Typically, after determining whether a business has synergy with one another, businesses will decide to combine by negotiating an acquisition or merger agreement. After this agreement is reached, credit committees at both companies work to approve the deal by evaluating while keeping in mind profit margins and return on investment (ROI). The next step is to seal the deal by working out any last minute details that have come up in these negotiations.
Budgeting is the process of forecasting revenue and expenses for a period of time. In order to effectively set a budget, you must first define how much revenue and how much expenses you expect to receive during that period of time. The agreement will then be determined by these forecasted numbers.
The price for acquiring another business should closely match the forecasted revenue expectations in the acquisition agreement. The great part about doing this is that it creates more value for both parties because the company’s P&L (Profit & Loss) statement will reflect fair market value by incorporating both companies’ forecasted metrics into it.
Budgeting has been shown by budget process consultants to increase ROI by improving forecasting capabilities and project performance as a whole. When companies budget well, they begin planning sooner in the year, which allows them to develop a better plan with more accurate expectations of revenue and expenses. This also allows companies to create realistic budgets for product development, which helps with resource allocation, forecasting, and development of new products or services.
In the process of M&A, an acquisition is essentially “buying” the company from its owners. To do that, you must pay for their stock (not necessarily all of it) or take on debt with the bank. An acquisition always involves the acquisition price, which is the amount it would cost to buy another business. The key part of the acquisition process is to negotiate with other companies and find a fair price.
In a strategic financing process like mergers and acquisitions (M&As), the budget is the first step in planning how to achieve success. The budget is the final overview of a company’s financial plan for capitalizing an acquisition, it serves as a guideline for what makes sense to do and how much money this will cost. The budget also formulates which assets will be sold off, what can be retained, and what new investments are going to take place during this process.
There are a variety of different types of budgets that M&A professionals use including: proforma budgets, project pipelines, scenarios-based budgets and hybrid budgets. In this blog post you’ll discover which type might be best for your situation.
Proforma budgets are used to forecast a company’s financial statements. They are important because they give the investor insight into how the acquired company’s assets and liabilities would be treated in the case an acquisition was made. Proforma is a Latin word meaning “for the sake of form” or “as a matter of form”, indicating an action done in accordance with established rules, rather than for any useful result. The proforma income statement includes all expenses related to running the business, regardless of whether or not it has been incurred yet. The proforma balance sheet lists all assets, liabilities and equity balances as if they have been acquired. It includes all of the assets and liabilities assumed from the proposed acquisition target, including intangible assets and any outstanding liabilities.
Proforma budgets can be used to make assumptions about the future that are believed to be reasonable. The proforma income statement is a set of forecasted results that reflect changes that will occur in a company’s operations due to the acquisition. Proforma financial statements are designed to include the effects of an acquired company’s previous year-end balance sheet and income statements, as well as changes in working capital and long-term debt due to an acquisition or merger.
A proforma budget is only as useful as the assumptions and projections used to generate it. The proforma budget might not include key information that the deal’s financial advisor believes is essential for an investor to make an informed decision whether or not to recommend their investment. For example, if the acquired company had a strong balance sheet and projected revenue growth, but you didn’t take into account that they were in the process of developing numerous new products and licensing agreements with other companies all over the globe, your forecast may be conservative.
An investor can input assumptions into a proforma budget by inserting assumptions into spreadsheets or through a programming language like Microsoft Excel. Proforma financial statements are commonly used to assist the buyer in determining how much it is going to take to close the deal.
Project pipelines are used during M&A due diligence and consist of a series of finance scenarios depicting how an acquisition might play out through the completion of the process. A good M&A/finance professional will compile as many scenarios as possible that depict all possible outcomes from the acquisition including: seller financing, seller equity, seller debt, seller cash and other items such as confidentiality agreements or termination clauses in the event that one or both parties decide not to complete the transaction. These scenarios could include multiple potential paths for achieving break-even by different combinations and timing of expenses. For example, analyst firms such as Maxim Group have been known to include up to ten different scenarios.
A key benefit to project pipelines is that they create greater transparency when it comes time for the acquisition’s financial advisor to give the seller and lead investor a sense of what their exposure may be during due diligence. In the example above, if your company was in discussions with a private equity firm over an acquisition, you would want them to be able to see what your exposure might be under each scenario and how it relates to their investment.
Project pipelines are similar to proforma budgets but differ in a few areas. First, for each scenario, the project pipeline will determine what information is important to include in the report. Project pipelines are typically much more detailed than proformas as they list all of the key items such as date -of-close, break-even, intangible assets and other details that will be needed for analysis and reporting. Second, projects pipelines can include assumptions about future events that are not included in the proforma budget. These additional assumptions might be needed to ensure that transactions are completed at an acceptable price or that certain specified timescales can be met.
A hybrid budget is a balanced budget that incorporates elements from each type of budget. Hybrid budgets combine elements from fixed and variable budgets in order to provide a more accurate view of a project’s potential impact on the acquired company’s operations. A hybrid budget can be constructed at various stages in the acquisition process, for example:
When deciding which assets can be retained or sold, the company might use proforma and project pipelines. The buyer may also use simulations of future transactions using different scenarios as part of their due diligence. These scenarios are created by a combination of fixed and variable budgets as well as assumptions such as revenue growth and market share achieved during the deal.
The idea for a hybrid budget has its roots in dynamic or flexible budgets. Dynamic or flexible budgeting is a budgeting system that shows how money is to be spent and the impact of spending changes on future revenues and costs. Conventional budgets focus more on form than substance, while dynamic/flexible budgets focus more on substance than form. As one of several alternatives to traditional forecasting, dynamic/flexible budgets can be used at almost any stage of the M&A process:
During due diligence, dynamic/flexible budgets are often used by financial advisors to help determine payback periods and other metrics necessary for the buyer to assess the initial investment opportunity. Retailers are more likely to use hybrid budgets for the same reason.
If the buyer is evaluating a deal for introduction to their board of directors, it might feel like the company’s senior management team has been keeping things from them. In this case, a consultant can help by creating a dynamic/flexible budget such as a revenue and profit forecast. A dynamic/flexible budget enables companies to develop internal forecasts as well as evaluate forecasts from external sources. An internal dynamic/flexible is easier to digest for senior management teams, who are concerned about long-term results rather than short-term concerns such as quarterly operating performance.
A company could use a dynamic/flexible budget to determine whether the purchase would pay off before investing the money. A dynamic/flexible budget enables an organization to see where the benefits of a deal outweigh its costs or risks. This can be useful when making major decisions such as whether to invest in an acquisition, new products or equipment, or other items.
An important thing to keep in mind is that there is no one-size-fits-all approach when it comes to acquiring other businesses. It all depends on several factors such as your company’s size, industry, location, etc.