4. Proceed With The Preliminary Business and Financial Investigation Of The Most Attractive Seller. - A discussion of all the points that must be investigated at this stage of the acquisition is too extensive for this article, as the investigation will cover all facets of the seller's business. However I will highlight the 14 most significant points that should be covered in the preliminary investigation of the seller's business:
A. Define its corporate culture. Assure that it is compatible with your philosophy of managing a business.
B. Assess the seller's product lines and markets served. Make sure they are either compatible with yours, or their diversity from you provides a strategic benefit. In many acquisitions, this diversity in product lines and/or markets is one of the strategic, synergistic benefits that is wanted from a deal. The impact of these factors on future growth and profitability should be determined.
C. Determine how the seller obtains its sales and customers. Could the acquisition pose a realistic threat to a portion of its customer base? Are the customers likely to be as comfortable and satisfied with the acquirer after the deal, as they were with the seller before? A determination must be made of any expected diminution of the customer base due to the acquisition. Obviously, this should be factored into the offering price.
D. Evaluate any concentration of customer base issues. To the extent there is a concentration of customer base, assess how this risk could impact the seller's future sales level.
E. Assess the cost efficiency of the warehousing operations and purchasing capabilities. Determine how these functions can be integrated with your operations and their projected impact on future profitability. Will the acquirer's projected procurement costs increase future profitability?
F. Evaluate the capability of the seller's distribution center to handle any projected future sales expansion. Are there any additional capital expenditures required to bring the warehouse capacity to the level needed to handle future volumes?
G. Define the seller's future growth possibilities. What is the likelihood of them occurring? What is the expected cost to bring them to fruition?
H. What are the seller's future business vulnerabilities? These could include the expected loss of certain key customers or market segments, the expected entry into the market of certain large foodservice distributors that could impact future volume or order pricing, the possible loss of key personnel, etc.
I. Does the seller have adequate management depth? If it doesn't, what are the expected personnel additions and their cost?
J. Assess the likelihood of retaining key management and sales personnel. To the extent there is risk in this area, define what it will take to minimize this risk. What are the potential costs, if these risks become reality? Would it be beneficial to sign key management and sales personnel to employment contracts concurrently with closing the deal? However, regarding that consideration, remember that signing key personnel to an employment contract only assures the continuity of their employment. It does not guarantee the effectiveness of their performance. Nevertheless, one certain benefit of signing key personnel to employment contracts is that these contracts should contain strong covenants-not-to-compete, which will prevent key employees from competing against you in the near-term.
K. Review and assess the fringe benefit programs. Are they compatible with yours? If not, what are the costs to bring the fringe benefit programs in-line? If the fringe benefit packages are considerably in excess of yours, what is the likely impact on the employees' future performance, if their fringe benefits are reduced to your levels?
L. Assess any potential environmental or litigation exposure that you might have related to outstanding issues or those that might arise from the seller's business. Obviously, you want to avoid any exposure for these environmental or litigation costs. Determine what the seller has done to verify its level of environmental exposure. Ascertain the position of the seller's legal counsel on environmental and litigation issues that could arise. This must be determined at an early date, as this area is fraught with "deal breakers" that can make an otherwise attractive deal, one that must be avoided at all costs.
M. Have your CPA verify the overall reasonableness of the prior financial results. This verification need not be a full audit of prior financial results.
N. Have your acquisition advisor, assisted by the CPA, develop or review any projected forecasts for the seller's business. This is especially important because the true determinant of a reasonable deal price is the expected future earnings/EBITDA and the risk involved in achieving those earnings/EBITDA.
5. Develop the Initial Offer and Submit It to the Seller. This Should Eventually Lead to the Negotiation of a Letter of Intent (LOI) between the Parties.
A. Make your initial offer. This should serve as the basis for negotiations leading to the execution of a LOI.
B. The LOI should have a clause that prohibits the seller from having any further conversations with prospective acquirers.
C. Concurrent with negotiating the LOI, discuss with seller's legal counsel the rep, warranty and indemnification issues of the DPA. Make sure there is conceptual agreement on how the risks related to these issues will be shared. These issues are of equal importance to the transaction price, itself. If there is not a reasonable "meeting of the minds", there is no reason to try and consummate a deal. If these issues cannot be resolved in a satisfactory manner, an acquirer is well-served to not transact a deal.
D. The drafting of the initial DPA is of critical importance. The acquirer should make it a high priority to obtain the right to draft this document.
E. If all these items can be satisfactorily resolved, then the LOI should be executed.
6. Perform Your Due Diligence, Negotiate the Definitive Purchase Agreement and Close the Deal.
A. At this point, your acquisition advisor, CPA and management group should perform all necessary due diligence steps. Do not "cut corners" in this area. Make sure that all issues are investigated thoroughly. Once the transaction has been completed, except for the protections provided in the rep, warranty, covenants and indemnification sections of the DPA, all future liabilities arising from the seller's business will be yours. All key facts pertinent to the seller and its prior operations should be investigated before a deal is closed. The performance of the due diligence must be done with the utmost sophistication and expertise. Otherwise, it can lead to a deal where the hidden costs that arise after a deal are devastating.
B. Negotiate the DPA and ancillary documents that will serve as the legal governing documentation for any issues that arise after a deal. Your acquisition advisor should direct all negotiations on your behalf. Legal counsel should work in-conjunction with him/her but under his/her direction. The acquisition advisor should be the one making the business judgment on the financial consequences of the legal issues resolved in the DPA.
C. The deal should be structured so there are financial incentives, either positive or negative, that will accrue to the seller based on their cooperation after a deal. Verbal assurances of cooperation are meaningless, unless there are financial consequences attached to a lack of cooperation in the governing transaction documents.
D. Obtain long-term, restrictive covenants-not-to-compete from all of the seller's shareholders and their families. A term of five years, or more preferably, 10 should be obtained. If the seller balks at this, it raises serious doubts about their intention of staying out of your markets. Without these covenants, the seller's company is worth considerably less than it otherwise would be. The absence of these covenants increases your risk factor to an unacceptable level.
E. Any employees that execute employment contracts with you should be placed under strong covenants-not-to-compete. However the duration of these covenants should be for a much shorter period than that suggested for the selling shareholders, or they will not be legally enforceable.
F. Define what should occur during the transition process after the deal is consummated. This will define how the seller's operations will be consolidated with yours and how the company will be managed after the deal. It will cover how the seller's employees will function within your organization. These procedures should be defined and agreed to. They should begin to be implemented upon the consummation of an acquisition, and the transition process should immediately be operating at full speed. This is of the utmost importance to a sophisticated acquirer, as they realize that many otherwise potentially attractive acquisitions produce disastrous results because of a poorly-planned, inept transition process.
As an acquirer pursues its acquisition program, he should remember that many of a company's best deals are the ones that aren't closed. If a deal can be done right, it should be pursued with maximum intensity and closed as quickly as practical. However, if a deal's price, terms, structure or risk are inconsistent with the expected return that you require, the deal should be terminated regardless of how close to finalization it is. Never allow yourself to be so emotionally committed to a deal that the seller will be able to obtain terms or conditions that are not commensurate with the value of the company. If an acquirer follows this psychological mandate, they significantly increase their chances of consummating only good deals.
An acquirer that bases his acquisition and expansion program on these fundamentals and executes them with professional expertise and guidance is likely to have a successful acquisition program that contributes to a strong and profitable business.
George Spilka is president of George Spilka and Associates, a Pittsburgh-based merger and acquisition consulting firm that specializes in middle market, closely-held corporations. This is his third article on sales and acquisitions in ID Access. Visit his website at www.georgespilka.com
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