The Buy Side of the M&A Process

The merger and acquisition (M&A) process can be either lengthy or short. It is not uncommon for transactions involving two large companies with global operational footprints to take several years. Alternatively, both multi-billion dollar and smaller middle-market transactions can take just a few months from initial exploratory dialogue to the closing documents and transaction announcement to the markets.

The M&A process can start in a variety of ways. Management of the acquiring company, as part of its ongoing strategic and operational reviews, assesses the competitive landscape and discovers alternative scenarios, opportunities, threats, risks and go-forward value drivers. Mid- and senior-level analysis is done both by internal personnel and external consultants to study the marketplace. This analysis assesses the direction of the industry and the strengths and weaknesses of current competitors.

With the mandate and objective of increasing the value of the company, management—often with the aid of investment banks—will attempt to find external organizations with operations, product lines and service offerings, and geographical footprints to complement their own existing operation. The more fragmented an industry is, the more an intermediary can do in terms of analyzing potentially suitable companies to approach. With relatively consolidated industries, such as large commodity-type chemicals or bridge manufacturers, a company's corporate development staff is inclined to do more of the M&A work in-house.

Smaller companies often experience leadership planning or family issues, which may present opportunities for an acquisition, merger or some derivation thereof, such as a joint venture or similar partnership. Most potential acquirers employ the services of a third party such as an investment bank or intermediary to conduct exploratory conversations with targeted companies.

The M&A advisor contacts several companies meeting their client's qualified acquisition criteria. For instance, a client company might wish to expand to certain geographical markets or be interested in acquiring companies of a certain financial threshold or product offering. Once the advisor is engaged in initial dialogue, it is prudent not to ask blunt questions such as, "Is your company for sale?" Operators often find such a direct inquiry to be offensive and often raise insurmountable barriers to further discussions. Even if the company is currently for sale, such a direct approach will likely trigger a flat rejection.

Rather, effective M&A advisors will ask whether the potential target is open to exploring a "strategic alternative" or "complementary working relationship" to drive value for its shareholders and/or strengthen the organization. Such a query is gentler in its approach, and coaxes existing owners to contemplate on their own whether or not a partnership with an external organization could create a stronger overall organization. (For more, see:  Mergers Put Money in Shareholders' Pockets.)

Further dialogue typically revolves around the potential and strategy for market share increases, diversification of product and service offerings, leveraging of brand recognition, higher plant and manufacturing capacity, and cost savings. The intermediary will also find out what the target management's objectives are, as well as the organizational culture to assess fit. For smaller companies, family disputes, an aging CEO or the desire to cash out during an unusually hot market flushed with investor capital can make the prospect of a merger or acquisition more enticing. 

If there is interest in moving forward with the discussion, other details can be covered, including how much equity the existing owner is willing to keep in the business. Such a structure can be attractive for both parties since it leaves some equity in the business for the acquirer and the existing owner can sell most of the current equity now and sell the rest later, presumably at a much higher valuation.

Many mid-market transactions have the exiting owner keep a minority stake in the business. This allows the acquiring entity to gain the cooperation as well as expertise of the existing owner because the equity retention (typically 10-30% for mid-market transactions) provides the existing owner incentive to continue to drive up the value of the company. Many exiting owners who retain minority stakes in their businesses find the value of those minority shares to be even higher with new owners than when they previously controlled 100% of the business.

Existing owners may also want to stay and manage the business for a few more years. Thus, stock participation often makes sense as a value-driven incentive. In a competitive market, incoming shareholders who succeed in finding a good acquisition opportunity do not want to risk blowing their deal by taking a rigid stance with sellers. (For related reading, see: The Basics Of Mergers And Acquisitions.)

Many advisors will share their client's financial and operational summary with the existing owner. This approach helps increase the level of trust between the intermediary and potential seller. The sharing of information can also encourage the owner to reciprocate. If there is continued interest on the seller's part, both companies will execute a confidentiality agreement (CA) to facilitate the exchange of more sensitive information, including additional details on financials and operations. Both parties may include a non-solicitation clause in their CA to prevent both parties from attempting to hire each other's key employees during sensitive discussions.

After the financial information for both companies has been analyzed, each side can begin to set a possible valuation for the sale. The seller will most likely calculate anticipated future cash inflows with optimistic scenarios or assumptions, which will be discounted by the buyer, sometimes significantly, to lower a contemplated range of purchase prices. (For more, see: The Merger - What To Do When Companies Converge.)

If the client company wishes to proceed in the process, its attorneys, accountants, management and intermediary will create a letter of intent (LOI) and send a copy to the current owner. The LOI spells out dozens of individual provisions outlining the basic structure of the potential transaction. While there can be a variety of important clauses, LOIs can address a purchase price, the equity and debt structure of a transaction, whether it will involve a stock or asset purchase, tax implications, assumption of liabilities and legal risk, management changes post-transaction, and mechanics for fund transfers at closing.

Additionally, there may be considerations involving how real estate will be handled, prohibited actions (such as dividend payments), any exclusivity provisions (such as clauses preventing the seller from negotiating with other potential buyers for a specific time period), working capital levels as of the closing date, and a target closing date.

The executed LOI becomes the basis for the transaction and helps eliminate any remaining disconnects between the parties. At this stage, there should be a sufficient agreement between the two parties before due diligence takes place, especially since the next step in the process can quickly become an expensive undertaking on the part of the acquirer. (For related reading, see: How legally binding is a letter of intent?)

Accounting and law firms are hired to conduct due diligence. Lawyers review contracts, agreements, leases, current and pending litigation, and all other outstanding or potential liability obligations so the buyer can have a better understanding of the target company's binding agreements as well as overall legal-related exposure. Consultants should also inspect facilities and capital equipment to ensure the buyer will not have to pay for unreasonable capital expenditures in the first few months or years after the acquisition.

The accountants and financial consultants focus on financial analysis as well as discerning the accuracy of financial statements. Also, an assessment of internal controls is conducted. This aspect of due diligence may reveal certain opportunities to lessen tax liabilities not previously used by existing management. Familiarity with the accounting department will also allow incoming management to plan for consolidation of this function post-transaction, thereby reducing the duplication of efforts and overhead expenses. A buyer should understand all of the legal and operational risks associated with a proposed acquisition.

Prior to the closing of the transaction, both the seller and the buyer should agree to a transition plan. The plan should cover the first few months after the transaction to include key initiatives in combining the two companies. More often than not, acquisitions lead to shakeups in executive management, ownership structure, incentives, shareholder exit strategies, equity holding periods, strategy, market presence, training, make-up of sales force, administration, accounting and production. Having a checklist and timeline for each of the functions will facilitate a smoother transition. The transition plan also helps direct mid-level managers to complete tasks that move the combined company toward achieving its business plan and financial metrics. It is the go-forward plan after all that, if accomplished, realizes the value for both the exiting and incoming shareholders.

(For further reading, see: The Wacky World Of M&As.)