Preliminary due diligence is an important process for any acquisition, but it is especially critical for acquisitions of private companies. It’s not enough to show how the company makes money—you also need to be able to articulate how (and why) you want it in your portfolio and what contribution it will make relative to its cost.
Business cases are available in a number of forms and can be represented in written, oral or graphical format, but they all have the same basic goals. You want to show:
- What purpose the investment will serve (financial metrics);
- Why that purpose is important; and
- How you want to leverage your investment (your investment thesis).
By understanding the importance of business case preparation, you can plan ahead to ensure that your team has everything it needs to complete this process prior to closing a transaction. The first steps are outlined below.
Steps for Business Case Preparation
Discovering the Business: Identify and understand the purpose of your investment (financial metrics). Factors you will analyze include: 1) economics or cash flows; 2) market share or growth prospects; 3) customer base or distribution channels; 4) products or services (or former products/services); 5) technology, patents and intellectual property; 6) industry segments (e.g., “boutique” vs. “mass-market”); 7) competitive analysis (industry and company); 8) financial position; and 9) business processes (i.e., how the company operates).
Understanding the Business: As you review the information that you’ve gathered, you need to start thinking about the proposed acquisition as a potential portfolio investment. What will you do with it? How will it fit into your existing operations? These questions need to be answered prior to looking at valuation.
Understanding the Target: When reviewing the target’s financials within your business case, analyze each line item in more detail so that you can identify potential impacts on—and opportunities for—future performance. Identify the target’s:
- product/service offerings;
- customer base;
- distribution channels;
- sales force (how customers are acquired);
- products or services that are in greatest need of an upgrade/redesign;
- technology (including patents and intellectual property);
- profitability (i.e., gross margins and operating margins); and
- financial position, including cash flow and debt levels, as well as equity position in relation to other companies within the portfolio.
As you identify opportunities and threats, you need to determine whether the target is a “good candidate” for an acquisition or whether it is a “bad candidate.” A good candidate is defined as one that has value-add potential (i.e., significant long-term upside) and with which you have strong strategic or operational ties. A bad candidate is defined as one that is not a good fit (i.e., higher risk/return), has less promise than value, or has unknown limitations.
The following are examples of when a company is a bad candidate:
- If you haven’t worked with the company or the management, or if you don’t have an intimate awareness of their culture, environment and operations;
- If there is no history of success in acquiring or integrating this type of target (your team must be versed in how to work with this type of target);
- If there are serious issues as to whether regulatory approval will be granted for the acquisition;
- If more than one industry segment is involved (core competencies differ);
- If your team cannot articulate clear value creation opportunities, particularly from a technology perspective;
- If the company’s earnings are below its cost of capital;
- If there is little liquidity within the target’s share structure or limited ability to issue shares (i.e., private equity financing); and
- If there are unknown liabilities or legal issues with the target.
As you begin your due diligence, uncover any potential problems that currently exist and identify any potential risks that could impact the acquisition (i.e., headcount reductions, technology changes). Your goal is to determine whether these issues can be mitigated once you have control of the target (e.g., focus on cash flow), as well as what plans need to be put in place so that they don’t become obstacles to future growth.
Understand the Competition: The next step in completing your business case is to understand the competition. This analysis should help you uncover possible value creation opportunities that may not be obvious now. You’ll want to look at:
1) gross margins;
2) operating margins;
3) growth prospects (e.g., customer base, new product/service launches);
4) profitability (i.e., cash flow and returns on assets);
5) return on capital; and
6) return on investment (where applicable).
The following are examples of when competition is a bad candidate:
- If the target has failed to successfully compete against stronger or potentially stronger rivals or seen them thrive as your target has underperformed;
- If the companies within the target’s market have a greater amount of capital to spend on research and development (R&D), thereby allowing them to gain a significant technological advantage;
- If the target’s industry is characterized by low demand elasticity, thin margins and high customer switching costs;
- If there are increasing barriers to entry (increased capital requirements, increased customer switching costs, increased channel control);
- If the target’s customer base is fickle or highly price-sensitive in comparison to its competitors;
- If there are fewer opportunities for innovation and differentiation for your target;
- If there are new entrants into the marketplace that can offer unique products or services at lower prices (i.e., disruptive innovation);
- If you are unable to articulate clear value creation opportunities in the target’s market, particularly from a technology perspective;
- If the target’s business model is no longer viable or cannot compete against peer industries (e.g., declining gross margins); and
- If there are unknown liabilities or legal issues with the target.
Analyze the Cost Structure: The fourth step is to identify the cost of capital in your proposed acquisition, establish whether the acquisition has an operational fit within your business case and determine whether it has a potential for long-term profitability within your portfolio holdings. The following are examples of when cost of capital is a bad candidate: 1. If the target’s cost of capital is higher than your cost of capital (i.e., you’ll be incurring more financial risk); 2. If the target has a high level of leverage and no ability to absorb excess cash (i.e., will require additional funding to grow); or 3. If your proposed acquisition is too big, thereby increasing your risks and volatility as well as its costs.
Analyze the Cost Structure: The fourth step is to identify the cost of capital in your proposed acquisition, establish whether the acquisition has an operational fit within your business case and determine whether it has a potential for long-term profitability within your portfolio holdings. The following are examples of when cost of capital is a bad candidate:
1. If the target’s cost of capital is higher than your cost of capital (i.e., you’ll be incurring more financial risk);
2. If the target has a high level of leverage and no ability to absorb excess cash (i.e., will require additional funding to grow); or
3. If your proposed acquisition is too big, thereby increasing your risks and volatility as well as its costs..
In either case, this can create a situation where you’re not able to obtain adequate returns on your investment in an acquisition and will be required to sell at a lower price than if you had acquired at a lower price based on maximizing your return (i.e., truly disciplined buying).
Exit Strategy
Exit Strategy is the process of deciding how, when and whether to sell your investments. In order to make the best decisions, you need to understand the various exit strategies available in order to mitigate risk and realize the value of your investment. At Horizon Partners, we help our clients identify and access all possible exit strategies. We then assist them in executing each strategy with confidence and integrity.
