Selecting a Potential Target Company for Acquisition
As was discussed in Chapter 4, the search for and screening of a potential target candidate require applying a set of criteria such as the industry of the target firm and size of the deal. Of course, the size of the transaction is determined by the price of the target company.
Specifically, selecting a target company for mergers and acquisitions (M&As) involves implementing the following tasks.
Identifying and Understanding the Industry of Target Company
In goal-oriented acquisitions aiming to fulfill the strategic plan of the acquiring firm, identification of the industry in which to acquire a company has already taken place in formulating the strategy.
To understand an industry, however, one should know the competitors and degree of competition in the market. A popular method of measuring the degree of concentration in industries is Herfindahl–Hirschman index (HHI).
HHI measures the degree of competition in an industry and is the sum of squares of market shares of the firms in an industry. Formally, we express HHI as follows:
where Si denotes the market share of the ith firm in the industry, and n is the number of firms in the industry.
We use an example to illustrate the meaning of HHI. Suppose a single seller dominates an industry, that is, the company is a monopoly. This situation implies that the monopoly has 100 percent of the industry’s sales. Using the HHI formula, we have 
. The number 10,000 means that degree of concentration in the industry is 100 percent, or there is no competition in the industry.
Now, suppose the industry consists of 100 firms and each firm has 1 percent of the total sales of the market. Again, using the HHI formula we have
This number is the lower bound of concentration measure in this example and implies no concentration. Therefore, the value of HHI in this example falls in the interval 100 ≤ HHI ≤ 10,000. Note that in an industry with 1,000 firms, where each firm has one-tenth of the market share,
In the above examples, the analysis implies that the maximum upper bound for the index cannot exceed 10,000, the lower bound varieties according to the market shares, and number of the firms in the industry. In general, the higher the value of HHI, the higher the degree of concentration in the industry.
Assessing the Market Size and Growth Potential
Market share refers to the company’s total sales as a percentage of total sales by all firms in the industry. One could purchase market share data from vendors such as Market Share Reporter, Global Market Information Database, and Mintel Market Research Reports.
Of course, having some measure of concentration in an industry is useful in knowing the competitors in the industry and assessing the potential for growth based on the reality of the market. For example, an acquirer might merge with a target to achieve economies of scale and increase its market power in an industry with many competitors and firms with little market power.1
Assessing the Technological Changes and Trends in the Industry
Appraising technological changes requires an intimate knowledge of the current technologies in the industry. Employees with technical expertise should perform the task in the technological fields. Mowery argued that one reason for the development of research and development (R&D) departments by large companies is monitoring technological opportunities and threats faced by them (Mowery 1990).
Identifying Barriers to Entry in the Industry
Barriers to entry into an industry could be formidable in industries with low competition. Barriers to entry include economies of scale, patents, copyrights, licenses, control of inputs, brand royalties, and high cost for consumers to change their supplier. The barriers to entry should be identified during the selection process.
After the selection of an industry based on the factors above, a preliminary research for identification of a target company in the industry must be conducted. This task requires that the acquiring company develop the acquisition candidate pool.
Developing the Acquisition Candidate Pool
This step of the process should be based on the following:
• Assessing competitive position of the firms within the selected industry:
As discussed previously, one could use HHI in determining the degree of competition in the industry of the target firm.
• Estimation of revenue and size of the firms:
One could use annual revenues, asset value, or a number of employees of the target in determining the size of the firm.
Market capitalization refers to the total value of a company’s outstanding shares. Of course, the value varies according to the price of the stocks.
• Location of operations:
Location of operations especially in cross-border acquisitions should be identified.
Target-Screening Process
The target-screening process involves developing target profiles, defining screening criteria, and prioritizing targets. We discuss these tasks next.
Developing Target Profiles
In developing profiles of the target companies, one should keep the following considerations in mind:
• Business strategy (What is the target company’s business strategy?)
• List of products sold by the target
• Major news about the firm
• Customer data
• Target firm’s consolidated financial data
• Regional and international performance data of the target firm
• Cultural assessment
• Organizational assessment
• Integration options: absorb, maintain separate identity or operations, and partially absorb
• List of subsidiaries, affiliates, properties, directors, and executives
• Based on these considerations, select some target candidates from a larger list of target companies.
Defining Screening Criteria
The criteria used for screening should be based on the M&A strategic plan, financial plan, budget, and resource requirements, and should include the following items:
• Affordable price range (how much the acquirer can afford to invest in purchasing the target)
• Target size preference (determine the size of the potential target by market capitalization, revenues, net asset value, and so on)
• Profitability requirements (estimate earnings before interest, taxes, depreciation, and amortization [EBITDA or EBIT], net margin, and free cash flow requirements)
• Determine the desired level of control over the target
• State preference for transaction structure (acquisition of shares vs. assets and acquisition vehicle inside or outside of acquiring company’s home country)
• Management requirements (decide on leadership style, expertise needs, receptivity to change, compatibility of culture, and model of postmerger management)
• Define marketing factors such as product lines, customer base, brand reputation, geographic presence, and distribution channels
• Identify R&D requirements such as licenses, patents, R&D centers, and investment
• Examine production requirements such as facilities, labor supply, production methods, and capacity.
Prioritizing the Targets
After screening the targets, they should be ranked so that the highest ranked firm is approached for acquisition or merger talks.
Financial Assessment of the Acquiring Company
After identification of a target industry or firm, the acquiring company should evaluate its value before the further pursuit of the target. The self-financial assessment enables the acquiring firm to determine its financial strength and learn whether it can absorb another entity. The acquiring company should assess its working capital and capital investment requirements through cash flow projection.
The following important questions must be answered.
1. What is the total financing requirement of acquiring the target and continuing future operations?
2. Will the cash flow generated by the company pay interest and principal on loan for financing the acquisition?
To answer these questions, we first need to define several terms.
Cash Flow Statement
A statement of cash flows is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities (Wikipedia 2014).
Operating Activities Cash Flow
Operating activities cash flow emerges from payment of expenses relating to production, sales, and delivery of products to customer activities as well as a collection of payments from the customers.
Investing Activities Cash Flow
Cash flow from investing activities emerges from purchase or sale of a real or financial asset, for example, land, building, machinery, and financial securities.
Financing Activities Cash Flow
Financing activities cash flow emerges from the inflow of cash from investors, banks, shareholders, and outflow of cash to shareholders, and interest payment.
Example:
A company acquires a target firm. The postmerger financial statements show the following cash flows:
• Sales revenues: $25,000
• Cost of goods sold: $12,000
• Net interest payment: $2,000
• Dividends: $500
• Cost of assets acquired: $8,000
• Wages and salaries: $7,000
A cash flow statement for this company is given in the below table.
Statement of cash flow: January 1, 2017 to December 30, 2017
|
Cash flow from operations |
25,000 – (12,000 + 7,000) = $6,000 |
|
Cash flow from investing activities |
($8,000) |
|
Cash flow from financing activities |
($2,000 + 500) |
|
Net cash flow |
($4,500) |
Problem 5.1
Company XYZ has the following cash flow activities during 2017:
Net cash flow from operating Activities: $194,000
Investing activities:
Land purchase: $70,000
Building purchase: $200,000
Equipment purchase: $68,000
Financing activities:
Dividend payment to shareholders: $18,000
Issuance of bonds payable: $150,000
Prepare a cash flow statement for the company.
Due Diligence
After identification of the target firm, due diligence activities should take place. As discussed before, due diligence refers to processes in M&As with the aim of assessing the potential risks of proposed transactions by close examination of the past, present, and future (so long as the prediction of future is possible) of the target enterprise. The aims of comprehensive due diligence are said to be
. . . an objective examination of the target company’s financial stability and adequacy of its cash flow, its products and services, the way that the company makes and loses money, the future market, its competitive position, and management’s ability to meet strategic objectives. Due diligence should be a comprehensive analysis of the target company’s business—its strengths and weaknesses—its strategic and competitive position within its industry. (Angwin 2001, 35)
It is useful to start due diligence activities by preparing a preliminary information request list. An initial information request list follows:
• What are the issues identified in a preliminary assessment of the target?
• What is the financial position of the target enterprise?
• What is known about the background of the potential target firm’s management team?
• What is the reputation of the potential target company?
• Are the financial conditions and track record of the potential target firm consistent with the acquiring company’s tolerance for risk?
• What is the impact of the regulatory environment on the target firm’s future operations?
Often, specific issues arise in due diligence information-gathering processes. Some of the typical problems are listed as follows:
• Potential targets are unwilling to supply the requested information for due diligence review.
• Financial statements may be ambiguous or inaccurate due to different accounting principles used in preparing them.
• Much of due diligence information may not exist or may not be available.
• Differences in valuation methods could pose difficulties.
• The target company may hold nontransferable assets such as licenses.
As stated previously, due diligence processes aim to gain an understanding of the strengths and weaknesses of the target enterprise. In general, due diligence involves two stages: the preliminary stage and the full stage. Full diligence is conducted only after initial due diligence warrants further exploration in the processes of acquiring the target firm.
Full diligence, sometimes called confirmatory due diligence, is often outsourced to professional firms such as consulting companies or law firms specializing in M&As after the terms of the acquisition have been agreed upon. Due to its specialized activities, full due diligence may be divided into financial, legal, market, technology, and personnel categories. We discuss each of these due diligences next.
Financial Due Diligence
In financial due diligence, accountants take the responsibility of compiling and analyzing the financial data that are supplied by the target firm. The analyses of the data enable the acquiring firm to gain an understanding of the financial conditions of the target company. Furthermore, the accounting analyses would reveal the customer base of the target firm, the main suppliers of the materials to the target, the time frame of the accounts receivable and payable, the risks associated with acquiring the target, the turnover rate of staff, and tax liabilities. Financial due diligence takes the financial data provided by the target to be true and does not make any statements about the validity of the report it produces, which is based on the data supplied by the target firm. The task of validating the data supplied by the target firm is in the purview of an audit firm. However, auditing the target firm is substantially costlier than financial due diligence and takes a much longer time to perform compared with financial due diligence.2
Legal Due Diligence
Legal due diligence involves verification of the legal status of the target, validation of licenses held by the target, enumeration, and verification of the target’s liabilities and assets, and identification of owners of target company’s assets. Furthermore, the entity or team conducting legal due diligence advises the acquiring company the legal and business risks of the liabilities of the target. Legal due diligence is often performed by professional law firms or attorneys. To illustrate the potential costs associated with inadequate legal due diligence, we examine the case of Ralls Corporation, a Chinese enterprise, which acquired a wind farms company in the State of Oregon, United States, in Part III of the book.
Market Due Diligence
By market due diligence activities, the acquiring company aims to understand the market position, market share, and marketing capability of the target company. The marketing due diligence team usually comprises members from sales, R&D, procurement, and technology areas of the acquiring firm.
Technical Due Diligence
Technical due diligence assumes importance for the acquisition of the target company with advanced technology such as information technology, advanced manufacturing, engineering, and emerging technologies. If the acquiring company has expertise in the same technological areas of the target firm, an in-house team can conduct due diligence. In cases where the target and acquiring companies have vastly different technologies and operate in various technological fields, outsourcing of technological due diligence and hiring a technology consulting firm are required.
Personnel Due Diligence
The acquiring company aims to gain an understanding of how the key managers and major shareholders of the target company arrived at their current standing through personnel due diligence. The issues of interest in personnel due diligence are determining the educational backgrounds, criminal backgrounds, family relationships, and civil litigation involvements of top executives of the target company. Personnel due diligence is often outsourced, and professional background check organizations are employed for the preparation of the personnel due diligence report.
Culture is an important determinant of organizational effectiveness, especially during organizational transitions that are associated with M&A.
Organizational culture plays a pivotal role in the acquisition by exercising a profound influence on coordination and control functions during postacquisition integration (Pablo 1994). Reducing cultural differences, both organizational, in cases of domestic acquisitions, and societal in cross-border ones can enhance organizational stability. Accordingly, cultural due diligence in the early stages of acquisitions has dramatic effects on their outcome.
Preparing a term sheet is prudent before the conduct of due diligence.3 A term sheet is a memorandum of understanding between the parties that are engaged in cross-border M&A discussions. It stipulates the main terms such as valuation of the target, financing mechanism, and other related issues of the business transaction that is to take place. The absence of such a memorandum of understanding between the target and the acquiring firm could result in the wasteful expenditure of a large sum of money and substantial time in due diligence and other negotiation activities that are doomed to fail in reaching an agreement.
A term sheet is different than a legal agreement for investment or a sale agreement. The term sheet differs from the latter two agreements for three reasons. First, a term sheet is legally nonbinding. The terms of the initial deal are subject to change during the negotiation processes as more information becomes available to both parties. Second, a term sheet is written by the financial adviser or the negotiation team in simple language and not by a lawyer in a legal format. Third, a term sheet is valid for a specific period, for example, a few weeks, a month, or two months. After the expiration of the term sheet, the parties are allowed to negotiate with other interested parties or agree on a new set of terms.
It should be noted that poor planning and inadequate due diligence of governmental policies of the host country, particularly insufficient due diligence in environmental policies and labor market conditions of the host country, could pose significant obstacles to successful integration.
To illustrate potential challenges inadequate cross-border acquisitions of enterprises may pose, we cite the example of the China International Trust and Investment Company (CITIC) acquisition of Sino Iron, a multibillion-dollar company in the business of extraction of magnetite iron ore in Western Australia in Part III of the book.
Summary
This chapter dealt with target selection processes for M&A. It discussed steps involved in the acquisition of candidates and developing target profiles, and defined screening criteria and examined varieties of due diligence: financial, legal, market, technical, personnel, and cultural. As part of target selection, the cash flow statement analysis of a target firm was discussed. Moreover, to illustrate the detrimental effects of inadequate due diligence, two case studies involving a Chinese acquisition in the United States and a greenfield investment in Australia were presented.