The acquisition phase arguably starts long before the purchase of the company is agreed upon. Although every acquisition is unique one can dissect three different stages: the quick triage, the serious discussions and the in-depth due diligence.
During the quick triage, the searcher will test the congruence of company and industry information with the predetermined characteristics these should have. This allows the searcher to decide whether to spend more time and resources in the next phase or to pass.
If the company passes this first stage, the searcher typically proceeds by having more in-depth discussions with the seller. A LOI (Letter of Intent) is often signed at this stage. The searcher will continue to analyze the company and the industry, as well as prepare a list of items that need further discovery during the in-depth due diligence. It is critical that the searcher assesses the seller’s willingness to sell as well as checks that both parties are in the right ballpark when it comes to valuation. Remember, time is of the essence.
Assuming that further analysis into the industry and company has not been disappointing, that they are not too far apart in their valuations, and that the searcher deems to be talking to a willing seller; resources will now be allocated to in-depth due diligence. The focus of due diligence will be multiple, and not limited to: financial, accounting, human resources, operations, information systems, legal or environmental.
The commitment of acquisition capital is, from a risk perspective, far more significant than the commitment of search capital. Maintaining a good level of investor communication during this phase will be essential. Before closing the acquisition the searcher will send all investors the legal documents as well as an EOM (Equity Offering Memorandum).
As mentioned, the searcher is looking to buy a good company at a reasonable price. Having limited resources, optimization increases the searchers chance of success. Building a good, quick triage system is an essential part of the process. It helps to distinguish strong leads from weaker ones, allowing the searcher to spend more time and resources on opportunities that can generate a successful acquisition.
Although the time commitment of the seller is still low at this stage, the searcher will get access to non-public information. This is why he will sometimes be asked to sign a NDA (Non-Disclosure Agreement). Apart from comparing the industry dynamics and company characteristics to preset targets and alternatives, the searcher will also try to come up with an approximate range of valuation, meet the seller and determine what key issues have to be addressed in order to make a well-informed investment decision.
It is good practice to meet the seller to assess if both parties have a common understanding of the process and if the seller is genuine. It is equally important for the seller to assess if she could be comfortable in selling the company to the searcher. Before setting up a meeting with the seller, it is wise to reach out to some investors to get their initial input on the industry and company.
Note that if the deal was sourced through a broker, an IOI (Indication of Interest) will at times be requested before proceeding to the next stage. In the IOI the searcher will include a valuation range as well as a request for specific additional information. It is non-binding.
The serious discussion stage builds on the work done previously by getting a better understanding of the company and industry, and by further assessing the willingness of the seller to sell. Additionally it lays the groundwork for the work that will be done during the in-depth due diligence stage.
The searcher should get access to more complete financial information (e.g. past audited financial statements and pro forma forecasts) and information around the key drivers and risk factors of the business. It is in this stage that the searcher wants to determine if the company has moat, to understand where the pockets of risks are, and how these could be mitigated. The provided information should also allow the searcher to determine a range of valuations and see if the seller has similar thoughts.
Additionally the searcher will prepare a prioritized list of items to analyze during the in-depth due diligence stage, develop important legal terms for the proposed acquisition, start initial discussions with potential lenders and solicit feedback from investors.
Typically, the searcher will get more access to the seller and sometimes to senior management. To document this increased level of engagement as well as interest, a LOI is signed. It outlines the principal terms of a proposed deal and serves as an agreement to agree, providing the due diligence does not reveal material issues. It is similar to a term sheet but differs in structure.
In-depth due diligence
There is an old military adage stating that time spent in reconnaissance is seldom wasted. The same holds true for due diligence, a process whereby the searcher researches and analyses factors of importance in preparation for the acquisition. The searcher aims to limit the uncertainty around value drivers and risk factors to avoid post-transaction surprises. It is also the time to define how certain post-transaction situations would be handled if certain events materialized. These could be dealt with through terms in the purchase contract.
Each acquisition is unique and depending on the company, the industry, the seller and the searcher, different issues will be subjected to the due diligence process. As not all of these have the same level of importance, it is good to prioritize these aspects that are mission critical. We like to distinguish deal-breakers from price and terms issues. While deal-breakers when uncovered signify an end to the possible transaction, the latter two can be addressed through either an adjustment in the transaction value or through a transfer of the risk to the seller as defined in the term sheets.
Entire industries such as investment banks, accounting and law firms, management and information system consultants, can assist the searcher in the due diligence process. Our advice would be, where it makes sense, for the searcher to do as much as possible himself. It will allow for a better understanding of the business once taking over, clearer discussions with seller, lender and investor, and a better formulation of potential solutions once running the company. Naturally, where expertise is of essence (e.g. matters of accounting or law), professionals with expertise in the matter are required.
A note of caution. While the entire effort of searching, acquiring and running a company is intense, the due diligence stage is often qualified as tedious and hard. This can lead to tunnel vision as well as confirmation bias. While the former refers to the tendency to focus exclusively on a limited point of view, the latter is defined as the seeking or interpreting of evidence in ways that are partial to existing beliefs, expectations, or a hypothesis at hand (Nickerson). In addition to providing useful insight in the due diligence process, investors can be helpful in addressing both.