Buying a business can be a great way to grow an existing enterprise, or a faster and more secure way of starting a new one.
However, without proper planning, transactions can often fall through prior to completing or fail shortly after completion because of issues that could have been identified earlier in the process.
Here are some important factors that potential buyers should think about before, during, and after a transaction process.
Is the business a strategic fit?
A buyer’s wider strategic ambitions should inform its acquisition plans, and each potential acquisition opportunity should be critically assessed against more than just economic factors. Potential considerations include:
- Will the acquisition expand the buyer’s geographical reach?
- Are the brands and reputations of the two businesses aligned?
- Does the acquisition represent a move into a new industry or service line?
- Do potential synergies exist between the two businesses outside of pure cost savings?
- Are the two businesses culturally compatible?
- Do the two businesses operate similar systems and control environments?
These are all important considerations to reflect on before starting a transaction process.
Valuation of a business
Before entering into any negotiation and making a formal offer, forming a commercial view of how much the business is worth is essential. The nature of the target business and the industry in which it operates can have an influence on the most appropriate valuation method. The target’s financial position, current trading and projected future earnings can all impact on the valuation outcome and therefore require careful consideration by an acquirer.
When using projected financial performance to determine valuation, it is important to ensure that forecasts are realistic, achievable, and that the underlying assumptions and drivers have been scrutinised and sensitised appropriately. Typically where projections are key to valuation, we would expect appropriate protection against future underperformance against forecasts. This is commonly achieved through the use of an earn-out mechanism, which makes a certain proportion of total consideration contingent on forecast performance being achieved by a certain time or date.
Buy-side valuation services provide an independent analysis of the key drivers and issues underpinning the valuation of a business or part of a business. This analysis can form the basis of subsequent negotiations between the two parties in agreeing headline price and deal structure. Potential key risks to be reviewed in further detail during due diligence can also be identified at this stage.
Transaction structuring and post-completion considerations
It’s never too early to start planning. Once a target business has been identified, a buyer should be thinking about transaction structure and planning the terms of the deal, including:
- What proportion of consideration will be upfront versus deferred, and
- Whether an earn-out mechanism is appropriate, and any post-completion conditions.
It is also necessary to consider the structure of the transaction from a tax perspective, to ensure that the process is as tax efficient as possible for both parties.
Planning for how the business is to be operated post-completion is critical. Usually, a buyer will seek to retain key members of the existing management team to ensure a seamless transition and to minimise any disruption to trading. When the target company is an owner-managed business, this will often involve retaining the outgoing shareholders and implementing service agreements for a period of time post-transaction. It can be advisable to align this period to any agreed earn-out period to ensure that outgoing shareholders remain incentivised throughout the post-transaction period. It is important to negotiate these arrangements and to set expectations with these individuals before completion, and to begin considering succession plans for these roles beyond the earn-out period.
A buyer may be able to fund an acquisition through its profit-generated cash reserves, but in many cases, buyers seek to raise funding from banks or alternative finance providers to support these transactions. Once a valuation has been determined, it is important for a buyer to consider how to fund any initial cash requirement, elements of deferred consideration, and transaction fees. In many cases, where external funding is required, it is advisable for a buyer to consider appointing a specialist debt adviser for to assist with a fundraising process.
Due diligence when buying a business
Due diligence is the process of gathering and analysing information about a target business in order to identify any potential risks that may be relevant to price negotiations, to the level of protection required in a sale and purchase agreement (SPA), or, in some circumstances, to the ultimate success or failure of the deal.
It is always recommended that a buyer should obtain financial, tax and legal due diligence before completing any deal, irrespective of the purchase price or industry. Buyers may also consider it appropriate to obtain commercial, environmental, social and governance (ESG), and technology due diligence depending on the target’s industry and operations, the size of the deal, and the perceived level of risk in each of these areas. On smaller and/or lower risk deals, a buyer may instruct advisers to carry out red-flag due diligence exercises. Red flag due diligence is less complex and is intended to identify potential deal breakers as early as possible, this typically focuses only on areas that directly impact pricing or core business activities.
Financial due diligence involves a detailed review of a target’s financial health and performance, including a review of historical trading, the identification of any financial risks, and a review of the target’s projected future performance. Generally, financial due diligence includes detailed review of monthly management information, annual statutory accounts, and detailed forecasts, as well as through detailed discussions with the target’s management team. The benefits of obtaining financial due diligence include:
- Obtaining a detailed understanding of the target’s historical financial performance. This includes understanding key drivers of profitability, the impact of seasonality on the business, and the extent to which the business is reliant on key clients and suppliers.
- Providing a detailed understanding of the nature and value of the target entity’s assets and liabilities.
- Ensuring that any price-impacting aspects of a target’s financials have been properly considered, including quality of earnings analysis and identification of debt and debt-like items. Most transactions also include an adjustment for working capital and so financial due diligence typically includes a comprehensive view on what a normal level of working capital is for the target entity, including a view on the price adjustment required to reflect any surplus or deficit of working capital at completion. Having an experienced adviser on board that understands the nuances of transaction mechanics reduces friction in a transaction and provides an objective view on potentially contentious areas.
- Providing an assessment of the assumptions underlying the financial projections, including a comparison of these assumptions to actual historical financial performance. This can be critical to pricing and to setting the parameters of any earn out.
- Depending on the level of detail requested by a buyer, financial due diligence can also provide context on wider commercial aspects of the deal, such as market outlooks and trends, including the target’s competitive advantage within its given sector or industry.
Tax due diligence is important for a number of reasons. Primarily this involves the identification of any potential tax liabilities that have not been correctly captured by the target and providing comfort over historical tax compliance to reduce any post-transaction surprises. However, this also includes identifying tax planning opportunities and summarising the tax implications of the transaction to the buyer.
Regulatory and legal considerations when buying a business
As well as financial and tax due diligence, it is important that a buyer conducts appropriate legal due diligence. This involves reviewing the target business’ contracts, verification of ownership and title, intellectual property, and the assessment of the business’ compliance record and other legal documentation. The primary purpose of legal due diligence in a corporate transaction is to thoroughly assess and evaluate the legal aspects and risks associated with the target company. This process is crucial for the acquiring company to make informed decisions and mitigate potential legal liabilities.
The role of the legal adviser continues beyond due diligence into the drafting of the SPA and other legal documentation, this is vital to ensure that the terms of the deal that have been commercially agreed between the two parties are properly reflected in the definitive sale documentation, with appropriate protections in place for both the buyer and seller.
ESG due diligence
ESG due diligence is increasingly common in corporate transactions. This enables the acquiring company to identify and understand the environmental, social, and governance risks and opportunities associated with the target company, including its compliance with necessary climate reporting requirements. This process helps buyers to make informed decisions that align with responsible and sustainable business practices.
Sustainable practices are no longer a choice, but a prerequisite for resilience and growth. It is therefore unsurprising that recent research conducted by KPMG showed that 53% of investors surveyed in 2023 had cancelled merger and acquisition (M&A) deals because of material findings in ESG due diligence.
How can we help?
Buying a business is a complex process that requires detailed research, thorough planning, and careful execution. Appointing experienced advisers, both financial and legal, can significantly increase the chances of a successful deal process.
Our Corporate Finance team offers a full suite of buy-side advisory services, which can be tailored to a buyer’s requirements and the nature of the proposed transaction. Our services include:
- Financial due diligence,
- Tax due diligence,
- Red-flag bid support,
- Valuation services,
- Offer, Heads of Terms and SPA review,
- Taxation structuring,
- Financial model review,
- Completion review, and
- Buy-side advisory services.
If you have any questions on any of the content set out in this article, or would like to discuss a potential transaction process with one of our team, please get in touch with Seb Cartwright.