Buying a U.S. company offers a quick and easy way to acquire a client base without having to build one up slowly through traditional sales and marketing efforts, efforts that can be expensive, time consuming and not always successful. As described in part one of this series, acquisitions can provide U.S.-based expertise and infrastructure that can be used to re-invent and re-energize a business by shifting some portion of its production and service operations to more competitive locations.
International and U.S. buyers can reinvent stagnating U.S. firms through a business model that is referred to here as the acquisitions plus globalization (A+G) model. The A+G business model can be applied to companies that have either not rationalized enough of their production and service operations to competitive locations around the globe or have done so through high-cost arrangements that can be scrapped and redone.
In detailing the steps to be taken to make an acquisition, we begin by looking at strategy development, which precedes the formal acquisition process. The role of investment banks in managing each step in the deal process is specified because it is assumed that all buyers will be retaining a qualified investment bank except for those that have built up their own in-house acquisition team that is used to making frequent acquisitions. An introduction to the role of investment banks in the acquisitions process is the subject of part two of this series
Step One: Strategy Development
The acquisition process begins with strategizing about which line of business and market sector buyers should focus on. This strategy will guide the development of criteria to be used to identify potential acquisition targets. The development of a business strategy can and usually should be accomplished before the formal acquisition process begins. Making an acquisition without first developing a sound business strategy invites expensive failures, even when the rest of the acquisition process is managed flawlessly.
Although some established U.S. firms may have researched and developed their own strategies prior to launching an acquisition process, formal strategy development is recommended for the following:
- U.S. firms that have not recently gone through the exercise, especially if they are about to depart from their core business sectors
- Non-U.S. firms that are not already well established with U.S.-based operations in the industry sector they target for entry or expansion
Buyers can find that their profitability and competitiveness within the U.S. market can be improved and their risk exposure controlled by working with an investment bank or other qualified advisor on strategy development. Major U.S. investment banks can charge US$250,000 or more for strategy development, whereas mid-market ones may be able do the work for less than a tenth of that price.
Formal strategy development helps buyers assess whether the type of company and business sector they are considering will enable them to maximize their advantages and competitive strengths. As the acquisitions process proceeds, a buyer will be able to assess acquisition targets in terms of how those candidates meet their strategic goals.
A strategy project can begin with the collection and analysis of data on three business sectors that are a priority for a buyer. The project can include the following three tasks:
- How the business sector and its markets are defined, to include market and firm sizes, firm distributions, growth rates and trends;
- The capabilities and potential synergies available to the buyer in each segment; and
- Prior acquisitions in each segment and how valuations and deal structures evolved.
The results of the third task may indicate that a business sector has so few attractive targets that there are price premiums on acquisitions in that sector. There may be a finding that the ease of integrating an acquisition and transferring client or brand loyalty varies between business sectors.
A strategy project can help a buyer decide which business sector to target for an acquisition and the types of firms that will be considered attractive acquisition targets. Where an acquisition is to be accompanied by globalization of production and service operations, a buyer may not be deterred by finding that a business sector is experiencing low profit growth.
The results of a strategy project, if accepted by a buyer’s management and principal owners, lowers the chance that a buyer will hesitate or back down when a final decision is called for on whether to close an acquisition.
A strategy project begins with a meeting to define the scope and parameters of the research. Research staff at an investment bank may need about five weeks to complete such a project. The results are then incorporated into the development of search criteria for acquisition candidates and, more significantly, in selecting a market segment and business sector. The strategy project’s results do not replace the subsequent criteria-development step.
Step Two: Criteria Development
The development of acquisition criteria represents the formal beginning of the acquisition process.
Criteria can include the following:
- Industry sector, industry position and industry role
- Financial condition and performance
- The type of work being conducted
- How well the work of a target firm could be conducted by offshore managers and staff
- Volumes and profit margins on work that could be shifted
- Size and timing of investments that buyers are seeking to make
- Preferred locations of targets and their customers
- Types of customers and the stability of the customer base
Criteria can distinguish the type of company to be purchased. Some buyers will prefer privately held companies, whereas others may look for divisions of larger firms. Other buyers will only be interested in publicly traded firms, which can be used to raise capital or to make additional acquisitions through stock trades. The corporate culture and management characteristics of potential targets will be a major consideration for some buyers, particularly those that intend to retain significant functions of the acquired firm in the U.S.
In calculating post-acquisition financial performance, the margins gained by cost differentials between onshore and offshore operations will be taken into account — and incorporated into the criteria to be used to search for acquisition candidates. Where the A+G model is being applied to firms already engaged in outsourcing, price differences between existing offshore outsourcing arrangements such as the use of an Indian call center at US$18 per production hour and the buyer’s own facility can be included in calculations of post-acquisition financial performance.
Exceptions to explicitly costing out savings from the A+G model may be encountered where financing an acquisition is to be done in stages. For example, an investor group from Pakistan that I’ve been assisting is planning to raise their first round of capital to acquire a top-tier U.S. financial services firm. First round funding will be based on the performance and profitability of the firm as it currently operates in the U.S., and will only be enough to support that acquisition.
Once the acquisition is complete, a second round will be raised, possibly overseas, to build or buy offshore capacity to handle about half of the service work of the acquired firm. The multi-round approach is less complicated than going out for full funding at the onset, but hinges on a top performing U.S. firm being acquired. Top performing firms are more expensive than mediocre ones but can ultimately provide better value and lower risk for buyers, particularly international buyers.
Step Three: Apply Criteria to Identify Candidate Firms
Search criteria are applied by an investment bank’s research staff to identify candidate firms. To identify candidates, searches can be conducted on public, proprietary and subscription databases. The process of developing and applying criteria normally takes six weeks.
The optimum number of initial candidates should range from between 75 and 125. If less than 75 candidates initially pass the criteria, then the criteria are too restrictive. If more than 125 candidates make the list, then the criteria are too broad and need to be revised.
Step Four: Approach Targeted Firms
The investment bank prepares documents for approaching target firms. Documents describe the interested buyer, how the acquisition could work, and benefits that an acquisition could provide. Follow up documents can include financial statements of the buyer and exit options for sellers. These documents are intended to encourage targeted firms to consider being acquired.
The fact that an initial inquiry is made by an investment bank can encourage recipients to respond favorably. This can be particularly helpful if the buyer is a non-U.S. firm without widespread name recognition in the U.S. and if the target firm has not previously considered being acquired. Otherwise, the target firm may suspect that the buyer is conducting a fishing expedition to gather competitive information that can be used to compete against the target.
Once initial responses have been received, the investment bank can initiate negotiations with multiple target firms. Multiple simultaneous negotiations generate better information on market conditions and enable buyers to undertake negotiations from a position of strength. Initial contacts are usually made confidentially by the investment bank, typically in weeks seven through ten. The bank has non-disclosure agreements (NDAs) executed with interested parties and then screens candidate firms to assess their suitability. The bank’s staff arranges for meetings and presentations.
In a research-driven acquisition process, NDAs can be executed with 20-25 prospects. This number is culled down to 7-10 firms to whom offers are made. Out of that batch, detailed negotiations may be conducted with three or four target firms. A single acquisition can be concluded at the end of the sixth month, although in some circumstances this process can take as long as one year.
Step Five: Initial Due Diligence
Weeks 11 through 14 are typically spent making conference calls and site visits. Initial due diligence activities are conducted during this phase. Information is collected on the finances, operations and market positions of target firms. The investment bank will introduce the buyer’s decision makers to the most attractive target firms via conference calls, meetings and site visits.
Step Six: Letters of Intent
In weeks 15 through 19, letters of intent (LOIs) will commonly be sent to one or more target firms. Although the preparation of a LOI is typically the responsibility of the buyer (through its legal counsel), the investment bank usually provides advice on all aspects of these documents.
LOIs formally indicate the interest of the buyer to negotiate for an acquisition. LOIs are not meant to be legally binding, except in regard to establishing confidentiality protections and barring the parties from recruiting each other’s personnel. LOIs can clarify that each party is responsible for its own expenses.
The LOI will usually specify a period of exclusivity, during which the seller will only negotiate with the buyer and not with other suitors. Due diligence and negotiation activities require considerable effort and resources from both parties. If these efforts are to be expended, then the parties may wish to confirm that there is a reasonable chance that these efforts will not be wasted.
The LOI summarizes the intended price and principal terms that the buyer is likely to offer, thereby enabling the seller to determine whether a deal is likely to happen. The LOI provides an overview of the price the buyer is willing to pay, the assets it is seeking to purchase, the structure of the deal, and the process that the buyer proposes to undertake to complete the transaction. I like to keep these aspects of the LOI in mind once it has been accepted and detailed negotiations begin, because they can help forestall the seller from attempting to renegotiate what was already agreed upon in the LOI.
To prevent confusion about whether the LOI binds either party to conclude the acquisition process, the LOI can emphasize that the document does not create a binding contract regarding the terms of the acquisition. It can also describe how negotiations can be terminated and whether either party may incur any liabilities in the event that termination occurs outside the parameters allowed by the LOI. The LOI may allow the buyer to conduct simultaneous negotiations with other targets while establishing an exclusivity period for the seller, as indicated above.
If the seller accepts the LOI, then negotiations and further due diligence activities often proceed simultaneously. Exclusivity periods often extend for only two months, leading to intense due diligence activities as the buyer seeks to understand the true state of the seller’s assets and liabilities. This understanding is used by the buyer for valuation purposes, to conduct price negotiations, and to determine how liabilities will be allocated between buyer and seller.
In one acquisition that I worked on to buy an online document management firm, no LOI was used. The business was small, the deal relatively simple, and the parties so keen to conclude a deal that we proceeded directly to an acquisition agreement. In other acquisitions where the issues were complex and valuations were only completed at the last moment, LOIs were not used because the parties had trouble agreeing and only wanted to go through negotiations once.
In most acquisitions, the LOI helps the parties to concentrate on making a deal and encourages them to either reach an agreement or walk away within a reasonable period.
Step Seven: Negotiations and Due Diligence
Once a LOI has been executed, negotiations and due diligence activities may be conducted simultaneously in weeks 20 through 26. Pre-LOI due diligence concentrates on finances. The post-LOI focus is usually on legal liabilities.
The final steps of an acquisition will be described in a subsequent article on CRM Buyer:
- Step Eight: Acquisition Agreement
- Step Nine: Signing
- Step Ten: Closing
- Step Eleven: Post Acquisition Transitions
Upcoming articles will examine transaction costs for buyers, the use of accountants and attorneys, ingredients for successful acquisitions, and pitfalls to avoid.
The process of managing acquisitions is not identical for all investment banks. Many investment banks approach the market differently from the process outlined above. Time lines, costs and processes vary widely across the industry.
For instance, many investment banks do not even conduct research or develop target lists with a substantial number of potential candidates. Their process of identifying target firms may therefore take less than the six weeks allotted here.
Some banks, if they do conduct research and develop a target list, may not typically arrive at 75 – 125 targets, and then qualify the list down to 20 – 25 prospects and then make 7 to 10 offers. The research-driven approach that is described in this article is therefore not true for the entire middle-market investment banking industry.
Anthony Mitchell , an E-Commerce Times columnist, has beeninvolved with the Indian IT industry since 1987, specializing through InternationalStaff.net in offshore process migration, call center program management, turnkey software development and help desk management.