After identifying a suitable market to enter, the next stage of evaluating a potential acquisition target is to conduct a detailed analysis into the target company to determine if it is investment worthy. Generally, we should consider a few criteria: (1) the commercial value of the Target’s business model, (2) the Target’s financial condition and (3) if the Target is subject to any material legal risks.
Is the Target’s business model commercially attractive?
The first step of the process is to understand the Target’s business model. It is imperative to fully understand how the business operates and if there is any potential for growth. We should study the Target in the context of the industry to assess if the business model is viable in the long run.
Next, we should consider the market position that the Target is in. It is important to study the value chain of the industry and assess where the target firm fit in. Furthermore, we should examine the dynamics of the industry and determine if the Target has a competitive positioning.
Following which, work should be done to assess the products and services offered by the Target. This is where potential revenue synergies between the Acquirer and the Target can be identified. Synergies can be harnessed from cross selling of products/services between the two firms, sharing of distributions channels or complementing the existing product/service portfolio.
Lastly, we should consider any technical expertise that the Target possesses. It could be in the form of intellectual property rights, research & development knowledge or certain trade secrets. There could be integration of the technical expertise with the Acquirer’s business to enhance the overall value of the combined firm.
Is the Target’s financial condition desirable?
A thorough analysis of the Target’s financial forecasts is a cornerstone in determining the desirability of any investment. After all, any purchase consideration for a firm must be compensated with the future returns that the Target can generate.
The first consideration for the Target’s forecast should be on the revenue. This is where we consider the Target’s business model and determine the factors that drive the revenue. We should consider the growth of the Target’s market and whether the firm is able to gain market share based on the strength of its competitive advantage. In addition, revenue projections should also account for the potential synergy between the two firms.
Next, we should consider how the operating margins of the Target will look like. We should understand the cost structure and if they are going to change to support any future strategic goals. Furthermore, projections on costs should account for any synergies of the combined entity. In addition, capital budgeting should be done to assess how much capital expenditure is needed for future expansion.
Lastly, we should decide on the optimal capital structure, in terms of both debt and equity, the Target firm should hold. This is to take advantage of any available debt headroom to lower the cost of financing the acquisition while avoiding taking on too much risky leverage.
Is the Target subjected to any material legal risks?
Under most circumstances, the Acquirer usually assumes all the liabilities of the Target after the acquisition is complete. Therefore, it is imperative to uncover all potential acquisition risks, hidden liabilities and problems that the Target may have. The due diligence process will cover the organizational structure, operating license, material contracts and any pending litigation that the Target is facing.
In order to increase the success of a M&A, a great deal of work has to be done to determine the risk and reward that a Target firm can provide. All these will help determine what is the fair purchase price of the Target and help with the overall integration process. If done well, the synergies of the merger will prove the attractiveness of the deal and generate superior returns for the investors of the combined firm.
