Tuesday, May 31, 2011

Lesson #38: Things to Consider When Buying a Business

Posted By: George Deeb - 5/31/2011


& Comment

At times, it may makes sense to acquire a business.  Reasons could include acquiring technology or other assets, patents, or a revenue stream or client base.  Or even, for simply taking out a potentially competitive long term threat.  In today's post, we will assess how to go about: (i) identifying targets; (ii) approaching targets; (iii) things to look out for during due diligence; (iv) valuing target companies; and (v) structuring the deal.

As for identifying targets, my guess is you most likely have a target in mind if you are reading this post.  But, if not, there are many places to look for prospective targets.  Most industry associations have lists of key companies in their industry.  Many journalists or bloggers have specific industry or startup focus, and they may know about various players in the space.  As, do various investment bankers, many of whom typically have a specific industry focus.  So, use Google to track down who these key players are, that can point you in the right direction.  In addition, there are several websites that advertise companies for sale by industry, including BusinessesForSale.com,   BizQuest and BizBuySell.com, to name a few.

When you have found a target, how you approach them will go a long way towards increasing your odds of getting to the finish line.  Sometimes it makes sense to approach them directly, and other times it makes sense to approach them through a third party intermediary.  The latter is better with highly competitive businesses or with executives that may not present well on a first call.  And, when you do approach targets directly, I recommend not jumping right into merger discussions.  This is all about building up a relationship and comfort for the target company.  So, I like to start with "potential partner" discussions, that ultimately evolve into "potential merger" discussions down the road.  And, worth mentioning, the word "merger" sounds less harmful than "acquisition", for the target who is not quite ready to let go the reins.

During due diligence of the target company, make sure you have your lawyer send over a detailed information request list, which could include, review of: (i) all company financial statements, historical and projected; (ii) all company ownership history and shareholder records; (iii) list of all known assets of the business; (iv) a list of all known liabilities of the business, or its shareholders; (v) a list of all current and past employees by title, including resumes;(vi) a list of all contracts of the business; and (vii) a list of all intellectual property, to name a few.  These schedules will become the basis of any representations or warranties made by the seller in the closing documents.  But, more important than anything, make sure you trust the people you are "getting in bed" with.  So, make sure there is a good personality fit, a good skill fit and a good trust factor with the selling company and their shareholders.  Call their trade and personal references as a critical step during due diligence.

In terms of valuing a target business, the methodologies are no different than how you would value your own startup business with prospective investors, which we discussed back in
Lesson #32.  So, please re-read that post for the details.  But, with a merger, there is one additional technique which can be used, which is a "relative contribution analysis".  The relative contribution could relate to revenues or profits or website visitors or customers or whatever other metric the two companies can agree properly value their relative contributions.  So, let's say the acquiring business has $1MM of revenues and the target business has $500K of revenues.  In this example, Newco could be owned 66.7% by the acquiring company and 33.3% by the target company, using this methodology. 

But, if you do not like what the relative contribution method has to say, or if you don't want any outside shareholders in Newco, cash will be your primary currency using one of the techniques discussed in Lesson #32.  Beyond making the cash or equity acquisition decision, other structural considerations include the following.  The most important is deciding between an "equity purchase" or an "asset purchase".  The latter is preferred, as it leaves all the liabilities and other "skeletons in the closet" with the target company's shareholders, and do not transfer to Newco.  The timing of payments is another consideration.  If you don't have all the cash day one, you can structure payments over time if the seller is willing to take a seller's note from the buyer at closing.  Or, if you cannot agree on upfront valuation, you can put earn-out mechanisms in place, to get the target future upside payments if certain projection thresholds are met.  But, earn-outs are complicated to write for both the buyer and the seller, so get good legal advice here.  The other structural consideration is making sure the seller gives the buyer proper representations and warranties (from both the company and their underlying shareholders, individually and collectively), to make sure there are refunds to the buyer if anything was not delivered as promised after closing.  And, don't forget to make sure the target company is delivered to you with an adequate amount of working capital, in line with historical levels.

At the end of the day, there are a lot of things that go wrong with acquisitions, and very few go perfectly to plan.  So, be conservative in your forecasts, and consider haircuting target revenues by 50% as a cushion, especially if the "entrepreneurial fire" of the target's CEO are not going to be a part of Newco.  And, before going down this road in the first place, make sure you have done a complete "buy vs. build" analysis for this decision.  As, it may be cheaper to ultimately build the solution yourself, and not have to deal with any of the business combination or cultural integration issues of a merger or acquisition.  Proceed only with caution here, to not upset the apple cart.

This is too complicated a topic to detail in a simple post, so get a good lawyer to help you here.

For future posts, be sure to follow me at:  www.twitter.com/georgedeeb

Red Rocket is a featured contributor on entrepreneurship for many trusted business sites:

Copyright 2011- Red Rocket Partners, LLC