do what analysis they can to do the first screening of the acquisition opportunity. After that, however, it will be money well spent to hire independent due diligence professionals who can be more objective to analyze all the weaknesses and threats for the acquisition.
WHAT TO LOOK FOR
a) Integrity of financial statements
Have the financial statements been audited by an independent and respected audit firm? If not, to what degree can the accounts be relied upon as a true reflection of the financial performance of the business?
b) Quality of assets
Be sure to have an expert appraiser provide a valuation of the tangible and intangible assets of the target company. This appraisal should include an appraisal of the quality of the inventory and accounts receivable. If the assets are equipment, how many hours a week is the equipment productive, how long has the equipment been in use, how old is it, cost of servicing, productive life remaining, replacement value, auction value, what kind of income does that piece of equipment turn out?
c) Quality of revenue
How many large customers control the majority of the revenue? Is revenue from diversified and unrelated industries? If Chrysler is 90% of a company's revenue, then that would be classed as poor quality revenue. If on the other hand, no client accounts for more than 6% of revenue, the top 10 clients are diversified across unrelated industries and all the customers have a quality balance sheet and pay on time, then that would be classed as high quality revenue. The highest quality revenue would share the above characteristics, be recurring revenues and also be under a self-renewing service contract, which is required by law. You need to determine what proportion of customers will continue to be successful and will continue ordering and paying their bills on time. Also, take a look at pricing before the sale. Has the Company reduced prices to protect revenue, but sacrificed gross profit? If yes, the revenue is lower quality and will likely suffer if you raise prices immediately after new ownership to restore profit margins.
d) Quality of earnings
Take a look at the earnings history. Were there unusual events to cause the Company to have strong earnings from weather patterns, or did commodity prices go in their favor which would not normally be that high? If yes, then you need to normalize the numbers. On the other hand, were their earnings unnaturally low because of high commodity prices, in which case adjust earnings higher. As is often the case, the answer is to create a financial model, which allows you to see the results of any number of different earnings scenarios. Has the Company implemented cost cutting in the year leading up to the sale to boost EBITDA? If yes, does it prevent the Company from maintaining or growing sales, service or operation levels with the current infrastructure cost? If yes, then the earnings are not as high quality and reliable as they may first appear.
e) Risk assessment
Studying workers compensation claims, product liability claims, safety or environmental issues and litigation from employment issues.
f) Industry trends and projections
Consider independent and expert analysis on where the industry is going and what new trends are likely to appear. Consider how each different scenario could impact the earnings of the company you're acquiring. A cyclical industry with weak forecasts and a weak outlook could actually present a great opportunity to look for acquisition opportunities if you are able to acquire the Company and ride out the storm. Not only can you acquire the company for a lower multiple because of the poor forecasts, but you can also roll up a number of different companies in the industry if you are well-capitalized. You just need to make sure you have factored in all possible scenarios when considering your valuation and offer price.
g) Competitor analysis
Analyze the strengths, weaknesses, opportunities and threats of the leading competitors in the industry. You should be able to use this information and assumptions to forecast different scenarios for increasing or losing market share.
h) Reputation in the marketplace
How important is the company's reputation in the marketplace? How important is repeat business and how strong a reputation does the company enjoy? Will that reputation endure through changing ownership?
i) Potential litigation and unforeseen liabilities.
This could range from product liability, employment related claims, to environmental or OSHA related penalties.
j) Quality of receivables
How much of the company's receivables are current, how much is past due and what is the current turnover? You do not want to value receivables too highly if they have to be discounted to be collected.
k) Quality of inventory
What is the inventory turnover and what is the average number of days in inventory? If the inventory is good, high quality and can be sold quickly, then you can assign close to full value. On the other hand, if 30% has been in inventory a year or longer, then you need a realistic value of what you would be able to liquidate it for today. If the Company has been in trouble, has it reduced inventory levels to the point where it has damaged its reputation or lost market share? Reputation and market share are quicker to lose than to win back.
The above points only scratch the surface of work that needs to be done in due diligence, but hopefully this will give you ideas of particular questions you should be asking yourself in a troubled economy.
5) Financial Modeling in a Troubled Economy
Financial models are a valuable tool for business owners, debtors, creditors, investors and advisors in making financial, operational and strategic decisions.
Financial models are designed to forecast the future earnings and performance of a company. Well-worked models create credible projections of the viability of an investment under a feasible range of uncertain variables. The projections are based on the historical data and a range of assumptions for the future. These assumptions could include sales volumes, costs, debt levels, interest rates, macro-economic changes, industry projections and price competition.
If merging two companies together, you could forecast the cost implications of successfully or unsuccessfully integrating the sales, marketing and administrative expenses. You could predict the outcome if your prices had to be reduced by 5%, 10% or 15% to compete in the market. You would be able to understand the critical success factors that could affect future revenue or cost. You could look at different scenarios of commodity costs and consider a range of scenarios for the volatility in that commodity. Ideally, you should model every possible scenario.
If you were considering new suppliers in Asia, you could model the possible impacts that would have. Would sourcing from abroad bring additional freight costs? How would sourcing internationally impact the timeliness of supply, quality control issues and product recalls? Would there be potential delays to deliver products to your customers and if you had to offer discounts for associated delays what impact would those discounts have?
So, how do you go about preparing and creating a model?
First, you need to gather up past historical (monthly if possible) Income Statements, Balance Sheets and Cash Flow Statements dating back at least three years in order to analyze the past performance of the company and identify trends. If you only have past statements available in an annual format, you will also want to locate monthly statements for the company’s last complete month of the current year and the previous year in order to calculate the company’s trailing twelve month performance.
For example, if you’re putting together a model today, you will need the Company’s fiscal year end data, annual statements for each of the three previous fiscal years along with monthly statements from November 2008 and November of 2007.
After modeling out the company’s historical performance, the next step is to combine the historical performance with forward assumptions to derive projections five years ahead. The key assumptions that determine important performance measures include:
• Sales
• COGS
• SG&A
• Working Capital
• Capital Expenditures
• Depreciation
• Dividends
• Debt Repayment
• Stock Repurchases
• Tax Rates
The quality of assumptions determines the quality of the analysis and projections, but the best models will allow you to create scenarios for an infinite number of scenarios ranging from best to worst case. A lender may want to analyze the worst case scenario and analyzing the debt risk before lending money.
Once the core financial statements have been set up and the key assumptions have been developed through a detailed and sound analysis of the company and its industry, the following must be built out in order to drive the future results of the core financial statements:
• Working Capital
• Depreciation & Amortization (PP&E)
• Other Balance Sheet Items
• Shareholder’s Equity
• Debt & Interest
You will then want to project out future debt payments based on a series of factors including the different loan types, the amount of each loan and the interest rate tied to those facilities, which can either be fixed or floating. Using this information, you can now project out future debt balances to be reflected on the Balance Sheet (which are then reflected on the Cash Flow Statement) and Interest Expense on the Income Statement.
Now that you have modeled out all of your projections, the last step is to ensure that the change in cash reflected on the bottom of your Cash Flow Statement is the same as the change in cash reflected between years on the Balance Sheet. If so, you’ve succeeded in building a successful model and can now change assumptions such as revenues, expenses, interest rates or leverage on the company to immediately see the impact on financial performance years ahead.
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