AccountingTools ® Series

Mergers &
Acquisitions
A Comprehensive Guide
Second Edition
Steven M. Bragg, CPA
Mergers & Acquisitions

A Comprehensive Guide

Second Edition

Steven M. Bragg
Copyright © 2013 by AccountingTools LLC. All rights reserved.

Published by AccountingTools LLC, Centennial, Colorado.

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Table of Contents
Chapter 1 - Acquisition Strategy .....................................................................................1
The Sales Growth Strategy ...........................................................................................1
The Geographic Growth Strategy ...............................................................................2
The Product Supplementation Strategy ....................................................................2
The Full Service Strategy ..............................................................................................3
The Vertical Integration Strategy ................................................................................4
The Adjacent Industry Strategy ...................................................................................4
The Diversification Strategy .........................................................................................5
The Market Window Strategy .......................................................................................6
The Bolt-on Strategy ......................................................................................................6
The Low-Cost Strategy ..................................................................................................8
The Industry Roll-up Strategy ......................................................................................8
The Size Consideration..................................................................................................9
The Competitor Consideration .................................................................................. 10
The Weak Link Consideration .................................................................................... 11
The Ego Consideration ................................................................................................ 11
The Failings of Acquisition Strategy ........................................................................ 11

Chapter 2 - The Acquisition Process ............................................................................ 13

The Acquirer’s Acquisition Process ........................................................................ 13
The Seller’s Acquisition Process .............................................................................. 18
The Bankrupt Seller Acquisition Process ............................................................... 31
Reconciling the Acquisition Processes .................................................................. 32

Chapter 3 - Regulatory Approval ................................................................................... 35

Antitrust Laws ................................................................................................................ 35
Hart-Scott-Rodino Act .................................................................................................. 35
Industry Concentration Concerns ............................................................................ 38
The Failing Company Doctrine .................................................................................. 41
The European Union Merger Regulation ................................................................. 41

Chapter 4 - Exit Planning ................................................................................................. 43

Reasons for Selling ...................................................................................................... 43

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 Alternatives to Selling .................................................................................................. 46
Clean Up the Business ................................................................................................ 47
Timing of the Sale ......................................................................................................... 57
Information Sharing ...................................................................................................... 58
Risks of a Failed Exit .................................................................................................... 60

Chapter 5 - The Data Room ............................................................................................. 62

The Physical Data Room ............................................................................................. 62
The Electronic Data Room .......................................................................................... 63

Chapter 6 - Valuation of the Target ............................................................................... 66

Board of Directors Liability......................................................................................... 66
Timing of the Deal ......................................................................................................... 67
Liquidation Value .......................................................................................................... 68
Real Estate Value .......................................................................................................... 68
Relief-from-Royalty Method ........................................................................................ 69
Book Value ...................................................................................................................... 69
Enterprise Value ............................................................................................................ 71
Multiples Analysis ......................................................................................................... 72
Discounted Cash Flows ............................................................................................... 75
Replication Value .......................................................................................................... 82
Comparison Analysis ................................................................................................... 83
52-Week High ................................................................................................................. 85
Influencer Price Point ................................................................................................... 86
The Initial Public Offering Valuation ........................................................................ 86
The Strategic Purchase ............................................................................................... 87
Extraneous Valuation Factors ................................................................................... 87
The Control Premium ................................................................................................... 87
The Earnout .................................................................................................................... 88
The Valuation Floor and Ceiling ................................................................................ 90
The Fairness Opinion ................................................................................................... 92

Chapter 7 – Synergy Analysis ........................................................................................ 94

The Need for Synergies ............................................................................................... 94
Synergy Analysis for Expenses ................................................................................ 95

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 Synergy Analysis for Revenue .................................................................................. 98
Synergy Analysis for Capital Expenditures ......................................................... 102
The Synergies Table ................................................................................................... 103
Synergy Analysis for Risk Reduction .................................................................... 104
Synergy Secrecy ......................................................................................................... 105
The Cost of Synergies................................................................................................ 106

Chapter 8 - Hostile Takeover Tactics ......................................................................... 108

The Williams Act .......................................................................................................... 108
Schedule TO ................................................................................................................. 109
Initial Share Acquisition ............................................................................................ 110
Initial Communications .............................................................................................. 111
The Bear Hug ................................................................................................................ 112
The Tender Offer ......................................................................................................... 112
The Partial Tender Offer ............................................................................................ 115
The Partial Tender Offer ............................................................................................ 115
The Two-Tiered Tender Offer ................................................................................... 116
The Creeping Tender Offer ....................................................................................... 117
The Mini-Tender Offer ................................................................................................ 117
The Proxy Fight ........................................................................................................... 118
Hostile Takeover Defenses ....................................................................................... 119

Chapter 9 - Due Diligence .............................................................................................. 127

Due Diligence Preparation ........................................................................................ 128
Due Diligence Expectations ..................................................................................... 129
Due Diligence Cost ..................................................................................................... 129
Target Company Overview ....................................................................................... 130
Corporate Culture ....................................................................................................... 132
Target Company Management ................................................................................. 133
Employees .................................................................................................................... 136
Employee Benefits ...................................................................................................... 139
Financial Results ......................................................................................................... 139
Internal Reports ........................................................................................................... 142
Revenue ......................................................................................................................... 143

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 Cost Structure .............................................................................................................. 145
Intellectual Property ................................................................................................... 146
Fixed Assets and Facilities ....................................................................................... 147
Liabilities ....................................................................................................................... 148
Equity ............................................................................................................................. 150
Taxes .............................................................................................................................. 151
Accounting Policies.................................................................................................... 153
Product Development ................................................................................................ 155
Selling Activities .......................................................................................................... 156
Marketing Activities .................................................................................................... 157
Production Operations .............................................................................................. 158
Materials Management ............................................................................................... 160
Information Technology ............................................................................................ 162
Treasury and Risk Management .............................................................................. 163
Legal Issues .................................................................................................................. 165
Regulatory Compliance ............................................................................................. 167
Service Companies ..................................................................................................... 168
International Issues .................................................................................................... 169
Due Diligence Results ................................................................................................ 170
Indicators of a Strong Acquisition Candidate ..................................................... 172
Factors that Terminate a Deal .................................................................................. 173

Chapter 10 - Payment Structure of the Acquisition ................................................ 175

The Stock-for-Stock Exchange ................................................................................ 175
The Exchange Ratio ................................................................................................... 177
The Impact of Options, Warrants, and Convertible Securities ........................ 178
Issues Impacting the Stock Payment Decision ................................................... 179
Stock Payment Based on Fixed Share Count or Fixed Price........................... 180
The Debt Payment ....................................................................................................... 182
The Cash Payment ...................................................................................................... 183
The Consulting Contract ........................................................................................... 184
Impact on Earnings per Share ................................................................................. 184
The Earnout Payment ................................................................................................. 185

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 Practical Considerations ........................................................................................... 186

Chapter 11 - Legal Structure of the Acquisition ...................................................... 188

Tax Issues in an Acquisition .................................................................................... 188
Issues with Stock Purchases ................................................................................... 189
General IRS Requirements to Avoid Gain Recognition .................................... 190
The Type “A” Acquisition ......................................................................................... 191
The Type “B” Acquisition ......................................................................................... 191
The Type “C” Acquisition ......................................................................................... 192
The Type “D” Acquisition ......................................................................................... 193
Triangular Mergers ..................................................................................................... 194
The Asset Acquisition ................................................................................................ 195
Impact of the Acquiree Organizational Form ....................................................... 196

Chapter 12 - Acquisition Documents ......................................................................... 198

The Letter of Intent ..................................................................................................... 198
The Term Sheet ............................................................................................................ 205
The Purchase Agreement .......................................................................................... 205
Positions of the Parties ............................................................................................. 210
The Closing Memorandum ........................................................................................ 212

Chapter 13 - Acquisition Integration........................................................................... 214

General Integration Topics ....................................................................................... 214
Team Composition ...................................................................................................... 216
Integration Planning ................................................................................................... 217
Competitor Reactions ................................................................................................ 217
Accounting Integration .............................................................................................. 219
Culture Integration ...................................................................................................... 224
Customer Service Integration .................................................................................. 225
Divestment Issues....................................................................................................... 226
Employee Integration ................................................................................................. 226
Human Resources Integration ................................................................................. 228
Information Technology Integration ....................................................................... 231
Legal Integration and Issues .................................................................................... 233
Management Structure Integration ......................................................................... 234

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 Marketing Integration ................................................................................................. 235
Materials Management Integration ......................................................................... 236
Production Integration ............................................................................................... 238
Selling Integration ....................................................................................................... 238
Treasury and Risk Management Integration ........................................................ 240
Post-Integration Analysis.......................................................................................... 241
Integration for the Serial Acquirer .......................................................................... 241

Chapter 14 - Accounting for Acquisitions ................................................................. 243

Overview of Business Combinations ..................................................................... 243
Identifiable Assets and Liabilities, and Noncontrolling Interests ................... 245
Goodwill or Gain from Bargain Purchase ............................................................. 247
Goodwill Calculation ................................................................................................. 247
Bargain Purchase ....................................................................................................... 248
Reverse Acquisitions ................................................................................................. 249
Related Issues .............................................................................................................. 251
Acquisition of Assets .................................................................................................. 251
Transactions between Entities under Control of Same Parent .............................. 252
Pushdown Accounting ............................................................................................... 252
Income Taxes ............................................................................................................... 252
Goodwill ......................................................................................................................... 253
Variations under IFRS ................................................................................................ 258

Chapter 15 - Acquisition Personnel ............................................................................ 259

The Acquisitions Attorney ........................................................................................ 259
The Investment Banker .............................................................................................. 261
The Valuation Specialist ............................................................................................ 262
Other Consultants ....................................................................................................... 262
The In-House Acquisitions Department ................................................................ 264

Chapter 16 - Reverse Mergers ...................................................................................... 266

The Reverse Merger Concept................................................................................... 266
Advantages and Disadvantages of the Reverse Merger ................................... 267
The Price of a Shell ..................................................................................................... 270
Shell Due Diligence ..................................................................................................... 270
Trading Volume ........................................................................................................... 272

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 Other Reverse Merger Issues .................................................................................. 273

Glossary ............................................................................................................................. 276

Index ................................................................................................................................... 283

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Preface
The process of locating, acquiring, and integrating another company is fraught with
difficulties, resulting in many failed acquisitions. Similarly, the seller of a business
may not know how to market it properly, or determine if a fair price is being offered.
In Mergers & Acquisitions, we present a complete view of the acquisition process
from the perspectives of the buyer and the seller.
In Chapter 1, we discuss the reasons why a business might want to engage in an
acquisition. We then move on to a description of the acquisition process in Chapter
2, from the perspectives of the buyer and the seller. There is a side discussion in
Chapter 3 about regulatory approvals for acquisitions, after which we return in
Chapters 4 and 5 to the exit planning steps that a seller should pursue. Chapter 6
contains a lengthy discussion of the various methods used to value a business, while
Chapter 7 addresses the concept of synergy. Chapter 8 covers the techniques used to
engage in and block hostile takeover attempts. Chapters 9 through 13 cover the steps
needed to complete an acquisition once the parties have decided to go forward with
a deal. This includes due diligence, the types of payment and legal structures used in
an acquisition, the legal documents used to purchase a business, and the integration
process that occurs after the purchase is complete. In the final three chapters, we
cover topics related to the acquisition process; this includes accounting for
acquisitions, the personnel involved in acquisitions, and the use of reverse mergers.
You can find the answers to many questions about mergers and acquisitions in
the following chapters, including:
• Which acquisition strategy should I follow?
• How does the auction process work?
• How can I improve the value of a business that I want to sell?
• What methods are available for valuing a business?
• How can I fend off a hostile takeover attempt?
• Which issues should I examine as part of the due diligence process?
• What are the advantages of a stock-for-stock exchange?
• How can I structure an acquisition to defer taxes?
• Which terms should I include in a letter of intent?
• How do I go about integrating an acquired business into my main business?
• How do I account for an acquisition?

Mergers & Acquisitions is designed for both professionals and students.

Professionals can use it as a reference tool for engaging in acquisition transactions,
while it provides students with an overview of the entire process. Given its complete
coverage of the mergers and acquisitions topic, Mergers & Acquisitions may earn a
permanent place on your book shelf.

Centennial, Colorado
August 2013

viii
About the Author
Steven Bragg, CPA, has been the chief financial officer or controller of four
companies, as well as a consulting manager at Ernst & Young. He received a
master’s degree in finance from Bentley College, an MBA from Babson College,
and a Bachelor’s degree in Economics from the University of Maine. He has been
the two-time President of the Colorado Mountain Club, and is an avid alpine skier,
mountain biker, and certified master diver. Mr. Bragg resides in Centennial,
Colorado. He has written the following books:

Accountants’ Guidebook
Accounting Controls Guidebook
Accounting Procedures Guidebook
Budgeting
Business Ratios Guidebook
CFO Guidebook
Closing the Books
Corporate Cash Management
Cost Accounting Fundamentals
Cost Management Guidebook
Credit & Collection Guidebook
Financial Analysis
Fixed Asset Accounting
GAAP Guidebook
IFRS Guidebook
Investor Relations Guidebook
Lean Accounting Guidebook
Mergers and Acquisitions
New Controller Guidebook
Payroll Management

On-Line Resources by Steven Bragg

Steven maintains the accountingtools.com web site, which contains continuing
professional education courses, the Accounting Best Practices podcast, and hundreds
of articles on accounting subjects.

ix
Mergers & Acquisitions is also available as a continuing
professional education (CPE) course. You can purchase the course
and take an on-line exam at:
www.accountingtools.com/cpe

x
 Chapter 1
Acquisition Strategy
Introduction
Many acquirers do not have a specific acquisition strategy. Instead, they examine
any acquisition that comes to their attention. Over time, serial acquirers will likely
find that one particular approach to acquisitions works best for them, and so they
will use it as the primary basis for engaging in additional acquisitions. While other
strategies may occasionally be employed, these acquirers are most likely to follow
the strategy that has worked for them in the past. In this chapter, we will review a
number of different reasons for engaging in acquisitions – some of which yield
better results than others.

The Sales Growth Strategy

One of the most likely reasons why a business acquires is to achieve greater growth
than it could manufacture through internal, or organic, growth. It is very difficult for
a business to grow at more than a modest pace through organic growth, because it
must overcome a variety of obstacles, such as bottlenecks, hiring the right people,
entering new markets, opening up new distribution channels, and so forth.
Conversely, it can massively accelerate its rate of growth with an acquisition.
Consider the following calculation of growth rates:
• A company has $1,000,000 of sales, and is growing at a reasonable 10% per
year. Assuming a consistent rate of growth for five years, the business will
have grown to $1,611,000 in sales at the end of that period.
• The same company buys a competitor whose sales are $500,000, so that its
initial combined sales are $1,500,000. Assuming the same rate of growth per
year, the business will have grown to $2,416,000 after five years.

The difference in ending sales between the two scenarios is $805,000. If we also
subtract out the $500,000 in sales that were purchased through the acquisition, there
is still $305,000 of new incremental sales. This incremental difference is the result
of growing the acquired business at 10% per year for the five-year period. Thus, the
acquirer has jump-started its growth by increasing the baseline level of sales to
which its normal growth rate is applied. Of course, this line of thinking assumes that
the same growth rate applies to both the acquiring and acquired businesses.
Another version of the growth strategy is when the expansion rate of a business
is slowing down or has stalled, possibly because it is located in a market niche that
has a slow rate of growth. The company could acquire a business located in a faster-
growing niche, thereby giving the company as a whole a faster rate of growth. It
 Acquisition Strategy

may be possible to engage in a series of such acquisitions, continually skipping from

niche to niche within an industry to position the business in the fastest-growing
areas.

The Geographic Growth Strategy

A business may have gradually built up an excellent business within a certain
geographic area, and wants to roll out its concept into a new region. This can be a
real problem if the company’s product line requires local support in the form of
regional warehouses, field service operations, and/or local sales representatives.
Such product lines can take a long time to roll out, since the business must create
this infrastructure as it expands.
The geographical growth strategy can be used to accelerate growth in this
situation. This involves finding another business that has the geographic support
characteristics that the company needs, such as a regional distributor, and rolling out
the product line through the acquired business. Under this approach, an acquirer
would likely need to find an acquisition in each area in which it plans to conduct a
geographic expansion. It can be difficult to find suitable target companies in less-
populated regions, so a business may have to build its own distribution systems in
those areas, while growing through acquisition elsewhere.

Tip: The geographic growth strategy is an especially good idea when entering other
countries, since the acquirer can avoid the lengthy delays caused by permitting,
building relationships with new business partners, and understanding local customs
and traditions that might call for the rebranding or repositioning of the product line.
However, this advantage disappears if an international acquisition is outside of a
company’s core area – performance tends to be quite poor, since the buyer does not
understand the market or the country.

The Product Supplementation Strategy

An acquirer may want to supplement its product line with the similar products of
another company. This is particularly useful when there is a hole in the acquirer’s
product line that it can immediately fill by making an acquisition. This approach is
most useful in the following situations:
• Customer progression. Customers may progress from an introductory model
to a more complex model over time. If the company does not have more
complex models to sell, it will eventually lose customers to its competitors.
• Competitor marketing. Competitors may be marketing their wares by
publishing comparison charts in which they point out the absence of certain
products or product features from the product line of the company.

However, the acquirer should also examine its acquisitions under this strategy for
several characteristics, to see if the products will be a good fit. They are:

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 Acquisition Strategy

• Branding coverage. Can the acquirer easily shift the acquired products
under the umbrella of its corporate or product-line brand without too much
trouble? The acquired products cannot be so different that they are not seen
by customers as being a good fit within the company’s product line.
• Field servicing. Is the company’s own field service or in-house warranty
repair staff capable of repairing these products? This is a particular problem
for more complex products. It can also be a problem when an entirely dif-
ferent set of parts must be stocked for the acquired products.
• Manufacturability. Can the acquired products be produced within the
company’s production facilities, or do they require such different manufac-
turing processes that they must remain within their current production facili-
ties?
• Product life cycle. Are the products to be acquired near the end of their life
cycles, and does the acquiree have replacement products ready for release?
If not, the new products may not last long in the marketplace.
• Product strength. The products must be considered among the most
competitive in the industry. There is no point in acquiring products that are
considered substandard.
• Profitability. Do the products have price points and cost structures that
allow them to generate a reasonable profit?

The number of considerations just presented should make it clear that the product
supplementation strategy requires considerable due diligence to see if the products
of a target company can actually be integrated into the product line of the acquirer.
Realistically, this will be difficult to achieve, and may only make this strategy
possible in a minority of situations.

The Full Service Strategy

An acquirer may have a relatively limited line of products or services, and wants to
reposition itself to be a full-service provider. This calls for the pursuit of other
businesses that can fill in the holes in the acquirer’s full-service strategy. This
approach usually involves the combination of products with supporting services,
which may then be extended into multiple geographic regions. The following are
examples of the full-service approach:
• Auditing (services). From the perspective of an auditor, the larger multi-
national companies are willing to pay higher prices than smaller local firms.
Therefore, an appropriate strategy is to buy other firms throughout the
world, and with specialists in many audit, tax, and consulting disciplines.
Then, as a full-service provider, an audit firm can pursue larger companies
and charge them higher fees.
• Heating supplies (reseller). A heating supply company sells a number of
brands of furnaces and air conditioning units to retail customers. Since cus-
tomers are more likely to buy items when the seller can also offer 24×7 sup-

3
 Acquisition Strategy

port, a full-service strategy might be to acquire a field service operation in

the areas where the company does business.
• Furniture (manufacturer). A furniture company manufactures a single line
of products for sale to commercial customers. Its customers tend to buy
from suppliers who have a broader range of product offerings, and who can
assemble the furniture at all of their locations. Therefore, a full service strat-
egy would be to acquire not only other furniture manufacturers who sell into
the commercial market, but also possibly furniture delivery and assembly
companies.

The Vertical Integration Strategy

A company may want to have complete control over every aspect of its supply
chain, all the way through to sales to the final customer. This control may involve
buying the key suppliers of those components that the company needs for its
products, as well as the distributors of those products and the retail locations in
which they are sold. The following are all examples of vertical integration:
• A utility buys a coal mine in order to assure itself of raw materials for its
power plants.
• A consumer electronics firm buys an electronics website store in order to
secure a retail channel for its products.
• A furniture company buys a hardwood forest in order to assure itself of
having sufficient raw materials.
• An automobile manufacturer wants to use the just-in-time manufacturing
system, under which component parts are delivered to its factory just as they
are needed. To assure itself of a dependable source of supply for this system,
it acquires a manufacturer of car seats.

A company does not normally engage in a comprehensive vertical integration

strategy, but instead focuses on those suppliers who control key raw materials and
production capacity, as well as those sales channels that generate the most profit.
A problem with the vertical integration strategy is that the upstream suppliers
owned by the corporate parent have an assured customer, so they tend to be less
watchful in controlling their costs, which can eventually impact the cost structure of
the entire group of businesses. This problem can be overcome by allowing
downstream companies within the group to buy their materials from outside
suppliers; this forces each company within the business group to remain
competitive. Alternatively, the transfer price at which goods are sold within the
company should be based on the market price. A transfer price is the price at which
one part of an entity sells a product or service to another part of the same entity.

The Adjacent Industry Strategy

An acquirer may see an opportunity to use one of its competitive strengths to buy
into an adjacent industry. This approach may work if the competitive strength gives

4
 Acquisition Strategy

the company a major advantage in the adjacent industry. Examples of adjacent

industry strategies are:
• A company devises an extremely low-cost method for heating a home, and
wants to move the technology into the adjacent commercial heating market.
• A company creates a popular web site store for sports equipment, and wants
to expand the items distributed into the home furnishings market.
• A company uses enormous production volume to become the low-cost
leader in the automobile industry, and wants to expand into the golf cart
industry, where most of its cost efficiencies can be applied to build very
low-cost golf carts.

However, it is usually dangerous to rely upon a few strengths, no matter how large
they may be, to move into a new market space. For example, a company may feel
that it can bring impressive new technology into an adjacent industry, only to find
that competition in that industry is based more on control over distribution channels
than technology. Consequently, it is important to make acquisitions in adjacent
industries where acquirees have the competitive advantages that the acquirer lacks.

The Diversification Strategy

A company may elect to diversify away from its core business in order to offset the
risks inherent in its own industry. These risks usually translate into highly variable
cash flows which can make it difficult to remain in business when a bout of negative
cash flows happen to coincide with a period of tight credit where loans are difficult
to obtain.
For example, a business environment may fluctuate strongly with changes in the
overall economy, so a company buys into a business having more stable sales. Or, a
business specializes in winter activities, and so buys a business whose sales are
primarily in the summer months. Further examples of the diversification strategy
are:
• Season based. A store that specializes in ski and snowboard equipment
acquires another business that specializes in baseball and football equip-
ment, and merges them into the same store, thereby ensuring a consistent
sales level throughout the year.
• Economy based. A company that builds homes finds that its industry is a
leading indicator of swings in the general economy, so it acquires a dam-
building company, which is involved in decade-long projects that are less
subject to swings in the economy.
• Credit based. A mortgage lender finds that its ability to generate lending
revenue fluctuates with the level of interest rates, so it acquires a chain of
payday loan shops, where customers are less sensitive to interest rates.

The trouble with the diversification strategy is that there are usually few synergies to
be gained, since the businesses are so different from each other. On the contrary, it
usually requires more expenses for an additional layer of corporate oversight to

5
 Acquisition Strategy

manage the disparate businesses. Thus, the main benefit of the diversification
strategy is more consistent cash flows, rather than more profits.
To reduce the risk of diversification, an acquirer can buy businesses in adjacent
market spaces, or in different niches within the same market, rather than acquiring
too far afield. By doing so, it may be able to profit from some revenue enhancement
or cost reduction synergies, while still mitigating some of the risk of its original
operations.

The Market Window Strategy

A company may see a window of opportunity opening up in the market for a
particular product or service. It may evaluate its own ability to launch a product
within the time during which the window will be open, and conclude that it is not
capable of doing so. If so, its best option is to acquire another company that is
already positioned to take advantage of the window with the correct products,
distribution channels, facilities, and so forth. Such an acquisition will allow the
acquirer to gain market share in an area where it otherwise would have had no
chance of competing at all. Here are several examples of business features that
might be attractive to a buyer under a market window strategy:
• A key patent needed to compete in a new market area
• A government certification needed to bid for work in an area that just
received an infusion of government funding
• A distribution network already in place to distribute goods into a country
that just loosened its import restrictions

The downside of the market window strategy is that correctly-positioned target

companies know they are valuable commodities, and so may be entertaining offers
from multiple bidders. Thus, a business that wants to use acquisitions to improve its
market window positioning will likely pay high prices to do so.

Tip: Be careful about buying into a company whose product line might be
considered a fad. The market window associated with a fad might snap shut in just a
few months, leaving the acquirer with a low-performing acquiree.

The Bolt-on Strategy

One of the more successful acquisition strategies is to only acquire similar
businesses in the same market, where the acquirer has considerable knowledge of
how businesses are operated. This is called a bolt-on acquisition, since the acquired
business is typically added directly onto the acquirer’s existing business lines.
The bolt-on strategy pursues enhanced value by two avenues, which are
increased aggregate revenues and reduced aggregate expenses. These two objectives
have substantially different success levels, as noted below:
• Revenue enhancement synergies. Revenue enhancement can be achieved by
multiple means, such as cross-selling the products of the two businesses,

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 Acquisition Strategy

placing acquired products under the brand name of the other business, and
selling acquired products through additional distribution channels. The trou-
ble with this type of synergy is that it depends upon the generation of entire-
ly new sales, which in turn depends upon the cooperation of customers.
Thus, it is difficult to quantify the synergies that might be gained from reve-
nues, which makes it dangerous to base an acquisition valuation on this type
of synergy. In practice, many acquirers find that combined revenue levels
decline following an acquisition, due to customer uncertainty and the depre-
dations of competitors who view this as an opportunity to steal customers.
• Cost reduction synergies. Cost reduction synergies arise from the identifica-
tion and elimination of overlapping functional areas within a business, as
well as from overall cost reductions due to economies of scale. Cost reduc-
tions can come from such areas as overlapping administrative positions,
duplicate warehouse systems, duplicate computer systems, excess produc-
tion capacity, and volume purchase discounts. A particularly fine cost reduc-
tion synergy is when the acquirer has excellent operational knowledge, and
is able to impose it on the operations of acquired companies (usually in the
manufacturing area). It is relatively easy to quantify and implement cost
reduction synergies, especially since they are entirely under the control of
the acquirer. Many serial acquirers only rely upon cost reduction synergies
when reviewing target companies and formulating offer prices for them.

The bolt-on strategy usually only works if the acquirer has a strong management
team and a methodology for spotting synergies and following through on them. If it
does, then the typical practice is for the acquirer to become a serial acquirer that
operates in the following manner:
• It is constantly on the watch for similar companies that might be amenable
to an acquisition. This involves building relations with other companies in
the industry.
• It has an excellent sense of the valuation of target companies, knows the
price points at which it can generate a profitable deal, and is willing to back
away during bidding wars or periods of excessively high valuations.
• It has one or more due diligence teams that are well-versed in rooting out
problems and opportunities at target companies.
• It has one or more acquisition integration teams that can implement the
synergies needed to make an acquisition a success.

This type of acquirer typically assumes that a portion of its ongoing strategy will
encompass the examination, purchase, and integration of other businesses, and so
budgets for the expenses required by these types of activities.
The bolt-on strategy tends to be less successful when a business attempts it for
the first time. In this case, it does not know which planned synergies will be viable,
nor whether it has the management skill to carry them out, usually resulting in
smaller improvements than expected. If an acquirer can objectively see why it made

7
 Acquisition Strategy

these mistakes in its first acquisition, it may eventually develop into a successful
serial acquirer, but its progress to that point could be painful.
If a business continues to acquire companies without engaging in thorough
integration efforts, it may find that it must hire more staff to administer an ungainly
set of disparate businesses. If so, rather than achieving synergies, it has attained
diseconomies of scale, where it must spend more money to coordinate the various
businesses than would be the case if they were operating as separate entities.

The Low-Cost Strategy

In many industries, there is one company that has rapidly built market share through
the unwavering pursuit of the low-cost strategy. This approach involves offering a
baseline or mid-range product that sells in large volumes, and for which the
company can use best production practices to drive down the cost of manufacturing.
It then uses its low-cost position to keep prices low, thereby preventing other
competitors from challenging its primary position in the market.
This type of business needs to first attain the appropriate sales volume to
achieve the lowest-cost position, which may call for several acquisitions. Under this
strategy, the acquirer is looking for businesses that already have significant market
share, and products that can be easily adapted to its low-cost production strategy. In
addition, a business pursuing the low-cost strategy is more likely to acquire another
business that enters its market space and which is following the same strategy.
In short, this strategy can be used both to initially expand into the role of the
dominant player in an industry, and as a competitive weapon for taking over any
business that threatens its position.

The Industry Roll-up Strategy

Some companies attempt an industry roll-up strategy, where they buy up a number
of smaller businesses with small market share to achieve a consolidated business
with significant market share. While attractive in theory, this is not that easy a
strategy to pursue. In order to create any value, the acquirer needs to consolidate the
administration, product lines, and branding of the various acquirees, which can be
quite a chore. There is a further risk in that a roll-up involves multiple acquisitions
within a relatively short period of time, which makes the integration goals even
harder to achieve. Further, an acquirer that is good at the legal aspects of buying
many other businesses may not have an equivalent level of expertise in integrating
them, which leads to more of a conglomeration of companies than a seamless, well-
oiled business machine.

Acquisition Story: An acquaintance once completed a roll-up within the ladder

industry by first obtaining a unique liability insurance policy to mitigate the risk of
lawsuit judgments against ladder manufacturers, which attracted a number of
acquirees.

8
 Acquisition Strategy

An interesting variation on this strategy is to aggregate several quite small

businesses, so that the combined group is now larger than the minimum acquisition
threshold of a major industry acquirer. Larger acquirers understand that it is not
cost-effective to buy very small businesses, since they must spend nearly the same
amount of time and money on due diligence that they would on a larger target
company. The trouble with this strategy is that the acquirer engaged in the initial
roll-up will spend a considerable amount of time on its own due diligence, as well as
on the consolidation and rebranding of the acquirees, before it can make any money
by flipping the company to a larger acquirer.

The Size Consideration

No matter which acquisition strategy a company follows (if any), it must be
concerned with the size of the acquiree. The issues related to large and small
acquisitions are as follows:
• Smaller acquisition. A new acquirer can easily digest a series of smaller
acquisitions, learning from each one how to select and integrate acquisi-
tions. If there turn out to be problems, the acquirer will be at less risk of
failure from having engaged in the transaction. Also, small companies are
less likely to resist the synergy changes that the acquirer may want to make,
and may also welcome the presumably better benefits package that a larger
company typically has. Further, the employees of a small acquiree may be
actively interested in assisting the acquirer, if only to participate in the pre-
sumably higher level of stability offered by a larger enterprise.
• Larger acquisition. A larger acquiree is more likely to be a complex
organization, which takes longer to sort through and properly integrate into
the acquirer. Also, there is a large infrastructure and employee base in a
company of this size, which is more likely to resist any changes imposed by
the acquirer. Thus, it is more likely that some portion of the acquiree’s man-
agement team will be terminated because of their resistance, which will
require reshuffling to keep the acquiree running as a coherent organization.
Also, if the management of the acquiree retains too much power, there may
be a protracted power struggle between the managements of the two entities,
which will keep the organizations from integrating properly.

Clearly, there are significant differences in the potential outcomes of acquisitions,

depending upon their size in comparison to the acquirer. In most cases, the risk level
is much reduced if the acquirer only buys smaller businesses. Though it may take a
number of these acquisitions to equate to the combined results of a single large
acquisition, the odds of success are higher.
The main concern with only engaging in smaller acquisitions is the amount of
cost and effort involved in completing a deal in comparison to the amount of benefit
gained. For example, the due diligence involved in the acquisition of a company
with $10 million in sales is not appreciably less than the effort required to inspect a
company with $50 million in sales. So based on just the efforts-expended criterion, it

9
 Acquisition Strategy

makes more sense to maximize the size of the acquiree. The only situation where it
makes sense to acquire a really small company is when the acquirer intends to pluck
out a specific asset, such as a key product, patent, or employee.
Another consideration involving larger acquisitions is that one such deal within
an industry can trigger a number of similar deals, as competitors suddenly realize
that the acquirer has now attained such competitive mass that they too must acquire
in order to compete. This knee-jerk reaction is less likely to occur when a business
engages in a number of smaller acquisitions, so that the acquirer only gradually
increases in size.

The Competitor Consideration

When a company acquires another business, it also becomes the focus of attention
for any of that business’ competitors. This is not a great concern when the acquirer
and acquiree are in essentially the same market niche. However, it is a much greater
concern when the acquiree is in a different market niche that is populated by strong
and aggressive competitors. The acquirer has now inherited those same competitors,
and can probably expect any number of competitive attacks from them, including
price wars, luring away employees, lawsuits, marketing attacks, and so on.
Consequently, part of the due diligence process on a prospective acquisition should
be a review of the competitors that the acquirer will be inheriting.
When an industry contains a number of niches, some with strong competitors
and others without such problems, this may drive at least a portion of the acquisition
strategy; a company may be much more inclined to make purchases in areas where
the level of competition is relatively congenial. Such niches tend to be rather small,
because no other competitors find it worth their effort to fight for sales.
A variation on how to treat competitors when engaging in acquisitions is to
maneuver them into buying less-desirable companies. This can be done by engaging
in a continual review of the possible acquirees in an industry, and picking up the
choicest target companies by whatever means possible. If a competitor wants to keep
up with the company’s increased market share, it can only do so by acquiring one of
the remaining businesses, which have flaws that will make them difficult to
integrate.

EXAMPLE

Radiosonde Communications owns a number of country and western radio stations across the
country. It conducts a continual review of the areas in which it does not own radio stations,
looking for companies that own highly-ranked stations in markets with populations of at least
250,000. Radiosonde locates one such company, in the Tennessee market, and makes a high
pre-emptive bid, under the condition that the owner of the company does not shop the bid to
any competitors. The result is a sudden increase in national market share of 5%. If any of
Radiosonde’s competitors want to keep up in terms of market share, their remaining choices
are to make purchases of lower-ranked radio stations in smaller markets, where the return on
investment is lower.

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 Acquisition Strategy

The Weak Link Consideration

An acquirer may be tempted to acquire businesses that supplement the weakest parts
of its business. For example, a car manufacturer may have a sports car in its lineup
that produces anemic sales and profits, and so wants to acquire a manufacturer of
sports cars to bolster this aspect of its operations. This is generally not a good idea,
for doing so means that an acquirer is pouring its valuable cash into that part of its
business that is providing the lowest return. The presumed result of such behavior is
that the return will remain relatively low, despite management’s best efforts. Instead,
it is usually best to accept that some portion of a company’s operations will perform
at a low level, and either accept the situation or sell off the business. By taking the
latter approach, a business can garner additional funds that can be poured into the
best-performing part of the organization.

The Ego Consideration

Unfortunately, a series of successful acquisitions may lead the management team of
an acquirer to believe that they understand the “secret sauce” needed to make an
acquisition succeed in their industry. The resulting ego boost causes them to engage
in an accelerating series of larger and larger acquisitions, usually at high prices,
ultimately resulting in either the failure of the entire enterprise or a bloated and
highly leveraged business that is incapable of further growth.
This ego boost is further fed by the increase in compensation that usually comes
with a larger business. The industry pay scales monitored by all human resources
departments show that larger companies pay more to their senior managers than
smaller companies. Therefore, the CEO that engages in many acquisitions becomes
a rich CEO. This issue may reach the point where a CEO engages in acquisitions
primarily to drive up his or her compensation.
While we can certainly advise that no “secret sauce” can transform all acquirees
into massive success stories, this does not mean that management teams will heed
our advice and continue to exercise caution in their acquisition due diligence.
Instead, the lures of their historical success, increased compensation, and overall
level of self-satisfaction will likely drive them into an eventual failure. The only real
check on these heightened egos is the board of directors. They should examine each
proposed transaction with great care, and be prepared to vote it down if it does not
meet a predetermined set of criteria. Thus, without the calming influence of a strong
board, an acquisition spree may doom a company.

The Failings of Acquisition Strategy

A business located in a moribund industry may see an acquisition strategy as its road
to glory – more sales must equate to more shareholder value, right? Instead, when an
acquirer assembles a group of companies in the same industry, all it may achieve is a
group of companies that now operate under a single parent company. These
businesses have no better growth rate than they had when operating alone, their
product lines overlap, their salespeople call on the same customers multiple times a

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 Acquisition Strategy

month, and so on – and on top of that, the acquirer has squandered its resources to
complete the acquisitions, and now has a massive debt burden. So where was the
value in the acquisition strategy?
This not-uncommon scenario points out the main problem with acquisitions –
growing for the sake of reporting a larger amount of total revenue does not generate
value. Instead, it may destroy value, since all of the businesses now sheltering under
the umbrella of the corporate parent may no longer have an incentive to compete
against each other through innovation or cost reductions.
Instead of simple growth, the acquirer must understand exactly how its acquisi-
tion strategy will generate value. This cannot be a simplistic determination to
combine two businesses, with a generic statement that overlapping costs will be
eliminated. The management team must have a specific value proposition that makes
it likely that each acquisition transaction will generate value for the shareholders.
Here are several examples of properly-designed acquisition strategies:
• The acquirer only wants to buy the patents of a target company, which it can
then use to pursue licensing deals.
• The acquirer already sells to a major national retail chain, and plans to
introduce the products of the target company to that chain.
• The acquirer has several large contracts with the federal government, and
can slot the consultants working for a target company directly into those
contracts.

In all of the examples just noted, the ultimate goal of the acquirer is not solely to
increase its revenue, but primarily to increase its profits. Only through the consistent
pursuit of profits can a business hope to be sustainable and provide shareholder
value over the long term. Unfortunately, many acquirers lose sight of that goal and
focus instead on simple revenue expansion, which can be disastrous.

Summary
This chapter has described a number of acquisition strategies that a company may
pursue. These are simply conceptual frameworks that an acquirer should keep in
mind when it considers a potential purchase. It does not mean that an acquirer
should lock itself into a particular acquisition strategy; it may use several strategies
within a single year, and do so quite successfully. The key point when considering
acquisitions within the structure of an acquisition strategy is that the result must be
profitable for the acquirer. Thus, a company must fully understand why it is entering
into a purchase transaction, what it expects for an outcome, and how to attain that
outcome.

12
 Chapter 2
The Acquisition Process
Introduction
There are two very different perspectives from which the acquisition process can be
viewed. The serial acquirer follows a certain set of steps when it engages in
acquisitions. Conversely, a seller takes an entirely different approach to being sold.
In this chapter, we will address these two different ways of engaging in the
acquisition process, so that you can see it from the perspectives of both the acquirer
and the seller. We also briefly address a variation on the seller auction, where the
seller is in bankruptcy.

The Acquirer’s Acquisition Process

In this section, we address the process that a serial acquirer goes through to research
target companies, contact them, and engage in purchase discussions.

Researching Target Companies

A serial acquirer typically builds a database of the companies competing in the
market in which it has an interest. This may be organized as a matrix, with each
company categorized by such factors as revenue, profitability, cash flow, growth
rate, number of employees, products, intellectual property, and so forth. The
database will never be complete, since privately-held companies in particular are not
willing to reveal information about themselves. Nonetheless, there are many sources
of information that can be used to continually improve the database, such as:
• Public information. There may be snippets of valuable information in press
releases, industry publications, product brochures, and company websites.
• Public filings. It is much easier to collect information about publicly-held
companies, since they are required to reveal a large amount of information
about themselves in the annual Form 10-K and quarterly Form 10-Q.
• Personal contacts. Trade shows are an excellent place to learn about other
companies. Also, the acquirer’s own sales staff may have excellent connec-
tions within the industry. Other possible sources are business partners and
employees hired from other companies within the industry.
• Alliances. An acquirer can enter into various business arrangements with
other companies, perhaps for joint product development or distribution
deals, and use the arrangements to evaluate these entities as possible acqui-
sition candidates. This approach is a good way to meet the management
teams of the other organizations, evaluate how they operate, and discern the
quality of their intellectual property. Better yet, a joint distribution deal tells
 The Acquisition Process

the acquirer how well the other party’s products will sell in concert with the
acquirer’s own products, which is useful for estimating the revenue syner-
gies that might arise from an acquisition. This can yield high-grade infor-
mation that can be included in the acquisitions database.
• Minority investments. An acquirer can make a number of investments in
smaller startup organizations. By doing so, it gains access to the financial
information of these businesses, and may also obtain board seats that entitle
it to additional information. Better yet, a sufficiently large investment might
give the acquirer the right of first refusal, in case the investee receives a
buyout offer from a third party.
• Third party reports. Third parties may occasionally release industry
analyses that can be purchased. It is also possible to obtain market analysis
reports issued by industry analysts who work for large brokerage houses.
Such reports are not necessarily updated on a regular basis, so this type of
report should be treated as supplemental to other information.
• Patent analysis. An acquirer could hire a patent attorney to investigate the
key patents impacting the target market, and who owns them. By examining
the dates on which patent applications are filed, this may also reveal the
direction in which technology trends are moving in the industry, which can
be of use in determining the best acquisition candidates.

Pursuing this level of data collection over a long period of time can yield a detailed
database that gives an acquirer excellent insights into the structure of the industry
and which companies could potentially be valuable acquisitions.
It can be particularly useful to restate the information in the database into a
format that highlights those companies that most closely meet the acquirer’s criteria
for acquisition candidates. The following table shows a possible layout in which
those companies meeting the largest number of criteria are highlighted for further
review (Quark Malt Inc. is highlighted). This type of aggregated layout is useful for
culling the list of targets to a more manageable group.

Sample Criteria Matching Table

Revenue Over Cash Flow Over Intellectual 10% 3-Year
$50 Million $5 Million Property Growth Rate
Charleston Brewers Yes Yes
Franklin Suds Inc. Yes Yes
Poppy Refiners Co. Yes
Quark Malt Inc. Yes Yes Yes Yes
Rippin’ Lager Co.
Salty Suds Co. Yes Yes
Zelda Malt Ltd. Yes Yes

This table format is quite simplistic, and so only serves as a general guide to which
target companies should be pursued. In reality, some criteria will be more important
to the acquirer than others, and so should receive a greater weighting. In addition,
the perfect acquisition candidates may not be willing to discuss an acquisition deal,

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 The Acquisition Process

so the acquirer may find itself addressing candidates that are not considered ideal
within the criteria stated in the table.
The acquirer should also maintain a listing of the acquisitions that have taken
place in the industry recently, with particular attention to the market niches in which
they are most common. This is useful for discerning the prices at which other sellers
might expect to be sold, since everyone in the industry reads the same press releases,
and so is aware of the acquisitions. A recent upsurge in prices might indicate to an
acquirer that the market is overheated, and not worth participating in during the near
term.

The Initial Contact

There are a number of methods that an acquirer can use to scout out possible
acquisition candidates. Here are several of the more common methods:
• Discrete contact. One of the better ways to buy a business is the discrete
inquiry. This is initiated by a simple phone call to the owner of the target
company, requesting a meeting to discuss mutual opportunities. The word-
ing of the request can vary; use whatever terms necessary to initiate a one-
on-one discussion. The intent is not necessarily an immediate offer to buy
the company; instead, this may simply begin a series of discussions that may
last for months or even years, while the parties become accustomed to each
other. Eventually, if the circumstances are right, this approach may eventu-
ally lead to an acquisition. Even if it does not immediately do so, the owner
of the target company will certainly be aware of the acquirer’s general inter-
est, and will be sure to reach out when he or she decides to explore a possi-
ble sale.
• Joint venture. One of the better methods for determining the best possible
acquisition candidates is for the acquirer to enter into joint venture agree-
ments with those companies who might eventually be acquisition candi-
dates. The creation and management of these joint ventures gives the ac-
quirer an excellent view of how well the other company operates, thereby
giving it more day-to-day operational detail than it could have obtained
through a standard due diligence investigation.
• Third party. There may be situations where the acquirer does not want
anyone to know of its interest in making acquisitions within a certain mar-
ket. If so, it can retain the services of an investment banker, who calls target
companies on behalf of the acquirer to make general inquiries about the
willingness of the owners to sell. The recipients of these calls may not want
to talk about their intentions to someone who refuses to be identified, so this
approach does not necessarily yield a great deal of information. Still, they
can lead to more specific discussions between the principals of both compa-
nies.

There are several situations in which the acquirer is more likely to meet with a chilly
reception. They are:

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 The Acquisition Process

• New president. If a target company has just brought in a new president, that
person probably wants to make his mark over several years before even
considering a sale. In this situation, a large unsolicited offer directly to the
board of directors is probably the only way to achieve a purchase.
• New funding. If a target company has just obtained a new round of funding,
it probably intends to use those funds to increase its value, and so will have
little interest in an immediate sale.

Both issues are short-term ones. An acquirer should merely make a note to approach
these companies in a year or two, after the situation has settled down.

The Non-Disclosure Agreement

If the target company concludes that it may have an interest in selling to the
acquirer, the parties sign a non-disclosure agreement (NDA). This document states
that all information stamped as confidential will be treated as such, that the
information will not be issued to other parties, and that it will be returned upon
request.

The Letter of Intent

Once the NDA has been signed by both parties, the target company sends its
financial statements and related summary-level documents concerning its historical
and forecasted results to the acquirer. Based on this information, the acquirer may
wish to proceed with a purchase offer, which it documents in a letter of intent (LOI)
or term sheet (see the Acquisition Documents chapter). The acquirer should request
an exclusivity period, during which the target company commits to only deal with it.
In reality, many sellers attempt to shop the offered price around among other
possible buyers, which violates the terms of the exclusivity agreement. When this
happens, the acquirer may elect to walk away from further discussions, since the
seller has proven to be unreliable.
If the acquirer is certain that it wants to buy another company, one option is to
offer a high price that is well above what other potential buyers might pay. Using
this admittedly expensive approach yields several favorable results:
• It sends a signal to the marketplace that the acquirer is serious about its
offer, and so is more likely to counter any price that another bidder might
offer.
• It gives the target company’s board of directors a reasonable excuse that
they sold the business for the highest possible price, thereby giving them
less reason to shop the business.

16
 The Acquisition Process

Acquisition Story: The author has been involved in dozens of acquisition

discussions where the acquirer revealed in a letter of intent the price at which it
might buy a business. The owners almost always took this figure as a baseline price
that should be ratcheted up, not realizing that we were already offering quite a fair
price. A common result was that we walked away from deals, only to hear back from
chastened target companies many months later that they were now willing to deal at
the original price point.

Due Diligence
The acquirer then sends a list of due diligence requests to the target company. This
topic is addressed in the Due Diligence chapter. It is entirely likely that the target
company will not have the requested information in a format ready for immediate
distribution. Instead, it may take a considerable amount of time to find some
documents. In addition, since the target was not necessarily preparing itself to be
sold, it may not have audited financial statements. If so, the acquirer may want to
wait for these statements to be prepared, which could take about two months.
Audited financial statements give some assurance that the information in them fairly
presents the financial results and condition of the target company.

Acquisition Story: The author’s company was once so interested in buying a

business that it offered to pay the cost of converting its financial statements from the
cash basis to the accrual basis of accounting, and then having them audited for two
years, which cost $50,000. Subsequently, the parties could not come to a mutually
agreeable price, so the acquisition discussions were terminated.

Final Negotiations
The due diligence process can require a number of weeks to complete, with a few
stray documents being located well after the main body of information has been
analyzed. Once the bulk of the information has been reviewed, the due diligence
team leader can advise the senior management of the acquirer regarding issues found
and any remaining areas of uncertainty, which can be used to adjust the initial
calculation of the price that the acquirer is willing to offer. The usual result is a
decrease in the price offered.
If the acquirer wants to continue with the acquisition, it presents the seller with
the first draft of a purchase agreement. Since the acquirer is controlling the
document, it usually begins with a draft that contains terms more favorable to it. The
attorney working for the seller must bring any unsatisfactory terms to the attention
of the seller, for decisions regarding how they can be adjusted. If the seller does not
retain an attorney who specializes in purchase agreements, the seller will likely
agree to terms that favor the acquirer.
The parties may not agree to a deal. A serial acquirer should have considerable
experience with which types of target companies it can successfully integrate into its
operations, as well as the maximum price beyond which a deal is no longer

17
 The Acquisition Process

economically viable. Thus, the acquirer should compare any proposed deal to its
internal list of success criteria, and walk away if need be. Similarly, since the
acquirer likely has a hard cap above which it will not increase its price, the seller
must decide if the proposed price is adequate, and may elect to terminate the
discussions. If the deal does not appear to be viable in the near future, the parties
should be on their best behavior when agreeing to stop the acquisition, since they
may re-enter negotiations at some point in the future.

Post-Acquisition Review
A serial acquirer is very concerned with its acquisition process, since this is an
activity that it will engage in over and over again. Consequently, a committed serial
acquirer will probably review the following issues after it has completed each
acquisition:
• Were there any due diligence issues that it did not discover until after the
deal had been concluded? If so, should it include them in the standard due
diligence checklist?
• Was the total time required to complete this transaction appropriate? If not,
what can it do the next time to compress the process?
• Did its valuation model result in a reasonable price? Did it overpay? If so,
how can it improve the valuation model in the future?
• Were the results of the acquisition integration as expected? If not, where did
it go wrong, and how can it improve upon the situation the next time?

It may take some time for the issues with an acquisition to resolve themselves,
sometimes requiring as much as a year after the deal was completed. Accordingly,
do not schedule post-acquisition reviews to take place immediately after a deal has
closed.
The resulting review report should be sent to the acquisition team and selected
senior managers for their review, possibly with a follow-up meeting to decide upon
any additional actions to take.

Summary
The serial acquirer is faced with a sharply tapering acquisitions funnel. At the top of
the funnel reside a large number of potential target companies. Upon further
investigation, the acquirer will winnow this down to a small number worthy of
contact, which will then narrow further, resulting in a very small number of actual
acquisitions. Consequently, a business that wants to generate a portion of its annual
growth from acquisitions must have a full-time acquisitions team that continually
trolls the target market, looking for likely purchases.

The Seller’s Acquisition Process

When the owners of a business choose to sell it, they will likely take the path of
arranging an auction, so that they can obtain the best possible price in a competitive

18
 The Acquisition Process

bidding situation. In this rather lengthy section, we will address the acquisition
process from the perspective of the seller.
We will assume that the sellers have a good reason for auctioning the business,
and have engaged in whatever tasks they considered necessary to initially make their
business as presentable as possible. These issues are addressed in the Exit Planning
chapter. We then move into the core acquisition processes for the seller, beginning
with hiring an investment banker.

Hiring an Investment Banker

In a great many situations, it makes considerable sense to hire an investment banker
to assist with the sale of the business. The investment banker should have a very
good knowledge of the industry, can assist in selecting prospective purchasers, and
helps to negotiate the final deal. More specifically, the investment banker assists
with the following tasks:
• Valuation. Bankers engage in sales transactions all day, and also have access
to private databases that contain the results of recent acquisitions. From their
experience and information sources, they can not only estimate the price at
which a business should sell, but also the actions the owners should take to
garner a higher price.
• Timing. Bankers can judge the selling momentum in a market from the
perspectives of both buyers and sellers (i.e., supply and demand), and use
this knowledge to advise their clients on the proper timing of a sale. In some
cases, slackening demand may mandate the delay of a sale, while a hot mar-
ket could accelerate going to market.

Tip: A sign of a good investment banker is one willing to delay a sale transaction
until the seller is fully prepared and there is sufficient demand in the marketplace.
Someone only interested in collecting a fee will push for an immediate sale.

• Sale preparation. There are a number of steps that the seller can pursue to
increase the value of the business, which are discussed in the Exit Planning
chapter. The banker can identify which of these steps will yield the largest
improvement in the eventual sale price of the business. If the banker has a
particular acquirer in mind, he may know which specific characteristics that
company looks for in its acquisitions, which can be used to tailor the seller
entity to that buyer.
• Selling methodology. There are a number of ways to sell a business, ranging
from approaching a single acquirer in a very private transaction to engaging
in a broad-based auction. The banker should tailor the selling methodology
to the characteristics of the selling entity and the manner in which acquirers
like to buy other businesses. For example, a serial acquirer may have a poli-
cy of never engaging in auctions, so taking an auction approach would au-
tomatically exclude a serial acquirer who might otherwise have been very
interested in buying the company.

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 The Acquisition Process

• Contact list. A banker who specializes in a particular industry will probably

have not just a list of contacts among the prospective bidding firms, but may
have brokered deals with them in the past. This level of contact with pro-
spective buyers is one of the most valuable skills that an investment banker
brings to a seller.
• Offering memorandum. As discussed later in this section, the offering
memorandum is a summarization of the business, and is the chief marketing
tool used to sell it. The banker assists in the construction of the offering
memorandum, since he knows what information buyers want to see, and the
format in which it should be presented.
• Data room. The seller will eventually need to provide detailed information
to bidders as part of the due diligence process, which is commonly stored in
an online data room (see the Data Room chapter). The banker routinely
deals with the various third party data room providers, and so can present
the seller with a selection of the best providers, as well as recommend a file
structure for the data room.
• Meeting logistics. The banker is responsible for coordinating all meetings
between bidders and the seller, which primarily involves presentations and
plant tours.
• Auction schedule. If there is to be an auction among multiple bidders, the
banker stays in touch with the bidders to answer questions and ensure that
bids are submitted on time.
• Negotiations advisor. The banker advises the seller regarding the key
financial points of the purchase agreement (see the Acquisition Documents
chapter). This can involve such factors as the legal structure of the deal, the
calculation of earnout payments, the amount to allow in escrow, and repre-
sentations and warranties. The seller’s attorneys will also advise on these
and other issues, but the banker has the best knowledge of terms currently
being agreed to in other acquisitions, and so can interject a note of realism
into the proceedings.

In addition, the banker acts as a buffer between bidders and the seller. This means
that the banker can contact possible bidders while keeping the identity of the seller
secret, as well as answer the more routine bidder questions without bothering the
seller, while also handling the more difficult negotiating points without getting the
principals in a transaction angry with each other. Handling these tasks on behalf of
the seller allows the management team to continue running the business with
minimal interruptions. Though not listed as one of the preceding bullet points, this
buffer role is a crucial one, and can be of great assistance to the seller.
This task list represents skills that the owner of a business typically does not
have, which can make an investment banker quite valuable. Of course, this value
comes at a price. The typical investment banker will require a monthly retainer,
which is to be paid irrespective of the outcome of any prospective sale transaction.
In addition, the banker will be paid a percentage of the sale price of the business;

20
 The Acquisition Process

there are a number of ways in which this percentage may be calculated. Here are
several examples taken from actual investment banker arrangements:
• Used for the sale of a small business. $10,000 monthly retainer, plus a
minimum $500,000 fee upon sale of the business, and 3% of the sale price
above the first $25,000,000. In this case, sale of the business was uncertain,
so the banker wanted to make sure that he could recoup his monthly expens-
es (which continued for a full year). The sale price turned out to be low, so
the banker “only” received the $500,000 fee. This proved to be a difficult
sale, which almost certainly would not have occurred without the banker.
• Used for the sale of multiple divisions. $5,000 monthly retainer, plus a
minimum $250,000 fee for the sale of each division, and 5% of each sale
price above $5,000,000. In this case, there was some likelihood of selling at
least one division fairly soon, so the banker was willing to accept a smaller
monthly retainer and minimum fee in exchange for what appeared to be an
easy sale. The sale proved to be more difficult, and only one division was
sold.
• Used for the sale of a mid-size business. $25,000 monthly retainer, plus 6%
of the sale price above $50,000,000. In this case, the seller had some in-
house acquisitions expertise, and so felt that it could sell the business with
no assistance for at least $50,000,000. Thus, the banker would only be com-
pensated for the amount of a sale that it could achieve above the
$50,000,000 level. The sale effort was more elaborate, thereby justifying the
larger monthly retainer.

In short, the investment banker can bring considerable value to the selling process,
but this value comes at a high price. Bankers are very highly paid, but if a seller has
little practice in selling businesses, a qualified investment banker can be of great
assistance in managing the sale process and obtaining a good price.

Tip: Just because we have included the hiring of an investment banker as a step in
the acquisition process does not mean that it is always necessary to hire one. In some
cases, there may be an unsolicited offer that is clearly excellent and therefore
requires no auction process, or there may be sufficient in-house expertise to handle
the steps required to sell a business.

Identifying Buyers
There are two types of possible buyers for a business. One is the strategic buyer,
who can see where various synergies between its own business and that of the seller
can result in major improvements in the results of the combined entity. Or, there is
the financial buyer, who is more likely to make additional investments in the
business to improve it, and later sell it off for a profit. Strategic buyers tend to pay
more than financial buyers for an acquisition, and so are highly prized. However,
they are also choosier about what types of businesses they want to acquire, and can

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 The Acquisition Process

take a long time to fully investigate the range of possible synergies and come to a
decision. Consequently, the prudent approach is to identify a mix of buyer types.
There are several sources of information that will lead to the identification of a
group of prospective buyers. They are:
• Investment banker. If the seller is using an investment banker with
knowledge of the industry, the banker will likely have a number of possible
buyers in mind, and may have dealt with them in the past. The banker can
also consult any number of private databases to ascertain which companies
have been making purchases recently in the market in which the company
competes. If a possible buyer has recently acquired a business similar to the
company, it may be more interested in a purchase, since it could combine
the two entities.
• Management team. Any management team with a reasonable set of industry
contacts should have a good idea of which competitors are most likely to be
interested in acquiring the company. These contacts are more likely to be of
the strategic buyer variety, and so can be quite valuable.

Tip: You can refine the list of possible financial buyers by reviewing their websites
to see the industries in which they prefer to invest, as well as the typical size of their
investments. They usually list the companies in which they currently have
investments.

Approaching Buyers
Once a list of prospective buyers is in place, the seller must decide upon how many
to initially contact. The following issues can impact the decision:
• Price. If the seller wants to obtain the best possible price, it will probably
require an auction to obtain it. A competitive bidding situation will nearly
always extract the best price. However, this comes at the cost of a protracted
auction process that will likely span a number of months, and which will
likely cause the loss of confidentiality. A possible midway solution is to
conduct a selective auction among a relatively small group of qualified buy-
ers. This can compress the time required to close a deal by a few weeks or
perhaps even a month, while possibly keeping information from leaking out.
• Time. If the seller is in a rush to sell (perhaps due to a sudden need for cash),
then approaching a single buyer is clearly the best method. However, the
lack of competition may result in a lower price than the seller could other-
wise have obtained.
• Confidentiality. If the seller is concerned about the confidentiality of the sale
transaction, then consider contacting prospective buyers in tranches. Thus,
an initial tranche of a few dozen buyers may uncover an excellent offer, and
no further contacts will be required. However, if there are no bids or the bids
appear too low from this first group, then a second tranche can be contacted.
The alternative to this staggered approach is to simply shotgun the seller’s

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 The Acquisition Process

information throughout the industry, thereby destroying any possibility of

conducting an even moderately confidential sale transaction.

Based on these issues, the seller has the following choices for approaching buyers:
• Single buyer. There will be situations where the seller knows a potential
buyer extremely well, and is confident that a sale to it would result in fair
treatment of the seller’s employees, a fair price, a high degree of confidenti-
ality, and so on. There may also be a reduced need to create a formal presen-
tation package for the other party. If so, it may be reasonable to enter into
discussions with just that one entity, or perhaps expand the contact list to
just a few additional entities. This could result in a sale without anyone oth-
er than top management even being aware of the situation.
• Selective auction. There may be a fairly limited number of high-quality
buyers. If so, the seller or investment banker could contact each of them,
possibly with custom-designed marketing materials. This approach will
require the preparation of an offering memorandum, as well as management
presentations. The result is likely to be a good price for the business, though
it may place the seller at risk of having confidential information escape into
the marketplace.
• Broad auction. All possible buyers are contacted. It will be very difficult to
keep the transaction confidential, so expect employees to hear about it be-
fore the transaction has been completed. However, since nearly all possible
buyers will have been contacted, this approach is likely to obtain the best
price. If a broad auction fails, this can prevent a business from going to
market again for several years. Note the following acquisition story.

Acquisition Story: The author was once associated with a business owned by
several venture capital firms that were trying to liquidate their investment by selling
the business. For various reasons (not the least being a demand for a high price), no
one made an offer. As a result, the company was continually being marketed
throughout the industry for years. It eventually earned a reputation for being
unsellable.

The time required to complete a sale can vary from just a few months for a single
buyer to a half-year for a broad auction.

The Teaser Letter

If the seller decides that an auction is needed to sell the business, then it has the
investment banker representing the firm issue a teaser letter to a list of possible
bidders. The teaser letter is a short description of the business and it chief financial,
operating, and competitive characteristics, and is intended to present the best
possible view of the business and its future prospects. The main components of the
letter are:

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 The Acquisition Process

• Business overview. This is a brief description of the business, its products

and services, and the market in which it operates.
• Investment opportunity. This states the key factors that may make the
company a good acquisition candidate.
• Financial results and projections. This is a condensed summarization of the
company’s historical financial results, as well as its projected results for the
next few years.
• Contact information. This states the contact information for the investment
banker or other contact that is representing the business.

An example of a teaser letter is shown below.

Sample Teaser Letter

Leading Body Armor Manufacturer for Sale

The Company is based in the U.S. Northeast region. It designs and produces body armor for
the executive client. It is staffed by a combination of leading clothing designers and
weaponry deterrence researchers, which produces off-the-rack styles that are then custom-
fitted to its more discerning clients. With sales offices in five international commerce
centers, it currently sells to 1,400 customers, representing more than half of the Fortune 500.
The management team plans to increase the number of sales offices to 20 over the next three
years, while also partnering with several Italian designer labels to offer its flexible body
armor fabrics through their distribution outlets.

Investment Opportunity

The following factors make the company an excellent acquisition candidate:

• Trends. Continuing increases in the rate of terrorism and executive kidnappings
worldwide make this a growth field for the foreseeable future.
• Line expansion. The body armor concept can be further extended into other areas,
such as high-impact sports equipment, high-risk work environments, and casual
clothing.
• Intellectual property. The company owns 80% of the patents in the flexible body
armor clothing category.
• Branding. The company spends 10% of revenues on branding activities, and so has
the best-known name in the field.

Financial Results and Projections (000s)

Historical Results Projected Results

20x1 20x2 20x3 20x4 20x5
Revenue $15,400 $15,900 $16,400 $17,000 $18,000
Gross profit 6,200 6,300 6,400 6,500 6,700
EBITDA 2,400 2,200 2,100 2,300 2,500
Net profit $800 $700 $680 $760 $830
EBITDA % 16% 14% 13% 14% 14%
Net profit % 5% 4% 4% 4% 5%

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 The Acquisition Process

Contact Information

Gunarsson Investments is the Company’s exclusive investment banker, retained

to assist in the sale of the business. To review the Company’s offering memorandum,
please contact:

Arnold Gunarsson
Managing Partner
(303) 123-4567
Arnold.gunarsson@gunarsson.com

Tip: Ensure that the information in the teaser letter is accurate, and verify that the
information it contains matches the numbers used in the follow-up offering
memorandum. Recipients have a way of finding and questioning disparities between
these documents.

The seller is not identified anywhere in the letter. Instead, the investment banker acts
as a front for the seller, issuing the letter and receiving any responses to it.
If a recipient of the letter is interested in receiving further information, the
banker has the recipient sign a confidentiality agreement and then sends the offering
memorandum, which is described next. The banker may question the recipient about
its reasons for requesting the offering memorandum, and may refuse to send any
further information if it seems possible that the recipient is simply fishing for
information, and has no real interest in an acquisition.

The Offering Memorandum

The offering memorandum is the primary tool that the seller uses to communicate
the value of the business to prospective bidders. It does not have to be a
comprehensive document, since bidders will also be expected to conduct due
diligence on the selling entity (see the Due Diligence chapter). Nonetheless, it needs
to communicate the reality of the company’s recent history, its products and
services, intellectual property, employee assets, and expected future results as
accurately as possible. Any glaring errors or falsehoods in the memorandum may
short-circuit the prospects for a sale, as well as damage the reputation of the
investment banker representing the seller. The key components of the offering
memorandum are:
• Investment summary. This addresses the key points of the remainder of the
offering memorandum, with the intent of giving the reader the general out-
lines of the company’s operations, financial results, and future prospects.
• Business overview. This is a broad overview of the business. As such, it may
contain many sub-sections, including the following:
o Company history
o Product offerings
o Current research and development efforts

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 The Acquisition Process

o The markets in which the company competes

o Its ongoing sales and marketing activities
o Types of customers, possibly referencing any concentrations of
sales among the larger customers
o Major facilities
o Condensed biographies containing the positions, qualifications, and
achievements of the core management team
o The general number of employees in each functional area, possibly
also including their average tenure with the company and educa-
tional backgrounds
o Environmental issues and how the company has mitigated them
o Legal issues currently outstanding

Tip: It is acceptable to disguise the names of key customers, suppliers, and

employees in the offering memorandum, if it seems possible that a recipient could
use this information to harm the company in any way.

• Industry overview. This section describes the structure of the industry, the
major players within it, its historical rate of growth, and other pertinent in-
formation. If all bidders are expected to come from within the industry, this
section can be excluded.
• Products and services. This section contains a summary of each major
product or product line, their sales levels, gross margins, and related distri-
bution channels.
• Management. This section describes the qualifications of those key manag-
ers who are expected to remain with the business, and their roles within the
company.
• Financial overview. This section contains both historical and forward-
looking information for both the income statement and balance sheet. The
income statement should include a line item for earnings before interest,
taxes, depreciation, and amortization (EBITDA), since that gives a better
view of earnings from operations. The historical information should be for
the last five years, as well as the year-to-date information for the current
year. The amount of forward-looking financial information should encom-
pass at least the next three years. There may be some justification for re-
moving certain expenses from the income statement, such as excess owner
compensation, but it is better to state this information separately, so that
readers can see the untrammeled company results first, and then make their
own decisions about what the results could be following acquisition integra-
tion activities.
• Capitalization table. This summarizes the ownership of the business by
class of stock outstanding.
• Exhibits. There may be a small number of exhibits attached to the offering
memorandum to provide additional detailed information in a few key areas.

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 The Acquisition Process

Examples of such exhibits are audited financial statements, itemizations of

historical product sales, and lists of patents owned.
• Other. It may be possible to spice up the offering memorandum with photos
of company facilities, products, and production lines, which may increase
the level of recipient interest in the company.

Tip: Subject the offering memorandum to an unusually high degree of examination.

This may call for reviews by the managers of every functional area in the company,
as well as the company’s attorneys, auditors, and investment banker, to ensure that
the information presented is accurate.

When a company sends an offering memorandum to a prospective bidder, it should

only do so after the other party has signed a confidentiality agreement in which it
also agrees not to solicit the company’s employees with job offers for at least the
next year. Since the offering memorandum contains crucial information about the
qualifications of the company’s senior management team, it could be used as a
recruiting tool.
After a week to ten days, all recipients of the offering memorandum are
contacted to see if they have any interest in buying the company. If so, they are
requested to submit an expression of interest in the company, with a stated price they
may be willing to pay, subject to additional due diligence in the business. There is
no standard format for an expression of interest, and could be as simple as a one-line
e-mail. A more detailed version could include:
• The total amount of consideration
• The form of that consideration
• Contact information for those assigned to the due diligence team
• The expected number of days to close the transaction

The seller then schedules the likeliest group of bidders for presentations by the
management team.

Presentations
The next step is for each bidder to send in a team for a tour of the facilities and a
management presentation. In most cases, it makes sense to have the presentations at
an off-site location, to preserve the confidentiality of the proceedings.
The meeting room should be well-prepped for the presentations. This means that
drinks and snacks should be served at the beginning of each meeting and
periodically refreshed during the meeting. The projector should be tested in advance,
as well as all other equipment needed for the presentation. To ensure that all details
are settled properly, someone from the presenting team should be on-site an hour
before the presentation is scheduled to begin.
Most presentations are made in a room having a standard boardroom configura-
tion, with a long table down the middle and the presentation screen at one end. If so,
the two teams generally sit across from each other. If the presentation is held in a

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 The Acquisition Process

larger room where the tables are set up in a “U” configuration, the bidder’s team is
usually positioned across the bottom of the “U” so that they face the screen.

Tip: Try not to include too many managers in the presentation. Otherwise, a small
team from an interested party might feel overwhelmed by the large number of
people in the room.

If there is an investment banker, this person usually begins with welcoming

comments and then turns over the meeting to the owner or most senior manager
from the selling company. This person introduces his or her team, after which the
most senior person from the visiting group does the same. The management team
then begins its presentation.
The management presentation typically follows the general areas already
addressed in the offering memorandum. The presenters are those key members of
the management team whom prospective bidders will be most interested in meeting.
They should elaborate upon key aspects of the offering memorandum and take
questions from the audience.
The presentation team should give the best possible presentation. This means
formatting the PowerPoint presentation so that each slide is cogent and formatted in
a consistent manner. The entire team should run through the presentation several
times in advance, critiquing and adjusting the presentation. Also, prepare a list of
questions and pose them to the presenters during practice sessions. The investment
banker has seen many presentations, and so can play an important role in this review
process.

Tip: It is extremely important to keep the presentation as short as possible. A

lengthy, rambling talk does not impress attendees. Instead, keep presenters from
digressing, and encourage them to be brief in their expansions upon each bullet point
shown on the screen.

It makes sense to schedule the least likely bidders first, so that the presenters can
work through their presentation mistakes with this group and gradually refine it for
the later presentations with bidders more likely to buy the company. Where possible,
the bidder having stated the best offer should go last, when the presenters will have
already formulated a reply to every possible question, and will have arrived at the
most polished presentation.

Tip: Have someone record the amount of time taken on each slide and take down
audience comments, both during the review sessions and actual presentations. This
allows for continuing adjustments to the presentation.

Always provide the audience with copies of the PowerPoint presentation. By doing
so, they will spend less time taking notes and more time interacting with the
presenters.

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 The Acquisition Process

Acquisition Story: One company of which the author was the CFO had run through
its management presentation numerous times, so that everyone knew how much time
they should spend on each slide. One manager decided that he needed to ensure his
employment with a bidder, and so spent 20 minutes describing his personal
background, despite a 30-second time budget for that item.

There may also be a plant tour. If the facilities of the seller comprise a key part of its
value, such as a manufacturing facility, then absolutely schedule a tour. However, if
the company is essentially a sea of cubicles, as is the case in many industries, it may
be better to preserve confidentiality and have either an abbreviated tour or none at
all.
If there is to be a plant tour, be sure to examine the tour area carefully at least a
week in advance. This gives enough time to spruce up the area before any tour
groups arrive. Consider a new coat of paint, moving out all trash and unused
equipment, and possibly paring back on the amount of inventory stored along the
route that the tour will take.
After the presentations have been completed, the seller or investment banker
contacts the meeting attendees to see if they are still interested in the company. If so,
they are sent access codes to use the company’s online data room (see the Data
Room chapter for more information). The company can monitor their usage of the
data room; continual accessing of information over several days is a good sign of
continuing interest.

The Auction Process

In many situations, the seller will opt for a selective auction, which is conducted
among a small number of prospective bidders who are most likely to have a strong
interest in acquiring the company, and in offering a reasonable price. There is some
chance that an outlier bidder will not be invited who might have offered more for the
business. However, having a short list of bidders involves less work interruption by
the seller’s management team, shortens the auction process somewhat, and may
improve the level of confidentiality.

Tip: Once the seller has selected the auction finalists, contact all other recipients of
the offering memorandum (and any other confidential materials) and ask them to
return the documents. This can preserve some degree of confidentiality.

If the management presentations and plant tours have gone well, it is now time to
solicit letters of intent (LOIs). It is better to solicit LOIs, rather than term sheets,
since term sheets are less specific (see the Acquisition Documents chapter).
Expect bidders to submit their LOIs at the last possible moment, or even
deliberately wait a day or two after the due date before making a submission.
Bidders do this because they are always suspicious that their offers will be shopped
to other participants. Consequently, it is not uncommon for a final submission date

29
 The Acquisition Process

to come and go with only a few LOIs trickling in; better offers may still be on their
way.
A brief review of the LOIs will not necessarily reveal a clear winner. Instead, it
may be necessary to create a matrix in which the various factors offered by each
bidder are enumerated. For example, one bidder may offer a higher price, but with
half of the payment structured as a five-year note, while another bidder is willing to
offer an all-cash deal but at a price 25% lower than the highest bid. The seller needs
to sort through these offers and evaluate each one. If there is an investment banker
involved, this person can offer valuable advice, especially based on any experience
he or she may have had with these bidders in the past. Nonetheless, the final
decision rests with the seller.

Tip: Never reveal to bidders the identities of other bidders. Not revealing this
information keeps bidders wondering if someone else is available to supplant them,
which tends to keep them from negotiating for an excessively low price.

Based on this decision, one bidder is selected, and negotiations over the exact terms
of the purchase agreement commence, using a purchase agreement template that is
provided by the seller. This can be an arduous process that does not always end in a
sale, so the other bidders should be politely put on hold.

Acquisition Story: In one situation where a subsidiary was being sold and its
president insisted on a generous employment contract with the buyer, the parent
company had to go to the fourth bidder among the finalists before it could obtain a
deal that incorporated this condition.

All aspects of the purchase agreement are open to negotiation, so settling upon a
mutually agreeable version can require a significant amount of work by the attorneys
representing both sides. One item that is likely to be reduced through these
negotiations is the price. For example, the seller may not want to escrow any part of
the purchase price, which the bidder will only agree to in exchange for a reduction in
the price. Or, the seller may want a certain legal structure for the deal that improves
its tax liability situation, which the bidder will only accommodate in exchange for a
price reduction. Another common scenario is that the bidder finds problems during
its due diligence investigation, and demands a compensatory price reduction. Thus,
the price stated in the LOI tends to be the maximum that the seller is ever likely to
see, with a variety of issues forcing it down to a lower level.
It is of some importance to not allow too long a period to elapse before complet-
ing a transaction with the designated high bidder, since negotiations may fail, and
the seller may need to turn to the next-highest bidder to conclude a deal. This can
also be a negotiating tactic by the bidder, to delay matters so long that the seller no
longer has any other interested parties. It will likely require 60 days to complete any
remaining due diligence, negotiate the terms of the agreement, and close the deal. If
the bidder extends this period past 90 days, the seller needs to start considering

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 The Acquisition Process

shifting to the second-best bidder. Of course, no discussions with other bidders can
commence until the exclusivity period stated in the LOI has expired.

Tip: The seller should schedule a meeting immediately after the LOI exclusivity
period has terminated, to see if the selling process appears to be proceeding on
schedule, or if it should terminate discussions at once and move to the next-best
bidder.

During the negotiation of the purchase agreement, the attorneys for the two parties
take over and work their way through each draft of the document, summarizing
issues found and sending them back to their principals for direction. There will also
be some areas in which information is missing, requiring fast-tracked research to
find, verify, and incorporate it into the document. Also, due diligence has typically
not been completed by the time the purchase agreement is being drafted, so last-
minute items found in due diligence will have to be incorporated into the purchase
agreement. All of the iterations involved in this process result in spectacular legal
bills once the acquisition has been completed, but that is part of the acquisition
process.
There is a tendency for bidders to delve into due diligence issues long after all
substantive issues have been discovered. By doing so, they can continue to nibble
away at the price being offered. The seller can put a stop to this by being firm about
the targeted closing date, and persistently following the progress of the closing to
ensure that it is completed on time.

Acquisition Story: In one transaction, the buyer’s legal due diligence team kept
digging through inconsequential issues, and had already dragged out the planned due
diligence period by two weeks. The CEO of the seller finally called the president of
the buyer late one night and demanded payment by the following morning, or else
the deal was off. The money arrived as soon as the banks opened the next day.

Summary
Without question, the auction process is a slower method for selling a business, but
it tends to yield a higher price than if the seller were to engage with a single bidder.
The board of directors may insist on the auction approach, since it can prove to
investors that it engaged in all reasonable efforts to give them the highest possible
return on their investment in the business. As just noted, the downside of this higher
price is the longer period of time involved – typically 12 weeks to close a deal, with
some transactions requiring many additional weeks.

The Bankrupt Seller Acquisition Process

The preceding discussion of the auction process for the seller also applies when a
company is being sold while under bankruptcy protection, though there are some
differences in the process and in who makes decisions. Some issues are:

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 The Acquisition Process

• Trustee. A bankruptcy trustee may be appointed by the bankruptcy court to

run the business. This person may elect to sell the business, if that outcome
is expected to yield the highest return to the company’s creditors.
• Investment banker. Given the poor financial condition of the seller, it is
more necessary than usual to hire an investment banker. A good one may
have so many contacts among potential buyers that it can consummate a sale
transaction much more quickly than would otherwise be the case.
• Bid deposit. Any entity entering a bid for a bankrupt company must pay a
deposit, which is based on a percentage of the bid they are submitting. The
entity will lose this deposit if it is awarded the sale and then cannot close the
deal.
• Notice of sale. If someone makes a bid for the company, notice of this bid
must be sent to other interested parties to ensure that the best price was ob-
tained for the creditors. Thus, an initial bidder is at risk of having its bid
topped by another party.
• Final approval. Instead of the seller approving the highest bid, the bank-
ruptcy court approves it.
• Subsequent apportionment of price. Though not of direct interest to the
acquirer, the price it pays must be apportioned among the various creditors
who are entitled to it – which may require one or more years to settle.

In addition to the preceding points, an overriding issue is speed – a bankrupt

business is probably losing customers, suppliers, and employees at a rapid rate, so it
is essential to sell it as quickly as possible. Entire transactions may be concluded in
as little as a few weeks or a month. The focus in these rapid sales is not necessarily
to obtain the best possible price, but rather to obtain a good offer, fast. Doing so
returns as much money as possible to the creditors before the underlying business
fails.

Reconciling the Acquisition Processes

This section addresses the key differences between the two main acquisition
processes described in this chapter, including such issues as price, timing, due
diligence, and control of the purchase agreement.
The most important difference in the two acquisition processes is price. A single
acquirer that approaches a target company is not being forced by an auction process
to pay the highest possible price, and so will not do so, unless it uses a pre-emptive
bid to keep anyone else from making a bid. Conversely, the auction process is more
likely to obtain a high bid, though some serial acquirers refuse to engage in auctions.
There is a difference in the time required to purchase a business under these
approaches. The auction process can be several months longer, since extra time is
required to locate and solicit potential bidders, as well as conduct presentations to
multiple companies, and possibly negotiate with several bidders. This can be a
problem for a motivated seller who needs cash immediately.

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 The Acquisition Process

A significant difference between the two processes is that a serial acquirer is

likely dealing with sellers who have not prepared any information for them, whereas
sellers who have initiated the process will have audited financial statements and a
complete set of due diligence information posted into an electronic data room. This
difference can cause major delays in the acquisition process for the serial acquirer,
who may have to wait several months for a financial statement audit to be
completed. There may also be a number of documents requested for the due
diligence process that are missing (such as board minutes), and which may never be
found. Thus, the serial acquirer is faced with a more prolonged due diligence
exercise than a bidder taking part in an auction process.
Control of the purchase agreement is a subtle but important difference between
the two approaches. A serial acquirer that approaches other businesses about an
acquisition will insist on using its own purchase agreement and making any changes
to it, while the seller provides this document in an auction environment. It is up to
the party not controlling the purchase agreement to identify and negotiate changes to
any disagreeable provisions, so there is a negotiating advantage in controlling the
purchase agreement.
The acquisition process flows presented in this chapter are certainly different,
but their results tend to become more similar as they get closer to a purchase
agreement. In both cases, the acquirer sets a price that it is not certain will be
justified by the information that it uncovers during the due diligence process. Then,
as due diligence progresses, the operational and financial condition of the seller
becomes more certain, which tends to result in a continual series of incremental
reductions in the proposed purchase price. Thus, irrespective of the acquisition
process, the seller will be on the defensive during the last stage of an acquisition,
fighting to retain the proposed price. Even if the final price ends up being
substantially lower than the initial proposed price, the seller may still accept the
deal, because it has become committed to completing the sale.
A final note is that serial acquirers tend to avoid auction situations, since their
own search techniques and negotiation methods give them a different means for
acquiring businesses, and typically at lower prices than would be required in an
auction environment. Nonetheless, a serial acquirer may engage in an auction for a
particularly choice seller. Or, it may monitor the auction proceedings and swoop in
later if no one successfully completes a deal with the seller.

Summary
This chapter has outlined the acquisition process flow from the perspective of the
serial acquirer and the seller that uses an auction process. Each party uses its own
approach for a very good reason – the serial acquirer needs to initiate contact
continually with a large number of targets to achieve a much smaller number of
completed deals, while the seller prefers to contact a broad number of potential
bidders to ensure it itself of the best price. Despite their differing goals, both parties
use the same general technique – starting with a large number of potential
respondents and then winnowing down the field.

33
 The Acquisition Process

The processes presented here do not reflect the method used by more occasional
participants in the acquisitions game. It is entirely possible that the owners of two
businesses quietly agree to a deal without many of the other steps noted here, at a
price that both parties deem to be fair. They bring in their attorneys to draft a
purchase agreement without the advice of any investment bankers, and the deal is
done. This alternative may not result in the most perfect corporate match for the
acquirer, or the best price for the seller, but it is still a method that is used a great
deal.
In the next chapter, we address one additional step in the acquisition process that
can interfere with larger deals – regulatory approval.

34
 Chapter 3
Regulatory Approval
Introduction
There is antitrust legislation in both the United States and the European Union that
prevent some acquisitions from being completed if they are expected to result in an
excessive reduction of competition within an industry. In this chapter, we focus in
particular on the filing requirements and antitrust analyses mandated by the Hart-
Scott-Rodino Act, which applies to many acquisitions in the United States. Though
few acquisitions are halted due to antitrust concerns, the government must be
notified of larger acquisitions so that it can engage in an obligatory antitrust
examination.

Antitrust Laws
A number of antitrust laws have been passed in the United States that prohibit
actions by businesses that will reduce the level of competition. The following table
itemizes the key laws and those aspects of the laws that impact acquisitions:

Antitrust Laws
Law Impact on Acquisitions
Sherman Antitrust Act Prohibits all business combinations that result in the
restraint of trade
Clayton Act Prohibits the acquisition of the stock of a competing
business if doing so lessens competition; can be applied at a
regional level
Federal Trade Commission Established the Federal Trade Commission and empowered
Act it to enforce the Clayton Act
Celler-Kefauver Act Prohibits asset acquisitions when the effect is to lessen
competition
Hart-Scott-Rodino Antitrust Requires the prior review of selected acquisitions by either
Improvements Act the Federal Trade Commission or the Justice Department
(see the next Section)

Many of the issues raised in these laws are encompassed by the review described in
the next Section.

Hart-Scott-Rodino Act
Some larger acquisitions are subject to the provisions of the Hart-Scott-Rodino
Antitrust Improvements Act of 1976 (HSR). This Act mandates that the Federal
Trade Commission (FTC) and the Justice Department review certain acquisitions
 Regulatory Approval

prior to their closing dates to see if they cause antitrust issues. The Act contains a
waiting period requirement while this review takes place. Consequently, any
acquirer needs to know the terms of HSR, to see if a proposed deal will be subject to
it, and file the proper paperwork in a timely manner in order to avoid delaying
completion of a deal.
An HSR filing is based on minimum thresholds that are updated by the FTC at
the beginning of each year, based on changes in the gross national product. As of
2013, the minimum threshold requiring an HSR filing was a transaction where both
of the following tests were positive:
• Size of transaction test. The value of the voting securities to be held as a
result of an acquisition exceeds $70.9 million; and
• Size of person test. One party has total sales or assets of at least $141.8
million, while the other party has total sales or assets of at least $14.2 mil-
lion.

If the transaction size exceeds $283.6 million, the acquirer must submit an HSR
filing, irrespective of the results of the size of person test. There are other
notification thresholds as well, but these tests will identify most reporting situations.

Filing Fees and Penalties

There is a filing fee that accompanies an HSR filing. There are three predetermined
levels at which different filing fees are required. These levels are adjusted each year.
The filing fee structure for 2011 is:

Filing Fee Applicable Range

$45,000 Value of the transaction > $70.9 million and < $141.8 million
$125,000 Value of the transaction ≥ $141.8 million and < $709.1 million
$280,000 Value of the transaction ≥ $709.1 million

If no filing were to be made for a transaction that falls within the HSR requirements,
there is a penalty of $16,000 for every day in which the Act continues to be violated.

Filing Form
The form used to notify the government under HSR is available on the Federal
Trade Commission website at ftc.gov. The main blocks of text within the form are:
• Identification information for the individual filing the document, the
acquirer, and the acquiree
• The type of acquisition contemplated, the value and percentage of voting
securities already held by the acquirer, and the same information regarding
voting securities once the acquisition is complete
• Description of the acquisition transaction
• Index of available annual reports, analyses, and other documents
• Dollar revenues by non-manufacturing industry code and by manufactured
product code

36
 Regulatory Approval

• Holdings of the person filing the form, and for related parties
• The amount of overlapping revenues between the two businesses
• Identification of prior acquisitions by the acquirer

An additional section of the form only applies if the acquisition is in the form of a
joint venture.

Tip: The form requires the inclusion of the assets and revenues of each party to the
transaction, sorted by Standard Industrial Classification (SIC) code. When filling out
this form, define the SIC codes as broadly as possible in order to present a combined
entity that has the smallest possible market share. Doing so makes it less likely to
attract the attention of the FTC or Justice Department.

Filing Date
The HSR form must be filed by the acquirer when it announces an offer for the
target company. The target company must file a response within 15 days of the filing
by the acquirer.

Waiting Period
If the acquirer is making a cash tender offer or the acquiree is in bankruptcy, then
the HSR waiting period is 15 days. For all other types of transactions, the waiting
period is 30 days. If the government wants to scrutinize the proposed transaction
more closely, it will issue a second request. This second request extends the waiting
period for cash tender offers and bankruptcy sales by 10 days, and extends the
waiting period for all other types of transactions by 30 days. It is extremely unlikely
that a second request will be made for any proposed transaction, though the
likelihood increases with the size of the proposed deal. Following a second request,
the FTC or Justice Department can delay making a judgment on a case for many
months, while they consider anti-trust implications and possibly impose various
conditions on the sale. If there is significant opposition from the FTC or the Justice
Department, it is generally easier to drop the proposed acquisition than to potentially
spend years attempting to have the deal approved, or its terms modified to meet with
government approval.
If there is any expectation that a second request may be made, be sure to file the
HSR form as soon as possible. Otherwise, the closing date could be seriously
delayed.

HSR Exemptions
There is no need to file an HSR form if an individual is acquiring up to 10% of the
voting securities of a business, but only if the intention is to hold the securities as an
investment. Purchases made by brokerage firms are also exempt for the same reason,
as are purchases of convertible securities, options, and warrants.

37
 Regulatory Approval

There are also exemptions to HSR noted in Section 4.22 of the Anti-Trust
Enforcement Guidelines for International Operations, which are posted on the
Department of Justice website. They state that:

“Acquisitions of foreign assets by a U.S. person are exempt [from HSR filing] when
i. no sales in or into the United States are attributable to those assets, or
ii. some sales in or into the United States are attributable to those assets, but
the acquiring person would not hold assets of the acquired person to which
$25 million or more of such sales in the acquired person's most recent fis-
cal year were attributable.

Acquisitions by a U.S. person of voting securities of a foreign issuer are exempt

unless the issuer holds assets in the United States having an aggregate book value of
$15 million or more, or made aggregate sales in or into the United States of $25
million or more in its most recent fiscal year.

Second, some acquisitions by foreign persons are exempt. An exemption exists for
acquisitions by foreign persons if:

i. the acquisition is of voting securities of a foreign issuer and would not

confer control of a U.S. issuer having annual net sales or total assets of $25
million or more, or of any issuer with assets located in the United States
having a book value of $15 million or more; or
ii. the acquired person is also a foreign person and the aggregate annual net
sales of the merging firms in or into the United States is less than $110
million and their aggregate total assets in the United States are less than
$110 million.

In addition, an acquisition by a foreign person of assets located outside the United

States is exempt. Acquisitions by foreign persons of U.S. issuers or assets are not
exempt.”

Industry Concentration Concerns

When the Justice Department or FTC reviews an HSR filing, they rely upon the
Horizontal Merger Guidelines, which are posted on the Justice Department website
at justice.gov. These guidelines are updated from time to time, with the most recent
edition dated August 2010. The intent of the Guidelines is to be a tool for identifying
and preventing those acquisitions that would “create, enhance, or entrench market
power or … facilitate its exercise.” An acquisition that enhances market power is
one that is:

“…likely to encourage one or more firms to raise price, reduce output, diminish
innovation, or otherwise harm customers as a result of diminished competitive
constraints or incentives. In evaluating how a merger will likely change a firm’s
behavior, the Agencies focus primarily on how the merger affects conduct that
would be most profitable for the firm.”

38
 Regulatory Approval

The Guidelines allow the agencies to collect information from a variety of sources
and consider it from various perspectives to arrive at a judgment regarding the
market power arising from a proposed transaction. The Guidelines mention the
following topics that the agencies might consider during their analysis:
• Changes in pricing behavior
• Changes in bargaining power between firms
• Changes in the level of capacity remaining in the industry
• Changes in the level of innovation and the number of product offerings
• Changes in the level of coordination between the remaining competitors
• Changes in the buying power of competitors

Most of this information is difficult to assemble into any type of quantitative

calculation to predict whether the government will accept or reject a proposed
transaction.
A key exception to the predominantly judgmental analysis of a HSR filing is the
Herfindahl-Hirschman Index (HHI), which is described in Section 5.3 of the
Guidelines. In essence, the HHI is the sum of the squares of the market shares of
each company in an industry. A low HHI indicates a high level of competition,
while a high HHI indicates the reverse. The following table shows the relative levels
of industry concentration indicated by different HHI scores:

HHI Implications on Industry Consolidation

HHI Score Level of Industry Consolidation Maximum Point Change Allowed
0 to 1,500 Unconsolidated (competitive market) None
1,501 to 2,500 Moderate level of concentration 100 Points
2,500+ High level of concentration 100-200 Points

In the table, the “maximum point change allowed” column indicates the maximum
HHI point change that a proposed transaction will cause before it triggers a more
intensive level of review.
For example, if an industry contains five competitors whose market shares are
5%, 15%, 20%, 25%, and 35%, then its HHI is calculated as:

52 + 152 + 202 + 252 + 352 =

25 + 225 + 400 + 625 + 1,225 = 2,500

The score of 2,500 designates the industry as being at the upper end of the moderate
level of concentration. Interestingly enough, if the same five companies simply
shared the market equally, the HHI score would drop, as noted below:

202 + 202 + 202 + 202 + 202 =

400 + 400 + 400 + 400 + 400 = 2,000

Thus, the presence of a single competitor with significant market share in an

industry can designate the entire industry as having a high HHI score, which makes
it more difficult to complete an acquisition in that industry. However, the situation is

39
 Regulatory Approval

not so grim for smaller acquirers making smaller acquisitions. As noted in the
preceding table, the maximum point change allowed even in a highly concentrated
industry should not prevent a smaller acquisition.

EXAMPLE

Dillinger Designs, makers of custom-fitted rifles, has a 5% market share in the armaments
industry, which is an industry considered to have a high level of concentration. It wants to
purchase Clyde Shotguns, which has a 3% market share. The HHI score for Dillinger is 25,
and the score for Clyde is 9, for a total HHI of 34 points. If Dillinger acquires Clyde, the
combined entity will have an 8% market share, which carries with it an HHI of 64. The net
increase in HHI from this transaction is 30, so the transaction would probably be approved,
irrespective of the level of concentration in the industry.

High Noon Armaments has a 30% market share, and is considering putting in a bid for
Clyde. The entities have a combined HHI of 909 prior to the acquisition (calculated as 900
HHI + 9 HHI) and would have a consolidated HHI of 1,089 after the acquisition (calculated
as 332), for a net change in HHI of 180 points. Once High Noon becomes aware of this
problem, it withdraws from consideration, leaving Dillinger to complete its acquisition.

The preceding example does not mean that it is impossible for a company with large
market share to acquire other businesses, only that those acquisitions must be quite
small. For example, a company with 50% market share in a highly concentrated
industry could only avoid the attention of the Justice Department if it were to engage
in acquisitions where its total market share increased by less than 2%. For example:

50% market share = HHI of 502, or 2,500

52% market share = HHI of 522, or 2,704
Net difference is 204 points, which exceeds the 200 point limitation

An unusually high HHI resulting from a proposed acquisition does not necessarily
automatically terminate an acquisition. Instead, other factors may mitigate the
impact of a high HHI, as noted in the Horizontal Merger Guidelines, Section 5:

The purpose of these thresholds is not to provide a rigid screen to separate

competitively benign mergers from anticompetitive ones, although high levels of
concentration do raise concerns. Rather, they provide one way to identify some
mergers unlikely to raise competitive concerns and some others for which it is
particularly important to examine whether other competitive factors confirm,
reinforce, or counteract the potentially harmful effects of increased concentration.
The higher the post-merger HHI and the increase in the HHI, the greater are the
Agencies’ potential competitive concerns and the greater is the likelihood that the
Agencies will request additional information to conduct their analysis.

An interesting effect of HSR is that it is based on the existing level of consolidation

within an industry. Therefore, a canny acquirer could complete several acquisitions

40
 Regulatory Approval

early on in a relatively unconsolidated market, when no purchases will trigger the

attention of the FTC or the Justice Department. An acquirer who is late to the game
will find that the increased level of industry concentration makes it more likely for
an acquisition to be rejected.

The Failing Company Doctrine

Section 11 of the Horizontal Merger Guidelines states that the government can
approve an acquisition even if it results in an HHI increase, if the company to be
acquired would otherwise fail. The government’s justification for this concept is:

A merger is not likely to enhance market power if imminent failure of one of the
merging firms would cause the assets of that firm to exit the relevant market. This is
an extreme instance of the more general circumstance in which the competitive
significance of one of the merging firms is declining: the projected market share and
significance of the exiting firm is zero. If the relevant assets would otherwise exit
the market, customers are not worse off after the merger than they would have been
had the merger been enjoined.

This doctrine only applies under all of the following circumstances:

• The failing firm is not expected to meet its financial obligations in the near
future;
• It is not expected to reorganize successfully in bankruptcy; and
• It has tried to obtain alternative offers to keep its assets in the market and
pose a reduced danger to competition than the proposed transaction.

Section 11 goes on to state that the failing company doctrine can be applied to a
failing division, but only if both of the following conditions apply:
• The division has persistently negative operating cash flow; and
• The owner of the division has tried to obtain alternative offers to keep its
assets in the market and pose a reduced danger to competition than the pro-
posed transaction.

The European Union Merger Regulation

If an acquirer or a target company that it wants to acquire does business within the
European Union, it may be subject to the provisions of the Merger Regulation 1,
which is similar in intent to the Hart-Scott-Rodino Act. The Merger regulation
applies to any proposed transactions where:
• The aggregate worldwide sales of the combined entities is more than
€5,000,000,000; and

1
Most recently updated in 2004

41
 Regulatory Approval

• The aggregate Community-wide sales of each of at least two of the under-

takings 2 concerned is more than €250,000,000, unless each of the undertak-
ings achieves more than 2/3 of its Community-wide turnover within one
member state of the Community.

Under the Merger Regulation, a qualifying deal must be approved in advance by the
European Commission (EC). The overriding goal of the EC is to prohibit:

“a concentration which would significantly impede effective competition, in the common

market or in a substantial part of it, in particular as a result of the creation or strengthening of
a dominant position.”

To see if a proposed concentration would impede competition, the EC compares the

expected amount of reduction in competition to the efficiency gains resulting from
the transaction. Different groups tend to experience varying degrees of gain or loss
from an acquisition, so the EC must estimate the effect on total welfare arising from
an acquisition transaction. For example, an acquisition may lead to an increase in
prices that is caused by reduced competition, which is a loss to consumers. Against
that loss can be weighed the increased profits resulting from the combination of the
two firms and achievement of targeted synergies.

Summary
This chapter has indicated the need to make an HSR or EU filing for larger
acquisitions. In nearly all cases, the government will not object to an acquisition, so
the only impact of the filing is the necessary time delay and a rather hefty filing fee.
However, a large acquisition in a less-competitive industry may be opposed by the
government. Given the size of the administrative and professional costs associated
with an acquisition, it can make sense for a larger acquirer to have a private review
done on all possible acquisitions by an expert in the field to determine in advance
which ones are likely to be opposed by the government. This information should
place boundaries on the company’s subsequent acquisition efforts, keeping it from
engaging in transactions that will probably not be approved.
At a minimum, there should be a notation in the closing checklist for the
acquirer, in which consideration is given to the need for an HSR or EU filing. This
item should always be reviewed, even if it is unlikely that a filing should be made, in
order to avoid the large fines associated with a missed filing.

2
In European Union antitrust law, any entity engaged in an economic activity is considered
an undertaking

42
 Chapter 4
Exit Planning
Introduction
The sale of a business rarely occurs because an unsolicited offer arrives for which
the owner was unprepared, with the business being sold a few months later. Instead,
the sale is usually the result of much soul searching by the owners about what to do
with their business, followed by months or years of work to prepare it for sale. This
chapter addresses the reasons for selling, the disposal options available to the seller,
the many exit planning activities to complete, the timing of the sale, and several
related issues.

Reasons for Selling

Entrepreneurs usually set up businesses because they see an opportunity and want to
exploit it – they do not typically think of their exit strategies at this time. However,
one of the following factors may trigger a need to sell the business:
• Competition. The level of competition may have increased substantially
over time as new competitors enter the market, or because the market is
shrinking in size and the existing competitors are fighting over fewer sales.
There is little value in this scenario for an acquirer, so purchase prices tend
to be quite low.
• Conflicts. If there are several owners, there may be differences of opinion
about such issues as the future direction of the business, changes in compen-
sation, or issuing a large dividend, all of which may lead to the decision to
sell.
• Divorce. A divorce settlement might require a substantial cash payment that
can only be raised by selling the business.
• Estate taxes. The owner may have died, and the resulting estate taxes are so
large that the business must be sold to raise funds. In this case, the inheriting
owners of the business should retain an experienced broker to represent
them in the sale, or else a canny acquirer will bid an excessively low price
for the business.
• Financial decline. The business may have entered a financial decline so
severe that the owner can no longer fund it, and needs to sell. In this situa-
tion, the decision to sell may be forced upon the owner in the form of a cri-
sis, where there are no funds left to pay creditors and lenders. In this case,
due to lack of planning, the owner may not be able to attract more than a
token price for the business.
 Exit Planning

• Investment fund. If the company received cash from an investment fund,

such as one managed by a venture capital fund, it may be necessary to sell
the business in order to return the funds to the original investors.
• Patent expiration. The company may have a strong competitive position that
is protected by a patent, but that patent is nearing its expiration date. The
owner may be concerned about the increased competitive pressures that will
result following the expiration date.
• Purchase offer. The owner may not have had any intention of selling, until
receiving such a lucrative buyout offer that it would be foolish not to con-
sider it.
• Rapid growth. The company may be growing so fast that it cannot obtain
sufficient financing to fund its working capital and product development
needs. In this case, the owners should be able to sell at a good price, since
they can provide proof of strong demand from customers. Also, their ser-
vices may be needed by the acquirer to continue running the business, so
continued employment may be a strong possibility.
• Restricted stock. A company may have issued restricted stock to its share-
holders, which means that they cannot readily sell the shares to third parties.
If this is the case, there may be substantial shareholder pressure to take the
company public, thereby allowing them to sell their shares. This means that
a new set of shareholders may take control of the business.
• Retirement. The owner may be at an age where retirement looks like a good
option. If so, the owner would be best served by establishing a long time
line for the sale process, so that all possible bidders can be located and the
maximum possible price obtained. Also, a retiring owner may be more in-
clined to hold out for special treatment of his or her employees, which may
require the inclusion of special employment agreements in the purchase
contract.

The seller must not only be clear about the reasons for selling, but also be able to
discuss the issue with any prospective buyers. If the seller is not willing to do this,
then acquirers assume the worst – that the seller is trying to hide undisclosed
liabilities or other issues that impair the value of the business. Consequently, a
clearly enunciated reason for selling may keep a business from being sold at a
reduced price.
The reason for selling may even impact the type of sale transaction that is
eventually achieved. For example, we will return to the preceding list of reasons for
selling, and discuss what type of sale would be most beneficial in each case. The
results are shown in the following table:

Reason for Selling Sales Arrangement

Competition Since future prospects are grim, the owner may prefer a cash offer, in
order to be totally disassociated from the future performance of the
business. An alternative is to merge with a competitor, in an effort to
obtain greater market share.

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 Exit Planning

Reason for Selling Sales Arrangement

Conflicts If there are conflicts over the direction of the business, an alternative is
to spin off parts of it to each founder. Alternatively, if the conflict is
over compensation and payout levels, the payment recipients will
probably be more interested in cash, and less interested in being paid
with the stock of the acquirer.
Divorce A divorce settlement could call for joint ownership of the business, or
selling the business for cash in order to pay the spouse, or using the
business as collateral for a loan that can be used to pay the spouse, or
selling a minority interest to raise cash.
Estate taxes Estates require a cash payment, but this does not necessarily require the
sale of the entire business. It may be possible to sell a minority interest
to raise the cash, or use the business as collateral on a loan.
Financial decline If the business is in decline, the owner almost certainly wants to cash
out completely and walk away from the business.
Investment fund Investment funds do not necessarily pay their investors in cash. If the
company is publicly held, or can be taken public, then it may be
possible to issue shares in the company directly to the investors. It may
also be possible to have a stock buyback under which the fund
investors are paid by the company for their shares.
Patent expiration This is similar to the financial decline issue, except that it has not yet
happened. The owner will probably want a cash offer in order to walk
away from the business and its reduced future prospects.
Purchase offer An unsolicited purchase offer can result in any type of compensation –
cash, debt, or stock, and it may be for all or just a minority stake in the
business. Also, if the owner is young and still interested in being
involved in the business, this might shift the form of payment more in
the direction of stock, so that he or she becomes a shareholder of the
acquirer.
Rapid growth Selling a minority interest in the business or taking the company public
will raise cash for growth, and so are alternatives to an outright sale. If
the owner sells, then taking payment in stock may yield significant
upside potential if the acquirer can grow the business.
Restricted stock If the primary owner still wants to retain control of the business, it may
be possible to register only the shares of the dissident shareholders with
the Securities and Exchange Commission, thereby allowing the
dissidents to sell their shares, but no one else. Alternatively, the
company can commit to buy back and retire their shares.
Retirement An owner who wants to retire is probably more interested in a cash
settlement, but tax considerations may make a multi-year debt payment
a more effective approach.

As the preceding table shows, there are many alternatives to the outright sale of a
business, including using it as collateral for a loan, selling a minority interest, a spin-
off, sharing ownership, and different types of payments. The seller should consider
these alternatives when deciding whether it is really necessary to sell a business.
The seller must also consider the downside of a sale. Company founders closely
identify themselves with their businesses, and so can find themselves at a loss once
they have handed over the business to someone else (even in exchange for a large

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 Exit Planning

pile of cash). This is a particular problem if there was a great deal of prestige
associated with owning the business. Also, it may be that a subsequent change in the
business climate might trigger a surge in the company’s business – after it has been
sold. The subsequent success of the business may lead to second thoughts about the
advisability of having sold it. In short, the owner should be absolutely certain that
selling is the appropriate course of action before doing so.

Alternatives to Selling
The focus of this book is on mergers and acquisitions, so we assume that the owner
of a business will eventually decide to sell the business through an acquisition
transaction. However, there are a number of other alternatives available. These other
options may not result in the greatest transfer of wealth to the owner, but might
fulfill other needs, such as keeping the business within the family or giving back to
the community. We note a number of these other options in the following bullet
points, but do not deal with them further, since they are outside of the scope of this
book:
• Gift to charity. The owner could gift some shares to a charity, which has
certain tax advantages and also supports the local community.
• Leveraged buyout. This is essentially a sale to the management team of the
business, which ensures some continuity and allows others within the busi-
ness the opportunity to eventually profit from it, too. This usually involves
imposing a large debt burden on the business, so this approach can put the
business at risk until the debt has been paid down.
• Liquidation. This option is most common for a sole proprietorship or
partnership, where the owners simply wind down the affairs of the business
and close it.
• Minority interest. If the owner wants to cash out and still retain some
control, it may be possible to bring in a minority investor, perhaps with an
option to later purchase the entire business.
• Sell or gift to family. This may not even be a formal sale transaction, but
rather the transfer of share ownership. This can have significant tax ramifi-
cations, and so requires expert tax assistance. There are many management
continuity issues here, since siblings and children may not be capable of
running the business.
• Sell to employees. This involves the creation of an employee stock owner-
ship plan that gradually purchases the shares of the owner. This approach
works well if the owner is concerned about having an acquirer break up the
business.
• Share repurchase. If there are few shareholders (or just one), the board of
directors can authorize the repurchase of shares at a certain price point. This
can provide liquidity to the owner without a loss of control.
• Spin off. The owner may simply want to run a smaller business, in which
case he or she could spin off or sell part of the business to other investors,
leaving a more manageable core operation.

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 Exit Planning

Of the preceding alternatives, the charitable giving and gifting options are clearly of
the lowest monetary value to the owner, but may fulfill other needs, such as giving
back to the community. However, given their low return to the owner, such
alternatives are normally combined with other options, so that the owner still obtains
an acceptable return.

Clean Up the Business

When a potential acquirer is reviewing a target company, its due diligence team will
root around in the underbrush of the company’s liabilities, products, business partner
relationships, and so forth, looking for issues that will make the purchase
unpalatable to the acquirer. In fact, it can be said that due diligence teams are
looking for an excuse not to complete an acquisition.
When the owners of a business decide that they want to sell it, they need to
critically review their business from the perspective of that due diligence team,
looking for issues that could drive away a prospective acquirer. In the following sub-
sections, we will address the more important clean up issues.

Environmental Liabilities
Without question, the number one issue that will drive away any acquirer is
environmental liabilities. These liabilities can be enormous, can be transferred to the
acquirer even through an asset sale, and may even make the officers of the acquirer
personally liable. The best way to mitigate environmental concerns is to hire a
consultant to conduct an in-depth environmental analysis of the company’s
properties. This can involve the following activities:
• Chemical handling. Review all hazardous chemicals on the premises to see
how they are stored, used, and disposed of.
• Complaints. Examine all complaints received concerning environmental
issues, the issues causing the complaints, and how they were remediated.
• Permits. Ensure that there are permits for all activities that can have
environmental repercussions. The company should be in full compliance
with them, and the permits should not have expired.
• Policies and procedures. Verify that there are policies, procedures, and
detailed work instructions for the handling and disposal of all types of
waste.
• Testing. If necessary, take soil samples and examine them for hazardous
waste contaminants.

The seller should fix any issues found, which may take quite a long time and require
a considerable expenditure. Nonetheless, remediation is absolutely necessary, since
not fixing environmental problems essentially ensures that the company will not be
sold. Also, it is less expensive to remediate these issues at the company’s pace,
rather than in an accelerated manner as part of an acquisition. Further, the company
may be able to shift ownership of the problem areas to a different entity, leaving the

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main part of the business free of environmental liabilities and therefore much more
marketable.
The seller should have a copy of the consultant’s report available for any due
diligence team. It may even be worthwhile to prepare additional documentation that
shows what the company did in response to any findings noted in the consultant’s
report. Or, if an initial report found a number of problems, the company could then
commission another report after having completed its remediation activities, to show
the current state of its environmental issues.
This approach not only gives the seller time to engage in the most serious
remediation activities, but it also yields enough time to properly evaluate the
potential risk and remediation cost associated with any remaining issues. This is a
useful counter to the more inflated environmental costs that a more cursory (and
conservative) due diligence review would likely generate.
Addressing environmental issues in advance is very useful for keeping an
acquisition process on track. If the information provided by the seller is sufficient,
the due diligence team may elect not to conduct any additional analyses. The time
usually required for an independent environmental analysis, and especially the time
needed for remediation activities, would frequently be sufficient grounds for the
termination of further acquisition discussions.

Legal Issues
Whenever there is a lawsuit outstanding at the time of an acquisition transaction, the
due diligence team will spend an inordinate amount of time investigating the
circumstances of the case and attempting to quantify the worst-case judgment
against the company. If there is considerable uncertainty about the outcome, the
acquirer could walk away from the deal. Or, the acquirer will attempt to subtract the
worst-case payout scenario from its initial offer price.
A way to partially mitigate the effects of legal issues on an acquisition is to
settle all outstanding cases out of court, so the level of legal risk is minimized at the
time the company puts itself up for sale. However, a history of the same type of
legal issues (such as product failure cases) may terminate an acquisition, simply
because there is a reasonable expectation that similar lawsuits will arise in the
future.
In addition, the seller should engage the services of a law firm and have it
conduct an audit of all legal aspects of the business. This audit can encompass such
factors as a review of the bylaws, articles of incorporation, board minutes, and
contracts to see if there are any issues that should be corrected prior to a sale. At a
minimum, this will likely result in a number of minor board motions to correct
missing documentation. At worst, the audit might point out significant potential
liabilities in contracts that must be corrected. The legal audit can be expensive, but is
well worth the time to avoid any last-minute problems uncovered by the attorneys
working for an acquirer.
After environmental problems, legal issues are likely to be the next-most-serious
issue that can terminate acquisition discussions, since they represent potentially
large contingent liabilities.

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Takeover Defenses
In the past, the company may have instituted a number of takeover defenses, such as
special voting rights, supermajority voting, and fair price provisions, in order to fend
off a hostile takeover; see the Hostile Takeover Tactics chapter for more
information. If so, and the owners now want to sell the business, they may need to
dismantle some or all of these defenses; otherwise, they may cause sufficient
difficulties to ward off a friendly acquirer. Doing so sometimes requires a
shareholder vote. Since shareholder votes might only be scheduled once a year at the
annual meeting, this means that the owners may need to plan well in advance to
dismantle takeover defenses.

Financial Statements
The first item that a due diligence team wants to see, probably before its team is on-
site, is financial statements. If these statements have not been audited, the team will
want to conduct considerably more due diligence than normal, in order to replicate
some of the audit steps needed to give it assurance that the statements fairly
represent the results of the business. In some cases, an acquirer will not bother to
send in a due diligence team unless the company can provide it with audited
financial statements. Thus, the seller must have its financial statements audited
before putting the business up for sale.
Any acquirer will want to see financial statements that have been audited for at
least one year. If the acquirer is publicly-held, it will probably want audited
statements for the last two or more years. The auditing process is not a fast one, so
the seller should schedule all required audits multiple months prior to when it wants
to put the business up for sale. In addition, audits scheduled during the audit busy
season (January through April) may be more expensive, so if the seller wants to save
money, it should schedule the audits outside of this period.

Asset Issues
If the acquirer is contemplating an asset purchase, then the asset portion of the
company’s balance sheet must be in exquisite condition. In particular, the seller
should conduct a cleanup in the following areas:
• Investments. If cash has been invested in long-term investments, unwind
these investments and shift the resulting cash flow into short-term, low-risk
investments. Otherwise, there will be considerable debate about the amount
at which these investments will eventually be settled.
• Accounts receivable. The due diligence team will concentrate its attention
on the aged accounts receivable report. Therefore, be sure to improve the
report in three areas:
o Record keeping. The report total should match the balance in the
general ledger.
o Residuals. All residual debits and credits in the report have been
cleaned up.

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o Overdue items. Disposition all of the seriously overdue accounts re-

ceivable in the report. This means either engaging in vigorous col-
lection activities, settling them at a discount, or writing them off.
• Prepaid expenses. The prepaid expenses account tends to accumulate items
that should have been charged to expense already. If this is the case, charge
them off at once. Also, raise the minimum standard for including items in
the prepaid expenses account, so that it will contain the smallest possible
number of items for a due diligence team to investigate.
• Inventory. An experienced acquirer understands that the inventory asset can
be seriously overvalued in a company’s accounting records in comparison to
its market value, and so will spend an inordinate amount of time in this area.
The seller can improve this area in the following ways:
o Inventory record accuracy. It is impossible to determine inventory
valuation if you cannot find the inventory, so the first step is to cre-
ate inventory locations in the warehouse, assign inventory to those
locations, and track accuracy levels with cycle counting. Cycle
counting is the process of counting a small proportion of the total
inventory on a daily basis, as well as investigating and correcting
any errors found.
o Obsolescence review. Set up a system for reviewing the inventory
on a monthly basis to locate and properly disposition all items that
are obsolete. This involves the creation of a review procedure and
regularly-scheduled meetings.
o Improve turnover. Even if inventory items are not obsolete, there
may be too many of them. There are many ways to shrink the inven-
tory, such as adopting a practice of ordering in smaller quantities,
having deliveries made in smaller quantities, installing a just-in-time
manufacturing process, and so forth. These tend to be long-term
projects.

• Fixed assets. If a business has a large investment in fixed assets, a signifi-

cant part of the acquirer’s purchase price will be targeted at these assets, so
expect a detailed due diligence review. The seller can improve this area in
the following ways:
o Record keeping. The fixed asset register contains the detailed listing
of the costs of all fixed assets. Verify that the report total matches
the total in the fixed asset accounts in the general ledger.
o Audit. Verify that all of the assets listed on the fixed asset register
actually exist, and make note of any items that are in poor condition.
o Usage. If any fixed assets are not being used and there is no pro-
spect for using them, then sell them at once.
o Replacement. If some equipment is not completely functional, then
either replace the necessary parts or the entire asset.
o Maintenance. A proper investment in equipment maintenance, along
with a preventive maintenance program that is religiously followed

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indicates to the acquirer that there are unlikely to be any unplanned

equipment replacements in the future.
o Sprucing up. Conduct a walk-through of the company’s facilities
and create a list of minor upgrades to install. The intent is to make
the company more visually appealing to acquirers. For example,
sprucing up facilities could involve new paint, carpeting, and ceiling
tiles, as well as washing windows or painting new lines for the park-
ing spaces in the parking lot.

Essentially, the reasons for these clean up tasks are to present the acquirer with
assets that are properly recorded, properly valued, and in good condition, with little
risk of not being able to eventually convert them to cash.

Liability Issues
In any acquisition where the acquirer plans to buy the entire target business and not
just its assets, the due diligence team will review all recorded liabilities, as well as
search for unrecorded ones. The seller should investigate and make adjustments in
the following areas:
• Accounts payable. Verify that the total amount in the aged accounts payable
report matches the accounts payable total in the general ledger. Also, clean
up any stray debits and credits in the report and settle any seriously overdue
payments.
• Accrued liabilities. The seller should investigate the following accrued
liability items to ensure that they are properly recorded:
o Calculation. If there is a calculation supporting an accrued expense,
examine the calculation to ensure that it is functioning properly and
adequately reflects the actual amount of the expense.
o Missing accruals. Are there any expenses that are not being accrued,
such as unpaid wages or unpaid vacation time? If so, create a proce-
dure to record them, and verify that it is being followed.
o Reversals. Many accrued liabilities should be reversed in the fol-
lowing period. Investigate the liability accounts to see if there are
any residual accruals that should be eliminated from the books.
• Taxes payable. Examine the accounts payable records to verify that all sales
taxes and income taxes have been paid, and in the correct amounts. Also,
evaluate whether there may be a use tax liability, and proactively calculate
and pay it if this may be an issue for the acquirer. Further, evaluate whether
the company has operations in states where it is not currently paying taxes,
and obtain business licenses in those areas.
• Leases payable. If there are any lease liabilities, verify that the company is
current on these payments, and that the company is aware of any automatic
lease extension dates. Generally, leases should be terminated when there is
an option to extend, so that the acquirer has fewer long-term liabilities to be
concerned with. For example, it may make more sense to incur a higher

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month-to-month rent payment on office space than to enter into a five-year

lease for which the acquirer will have to make payments.

Acquisition Story: The division president of a company for which the author
worked elected to renew an expensive five-year lease on office space. Two months
later, the parent company tried to sell the division, only to have bidders subtract the
remaining payments on the new lease from their bid prices.

• Pension plan funding. If there is a company pension plan and it is under-

funded, the company can document the amount of the underfunding and
accept that this will be a deduction from any offer made to buy the business,
or else fully fund the plan.
• Debt. Verify that the amount of debt recorded in the company’s books
matches the liability recorded by its lender. In the event of an acquisition,
the lender usually accelerates its debt and demands payment, so there is less
due diligence in this area, other than to verify the amount owed.
• Earnouts. If the company has engaged in its own acquisitions in the past,
and promised residual payments to the owners of those businesses, it might
make sense to settle and pay off any remaining liabilities under these ar-
rangements.
• Unrecorded liabilities. Due diligence teams are particularly interested in
unrecorded liabilities, so expect them to inquire about lawsuits, missing
accruals, invoices that only arrive at long intervals, guarantees, contingent
liabilities, disputed liabilities, and so forth. The company should conduct its
own investigation of these items well in advance, and document the status of
each item. It may be useful to obtain insurance for some types of contingen-
cies.

An additional concern is the personal guarantees that the owner may have entered
into as part of any debt agreements. If possible, it is useful to at least attempt to have
these guarantees eliminated prior to a sale. Otherwise, in the rare event that the
acquirer actually manages to continue the loans held by the company, the parties
will have to unwind the owner from these guarantees. No owner wants to have a
personal guarantee outstanding when he or she no longer owns the underlying
business, and therefore has no control over the ability to repay the associated debt.
The liability issues noted here are critical if the seller expects that acquirers will
want to purchase the entire business entity.

Equity Issues
The details of a company’s equity structure will not derail an acquisition or put off
an acquirer, but a simplified and well documented structure makes it easier to create
the purchase agreement. Here are several considerations:
• Complexity. Though not a deal breaker, it is easier for an acquirer to sort
through a simple equity structure that contains a minimal number of types of

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stock, with few (if any) stock options and warrants. It is a very long-term
project to clean up a complex equity structure, and may not be worth the
effort.
• Documentation. There should be a detailed list of all shareholders and the
exact number of shares held, as well as the same information for stock op-
tions, warrants, and convertible instruments.

It may be too difficult to clean up a complex equity structure, in which case the more
important issue is ensuring that the equity situation is very well documented. The
attorneys will need to incorporate this information into the purchase agreement.

Revenue Issues
Expect acquirers to examine the company’s revenue information in inordinate detail,
since this is the key indicator of corporate growth. They will want to learn not only
about the company’s historical sales record, but also its short-term expected future
sales. The seller can prepare for these questions with the following two systems:
• Backlog system. Create a system that shows the company’s sales backlog. It
is useful to record in the backlog system the name of each customer, the
duration of each contract (if any) and the type of customer. An acquirer may
want to run multiple reports on this database to gain greater understanding
of the nature of the backlog.
• Trend reporting. Construct a system that shows the revenue trend line by
product, product line, key customer, store, and/or distribution channel. An
acquirer will want to see this information to ascertain where the company
generates its business.

If a company is in the retail or consumer goods markets, it probably will not have
much backlog information to reveal. However, if it deals with longer-term contracts,
the backlog system will be picked over in great detail.
Another issue to address is the diversity of customers. A small business
generally has a correspondingly small customer base, which puts its revenues at risk
if just one or two of the larger customers were to leave. This is a major concern for
acquirers, so the company should pay particular attention to broadening its customer
base in the years leading up to a sale.

Marketing Issues
An acquirer that wants to retain a business or its products as a going concern will
want to see a consistent pattern of expenditures to build the company’s brands. This
may not be considered a significant issue, since an acquirer with substantial financial
resources could plan to engage in its own branding activities, thereby boosting future
sales.
The company should begin a marketing campaign several years in advance of
the sale, which raises the company’s profile with both customers and prospective
acquirers. This could involve the following activities:

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• Trade shows. A presence at the major industry trade shows is one of the best
ways to make acquirers aware of the business, since participants in these
shows routinely scout other attendees.
• Press releases. A press release is more of a scattershot approach than a trade
show; there is no guarantee that an acquirer will see the posted information.
Still, a continuing policy of issuing press releases over several years will
increase the level of industry awareness of the company.
• Trade group participation. The company could send its key people to trade
group meetings as speakers, or have them write articles for the primary in-
dustry publication. These meetings and publications are an excellent way to
raise the profile of the business.

Another issue is the state of the company’s web site. Many acquirers eliminate these
sites in favor of their own versions after an acquisition has taken place. However,
there should be a quality web site in place before looking for acquirers, if only to
show that the company is serious about its on-line marketing. An exceptionally poor
web site may even drive away prospective bidders.

Expense Issues
A prime source of potential synergies will be a company’s expenses, so expect due
diligence teams to spend time examining the details of the larger expense line items.
In anticipation of this activity, review the following items:
• Personal expenses. A due diligence team will be looking for non-business
expenses that are owner reimbursements, since these will not be present
post-acquisition, and can be considered easy synergies. The seller should
make this job easier by identifying such expenses in advance.
• Sustaining expenses. If the acquirer is interested in running the business as a
going concern, it is helpful to ensure that the key expenses needed to sustain
the business over the long term are being incurred. Accordingly, do not stint
in such areas as fixed asset replacement, maintenance, training, and market-
ing. In fact, document these expenditures for the past few years in order to
prove that the company is well-maintained, and that management has not
been scrimping in these areas in order to artificially increase profits.

Note that these expense recommendations do not include cutting back on any
expenses. Instead, the company is primarily constructing documentation that a buyer
can use as part of its due diligence process.

Profitability Issues
The analysis of profitability is a value-added area in which excellent systems are
greatly appreciated by the due diligence team, and can increase the price paid. In
particular, consider the following tasks:
• Gross margin analysis. If the company does not currently track the gross
margin on its products, services, customers, stores, or distribution channels,

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start now. The seller should be able to report this information on a trend line
as part of its presentation to the acquirer. This information is of considerable
importance, since the acquirer wants to see where the company earns its
profits. Gross margin analysis can involve a redesign of the company’s in-
ternal reporting systems, and may require the services of a cost accountant.
• Target costing. If the company designs its own products, the seller should
install a target costing system. This is a design philosophy under which a
target cost is decided upon as part of the product design process, with a de-
sign team modifying the product to match the cost goal. This system im-
proves product profitability, and can be a strong selling point to acquirers
looking for a well-run business.
• Estimating quality. If the company produces custom products, there should
be a robust estimating system in place that rarely under- or over-prices
quotes to customers. Be sure to document this system thoroughly, and have
a procedure in place for reviewing the system when incorrect quotes are
issued. A due diligence team will want to examine the documentation, and
also review the company’s system of assigning costs to production jobs.

All three of the profitability items just noted are excellent systems to install and
retain, even if an acquisition falls through and the company continues to operate on
its own.

Business Complexity Issues

A difficult issue to address is the overall complexity of a business. An acquirer likes
to see a simple business model that it can easily understand, rather than a jumble of
unrelated product lines, multiple layers of subsidiaries, or unconsolidated
acquisitions. A high degree of business complexity also indicates that the
management team has not been focused on a vision for the entire business, and
instead has pursued opportunities in a variety of areas as opportunities arose.
Reducing the level of business complexity can make it much easier to sell a
business. However, doing so may also require that some parts of the business be
closed down or spun off, resulting in a core operation that is much smaller, and
which will therefore attract fewer potential acquirers. Nonetheless, a high degree of
complexity is a serious issue, and calls for concerted management attention.
Unfortunately, management’s inattention to strategy and operations probably caused
the heightened level of complexity, so it is unlikely that those same managers can
straighten out the situation.

Employee Issues
A quality due diligence review will engage in a protracted analysis of the employee
assets of a business, which will likely involve a series of interviews. There is little
preparation to be done here, but the seller should be mindful of the following topics:
• Nepotism. If the owners of the business have hired a number of their friends
and family, conduct a realistic assessment of which ones are cost-effective

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employees, and terminate the employment of those who are not. An acquirer
would probably do this anyways shortly after taking over the business.
• Conflicts of interest. Are there any employee-owned suppliers with which
the company does business, or ones owned by friends and family, where the
prices paid by the company are above the market rate? If so, terminate these
arrangements now, or negotiate prices down to market levels. Again, an
acquirer will probably do this anyways soon after taking over the business.
• Safety. Have a safety expert review the company and determine if there are
any safety failings that could cause employee injuries. If so, invest in what-
ever is needed now, so that a due diligence team will not find them at a later
date.

An argument can be made that nepotism issues and conflicts of interest will be
resolved by the acquirer, but the seller might want to handle them in advance,
thereby improving the reported profits of the business and making it more likely that
an acquirer will be attracted to its financial results.

Management Issues
A business may be a “one man show,” where the owner is very much in charge of all
activities within the company. If so, there could be a valid concern that the owner
will leave when the business is sold, leaving no one in a position to take over. To
avoid this concern, the owner should begin bolstering his or her management team
in the year or two leading up to the sale. This means having vice president-level
managers in place for all key functions. In addition, someone should be promoted
into at least the chief operating officer position, if not the chief executive officer
spot. The owner then shifts into the role of chairman of the board. By taking these
steps, an acquirer would have some assurance that the existing management team,
without the owner, is capable of running the business once the owner cashes out.

Intellectual Property Issues

Intellectual property may be the primary reason that an acquirer wants to buy a
business, especially if it is a new company that has not yet generated much revenue.
Accordingly, be sure to document and establish the ownership of all intellectual
property, as noted below:
• Documentation. Document all patents and trademarks owned by the
company, and also identify which products and concepts are in various stag-
es of development. A due diligence team uses this information as the start-
ing point for its investigations.
• Patents. Have a patent attorney examine the intellectual property that the
company has developed or owns, and see if they have been properly patent-
ed in all jurisdictions where the patents would be of use. If not, apply for
these patents at once. This will be a key focus of analysis if an acquirer be-
lieves that the company has valuable intellectual property.

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• Patent ownership. Identify any patents that are owned by other parties than
the company (such as employees), and attempt to acquire them if they will
be valuable to an acquirer.

A company should consider being somewhat verbose in its documentation of

intellectual property, since this is one area in which too much information is better
than too little. Since this is a key area that adds to the value of a business, it is
important to impress acquirers with it as much as possible.

Summary
Many of the activities recommended in this section involve the documentation of
certain processes. A well-documented system can be a strong selling point. Thus, the
seller should make a point of forwarding its documentation of well-run systems to
anyone reviewing the company.
All of the improvements noted in this section can also be considered nothing
more than good management practice. By implementing these recommendations to
arrive at a sale-ready business, the management team may find that the acquirer is
more likely to retain their services in the future. The business is clearly so well run
that it reflects well on the management team.

Timing of the Sale

There are a number of factors that go into selecting the time when a business should
be sold. Consider the following:
• Financial results. A seller may be ready to sell the moment the business has
a great month of results. However, most acquirers tend to look at trailing 12-
month results, rather than the results of just the past month, so be sure to
begin selling activities only after there is a history of revenue and profit
growth.

Tip: If the business is seasonal or you are expecting a modest decline in sales in the
near future, and the acquisition process will take multiple months, there is a good
chance that the company’s financial results will be declining through the sale
process. To avoid this, time the sale transaction to occur several months earlier, so
that sales are robust right through the expected sale date.

• Audit. If the company has recently completed a fiscal year, some acquirers
refuse to conduct due diligence until an audit has been completed – so the
buyer should certainly time the sale to begin no sooner than the completion
date of the audit.
• Backlog. It may sometimes be sufficient to look for buyers as soon as the
company has landed a monster contract, even if it has not yet generated any
sales. This may be especially useful if the contract is scheduled to last for

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years, and the seller does not want to wait a year to translate the backlog
into trailing 12-month revenue.
• Intellectual property. In some businesses, the primary reason for a sky-high
valuation is its intellectual property, not its revenues or profits. If so, selling
should not commence until there is clearly-demonstrated intellectual proper-
ty for which the business has at least applied for patents.
• Complete product line. A seller does not want to look like a “one hit
wonder” that only sells a single product. There may be much more value if a
company can create a complete product line, with proven viability in the
marketplace.
• Taxation. Has the business been converted to a form of organization (such
as a subchapter “S” corporation) that minimizes taxes on the sale? And is
the owner in a tax position where some of the gain from the sale can be de-
ferred?
• Trade show. If the sales department is attending a trade show and they know
about the pending sale of the business, it is entirely likely that they will leak
this information at the trade show – where competitors will hear about it.
Consequently, the seller should either not tell the sales department about the
pending sale (an excellent idea), or initiate selling activities between trade
shows.
• Declining business. If the business is in a tail spin and there does not appear
to be a good prospect of improvement, then the seller should put the compa-
ny up for sale at once. Delaying even a month will reveal worse financial
results that will only further reduce the value of the business, as well as
place the seller in a poor negotiating position.

The timing of the sale may not be based on any one of the preceding trigger events,
but rather on the attainment of a “complete package” – a complete product line
bolstered by patents, broad distribution, an excellent management team, and so on.
Of course, it takes longer to achieve this rarified level, but waiting may result in a
much higher price. Thus, the proper positioning of a business for sale should
certainly require one year, and possibly many more.

Tip: It is much better to wait and have concrete financial, operational, and
intellectual property assets to show to sellers, rather than selling too soon, when the
company only has pending products and contracts that are less valuable to an
acquirer.

Information Sharing
A major exit planning decision for the seller is the extent to which he or she wants to
share any plans to sell the business. Initially, it may be possible to work with an
outside advisor, such as an investment banker, at an off-site location, thereby
keeping the information away from everyone in the business. This may be a wise
choice, especially when the seller is still in long-range planning mode and only

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wants to position the business for sale over several years. Doing so absolutely avoids
the risk of rumors starting within the company. As a general rule, secrecy early in
the selling process is an excellent idea, since this may cover a protracted period of
time during which there would be great uncertainty (and loss of productivity) among
employees if they were to learn of the situation.
As the owner’s plans to sell shift into more of a short-range mindset, it will at
least be necessary to include the chief financial officer (CFO) in the planning
process. The CFO will be responsible for assembling many of the documents that a
due diligence team requests, so it is nearly impossible to avoid including the CFO.
Similarly, it is likely that several people within the accounting department will
become aware of the situation, because they are also involved in the document
assembly process.
It may be possible to avoid informing most or all other members of the man-
agement team until the sale discussions have reached the point where the team will
be needed to make presentations to potential acquirers, or to interact with due
diligence teams. At this point, the owner should call a meeting to discuss the
situation in detail with the managers, and answer any questions they may have. Any
meetings amongst this group concerning the sale should be held off-site, until it is no
longer possible to keep news of the sales effort from other employees.

Tip: If it seems necessary to be unusually secretive about selling the company,

request that all e-mails concerning the sale be exchanged between the personal e-
mail accounts of those employees involved in the process. Otherwise, there is a
chance that an associate or an administrative assistant might access the sale
information.

The sale of a business is of great interest to the management team, which will be
concerned about whether their employment will be terminated by the acquirer. This
is a particular concern when the likely acquirer has a reputation for consolidating
acquired operations into its existing businesses. However, other acquirers (especially
those new to the industry) will be more interested in keeping the entire management
team. Thus, the employment concerns of managers are driven to some extent by the
reputation of the acquirer.
It is possible to allay the fears of the management team in several ways. These
include the following:
• Employment contract. The company can unilaterally offer an employment
contract to each manager for a period of at least one year, which guarantees
them employment or a large severance payment if they are terminated prior
to the end of the contract period. This can be a problem for the acquirer,
who may indeed have been planning a layoff, and must now incur additional
payroll expenses. If so, the acquirer may attempt to reduce the purchase
price by the present value of these contracts.
• Closing bonus. The seller needs the active cooperation of the management
team, which must deal with a large number of acquirer requests for infor-

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 Exit Planning

mation. To compensate them for their assistance, a bonus plan could be

created, under which they receive a substantial bonus when the deal closes.
• Stock options. If the company grants stock options with a change of control
clause, this means that the options can be exercised when the company is
sold. This is a variation on a closing bonus, because it gives managers an
extra incentive to work for the highest possible sale price, so that they can
earn more from their options.

The employment contract and closing bonus are usually offered by the existing
owners of a business. In addition, the prospective acquirer could be encouraged to
offer retention bonuses to those managers and other key employees who will be
terminated, but whose services are needed during a transition period. This bonus
should be sufficiently large to keep them from accepting job offers during the
transition period.
The tone of this discussion has been to keep information about a possible sale
tightly locked down. The seller should strive to maintain this lock-down for as long
as possible, because a prolonged selling process only increases the risk that
concerned employees will look for new jobs. Even if few employees leave the
business, it is quite likely that efficiency will decline during the selling period, as
everyone spends time trading rumors and looking for new jobs. Thus, the ideal
timing of information sharing for most employees is the introduction of the new
owner, who immediately reassures them regarding the retention of their positions or
gives them notice of terminations – either way, the period of uncertainty is reduced
to a few hours, rather than several months.

Tip: If there is an announcement of a pending sale of the business, do it verbally.

That way, there is no memo, e-mail, or video that can be forwarded outside of the
company and into the hands of the news media or competitors.

Risks of a Failed Exit

The seller should be mindful of the risks to the business if an exit strategy fails. This
issue is not the sense of let-down from not having cashed out, but rather from the
very real risk of having allowed potential acquirers access to the company’s most
sensitive competitive information. Some competitors may even act like acquirers
just to gain access to this information, and then back out of the bidding, having
achieved their objective. This can have the following ramifications:
• Employee pay rates. Competitors may gain access to the pay rates and
compensation plans of the company’s key employees, which allows them to
make precisely-tailored offers to lure away the company’s best staff. This is
a particular danger in the areas of sales and engineering, where a company
could suddenly find itself without its most productive employees.
• Cost information. A competitor could review cost information for the
company’s products, to see how much they cost to construct. This infor-
mation can be of use when designing competing products.

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 Exit Planning

• Gross margins. A competitor could obtain access to profitability infor-

mation about which products, product lines, customers, stores, regions, and
distribution channels are the most profitable. This is very useful information
for copying the more profitable aspects of a business.
• Customers. A competitor could use the company’s list of primary customers
to lure them away with offers of improved pricing, marketing rebates, and
so forth.

It is possible to avoid these problems to some extent by simply refusing to issue

information to some bidders if it appears that they are not going to make serious
offers. Another option is to deliberately obscure some of the information, such as
stating the total number of employees and total compensation paid, but not
identifying specific compensation levels per person. Another possibility is to offer
more detailed information about the company after preliminary offers have been
received, thereby stripping away the more casual bidders. It is also common to
request that all due diligence materials be returned in the event of a failed bid
(though it is easy enough to photocopy this information). Also, if the seller is storing
its information in a data room (see the Data Room chapter), it is possible to track
which bidders are downloading specific documents, which may be of use if the
seller later wants to take legal action against a bidder for using the information
against the company. Finally, the company can provide some information on an
“eyes only” basis, so that nothing can be copied (though cell phone cameras make
this a less viable alternative).

Summary
Many of the exit planning activities noted in this chapter were simply preparation for
the items listed in the Due Diligence chapter. Thus, to be fully prepared for the
examination of any future acquirer, consider reviewing a standard due diligence
checklist to see how the business will fare on each item. The Due Diligence chapter
covers many additional areas that may be of interest for exit planning, including
product development, sales and marketing, production operations, materials
management, and information technology.
It may be useful to obtain a second opinion on which exit planning activities to
implement, and when is the best time to sell. For this advice, consider retaining an
investment banker who has experience in the company’s industry. This person
knows how various aspects of businesses were valued in similar acquisitions, and
can translate this information into a discussion of which improvements a business
should complete prior to entering the selling process.

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 Chapter 5
The Data Room
Introduction
In some acquisitions, there is a single bidder who submits a request for information,
and which the seller responds to with a large number of documents. However, what
about auction arrangements where there are many bidders? It would be enormously
ineffective for the seller to provide a customized set of information to each bidder.
In this chapter, we address data rooms and how they are organized to deal with large
numbers of bidders.

The Physical Data Room

The general concept of the data room is that the seller consolidates all of the
information requested by bidders in a single location. Due diligence teams
successively visit this room and review the information until they have answered
their own questions. There may be a security guard in the room or security cameras
to ensure that no information is taken from the premises. This approach has several
advantages:
• Confidentiality. The data room can be set up away from the seller’s
premises, which is a good way to keep information about the sale from get-
ting back to employees.
• Cost. It is much less expensive to keep all due diligence information in one
place than to create a separate set of documents tailored to the requirements
of each bidder.
• Security. The information can be stored in one location, from which one can
be reasonably certain that the information will not be stolen (if there is on-
site monitoring).
• Standardization. Each bidder has access to exactly the same set of infor-
mation, so there should be no issues with anyone gaining access to unique
information.

Despite these advantages, there are also several shortcomings associated with the
physical data room. One is that the ubiquitous cell phone, with its built-in camera,
makes it much less likely that confidential information will not be taken from the
room. Another issue is that, though the cost to the seller is low, the cost to the bidder
is relatively high; each bidder must pay to send a team to the data room, and pay
their expenses for however many days are required to examine documents.
 The Data Room

The Electronic Data Room

The electronic data room is built around the same concept as the physical data room,
where the information requested by due diligence teams is stored in one place. The
difference is that the “place” is a secured website. This is extremely convenient for
bidders, who no longer have to send employees and other investigators long
distances for due diligence (though more in-depth analysis of facilities, as well as
employee interviews, will still require on-site visits). The added level of
convenience may even attract more bidders who would otherwise not be willing to
send in a team for an initial review of the business. This approach also works well
for those sellers that do not want to maintain a physical facility and related security
systems for their due diligence documents.
A seller could set up its own electronic data room, but it would not contain a
variety of security and other features included in the offerings of several third-party
providers. Consequently, it is customary to pay a third party for this service. When
looking to rent an electronic data room, consider the following features and services:
• File formats. All file formats should be allowed for storage. At a minimum,
it should be possible to store Excel, Word, and PDF files. Also, there should
be no limit on the size of files.
• File structure. The site should allow the seller to set up a coherent subdirec-
tory structure into which documents can be stored, where there is no limita-
tion on the number of subdirectories. For example, the file structure might
include subdirectories for the following types of information:
o Employees
o Financial statements
o Intellectual property
o Legal issues
o Licenses and permits
o Organizational information
o Products
o Real estate
o Sales documentation
o Tax returns

It should also be easy to move files from one subdirectory to another within
the file structure.
• Hosting. The site should store data on its own servers, rather than on the
servers of a third party where it would be easier for a someone to hack into
files.
• In-house uploading. If the seller elects to have the data room provider scan
documents and upload them to the site, the provider should use its own staff
to do the scanning. Outsourcing this work presents the risk that a third party
will gain access to the seller’s confidential documents.
• Print control. The site should allow the seller the ability to restrict a user
from printing a document.

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 The Data Room

• Reporting. The provider should have a reporting system in place that reveals
which documents have been viewed, who viewed them, when they were
viewed, and for how long each document was viewed.
• Security. The site must require password access, and may also require
additional access to certain parts of the site. For example, someone identi-
fied as an accountant might only be given access to the financial statements
and supporting documents, while someone else identified as an attorney
might only be allowed access to legal documents.
• Security certification. Have the site show proof that a security review of it
was conducted recently by a third party.
• Speed. It should be possible to set up a site in just a few hours, though the
associated training required to administer the site may extend the initial set
up period.
• Support. Due diligence reviews are famous for going on through the middle
of the night, as well as weekends and holidays. That means any issues with
the electronic data room must be resolved at once, at any time of the day or
night.
• Training. There should be on-line training available for any employees who
need to learn the functionality of the site, as well as a help desk to assist
with any problems found.
• Uploads. The site must allow the seller’s staff to scan all documents and
efficiently upload them into the site.
• Watermarking. Some sites incorporate a watermark in documents, which
prevents anyone from printing documents or taking screen shots without the
revealing watermark.

The preceding list of desired features is heavy on security, since a key concern of
any seller is to keep its confidential information from being scraped from the site by
a competitor. The seller should peruse the reports provided by the site manager to
see if anyone is downloading large volumes of material, and then decide if that
entity’s user access should be denied to keep too much material from falling into the
wrong hands.

Tip: The reporting features of an electronic data room are of particular interest,
since the seller can use it to see if different people from a particular bidder are
sequentially reviewing documents. This is a sign that the seller passed an initial
review, at which point a different set of reviewers were tasked with another tranche
of review activities.

The typical pricing structure for an electronic data room is a one-time fee to initially
set up the site and load documents, followed by a monthly storage charge for
however many months the seller needs to keep the information available during the
auction process. Any user should expect to spend at least $10,000 for an electronic
data room, with the price increasing in proportion to the number of documents

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stored on the site and the time period over which the documents are stored. The cost
per page stored declines as the number of pages increases, but expect to pay at least
$1.00 per page with the initial setup of the site. This price increases substantially if
the seller wants the site provider to also scan and upload its due diligence
documents.

Tip: If the seller has engaged the services of an investment banker to assist in the
sale, the banker may have experience in setting up the structure of an electronic data
site, and may even assist with uploading documents to it. This can increase the
rollout speed for the site.

Summary
For larger transactions, the electronic data room has become the information
distribution system of choice. This does not necessarily mean that the physical data
room has been completely supplanted – far from it. The operators of electronic data
rooms charge relatively high prices for their services, so a smaller company that is
likely to have mostly local bidders can get by quite cost-effectively with a physical
data room. However, the key point is that any auction-style selling environment
must have either type of data room; dealing with individual due diligence requests is
far too time-consuming for the selling entity.

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 Chapter 6
Valuation of the Target
Introduction
There are many ways to value a business, which can yield widely varying results,
depending upon the basis of each valuation method. Some methods assume a
valuation based on the assumption that a business will be sold off at bankruptcy
prices, while other methods focus on the inherent value of intellectual property and
the strength of a company’s brands, which can yield much higher valuations. There
are many other valuation methods lying between these two extremes.
We need all of these methods, because no single valuation method applies to all
businesses. For example, a rapidly-growing business with excellent market share
may produce little cash flow, and so cannot be valued based on its discounted cash
flows. Alternatively, a company may have poured all of its funds into the
development of intellectual property, but has no market share at all. Only through
the application of multiple valuation methods can we discern what the value of a
business may be.
In this chapter, we cover how to arrive at a valuation. You will see not only the
calculation methodology, but also the assumptions underlying each one, and the
situations to which they might be applied. They are presented beginning with those
likely to yield the lowest valuations, and progress through other methods that usually
result in higher valuations. The methods are summarized at the end of the chapter, in
the Valuation Floor and Ceiling section.

Related Podcast Episode: Episode 75 of the Accounting Best Practices Podcast

discusses acquisition valuation. You can listen to it at: accounting-
tools.com/podcasts

Board of Directors Liability

The board of directors of any company has a fiduciary responsibility to its
shareholders to obtain the highest possible return on their investment in the
company’s shares. This means that, if the company receives a purchase offer, the
board should spend sufficient time examining the bid and weighing it against other
offers and the advice of experts to reasonably ensure that shareholder return is being
maximized. If the board does not engage in this level of due diligence, it runs the
risk of being sued for negligence by the shareholders for having accepted an
inadequate offer.
Given the liability of the board of directors, they should be aware of the
valuation methodologies outlined in the remainder of this chapter.
 Valuation of the Target

Timing of the Deal

The following sections contain a broad array of methods used to derive the valuation
of a target entity. What they do not mention is that the date on which a valuation is
calculated can have a profound impact on the valuation. Most acquisitions are
completed during an upswing in the market, when the results of acquirees are
unusually good, acquirers have accumulated some cash for purchases, and lenders
are more willing to advance funds for an acquisition. During these times, the
valuation of an acquiree may be inordinately high in comparison to how it was
performing at the previous low point in the business cycle. If an acquirer completes
an acquisition at this time, the price paid may be so high that it will be quite difficult
to produce enough cash flow from the deal to ensure that it pays off in the long run.
Given this timing issue, it makes more sense to engage in acquisitions during the
depths of the business cycle, when acquirees cannot point to outlandish financial
results to justify high valuations. If an acquirer can complete a deal at these lower
valuation levels, the risk of overpayment is low. However, the goal of only buying in
a down cycle is not easy to achieve, for several reasons:
• Financial discipline. An acquirer must pile up a large amount of cash during
high points in the business cycle, in order to have the financial wherewithal
to snap up companies in the depths of a downturn.
• Ego. Some company presidents love to publicize their acquisitions, and the
resulting increase in size of the businesses they control. Buying in a down-
turn requires the patience to wait for the right deal at the right price, and
walking away from everything else. Many presidents do not have the forti-
tude to do so.
• Willing lenders. Lenders typically tighten their lending standards during a
downturn, so it can be difficult to obtain debt financing for an acquisition.
This makes it even more imperative to maintain a large cash reserve.
• Willing sellers. The owners of a business should be unwilling to sell during
a downturn, since they know the valuation they receive will be substandard.
Consequently, a prospective buyer may find that only the financial weak-
lings in an industry, which are teetering on the edge of collapse, are willing
to sell out. Conversely, this also means that the most robust competitors will
see no need to accept a low-ball offer, and so will not be available for sale.

Despite the difficulties inherent in making a downturn-oriented strategy work, an

acquirer can conclude deals at a fraction of what they would have paid at the peak of
the market.

EXAMPLE

Global Camper, Inc. produces mid-sized motorhomes for campers in North America and
Europe, with an emphasis on reasonable pricing. Global is parked in the middle of the
market, scooping up roughly 50% of all industry profits. The motorhome market is
comprised of a few larger producers and many smaller manufacturers that specialize in niche

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products. Global has a standard acquisition strategy of maintaining large cash reserves,
which it employs to buy smaller competitors with all-cash offers during periodic industry
downturns.

If a business broker ever approaches Global with an offer from a seller that is excessively
high, the acquisitions manager immediately turns down the deal and puts the seller on her
watch list, to see if its prospects decline over time. If so, Global extends a lower offer. If the
seller rejects the offer, the acquisitions manager is content to wait and see if the business
enters bankruptcy, in which case Global may make an even lower-priced offer.

A key competitor, High-Line Camper, has stolen away a number of deals from Global by
offering higher prices to sellers. High-Line has been able to do so by financing its acquisition
spree with low-cost debt. Global bides its time and waits for interest rates to rise; when they
do so, High-Line cannot pay off its debt, and Global buys the company out of bankruptcy,
along with all of the companies that High-Line had previously acquired.

Liquidation Value
Liquidation value is the amount of funds that would be collected if all assets and
liabilities of the target company were to be sold off or settled. Generally, liquidation
value varies depending upon the time allowed to sell assets. If there is a very short-
term “fire sale,” then the assumed amount realized from the sale would be lower
than if a business were permitted to liquidate over a longer period of time.
The liquidation value concept is based on the assumption that a business will
terminate, for one that continues in business has additional earning power from its
intellectual property, products, branding, and so forth. Thus, liquidation value sets
the lowest possible valuation for a business. The concept is useful for the acquirer to
address even in cases where it intends to pay a great deal more for a target company.
The reason is that the difference between the liquidation value and the amount
actually paid is the amount for which the acquirer is at risk, in case there are
problems with the target company that require it to be liquidated.
The owners of a business would be foolish to sell at the liquidation price, since
they could just as easily liquidate the business themselves as sell it to someone else
and have them liquidate it. Nonetheless, if a business is suffering from any number
of factors related to its operations or the business environment, it is possible that an
astute acquirer might actually complete a purchase at a valuation relatively close to
the liquidation value of the target.

Real Estate Value

If a company has substantial real estate holdings, they may form the primary basis
for the valuation of the business. This approach only works if nearly all of the assets
of a business are various forms of real estate. Since most businesses lease real estate,
rather than owning it, this method can only be used in a small number of situations.

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EXAMPLE

High Noon Armaments is interested in acquiring Home Caliber, a chain of gun shops. Upon
further investigation, High Noon finds that the shops are barely profitable, but that Home
Caliber owns both the land on which its stores are situated and the stores themselves. The
CFO of High Noon elects to compile a valuation based on the underlying real estate, rather
than the cash flow fundamentals of the business.

If the acquirer has no experience in dealing with real estate, and plans to sell off the
real estate, then it may apply a discount to the real estate values that it derives.
However, since the real estate valuation is being used as the primary source of
information for the valuation, and the acquirer expects to sell the real estate, this
brings up the issue of why the acquirer is making an offer at all.
From the perspective of a seller that wants to be sold, it may make more sense to
gradually sell off the real estate in such a manner as to maximize prices, and use the
funds to either buy back shares or issue a large cash dividend to shareholders. This
approach shifts all of the cash directly to the shareholders, without worrying about
any discount that might be applied by a prospective acquirer. Company management
can then pursue the sale of the remainder of the business to realize any residual cash,
which also goes to the shareholders.

Relief-from-Royalty Method
What about situations where a company has significant intangible assets, such as
patents and software? How can you create a valuation for them? A possible
approach is the relief-from-royalty method, which involves estimating the royalty
that the company would have paid for the rights to use an intangible asset if it had to
license it from a third party. This estimation is based on a sampling of licensing
deals for similar assets. These deals are not normally made public, so it can be
difficult to derive the necessary comparative information.
Under this method, any savings from not licensing an asset are considered on an
after-tax basis. The reason is that, if the company had indeed licensed the rights
from a third party, there would have been a licensing expense that reduced taxable
income.
The relief-from-royalty method is hardly one that can be used to value an entire
enterprise, since it only addresses intangible assets. Nonetheless, it is one of the few
methods available for putting a price tag on intangible assets, and so can be of use in
situations where intangibles comprise a large part of the assets of a target company.

Book Value
Book value is the amount that shareholders would receive if a company’s assets,
liabilities, and preferred stock were sold or paid off at exactly the amounts at which
they are recorded in the company’s accounting records. It is highly unlikely that this
would ever actually take place, because the market value at which these items would

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 Valuation of the Target

be sold or paid off might vary by substantial amounts from their recorded values.
There could be particularly large disparities between the recorded and market values
of items in the following areas:
• Inventory. If a company uses the last in, first out method of inventory
costing, this could mean that some portions of the inventory are assigned a
cost that could be a number of years old. Also, if a company is located in an
industry where inventory obsolescence occurs quickly, then the recorded
cost of inventory may be much higher than the amount at which it could
actually be sold.
• Fixed assets. Fixed assets are recorded at their purchase costs. That cost is
reduced over the useful life of the assets with depreciation. However, the
depreciation charge does not necessarily relate to the decline in the market
value of an asset over time. Instead, there can be a significant difference
between the net book value of a fixed asset and its sale price.
• Intangible assets. Intangible assets are recorded at their purchase costs,
which are then reduced over the useful life of the assets with amortization.
There can be very large differences between the market value of these assets
and their net book value. For example, a patent may have an increasing
market value that greatly exceeds its recorded cost.
• Contingent liabilities. There may be any number of contingent liabilities that
are not recorded in the accounting records of a business at all, and yet repre-
sent significant liabilities. For example, there may be a potential for adverse
judgments in lawsuits, or as a guarantor for a debt.

Book value is an imprecise measure of the value of a business, since it simply

reflects a variety of accounting standards used to record accounting transactions. It
does not necessarily reflect the value of a business at all. In general, it may be used
as a baseline around which more valid valuation results may fall.
Book value may also be used as the denominator in the calculation of sale price
to book value for the sales of similar businesses. Thus, if a mix of other companies
in the same industry sold for a multiple of five times book value, then one might
apply that same relationship to another prospective sale when determining a price
for it.

EXAMPLE

High Noon Armaments wants to determine the sales price to book value ratio for recent sales
in the armaments industry, to see what types of multiples it should apply when formulating
offer prices for other businesses. It compiles the following information about five other sale
transactions that were completed within the past 12 months:

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 Valuation of the Target

Sale Book Sale-to-Book-Value

Transaction Price Value Ratio
A $10,000,000 $3,800,000 2.6x
B 27,500,000 8,900,000 3.1x
C 42,650,000 10,900,000 3.9x
D 16,250,000 5,800,000 2.8x
E 6,500,000 4,800,000 1.4x
Totals $102,900,000 $34,200,000 3.0x

Upon further examination of the underlying information, High Noon’s CFO finds that
Transaction E involved the sale of a business that was in severe financial difficulties, so he
throws out the outlier ratio that resulted from that transaction. The remaining transactions
yield an average sale-to-book-value ratio of 3.3x.

There are a number of problems with using the sale price to book value ratio as the
basis for a valuation. They are:
• Intellectual property. Another business may have garnered an unusually
high price in comparison to its book value, because it had unusually excel-
lent intellectual property that may not have even been recorded as an asset in
its accounting records.
• Early-sale effect. If there is a surge in acquisitions within an industry,
typically the highest-quality firms are snapped up first. This means that the
highest ratios of sale price to book value appear early in an acquisition cy-
cle; the ratio should decline later in the cycle, as lower-quality firms are
purchased.
• Asset efficiency. Some companies are much more efficient in the use of their
assets than others, leading to significant disparities in the ratio.

In short, book value is of dubious use in deriving the valuation of a target company.
You should certainly not use it as the sole basis for deriving a valuation.

Enterprise Value
What would be the value of a target company if an acquirer were to buy all of its
shares on the open market, pay off any existing debt, and keep any cash remaining
on the target’s balance sheet? This is called the enterprise value of a business, and
the calculation is:

+ Market value of all shares outstanding

+ Total debt outstanding
- Cash
= Enterprise value

Enterprise value is only a theoretical form of valuation, because it does not factor in
the effect on the market price of a target company’s stock once the takeover bid is

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announced. Also, it does not include the impact of a control premium on the price
per share (see the Control Premium section). In addition, the current market price
may not be indicative of the real value of the business if the stock is thinly traded,
since a few trades can substantially alter the market price. Further, the removal of
cash from the target company does not indicate the need for that cash in order to
continue operating the target business. Nonetheless, enterprise value is of some use
in determining the “raw” valuation prior to estimating the control premium and other
factors that typically boost the valuation of a business.

EXAMPLE

High Noon Armaments is preparing the valuation of a target company, and the CFO wants to
know the amount of its enterprise value. The target has one million shares, and today’s
market price is $12.50 per share. According to its most recent quarterly Form 10-Q filing, the
target has $2.4 million of outstanding debt, and $200,000 of cash on hand. Based on this
information, its enterprise value is:

+ Market value (1,000,000 shares × $12.50/share) $12,500,000

+ Debt 2,400,000
- Cash -200,000
= Enterprise value $14,700,000

Multiples Analysis
It is quite easy to compile information based on the financial information and stock
prices of publicly-held companies, and then convert this information into valuation
multiples that are based on company performance. These multiples can then be used
to derive an approximate valuation for a specific company. The typical approach is
as follows:
1. Create a list of the top ten publicly-held companies most comparable to the
company for which a valuation is being compiled.
2. Find the current market valuation for each business, which is easily obtained
through Yahoo Finance or Google Finance.
3. Obtain the revenue information for the past 12 months for each business,
either from SEC filings or the Internet sites just noted. Compare revenues to
the total company market valuation to arrive at a sales-to-market-value mul-
tiple.
4. Obtain the EBITDA information for the past 12 months for each business,
either from SEC filings or the Internet sites just noted. EBITDA is earnings
before interest, taxes, depreciation, and amortization. It is a rough measure
of the cash flows of a business. Compare EBITDA to the total company
market valuation to arrive at an EBITDA-to-market-value multiple.
5. Multiply the target company’s revenue and EBITDA amounts for the past
12 months by the median multiples for the target group to derive valuations.

The following example illustrates the concept.

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EXAMPLE

High Noon Armaments routinely acquires other businesses within the firearms industry, and
so conducts an annual review of the revenue and EBITDA multiples associated with the
smaller publicly-held companies in the same industry. Accordingly, the acquisitions staff
prepares the following multiples analysis.

Multiples Analysis
Firearms Industry
As of January 10, 20xx
(000s)

Market One Year One Year Revenue EBITDA

Name Capitalization Revenues EBITDA Multiple Multiple
Arbuckle Weapons $145,000 $174,000 $19,300 1.2x 7.5x
Billy the Kid Designs 90,000 117,000 11,500 1.3x 7.8x
Heston Shotguns 128,000 160,000 24,200 0.8x 5.3x
Patton Siege Guns 210,000 210,000 30,000 1.0x 7.0x
Plasma Weapons 52,000 24,000 3,900 2.2x 13.2x
Quigley Artillery 360,000 240,000 42,400 1.5x 8.5x
Rifled Custom Guns 76,000 19,000 3,200 4.0x 24.0x
Totals $1,061,000 $944,000 $134,500 1.1x 7.9x

Thus, the review shows a weighted-average revenue multiple of 1.1x and a weighted-average
EBITDA multiple of 7.9x.

One month later, High Noon is engaged in a valuation analysis of a prospective acquisition,
which has annual sales of $6.8 million and EBITDA of $400,000. Based on the multiples
analysis, High Noon arrives at the following possible valuations for the company:

Revenue EBITDA
Target company results $6,800,000 $400,000
× Industry average multiple 1.1x 7.9x
= Valuation based on multipliers $7,480,000 $3,160,000

The results suggest quite a broad range of possible valuations, from $3,160,000 to
$7,480,000. It is possible that the target company has unusually low EBITDA in comparison
to the industry, which is causing its EBITDA-based multiplier to be so low. This means that
High Noon might want to push for a lower valuation if it proceeds with the acquisition.

It is most common to multiply the valuation multiples by the revenue and EBITDA
information for the target company for its last 12 months. This is known as trailing
revenue or trailing EBITDA. This is the most valid information available, for it
represents the actual results of the business in the immediate past. However, if a
target company expects exceptional results in the near future, then it prefers to use
forward revenue or forward EBITDA. These measurements multiply expected
results for the next 12 months by the valuation multipliers. While the use of forward
measurements can create a good estimate of what a business will be worth in the

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near future, it generally incorporates such optimistic estimates that it tends to result
in excessively high valuations.

Tip: If you allow a target company to derive its valuation based on forward revenue
or EBITDA, then insist that the target does so based on its internal budgeted
information for the projected period, and only if it has a solid track record of having
met its budgeted numbers in the past.

A multiplier analysis that is based on revenues is useful in cases where a business is

in high-growth mode, where there are typically fewer profits. This is because such
businesses have elevated expenditure levels to hire staff, acquire more facilities, and
other issues related to faster growth. However, creating a valuation based solely on
revenues is dangerous, since a target company may be generating those revenues by
selling at such rock-bottom prices that it will be impossible for the acquirer to turn a
profit. Also, high revenues do not mean that a business is being well run. In short, a
revenue-based multiplier should be supplemented by other valuation techniques.
The EBITDA multiple is a much better basis for a valuation than the revenue
multiple, since it reflects the ability of a business to generate a profit. However, you
should examine the EBITDA for the past few years as well, to see if the
management of the target company is cutting back on expenditures in the current
year in order to make the business appear more profitable.

Tip: Apply both the revenue and EBITDA multiples to each acquisition. If the
revenue multiple results in a lower valuation than the EBITDA-based valuation, then
the target company has higher profits than the average for the industry. The reverse
situation indicates lower-than-average profitability. In either case, the relationship
between the valuation levels can be used as the basis for additional due diligence.

There are several problems with multiples analysis to be aware of. They are:
• Company size. The information used for multiples analysis comes from
publicly-held companies, and those companies are generally larger ones.
Thus, the multiples that they command may not be applicable to smaller,
privately-held organizations.
• Conglomerates. If a target company dabbles in multiple industries, then it is
extremely difficult, if not impossible, to construct a multiples analysis for it.
This is a particular problem when a target company insists on a valuation for
the entire company that is based on the subsidiary located in an industry
where multiples are highest. Given the difficulty of analysis, it may be better
to use the discounted cash flows method instead (see the Discounted Cash
Flows section).
• Market capitalization. A very large publicly-held company may have higher
multiples than smaller companies, if only because it has a more liquid mar-
ket for its shares and more institutional investors authorized to own its

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shares. Thus, comparing a larger firm’s multiples to a small private compa-

ny can be misleading.
• Outliers. It is quite common for a few companies in the comparison analysis
to have unusually high or low multiples. It is also common for an acquirer to
fixate on those businesses with the lowest multiples, while target companies
do the reverse. Instead, throw out the high and low outliers and focus on the
median multiples, which give the best general idea of valuation.
• Price swings. The stock price of a company may vary significantly over just
a few days, so the specific date on which a multiples table is compiled can
have a resounding impact on multiples. You can avoid some of this difficul-
ty by using the average stock price for the past month.
• Thin trading. A public company whose shares trade over-the-counter rather
than on a stock exchange will likely be thinly traded, which means that even
a few trades may significantly alter share prices, resulting in unusual multi-
ples.
• Transitory revenue. Both the revenue and EBITDA multiples can be skewed
if the target company has recorded transitory sales. These are typically larg-
er, one-time sales that are not expected to recur. Examine the underlying
details of a business and strip away these sales before applying any revenue
or EBITDA multiples.
• Underlying quality. A major problem with using multiplies to derive
valuations is that you are assuming the business being valued is about the
same as every other company included in the multiples analysis. If the busi-
ness has much better fundamentals than other companies, such as a more
recent product line, then it may be worth much more than the multipliers
would indicate. Conversely, a poorly-run business with low-quality assets
may not justify the valuation that a multiplier analysis would indicate for it.

The last point, regarding the underlying quality of a target company, underscores the
main problem with multiples analysis. In short, this may seem to be an ideally
quantitative type of analysis that yields a strong justification for a particular
valuation, but in reality it only suggests what an average business may be worth,
based on a cluster of other average businesses. A company with unusual business
fundamentals could be worth substantially more, or less, than multiples analysis
would indicate.

Discounted Cash Flows

One of the most detailed and justifiable ways to value a business is through the use
of discounted cash flows (DCF). Under this approach, the acquirer constructs the
expected cash flows of the target company, based on extrapolations of its historical
cash flow and expectations for synergies that can be achieved by combining the two
businesses. A discount rate is then applied to these cash flows to arrive at a current
valuation for the business. The steps in the process are:

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 Valuation of the Target

1. Create an estimate of the cash flows to be derived from the target company
in each of the next five years, including any expected synergies.
2. After the five-year period, estimate a second set of cash flows that are
assumed to continue in perpetuity at a certain rate of growth (or decline) per
year. This is typically based on the cash flows in year five. We use this ap-
proach after year five, because it is impossible to estimate cash flows with
much precision so far in the future.
3. Calculate the net present value of all future cash flows, using a discount rate.
The result is the present value of the target company.

Post Five-Year Cash Flows

The preceding itemization of the steps to follow for a DCF included the assumption
of a perpetual rate of growth or decline in the target company following five years of
detailed cash flow analysis. This is an extremely difficult number to arrive at, for
slight changes in the rate of growth or decline can have a major impact on the
valuation of the target. Here are several options for dealing with these post five-year
cash flows:
• Ignore. The acquirer can base its valuation on only five years of cash flows,
and ignore any further cash flows. This argument is based on the quite likely
position that there is considerable risk that the acquisition will not work, and
so there is a significant chance that there will be no cash flows after five
years.
• Risk adjustment. If the acquirer elects to use a perpetual rate of growth or
decline, it can use an extremely high discount rate to reduce the present
value of these cash flows to quite a small amount. The discount rate applied
to the first five years of cash flows may be substantially smaller, since those
cash flows are in the near future, and so can be more easily predicted.
• Assume sale of the business. The acquirer can assume that it will sell the
target company to a third party at the end of year five. This brings up the
issue of what the business might be worth in five years, which is difficult to
determine, and which may call for a higher discount rate to reduce its pre-
sent value.

In general, the acquirer does not want to deal with post five-year cash flows, due to
their uncertainty, while the target company wants them to be considered in order to
increase the valuation of the business. The result may be any of the preceding
options. The author has generally ignored cash flows more than five years in the
future, based on considerable experience with being unable to predict such flows.
Actual cash flows have nearly always been lower than predicted even a few years in
the future, so any use of post five-year cash flows should be reduced to the greatest
extent possible. Otherwise, the acquirer will almost certainly assign too high a
valuation to a business.

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Negotiation of DCF Contents

There can be a considerable amount of manipulation involved in adjusting the items
to be included in a discounted cash flow analysis. The seller invariably wants to
exclude selected expenses from the calculation, on the grounds that they were one-
time events that the acquirer will not experience in the future. The seller will also
identify a large number of expense exclusions that are based on presumed synergies.
The result, according to the seller, is likely to be startlingly high cash flow that the
target would be unlikely to ever achieve in practice. It is the task of the acquirer to
sort through these alleged expense reductions and verify which ones may actually be
achieved.

The Discount Rate

The rate used to discount cash flows to their present value is generally considered to
be the cost of capital of the acquiring entity. The cost of capital is comprised of the
cost of a company’s debt, preferred stock, and common stock.
The cost of a company’s debt is not just the average interest rate that it pays for
all outstanding debt. Interest expense is tax-deductible, so you must reduce the
interest rate by its tax impact. The calculation of the cost of debt is:

Interest expense × (1 – tax rate)

= After-tax interest rate
Amount of debt

For example, if a company has $1,000,000 of outstanding debt at an interest rate of

6%, and its income tax rate is 35%, then its after-tax interest rate is:

$60,000 interest expense × (1 – 35% tax rate)

= 3.9% after-tax interest rate
$1,000,000 of debt

Preferred stock is the next component of the cost of capital. It is a form of equity
that does not have to be repaid to the investor, but for which a dividend must be paid
each year. This dividend is not tax-deductible to the company, so preferred stock is
essentially a more expensive form of debt. The calculation of the cost of preferred
stock is:

Dividend expenditure
= Preferred stock dividend rate
Amount of preferred stock

For example, if a company has $2,000,000 of preferred stock that requires an annual
dividend payment of $180,000, then the cost of the stock on a percentage basis is:

$180,000 dividend expenditure

= 9% preferred stock dividend rate
$2,000,000 of preferred stock

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 Valuation of the Target

The final component of the cost of capital is common stock, which is a more
difficult calculation. The best way to calculate this cost is through the capital asset
pricing model (CAPM). The CAPM is comprised of the following three elements:
• The risk-free rate of return, usually considered the return on a U.S. govern-
ment security.
• The return on a group of securities considered to have an average risk level,
such as the Standard & Poor’s 500 or the Dow Jones Industrials.
• The beta of the company’s stock, which defines the amount by which its
stock returns vary from the returns of stocks having an average level of risk.
A beta of 1.0 indicates average risk, while a higher figure indicates in-
creased risk and a lower figure indicates reduced risk. Beta is available from
a variety of research firms for most publicly-held companies.

The preceding component parts then plug into the following calculation of the cost
of common stock:

Risk-free return + (beta ×

= Cost of common stock
(average stock return – risk-free return))

For example, if the risk-free return is 2%, the return on the Standard & Poor’s 500 is
9%, and a company’s beta is 1.2, the cost of its common stock would be:

2% risk-free return + (1.2 beta ×

= 10.4% cost of common stock
(9% average stock return – 2% risk-free return))

If a company is privately-held, there will be no beta information for it. Instead, you
should select a publicly-held firm that is operationally and financially similar to the
company, and use the beta for this proxy firm.

Note: As interest rates decline, the debt portion of a company’s cost of capital also
declines, which means that the present value of cash flows associated with
acquisition targets increases, which in turn increases the prices paid for acquisitions.

After you determine the cost of each element of the cost of capital, the next step is to
calculate the weighted average cost of capital, which is based on the amount of
common stock, preferred stock, and debt outstanding at the end of the most recent
accounting period. The following table shows how to conduct the calculation. Note
that the weighted average of the various elements of the cost of capital in the sample
calculation is 12%, which would then be used in the discounted cash flow
calculation as the discount rate.

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 Valuation of the Target

Sample Cost of Capital Calculation

Outstanding Interest
Amount Rate Cost
Common stock $10,000,000 15% $1,500,000
Preferred stock 2,000,000 8% 160,000
Debt 4,500,000 7% 315,000
Totals $16,500,000 12% $1,975,000

There are two situations where you might use a different discount rate than the cost
of capital. They are:
• Incremental borrowing rate. If there is a specific interest rate at which the
acquirer intends to borrow funds in order to pay for an acquisition, it is rea-
sonable to use that rate as the discount rate.
• Risk adjustment. If the acquisition is perceived to be unusually risky, you
can increase the discount rate to account for the additional level of risk. In
particular, you could increase the discount rate for each successive year of
the DCF analysis, since cash flows become more difficult to predict further
in the future. You could also add a risk adjustment if the target company
operates in a country where there is a risk of expropriation or where the
regulatory environment is burdensome. The proper amount of a risk adjust-
ment is difficult to quantify.

Barring the two circumstances just noted, use the company’s cost of capital as its
discount rate for the DCF model.
Once you have the discount rate, how do you apply it to the cash flows in a DCF
model? You should incorporate it into a calculation of the present value of 1 due in
N periods. The calculation is:

1
-----------------------------------------
Number of years
(1 + Interest rate)

In Excel, the formula is:

(1/(1+Interest rate)^Number of years)

For example, if the discount rate is 10% and you want to determine the discount for
cash flows that will occur three years in the future, the Excel calculation is:

(1/(1+0.1)^3) = 0.75131

The following table includes these discount rates for the present value of 1 due in N
periods for a period of five years, which is sufficient for calculating net present
value for five years, using a range of likely interest rates:

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 Valuation of the Target

Number
of Years 6% 7% 8% 9% 10% 11% 12%
1 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929
2 0.8900 0.8734 0.8573 0.8417 0.8265 0.8116 0.7972
3 0.8396 0.8163 0.7938 0.7722 0.7513 0.7312 0.7118
4 0.7921 0.7629 0.7350 0.7084 0.6830 0.6587 0.6355
5 0.7473 0.7130 0.6806 0.6499 0.6209 0.5935 0.5674

To use the table, move to the column representing your discount rate, and move
down to the “number of years” row indicating the discount rate to apply to the
applicable year of cash flow. Thus, if a DCF calculation were to indicate $100,000
of cash flow in the fourth year for a target company, and the acquirer’s discount rate
were 10%, you would multiply the $100,000 by 0.6830 to arrive at a net present
value of $68,300 for those cash flows.
The following example illustrates the compilation of cash flows for a target
company, as well as their reduction to net present value using a discount rate.

EXAMPLE

The CFO of High Noon Armaments is constructing a discounted cash flow forecast for
Sinclair Side Arms. The CFO begins with the cash flow for the preceding 12-month period,
which was $5,800,000. The Sinclair management team claims that the following items
should be added back to the cash flow figure:
• Extraordinary charge of $200,000 related to lawsuit judgment
• One-time bonus payment of $120,000 made to the management team
• Elimination of $60,000 for CEO travel and entertainment expenses that would go
away once the CEO is terminated
• Reduction of $400,000 in salary and payroll taxes related to the CEO, who will be
terminated
• Reduction of $92,000 for a leased warehouse that the management team had not
quite gotten around to terminating on its own

The CFO does not exclude the $200,000 lawsuit judgment, on the grounds that Sinclair has
incurred a series of similar judgments from similar lawsuits in the past, and there is a
significant possibility that it will continue to do so in the future. The CFO also does not
exclude the $120,000 bonus payment, since further investigation reveals that this was a
performance-based bonus, and there is an expectation in the industry for this type of bonus to
be paid; further, the amount is not unreasonable. The CFO accepts the combined $460,000
expense reduction related to the CEO, since that expenditure will not be required in the
future. Finally, the CFO elects not to exclude the $92,000 warehouse lease, on the grounds
that there is no evidence yet that the company can operate without the additional warehouse
space.

In addition, the CFO’s due diligence team comes up with the following suggestions, which
are added back to the cash flow report for valuation purposes:
• $200,000 for duplicated corporate staff who can be terminated
• $80,000 from volume purchasing discounts
• $320,000 from the consolidation of leases
• $38,000 from the elimination of duplicated software maintenance charges

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 Valuation of the Target

The due diligence team also notes that Sinclair’s fixed assets are very old, and will require
$2,000,000 of expenditures in years two, three, and four to bring them up to standard.

Finally, the due diligence team prudently recommends that High Noon assume that Sinclair’s
cash flow will likely drop 5% in the year following the merger, as uncertainty causes some
customers to switch to competitors. Cash flow growth thereafter should be 5% per year.

The CFO combines this information into the following table, in which he estimates the most
likely cash flow scenario for the next five years. High Noon has a cost of capital of 9%,
which is used to derive the discount rates noted in the table.

Year 1 Year 2 Year 3 Year 4 Year 5

Beginning* cash flow $5,800,000 $6,608,000 $6,938,000 $7,285,000 $7,649,000
Base level % change -290,000 +330,000 +347,000 +364,000 +382,000

CEO expense reduction +460,000

Fixed asset replacements -2,000,000 -2,000,000 -2,000,000
Duplicate staff +200,000
Volume discounts +80,000
Lease consolidation +320,000
Software maintenance +38,000
Net cash flow $6,608,000 $4,938,000 $5,285,000 $5,649,000 $8,031,000

Discount rate 0.9174 0.8417 0.7722 0.7084 0.6499

Present value of cash flows $6,062,000 $4,156,000 $4,081,000 $4,002,000 $5,219,000

Present value grand total $23,520,000
* Considered to be the cash flow for the year, based on prior year results, not including fixed asset
replacements

The CFO did not include any valuation for Sinclair after five years, citing the uncertainty of
cash flow projections that far in the future.

Note: You may also need to factor into the DCF model any expected changes in
working capital requirements for the target company. For example, if there is an
expectation of increased sales through the forecast period, it would be reasonable to
assume a reduction in cash flow based on the need for more accounts receivable and
inventory to support the incremental increase in sales.

If the target company has exhibited unstable cash flows in the past, it is a very good
idea to create several DCF models for it, in which you test the key factors that
appear to be causing its cash flows to vary. For example, you could model the loss
of a major customer, or a sudden increase in raw material costs, or the loss of a
patent lawsuit – whatever is indicated by the circumstances. These extra analyses
may point out specific weaknesses or potential strengths that may lead the acquirer
to adjust the size of its offer to a target company.
In summary, the DCF model incorporates considerable detail about the cash
flows of a target company and the synergies to be expected from it, though there is

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an increasing amount of uncertainty as cash flows go further into the future. The
resulting model gives what is likely to be the most realistic view of the valuation of
a business. However, it also incorporates many estimates regarding future events, so
the model must be constructed carefully to yield results that can be attained in
practice.

Replication Value
An acquirer can place a value on a target company based upon its estimate of the
expenditures it would have to incur to build that business “from scratch.” Doing so
would involve building customer awareness of the brand through a lengthy series of
advertising and other brand building campaigns, as well as building a competitive
product through several iterative product cycles. It may also be necessary to obtain
regulatory approvals, depending on the products involved. There is also the prospect
of engaging in a price war in order to unseat the target company from its current
market share position. Here is a summary of the more likely expenditures to include
in the derivation of replication value:
• Product development
• Production design and investment in new production equipment
• Working capital to support new product line
• Startup scrap and spoilage costs
• Branding expenditures
• Expenditures to set up and support a new distribution channel
• Cost of additional sales force or retraining of existing sales force

Further, if the acquirer could have bought a target company at once to avoid the
preceding replication expenses, you should also include in the replication value the
present value of foregone profits that the company could have earned during the
process of replicating the business of the target company. In short, it is usually a
very expensive process to replicate a business.

EXAMPLE

A target company is resisting a $5 million buyout offer by High Noon Armaments, so High
Noon examines the cost of replicating the product line that it wants to acquire. It estimates
the following information:

Cost Estimate Time Estimate

Product development $420,000 10 months
Production line redesign 100,000 2 months
Startup scrap costs 20,000 --
Branding expenditures 180,000 6 months
New distribution setup 110,000 4 months
$830,000 22 months

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 Valuation of the Target

The analysis shows that the replication value is less than $1 million. Also, High Noon
estimates that the present value of the profits that it would forego in the next 22 months by
not purchasing the company is $570,000. This leaves an incremental acquisition cost of $3.6
million associated with buying the company right now. Also, the replication process will
require nearly two years.

High Noon needs to decide if it is worth offering more than the $3.6 million incremental cost
of buying the company in order to be in the market with an active product line right now,
rather than in two years.

The replication cost requires an additional analysis, which is how long the
replication will take. If the acquirer wants to jump into a market in the near future,
replication of a target company is a near impossibility, since doing so may require
multiple years of effort. Thus, the analysis of replication cost and time may lead an
acquirer to assign quite a high price to a target company. In many instances, this
results in what may appear to be an inordinately high valuation for a target company
that is not generating much cash flow.
The analysis of replication value is an interesting one, for it involves the
collection of estimates from within the company about replication costs, rather than
the more typical analysis of a target company. This does not mean that the resulting
information is more accurate – on the contrary, the acquirer does not own the
products and businesses under consideration, and so may arrive at quite inaccurate
estimates of replication costs. For this reason, you should always consider
replication cost to be a supplemental analysis method, and use a more detailed
analysis, such as discounted cash flows, as the primary valuation technique.

Comparison Analysis
A common form of valuation analysis is to comb through listings of acquisition
transactions that have been completed over the past year or two, extract those for
companies located in the same industry, and use them to estimate what a target
company should be worth. The comparison is usually based on either a multiple of
revenues or cash flow. In rare instances, the analysis may be based on recurring
(contract) sales. Information about comparable acquisitions can be gleaned from
public filings or press releases, but more comprehensive information can be obtained
by paying for access to any one of several private databases that accumulate this
information.

The Comparison of Sales Multiples

A common approach for deriving the value of a business is to assemble the ratio of
sale price to revenues for a group of comparable companies, and apply that ratio to
the sales of the target company. This is a very easy approach, since the information
is available in a number of merger and acquisition databases. Any company that
wants to be sold will engage the services of an investment banker who will use sales

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 Valuation of the Target

multiples to derive the value of the business. However, there are a number of
problems with the sales multiple valuation method, including the following:
• Link to profits. A target company may generate sales by setting its prices
extremely low. Doing so means that profits and cash flow will be low, if
they exist at all. Thus, someone paying a multiple based on sales may find
that it has acquired an essentially worthless business that will never generate
a profit.
• Comparison group. The seller will attempt to match itself to whichever
industry niche has generated the highest sales multiples. The acquirer must
verify that the target company actually engages in the same line of business
as those in the comparison group, and not a different group in another indus-
try niche for which sales multiples are lower.
• Fundamentals. Another company may have obtained a high sales multiple,
but for a very specific reason that was attractive to the acquirer, such as a
key patent or distribution channel. If the target company does not have a
similar feature that is worthwhile to the acquirer, there is no reason to apply
the comparison sales multiple to the proposed transaction.
• Outliers. A target company may collect a group of unusually high sales
multiples from other transactions and attempt to apply them to the proposed
sale transaction. The acquirer should be wary of these selective comparable
transactions, which may in fact be outliers in comparison to the normal sales
multiples typically obtained in the industry.

In short, the sales multiple is more of a tool for the target company, not for the
acquirer. It can distort the valuation of a business, since the comparison solely to
sales does not account for any other factors, such as profitability or cash flow, with
which an acquirer should be deeply concerned.

The Comparison of Cash Flows

If you create a valuation based on a comparison of cash flow multiples elsewhere, be
aware that these multiples vary widely by industry. Thus, you will find that the cash
flow multiple for software may exceed 20x, while manufacturing multiples are in the
range of 5-10x, and retail is typically 2-4x. Consequently, be very clear about which
cash flow multiples you are including in a comparison. This is a particularly difficult
comparison when you are reviewing the results of a sale that involves businesses in
multiple industries, since the multiple cannot easily be assigned to a single industry
area.

The Comparison of Contract Revenues

If a target company is situated in the government sector, or in any other sector where
revenues are associated with large contracts, a possible valuation technique is a
multiple of recurring yearly contracts. There is a considerable difference between
one-time contracts and those expected to renew for a number of years, since a
recurring contract represents more reliable cash flow. There may be a history of

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prior sales for which contract multiples are available, in which case it could be
applied to a valuation. However, there are several considerations that can alter a
valuation based on this type of multiple:
• Remaining contract period. The group of contracts to which the contract
multiple will be applied will be of different lengths. Some may be funded
only for the next year or two, while others may have considerably longer
terms. You may need to apply a reduced contract multiple if the bulk of the
contracts are scheduled to expire sooner, rather than later.
• Prospects for renewal. The multiple may require modification if the
preponderance of contracts have a high or low likelihood of renewal. Also,
even if a contract is very likely to be renewed, what if the period of the re-
newed contract is only a few months or a year? This can also impact the
multiple. Determining the prospects for renewal is very judgmental, and so
can result in great variability from actual results.
• Prospects for new contracts. Any acquisition candidate always makes a
strong case for the business that it has almost closed, and how that should be
included in the valuation. See the Earnout section for a discussion of this
issue.
• Margins on contracts. There could be a broad range of profit margins
associated with the various contracts, but you are applying a single contract
multiple to the entire group of recurring contracts. If there are substantial
profit differences by contract, it may make sense to divide the contracts into
groups by profit ranges, and apply a different multiple to each one.

The preceding list of considerations should make it evident that applying a single
multiple to a group of contracts is an extremely rough way to calculate the valuation
of an acquisition target. If you intend to use this method, it would be better to adopt
a high degree of precision and apply different multiples to groups of contracts, based
on their remaining duration, profitability, and prospects for renewal.

52-Week High
The seller of a publicly-held business tends to be fixated on the highest stock price
that it achieved over the preceding 52 weeks, and will insist on selling at a price near
that price point. There are two reasons for this fixation:
• Psychological. No matter how much the stock price may have subsequently
declined, the 52-week high represents a relatively recent valuation, and the
seller still believes it is worth that amount.
• Lawsuit risk. The board of directors may feel that selling at this price point
reduces the risk that they will be sued by shareholders for not negotiating a
fair price.

It may be difficult for the acquirer to justify paying a price anywhere near the 52-
week high, especially if the stock price has declined markedly since then. If so, it

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would be best to walk away from the deal and wait for the buyer’s expectations to
decline.

Influencer Price Point

A potentially important point impacting price is the price at which key influencers
bought into the target company. For example, if someone can influence the approval
of a sale, and that person bought shares in the target at $20 per share, it could be
exceedingly difficult to offer a price that is at or below $20, irrespective of what
other valuation methodologies may yield for a price.
Further, if influencers have held their shares for some time, they may expect a
rate of return on their initial investment, which the acquirer can roughly estimate.
Thus, if an influencer bought shares at $20 one year ago, and a similar investment in
the same time period should have yielded a return of 10%, then the influencer will
probably not accept a purchase offer of less than $22 per share.
The influencer price point has nothing to do with valuation, only the minimum
return that key influencers are willing to accept on their baseline cost. If the amount
they want is nowhere near what more rational valuation methods state the business is
actually worth, then it may be best to walk away from the deal. It is possible that,
once sufficient time has passed, key influencers may want to shift their holdings into
other investments, and will therefore take a reduced price once rational thinking has
set in.

The Initial Public Offering Valuation

A privately-held company whose owners want to sell it can wait for offers from
potential acquirers, but doing so can result in arguments over the value of the
company. The owners can obtain a new viewpoint by taking the company public in
the midst of the acquisition negotiations. This has two advantages for the selling
company. First, it gives the company’s owners the option of proceeding with the
initial public offering and eventually gaining liquidity by selling their shares on the
open market. Also, it provides a second opinion regarding the valuation of the
company, which the sellers can use in their negotiations with any potential acquirers.
However, this approach also has some problems. First is the million-dollar cost
usually associated with taking a company public. Also, the IPO process requires an
enormous amount of effort, and can seriously interfere with management’s ability to
run the business. And finally, the sellers may find that they are required to hold their
shares in lockup agreements as a condition of taking the company public, and so
cannot liquidate their shares for at least six months after taking the company public.
The problems just noted keep most companies from engaging in the IPO ploy to
obtain a high valuation. Nonetheless, it may be worthwhile for a privately-held
business that is sufficiently large to go through with an IPO, and which is having a
difficult time convincing suitors to propose a valuation that the owners believe
properly values the business.

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The Strategic Purchase

The ultimate valuation strategy from the perspective of the target company is the
strategic purchase. This is when the acquirer is willing to throw out all valuation
models and instead consider the strategic benefits of owning the target company. For
example, an acquirer can be encouraged to believe that it needs to fill a critical hole
in its product line, or to quickly enter a product niche that is considered key to its
future survival, or to acquire a key piece of intellectual property. In this situation, the
price paid may be far beyond the amount that any rational examination of the issues
would otherwise suggest.
The downside of a strategic purchase is that the buyer is more likely to disman-
tle the target company and fully integrate the business into its own operations, on the
grounds that the strategic value gained must be maximized by rolling it into the
acquirer’s organization to the greatest extent possible. Thus, this type of valuation
certainly maximizes the return to shareholders, but sometimes at the cost of the
complete elimination of the underlying business as a cohesive unit.

Extraneous Valuation Factors

An acquirer may be unduly influenced by a number of factors that have little to do
with the intrinsic value of a target company. These other factors may increase the
price it is willing to pay to levels that are well beyond the results of any reasonable
quantitative analysis. For example:
• Purchase by competitor. There may be a considerable value associated with
keeping a target company away from a competitor, if only to acquire intel-
lectual property that could interfere with the business of that competitor.
• Speed. The acquirer may be interested in closing a deal fast for a number of
reasons, such as meeting an acquisition target by year-end, or prior to a
shareholders meeting.

The Control Premium

When investors purchase stock in a business, they gain the right to dividends, any
appreciation in the market price of the stock, and any final share in the proceeds if
the business is sold. If an investor buys at least a 51% controlling interest in a
business, then it also obtains the right to redirect the business in any way it chooses.
Consequently, obtaining a controlling interest is worth an additional price, which is
known as the control premium. This premium can be an insignificant issue if the
target is on the verge of bankruptcy, since the presumably short-term nature of the
business makes the control premium essentially irrelevant. However, if the target is
a robust business that can be enhanced by the acquirer, then the control premium can
be a significant factor. Historical evidence shows that control premiums for healthy
businesses can range from 30% to 75% of the market price of a company’s stock.
The control premium is not a black-and-while concept, where the first 51% of
ownership is more valuable than the remaining 49%. Instead, consider the multitude
of situations where ownership is split among many owners. For example, what if

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there are three shareholders, with two owning 49% and one owning 2% of the
shares? In this case, the 2% shareholder owns an extremely valuable piece of the
business, given its ability to impact votes, and which would certainly command a
premium. Alternatively, what if there are hundreds of small shareholders and one
shareholder who owns 35% of a business? Owning that 35% might not result in
outright control of the business, but it may be so much easier to obtain in
comparison to the pursuit of hundreds of other shareholders that it commands a
premium.
The control premium concept is a key reason why acquirers sometimes reduce
their offer prices for any remaining shares outstanding in a two-tier acquisition (see
the Hostile Takeover Tactics chapter). If an acquirer has already attained control
over a business, there is no longer a control premium associated with any additional
shares, which therefore reduces their value.

The Earnout
A significant problem for the acquirer is a seller that insists upon a valuation that is
based on future expectations for the business. For example, the target company may
be “just a few months” away from landing a major new contract, or launching a new
product, or opening up a new distribution channel. The seller may believe that these
prospective changes will have immense value, while the acquirer rightfully feels that
these future prospects are entirely unproven, and may never occur or generate
additional cash flow. These differences of opinion can cause major differences in the
assumed valuation of the business.
When future expectations are causing a difference of opinion regarding valua-
tion, one solution is to put off the acquisition until such time as the projected change
has occurred, and its impact appears in the financial statements. However, these
changes may take months or years to be completed, and may never occur at all. If so,
the two entities are never able to close an acquisition deal.
An alternative that bridges the valuation gap between the two parties is the
earnout. An earnout is a payment arrangement under which the shareholders of the
target company are paid an additional amount if the company can achieve specific
performance targets after the acquisition has been completed. It has the following
advantages:
• Payment source. The improvements generated by the target company will
likely generate sufficient cash flow to pay for all or a portion of the earnout,
so the acquirer may be cash flow neutral on the additional payment.
• Target achievement. The shareholders of the target company will push for
completion of the performance targets, so that the acquirer pays the earnout.
This helps the acquirer, too (despite having to pay the earnout), since the
results of the target company will have been improved.
• Tax deferral. The shareholders of the target company will be paid at a later
date, after the earnout is achieved, which means that the income tax related
to the earnout payment is also deferred for the payment recipients.

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Despite these advantages, an earnout is generally not a good idea. The trouble is
that, even after purchasing it, the acquirer must leave the target company as a
separate operating unit, so that the target’s management group has a chance to
achieve the earnout. Otherwise, there is a considerable risk of a lawsuit in which
there is a complaint that the acquirer’s subsequent actions to merge the acquiree into
the rest of the company impair any chance of completing the earnout conditions. It is
risky for the acquirer to leave a newly acquired company alone in this manner, since
doing so means that it cannot engage in any synergistic activities designed to pay for
the cost of the acquisition – such as terminating duplicate positions or merging the
entire business into another part of the acquirer.
Further, the management of the acquired business will be so focused on
achieving the earnout that they ignore other initiatives being demanded by the
acquirer – and the acquirer may not be able to fire them for insubordination until the
earnout period has been completed. Also, the management team will have a strong
incentive to achieve the earnout, which can trigger fraudulent financial reporting
practices. In short, agreeing to an earnout clause subjects the acquirer to an
uncomfortable period when it cannot achieve its own goals for the target company
and must watch out for incorrect financial reporting.

Acquisition story: A small company was acquired by a large consumer products

company, and the management team was offered an earnout payment if a certain
target profit could be reached in the following year. The profit figure had to be
audited before the consumer products company would issue the earnout payment.
The auditors reported finding a startling number of “errors” in the financial records
that year, all of which enhanced the reported profitability of the business.

This does not mean that earnouts are impossible, only that they should be very
strictly defined. Here are several tips for mitigating the issues associated with them:
• Earnout period. Keep the period over which the earnout can be earned as
short as possible, so that the acquirer does not have to wait too long to enact
its own synergy-related changes.
• Continual monitoring. Have a performance tracking system in place that
keeps all parties aware of the progress toward the earnout goal, so that no
one is surprised if the goal is not reached. This lessens the risk of a lawsuit,
since expectations were managed.
• Sliding scale. Pay the earnout on a sliding scale. For example, if the target
company achieves 80% of the target, it is paid 80% of the earnout. This is
much better than a fixed target, where no bonus is paid unless an exact profit
figure is achieved. In the latter case, the shareholders of the target company
are much more likely to initiate a lawsuit, since they are not paid at all even
if there is only a slight performance shortfall.

In summary, earnouts appear to present a neat solution for acquirers that have a
substantial gap in valuation perception with their targets, but this solution can be a
thorny one. There are ways to mitigate the risk, but the acquirer needs to be willing

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to pay out the full amount of an earnout, just to avoid lawsuits claiming that it
impeded the actions of the target company in trying to achieve its earnout goals.

The Valuation Floor and Ceiling

We have presented a number of ways to create a valuation for a target company. The
trouble is that if you were to use all of them, there would be an incredibly broad
range of possible valuations from which to choose. There may be orders of
magnitude between the valuation indicated by a liquidation analysis and the price an
acquirer is willing to pay for a strategic purchase. How do you find your way
amongst these numbers?
The key issue is that, eventually, most acquisitions must present positive cash
flow to the acquirer, even if it takes some optimistic forecasts to arrive at positive
cash flow projections. The only valid reason for paying more than what any cash
flow projection indicates is when the purpose of the deal is to keep the target
company away from a competitor. Consequently, the discounted cash flow model
should be the key valuation methodology that every acquirer uses.
While you should always use a discounted cash flow analysis, this does not
mean that you should use it to the exclusion of all other methodologies. In the
following bullet points, we have clustered those valuation methods that tend to yield
low, medium, and high valuations. You should select one valuation method from
each of these clusters in order to establish a range of valuations. Doing so gives you
some leeway in regard to what the final price will be. Thus, you will be comfortable
using the valuation based on discounted cash flows, but will push for a price closer
to liquidation value, and may accept a price closer to the amount indicated by a
strategic purchase analysis. The valuations are:

Low valuation tendency

• Liquidation value. Tends to yield the lowest possible valuation. This is
useful for establishing the amount the acquirer can sell the business for if an
acquisition does not go as planned, rather than for establishing the price the
acquirer will insist on paying.
• Real estate value. Tends to be close to liquidation value, and only applies to
target companies with significant real estate holdings.
• Relief-from-royalty method. Is only used to measure the royalties avoided by
owning an intangible asset.
• Book value. States the amount at which a business could be sold at the
values stated in its balance sheet. Actual results likely vary considerably
from book value.

Medium valuation tendency

• Enterprise value. States the current amount at which you could buy a
business. It only applies to those businesses for which there is a ready mar-
ket for its stock, and does not include a control premium. Thus, it tends to be
one of the lower valuations.

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• Multiples analysis. Is based on the valuations of other publicly-held

businesses in the same industry, and so is similar to the enterprise measure-
ment approach; and like that measurement, it does not include a control
premium. Thus, it also tends to be one of the lower valuations.
• Discounted cash flows. Based on estimated future cash flows. If these cash
flows are carefully reviewed and tested against historical results, this can
yield excellent results. The results tend to be in the middle of the cluster of
valuations.
• Replication value. Indicates the “go it alone” cost required to duplicate a
business that an acquirer wants to buy. This can yield one of the higher val-
uations. Since it is largely based on estimates, it is not sufficient as the sole
source of valuation information.
• Comparison analysis. Estimates the valuation based on the prices paid when
similar businesses were sold in the recent past. This analysis includes the
control premium, and so tends to yield a higher valuation.

High valuation tendency

• 52-Week high. Based on an arbitrary high point in the stock price in the past
year. If that high point was an outlier price, the resulting valuation could be
inordinately high. This only works if there is an active market for the com-
pany’s stock.
• Influencer price point. Based on the price at which a decision maker bought
into the target company. This price point could be anywhere, ranging from
very low to very high.
• IPO valuation. Based on the price at which the target company intends to go
public. This can be a very high valuation. Due to the cost of an IPO, this
option is rarely used.
• Strategic purchase. Based on other considerations than cash flow, and can
yield a startlingly high price.

In summary, you might consider spending a modest amount of time establishing

liquidation value, certainly calculate a detailed discounted cash flow, possibly also
compile a comparison analysis, and then establish the high-end valuation by
engaging in a strategic purchase review.
An alternative way to determine the “right” price is to examine the estimated
amount of time it will take for a proposed deal to increase the earnings per share
(EPS) of the acquirer. In many situations, the price is so high that there will be an
initial “hit” to earnings per share as a result of the deal. If so, management may
proclaim that it can generate sufficient synergies from the acquisition to create an
EPS boost at some point in the future. The question is, when is “some point in the
future”? If this period is too long, the probability of the acquirer actually creating an
EPS boost is low to negligible, since the drive to create synergies tends to fade out
over time. A reasonable benchmark is to assume that the EPS boost must occur
within two years of the deal; if the expectation is for a longer period of time, then
the price being paid is probably too high.

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The Fairness Opinion

A fairness opinion is a detailed analysis of a purchase offer by a valuation firm or
investment bank, stating its belief that an offer made to acquire a target company is
fair. A fairness opinion is typically compiled late in the negotiations between the
buyer and seller, since doing so any earlier would be a waste of money if the deal
were to fall apart. The opinion is usually obtained on behalf of the board of directors
of the selling business.
A fairness opinion gives the board of directors a defense in case it is later sued
by investors for negligence in having sold the business for too low an amount. The
fairness opinion does not state whether the bid price is the best one that could be
obtained, only whether the price is fair. Thus, the fairness opinion only mitigates the
liability of the board of directors. Nonetheless, it can be an important defense if a
public company is involved in an acquisition transaction, since there is a greater
chance that a shareholder will sue the board over the transaction. It may be of
particular importance where there appear to be anomalies in the acquisition
transaction, such as a deal with a related party or where there was only a single bid.
There are some concerns about fairness opinions. First, they are expensive – a
six-figure or several million-dollar fee is not uncommon. The high price is charged
because the entity working on it is highly skilled and is also under considerable time
pressure – usually just a few days to a week. Also, the fairness opinion could be
used as evidence in a shareholder lawsuit, so it needs to be precise. Thus, the
elements of skill, time pressure, exactitude, and risk combine to yield a high price
for the opinion.
There is a concern that some fairness opinion work is handed to the investment
banks already involved in an acquisition transaction, which means that they will also
be paid a contingent fee if the business is sold. Thus, an investment bank that is
involved in both an acquisition and the fairness opinion is not necessarily an
impartial observer, which can skew the results of the opinion.
Fairness opinions are rarely used when transactions are between privately-held
companies, since there are so few shareholders involved that a lawsuit is much less
likely.

Tip: If the board of directors insists on obtaining a fairness opinion, it should pay a
completely impartial third party to do so, and not a firm that is already being paid to
participate in acquisition-related work.

Summary
Of the various valuation methods described in this chapter, the most quantitatively
precise one is the discounted cash flows method. However, even that method is
derived from a variety of estimates of future results, as well as estimates of expenses
that can be eliminated due to synergies. In short, even the DCF method can yield
results that turn out to vary widely from subsequent actual results.

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Valuation depends to a great extent upon the timing of the situation. If the target
company finds itself in a difficult financial situation and there are few potential
bidders, then an acquirer may be able to snap it up for an amount at the far lower end
of what would normally be considered reasonable. Conversely, a business that is
carefully built to provide a strategic advantage in a new market, and for which
multiple bidders see a strong strategic advantage, may sell at a price well beyond the
price created by most rational valuation calculations.

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 Chapter 7
Synergy Analysis
Introduction
Synergy is achieved when the value derived from combining two entities is greater
than what they can achieve separately. For example, if the cash flows generated by
two companies are each $10,000,000, but $25,000,000 can be achieved if the two
enterprises are combined, then the extra $5,000,000 of cash flows is the synergy
derived from the combination. The creation of synergies is a necessary part of the
acquisition process, since the acquirer may pay well above the market price for a
target company, and must locate ways in which to justify the additional amount paid.
In this chapter, we explore the large number of methods by which synergies can be
achieved, as well as the cost of those synergies.

The Need for Synergies

In a typical acquisition, the only way that an acquirer can convince the shareholders
of a target company to sell their shares is by offering to buy the shares at a premium
to the current market price of the shares. In some cases, the acquirer may find it
necessary to offer a substantial premium, both to convince shareholders to sell and
also to block competitors from making competing offers. When a large premium is
paid, the acquirer must find a way to increase the cash flows of the acquiree by a
similar or greater amount; otherwise, the acquirer has just invested a large amount of
cash in a business that cannot possibly generate an adequate return on investment.
The solution to paying a large premium is to locate synergies within the acquirer
and the acquiree that, in total, will yield a large increase in cash flows. The amount
of synergies located should be larger than the amount of the premium paid, for
several reasons. First, the synergies actually realized are likely to be less than
initially forecasted, so the acquirer must ensure itself of having a sufficient pool of
opportunities to yield an adequate return on investment. Also, the shareholders of
the seller will likely attempt to negotiate for themselves a share of the prospective
synergies, leaving a smaller share for the acquirer.
Synergies are not easy to achieve, especially when the target company already
has a reputation for being a low-cost operator, which therefore presents few
opportunities for expense reductions. In these cases, the management team of the
acquirer must be extremely careful to limit the size of the premium that it is willing
to pay for a target company. If the amount paid is too large, it will be impossible for
the acquirer to earn an adequate return in its investment.
In the remainder of this chapter, we address the various types of synergies that
can be achieved, as well as the side effects of enforcing synergies.
 Synergy Analysis

Synergy Analysis for Expenses

It is standard practice to evaluate a potential acquisition in terms of the types of
expense reductions that can be attained by merging the companies together. For
example, it may be possible to consolidate employees in a single building, thereby
eliminating a building lease, or perhaps some duplicate positions can be eliminated.
This is especially likely when the businesses are located within the same
geographical region, since there are greater opportunities to share employees,
facilities, and suppliers. Synergies can most predictably be achieved when the
acquirer and acquiree have similar operations and markets, since the acquirer is
highly familiar with the manner in which the acquiree is operating. Conversely, the
opportunities for synergies decline with distance; acquiring a foreign entity presents
the fewest opportunities for synergies, especially when the entity also operates in a
different industry with which the acquirer is not overly familiar.
Synergies related to expense reduction are one of the best areas in which to find
value in an acquisition, because they are entirely under the control of the acquirer. It
is easy enough to prepare a list of exactly which expense reduction synergies are
expected when formulating a purchase price, and then follow up after the acquisition
to ensure that the expense reductions are realized.
Expense reduction synergies are usually expected in the areas of facilities and
personnel, but it is possible to find reductions in other areas, too. Consider the
following areas of duplication in which expense reductions may be found:
• Salaries and wages. Particularly applies to duplicated administrative
positions, especially when the two corporate staffs are combined. The fol-
lowing expenses are also automatically reduced when employees are termi-
nated:
o Payroll taxes
o Benefits
o Telephone charges
o Travel and entertainment
o Office supplies
o Parking fees
• Facility reduction. Usually involves extra space made available through
either the termination of employees or the consolidation of manufacturing
and storage facilities. In a retail environment, this can also mean that stores
will be consolidated. The following expenses are affected when facilities are
eliminated or their usage is reduced:
o Utilities
o Janitorial services
o Building insurance
• Equipment reduction. Usually involves the elimination of manufacturing
equipment within facilities that are also eliminated, or simply equipment for
which there is no need for the additional capacity. The following expenses
are also affected when facilities are eliminated or their usage is reduced:
o Maintenance staff

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o Maintenance parts
o Utilities
• Sales and marketing. Typically involves the consolidation of advertising and
other marketing campaigns, as well as back-office operations. There may
also be reductions in the sales staff if there are overlapping sales territories.
The following expenses are also affected when sales and marketing costs are
reduced:
o Salaries, payroll taxes, and benefits
o Travel and entertainment costs
• Pension plan. The target company may have a defined benefit plan, under
which it commits to provide a certain set of benefits to employees through a
future period. Defined benefit plans can be very expensive, since they as-
sume a certain return on invested funds in the future that may not be real-
ized, and which will therefore require additional funding. An acquirer may
plan to reduce this cost dramatically by switching employees to a defined
contribution plan, under which the employer is only liable for an initial
payment into a pension plan. This type of synergy can result in major fric-
tion with the employees of the target company, since they will assuredly
suffer a decline in a key benefit. There are also significant legal issues with
terminating a pension plan; to avoid these issues, the target company typi-
cally agrees to terminate its plan before the planned acquisition date, after
which employees roll their residual benefits into the replacement plan of-
fered by the acquirer.
• Process improvement. The acquirer may have teams of process improve-
ment experts who comb through company operations to find cost reductions.
If these teams have built up a history of cost reduction performance, the
acquirer can assume that the same level of cost reduction can be achieved
with a target company. To be more precise in its cost reduction estimates,
the acquirer’s due diligence teams can include some of its process improve-
ment experts, who can then locate and quantify specific improvements dur-
ing their tours. This approach works best when the acquirer is primarily
interested in buying other companies that have similar operations; the ac-
quirer can then impose its own systems and processes directly onto these
other businesses.
• Product and product line termination. It is entirely possible that a target
company is suffering from management’s insistence on maintaining certain
products or product lines that do not earn a profit. This may be the case
when there is a historical attachment to certain products, or when manage-
ment insists on trying to gain continued access to a new market. In such
cases, the acquirer should conduct a thorough analysis to verify that losses
are being sustained, and can then decide if the products should be terminat-
ed. Doing so may not provide immediate gains, especially if there are large
stocks of inventory that must be drawn down, or if there is an obligation to
provide continued field support to customers.

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• Research and development. The combined entity could combine its research
operations, which may lead to expense reductions in the following areas:
o Outsourced research contracts
o Salaries, payroll taxes, and benefits
o Legal costs associated with patent defense
• Procurement. It is entirely possible that businesses operating in the same
industries can combine their purchasing activities to buy from fewer suppli-
ers in larger volume, thereby driving down supplier prices. This can impact
costs in all parts of the business, not just in the area of raw materials for
manufacturing operations. However, it can take time to consolidate purchas-
ing activities and negotiate volume purchase agreements, so full synergies
may not be realized for several years.
• Taxation. The combined entity may now have multiple subsidiaries located
within the same government jurisdiction. If so, it may be possible to merge
some of these subsidiaries in order to eliminate duplicate filing requirements
and fees. However, doing so can eliminate the tax advantages that have ac-
crued to a subsidiary, such as net operating loss carryforwards. Another
possibility is that the company may gain a low-tax location from which it
can own intellectual property, and bill out for use of that property. The result
can be a low tax rate on a large part of the company’s total income.

Tip: The advantages to be gained from taxation synergies can change at any
moment if governments choose to alter their tax policies. Accordingly, the benefits
to be gained from taxation issues are outside of the control of the acquirer, and so
should be excluded from an analysis of synergies as it relates to establishing a
purchase price for a target company.

• Foreign currency hedging. A business that routinely deals with foreign

currency transactions may find it necessary to curb its risk by purchasing
various currency hedging instruments. When two companies are combined,
it is possible that the net currency holdings of the two entities balance out,
resulting in less need to purchase hedging instruments.
• Financing costs. One of the entities may suffer from a low credit rating,
resulting in high borrowing costs. In an acquisition, the combined entity
may achieve an improved credit rating, which can lead to revised lending
arrangements with substantially lower borrowing costs.

In addition to the preceding areas of duplication, consider the reduction of costs

associated with the owners of a closely-held company. There may be excessive
expenditures in any of the following areas, all of which can be eliminated:
• Above-market senior manager compensation packages
• Wages paid to friends of family and other related parties
• Over-market lease payments made to entities owned by the shareholders

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• Unusually high expenditures for travel and entertainment by senior man-

agement
• Insurance premiums for policies where the company is not the beneficiary
• Excessive benefit and pension plans for senior managers
• Fixed assets exclusively used by the shareholders and senior managers, such
as condominiums and airplanes

The expenses just noted for a closely-held company may have been designed to
exactly offset company profits, so that a business does not pay income taxes. This
approach is so prevalent that the financial statements of many businesses may cloak
highly profitable operations; it takes an excellent valuation team to strip away these
excess expenditures to find the hidden value of a target company.
When arriving at a list of synergies related to expense reductions, be sure to
offset them with the one-time costs associated with those same synergies. For
example, there may be severance payments associated with employee terminations,
or termination fees associated with the early expiration of facility leases. Also, if
equipment is eliminated, the company may recognize a loss on any maintenance
parts that it had in stock, and which it must sell off at a loss.
It is not always possible to immediately realize gains from synergies, since legal
requirements may mandate that a certain amount of time must pass. For example,
some countries require that the work force be notified of a major layoff several
months in advance. Also, a union agreement may contain the same requirement.
Further, it may be easier to wait for a lease to expire in a few months than to attempt
to negotiate an earlier termination. Consequently, an analysis of synergies may need
to include a chart that shows when cost savings can take place (see the Synergies
Table section).
It is less likely that the last few synergies planned for implementation will be
achieved. This is because the most difficult synergies are pushed to the bottom of the
priority list, while the acquirer instead implements the “low hanging fruit” that can
be most easily completed. By the time the initial batches of synergies are finished,
the implementation teams will be tired of the project, while resistance toward the
last remaining synergy projects will likely have coalesced. A likely result is that
these few implementations are only followed half-heartedly, or are skipped entirely
when implementation teams are pulled away to work on new acquisitions.

Synergy Analysis for Revenue

When evaluating synergies, be particularly wary of those related to revenue. An
acquirer may believe that it can combine sales forces and have this aggregated group
sell the products of both businesses. Or, it can combine the products of both
companies in a single web store – and so on. The trouble with revenue synergies is
that they rely upon the agreement of customers that this is, indeed, a good thing,
resulting in more sales. Instead, it is exceedingly common for customers not to
respond as planned, resulting in little or no sales boost from an acquisition. In this

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section, we note specific instances where revenue synergies can be attained, but also
cases where it can be dangerous to assume that revenue increases will occur.
The reactions of competitors should certainly be considered when estimating
revenue synergies. Aggressive competitors will not only want to maintain their own
market shares – they will see an acquisition in the industry as an opportunity to pick
up customers who are nervous about the acquisition. To this end, competitors can be
expected to offer special pricing and service deals to key customers, and will likely
lure away several accounts. Consequently, the acquirer must be prepared to lower its
prices in order to retain its customer base, at least in the short term. Otherwise, a
possible result of an acquisition is for revenues to decline as customers depart.

EXAMPLE

Transcontinental Airlines, the largest airline in the African market, has just acquired Bright
Spot Air, which has a strong presence in the Indian market. The intent of the acquisition is
for Transcontinental to use the Bright Spot gate leases to expand the number of departures
from many Indian cities, thereby garnering market share. However, the Bright Spot unions
have taken exception to the deal and go on strike. Also, the legendary Indian bureaucracy is
slowing down the issuance of permissions for more flights. Consequently, Transcontinental
is finding that a multi-year effort will be required to achieve its goals. In the meantime,
sensing that the attention of Transcontinental’s management will be shifted away from the
African market for some time, the company’s African competitors go on the offensive,
lowering prices and upgrading their planes. The result is a prolonged period of indifferent
earnings and management turmoil for Transcontinental.

An area of concern when integrating sales forces is when the customers of the target
company are accustomed to a large amount of personalized hand holding by the
sales staff. In this case, customers may be extremely displeased when their personal
relationships are replaced by a national sales team or (worse yet) an in-house sales
staff that refuses to make on-site visits. The result could be massive defections to
competitors. In short, the acquirer must understand the level of sales staff
involvement with customers before instituting any changes.
One situation in which revenue synergies are more likely to succeed is when the
two entities sell in entirely different regions, and can sell each other’s products and
services without any sales force overlap. In this case, it may be possible for the
existing sales staff to achieve outsized gains in sales per salesperson. However, the
rollout of this concept may be slow, since the sales staff must spend time cross-
training on products (which may result in a sales decline during the training period).
Also, the distribution and field service operations of each entity must be rolled out
into the new sales regions, which can require a substantial amount of time.

EXAMPLE

Dawson Engineering was founded by a group of engineers with superb product design skills,
but little ability to market the resulting products. The company now has a broad range of

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high-end manufacturing robots, but only a small number of sales staff that concentrates its
efforts on appearing at the larger trade shows around the country.

Dawson is acquired by International Automation, a large international producer of industrial

robots. The company has an adequate engineering team, bolstered by an excellent
international dealer network. The company is especially well-known for its superb after-
market product support. In short, Dawson brings product design skills that International
lacks, while International can vastly improve the sales and support functions of Dawson.

The result is an immediate ramp-up in product sales at Dawson, to the point where the
company must invest heavily in new production facilities to keep up with demand.

Another situation in which revenues may be improved is when a company acquires a

business that produces add-ons to the company’s products. For example, a software
program may be added to another software program in order to increase its features.
Or, a GPS tracking system may be added to a farm tractor to enable farmers to more
accurately plow their fields. In these cases, the producer of the main product can
acquire the maker of the add-on product, and then market the add-on product as part
of a package with the main product. Doing so can bolster sales of the add-on
product.

EXAMPLE

Ruff ‘n Tumble produces extremely durable boat shoes for fishermen, which have drainage
holes incorporated into the design. An innovative add-on product made by Fish Weight Inc.
is a colorful pin that snaps into these drainage holes, signifying the size of the fish that a
fisherman has caught. Ruff ‘n Tumble buys Fish Weight and immediately sells a
prepackaged set of these pins along with its shoes. The concept catches on with fishermen,
who use the pins to claim that they have caught much larger fish than is actually the case.

It is possible to use an acquisition to generate ideas for entirely new products. This
situation is most likely to arise when the target company has a strong research and
development function, but has not yet built out much of a sales and marketing
infrastructure. In this case, the acquirer waits to see if a product idea is viable, and
then makes a buyout offer. This approach works well when an acquirer invests in a
number of small research startups, with the right of first refusal to acquire the
startups at a later date. Alternatively, the acquirer’s acquisitions team can
continually monitor new products just reaching the market, and make acquisition
offers as soon as there is proof of customer acceptance. The acquirer then takes over
the manufacturing and sale of a product, resulting in a rapid rollout of new products.

EXAMPLE

Swallow Pharmaceuticals is a major international supplier of prescription drugs, with a sales

force of more than 20,000 people. Its main strategy for increasing sales is to buy minority

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stakes in startup research partnerships, and then buy out the other investors in the
partnerships if viable drugs are created. Swallow then invests in the drug review process in
each country where the drugs are to be marketed, produces them in one of its centralized
manufacturing facilities, and rolls them out in short order through its sales force. This
approach requires relatively small up-front investments in product research, followed by
higher buyout costs and still larger drug review investments.

Yet another variation on revenue synergies is the concept of economies of scope.

Under this scenario, a smaller business must incur a considerable amount of fixed
costs in order to provide a service to its customers. Because of the high cost, it can
only afford to provide that one service, and so is constrained in the scope of services
offered. By acquiring another business that offers a different service, but to the same
type of customer, the acquirer can expand the scope of its offerings. This means that
more revenue can be generated from the same customer base. This approach is
particularly effective when there are a number of services that can be assembled
through a series of acquisitions. The result can be the transformation of a small
single-service company into a large-scale, multi-offering competitor. However, this
approach is also fraught with risks, since the acquirer must integrate one or more
new services with which it is unfamiliar. The result may be a lengthy breaking-in
period, while the various parts of the newly consolidated business learn to operate
with each other.

EXAMPLE

The Aardvark National Bank specializes in offering checking accounts to its largely blue-
collar clientele for minimal service charges, which has created a loyal following. The bank is
too small to branch out into other services, and so acquires Third Bank of Boston, which
specializes in certificates of deposit. Doing so allows the combined business to attract low
net-worth individuals with checking accounts, as well as to invest their excess cash in
medium-term deposits. Aardvark notes that a significant proportion of its supposedly low
net-worth customers own substantial businesses, and so acquires a wealth management
company to cater to their needs. At the end of this spending spree, Aardvark has garnered a
large and loyal following that appreciates the bank’s ability to offer a broad range of
services.

Even if a company can successfully integrate its products and sales forces with those
of a target company, there may still be an upper limit on the amount of additional
sales to be gained from customers. A cautious purchasing manager for a customer
may conclude that purchases must be spread among a number of suppliers, and so
will cap the amount of goods and services ordered from the newly-combined
company. This problem can be mitigated by maintaining separation between the
sales forces and marketing materials of the acquirer and acquiree, in order to give
the appearance that the companies are operating separately; however, this also

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means that any synergies from combining the sales functions of the businesses
cannot be pursued.
A variation on the concept of revenue synergies is when the acquirer purchases a
well-developed brand, with the intent of putting its own products within the
marketing umbrella of the acquired brand. Doing so would presumably equate to
greater customer acceptance of the rebranded products, which may translate into
higher unit sales or higher prices. However, a brand is created not just through long-
term marketing, but also with close attention to product quality, customer service,
and field support. If the acquirer attempts to force lower-grade goods into an
established brand, the likely outcome will be a weakening of the brand in the minds
of consumers, rather than increased sales. To make the brand extension concept
work, the acquirer must be willing to invest in upgrading the products it wants to
place within the brand, as well as the support of those products. This process can
take a considerable amount of time, which means that any synergies gained from
acquiring a brand may not be realized for several years.
A bright spot in the analysis of revenue synergies is that a larger combined
entity may have a better chance of winning government contracts. A government
may have purchasing rules that prevent it from awarding contracts to suppliers that
have revenues or assets below a certain threshold level. A business combination may
move a company above this level, which at least qualifies the organization to
compete. In reality, a business must still present proof of having experience
fulfilling larger government contracts, so it may take time before any additional
sales are obtained.
In summary, any gains to be had from revenue synergies can be hard to pin
down, and may never be realized at all. An acquirer should only plan for synergies
in this area if it has a history of achieving such gains with other acquisitions, and so
knows exactly which actions to take. Conversely, a company embarking on the
acquisition path for the first time will be uncertain of how to achieve revenue
synergies, and so should not assume that these gains can actually be achieved.

Synergy Analysis for Capital Expenditures

A synergy area that is not always considered is whether the capital expenditures of
the combined entities can be reduced below the level required for the businesses if
they were to be operated separately. This situation may arise when one of the two
businesses has recently made a large capital investment that results in excess
capacity, and which can accommodate the needs of the other business. If so, it may
also be possible to sell off some excess assets, in which case there may be some cash
to be gained from the acquisition.
While a reduced level of capital expenditure is a useful outcome of an acquisi-
tion, it is also a rare situation. More commonly, the target company has put itself up
for sale precisely because it does not have the cash reserves to meet its ongoing
fixed asset requirements. If this has been the case for some time, then the assets of
the target company may be in a state of considerable disrepair. This means that the
acquirer is more likely to make a large (and immediate) investment in the acquiree,

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just to keep operations functioning. Thus, the due diligence team is more likely to be
on the lookout for ancient equipment than for excess capacity that can be eliminated.
Another concern with capital expenditure analysis is the perceived need to
eliminate excess capacity. This is reasonable if the combined companies are not
subject to major swings in sales volume. However, a sharp cutback in production
facilities can also mean that the combined entity no longer has the ability to meet
surges in customer demand, which means that sales will be lost or at least delayed.
In short, the possibility of cutting back on total capital expenditures is a
tantalizing one, but can be difficult to achieve in practice without reducing the
overall capabilities of the combined business. If anything, the acquirer may find
itself burdened with an initial surge in capital spending.

The Synergies Table

Once all synergies have been analyzed, combine them into a table that shows the
amount of cash flow to be gained from each one over time. Doing so shows the
aggregate amount of synergies available to the acquirer, as well as any delays likely
to be experienced in achieving the synergies, and the costs associated with
implementing each one. A common occurrence is to see an initial cash expenditure
for some synergies, as the acquirer must make termination payments of various
kinds before ongoing savings can be achieved. A refinement of the table is to
include an estimated probability of success, so that a reader can readily discern the
perceived level of difficulty associated with each line item. A sample synergy table
is noted in the following exhibit.

Sample Synergies Table

Synergy Probability Quarter 1 Quarter 2 Quarter 3 Quarter 4
Staff reduction 100% -$250,000 $80,000 $80,000 $80,000
Close production line 80% -50,000 15,000 60,000
Sell excess equipment 60% 110,000
Eliminate advertising 100% 75,000 75,000
Reduce inventory 50% 25,000 50,000
Process improvements 80% 10,000 25,000 30,000 35,000
-$240,000 $190,000 $250,000 $250,000

The exhibit only shows synergy-related cash flows for the first year following an
acquisition. In reality, this table should be extended for several additional years, so
that the full impact of all synergies can be seen. This is of particular importance if
some synergies are expected to require several years to fully attain.
Another option in setting up the table is to also note any impact on contribution
margins that result from implementation of the synergies. For example, terminating
the employment of selected salespeople will likely reduce the amount of sales, as
well as the contribution margin associated with those sales. By using this approach,
one can see the full impact on total cash flows of expense reductions. In some cases,
the offsetting contribution margin declines may be so large that it does not make
sense to proceed with a proposed synergy project.

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The concept of incorporating contribution margin effects can be taken a step

further. A truly rigorous analysis of synergies can include all of the following
factors:
• Projected contribution margin changes
• Projected expense changes
• Projected capital expenditure requirements
• Projected changes in working capital
• Projected financing costs
• Projected tax impact

EXAMPLE

The acquisition team for Colossal Furniture is delving into the details of synergies involving
its prospective acquisition of Shrimpy Designs (which manufactures furniture for thin
people). One item on the list is a projected increase in contribution margin of $2,000,000 that
is expected from offering Shrimpy products for sale in the showrooms of Colossal. The team
finds that several other issues should be incorporated into this analysis:
• Working capital. Colossal will have to maintain $200,000 of additional inventory in
order to support the sales growth, for which the related financing cost is $20,000 per
year.
• Support. Shrimpy’s customers typically demand a moderate amount of field support
related to furniture installations. This added cost will reduce the contribution margin
by 5%, or $100,000.
• Sales staff. There must be one additional salesperson on hand at each of the five
stores where the Shrimpy products will be offered, which will cost a total of
$150,000 per year.
• Tax rate. The company’s incremental tax rate is 35%.

Based on these additional considerations, the actual amount of net profit that Colossal is
likely to achieve is $1,124,500, which is almost half of the original estimate.

Synergy Analysis for Risk Reduction

Most of the discussion in this chapter has been about finding ways to improve the
cash flows from an acquisition. An additional area worth contemplating is the ability
to reduce the overall risk of the acquirer or the acquiree by engaging in an
acquisition. Here are several examples of risk reduction:
• Environmental liabilities. An old manufacturing business owns a number of
“smokestack” production facilities, and wants to reduce its exposure to pol-
lution-related lawsuits. Accordingly, it embarks on a campaign of selling off
the old facilities and acquiring new businesses that do not involve the crea-
tion of hazardous waste.
• Key employee dependency. A company may have one person whose
knowledge and contacts are so crucial to the company that it would be una-
ble to function if that person were to leave. Engaging in an acquisition can

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greatly increase the pool of people with a high level of knowledge and expe-
rience.
• Large customer dependency. A business may have a relatively small number
of large customers that provide the bulk of its revenue. If so, there is a risk
of being too dependent on these customers. If just one were to stop buying
from the company, the result could be a sudden and substantial decline in
profits. Buying another company that has a broader customer base can miti-
gate this risk.
• Technology. A company may have an aging set of patents for key technolo-
gy that it has been unable to improve upon with new research investments.
Once the patents expire, the company will be laid open to lower-priced
competition. An acquisition can bring access to a new set of patents and
research facilities that will improve the competitive position of the business.

In the presented cases, the acquirer is still interested in generating positive cash
flows – otherwise, it would be difficult to run the business over the long term.
However, the orientation of where those cash flows are generated shifts to different
types of businesses, thereby mitigating the existing risk profile of the acquirer and
the acquiree. In many cases, the risk profile of the acquiree is especially enhanced
by an acquisition, since acquirees tend to be smaller organizations that are more
likely to suffer from specific types of risks.

EXAMPLE

Meridian Company accumulates information about oil and gas leases, and rents this
information to the larger oil and gas exploration firms, which use it to bid on parcel leases
being offered by the government. The trouble that Meridian has experienced is that it takes
more than five years to develop a quality salesperson that has sufficient knowledge to sell the
company’s products to new customers. As a result, Meridian only has two salespeople who
can consistently generate sales.

The president of Meridian learns that a competitor, Baseline Brothers, is putting itself up for
sale. Baseline employs three quality salespeople who are experienced in selling similar
products to the ones sold by Meridian. The board of directors of Meridian decides to make an
offer for Baseline, with the intent of increasing the company’s pool of key salespeople and
thereby reducing its risk of a sales decline caused by a salesperson departure.

Synergy Secrecy
When the acquirer develops a list of synergies, it customarily does not share this
information with the target company (or any valuation information, for that matter).
The reason is that synergies may be the prime source of excess profits from an
acquisition. The target company should have some idea of its own value, but not of
the additional value that it could bring to the acquirer through synergies.
Consequently, if the target were to obtain the acquirer’s list of synergies, it would

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demand that a portion of the savings be handed over as part of the purchase price.
Thus, synergies should be a closely guarded secret.
It is entirely possible that an aggressive seller will develop its own list of
synergies, usually with optimistically-high savings for each item. This list is used to
justify a higher purchase price for the business, on the grounds that the acquirer is
expected to profit from the synergies. If this situation arises, the acquirer will likely
end up squabbling with the seller regarding the realism of the opportunities listed on
the seller’s synergies list. The negotiating position of the acquirer is to question all
presented synergies, since doing so may yield a lower purchase price for the
business. This is an interesting position for the acquirer to be in, since its negotiating
team may privately consider the presented list to be entirely reasonable, and possibly
even the source of synergies that its own team did not uncover.

The Cost of Synergies

The main focus of a drive to achieve synergies is the reduction of expenses. This can
have a major impact on both employees and suppliers. The employees of both the
acquirer and acquiree can expect layoffs, which can have a severe impact on the
local community if the business is a large local employer. This may be less of a
concern if a business has a small footprint in a local community, but can have a
bearing on the decision to implement a synergy project if the owners are directly
impacting the livelihoods of their neighbors. If there is significant social pressure,
and/or if the owners of the acquirer are interested in building a “good neighbor”
image, it is more likely that staff cutbacks will be achieved through attrition over a
number of years.
A similar impact may arise for suppliers. The acquirer may want to aggregate
purchases with a small number of suppliers, in which case some suppliers may
experience a sudden and catastrophic decline in sales. However, if the impacted
suppliers are located away from the home base of the company, there is less social
pressure to stop dealing with these suppliers. Consequently, it is much less likely
that supplier-related synergies will not be pursued.
Few organizations are willing to avoid synergy projects in order to relieve the
dislocation experienced by employees and suppliers. Instead, they are more inclined
to make larger employment or contract severance payments. By doing so, they are
still assured of achieving planned cost reductions over the long term, while at least
providing some short-term support to those being impacted.

Summary
In a situation where a canny seller is pushing for the maximum possible sale price,
the acquirer must rely upon the use of synergies to eventually earn a positive return
on its investment. If so, the proper quantification of synergies is critical. It is not
sufficient to simply guesstimate a cost reduction or revenue gain for a set of
supposed synergies. Instead, the due diligence team should review possible
synergies in considerable detail, questioning the ability of the acquirer to implement

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each one. Once a set of reasonable synergy gains has been compiled, this
information is translated into an action plan, laying out exactly which steps must be
taken, how much will be saved, due dates, and who is responsible for each step.
Only after this action plan has been reviewed in detail and approved will the
acquirer have a reasonable understanding of the gains to be realized from synergies,
and therefore the maximum amount that it can afford to bid for the target company.
In addition, the board of directors (which must approve any acquisition deal)
should be particularly cognizant of the worst-case scenarios associated with a
synergy analysis, and the probabilities associated with those scenarios. If there is a
strong chance that lower synergy levels will be achieved, then the premium that the
board should be willing to pay should also be reduced. Otherwise, there is an
increased risk of achieving a reduced rate of return on the funds invested in an
acquisition.

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 Chapter 8
Hostile Takeover Tactics
Introduction
Whenever possible, there is a strong preference for engaging in friendly takeovers,
since the cost tends to be lower and the in-place management team is more
cooperative. However, when an acquiring business sees a strong need for some
advantage held by another business, it may resort to a hostile takeover. This chapter
discusses the primary techniques for doing so – the tender offer and proxy fight, as
well as the less-used bear hug. We also cover a variety of takeover defenses that the
acquirer may encounter. We begin with an overview of the Williams Act, which
governs some aspects of hostile takeovers.

The Williams Act

The Williams Act is an amendment to the Securities Exchange Act of 1934. It
requires the disclosure of information related to tender offers or the possibility of
tender offers. A key provision of the Williams Act is that a shareholder must issue a
notification to the Securities and Exchange Commission (SEC) on Schedule 13D
when its holdings of the common stock of a target company reach five percent of the
total number of common shares outstanding. In that schedule, the shareholder
describes the number of shares owned, the source of funds to be used to pay for any
shares purchased, the reason for acquiring shares, the plans of the shareholder if it is
successful in gaining control over the business, and a number of lesser issues. The
filing must be completed within ten days of reaching the five percent plateau. The
shareholder must continue to provide updated versions of the schedule when there
are material changes to the information, which means that an acquirer is typically
issuing a stream of follow-on schedules to document changes in its share holdings.
The Act also prohibits the use of false, misleading, or incomplete statements in
relation to a tender offer, and gives the SEC authority to engage in enforcement
lawsuits.
Further, the Act requires that an acquirer keep any tender offer open for a
minimum of 20 business days. The acquirer is not allowed to purchase any tendered
shares during that time. Instead, it buys the shares at the stated offer price at the
termination of the tender offer period. There are three scenarios for buying shares
under a tender offer:
• Inadequate tender offer. If the number of shares tendered is less than the
target amount designated in the tender offer, the acquirer may elect to either
buy or not buy the shares.
 Hostile Takeover Tactics

• Sufficient shares. If the number of shares tendered matches the target

amount designated in the tender offer, the acquirer must purchase all ten-
dered shares.
• Excessive shares. If the number of shares tendered exceeds the target
amount designated in the tender offer, the acquirer must purchase the target
amount, which means that shares will be purchased on a pro rata basis.

The Act allows shareholders to withdraw tendered shares at any time prior to the
completion date of a tender offer. This allows shareholders to evaluate bids from
other acquirers, and shift their shares to the tender offer giving them the best payout.
The procedure for doing so is to submit a withdrawal letter, along with a verified
signature.
If another party issues a tender offer while the first tender offer is still current,
the Act mandates that shareholders have at least 10 business days in which to
consider the new offer. This means that the duration of the first tender offer may be
extended to match the requirements of the Act.

EXAMPLE

High Noon Armaments issues a tender offer for Ninja Cutlery that terminates on August 31.
On August 27, a rival bidder issues a competing tender offer. There are five business days in
the period from August 27 to August 31, so High Noon extends its tender offer by five
business days to comply with the Williams Act.

There have been two key effects of the Act, which are:
• Higher payments. A considerable amount of information must be disclosed
along with a tender offer, and there is enough time for shareholders to con-
sider the offer, which tends to increase the amount paid for the shares of
target companies.
• Stronger defenses. There is a minimum waiting period before a tender offer
can be completed, which gives the management of the target company time
in which to mount a defense, if it chooses to do so.

Schedule TO
When any party makes a tender offer and accumulates more than five percent of a
class of the shares of a publicly-held business, it must file a Schedule TO (“Tender
Offer”) with the SEC, as well as send a copy to the target company’s executive
offices, and notify any exchanges on which the target company’s shares are traded.
The key items included in the schedule are as follows:
• Acquirer. Identify the entity making the offer.
• Financial statements. The acquirer must provide its financial statements
when the acquirer’s financial condition is material to the decision of a
stockholder to sell shares to the acquirer. There is no need to provide finan-

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cial statements when the offer is for cash, the offer is not subject to a financ-
ing condition, and the acquirer is a public reporting company.
• Purpose. Describe the purpose of the transaction.
• Shares owned. State the number of target company shares already owned by
the acquirer.
• Source of funds. State the source of funds or other consideration used to
make the stock purchases.
• Term sheet. Summarize the terms under which the acquirer is willing to
purchase shares. This includes the number of shares the acquirer is willing
to purchase, the expiration date of the tender offer, the procedures for ten-
dering and withdrawing shares, and the method of payment.

There are a number of other routine disclosures, but the main issues were noted in
the preceding bullet points.

Initial Share Acquisition

If an acquirer is planning a hostile takeover attempt of a publicly-held company, one
of its first steps is to begin accumulating shares in the target. By doing so, it can
purchase a small proportion of the target’s shares at a reasonable price, before the
market becomes aware of its intentions and begins to speculatively increase the
share price. Once the company makes its intentions public, it will have to purchase
the remaining shares at a much higher price, so this initial purchase reduces the
average cost of the entire acquisition transaction.

Tip: If the acquirer intends to take its time acquiring shares, it should keep any
purchased shares in the name of its brokerage firm, thereby concealing the identity
of the acquirer. See the next paragraph regarding disclosure of stock ownership.

The acquirer is required by law to disclose its holdings of a target company within
10 days of acquiring at least five percent of its stock. Thus, depending upon its
ability to acquire shares in the short term, an acquirer could reach the five percent
threshold and then keep acquiring shares for an additional 10 days before revealing
to the public its ownership interest in the target company.

Tip: If you reach the five percent ownership threshold on a Wednesday, you can
delay the disclosure of holdings for 12 days, since the 10th day of the allowed filing
period falls on a Saturday. You would then file on the next business day, which is a
Monday. This delay gives the acquirer more time to buy additional shares before the
investment community hears about the tender offer and ratchets up the share price.

The acquisition of an initial block of shares has the additional advantage of making a
potential white knight bidder think twice about making a bid, since it knows the
acquirer will become a hostile shareholder. A white knight is an entity that makes a

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friendly offer to acquire a business that is the subject of a hostile takeover attempt by
a third party.
Depending on the circumstances, an acquirer could decide to continue accumu-
lating stock until it buys a sufficient number of shares to gain control of the target
company, without using the other takeover techniques noted later in this chapter.
This approach may work if share ownership is not sufficiently concentrated in the
hands of those individuals or businesses that want the target company to remain
independent. However, once the investment community realizes that a large number
of shares are being bought, the share price will rise, which reduces the effectiveness
of this approach.

Tip: Once a hostile takeover attempt becomes public knowledge, arbitragers begin
to accumulate the shares of the target company, in hopes of realizing a gain when it
is bought by the acquirer. This presents an opportunity for the acquirer, which can
scoop up these large blocks of shares with just a few transactions (though possibly at
a high price). Arbitragers are willing to sell quickly (if the price is right), since the
alternative is to wait for a tender offer and regulatory approvals to be completed,
which delays their profit-taking on shares held.

The downside of this initial purchase is that the buyer may fail in its bid for the
target company, in which case it will likely sell the shares it has accumulated. The
market price may have changed by the time the buyer elects to sell the shares, and
the sale of a large number of shares will certainly exert downward pressure on the
stock price; this presents the risk of a loss on the transaction. Thus, if the acquirer
believes it will encounter a vigorous defense by the target company, it may be less
inclined to initially acquire shares.

Initial Communications
If the target company has a history of vigorously defending itself against buyout
offers, and has stated that it wants to remain independent, then there is little point in
engaging in any initial communications, even through third parties. Instead, you
probably want to prepare for a hostile takeover attempt in complete secrecy, so the
target does not have any additional time in which to mount its defenses. On the other
hand, there may be no information about a potential target’s stance on being
purchased. If so, a possibility is to have a third party, such as an attorney or
investment banker, contact the management of the target company. The objective of
this contact is to gain an idea of the response the acquirer would meet with if it were
to proceed with an offer. The third party may or may not reveal the identity of the
acquirer, depending upon the circumstances. Thus, the direction you take on initial
communications will vary by target.

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The Bear Hug

One approach to a hostile takeover is the bear hug; it is when the acquirer makes an
offer to buy the shares of the target company at a price that is clearly higher than
what the company is currently worth. The board of directors of the target company
has a fiduciary responsibility to obtain the best possible return for the shareholders
of the target business, so the board may essentially be forced to acquiesce and accept
the offer. Otherwise, the board may face lawsuits from shareholders. Another
advantage of the bear hug is that other potential bidders will very likely stay away,
since the price offered is so high that it would be uneconomical for them to top the
offer. Also, this approach is less time-consuming than a protracted takeover battle.
Yet another advantage is that the high price paid tends to mitigate hard feelings by
the employees of the target company, making them somewhat more likely to remain
as employees following the takeover.
If the board does not accept the bear hug offer, there is an implied threat that the
acquirer will then take the issue directly to the shareholders with a tender offer to
purchase their shares. Thus, the bear hug is essentially a two-step strategy: an initial
overwhelming offer to the board, followed by the same offer to the shareholders.
While there is a good chance that a bear hug strategy will work, the downside is
that it can be extremely expensive, so the acquirer has little chance of earning an
adequate return on its investment in the target. This approach is only needed for a
hostile takeover, since a friendly one can usually be achieved with a smaller
investment.

Tip: If you issue a bear hug offer, consider making the offer known to the public
shortly thereafter, perhaps through a press release. Doing so increases the pressure
applied by shareholders to the board of directors to accept the offer.

The Tender Offer

An acquirer may resort to a tender offer when it has made a friendly offer to
management that has been turned down. The acquirer uses a tender offer to go
around management and appeal directly to the shareholders. The SEC defines a
tender offer as follows:

“A tender offer is a broad solicitation by a company or a third party to purchase a

substantial percentage of a company’s … registered equity shares or units for a
limited period of time. The offer is at a fixed price, usually at a premium over the
current market price, and is customarily contingent on shareholders tendering a
fixed number of their shares or units.”

The particular advantage of a tender offer is that the acquirer is under no obligation
to buy any shares that have been put forward by shareholders until a stated total
number of shares have been tendered. This eliminates the initial need for large
amounts of cash to buy shares, and also keeps the acquirer from having to liquidate
its stock position in case the tender offer fails. The acquirer can include escape

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clauses in its tender offer that release it from the liability to purchase any shares; for
example, an escape clause could state that, if the government rejects the proposed
acquisition for anti-trust reasons, the acquirer can refuse to buy tendered shares.
Such an escape clause is only prudent for the acquirer, which would otherwise have
to buy shares that it no longer needs, since the acquisition will not be allowed to
proceed.
Another advantage of the tender offer is that the acquirer could potentially gain
control of the target company in as little as 20 days, if it can persuade shareholders
to accept its offer. This period will be extended if a rival bidder appears or if not
enough shares are tendered. Even so, the matter will typically be decided within a
few months.

Tip: A tender offer can be completed especially quickly if it is a cash offer, since
doing so avoids any review period by the SEC.

The courts have created two tests for determining whether a tender offer exists. The
first is the eight factor test. The following factors indicate the presence of a tender
offer; not all eight are needed to establish that a tender offer exists:
• Active and widespread solicitation of public shareholders;
• Solicitation for a substantial percentage of the target’s stock;
• The offer is made at a premium to the current market price;
• The terms offered are firm (i.e., not negotiable);
• The offer is contingent upon the tender of a minimum number of shares;
• The offer is open for a limited period of time;
• Those subjected to the solicitation are subjected to pressure to sell their
stock; and
• Public announcements precede or are issued at the same time as the rapid
accumulation of large amounts of the target’s stock.

Some courts also rely upon the totality of circumstances test, under which you
examine the totality of the circumstances to decide whether, in the absence of
compliance with the Williams Act, there will be a substantial risk that the
information provided to shareholders will be insufficient to make a considered
appraisal of the acquirer’s offer.
The general steps involved in a tender offer are:
1. The acquirer files Schedule TO (see the preceding section) with the SEC,
and delivers a copy to the target company. This schedule includes the terms
of its tender offer.
2. The target company files a Schedule 14D-9 within ten days of the com-
mencement of the tender offer. In this schedule, the target either recom-
mends that shareholders accept or reject the tender offer. If the target does
not make a recommendation either way, then it must state its reasons for
doing so.

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3. Shareholders tender their shares to an intermediary, which tracks the

cumulative total of shares tendered.
4. The tender offer ends on the designated termination date, or is extended for
a longer period of time while the acquirer tries to obtain additional shares. If
the acquirer intends to extend the tender offer, it must do so by 9 a.m. East-
ern time on the business day following the termination date of the current
tender offer. The notice of extension must include the number of shares
tendered to date.
5. If the number of required shares is reached, the intermediary holding the
shares pays shareholders the price stated in the tender offer.
6. Depending on the existence of any anti-takeover defenses, the acquirer
appoints its directors to the board of directors. The new board members
presumably enact any changes to the target company required by the acquir-
er.
7. The acquirer customarily de-lists the shares of the target company from any
exchanges on which it had been listed.

The acquirer can make its tender offer more attractive to shareholders by offering
them a choice of either cash or the securities of the acquirer. If a shareholder were to
select the securities of the acquirer, it might (depending on the circumstances) defer
the recognition of taxable income. However, a securities offering must be examined
by the SEC, so giving shareholders this choice may delay the tender offer.
Once a tender offer has been publicized, the board of directors of the target
company has the choices of resisting the bid in favor of remaining independent,
finding other bidders to raise the price, or of acquiescing to the tender offer. From
the standpoint of fiduciary responsibility to the shareholders, it is quite likely that
the board will at least attempt to find other bidders (and perhaps ones more
agreeable to the management team), thereby finding a higher offer that pays more to
the shareholders.
Given the likely reaction of the target company’s board, it makes sense for the
acquirer to make a bid sufficiently high that it will scare away other potential
bidders, while not being so high that it makes the bid uneconomical for the acquirer.
In addition, the board of the target company is less likely to resist an offer that is
mostly or entirely for cash. Thus, the acquirer needs to be very careful about crafting
the type and size of its tender offer.

Warning: If an acquirer has initiated a tender offer, it may be tempted to buy lower-
cost shares of the target company on the open market. However, this is prohibited
under the provisions of the Williams Act. The acquirer can sidestep the Williams
Act by terminating the tender offer, at which point it is permitted to buy shares of
the target company on the open market.

The tender offer can be an expensive way to complete a hostile takeover, since it
involves not only filing fees paid to the SEC, but also the costs of attorneys to
prepare the Schedule TO and other documents, the services of a proxy solicitation

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firm, and the advisory services of tender offer specialists. There must also be a
depository bank that verifies tendered shares and issues payments for them on behalf
of the acquirer. Further, it may attract another interested buyer, who ratchets up the
price even further. In addition, since the management of the target company was
circumvented, it is a reasonable assumption that this group will not want to continue
to work for the company after it has been acquired. In short, it is nearly always
better to successfully complete a friendly offer than to engage in a tender offer.

Tip: To reduce the cost of a tender offer, accumulate as many shares in advance as
possible, as noted earlier in the Initial Share Acquisition section. Not only is it less
expensive to acquire shares early, but it also improves the odds of completing the
tender offer, since the acquirer will own a number of shares at the start of the tender
offer. Also, if the battle shifts to a proxy fight, the acquirer will already control a
number of votes.

The Partial Tender Offer

It might seem reasonable to only issue a partial tender offer, since the acquirer’s
outlay to gain control of the target company would be lower. However, this is a less
effective approach, because there is a considerable risk of oversubscription to the
offer. When an oversubscription occurs, the acquirer accepts shares on a pro rata
basis, which means that shareholders would not necessarily be paid the full amount
they expect. Further, the shares they are left with may have a reduced value for the
following reasons:
• If the acquirer takes the company private, the remaining shares will no
longer be listed on an exchange.
• The investment community may subsequently conclude that the acquisition
has not gone well, and so drives down the market value of the stock.
• The acquirer may offer a lower amount to the shareholders for their
remaining shares, since it will have already paid a control premium to ini-
tially gain control over the business.
• The acquirer is more likely to pay cash in its partial tender offer, and is more
likely to pay with debt or its own shares to acquire any remaining shares at a
later date.
• After completing its initial expenditures to acquire control of the target
company, the acquirer may not have the wherewithal to buy the remaining
shares.

Consequently, shareholders are less likely to accept the terms of a partial tender
offer. If an acquirer wants to be more certain of success with a tender offer, a full
offer for all outstanding shares is the better approach, despite the greater cost.

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EXAMPLE

High Noon Armaments is engaged in a hostile takeover of Ninja Cutlery. Ninja has 10
million shares of common stock outstanding, and High Noon makes a partial tender offer for
6 million shares at a price of $10 each. Shareholders subsequently tender 8 million shares to
High Noon.

High Noon accepts Ninja shares on a pro rata basis, so for every eight shares proffered, High
Noon pays $60 for six shares, with shareholders retaining the remaining two shares.

The Two-Tiered Tender Offer

If an acquirer wants to create a rush of shareholders tendering their shares, a less-
expensive approach than a single, high-priced offer is to create a two-tiered tender
offer. Under the two-tiered approach, the acquirer offers a better deal for a limited
number of shares, such as a higher proportion of cash or a higher price. This initial
tier is designed to give the acquirer control over the target company. It then makes a
reduced offer for an additional group of shares through a second tier that has a later
completion date. This approach has two benefits from the perspective of the
acquirer:
• Cost. The overall cost of the tender offer is reduced.
• Timing. The shareholders of the target company will be more likely to
tender their shares more quickly, in order to avoid being placed in the sec-
ond tier and receiving an inferior compensation package.

The two-tier concept is not considered beneficial to shareholders, since they are
essentially being stampeded into accepting the deal immediately, or of being at risk
of receiving a lower payout at a later date.
It is possible for a company that believes itself to be a potential target to offset
the dangers posed by a two-tiered tender offer by making two key changes to its
corporate charter. These changes are:
• Fair price provision. This provision requires an entity bidding for a majority
of a company’s stock to pay at least the fair market price for the stock held
by minority shareholders. There are a variety of ways to calculate the fair
market value, such as a fixed amount, the market price paid within a certain
date range, or the maximum price paid by the acquirer for other shares.
• Redemption rights. This provision gives shareholders the right to force a
redemption of their shares under certain circumstances (such as a change in
control of the business). The redemption price or pricing formula can be
included in the provision.

The use of fair price provisions and redemption rights, as well as restrictive laws
passed by some states, has limited the use of two-tiered tender offers. Nonetheless, it
is an option worth considering if the target company has not enacted the appropriate
defensive provisions and there are no state laws barring its use.

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The Creeping Tender Offer

A creeping tender offer is the gradual accumulation of the shares of a company, with
the intention of acquiring control over the business or obtaining a significant voting
bloc within the company. This process is conducted through the acquisition of shares
on the open market, rather than through a formal tender offer.
By using the creeping tender offer method, an acquirer can obtain at least a
portion of the shares it needs to exercise control at market prices, rather than at the
more inflated rates that it would likely pay in the event of a tender offer. However,
this approach also means that failure of the acquisition bid will leave the acquirer
with a large block of stock that it will presumably have to liquidate at some point in
the future, possibly at a loss.
The creeping tender offer approach can be used to avoid the formal tender offer
reporting requirements imposed by the SEC under the Williams Act. Tender offer
reporting is required when an acquirer is soliciting for the shares of a business at a
premium, with the offer being contingent upon the tendering of a certain number of
shares.

The Mini-Tender Offer

A mini-tender offer is a tender offer in which the entity or person initiating the offer
will end up owning less than five percent of a class of stock of the publicly-held
business that is the subject of the tender offer.
The reason for initiating a mini-tender offer is that the party doing so does not
have to comply with the SEC’s filing requirements for a normal tender offer. This
results in less information being sent to investors about the offer. There is also no
requirement to file documents pertaining to the tender offer with the SEC or with the
management of the target company. This has the following ramifications:
• An investor may accept a mini-tender offer without realizing that the offered
price is lower than the current market price. The investor may also be unable
to withdraw his or her shares after initially agreeing to the offer.
• The entity initiating the tender offer does not have to comply with the
disclosures required by the SEC for larger tender offers.
• The management team is not informed directly of the mini-tender offer, and
so may be slow to react to it.

The mini-tender offer is generally not a good deal for stockholders, given the
likelihood of a low price being offered to them, but is a possible method for
acquiring a modest amount of stock in a target company at a low price, which the
acquirer can then use as the basis for a larger bid for more shares in the target entity.

Warning: Mini-tender offers have acquired a bad reputation, because they are
sometimes used to obtain shares at below-market rates by deceiving shareholders
about the terms of the tender offer. Thus, from an acquisitions perspective, many
acquirers do not want to be associated with mini-tender offers.

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The Proxy Fight

A proxy fight is an attempt by those not in control of a business to use the proxy
method of voting to obtain a sufficient number of shareholder votes to gain control
of the board of directors. The result is a change in the membership of the board,
which then leads to a change in the management of the target company. The new
board may approve of being acquired by the entity that initiated the proxy fight.
The term proxy fight is derived from the use of proxies. A proxy is the authori-
zation of shareholders to vote their shares for them at the shareholders meeting.
Since shares are voted at the shareholders meeting, and few shareholders bother to
appear for that meeting, they instead grant a proxy to someone else who will be
attending the meeting to vote their shares, such as the corporate secretary. It is the
task of the acquirer to obtain the proxies for as many shares as possible, which it can
then vote at the shareholders meeting.
Directors are elected once a year by the common shareholders, at the annual
shareholders meeting that takes place anywhere from two to five months following
the end of a company’s fiscal year-end. There may also be a special shareholders
meeting for such issues as considering an acquisition offer, if a sufficient percentage
of the voting shareholders request the meeting.
In a proxy fight, the acquirer and the target company use a variety of solicitation
methods to influence shareholder votes for members of the board of directors.
Shareholders must be sent a Schedule 14A, which contains a substantial amount of
financial and other information about the target company; if the proxy fight is over a
motion to sell the company, the schedule also includes the terms of the proposed
acquisition. The basic steps in a proxy fight are:
1. The acquirer hires a proxy solicitation firm, which is responsible for
contacting shareholders.
2. The proxy solicitor compiles a shareholder list and then contacts sharehold-
ers to state the case of the acquirer. In cases where shares are registered in
the names of stock brokerages, the brokerages consult with the share owners
regarding the voting positions they will take.
3. Individual shareholders or stock brokerages submit their votes to the entity
designated to aggregate the information, such as a stock transfer agent or
brokerage. These results are then forwarded to the corporate secretary of the
target company just prior to the shareholders meeting. Votes may be scruti-
nized by proxy solicitors and challenged if votes are unclear, voted multiple
times, or not signed.
4. Directors are approved based on the votes received.

It can be quite difficult to gain the attention of shareholders, since the vast majority
of them are completely apathetic in reviewing the options for directors. Instead, they
usually agree to the director voting recommendations mailed to them without any
examination of qualifications or underlying issues at all. The same level of apathy
may apply to acquisition votes. However, a proxy fight might be favorable for the
acquirer if the target company has been suffering from poor financial results, which

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might make shareholders restive. It is especially useful if the acquirer has a concrete
proposal for turning around the business or shifting more cash to shareholders, such
as through the use of asset sales, sale of the business, or increased dividends.
In a proxy fight, there are several voting clusters. The acquirer will have a
certain number of shares under its direct control, while the target will have shares
controlled by those loyal to the board of directors and management team. Between
these two groups are the shares held by institutions (such as pension funds) and
individuals, which may sway the outcome in the direction of either the acquirer or
the target company. Of this central group, the acquirer and the target are most likely
to concentrate their persuasive activities on the largest holders of stock, which are
usually the institutional shareholders. Individual shareholders typically hold too few
shares to influence a proxy fight in either direction, and so may be ignored.
A proxy fight is not a high-probability option for an acquirer. However, it can
still lead to changes, since the board of directors may be sufficiently scared by the
proxy fight to enact a few changes to keep from triggering another proxy fight in the
future. Examples of preventive changes include unusually large dividends and the
sale of assets. In short, the acquirer must consider the low probability of acquiring
through this approach and the costs incurred for proxy advisors, communications
with shareholders, litigation, and proxy materials.

Hostile Takeover Defenses

There are a number of defenses that a potential takeover target can engage in if its
management team wants the company to remain independent. The target company
may want to fight off hostile bidders for two basic reasons:
• Valuation. It feels the company should be selling for a higher price or will
be more valuable if management continues with its current business strate-
gy; or
• Power. The management team is entrenched and does not want to lose its
positions running the company.

If the target sets up a variety of defenses in the absence of a hostile bidder, it is

probably because management wants to retain its current positions running the
company. If the target sets up defenses only after a hostile bidder appears, then
either reason may be triggering the use of defenses.
The following list of takeover defenses is split into two large groups. The first
group, called preparatory defenses, requires advance action over a lengthy period of
time, usually in the absence of any hostile bids. The second group, called reactive
defenses, is employed in reaction to a specific hostile bid. Both types of defenses can
employ a variety of techniques, including acquisitions, legal stratagems, altering the
financial and operational structure of the business, and so forth. The most common
takeover defenses are:

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Preparatory Defenses - Acquisitions

A target company can make selective acquisitions of its own that will make it a
difficult takeover target. The goals with these acquisitions are to make its own
purchase subject to antitrust or other government oversight, or to alter the
fundamentals of the business enough to make it a less attractive takeover candidate.
The options are:
• Antitrust acquisition. The target company could buy another business
similar to its own operations. If the combined entity comprises a sufficiently
large part of the market, this could cause antitrust issues for an acquirer,
since its size when combined with the target company may now be too large
to be approved by the government.
• Regulated business acquisition. The target could buy a business located in
an industry where the government engages in considerable amounts of regu-
lation. The increased level of government oversight might subject an acquir-
er’s hostile takeover activities to a protracted purchasing process that may
even be rejected by the government. Examples of such industries are radio
stations and utilities.
• Unrelated acquisition. A target company may expend its funds on the
acquisition of another business located in a different field, which may be of
no use to the acquirer. However, the acquirer could simply purchase the
combined entity and then sell off the new subsidiary.

Preparatory Defenses – Legal

There are a variety of legal defenses that a target company can construct in advance
of a hostile bid. Many of these defenses are subject to the laws of the state in which
the target is incorporated, so it may be necessary to reincorporate in a different state
that has more favorable laws. Also, most legal defenses require prior shareholder
approval, so the target needs to be prescient enough to include them in the annual
shareholders meeting (or undergo the expense of having a separate meeting), and to
vigorously push for their passage by shareholders. Preparatory legal defenses
include:
• Accelerated vesting. This is a provision built into option and warrant grants,
under which the vesting period is automatically accelerated upon a change
in control of the business. This provision increases the number of shares
outstanding for the acquirer to purchase. This is a standard provision in most
option and warrant grants, and so is no longer considered a specific takeover
defense.
• Anti-greenmail provision. This is a provision in the corporate charter that
restricts the ability of the target company to pay greenmail (which is dis-
cussed later in this section), usually to the current market price.
• Fair price provision. This is a provision in the corporate charter that
requires a buyer to pay for the shares of minority shareholders at a fair price.
This may be the market price, a fixed price, the highest price paid to any
shareholder, a price/earnings multiple, or some variation on these pricing

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concepts. The effect of this provision is to increase the price that an acquirer
must pay in order to obtain total control over a target company. It is most
applicable when there is a two-tiered tender offer (see the Two-Tiered Ten-
der Offer section).
• Golden parachutes. The compensation plans of the senior management team
may specify large bonus payments in the event of a change in control. While
large, these payments are not usually a large proportion of the purchase
price, and so will rarely be a powerful defense against a hostile takeover.
• Reincorporate. Some states have more onerous antitakeover laws than
others. A target could reincorporate in one of these states. This involves
incorporating a subsidiary in the state having antitakeover laws, and then
merging the parent company into it.
• Shareholder rights plan. The target company issues rights to its existing
shareholders, under which they can acquire additional shares if anyone ac-
quires more than a certain amount of the target’s shares. This plan makes it
more expensive for the acquirer to gain control of the business, since doing
so will require the purchase of more shares.
• Special meeting limitation. An acquirer may try to call a special sharehold-
ers meeting, during which shareholders vote for the business to be acquired.
The target company can alter its charter to limit the ability of shareholders to
call special shareholder meetings, such as by requiring a high percentage of
shareholders to request the meeting.
• Special voting rights. A target company could create a separate classifica-
tion of shares that has greater voting rights than its common stock. Thus,
Class A stock might have one vote per share, while Class B stock might
have 10 votes per share. As long as the shares with the special voting rights
remain in the hands of those shareholders supportive of the company, it
might be very difficult for anyone to effect a takeover. A variation on this
concept is to issue preferred stock that converts into a number of shares of
common stock; if the holders of these shares elect to convert to common
stock, they will gain an inordinate number of common shares, along with the
associated voting privileges.
• Staggered board of directors. The members of the board of directors are
elected on different dates, such as one-third of them being voted into office
each year for three-year terms. This approach prolongs the time period re-
quired to replace the board through proxy fights. Also, if an acquirer buys
the target company, it may still have to deal with resistance from any re-
maining directors until their terms expire.
• Supermajority. Under a supermajority provision, more than a simple
majority approval is needed for certain actions, such as the sale of the busi-
ness, sale of a certain proportion of total assets, or transactions involving
significant shareholders. A supermajority clause may include a provision
that allows the board of directors to waive it if the board approves of an
acquisition proposal. The usual supermajority percentage is two-thirds,
which means that management only needs to control 33.4% of all votes to

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keep an acquirer from buying the business. Sometimes, the supermajority

percentage may be even higher, though it is more difficult to gain share-
holder approval for stratospheric percentages.

These legal preparatory defenses are frequently adopted en masse, so that the target
company presents a formidable array of legal defenses to a prospective acquirer.
The main issue with these legal defenses is that most of them must be approved
by the company’s current shareholders. Since shareholders want to earn a profit on
their holdings, the arrival of a suitor may very well be greeted with glee, rather than
concern. If so, shareholders will realize that adopting legal defenses may drive away
the suitor, which reduces the value of their shares. Consequently, gaining the
adoption of legal defenses can be a tough sell. The only case in which legal defenses
are readily adopted by shareholders is when a family or the management team owns
the bulk of the shares, and is more interested in retaining control over the business
than in earning a profit by selling out.

Preparatory Defenses – Financial

A company can engage in several financial tactics that can prove troubling for an
acquirer. This can involve acceleration clauses in debt agreements and the shifting of
stock into employee stock purchase plans. These defenses are as follows:
• Debt covenant. The target can ask its lender to add a change of control
clause to its debt covenants. This clause requires the target to pay back its
loans to the lender if there is a change of control of the business or if an
investor elects a block of board members. This is a particularly potent de-
fense if the target has fixed low-interest-rate loans that the acquirer would
have to refinance with higher-cost debt.
• ESOP. The target company could create an employee stock ownership plan
(ESOP) and contribute tax-deductible funds to the plan, which are then used
by the plan to buy shares of company stock. This effectively segregates
those shares acquired by the ESOP. However, it can take a substantial
amount of time for an ESOP to accumulate a sufficiently large part of a
company’s stock to be a reasonable takeover defense.

Preparatory Defenses – Operational

An acquirer may be attracted to a business because its share price is so low in
relation to the market value of its assets and intellectual property. If so, there are a
number of ways to increase the stock price, thereby making it more expensive for an
acquirer to buy sufficient shares to gain control of the business. Some of those
methods are:
• Cost cutting. The target could trim its discretionary spending for items that
do not impact its long-term competitiveness, thereby improving profits and
hopefully the share price.

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• Asset sales. The target could sell off underperforming assets or entire
divisions, which should increase the profit percentage for the remainder of
the business, which in turn will hopefully increase the share price.
• Intellectual property. The target could invest more funds in research and
development, as well as patent applications, to develop a portfolio of intel-
lectual property to which the investment community will assign a higher
stock price.
• Investor relations. The target could set up a full-service investor relations
group to communicate the value of its shares to the investment community,
thereby sparking a share price increase.

Reactive Defenses – Legal

Any acquirer launching a hostile takeover attempt should expect a vigorous response
on the legal front. There can be a variety of lawsuits on any number of topics that
are designed to void the attempt or at least delay it. These defenses include:
• Counteroffer. The target company could launch a counter-offer to buy the
acquirer. This approach may scare off the acquirer, especially if the target
company is perceived by the investment community to have the resources to
buy the acquirer. The preparation of a valid offer will result in added legal
fees, which can pile up quickly.
• No action letter. If an acquirer is engaging in a proxy fight, the target
company can petition the SEC to issue a no action letter, which disallows
the acquirer’s proposal. The SEC only issues a no action letter if the target
makes a persuasive case that the proposal is not in the best interests of the
shareholders or is only designed to address a personal claim by the share-
holder. Since this defense is designed to eliminate nuisance shareholder
proposals, it is not usually effective against the efforts of an acquirer.
• Litigation. The target company may initiate a variety of legal actions against
the acquirer, usually with the intent of delaying the takeover while it consid-
ers other options. Typical legal tactics are obtaining an injunction to halt the
acquisition, or stating that the bidder has provided inadequate disclosures to
shareholders.

Reactive Defenses – Monetary

An acquirer may want to purchase a target company because it has excellent cash
flow or an excellent balance sheet. The target can remove these attributes by piling
on debt or giving away its cash with a dividend. Or, it can issue such a large
dividend that it requires additional debt to fund the dividend. The actions are:
• Debt. An acquirer can use the asset base of the target to obtain an asset-
based loan that funds the acquisition. The target company can eliminate this
issue by piling on long-term debt that it cannot terminate without paying
substantial fees.
• Dividend. The target could issue a large cash dividend to its shareholders,
thereby so drastically reducing its financial position that it is no longer an

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attractive acquisition candidate. The dividend could be so large that the tar-
get company must incur debt in order to pay for the dividend. However,
many debt agreements restrict a business from using proceeds from a loan to
pay dividends.
• Greenmail. This is the repurchase of shares from a potential acquirer at a
premium, usually accompanied by a promise from the acquirer to discontin-
ue its activities to acquire the company. This may be considered less of a
defense and more of a partial capitulation, since the acquirer is essentially
earning a profit on its takeover activities at the expense of the target compa-
ny. A greenmail payment to an acquirer may trigger a lawsuit from other
shareholders, on the grounds that the company has made a preferential stock
repurchase for which there is not a valid business reason. It is also not con-
sidered a long-term solution to takeover bids, since it merely indicates to
other potential acquirers that the target is willing to make greenmail pay-
ments.
• Standstill agreement. This is a payment to an acquirer in exchange for an
agreement not to increase the number of shares of the target company that it
holds during a specific time period. A standstill agreement is usually incor-
porated into a greenmail agreement.
• Stock buyback. The target company can engage in a stock buyback program.
This has the same cash reduction goal of issuing a large dividend, but has
the added advantage of reducing the number of shares outstanding. If the
group of investors supporting the company does not sell its shares back to
the company, this means that the buyback program is essentially eliminating
shares that otherwise might have been used by the acquirer. Thus, a buyback
can increase the proportion of shares held by those favorable to manage-
ment. Further, the buyback may increase the share price, which makes it
more expensive for an acquirer to buy shares.

Reactive Defenses – Sale to Alternate Party

The target company may find the acquirer so repugnant that it is willing to sell itself
to someone else instead. This can be to the management team through a leveraged
buyout, or to a white knight. These options are:
• Leveraged buyout. Management could obtain sufficient outside financing to
buy up shares and take the company private. However, a leveraged buyout
may require supermajority approval under some state laws, so an acquirer
can block it by acquiring a sufficient number of shares to make it impossible
for management to obtain a supermajority of votes from the shareholders. A
leveraged buyout can be a risky alternative if the underlying cash flows of
the target company are so variable that it may not be able to pay off the debt
used to fund the transaction.
• White knight. The target could approach a more acceptable company than
the acquirer to see if an acquisition could be arranged. Management of the
target company may want to impose conditions on the white knight, such as

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retaining their jobs or not shuttering facilities for a certain period of time.
Given these restrictions, and coupled with the need to offer a price that is
competitive with the one being made by the acquirer, it may be difficult to
find a suitable white knight.

A variation on the concept of being bought by a white knight is for the target
company to buy a company. By doing so, the acquirer will be faced with the
daunting task of having to integrate two businesses, rather than one. Also, the
combined entity may now be so large that buying it would trigger an anti-trust
investigation that could ultimately result in the government preventing the proposed
acquisition. However, this can backfire if the acquirer views the situation as one in
which it can gain significant market share in a single transaction, and is willing to
sell off some assets to prevent an anti-trust ruling.

Reactive Defenses – Structural

The target company can alter itself to such an extent that the acquirer no longer
wants to buy it. One option is to sell off those assets considered to be the crown
jewels of the business. Of course, laying waste to the business in this manner also
means that it may be so crippled that it will fade into obscurity or fail following its
defense of the hostile takeover.
Some of the preceding defenses are so aggressive that they may interfere with
the ability of the target company to survive. In particular, the crown jewel sell-off,
special dividend, and leveraged buyout options may so severely restrict the business
for either operational or financial reasons that it may have to sell itself in order to
survive in any form.
In short, there are many takeover defenses available, several involving relatively
inexpensive legal changes. To determine the best set of defenses, a management
team should consult with an acquisitions specialist who has a detailed knowledge of
the state laws under which the company operates. However, resisting hostile
takeovers may not be in the best interests of shareholders who want to see the
highest possible return on their invested funds, so a management team that needs a
shareholder vote to install certain defenses may run into resistance, especially when
the company is not doing well or the share price is low. Only when a majority of
votes are closely controlled by management can it be reasonably assured of gaining
shareholder acceptance of anti-takeover measures.

Summary
It can be quite difficult to succeed with any hostile takeover attempt, because public
companies have implemented a variety of anti-takeover defenses. Thus, before
engaging in any of the tactics described in this chapter, you should consider the
lower probability of success, as well as the cost of a hostile takeover attempt. In
many cases, it makes more sense to maintain your cash reserves and wait until such
time as the target company is more amenable to a friendly takeover. In the
acquisitions game, patience is most certainly a virtue.

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If it still seems necessary to engage in a hostile takeover, the tender offer is

much more effective than the proxy fight. A proxy fight inherently favors the target
company, since most shareholders automatically vote in favor of management.
Conversely, a cash tender offer at a price above the current market rate gives the
acquirer a much stronger chance of effecting an acquisition.
All of the hostile takeover options and defenses described in this chapter only
apply to companies whose securities are publicly-held. If a target company is
privately held, it is essentially impossible to engage in any effective hostile takeover
activities.

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 Chapter 9
Due Diligence
Introduction
An essential part of any acquisition is due diligence, which is the investigation of all
aspects of the target company. It is addressed immediately after the parties have
agreed in principle to deal, but before a binding agreement has been signed. Doing
so tells the acquirer if there are any issues that might alter its valuation of the
business, or which might scuttle the deal entirely. It also produces useful
information for the eventual integration of the business into the acquirer.
In this chapter, we deal with several general due diligence issues – preparation
for it, expectations, and its cost. We then discuss the following due diligence areas:

• Target company overview • Taxes

• Corporate culture • Accounting policies
• Management • Product development
• Employees • Selling activities
• Employee benefits • Marketing activities
• Financial results • Production operations
• Internal reports • Materials management
• Revenue • Information technology
• Cost structure • Treasury and risk management
• Intellectual property • Legal issues
• Fixed assets and facilities • Regulatory compliance
• Liabilities • Service companies
• Equity • International issues

Some of the “softer” topics, including corporate culture, management, and

employees, are discussed first, because they are critical to the success of many
acquisitions. They are ignored by some acquirers in favor of “hard” topics, such as
accounting and legal issues, but we have found that the success of an acquisition is
usually founded upon proper deliberation of the “soft” topics first. Thus, while all of
the topics presented in this chapter are of importance in due diligence investigations,
we urge particular attention to the people and culture of the target company.

Related Podcast Episode: Episode 80 of the Accounting Best Practices Podcast

discusses due diligence. You can listen to it at: accountingtools.com/podcasts
 Due Diligence

Due Diligence Preparation

In the following sections, we address a large number of possible due diligence
issues, but you do not necessarily have to address all of them during an investiga-
tion. Doing so would be inordinately time-consuming and expensive. Instead, review
the information already available about the target company, and reach a number of
decisions to pare down the list of issues to be investigated. The intent is to cover
those items presenting the most significant risk to the acquirer. For example, all of
the following situations should trigger an in-depth review:
• Accounting. The target company’s financial statements contain no reserves
for bad debts, sales allowances, warranty claims, or obsolete inventory.
• Legal. The disclosures accompanying the target’s financial statements made
reference to a lawsuit one year ago, and do not mention it thereafter.
• Products. The target spent $10 million in the past year on product develop-
ment, yet there have been no press releases announcing new products.

Thus, the due diligence team should prepare a customized list of items to investigate.
Once the team begins its work, the situation it uncovers will inevitably alter the list
further, as the team backs away from some items and delves deeper into others.
From the perspective of the target company, this means it will expect a single
lengthy list of requests before the team arrives, followed by a series of follow-up
questions as the team examines the responses to its requests.
A significant concern with any due diligence investigation is the limited amount
of time allowed for it. The senior management team probably has a target closing
date in mind, which gives the due diligence team only a limited time period in which
to conduct its investigation. This can be a real problem if the target is a large,
diversified business with multiple locations, since there is no way to complete the
work within a tight timeline. Instead, it is the job of the due diligence manager to
push back at senior management and clarify the time needed to complete the work.
The amount of time needed will be hazy at first and become clearer over time, as the
team works its way through the list of items to investigate. Eventually, the team will
have a short list of areas that may contain significant risk, which the due diligence
manager will advocate investigating before the team is recalled from the field. There
is also likely be a larger number of lesser investigations in areas where the risk level
is considered minimal, and which can safely be abandoned if the team runs out of
time.
In short, it is best for the team manager to continually communicate to senior
management the current best estimate of a completion date, and the issues standing
in the way of completing its tasks by that date.

Tip: There is a definite limitation on the amount of time you should take for due
diligence. It can become so prolonged that it begins to appear that the due diligence
team is rooting around among excessively puny issues, while the target company
becomes increasingly annoyed with additional requests for information.

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(continued) The result may be that both parties become tired of the deal, and it
eventually falls apart simply from lack of interest in proceeding with it. Thus, the
team leader should set a time limit for due diligence that is reasonable, and attempt
to adhere to it as the investigation progresses.

Due Diligence Expectations

You can count on finding problems in any due diligence investigation – the most
incredibly well-run business on the planet still has problems of some kind. Thus, the
due diligence team must go into a company review with the expectation of
uncovering some issues. The team must sort through these concerns to determine
which ones are critical, and which are so minor that it is barely worthwhile to
document their existence.
The team is likely to find at least one issue significant enough to halt the
acquisition. In the author’s experience with dozens of due diligence investigations,
there was always such an issue, and it was usually so severe that senior management
elected to walk away from the deal. In fact, the mindset of the review team became
an assumption that the deal would probably not work, and that it needed to be
convinced that an acquisition should proceed.
This mindset may seem unusually conservative, but anyone who has engaged in
a sufficient number of due diligence investigations understands the severity of the
problems hiding in many companies. If an acquirer purchases a company without a
proper due diligence investigation, it is at considerable risk of buying into a business
whose problems are comparable to those of a toxic waste dump.

Due Diligence Cost

There may appear to be a significant cost associated with due diligence, since so
many people are involved. However, many participants are employees of the
acquirer, and so their salaries are essentially a fixed cost that the acquirer will pay,
irrespective of any due diligence investigations. However, there may be additional
costs associated with the use of outside experts, such as accountants, attorneys,
appraisers, and environmental risk analysis experts. These costs may be substantial,
and must be incurred, irrespective of the size of the company under review.

Tip: Some law firms that assist with due diligence investigations are less committed
to conducting cost-effective analyses and more committed to running up their bills
to the acquirer. The sure sign of this behavior (besides the final invoice) is a strong
tendency to drill down far too deeply to investigate picayune issues that cannot
possibly impact the acquirer’s decision to purchase the target company.

These additional costs of due diligence may be so significant that some serial
acquirers have established a minimum target company size, below which they will
not go. The reason is that the cost of due diligence is roughly the same across a
broad company size range, so acquirers would rather spend their money

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investigating larger businesses that will potentially have a greater impact on the
consolidated results of the company.
When the target company under consideration is quite a large one, the cost of
due diligence is immaterial to the total possible gain to be achieved from the
acquisition. In this case, the costs of a plethora of outside experts to identify the risks
associated with a deal are so small that it would be unwise not to hire them.
In summary, the largely fixed cost of due diligence makes it difficult for an
acquirer to even consider purchasing a smaller business, whereas its cost is
infinitesimal when a really large acquisition is being contemplated.

Target Company Overview

The due diligence team should begin work on the target company before it arrives
on-site by investigating a number of general issues concerning the intentions of the
company’s owners, its business plan and how it fits into its industry, and how it is
structured. These initial results can then direct the team into more or less analysis of
the questions posed in the following sections. It is also possible that some of the
information encountered in this general overview will be sufficient to terminate due
diligence, without having a team ever set foot on the company’s premises. The
overview topics are:
• Why selling? There must be a good reason why the owners of a business
want to sell it – and they may be excellent ones, such as raising funds for an
estate tax payment, a divorce, or retirement. However, there may also be
hidden reasons, such as the expectation of a lawsuit, or a downward trend in
the company’s prospects, that are really driving the sale. One of these hid-
den reasons could present such a significant problem that the acquirer must
back out of the transaction.
• Prior sale efforts. Have the owners of the target company attempted to sell it
before? If so, find out what happened. Former prospective buyers are unlike-
ly to talk about the issues they encountered, but an ongoing series of unsuc-
cessful sale discussions probably point toward underlying operational, risk,
or valuation concerns that must be uncovered. A common issue is that the
sellers have high valuation expectations. If so, it is useful to determine the
expectations as soon as possible, so the acquirer can decide if it wants to
back out now or continue with due diligence.
• Takeover defenses. The target company may have constructed a variety of
defenses against a hostile takeover, which may obstruct the ability of the
acquirer to purchase the business, even if it is perceived to be a friendly
acquirer. Examples of hostile takeover defenses are accelerated option vest-
ing, fair price provisions, and special voting rights. See the Hostile Takeover
Tactics chapter for more information. If such takeover tactics are present
and must be surmounted, it may be impossible to complete the acquisition.
• Business plans. Obtain a copy of not only the most recent business plan, but
also the earlier versions of it for the past few years. The team should peruse
these documents and compare them to the company’s actual performance

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and activities, to see if the management team is capable of implementing its

own plans.
• Complexity. How complex is the business? If it involves a large number of
disparate subsidiaries that deal with many products and services, it may be
too difficult for the acquirer to manage the operation. These types of busi-
nesses are also difficult to grow. Conversely, a company with a simple
product line or service is an excellent acquisition target.
• Analyst reports. If the company is publicly-held, obtain copies of reports
written about it by outside analysts. These reports can be quite useful in
providing background information about the industry and the company’s
place within it.
• Planned divestitures. Is the company planning to sell off or close down any
of its operations? If so, this is a clear indication of a change in direction for
the business. Find out why the divestitures are taking place, and what busi-
ness conditions (if any) have caused it.
• Market review. Review the primary players in the marketplaces in which the
target competes; determine the competitive niches occupied by each one,
and how their actions may impact those of the target company. Also, moni-
tor trends in the industry to see if there have been or are expected to be
changes in profit levels or the size of the market. Further, examine the ex-
pected impact of new technology on the market, and how the company is
positioned in relation to those technologies. This can be very difficult in-
formation to assemble, especially if the acquirer is new to the industry. A
good potential source of information is an industry trade group.
• Ease of entry. Is this an industry in which competitors can enter and exist
easily, or are there significant barriers to entry? Has there been a history of
new competitors arriving and taking significant market share, or does mar-
ket share appear to be locked in among the current players?
• Related acquisitions. Have there been other acquisitions in the industry
lately? Have other businesses put themselves up for sale? What is driving
these trends? It is possible that the industry is going through a period of
consolidation, which may impact the price the acquirer offers to the target
company.
• Reporting relationships chart. Obtain a chart that states the reporting
relationships within the business. This is useful for determining which man-
agers are in charge of which sections of the business, so that the team knows
who to contact for more information. It also tells the team who to investigate
for roles in the business if the acquisition is completed.
• Geographical structure. If the business is based on sales regions, examine
how the organization is structured to support regional sales. Is there an ade-
quate infrastructure at the regional level for such activities as sales, market-
ing, distribution, and storefronts? If there are weaknesses, what could the
acquirer do that would improve profits?

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• Organizational legal structure chart. Obtain a chart that states which

subsidiary entities are owned by which parent companies, where each one is
incorporated, and the ownership of each one. This is an important document,
for the team needs to know if there are any hidden majority or minority in-
vestors buried in the organizational structure of the company.

From a practical perspective, the team will need to move between topics as
information becomes available. Thus, the team may not have answered all of the
questions in this section to its own satisfaction until it is deep into the due diligence
process.
We now turn to the examination of several “soft” topics in the next few sections
– employees and the culture within which they operate.

Corporate Culture
Corporate culture is the manner in which a company conducts its business. It begins
with the general concept of how the senior management team wants to operate the
business, and percolates down through the organization in the form of management
structure, how decisions are made, policies and procedures, the types of people
hired, and even its marketing efforts. Examples of the opposite extremes of
corporate culture are:
• Command-and-control. Senior management makes all key decisions, and
restricts the flow of information to people lower in the organization. The
organizational structure is strongly hierarchical. This culture typically uses
close adherence to the annual budget as a “carrot and stick” method for re-
warding managers.
• Localized responsibility. The senior management team is in charge of
strategy, and shifts all tactical decision-making lower in the organization.
There is broad distribution of information throughout the organization.
There tends to be more emphasis on an upgraded work environment, in or-
der to spur productivity and reduce employee turnover.

There can be serious problems with an acquisition if the corporate culture of the
acquirer is of the command-and-control variety and the target company practices
localized responsibility. The typical result is a large initial surge in employee
turnover. If the reverse situation arises, employees of the target company will not be
used to having responsibility thrust upon them, which can result in a prolonged
period of confusion, reduced operating results, and employee turnover. In short, it is
difficult to mix these two extreme forms of corporate culture, and so the due
diligence team should estimate the impact of the acquirer’s culture on the target
company.
The dichotomy just noted was for the two extreme forms of corporate culture. In
reality, most organizations fall somewhere between these extremes, so the amount of
cultural conflict is likely to be reduced. Nonetheless, there will be conflicts, which
the due diligence team should highlight in its report to senior management.

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Seemingly trivial issues that the team should take note of include any differences
from the acquirer’s culture in regard to such issues as:
• Community involvement
• Dress code
• Flexible work hours
• Matching of contributions to non-profit entities
• Political activity
• Special events for employees

Another culture issue that is potentially serious is the presence of any illegal
activities. They could take the form of misstatement of the financial statements,
outright theft of assets, the routine circumvention of accounting policies, and so
forth. If there is evidence of such activities, it is entirely possible that the attitude of
the management team is allowing it to occur throughout the business. For example,
they may be ignoring the theft of assets by the family of the owner, or have imposed
such difficult goals that employees can only achieve them by committing fraud. This
type of environment is usually a clear indicator to an acquirer to terminate its pursuit
of the business and go elsewhere.

Target Company Management

Many of the due diligence issues noted in this chapter can be quantified, but the
abilities and mindset of the target company’s management team are among the least
quantifiable. The proper evaluation of managers calls for exceptional skill in
understanding the motivations of people with whom the due diligence team will
likely only have a small amount of interaction. During that time, you must somehow
come to conclusions about the following issues:
• Is a manager likely to stay after the acquisition has been completed?
• How will the manager react to the changes that the acquirer is likely to
make?
• How will the manager fit into the acquirer’s culture?
• How will the manager react to the acquirer’s compensation system?
• If there will be duplicate positions arising from the acquisition, should this
manager replace the incumbent?

Or, to summarize all of the preceding points, will the person be an asset or a
hindrance? Short of hiring a psychiatrist to evaluate each manager, here are several
techniques for gaining insights into them:
• Compensation focus. Does a manager already have a large compensation
package that places him at the upper end of the acquirer’s pay scale, and has
he repeatedly discussed further increases in compensation? This may indi-
cate an inflated sense of self-worth.
• Organizational structure. The organizational structure created by a manager
is strongly indicative of that person’s style. Thus, does that person’s area of

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responsibility have a dispersed decision-making structure, or is it more cen-

tralized? If it is centralized, the individual may have more difficulty taking
orders from others.
• Treatment of due diligence team. A manager should be on best behavior in
dealing with the due diligence team. If the individual exhibits unusual be-
havior to even this group, it is a sure sign of difficulties to come.

Acquisition Story: The author’s company hired an audit firm to audit the books of
an acquisition candidate. They found that the target company’s president exhibited
such odd behavior that they insisted on giving a full report about him, in addition to
delivering their audit report.

• Quality of subordinates. An excessively dominant manager is more likely to

have assembled a group of weaker subordinates, so there is no one to chal-
lenge or replace him.
• Training. Has the manager set up a training program for his staff, so that
they are well-versed in not only their own jobs, but capable of taking on
more responsibility? This could indicate a real prize – a manager not afraid
to bring others into positions where they could become competitors.
• Castle mentality. Are there indications that the manager wants to build walls
around his business and keep on running it after selling to the acquirer? This
usually leads to intransigence, which in turn delays the implementation of
those synergies needed to pay for the acquisition.
• Former employees. If there were any senior employees who left suddenly or
were fired, consider contacting them to discuss the management team. Their
opinions will almost certainly be skewed in a negative manner, but they can
still reveal excellent information about the personalities of the management
team.

Acquisition Story: During a due diligence investigation, the author contacted the
former chief operating officer of an acquisition candidate, who had left quite
suddenly. He gave a detailed portrayal of the chief executive officer and his
management quirks that turned out to be exceptionally accurate.

• Background check. It is very inexpensive to conduct a background check on

the Internet. The search should encompass criminal records databases, as
well as information on bankruptcies, liens, and judgments against the person
being reviewed.
• General Internet search. It may be useful to engage in a general Internet
search of a person. This can reveal a surprising amount of information, es-
pecially if they have a regularly-updated blog.

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Acquisition Story: The author was conducting a preliminary investigation of a

possible acquisition candidate in California, and found a blog authored by the
company president. Several blog postings revealed such an extraordinary temper and
willingness to vent publicly that we never even bothered to contact the company.

The preceding list gives some clear indicators to watch for when reviewing
managers. It generally does not take an inordinate amount of time to address these
points. A more dangerous approach that is much more likely to result in an incorrect
decision is to rely upon the initial chemistry between the parties. This is the
impression that the due diligence team gets from a few meetings with managers, and
perhaps during a few meals together. At this time, the managers of the target
company are on their best behavior, and so any impression the team obtains may be
a false one. Instead, it is better to investigate the issues just noted.

Tip: It is somewhat useful to interview the CEO about the quality of his or her
management team, but keep in mind that the CEO is likely to expand upon their
favorable attributes and downplay their weaknesses, in hopes of retaining them post-
acquisition.

Even if a manager appears to be excellent and well worth keeping, there are several
other factors to consider regarding whether they will stay. These issues are:
• Serial entrepreneurs. The founder of the company may love to start new
businesses. If so, expect that person to become increasing uncomfortable
within the larger business, and leave within a few months or years. The only
way to avoid this is to have a “hands off” policy towards the business, and
let the person manage it as he wishes. However, doing so eliminates all
chances of achieving any synergy gains.
• Health. The person may have a history of medical problems that may, at
best, only allow for a reduced work schedule.
• Age. The person may be reaching retirement age.
• Wealth. A significant problem is when the acquisition payout makes the
owners of the company wealthy enough to walk away. If they are paid in
stock, and there is a trading restriction on the stock, it is quite possible that
they will leave the company as soon as the trading restriction expires and
they have sold their stock.

In summary, there are many reasons why the managers of an acquired business will
leave on their own, and why others will not be asked to participate in the combined
business. The trick is to find those clearly superior managers who will be supportive
of the new business, and figure out the compensation structure or work arrangement
needed to persuade them to stay.

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Employees
There is a tendency for the due diligence involving employees to be a simple review
of pay levels and employment agreements, which are the two most easily
quantifiable topics related to employees. The team should dig deeper, to understand
how the employees work together, which ones are closely associated with
customers, the extent of nepotism, and so forth. This greater level of detail can yield
clues about how to manage the company, and how employees will react to the
acquirer. Issues to consider include:
• Types of employees. Obtain information about the number of employees in
the various functional areas of the company, such as production, materials
management, accounting, treasury, and so forth. When compared to overall
sales levels, this can provide clues to which areas are over- or understaffed.
• Key employees. As the team works its way through the due diligence
checklist, have them compile a listing of which employees actually operate
the business. This may run contrary to the formal organizational structure of
the company, since large clusters of staff may rely upon the knowledge or
experience of employees who are buried far down in the organization chart.
For example, they may be very productive salespeople, programmers, and
product developers. The team should identify the conditions under which
they are employed, and their propensity to leave if the company is acquired.
A reasonable way to define a key employee is one whose departure would
demonstrably damage the company, or who literally cannot be replaced.
• Customer linkages. Do any employees have such close contacts with
customers that they could take the customers with them if they were to leave
the company and go into business elsewhere? This is a particular problem in
specialized service industries, such as investment management, consulting,
and accounting services. This may be a real concern if employees have tak-
en customers with them in the past.
• Promotion tracks. Investigate any systems in place for tracking the suitabil-
ity of employees for promotion. This not only indicates the presence of an
excellent human resources system, but also gives the acquirer clues to who
might be promoted from within if it is necessary to terminate the employ-
ment of some existing managers.
• Total compensation. Compile the total cost of the top employees. This
means not only their base pay, commissions, bonuses, stock options, and
payroll taxes, but also benefits and any reimbursements for a variety of per-
sonal expenses. Be sure to include the cost of any support staff directly as-
signed to them. It may require a considerable amount of digging through the
accounts payable, payroll, and stock option records to compile this infor-
mation, but the result can be the discovery of some startlingly large pay
packages. This information can factor into who is to remain with the com-
pany following the acquisition, and what their compensation packages will
be. It may be useful to calculate this information for the past few months, to

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see if anyone has recently received outsized pay increases in anticipation of

the acquisition.
• Pay level philosophy. What is the company’s philosophy for the level of
compensation it pays to employees? Is it near the median pay rate for most
positions, or substantially higher or lower? If the pay rate is higher, does this
appear to be justified by lower employee turnover or productivity? Con-
versely, does a higher turnover rate appear to correlate to unusually low pay
levels?
• Pay history. Construct a chart detailing the last date when each person was
given a pay increase, and the amount of the increase. This is useful for esti-
mating future pay expectations.
• Pay freezes. If the target company has been in financial difficulty recently, it
may have imposed a pay freeze on its employees, with the promise of im-
mediate increases as soon as the financial situation improves. This creates
an expectation that the acquirer will immediately increase pay.
• Employment agreements. There may be agreements with some employees,
under which they are entitled to a certain amount of severance pay if the
company elects to terminate their employment. The team should locate all of
these agreements and document the amount of severance payments, in case
the acquirer decides to eliminate their positions or replace them as part of
the acquisition.
• Unions. Are some groups of employees within the company represented by
unions? If so, obtain a copy of the union contract and peruse it for scheduled
wage rate changes, work rule limitations, guaranteed benefits, and other
issues that may alter the costs of the business. In particular, look for re-
strictions on the ability of the company to outsource work or relocate facili-
ties. Also, if the union representation began recently, investigate whether
there were problems with the labor force that led to the union certification;
these problems may still exist, and be bothering the work force. Further, if
there has been a recent history of work stoppages and strikes, is the potential
recurrence of these problems sufficient to keep the acquirer from completing
the acquisition? Also, have there been any complaints to the National Labor
Relations Board in the past few years?

Tip: If the target company is about to engage in contract negotiations with a labor
union that represents a key part of its work force, it might be better for the acquirer
to wait for the negotiations to be completed. Doing so yields greater certainty about
the cost of labor, and also reduces the risk of buying a company that is about to
experience a strike.

• Discrimination claims. Are there pending discrimination claims against the

company? Has there been a history of such claims in the past? If so, are the
claims related to a specific person, or are they spread across the manage-
ment team?

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• Nepotism. Does the company employ relatives or friends of the family?

Nepotism is not necessarily a bad thing, as long as these employees are fully
qualified for their jobs. Nonetheless, if there is nepotism, be sure to pay
close attention to the performance of these individuals and their total com-
pensation. A possible issue is that they may act as a group, so the termina-
tion of one clearly unsuitable employee might lead to their departure en
masse.
• Conflicts of interest. Examine the contracts the company has with outside
parties, and see if any of those parties are owned by employees. This may
also involve the purchase or sale of fixed assets. For example, the CEO may
own the building in which the company is located, and is paid rent for that
usage. These arrangements may be acceptable, as long as the rates paid are
close to the market rate. However, if it takes considerable effort to uncover
the existence of a conflict of interest, that means the impacted employees are
likely benefiting from the relationship to an excessive extent.
• Recruiting problems. Are there any open positions for which the company
has been recruiting without success? If these are skilled positions, the find-
ing could be significant – it may be a position that is a bottleneck in the
company, and which is preventing it from generating additional sales. This
recruiting issue is usually found in the sales and engineering departments.
• Injury records. If the company is involved in manufacturing or distribution,
review its employee injury records. Does the business suffer from an inordi-
nately high proportion of injuries, or do workers’ compensation claims ap-
pear to be excessive? If so, consider bringing in a safety expert to review the
company’s facilities, and to estimate the cost of adding any needed safety
equipment, personnel, procedures, or training.
• Employee manual. Always obtain a copy of the employee manual. It should
contain a number of policies that impact the costs associated with employ-
ees, such as vacation and sick pay, vacation carry-forward, annual reviews,
jury duty, military pay, bereavement pay, severance pay, and so forth. The
team will also need this information to decide upon the extent to which the
acquirer should integrate its employment policies with those of the compa-
ny.

Due diligence on employees can be difficult, since much of the information about
employee knowledge and interrelationships is not formally maintained. This is a
particular problem if there are informal networks between employees strong enough
to possibly trigger a mass departure if one key person were to leave the company.
There is no easy way to uncover this information, other than lots of discussions with
employees.

Tip: If the senior management team is restricting contacts of the due diligence team
with other employees, this eliminates a major source of information for the team,
and may be sufficient cause for the termination of acquisition discussions.

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Employee Benefits
Benefits would be of concern to the due diligence team if only because they are such
a large expense. In addition, they can present a problem if there is a large disparity
between the benefits granted to the employees of the acquirer and the company,
especially if the acquirer is intent upon standardizing benefits across the entire
organization. Consider those two issues as you peruse the following due diligence
topics:
• Benefits. What medical insurance is offered to employees, and what portion
of it must be paid by the employees? Is any insurance also offered to retir-
ees? How do these benefits compare to what is offered to employees else-
where in the acquirer’s businesses? Is the standard amount of benefits of-
fered in the target company’s industry different from what is offered in other
industries in which the acquirer competes? If there are significant differ-
ences in the benefit plans offered within different industries, the acquirer
may need to offer a different benefit plan to the employees of the company.
• Undocumented benefits. Does the company have any informal benefits that
might be expected to continue after the acquisition, such as Christmas bo-
nuses, retirement gifts, or free turkeys at Thanksgiving?
• Pension plan funding. If there is a defined benefit pension plan, ascertain
whether the plan is underfunded, and if so, by how much. Also, review the
assumptions used to derive the level of funding; it may contain optimistic
assumptions concerning the future return on investments that are unlikely to
be achieved in practice. The potential amount of liability in this area can be
enormous, so be sure to engage in a thorough review.
• Vacations. Determine the amount of vacation time to which each employee
is entitled, and how that compares to the industry average and the compa-
ny’s stated vacation policy. It is possible that unusually lengthy vacation
periods have been allowed for key employees or friends and family, which
may be a problem from the perspectives of both overall cost and the ability
of the acquirer to standardize its vacation policy across the entire company.
• Unusual perquisites. Do employees, or perhaps just the senior management
team, receive unusual benefits? For example, there may be a company con-
dominium at the local ski resort, free meals at the cafeteria, or a company
jet. Compile the cost of these items, and also estimate the reaction of em-
ployees if the acquirer eliminates them.

Financial Results
The first type of information that many acquirers request is the financial statements,
since they show the financial results, current financial position, and cash flows of the
business. In short, they represent the financial health and productivity of the
organization. However, the financial statements are presented at an aggregate level,
so it is only possible to draw general conclusions from them. The team must dig
deeper, using the additional items noted in this section, to arrive at a thorough

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understanding of the financial aspects of a business. Key financial issues to address

include:
• Annual financial statements. Ideally, there should be financial statements for
the past five years, which the team should translate into a trend-line compar-
ison for the full five years. Doing so makes it easier to spot long-term
changes in the business. In addition, at least the most recent fiscal year’s
financial statements should be audited; this means that an outside auditor
has examined the accounting records for that period, and judges the infor-
mation shown in the financial statements to fairly represent the results and
ending financial position of the company.

Tip: Any financial statements other than audited ones are suspect. Reviewed
financial statements involve only a cursory review by an auditor, while a
compilation does not provide any assurance that the statements were examined.

• Monthly financial statements. Obtain all financial statements for each month
of the year-to-date. This gives the team a good view of short-term trends in
the business. It may also be useful to obtain the monthly results for the pre-
ceding year, just to obtain an idea of the seasonality to which the business is
subjected over a full year. Seasonality could be important, if the acquirer
finds that it may need to provide funding to the company at certain times of
the year when its cash flow is negative.

Tip: If the company has not supplied financial results for the last few months, this is
evidence that the business may be suffering a financial decline. It is especially likely
if the business is withholding this information because it is concerned about
“confidentiality”. Therefore, do not complete due diligence without financial
statements that are current through the immediately preceding month.

• Cash flow analysis. A key part of the financial statements is the statement of
cash flows. This document reveals the sources and uses of cash. Be mindful
of the information in this report when you are reviewing the income state-
ment, for the target may report substantial profits even while burning
through its cash reserves. Investigate the statement of cash flows for unusual
one-time payments, such as owner distributions or asset purchases from
related parties.
• Cash restrictions. Is cash restricted from use in any way? For example, the
local bank may have issued a performance bond on behalf of the company,
and has restricted a corresponding amount of the company’s cash. Another
example would be a cash restriction in order to fund a letter of credit. These
restrictions can severely impact the amount of cash that an acquirer might
expect to extract from an acquisition transaction.
• Non-operating results. Identify all non-operating transactions that arose
during the review period, and strip them out of the financial results to see

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how the core operations of the business performed. This includes extraordi-
nary income and expenses, proceeds from insurance claims and legal settle-
ments, gains or losses on asset sales, and so forth.
• Expenses categorized as non-operational. A company may shift expenses
into a non-operational expense category, such as extraordinary expenses, in
order to make its earnings from operations look more impressive. Be sure to
examine all expenses claimed to be non-operational, and reclassify them as
operational, if necessary.
• One-time events. See if there were any operational events that are unlikely to
occur again, and strip them out of the results of operations. This is a com-
mon problem for one-time sales to large customers, such as the sale of a
large number of software licenses to the federal government. This is a par-
ticular problem, because target companies have an annoying habit of putting
themselves up for sale immediately after such sales, on the assumption that
buyers will assume a continuing sales level in the future, and accordingly
pay a higher price for the business.
• Adjusting entries. Examine the financial statements for unusual adjusting
entries that have been used to prop up the results of the business, such as
accrued revenue, expenses shifted into a prepaid expenses account, or liabil-
ities that were not accrued.

Acquisition Story: The author once reviewed the financial statements of a software
development company as part of a due diligence investigation, and found an unusual
$1 million asset on its balance sheet for internally developed software. The
company’s management team had decided that its latest product was worth $1
million, so it recorded the asset; doing so also changed its equity balance from a
negative to a positive number.

• Restructuring charges. The target may have created an expense accrual for
restructuring charges, which is essentially the pre-recognition of expenses
that do not happen until a future accounting period. This is a warning flag
that managers are reducing expenses in future periods, possibly to spruce up
profits in anticipation of a sale.
• Disclosures. Audited financial statements should include a set of disclosures
on various topics. Review these disclosures in detail, since they can reveal a
great deal more information about a company than is shown in its income
statement and balance sheet.
• Public filings. If a company is publicly-held, it must file the Form 10-K
annual report, Form 10-Q quarterly report, and a variety of other issues on
the Form 8-K. All of these reports are available on the website of the Securi-
ties and Exchange Commission, which is www.sec.gov. These documents
are a treasure trove of information, and describe the results of a business in
considerable detail.

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• Management letters. After an audit has been completed, the auditors

sometimes compile a set of recommendations into a management letter,
which they distribute to the CEO and audit committee. Any such letters
issued for the past few years are worth reading, since they contain sugges-
tions to rectify deficiencies found in the company’s practices.
• Margin analysis. Nearly every viable business has one product, product line,
or business segment that generates outsized profits in comparison to the rest
of the company. The team needs to find this “golden goose,” to ensure that
the acquirer does not take any steps following the acquisition that will inter-
fere with its flow of profits. Conversely, this analysis may also reveal a
number of other aspects of the business that consistently lose money. In
short, margin analysis can be used in entirely different ways – to bolster
profitable parts of the business and restructure or even shut down money-
losing operations.

Tip: When calculating profitability for any portion of a company, it is generally best
not to allocate overhead to it, unless the overhead is generated by that portion of the
company. Otherwise, the resulting profits will be distorted, and not reveal the true
profitability of the underlying operations.

Near the end of the due diligence investigation, adjust the reported results of the
company for any synergies found, resulting in pro forma financial statements that
reveal what its financial results would have been for the past year if the acquisition
had taken place at the beginning of the year. Pro forma financial statements are the
complete set of financial statements issued by an entity, incorporating assumptions
or hypothetical conditions about events that may have occurred in the past or which
may occur in the future. If there is some concern about the ability to implement
certain synergies, then prepare pro forma statements based on best case, most likely,
and worst case scenarios.
After constructing the pro forma financial statements, also develop a one-year
cash flow forecast for the business, incorporating the best estimates of revenues and
changes caused by synergies. This information is needed to ensure that the target
will begin generating sufficient cash flows to make it worthwhile to proceed with the
acquisition.

Internal Reports
A potentially useful source of information for the team can be the internal reports
used by the management group – not necessarily because of what they contain, but
because of what they do not contain. In particular, see if there is a reporting system
in place that shows the contribution margin associated with each sales territory,
store, product line, and/or product. Contribution margin is the margin that results
when variable production costs are subtracted from revenue. If the company does
not have this information, it means there may be an opportunity for the acquirer to

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conduct a margin analysis and prune away unproductive parts of the business,
thereby generating an immediate improvement in cash flow.

Revenue
One of the most important due diligence areas is the future revenue stream, since
this is the foundation upon which most acquirers construct their expectations for a
business. As you will see from the following list, the revenue topic is comprised of
many issues. They are:
• Backlog. Ascertain the total amount of backlog, by month, for at least the
past year. This may reveal an increasing or decreasing backlog trend, which
is a strong indicator of near-term revenue levels. Also, divide the total back-
log amount into the average amount of monthly sales to arrive at the months
of sales in backlog metric; this is a useful leading indicator of future reve-
nues.
• Fulfillment issues. Is the company having any issues fulfilling its obligations
under some of the backlogged orders? This may relate to supply chain prob-
lems, production bottlenecks, or unusually strict customer approval proce-
dures. To what extent do these issues reduce the size of the backlog? Could
these problems expand to other orders within the backlog? If so, the backlog
may not represent as much short-term revenue as would normally be the
case.
• Recurring revenue stream. A key value driver in a business is its recurring
revenue stream. Determine the amount of baseline revenue that can be ex-
pected to arise on an ongoing basis. Also, consider whether this revenue is
based on subscriptions that lock buyers into longer-term purchases, or are
one-time purchases that happen to occur with considerable regularity.
• After-market sales. Investigate the profitability of after-market sales, which
involve the sale of replacement parts, upgrades, field service, maintenance,
and so forth. These sales can be enormously profitable, and in some cases
may exceed the total profits of the product lines upon which they are found-
ed. Also, does it appear that there is room for expansion of this line of busi-
ness? Given the high profit levels, an acquirer could generate easy profits by
expanding these types of sales.
• Customer changes. In the past three years, what changes have there been
among the company’s top ten customers for each product line? The intent of
this analysis is to see if there is a net decline or increase in larger customers,
which is an indicator of the general trend of sales.
• Available regions/channels. Are there any likely geographic regions or
distribution channels that the company has not yet entered? Attempt to
quantify the sales and margins likely to result from entry into these areas.
The result of this analysis is an estimation of the future growth potential of
the company, given its current set of product and service offerings.
• Pricing philosophy. How does the company set prices? Does it add a
percentage profit to its costs, or charge based on the value of the underlying

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product, or set its prices based on those of competing products? Does it po-
sition its prices somewhat low, to follow a value strategy, or somewhat high,
to follow a premium pricing strategy? If the team suspects that a different
pricing strategy could translate into higher profits, this could impact the
discussion of possible synergies.
• Pricing rigidity. Is there a history of how customers have reacted to price
increases in the past? Is it reasonable to expect the company to pass through
cost increases to its customers? Is there a competitor whose lower prices
might attract customers in the event of a price increase?
• Pricing variations. Is the sales staff allowed to diverge from stated prices? If
so, is there a standard policy for it? Is there evidence of significant depar-
tures from standard pricing, and if so, how prevalent is it? These issues may
be acceptable, if they are necessary to retain larger customer orders. Howev-
er, continual departures from standard prices are indicative of either exces-
sively high standard prices or poor pricing discipline among the sales staff.
• Estimating. Does the company have an estimating department that derives
prices for customized services or products? If so, examine the model for
soundness, and investigate whether the company has persistently lost money
on incorrect estimates in the past.
• Contract terminations. If revenues are derived from customer contracts,
obtain copies of the larger contracts and determine the remaining stream of
payments related to them, when they expire, and the likelihood of obtaining
follow-on contracts. Contract-based revenue has more value if there is a
long history of contract renewals.
• Accounts receivable. Review the most recent accounts receivable aging
report to see if there are any customer invoices that are overdue by unusual-
ly long periods of time, and find out the reasons why. If substantial, these
receivables may reduce the valuation that the acquirer assigns to the compa-
ny.
• Product life. Though subjective, make an estimation of the likely remaining
lifespan of each product. This may be based on historical records for previ-
ous products. Product life is a particularly important topic if a product might
be considered part of a fad, or subject to sudden changes in fashion.
• Franchises. If the company is in the franchising business, what is the annual
turnover of franchise ownership? What is the growth rate in franchise own-
ership? What has been the trend line of average franchise fees per franchise
for the past five years? This line of inquiry is intended to give some perspec-
tive on the likelihood of future changes in revenues.

Most of the avenues of investigation in this section are designed to use sales and
backlog information from the recent past to extrapolate what revenues might look
like in the future. This is an extremely inexact science, and could yield spectacularly
incorrect results. Consequently, the team needs to call upon its sources of
information not just in the company, but also for the industry as a whole, to make its
best estimates of future revenues.

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Cost Structure
A key area of concern is the cost structure of the company. This requires more than a
quick glance through the income statement. Instead, the team should consider the
following types of analysis to obtain a better understanding of how the business
operates:
• Target costing. Does the company have a system in place for managing the
cost of its products while they are still in development? This is an excellent
sign that the company is capable of avoiding excessive cost overruns on its
products, and so can achieve reasonable profitability levels. If such a system
is in place, investigate whether the design team includes members of the
marketing, purchasing, and industrial engineering departments, so that it is
creating products most likely to meet customer requirements, incorporate
low-cost components, and be designed for optimal manufacturing processes.
• Expense trends. Load the company’s income statements for the past five
years into a spreadsheet and create trend lines from this information as a
percentage of sales, to see how expenses are trending. If there are unusual
cost increases, ascertain the reasons for them.

Tip: Verify that all intercompany revenues and expenses between the subsidiaries of
the target company have been stripped out. Otherwise, they skew the results shown
in the financial statements.

• Core expenses. In addition to the expense trends just noted, investigate any
declines in expenses in areas where the company should be spending in
order to have a sustainable business. In particular, look for declines in
equipment maintenance, advertising, and research and development. An
even larger red flag is when these expenses have declined in just the past
year, which indicates that senior management deliberately elected to cut
expenses in order to improve the company’ reported cash flow for a pro-
spective sale.
• Retainer fees. Look for periodic retainer fees paid to legal, accounting, and
consulting firms for any number of services. Many of these can be eliminat-
ed, if the acquirer is already paying its own group of experts. Some of the
fees may also be made to outsiders who are friends or family, in exchange
for no discernible services. These fees can be a rich source of synergy sav-
ings.
• Questionable expenses. Review certain expense accounts for questionable
expenditures. These typically relate to such items as personal expenses
charged through the company, reimbursing employees for medical deduc-
tions, or excessive travel costs. The team can find this information in the
travel and entertainment, consulting, supplies, and benefits expense ac-
counts. At a more detailed level, some of this information can be found in
employee expense reports. This is useful information, not only for learning

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about the extent of favoritism and nepotism in a business, but also because it
represents a potential future expense savings.
• Loans to employees. Determine the amount of any loans extended to
employees. It is acceptable if these are small payroll advances for a short
period of time. However, if they are long-term loans under which little or no
repayment has been made, treat them as expenses that reduce the profits of
the company, and which therefore reduce the valuation of the business.
• Fixed assets. A key part of the cost structure of a business is its fixed assets.
If there have been few fixed asset replacements in recent years, it indicates a
lack of attention to the future competitiveness of the business. If a reduced
level of investment is evident, then the acquirer should reduce the valuation
of the company by the amount of extra investment it will have to make to
bring the fixed asset base back up to a reasonably operable level.
• Breakeven point. Calculate the sales level at which the business breaks even.
This is a function of the amount of fixed expenses that the business incurs
each month. A smaller amount of fixed expenses translates into a lower
breakeven point, which makes it less likely that the company will incur loss-
es at lower revenue levels.

Intellectual Property
In some industries, the majority of the price paid for a business is based on its
intellectual property (IP). This asset is usually not listed on a company’s balance
sheet, so the due diligence team needs to conduct a considerable amount of
investigation to determine what types of IP are owned by the business, and what it
might be worth. Consider the following due diligence tasks:
• Patents. Does the company have any valuable patents? It is extremely
difficult for a due diligence team to have sufficient technical knowledge to
sort through the various patents owned by a company, and figure out which
ones are truly valuable. It will likely require either an outside expert or the
services of the acquirer’s own R&D department to make this determination.
• Patent ownership. Verify that all patents are owned by the company. If not,
they are probably owned by an employee who licenses use of the patent to
the company. The latter situation provides no value to the business, and
presents the risk that the patent owner could retract usage rights. A related
issue is whether anyone has filed suit regarding ownership of the intellectual
property. If the case being made is reasonable, the acquirer must evaluate
whether the resulting loss of intellectual property could have a notable im-
pact on the value of the business.
• Trademarks. Has the company registered its trademarks? If not, see if
someone else is using them, and whether they have trademarks or have ap-
plied for them. In the latter case, the company may need to rebrand itself
and/or its products.
• Licensing income. Determine the size of any licensing income that the
company generates by licensing its patents to third parties. If there is little or

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no licensing income, this could be an opportunity for the acquirer to absorb

the patents into its own patent portfolio and aggressively market them to
third parties.
• Licensing expense. A company may have licensed critical intellectual
property from another party. If so, evaluate the time period left on the li-
censing agreement, as well as the ability of the licensor to retract permission
to use the license in the future.

Fixed Assets and Facilities

Fixed assets and facilities can be an enormously important topic in an asset-intensive
industry, or only of passing interest in more service-oriented businesses. The
following list assumes that the target company is in the former situation:
• Valuation. The net book value of fixed assets as recorded in a company’s
accounting records has nothing to do with what they are actually worth if
they were to be sold on the open market. If the acquirer intends to sell any of
these assets, the team should obtain a rough estimate of their value. This
may call for the services of a third-party appraiser. If the acquirer elects to
proceed with the acquisition, an appraisal will also be useful for assigning
part of the purchase price to the fixed assets in the accounting records.
• Equipment and facilities for sale. If the company has been trying to sell its
equipment or facilities for some time, compare their condition and price to
the market rate (which may require the services of an appraiser). The inves-
tigation will likely reveal that these assets are worth considerably less than
their net book value. This may impact the acquirer’s valuation of the busi-
ness.
• Inspection. Trace the fixed asset register to the fixed asset balance appearing
in the company’s general ledger to verify that it is complete, and then trace a
selection of the items on the register to the actual fixed assets. The point of
this inspection is to prove the existence of the most essential and/or valuable
fixed assets.
• Bottlenecks. If the company has its own manufacturing facilities, have a
production expert examine them to determine if there is a bottleneck, and
the extent to which it may be impacting the profitability of the business. The
acquirer may be able to alter the production configuration or outsource some
manufacturing, thereby increasing the profitability of the business.
• Utilization. Conduct a review of the more expensive fixed assets to see if
any are no longer in use. If such assets exist and they are not needed to sup-
port peak production periods, then note these items as being potentially
available for sale. In the case of facilities, someone from the team should
visit each one to determine the level of utilization. This is particularly im-
portant for warehouse space, some of which may be eliminated through the
reduction of inventory and other assets.
• Replacement rate. Review the company’s fixed asset replacement history
for the past five years. Has it replaced assets at a consistent rate, or is it fall-

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ing behind? If there is a declining investment in fixed assets, this issue

should attract detailed attention from the team. In a worst-case scenario, the
team may conclude that the existing fixed assets need complete replacement
in the near future, which impacts the price the acquirer will pay for the ac-
quisition.
• Maintenance. Have an experienced maintenance person examine the
machinery in the production area, as well as their associated maintenance
records, to see if maintenance levels have been adequate. In addition, inves-
tigate the presence of a preventive maintenance program. If maintenance
levels appear to have been inadequate, the team should estimate the cost
required to bring maintenance levels up to the acquirer’s standards. The
same issues apply to any buildings owned by the company.

Acquisition Story: The author was investigating the fixed asset records of a
software company, and found that a number of burial plots at nearby cemeteries
were listed. Upon further investigation, we found that the owner’s husband thought
that burial plots were a good investment, and had been purchasing them with
company money.

• Square footage. Divide the number of employees in an administrative

facility by its total square footage to determine the square feet per person. If
the result is a larger number than the acquirer has in its facilities, there may
be an opportunity to eliminate some facility space or put it to some other
use.
• Title records. Verify that the company has clear title to all property owned.
• Third party ownership. Is there any equipment in the company’s facilities
that is owned by a third party? These items may be removed by the owner in
the event of a change in control.

Liabilities
When reviewing the liabilities noted in this section, be sure to examine the payment
schedules and acceleration clauses associated with them. The acquirer does not want
to be surprised by a near-term balloon payment on a debt, or the acceleration of
payments that were triggered by a change in control of the business. The issues to
examine are:
• Accounts payable. Review the most recent aged accounts payable report to
see if there are any overdue payables, and find out why they have not been
paid.
• Leases. Determine if any equipment leases have bargain purchase clauses
that allow the company to buy assets at the end of the lease period for be-
low-market prices (such as $1). If so, make note of them so the acquirer can
take advantage of the purchase clauses when their exercise dates arrive.

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• Debt. Review the debt agreements associated with outstanding debt and see
if there are any clauses that accelerate payment in the event of a change in
control of the business. Also, there may be personal guarantees on debt that
must be removed before the current owners will consent to sell the business.
In addition, verify that the company is complying with any covenants in-
cluded in the debt agreements. In all likelihood, the acquirer will need to pay
off all debt as part of the acquisition, or arrange for replacement debt
agreements with the current or other lenders.

Tip: Investigate the outstanding debt of the target company as early in the due
diligence process as possible. The reason is that the target company’s lenders may
have the right to accelerate payment when there is a change in control. If the
acquirer cannot pay off these loans at once, then it may be necessary to enter into
protracted negotiations to give the lenders sufficient collateral and guarantees to
convince them to let their debt remain outstanding.

• Debts to related parties. Have managers, owners, or shareholders loaned

money to the company? What are the terms of these agreements, and do
they contain any clauses under which the other party can convert the debt
into the company’s common stock? These debts will likely need to be paid
off as part of the acquisition.
• Bonds. If the company has issued bonds, obtain the documents used to
create them, as well as a list of holders. This is particularly important if the
bonds are convertible into the company’s common stock, since this may
potentially alter the ownership of the business.
• Factoring. Review any factoring arrangements with lenders. Factoring is the
sale of receivables to a finance company. Under the arrangement, the cus-
tomer is notified that it should now remit payments to the factor. The factor
assumes collection risk. These arrangements typically carry high interest
rates, so the acquirer will probably want to terminate them in favor of other
types of financing.
• Warranties. Examine customer claims records that resulted in the replace-
ment or repair of products during the past year to determine if there are
product flaws that could result in significant expenditures in the future. Al-
so, compare warranty-related expenses to revenues over the past year, and
extrapolate that forward, based on future sales estimates, to determine the
likely amount of future warranty expenses. If warranty costs appear to be
high, then compare the warranty terms to those offered elsewhere in the
industry, to see if the terms are excessively generous.
• Earnouts. If the company has acquired other businesses in the past, does it
have any potential earnout liabilities to the shareholders of the acquired
companies? For more information about earnouts, see the Valuation of the
Target chapter.

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• Unrecorded liabilities. Use interviews with the employees and business

partners of the company to uncover unrecorded liabilities. They may include
potentially adverse outcomes of lawsuits, guarantees on behalf of third par-
ties, self-insurance, and contingent fees. Include in the due diligence docu-
mentation even those liabilities considered less likely, so that senior man-
agement can estimate the full impact of an outlier liability occurring.
• Collateral. Verify which assets have been designated as collateral by
lenders. The acquirer will need to have these liens released as part of its
likely termination of debts to lenders when the acquisition is completed.

It is generally easy enough to examine the liabilities that a company has recorded;
the problem is finding the liabilities that it has not recorded. Consequently, pay
particular attention to the “unrecorded liabilities” task noted in this section.
Unrecorded liabilities are usually contingent ones, and can be of considerable size.

Equity
The attorneys who create acquisition purchase agreements are very particular about
the target company’s shareholding information, since they must incorporate it into
the document. Consequently, be especially carefully when assembling and reviewing
the information noted in the following points:
• Shareholder list. Obtain a list of all shareholders of the company, along with
the share holdings of each one. Inquire about whether any of the larger
shareholders have been difficult to deal with; they may cause trouble if there
is a shareholder vote for the acquisition.
• Classes of stock. Verify the stock ownership of all classes of stock, as well
as the voting rights associated with each class. It is particularly important to
determine whether the ability to approve the acquisition is concentrated with
a few shareholders in a particular class of stock.
• Shareholder purchase price. Shareholders will be much more likely to vote
in favor of an acquisition if the purchase price translates into a gain on their
investment. Accordingly, find out the price per share at which the control-
ling shareholders bought into the company.
• Conversion rights. Examine all debt agreements to see if the debt holders
have the right to convert the debt to shares in the company. See if the ex-
pected price per share is likely to trigger any conversions to stock, and what
this will do to the controlling interest in the business.
• Options and warrants. Determine the amount of any stock options and
warrants outstanding, and when they expire. Options and warrants give their
holders the right to purchase shares of company stock at a certain price
point. See if the expected price per share is likely to trigger the purchase of
any stock.
• Unpaid dividends. If dividends have been declared but not paid, this
becomes a liability of the acquirer. Also, if there is preferred stock that has a

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set annual dividend percentage, verify that there are no unpaid, cumulative
dividends due to investors.
• Stock buyback obligations. Has the company committed to repurchase the
stock of any shareholders? If so, at what price and by what date?
• Employee stock ownership plan. Does the company have an ESOP? If so,
determine the number of company shares held by it, and obtain a copy of the
agreement under which it was created.

Taxes
One of the more critical areas worthy of investigation is the tax liability of the target
company. If the acquirer were to buy a business that has undocumented tax
liabilities, it could be incurring potentially massive liabilities that have penalties and
interest charges attached. Also, there are a large number of taxes for which a liability
could be incurred, not just income taxes. A target company may have failed to pay
its property taxes, payroll taxes, sales and use taxes, value-added taxes, and/or
franchise taxes – all of which could be substantial. The scope and severity of the
potential problem makes taxation due diligence a high priority item.
There are three issues with due diligence for taxation, each involving a different
level of effort to investigate. They are:
• Is the company continuing to pay taxes? This is an easy question to resolve.
If a company has been paying taxes in the past, then review its accounts
payable records to verify that payments are continuing to be made. Be par-
ticularly careful to ascertain the date of the most recent tax payment, to see
if the next scheduled payment will be before or after the planned acquisition
date.

Tip: The risk of incurring unpaid payroll taxes is substantially reduced if a company
has outsourced its payroll processing, since the supplier of this service should have
ensured that payroll taxes were remitted on time and in the correct amounts.

• Is the company paying the correct amount of taxes? Just because a company
is remitting tax payments does not mean that those payments are correct.
Accordingly, the team should audit the calculations used to derive a sam-
pling of tax payments, to see if the payments were calculated correctly. It is
preferable to audit more recent tax remittances, since those are the ones
more likely to be subjected to government audits.
• Are there undisclosed tax liabilities that have never been paid? This is by
far the most difficult tax due diligence task, for it addresses the complete
absence of tax payments. For example, does a target company have nexus in
a state, which means that it should be withholding sales taxes there? Or, is
the company liable for use taxes to the government where its facilities are
located? Or, has the company neglected to pay franchise taxes in states
where it does business? The due diligence team can burrow into these issues
for a long time, and still not detect all of the potential tax liabilities.

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If a company has facilities or subsidiaries in many states or countries, it is entirely

possible that there are several tax issues that may not become apparent until after an
acquisition has taken place. If so, it can easily take an additional year for the
acquirer to resolve the issues and pay any required fines. Despite the cost and
general annoyance level associated with these issues, it can be difficult to spot them
in advance. In short, a serial acquirer is likely to encounter unanticipated tax
problems, irrespective of the level of investigation conducted by its due diligence
teams.
There may have been tax audits in the past few years. If so, obtain documenta-
tion about why the audits were conducted, and their outcomes. In some cases, a
government authority may schedule an audit just to fish for extra tax revenue, while
in other cases they are searching for specific tax violations.
Another issue is the presence of any tax loss carry forwards held by a company.
These losses were generated in previous years, and can be applied against the
earnings (if any) of that business in future years. The IRS strictly limits the uses to
which these tax loss carry forwards can be used by an acquiring business with its
Section 382 limitation. In essence, an acquirer can only use the carry forwards in
very small amounts per year, and then only if the acquired entity earns a profit
against which the carry forwards can be offset.
The calculation of the tax loss carry forward that can be used by an acquirer is
the value of the acquired entity immediately before the change in ownership,
multiplied by the highest of the federal long-term tax-exempt interest rates (based on
the average market yield on obligations of the United States with remaining periods
to maturity of over nine years). The following example illustrates the concept:

EXAMPLE

High Noon Armaments is conducting due diligence on Armadillo Security Armor, and learns
that Armadillo has $840,000 of tax loss carry forwards. The price that High Noon expects to
pay for Armadillo is $2,500,000, and the interest rate on the highest of the United States
treasury bonds is 4.2%. The annual amount of the tax loss carryforward that can be used by
High Noon to offset any future profits generated by Armadillo is calculated as:

$2,500,000 company valuation × 4.2% interest rate = $105,000 carry forward usable per year

Thus, it will take eight years for High Noon to use up the tax loss carry forward, assuming
that it continues to operate Armadillo as a separate entity and that Armadillo generates at
least enough profits each year to offset the carry forwards.

The due diligence team should communicate to High Noon’s management the amount of the
tax loss carryforward and the amount that High Noon could probably use each year if the
company were to proceed with the acquisition. This information may alter the valuation
assigned to Armadillo, as well as the decision to continue operating it as a separate entity.

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Tip: If an acquired business has a large tax loss carry forward, the acquirer must
continue to operate the acquired business under its existing employer identification
number in order to take advantage of the carry forwards at a later date. If the
acquirer elects to dissolve the business and move its various components into the
rest of its operations, then it will lose the carry forwards.

In short, it is useful to determine if there is a tax loss carry forward, but it should not
heavily impact the decision-making related to the acquisition.
Another issue is the presence of any tax disputes currently going on with a
government entity. If there is one, discuss the issue with the company’s tax advisor,
and estimate the monetary impact if the dispute is settled against the company.
A final consideration is whether the company has an aggressive strategy to avoid
or delay tax payments. If so, does this strategy contribute to a large part of its cash
flow? If the acquisition is completed, will the acquirer be able to continue the
strategy, or is it more likely that the cash flow derived from that strategy will
evaporate? Generally speaking, it is unwise to acquire a business when a large part
of its performance is derived from clever tax strategies; governments may alter their
tax laws at any time, rendering these strategies useless, and thereby eliminating
much of the value in the business.
In general, the key issue in regard to taxation due diligence is whether the tax
liability of the acquiree can be reasonably estimated. If there is significant doubt
regarding the amount of liability outstanding, it may make considerable sense to
engage in an asset purchase, thereby sidestepping all potential tax liabilities.

Tip: Ascertaining the extent of a company’s tax liabilities is one of the slowest due
diligence tasks, since information may have to be dredged up from the archives or
from third parties. This is a particular problem if the target company has itself
completed several acquisitions recently, in which case the investigation must
encompass the tax liabilities of the acquired entities. Given this delay, it makes sense
to begin tax due diligence as soon as the due diligence effort begins, and expect to
pursue it until the end of the due diligence period.

Accounting Policies
The financial results of a company may be skewed by its accounting policies to such
an extent that they are misleading to the acquirer. This is a particular problem if the
financial statements provided by the company have not been audited. The due
diligence team can detect these issues by discussing accounting policies with the
accounting department. Here are several areas to be aware of:
• Gross or net revenue treatment. The company may be recording the entire
amount of a sale as revenue, when in fact it was acting as an agent for a
third party, and so should only record a commission on sales. This issue can
create enormous differences in revenue levels.

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• Timing of revenue recognition. If there are some residual services to be

provided to a customer under a contract, it is possible that the company must
delay its revenue recognition until those services have been completed. The
same issue applies if payment by the customer is very uncertain. If the com-
pany is not delaying its revenue recognition in accordance with accounting
standards, its reported revenue will be too high.
• Percentage of completion recognition. A company may use the percentage
of completion method to recognize revenues and expenses associated with
projects that it cannot yet bill to the customer. It is essential to investigate
the company’s justification for the percent complete for each large contract,
since inaccuracies in the percentage (which is a subjective number) can
yield inaccurate revenue and profit recognition.
• Transfer pricing. If goods or services are shifted between the divisions of a
company, there should be a policy for setting the price at which they are
transferred. This price may be anywhere from (at the low end) the variable
cost of the items transferred to (at the high end) their market price or fully
loaded cost. The team should be aware of this policy when determining the
profits generated by each division.
• Inventory cost layering. Profit levels can be impacted by the cost layering
method used to record inventory. The last in, first out method tends to yield
lower-than-normal profits, while the first in, first out method tends to yield
higher-than-normal profits.
• Receivable write-off method. If a company uses the direct write off method
to remove bad debts from its accounts receivable, this is delaying the recog-
nition of bad debts. It should instead be using the allowance for doubtful
accounts, which accelerates the recognition of bad debts.
• Depreciation. Smaller organizations sometimes wait under year-end to
record their depreciation expense for the entire year. If so, the monthly re-
sults prior to that point will not contain depreciation, and so will state exces-
sively high profits. Also, an accelerated depreciation method can result in
unusually low reported profit levels, even though cash flow may be quite
good.
• Accrual usage. A company should accrue expenses at the end of each
reporting period if the expense has been incurred, even if no related supplier
invoice was received or payment issued. If accruals are not being used, or
only to a limited extent, then expenses will be understated. There should be
expense accruals for unpaid wages, supplier services or goods received,
various expense reserves, and earned but unused vacation and sick pay.

If there are differences between the accounting policies of the acquirer and the target
company, then the financial statements of the target should be adjusted to match
those of the acquirer.

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Product Development
Product development is one of the most difficult areas in which to conduct due
diligence, for the team is being asked to render opinions on incomplete products that
are still in the development pipeline. Since these projects are not yet complete and
have no related sales information, it is only possible to render an educated guess
about the performance of the process and the resulting products. The following due
diligence activities can bring some clarity to the situation:
• Product success. Does the company have a history of releasing a string of
successful products, or does it have a more inconsistent record? If it has
been successful, then investigate why this is the case, and if its prior success
is likely to be repeated. The underlying factors are likely to include excellent
product designers, and may be supported by the organizational structure,
processes, and robust funding of research and development activities.
• R&D expenditures. The company should be expending a consistent and
noticeable fraction of its cash flow on research and development activities.
The team should divide these expenditures into those assigned to product
extensions, to new products within an existing product line or industry, and
to new products located in entirely new areas. These divisions show expend-
itures in increasing areas of risk and reward. It is also useful to compare
total R&D expenditures as a percentage of sales or cash flows to the same
metrics for the entire industry.
• Product delays. Are there any products for which completion dates have
been continually pushed further into the future? The team should obtain
clarification of their status, since it is possible that they will never be re-
leased to the market. If the company has a history of product delays, this
reveals a great deal about the inefficiency of the development team.
• Technology orientation. Is the product design staff oriented toward the use
of a certain type of technology? Does it appear that the market is shifting
away from that technology? Is the company taking any steps to address this
issue? Problems in this area could have a serious impact on the future viabil-
ity of the business. The team will probably have to bring in an expert to
evaluate this issue.
• Target costing. Does the company use target costing teams to continually
monitor product costs during the development process, and match costs to
desired product features? A robust target costing system is a strong indicator
of a company that routinely creates products that meet their gross margin
targets.
• Warranty claims. The team should examine the warranty claims database
and warranty claims expense to compile a list of product issues, and then
investigate what the engineering group is doing to fix them. The team may
need to determine if some product flaws are so severe that they could scuttle
the acquisition because of the risk of product liability.
• Product recalls. Has there been a product recall within the past five years?
If so, examine the underlying problem, and the steps taken to correct the

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issue. If the product design or production environment has not changed suf-
ficiently since then to avoid another product recall, this is reasonable
grounds for terminating the acquisition; the cost of a product recall can be
enormous.
• Product liability. Have there been significant lawsuits against the company
in the past regarding the failure of its products? Can these products cause
injuries? Or, if there have been no lawsuits, have there been ones against
other firms in the same industry? If the acquirer buys the company, it inher-
its these potential liabilities.
• R&D leadership. Is the company considered a leader in product develop-
ment, or more of a “me too” product follower that only adjusts product con-
cepts that already exist in the marketplace? If it is considered a leader, then
the engineering staff may contain a number of high-end product designers
who should be considered extremely valuable. In the latter case, the acquirer
will need to ensure that it retains the services of the R&D group after the
acquisition has been completed.

Selling Activities
A key focus of due diligence in the sales department is the efficiency with which
sales are made. In particular, the due diligence team should review the following
items:
• Organization. How is the sales department organized, and how does it make
sales? For example, is the organizational structure based on sales territories,
distributors, retail stores, the Internet, or some other approach?
• Productivity. Match sales records to sales personnel or storefronts to
determine which sales people and/or stores are the most and least profitable.
Is there an opportunity to prune some staff or stores? Should anything be
done to support the top salespeople or bolster the results of over-achieving
stores?
• Compensation plan. How is the sales staff compensated? What is the mix of
salaried versus commission pay, and how does it change over time as a per-
son transitions from sales trainee to salesperson? Does the reward system
properly motivate the sales staff? A sign of a poor compensation plan is a
high level of salesperson turnover. This can be a very difficult area to
change, especially if the sales staff is accustomed to a generous compensa-
tion plan.
• Skills match. Some products require a relatively non-technical sale that can
be assigned to someone with little background training. Other products re-
quire a much more detailed sales process that involves a more experienced
and well-trained sales technician. The team should review the types of sales
occurring, and the skill level of the sales technicians assigned to them. It is
quite possible that excessively skilled people are being used for some sales,
which increases the overall cost of selling.

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• Bottlenecks. The selling process may involve multiple steps, such as an

initial contact by phone, an in-person contact, a product demonstration, and
contract negotiations. The team should review the sales process flow to see
if there are any bottlenecks in these selling steps that are interfering with the
total amount of sales generated. This bottleneck is frequently in the product
demonstration area, since it is time-consuming and requires skilled sales
technicians.
• Salesperson hiring. Does the average sale require a certain amount of
technical skill? Is there a ready supply of such people? If not, does this mean
that the lack of salespeople may be a constriction on the growth of the busi-
ness?

Marketing Activities
Marketing activities can be critical, particularly in the retail sector. Accordingly, the
due diligence team may find it necessary to investigate the following issues:
• Comparative analysis. How do the marketing efforts of the company
compare to those of its competitors? You can conduct this examination in
many areas, including product packaging, quality, advertising, distribution,
pricing, catalog sales, telemarketing, Internet marketing, after-market servic-
ing, and so forth.
• Coordination. Does the marketing department coordinate its efforts with the
release of new products and work with the sales staff for coordinated sales
campaigns, or does it rely on general advertising? The lack of “in the
trenches” marketing may be an opportunity that the acquirer can use to bol-
ster sales.
• Branding. Is there a focus on branding every facet of a product’s outer case,
packaging, delivery, advertising, and so forth? If not, the acquirer may be
able to use branding to increase customer recognition and brand loyalty,
which in turn may justify a price increase.
• Reliability. How reliable are the company’s products? Does it have unusual-
ly high or low warranty claims in comparison to the industry? The team
should review the customer complaints log and aggregate the information by
types of complaints received.
• Ease of use. Are products designed for easy and intuitive use by consumers?
Are instruction manuals easy to read and free of errors?
• Ease of servicing. Are product servicing requirements minimal? If field
service is required, what is the speed of response? If products are mailed in
for repairs, what is the speed of response?
• Repeat purchasing. What proportion of customers continues to buy from the
company? Has this number changed sufficiently over the past few years to
indicate an increase or decrease in customer loyalty?

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Many of the issues noted in this section involve the active participation of other
parts of the business, such as product design and customer service, so the team may
have to pursue its answers to these questions across multiple departments.

Production Operations
The manufacturing area is a difficult one to judge based on just operational or
financial metrics. Instead, consider conducting a visual review of the company’s
facilities. Assign an experienced group of production personnel to these tours, with
each person assigned to look for specific issues. The group then assembles
immediately after each tour to document their findings. They should make note of
the following issues:
• Data entry. Look for manual data entry of process information, as opposed
to automated data entry devices. Ideally, there should be few data entry
forms or keyboards in evidence.
• Employee override. The best facilities have employees both close together
and closely involved in the manufacturing process. They can stop the pro-
duction line if there are problems, or adjust the production pace in order to
use up excess inventory that is forming between work stations.
• Feedback postings. If the facility is dedicated to improvement, there should
be postings of recent performance that are prominently displayed. This in-
formation may include such topics as fulfillment rate, inventory accuracy,
rework rate, and customer satisfaction ratings.
• Labels. There should be safety labels for emergency equipment, labels
indicating traffic flow, labels for where to store inventory in queue, clearly
posted maintenance records, and so forth. This indicates considerable atten-
tion to layout and process flow.
• Maintenance. All equipment should be clean and well-maintained, with
maintenance records posted prominently next to each machine. It is also
useful to ask employees about malfunctioning equipment. Equipment should
be relatively new.
• Procedures. Work instructions should be plainly posted.
• Production scheduling. A facility has either a push or pull production
scheduling system. A push system is more prevalent, and is readily apparent
from the extra amount of work-in-process in various parts of the production
area. A pull system has little work-in-process anywhere in the facility. The
team should be able to spot the difference.
• Receiving. Look at how goods are received. Are they delivered directly to
the production line, as would be the case in a highly-coordinated production
environment, or do they go through a central receiving area, after which
they are stored in a warehouse?
• Scrap analysis. Do employees simply throw scrap into a dumpster, or is it
set aside and analyzed to ascertain why it occurred? You can find out these
answers by asking employees about how scrap is handled.

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• Space usage. The production facility should be compressed into a relatively

small area, so that it uses space as efficiently as possible. This means there
should be minimal movement of inventory between work stations, with little
materials handling required. Equipment should be arranged by product line,
rather than by clusters of similar machines. There should be few forklifts,
since minimal space usage dictates little need for the mass movement of
inventory.
• Worker knowledge. A production area works best if its workers have a clear
knowledge of the entire production process and how they fit into it. You can
ascertain this by quizzing the workers in the facility.
• Work-in-process inventory. Count the number of units produced by a
machine per minute, and divide this into the amount of completed units sit-
ting next to the machine. Ideally, there should only be inventory there that
equates to a few minutes of production.

Once the team completes its tour, each team member should rate the production
facility on a scale of 1 to 10 for each of the preceding bullet points to which they
were assigned. This gives the acquirer an excellent view of the productivity of a
target company’s manufacturing operations. In particular, the team should focus on
the lower-scoring items and attempt to quantify the cost savings that could be
generated if the acquirer were to improve them.
It may even be possible to estimate the cost of sales of a target company through
a combination of breaking down its products and the information gleaned from a
plant tour. Here are several ways to obtain this information:
• Cost of materials. Have the acquirer’s engineers and purchasing staff break
down the company’s products and estimate the cost of components. Alterna-
tively, just ask the tour guide during a plant tour about materials as a per-
centage of sales.
• Labor. During a plant tour, ask how many people work in the production
area, the overtime percentage, and how many units are produced each year.
Then use industry averages for compensation and benefits to estimate the
labor cost of the entire facility, and divide it by the number of units pro-
duced. This yields the labor cost per unit.
• Overhead. This is an estimate, based on a combination of the efficiency of
the operations noted during the tour, the experience of the due diligence
team, and the amount and condition of the equipment used.

Clearly, the results of this cost of sales analysis will not be overly precise, but they
will generate an approximation of the cost structure of the company. This
information can be further refined if the team compiles and aggregates the same
information for all of its due diligence tours for other acquisition targets across the
industry, so that it has access to information about the general range of costs to be
expected, given facilities of a certain size and configuration.

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Materials Management
The topics addressed in this section are of particular importance to the due diligence
team if the cost of direct materials comprises a large part of the total expenses
incurred by the company. Conversely, materials management is nearly an
afterthought in other industries, such as those involving services. Consequently, the
team must match the following list of activities to the type of business under review.
The topics of investigation are:
• Supply chain. Does the company have a lengthy supply chain? If so, does it
maintain a sufficient amount of inventory reserves to keep the company
operating if there is a supply chain failure?
• Supply restrictions. Have sales been impacted during the past five years by
restrictions in the amounts of certain materials? What conditions caused the
restrictions to occur, and what was the impact on sales? Has the company
done anything since then to mitigate the risk, such as designing products that
use alternative parts, or vertically integrating with suppliers?
• Sole sourcing. If the company sole sources any of its purchases, estimate the
impact on the business if those suppliers were to halt their sales to the com-
pany.
• Transportation costs. What proportion of the cost of goods sold is com-
prised of transportation costs? This cost may be recorded within the direct
materials account, and so is difficult to derive. It is possible that long supply
chains require a large transport cost, which may be an opportunity for an
acquirer that uses a shorter supply chain.
• Spend management. Does the purchasing staff have a spend management
system in place that aggregates purchases by commodity type, and does it
use this information to engage in bulk purchasing activities? Does the pur-
chasing department monitor compliance with its spend management system,
and follow up with those who do not purchase from approved suppliers?
• Supplier identification. Obtain a list of the top suppliers with whom the
company does business. The acquirer may be able to shift more business to
these suppliers in exchange for volume discounts, or shift the business to its
own suppliers for the same reason.
• Supplier terminations. Have any suppliers refused to continue doing
business with the company recently? Contact them to ascertain the reason
for the termination.
• Design partnerships. Does the company have a sufficiently close relation-
ship with some suppliers that they cooperate in the design of new products?
If so, these are particularly valuable suppliers that the team should take spe-
cial notice of, so that they are not jettisoned as part of subsequent acquisi-
tion integration activities.
• Supplier contracts. Obtain copies of any supplier contracts or master
purchase agreements in which the company commits to certain purchasing
volumes over a period of more than the next few months. The team should

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estimate the likely cost of these contracts over their remaining time periods,
and whether the costs are above or below the current market rates.
• Bureaucracy. Does the purchasing staff insist on issuing purchase orders for
most items, or are automated ordering and procurement cards used to reduce
paperwork? This can represent a moderately-large cost reduction opportuni-
ty.
• Supplier certification. Does the company certify the quality of its suppliers,
track their performance, and offer them a streamlined delivery and payment
system? If not, there are likely to be opportunities for improvement in en-
hancing the quality of purchased parts, as well as in reducing the paperwork
associated with receiving and accounts payable.
• Inventory systems. How well does the company identify, store, and keep
track of its inventory? A well-organized warehouse area is a solid indicator
of inventory record accuracy, while the reverse should cast severe doubts on
the purported amount of inventory on hand.
• Inventory count. It takes continual attention to inventory records to achieve
a reasonable degree of accuracy, so be sure to conduct a few sample test
counts of the inventory to see if the valuation appearing on the balance sheet
is supported by the unit quantities in the warehouse.
• Inventory investment. If the company has an excessive amount of inventory,
the acquirer may have an opportunity for inventory reduction that reduces
the amount of working capital needed to operate the business. Accordingly,
the team should examine the age of the inventory, inventory turnover, and
the amount of work-in-process residing in the production area.
• Inventory obsolescence. In industries where product life spans are short, be
sure to examine the inventory for obsolete items, and estimate the price at
which they could be disposed of. This may impact the valuation that the
acquirer assigns to the business.
• Consignment inventory. Does the company segregate any consignment
inventory on its own premises, and have an adequate system for tracking its
own inventory held on consignment at the locations of third parties? The
latter is a particular concern, since a business may record sales when goods
are actually only being sent out on consignment.
• Year-end adjustments. Has the company been forced to record significant
write-downs at each of the past few year-ends, following its year-end physi-
cal counts? If so, its inventory record keeping is substandard, and it is prob-
ably overstating its inventory valuation.
• Distributor agreements. If the company uses distributors, do the distribution
agreements allow them to return unsold goods to the company? If so, can
the company charge them a restocking fee? Is there a time limit on how long
a distributor can retain goods before returning them to the company? These
are all issues that impact the risk of the acquirer owning more inventory than
expected.

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Information Technology
The amount of due diligence needed for information technology (IT) depends upon
the amount of in-house resources devoted to this area. In many companies, such
baseline systems as accounting, payroll, and sales management are outsourced, so
there are few IT issues to address. However, there are other situations where custom-
designed IT systems form a key part of the competitive stance of a company, and so
are worthy of a considerable amount of investigation. Here are a number of IT issues
to address:
• Systems in place. The team should create a complete list of all major
software packages being used by the company, their version numbers, annu-
al maintenance costs, number of users, and interfaces to other systems. This
basic step provides the information needed for many of the other IT issues
noted in this section.
• Licenses. Determine the number of valid software licenses that the company
has paid for each software application, and match this against the number of
users. This step can be time-consuming, so restrict it to those types of soft-
ware for which the license fee per person is high. This issue can be of im-
portance if the acquirer needs to purchase many additional licenses to bring
the business into compliance with its software agreements.
• Outsourcing agreements. If the company has retained the services of an
outsourcing firm to take over the bulk of its IT operations, review the
agreement carefully for such issues as baseline services, pricing for addi-
tional services, and change of control clauses. If these agreements are for
amounts in the millions of dollars, then the amount of due diligence investi-
gation should be considerable.
• Capacity. Depending upon the systems, it can be quite expensive to replace
or upgrade IT equipment. Consequently, the team should investigate the
usage level of existing systems, as well as the age of the equipment. If the
target company has not spent an adequate amount for IT on an ongoing ba-
sis, the acquirer could be faced with a substantial upgrade cost.
• Underlying systems. The investigation of IT also involves an understanding
of the business processes they support. This is a particular concern if the
acquirer intends to integrate selected processes into its own systems. If the
acquirer instead plans to leave the company alone to operate as a free-
standing entity, then this is less of a concern.
• Tax information. The acquirer must know where the information is stored
that is used to compile tax returns and remittances. If these systems are shut
down, the acquirer may find itself scrambling to re-implement systems and
run searches for missing information in order to complete tax returns by the
next filing date.
• Customization. What is the extent to which the company has modified any
packaged software that it has purchased elsewhere? It is possible that modi-
fications have been so extensive that there is no way to upgrade to the most
recent version of the software.

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• Interfaces. Investigate the interfaces that the company uses to link together
its systems. Any interfaces of particular complexity should be noted, since
these may need to be reconstructed if the acquirer wants to link into those
systems, too.
• Projects under way. If a large part of the IT department’s resources have
been allocated to new projects, the team should investigate the time and cost
required to complete each one, as well as the probability of success. This
information is useful for deciding upon budgeted funding levels for the next
few years in order to support those projects that should be completed.
• Legacy systems. Some organizations have custom-made software that
requires considerable resources to maintain. The team should locate these
systems, determine their annual maintenance cost, decide whether they
should be replaced with other systems, and estimate the replacement cost. In
some companies, replacing legacy systems can be a monumental undertak-
ing.
• Disaster recovery plan. Is there a disaster recovery plan that states how
information is to be backed up and recovered in the event of a system fail-
ure? Is the plan tested regularly? Is there a backup IT facility that is ready to
take over if the main facility is destroyed? These issues could be very im-
portant for a business whose core functions center around IT systems. It may
be less of a concern in a business where computer systems are mostly used
to record business transactions after-the-fact.

The issues noted here can be complex ones that do not always fall within the
expertise of most members of a due diligence team. If so, you should bring in
experts as needed to investigate specific technology issues. These may be
consultants or members of the company’s in-house IT staff. In either case, it may
require advance planning to obtain their services during the period when due
diligence is to be conducted.

Treasury and Risk Management

There are a variety of cash management issues that an acquirer should be aware of,
and may be able to improve upon. The due diligence team should also investigate
how the company insures its risks. Key issues to investigate are:

Treasury Topics
• Cash forecast. Have the company create a cash forecast for the next few
months, and revise it in light of all other information collected about the
business, as well as its historical cash flows. This information is useful for
estimating the cash levels that should be retained in the business by the ac-
quirer on a go-forward basis.
• Credit granting. What is the company’s credit granting policy? Is the
philosophy of management to have loose credit in order to encourage sales,
or tight credit in order to protect profits? Review the company’s recent bad

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debt history to see if it suffers from inordinate bad debt levels. If not, there
may be an opportunity to loosen the credit policy and generate incrementally
more profits than bad debts.
• Investments. What is the company’s investment policy? Is the policy
inclined more toward low risk and low return, or high risk and high return?
If the latter, how much of the company’s funds are invested in high-risk
investments, and when is the earliest date by which they can be released
from those investments without penalty?
• Repatriation problems. Is any cash located in countries which restrict the
flow of outbound cash? If so, cash appearing on the company’s balance
sheet may not be available for use elsewhere in the company.
• Loans to insiders. Has the company issued loans to owners, officers, or
other company insiders? If so, what are the terms of the loans, and what are
the chances of collecting them? In many cases, these loans may prove to be
uncollectible, in which case the acquirer should reduce its price for the busi-
ness by the amount of the loans that cannot be collected.
• Bid bonds and performance bonds. Has the company had difficulty obtain-
ing bid bonds and performance bonds in the past? These are bonds repre-
senting that a contractor will accept a contract with the customer, and will
complete it, respectively. The amount of bid and (especially) performance
bonds can be substantial, and can prevent a business from bidding for con-
tracts. If this is the case, an acquirer with significant financial resources can
be of great assistance in providing the appropriate bond funding, thereby
allowing the company to grow its business faster than had previously been
the case.
• Leasing. Does the company lease its products to customers? If so, is the
leasing program profitable? Does the company assume credit risk, or does it
shift the risk to a third party? If this is an off-balance sheet transaction,
move the leasing receivables and related debt back onto the company’s bal-
ance sheet to see what happens to its key ratios.

Risk Management Topics

• Hedging. Does the company engage in hedging strategies to avoid cost
increases related to changes in currency rates? What is the company’s histo-
ry of using hedging products in the past?
• Insurance. Does the company have an adequate amount of insurance to
cover the business risks to which it is subjected? Those risks will vary by
company and industry, but there should at least be general liability coverage.
Is the financial condition of the insurance carrier good enough to allow it to
pay claims made by the company? Has the company had trouble obtaining
insurance in recent years? What is its claims history? Has the company
elected to use self-insurance in some areas, and what has been its loss expe-
rience in those areas?

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• Penetrated aggregates. Has the aggregate amount of claims made by the

company come close to or exceeded its insurance coverage in certain areas?
If so, it is essentially uninsured if additional claims arise.
• Uninsured risks. Are there areas of the business where management has
deliberately or inadvertently elected to self-insure by not obtaining insur-
ance? It may call for the services of a risk management expert to uncover
these areas.

Problems with insurance may not be a problem if the acquirer intends to substitute
its own insurance coverage for coverage currently used by the target company. This
is a common cost-saving tool in acquisitions, since a large acquirer may be able to
obtain much better insurance coverage and pricing from a large and reputable
insurance carrier.

Legal Issues
It is mandatory to conduct a thorough investigation of every legal issue noted in this
section. Many of the topics addressed below are ones that can obliterate what might
otherwise have been a promising acquisition. The topics are:
• Current lawsuits. If there are any lawsuits outstanding against the target,
ascertain their status. This calls for a judgment as to whether an existing
lawsuit could presage the arrival of additional lawsuits of the same type.
Also, are certain types of lawsuits beginning to appear in the industry, and is
the company likely to be targeted by one? If there are any proposed settle-
ment agreements currently under consideration, obtain copies of them and
peruse their terms. If there is a reasonable chance of losing a court battle,
estimate a range of possible payouts, and assign a probability to each one.
• Prior lawsuits. If there were any lawsuits within the past five years that
were settled, obtain copies of the settlement agreements. These agreements
typically require a cash settlement, but they may also prohibit the target
from engaging in certain activities that could be a hindrance to the acquirer.
• Legal invoices. Review all invoices paid to law firms in the past three years,
and verify from them that all legal issues have been addressed.

Acquisition Story: The author was involved in an acquisition where the primary
reason for the acquisition was the purchase of a set of software packages developed
by the target company. Just as the acquirer was wrapping up negotiations, the seller
admitted that the lead software designer for the company had just filed suit, claiming
that he owned the software. The acquirer backed out of the deal immediately.

• Franchises. If the company is in the franchise business, what points of

contention have arisen between the parties? Have any of these issues result-
ed in lawsuits, and what was the outcome?

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• Contracts review. Examine all contracts that the target has entered into
within the past five years. Focus in particular on those requiring fixed pay-
ments, royalty or commission payments, or the issuance of stock.

Acquisition Story: The author was conducting a contract review and discovered
that a company had entered into a contract several years before under which it
committed to purchase a minimum quantity of data per year from a database
supplier. Only minimal payments had been made, and the contract was eventually
forgotten. The supplier learned of the due diligence investigation, found its copy of
the contract, and promptly demanded payment of an amount that would have
bankrupted the company. The issue was eventually settled for a minor payment.

• Lease review. Examine all facility leases for termination dates and price
escalation clauses. Also, if possible, compare the rates paid under the leases
to current market rates, to see if the renewal of a lease may call for a signifi-
cant change in the lease rate.
• Charter and bylaws. Always obtain the most recent version of the compa-
ny’s charter and bylaws, and review them in detail. They state voting proce-
dures for key events, such as the sale of the business.
• Board minutes. The board of directors must approve a number of decisions,
such as the authorization of more stock, the repurchase of existing stock,
certain compensation packages, acquisitions, and so forth. Consequently,
you should review all board minutes for at least the past five years, and pos-
sibly for longer periods of time. This search may reveal decisions that were
approved but never implemented, or decisions made that were never ap-
proved.
• Shareholder meeting minutes. Obtain the meeting minutes for the past few
years of shareholder meetings. These documents can prove instructive in
ascertaining the restiveness of shareholders.
• Audit committee minutes. If the board of directors has an audit committee, it
can be useful to review its minutes for the past few years to see if the com-
mittee was made aware of any control-related issues. This information might
also be available in reports made by the audit committee to the board of
directors.
• Regulatory changes. Are there any pending regulatory changes that may
impact the company? In particular, environmental or safety regulations may
require substantial expenditures.

If the target company has subsidiaries, you should obtain the charter, bylaws, and
board minutes for all of them, and verify the same information noted above for the
subsidiaries.

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Regulatory Compliance
Regulatory compliance is one of the areas in which an acquirer can find itself in
considerable difficulties if it did not conduct a thorough due diligence investigation.
Some of the issues noted in this section can have such severe ramifications that they
could bankrupt the acquirer and even extend personal liability to its officers. Key
issues are:
• Pollution. Have there been any complaints from regulatory agencies
regarding air or water pollution? Does the company own any property on
which there is evidence of pollution? If there is even a hint of a problem
related to pollution, hire qualified experts and have them review the situa-
tion.
• Adjacent pollution. Have any adjacent properties been found to have
environmental hazards? If so, what is the risk of the pollution moving onto
the company’s property?
• Pollution indicators. Does the company have any underground or surface
storage tanks that could potentially leak their contents? Are there on-site
sewage treatment facilities? Are its buildings old enough to contain asbes-
tos? Does it use chemicals in its operations that are considered toxic? These
are only indicators, but may warrant further investigation.
• Studies conducted. Has the company commissioned any studies involving
environmental hazards on its premises? If so, obtain copies and peruse them
to obtain an understanding of environmental risks and the extent of related
liabilities.
• Regulatory contacts. Obtain the contact information for every regulatory
agency with which the company has dealt for the past three years, and con-
tact them for their view of any outstanding issues.
• Licenses. Is the company in an industry where it requires a government
license to operate? If so, what is the renewal date of the license, and how
likely is it that the license will be renewed? Has the company received any
warnings from the government about noncompliance with the terms under
which its license was granted?
• Regulatory approval. Some products fall under the jurisdiction of govern-
ment safety agencies, such as the Food and Drug Administration. If so, have
a specialist review the status of the company’s applications for approval.
This can be one of the most important due diligence issues, if a product is
considered crucial to the future success of the company.
• Audits. Has the company been the subject of any environmental investiga-
tions by a government agency? What was the outcome of the audit?

Several of the issues noted in this section are important because of the associated
penalties that can accrue to the buyer. In particular, the acquirer should be aware of
the following environmental laws:
• Comprehensive Environmental Response, Compensation, and Liability Act
(CERCLA). In essence, this Act (also known as the Superfund Act) requires

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that anyone who creates hazardous waste is responsible for eliminating it.
The Act attaches liabilities to the following entities associated with waste:
o The current owner or site operator
o The owner or site operator when the waste occurred
o Whoever arranged for the disposal of waste
o The transporter of the waste to the dumping site
If an entity is in non-compliance with this Act, the daily fines can reach
$25,000.
• Toxic Substances Control Act. This Act limits the use of PCB products
(polychlorinated biphenyl), as well as lead-based paint, asbestos, and radon,
and may require mitigation of contaminated sites. Daily fines can reach
$27,500 for each violation noted.
• Clean Water Act. This Act requires a permit to discharge a pollutant into
navigable waters. Daily fines for violating this Act can reach $50,000, as
well as jail terms.

The laws noted here are not the only ones, but are notable for the extremely large
fines involved, as well as the broad basis upon which liability can be assigned. If the
acquirer believes that a contemplated acquisition may trigger any environmental
regulation, it may be best to step away from the proposed deal.

Service Companies
A service business is one in which revenues are primarily based on the hours worked
by its employees, such as consulting and accounting services. The foundation of any
service business is its employees, since they personally generate its revenues.
Consequently, the due diligence performed on a service business should pay
particular attention to the following issues:
• Revenue per person. This is not a simple case of dividing revenues by the
number of employees. Instead, the due diligence should encompass the bill-
ing rates per person, the revenues generated by specific individuals, and how
this information compares to industry averages.
• Turnover. Employee retention is key to the long-term success of a service
company, so the team should analyze not only the average employee turno-
ver rate for the past few years, but also why they left, whether those leaving
were top producers, and how the turnover information compares to the in-
dustry average.
• Profit per person. The team should match the revenues generated by each
person to their total compensation packages, including benefits. Though
time-consuming, this analysis is extremely useful for locating which em-
ployees generate outsized profits (or losses) for the company. The acquirer
can use this information to structure its employee retention packages.

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International Issues
If an acquirer wants to make acquisitions in other countries, it should consider
taking some additional steps to avoid problems that it might not otherwise be aware
of until after an acquisition deal has closed. Those steps are:
• Local due diligence staffing. Where possible, hire a local firm that has
experience in due diligence, and include it in your due diligence team. This
group should make the acquirer aware of any legal, cultural, operational, or
financial issues that are specific to the country, and which may impact the
valuation, purchase, or subsequent operation of the business. The local of-
fice of a Big Four accounting firm can be a good source for this type of
manpower.
• Local attorneys. Absolutely obtain the services of a local law firm, and have
it work in concert with the acquirer’s usual law firm to address the local
aspects of an acquisition. In particular, look for a law firm with excellent
knowledge of regulatory approvals for all business areas in which the ac-
quirer wants to engage.
• Employee-related regulations. Obtain the services of an expert on the local
labor laws. It is entirely possible that an acquisition will not work out, and
the acquirer will be forced to lay off a large number of employees at the
acquired company. If so, it should be aware of workforce reduction laws and
their attendant costs.
• Employee taxes. Obtain local advice regarding the taxes that employees
from the parent company must pay if they are to reside near the prospective
acquisition. This may call for an adjustment in compensation to pay back
employees for additional local-country taxes.

Tip: If the acquirer knows in advance that there will be employee terminations at a
target company, it might consider having the acquiree terminate the employees prior
to the acquisition. Depending on local laws, this may be easier to do prior to an
official change in control of the business.

• Local culture. Talk to employees at all levels of the company to determine

which labor policies are most important to them. Consider retaining or en-
hancing these policies, even if they are different from the policies used
elsewhere in the company. Thus, the acquirer will probably need different
employment manuals for each country in which it operates.
• Transfer pricing. If the acquirer anticipates that it will transfer goods or
services between a newly-acquired subsidiary in a foreign country and its
other subsidiaries, then it should carefully document and obtain advance
pricing agreements (where necessary) for the transfer prices that it intends to
use. An advance pricing agreement is an agreement between a taxpayer and
a taxing authority regarding the transfer pricing methodology to be used for
certain types of transactions between business entities.

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Clearly, there are a number of additional issues to consider when engaging in

acquisitions in other countries. This calls for the use of local experts in such areas as
accounting, taxes, and labor laws. This introduces additional cost and time to the due
diligence process.

Due Diligence Results

There is no such thing as a clean due diligence review. Every company contains
issues that the due diligence team must uncover and then properly document and
report to management. This does not have to be a simple laundry list of problems;
the team may also uncover any number of opportunities that could make the
acquisition an excellent deal for the buyer. Thus, the findings of the team should
address not only the problems, but also the opportunities associated with a
prospective acquisition.
The following is a modified and condensed version of a due diligence report on
a business that the acquirer elected not to purchase. All names have been altered in
the report.

Sample Due Diligence Report

Overview: The company is earning $7 million of annualized revenue and adjusted

annualized profits of $100,000 in the current year. The owner, Gerald Branson,
takes all of the profits from his production segment and pours it into his software
development group, with the intent of assembling a comprehensive suite of software
products. He uses no cash forecasting to determine when to add more developers.
Instead, he adds staff whenever there is a little cash left in the bank account. As a
result, periodic cash shortfalls have required him to lend more of his own money, as
well as cash from several bank loans. Thus, the company is in a tenuous financial
position despite a highly profitable core business, and may be on the cusp of rolling
out several significant software products.

Recommendation: There is a profitable core business that is comprised of low-end

production services work; this significantly reduces acquisition risk, since we could
quickly cut back on development staff to achieve profitability. The main risk is that
we have no idea which of the upcoming software products is likely to be successful,
since no business case has ever been made for any of the products. Thus, the key to
making this a successful acquisition is much tighter management of the develop-
ment segment. My recommendation is to proceed with the acquisition, as long as a
new development manager is imposed on the operation by us.

Production services: The production services component of the business earns

annualized profits of about $1.5 million. There are 50 employees in this group,
earning an average of $40,000. Starting pay is $32,000, and turnover appears to be
nearly 100% per year among introductory-level employees. The lowest-level
employees are invariably hired directly from school. Billing rates are $45/hour for
first-year employees, $60/hour for manager-level personnel, and $75/hour for senior
analysts. Average utilization is 75%, which is dragged down by the new employees
who are in training (five at the moment). This is the profitable core of the company.

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Administration: The total annual cost of this group is $300,000. This group engages
in no budgeting and no cash forecasting. They use QuickBooks for record keeping.
There does not appear to be sufficient discipline to ensure that all billable employ-
ees are recording their hours, so there is some risk that a few hours are not being
billed. Receivables appear to be collected reasonably promptly.

Sales: There are three high-quality salespeople, one sales assistant, and two sales
trainees. The average sales trainee pay is $50,000, while average base pay for the
other salespeople averages $100,000. Commissions are 2.5% of software sales and
1.5% of service sales, which incrementally increases to 3% and 2% after $1 million
of annual sales are reached. Commissions are paid quarterly. Total annual compen-
sation cost before commissions is $500,000.

Development: There are 25 people in the development group. The average pay of
this group is $70,000, with a high of $110,000 and a low of $50,000. The staff
averages 20% billable time, resulting in annualized revenue of $1,500,000. The net
annual loss of this group, prior to software sales and maintenance, is $700,000.

Customers: Primary customers are Alpha Corporation ($650,000), Beta Brothers

($600,000), Charlie Company ($300,000), and Delta Designs ($250,000).

Shareholders: Key investors are Mr. Branson (33%), Mrs. Branson (33%), Reginald
Johnson (26%), and Melinda Struthers (8%).

Benefits: Pays 100% of employee medical and short-term disability. The company
does not pay dependent insurance. They have 10 paid holidays. There are 12 earned
vacation/sick days per year, with unrestricted annual rollover. Employees cannot
take vacation if hours have not already been earned. There is no severance pay,
though terminations require two weeks’ notice. There are two employees working
under H1-B visas.

Legal: This is a Delaware corporation. There are no trademarks or patents. They

impose a 12-month non-compete agreement on all employees, which they have
enforced in the past against someone who went to work for a competitor.

Accounting issues: They do not track percentage of completion on fixed milestone

projects, so there is probably a small amount of revenue that should not yet be
recognized. Over $4 million of software development costs have been capitalized,
which significantly skews the reported results. When the software development cost
is factored back into the financial statements, the company has substantial negative
net worth, and is deeply in violation of its loan covenants.

Debt: A $250,000 revolving credit line with the First National Bank was added last
year, and was immediately maxed out. There is also a $500,000 loan with Washing-
ton Bank that is due in May, and which goes into default in the event of insolvency
or an ownership change. Another line of credit with Washington Bank is for
$600,000, and has a year-end maturity date. This one has a covenant of a 2:1 ratio
of debt to net worth, and also requires a 70% borrowing base. In addition, there are
multiple personal loans by the Bransons. Total indebtedness is about $1.5 million.

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Fixed assets: The capitalization limit is $500, resulting in 250 recorded fixed assets.
Using our capitalization limit of $2,500, there would be only 75 recorded assets.
The total dollar value of assets acquired in the most recent year was $60,000.
Recent asset purchases appear light, so some asset catch-up is probably needed.

The preceding analysis report succinctly presents a number of issues with the target
company. It has a profitable core business, is risking its cash flow on an unproven
set of software products, and is probably in violation of its loan covenants. Further,
its pay levels are clearly too low, resulting in considerable staff turnover. The
acquirer walked away from the deal because of the high degree of uncertainty
concerning the potential success of the new software products, and the high price
demanded by the owner.
Also, note the brevity of the sample report. In less than 1,000 words, the due
diligence team presented an overview of the business, as well as its condition,
strengths, and weaknesses. The report was sufficiently compressed to (hopefully)
hold the attention of anyone reading it.
Finally, be sure to organize the information collected during the due diligence
review. If the acquirer elects to proceed with the purchase transaction, those
documents will be useful not only for modifying the valuation calculation for the
target company, but also as source documents for the acquisition integration team.
However, it is also possible that the acquirer signed an agreement with the company
to return all materials obtained during due diligence, which is a valid requirement to
ensure that no sensitive documents are retained outside of the business.

Indicators of a Strong Acquisition Candidate

A typical due diligence effort will result in a mound of paperwork, from which the
due diligence manager must somehow extract those key nuggets of information on
which to base a recommendation to senior management. Which items are the most
important? The following are indicators of a strong, stable business:
• Employees: Low employee turnover, caused by a favorable work environ-
ment and competitive pay and benefits
• Employees: Stable management team with a history of promotion from
within
• Financial: A history of producing revenues and earnings from operations
• Financial: Audited financial statements
• Financial: Conservative accounting policies
• Financial: Evidence of a strong system of controls
• Financial: No special charges or history of extraordinary gains or losses
• Complexity: A simple, uncomplicated business model that is easy to
understand
• Legal: An uncomplicated legal structure with a minimal number of subsidi-
aries

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• Legal: No litigation, or litigation unlikely to yield significant judgments

against the company
• Markets: A strong, defensible position in either a long-term or fast-growing
market
• Markets: Sales are spread among many customers, with no dominant
customers whose absence would seriously impair the business
• Markets: Long-term investment in branding the company’s products and
services
• Products: Long-term investment in research and development, with a history
of regular product releases

While there may be other issues that could cause a prospective deal to dissolve, the
preceding factors should favorably dispose an acquirer toward proceeding with an
acquisition.
It is also useful to understand the key indicators of a business that an acquirer
may want to steer clear of. If you see a cluster of the following issues in an
acquisition candidate, it is a likely indicator of deep-seated problems that will lead to
a difficult acquisition:
• The outside auditor has resigned from the annual audit engagement
• Recent changes in accounting methods, particularly when the new methods
are not considered to be the standards used in the industry
• Transactions designed primarily to avoid income taxes
• A complex organizational structure when there is no discernible reason for it
• One or more people in key positions with criminal records
• The company has attempted to sell itself in the past, and failed to do so
• There is an extraordinary focus on meeting revenue and profit targets
• There is a command-and-control management structure, under which access
to information is restricted

Factors that Terminate a Deal

The due diligence investigation may turn up certain issues that will trigger an
immediate termination of discussions by the acquirer. These issues may be ones that
the acquirer has found to be particularly troublesome in previous acquisition deals,
and which it does not want to deal with again. Other factors are more generic in
nature, and are simply warning flags about substantial issues. The following are
factors that could cause the immediate termination of a deal:
• Maximized market share. The target company may have attained the highest
possible level of market share within its market niche. In all likelihood, the
acquirer will not be able to rely upon additional sales growth within this
niche, and so will have a difficult time generating additional value from the
deal.
• High sales with few customers. The sales of the target company may be
concentrated with a very small number of customers. If so, there is a sub-

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stantial risk of a sudden sales decline if just one customer were to stop buy-
ing from the company. This is a common scenario for small businesses that
have been lucky enough to gain a small number of contracts, but have not
expanded beyond this initial group of customers.
• Union relations. The target company may have a poisonous relationship
with its unions. If so, the acquirer may be faced with years of remedial labor
relations before it can gain the cooperation of the labor force.
• Criminal records. If any member of senior management has a criminal
record, the presumption is that their previous proclivities have carried for-
ward into the current business. This means the acquirer may be dealing with
false financial statements or other issues that may not immediately come to
light.

The preceding factors will not terminate a deal in all cases. If the acquirer can obtain
a company at a sufficiently low price, this can cause one to overlook a great many
problems.

Summary
Due diligence is a fast-paced review that must touch upon a broad range of topics
within a short period of time, while somehow uncovering the main risks to which the
acquirer will be subjected if it buys the company. This calls for the intelligent
identification of risk areas before the examination begins, as well as the redirection
of the due diligence team as the investigation progresses, to ensure that key areas
receive the most attention. In short, an excellent due diligence team leader who is
focused on risks is the key to success in any investigation.
The due diligence process will uncover a number of opportunities and problems.
More often than not, the target company will have already trumpeted most of the
opportunities, and none of the problems. Once the issues are revealed, the acquirer
may find it necessary to walk away from the deal. In the author’s experience, most
potential acquisitions progress no further than the due diligence phase, because of
the issues found.
The general recommendation should be that walking away from a potential
acquisition is a solid and risk-averse choice if there are clear-cut problems.
Nonetheless, the acquirer should always spend extra time examining how to quantify
any problems found, and ways to mitigate them. It is possible that an imaginative
approach can be found that mitigates the risk to the acquirer, while still giving it the
opportunity to earn an outsized return on its acquisition investment. In short, there
will always be some risks remaining following a due diligence examination; the
acquirer needs to decide if it can accept these risks and proceed with the purchase.

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 Chapter 10
Payment Structure of the Acquisition
Introduction
In a prior chapter, we talked about creating a valuation for a business. The valuation
must now be translated into a form of payment. The structure of this deal has
ramifications for both the buyer and seller in terms of risk, tax liabilities, liquidity,
and other issues. In this chapter, we will address the various reasons both for and
against the use of stock, debt, or cash in the structure of the deal. As you review
these options, please note that a typical deal is not black-and-white, using only one
form of payment. Instead, a deal that meets the needs of both the acquirer and the
seller may need to incorporate elements of several types of payments.

The Stock-for-Stock Exchange

In a stock-for-stock exchange (a type of like-kind exchange), the shareholders of the
selling entity swap their shares for the shares of the acquirer. A stock-for-stock
exchange is useful for the seller when its shareholders do not want to recognize
taxable gains in the near term. Instead, they pay income taxes only when they sell
the shares paid to them by the acquirer. They will pay taxes only on the difference
between their cost basis in the stock of the acquiree and the price at which they sell
the stock of the acquirer. However, this also means that shareholders will not have
liquid investment positions in the short term.
In a stock-for-stock exchange, the seller shares with the acquirer the risk that the
benefits of the acquisition are not realized. Thus, if the acquirer derives a purchase
price based on the realization of synergy gains and those gains are not achieved, it is
quite possible that the market will then force down the price of its shares. If the
seller’s shareholders now own some of those shares, the value of the payment to
them will decline.

Note: If a small company is being acquired by a much larger one, the success of any
subsequent synergies will not impact the overall financial results of the acquirer.
Thus, there is no real sharing of gains or losses accruing from the acquisition.

The seller should only accept shares as part of the payment structure under the
following circumstances:
• Registration rights. Unless the shares were already registered with the
Securities and Exchange Commission (SEC) through a shelf registration
(which is the registration of a new issuance of securities with the SEC in
advance of their distribution), the shareholders will have to either wait for
them to be registered or wait for a mandatory holding period to expire under
 Payment Structure of the Acquisition

Rule 144, after which they can sell the shares. The SEC’s Rule 144 allows
the holder of stock to sell shares on the open market after an initial holding
period has been completed, but only in small quantities over a relatively
long period of time. Acquirers tend to resist pressure to register shares, since
the process is both time-consuming and expensive. The inclusion of registra-
tion rights is the issue in a stock-for-stock exchange, since the stock recipi-
ent otherwise has no way to sell the shares.
• Registration timing. The acquirer must guarantee that shares will be
registered within a certain period of time. Otherwise, the seller is holding
shares that may decline in value over time. The deal structure may include a
penalty clause, such as issuing more shares to the seller if the registration is
not completed within a certain number of months following the purchase.

Note: Stock registration is sufficiently expensive and annoying that larger publicly-
held firms have a policy of not offering to pay stock for smaller acquisitions.
Instead, they limit their offers to cash or debt. It is only cost-effective to issue stock
for larger acquisitions.

In addition, the seller must examine the market for the acquirer’s shares to see if
there is sufficient trading volume for the seller’s shareholders to sell off their shares
within a reasonably short time period, and without driving down the price of the
stock. This is a serious issue if the acquirer is a smaller public company, and
especially if its stock is not traded on a major stock exchange.

Deal Structure Story: The author was involved in a deal where a small publicly-
held company issued several million shares to the owners of an acquiree. When the
new shareholders decided that they wanted to sell their shares, the trading volume
for the stock was so low that it became apparent that at least 10 years of steady
selling would be required to liquidate their positions.

Another issue for the seller to consider is the trading history of the stock. If the
acquirer has been publicly-held for a long time, its stock trades on an exchange, and
it has a well-run investor relations department, then its stock probably trades
consistently within a relatively narrow price range. This is the ideal situation in
which to accept a stock-for-stock exchange, since the shares received are more likely
to retain their value.
If a privately-held acquirer proposes a stock-for-stock exchange with no
prospect of registration rights, then the ability of the seller’s shareholders to
eventually convert the stock to cash is exceedingly tenuous. In these cases, the seller
should seriously question the proposed deal, if not reject it outright. If the seller
decides to proceed with the deal, it should at least impose a sharp discount on the
value of the acquirer’s stock in comparison to what it would have accepted in cash.

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Tip: In proposed stock-for-stock transactions, the seller can require the inclusion of
a put clause in the purchase agreement, under which the acquirer is required to buy
the shares of the seller’s shareholders after a certain amount of time has passed, and
at a certain price. This clause is useful in case a planned stock registration fails. It is
only triggered at the option of the shareholders.

The issuance of stock could present a control problem for the managers of the
acquirer. When a significant proportion of company shares are issued to pay for an
acquiree, the newly-minted shareholders may be in a position to vote for their own
members of the board of directors, or to pressure the board to take actions that it
would not usually consider, such as issuing dividends. The situation could be
particularly serious if the company’s bylaws require that a supermajority approve
certain measures, such as the sale of the company, and the new shareholders have
enough shares to swing this vote. Consequently, the existence of a potential
shareholder control situation could mean that payment in stock is not an option.

The Exchange Ratio

A stock-for-stock exchange is accomplished through the derivation of an exchange
ratio. The exchange ratio is the number of shares of the acquirer that it is offering to
exchange for each share of the seller. This calculation is based on the market price
of the shares of the acquirer and the price offered for the seller.

EXAMPLE

The shares of High Noon Armaments are currently trading at $14 per share. It is
contemplating the acquisition of Bolton Body Armor for $4,000,000. Bolton has 500,000
shares of common stock outstanding, so each share is valued at $8 per share.

Based on this information, High Noon offers an exchange ratio of 0.57143 shares of High
Noon stock for each share of Bolton stock. The exchange ratio calculation is:

$8 Bolton share price ÷ $14 High Noon share price = 0.57143 exchange ratio

Thus, the Bolton shareholders receive a total of 285,715 shares of High Noon stock. At the
current trading price of $14 per share, the High Noon shares issued to the Bolton
shareholders are worth $4,000,000.

The derivation of the exchange ratio can be quite a contentious one when the shares
of the acquirer are not publicly traded. If so, there is no market to independently
value the shares, resulting in a value that is largely based on opinion.

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The Impact of Options, Warrants, and Convertible Securities

Many companies issue contingent shares to various parties. These are instruments
that can potentially be converted into common stock. The three types of contingent
shares are:
• Options. This is the right to purchase a specific number of shares at a certain
exercise price. It is usually issued to employees.
• Warrants. This is the same as an option, except that it is issued to third
parties.
• Convertible securities. This is preferred stock or debt that is convertible into
common stock at a certain ratio. For example, one share of preferred stock
may convert into two shares of common stock.

Contingent shares have an impact on the exchange ratio (see the preceding section),
since they may result in more shares that must be converted into the shares of the
acquirer. However, this is only the case if the price per share offered by the acquirer
is sufficiently high to make it profitable for an option, warrant, or debt holder to
obtain the stock of the seller. For example, if the holder of an option can only buy
shares at a $10.00 price point and the acquirer is offering to buy the seller’s shares at
$9.00 each, there is no profit to be made, so the option is assumed to have lapsed for
the purposes of calculating the exchange ratio.
If some contingent shares are likely to be converted into common stock, then the
acquirer must buy the additional shares (assuming a total buyout of all outstanding
shares), which reduces the number of shares of acquirer stock exchanged for each
share of seller stock. The following example illustrates the concept.

EXAMPLE

This example continues with the prior example concerning the purchase of Bolton Body
Armor by High Noon Armaments. High Noon was expecting to offer $4,000,000, payable in
stock, for all of the 500,000 outstanding shares of Bolton. High Noon now learns that there
are 100,000 warrants outstanding that were granted to an initial investor years ago, and
which have not yet expired. The warrant holder can purchase 100,000 shares at an exercise
price of $6 per share. The warrant holder should exercise his warrants, since the price per
share is now $6.67 (calculated as $4,000,000 purchase price ÷ 600,000 shares), and he can
earn a profit of $0.67 on each share purchased, for a total profit of $66,667.

The presence of these warrants changes the calculation of the exchange ratio. Previously, the
calculation without any warrants was:

$8 Bolton share price ÷ $14 High Noon share price = 0.57143 exchange ratio

Now, with the reduced $6.67 price for the Bolton shares, the new calculation is:

$6.666 Bolton share price ÷ $14 High Noon share price = 0.47614 exchange ratio

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As the example shows, the impact of contingent shares is entirely on the

shareholders of the seller, since they obtain fewer acquirer shares in the stock-for-
stock exchange. Contingent shares have no impact on the acquirer, since it is still
issuing the same number of shares.

Issues Impacting the Stock Payment Decision

An acquirer is more inclined to offer stock-for-stock deals when it believes its stock
price is unusually high. During these times, it can offer fewer shares to pay for an
acquisition. Conversely, if it feels that the market is assigning it an unusually low
share price, it will be less inclined to pay with stock, for it must issue more shares.
The seller is placed in the reverse situation if it believes the acquirer’s stock to be
selling at too high a level, since there is a higher risk that the share price will
subsequently decline, and along with it the effective price paid to the seller.

EXAMPLE

The market is currently assigning a high $20 share price to the stock of High Noon
Armaments, well above its usual $12 trading price. Within the past year, its stock has traded
as low as $10 per share. High Noon is contemplating the purchase of a competitor for
$8,000,000. If it were to pay with stock, it would only issue 400,000 shares at the current
stock price. The number of shares would usually be 666,667 shares at the normal trading
price, or 800,000 at the lowest trading price.

If the acquirer believes that it has obtained a good (i.e., low) price for an acquisition,
it will be less inclined to pay with its own stock. If it were to do so, the price of the
stock should increase, and the shareholders of the seller would share in that increase.
In such a situation, the acquirer should be more interested in buying for cash; doing
so means that all share price increases will accrue to the benefit of existing
shareholders.

Note: If a canny seller feels that the stock price of the acquirer will increase as a
result of the acquisition, and it was paid in cash, then it can use the cash to buy the
shares of the acquirer. However, this will result in a short-term gain that is taxable at
a higher tax rate, unless the shareholder wants to hold the shares for an extended
period of time.

EXAMPLE

High Noon Armaments makes a low-ball offer for Black Powder Weaponry, which is
currently having cash flow problems. The price is $6,000,000, and High Noon believes that
the actual value of Black Powder is closer to $10,000,000. High Noon currently has
2,000,000 shares of common stock outstanding, at a market price of $12 per share, which
gives the company a total market valuation of $24,000,000. High Noon could pay with
500,000 shares of its stock (calculated as $6,000,000 price ÷ $12 per share). However, High

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Noon must consider the impact on its current shareholders if the market later increases the
price of its stock to reflect the full value of the Black Powder deal. The impact is noted in the
following table:

Deal Structure Stock Price Calculation

Pay in cash ($24,000,000 current valuation + $10,000,000 incremental valuation -
$6,000,000 cash) ÷ 2,000,000 shares = $14.00/share
Pay in stock ($24,000,000 current valuation + $10,000,000 incremental valuation)
÷ (2,000,000 existing shares + 500,000 new shares) = $13.60/share

Thus, paying with stock for the Black Powder acquisition reduces the eventual price per
share that the original High Noon shareholders would realize by $0.40.

If the seller drives an extremely hard bargain, where there is little room for the
acquirer to earn a profit from the transaction, the acquirer should be more inclined to
offer stock as part of the deal structure. By doing so, the seller’s shareholders take
on some of the risk that the value of the shares with which they are paid will decline
in value.

Tip: When the acquirer has plenty of cash available, but chooses to offer mostly its
own stock as payment, this is a signal that it expects to have problems achieving
sufficient synergies to make the deal worthwhile, and so is shifting some of the risk
of failure to the seller. Thus, if the value of the combined companies is less than
expected, the market price of the acquirer’s stock will decline, which reduces the
amount that the shareholders of the seller will realize.

Stock Payment Based on Fixed Share Count or Fixed Price

There are two ways in which a stock-for-stock deal can be structured. They are:
• Fixed share count. Under this method, the exact number of shares to be paid
is incorporated into the purchase agreement. This introduces some risk to
the seller, in that the market value of the acquirer’s shares could change in
the days leading up to the purchase date. However, it also gives the seller a
fixed percentage of ownership in the acquirer, irrespective of changes in the
stock price.
• Fixed price. Under this method, the total price to be paid is incorporated into
the purchase agreement. The actual payment is based on the market price of
the acquirer’s stock on the effective date of the agreement. This method
reduces the risk to the seller that the value of the underlying shares will de-
cline in the days leading up to the acquisition.

The problem with stock price variability and its impact on the purchase price is
sometimes resolved through the use of a collar agreement. A collar agreement is a
clause within a stock-for-stock purchase transaction, where the number of shares
paid to the shareholders of the seller will be adjusted if the market price of the

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acquirer’s shares trade above or below certain predetermined levels, which are
usually 10-20% above and below the midpoint stock price. The agreement may also
allow either party to terminate the acquisition arrangement if stock prices fluctuate
beyond specific price points.
There are several variations on the collar concept. In a fixed-price collar, the
price is fixed within the collar boundaries. For example, the price might be set at
$10.00 per share, within a share price range of $9.00 to $11.00. In this case, the
width of the collar is $2.00. If the price of the acquirer’s stock moves outside of the
collar, then the price is based on an exchange ratio. In this situation, the seller
benefits from gaining more shares if the acquirer’s stock price falls below the lower
collar, while the acquirer benefits from issuing fewer shares if its share price
increases above the higher collar. Thus, the price is fixed within the collar and
variable outside of the collar. The fixed-price collar works well when the seller
wants to be sure of obtaining a specific valuation amount.
In a fixed-exchange collar, the exchange ratio is locked between the collar
boundaries. This means that the acquirer is setting a fixed number of shares that will
be paid within the boundaries of the collar. Outside of the upper and lower
boundaries of the collar, the price is fixed. In this situation, the acquirer keeps from
having to issue more of its own shares if its share price plummets below the lower
collar, while the seller benefits from an increase in the share price of the acquirer
above the upper collar. Thus, the price is variable within the collar and fixed outside
of the collar. The fixed-exchange collar works well when:
• The acquirer wants to preserve for itself any upside potential in its stock price
• The seller wants to establish a floor on the value of the consideration it
receives

Tip: If an acquirer is engaged in a bidding war for a target company, it can modify
its bid to include a collar agreement. This reduces the risk for the seller, and so
makes the acquirer’s bid more valuable.

The collar agreement is particularly important in two situations:

• Volatility. Stock prices in some industries are unusually volatile, making it
difficult to pin down a price to use for the exchange ratio.
• Time to close. If regulatory approval is required, it will lengthen the time
required to close the purchase transaction. This means there is some risk that
the acquirer’s share price will gradually drift away from the amount at
which the exchange ratio was first calculated. For these longer closing
transactions, it is customary to adopt fairly wide collars.

In short, the collar agreement is useful for preserving the value of the compensation
that the seller receives, at least for the time period covered by the collar agreement.

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The Debt Payment

The acquirer may include debt in the structure of its deal to buy the acquiree. This
can be beneficial to the seller’s shareholders, since they do not pay income taxes
until they receive the debt payments.
The seller should not accept this form of payment unless it is very certain of the
financial condition of the acquirer. Otherwise, if the acquirer were to enter
bankruptcy, the seller’s shareholders would simply be categorized among other
creditors to be paid out of any remaining assets. The seller can mitigate this risk to
some extent by placing the holders of the debt in the most senior position of all debt
holders. However, most companies already have assigned senior debt positions to
other lenders, so the shareholders are instead placed in a junior debt position. The
seller could place a lien on the assets of the acquiree, but the seller will have no
control over those assets once the purchase agreement is finalized; this means that
the acquirer could sell off the assets and use the proceeds, or simply let the
equipment run down over time without proper maintenance, leaving little for the
seller’s shareholders to recover.

Tip: A common acquirer ploy is to offer a large proportion of cash and a smaller
amount of debt that is either unsecured or very junior to other debt. If the debt is
considered to be speculative in any way, the seller should essentially ignore it for
purposes of evaluating the offer, and instead focus on the cash component of the
deal.

Even if the seller is certain of the financial condition of the acquirer, accepting debt
means that the shareholders will have no access to cash until the debt payments
begin. This can be a problem if the shareholders previously received dividends or
other distributions from the target company, and are no longer receiving that cash
flow. Also, now that they are debt holders, rather than shareholders, they have no
ability to vote for a new board of directors, and so have no control over the business
that owes them money.

Tip: If the interest rate on a note is at the market rate, the seller may be able to sell
the debt to another party at its face value. However, there may be a discount related
to the perceived creditworthiness of the acquirer.

Payment in debt also means that the acquirer is in a position to profit from 100% of
any stock appreciation caused by the acquisition, while the seller is locked into a
fixed payment plan.

Tip: If it appears that a significant proportion of the purchase price will be paid in
the form of debt, the seller should insist on convertible debt. This means that the
seller’s shareholders can switch to stock if there is a surge in the price of the
acquirer’s stock, which allows them to share in the appreciation of the stock.

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The acquirer is more likely to offer debt, if only because it can then conserve its
cash. The use of debt may be the only alternative when it is difficult for the acquirer
to obtain credit from lenders. It is an especially useful tool when the acquirer can
force the seller to accept a junior debt position behind its other lenders, thereby
effectively placing the seller’s shareholders in a position not much better than that of
its general creditors.
In short, despite the favorable tax impact of debt payments, this is the worst
alternative for the seller. On the flip side of the deal, it is usually the best alternative
for the seller. Thus, the two sides are quite likely to dicker over the presence of debt
in a deal, the terms associated with the debt, and its convertibility into the acquirer’s
stock.

The Cash Payment

The form of payment generally preferred by shareholders is cash. It is particularly
appreciated by shareholders who are unable to sell their stock by other means, which
is the case for most privately-held companies. In addition, they no longer have to
worry about the future performance of their company impacting the amount that
they will be paid. The degree to which cash is preferred is indicated by the extent to
which sellers are generally willing to accept a smaller amount of cash rather than a
larger payment in stock or debt. However, a cash payment also means that the
selling shareholders must pay income taxes on any gains immediately.
From the perspective of the acquirer, a cash payment presents both pluses and
minuses. One advantage is that, in a competitive bidding situation, the bid of the
buyer willing to pay cash is more likely to be accepted by the seller. Also, not
paying in stock means that any future upside performance generated by the
acquisition accrues solely to the existing shareholders of the acquirer – the
shareholders of the acquiree are taking cash instead, so they are blocked from the
gains.
The main disadvantage of paying with cash is the availability of cash to the
acquirer. If the purchase will use up the bulk of its cash on hand, and the borrowing
environment is difficult, the acquirer could place itself in a tenuous financial
position. However, using cash places greater financial discipline on an acquirer, who
may therefore be more prudent in setting an offer price than a company that is
willing to pay with vast amounts of stock.
A possible point of contention is the tax effect of a cash payment. The seller’s
shareholders must immediately pay income taxes on any gain resulting from a cash
transaction, so they may want additional compensation to pay for the taxes. The
acquirer typically resists this pressure, on the grounds that cash is a scarce
commodity, and that the taxation status of the individual shareholder of the seller is
not under the control of the acquirer.

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The Consulting Contract

A common element in many deals is the consulting contract clause. This is
incorporated into the purchase agreement, and states that certain members of the
acquired entity will be paid a recurring amount to consult with the acquirer on
various issues to be named at a later date. This clause is a common addition to deals
where the bulk of the compensation is a stock-for-stock deal, because the sellers
need some liquidity in the short term, and the “consulting” arrangement provides the
necessary cash.
The consulting obligations of the person being paid are usually perfunctory; if
there are obligations, they usually involve short-term transitional issues, after which
there is little expectation of providing services. The associated cash payments are
taxable to the recipient as ordinary income, which is the highest tax rate, so the deal
should be structured not to assign too much of the total compensation to the
consulting contract.

Impact on Earnings per Share

The investment community may take the simplistic approach of evaluating the
structure of an acquisition deal based solely on the resulting earnings per share
(EPS) of the combined entity. In reality, the impact of a business combination may
not be fully realized for years, whereas EPS has more of a historical orientation.
Nonetheless, it is useful to understand the calculation of the combined EPS in order
to anticipate the reaction of investors and analysts. The calculation is:

Acquirer earnings + Acquiree earnings

Total shares outstanding following = Combined earnings per share
acquisition

EXAMPLE

High Noon Armaments acquires Barbary Coast Rifles for 250,000 shares of its common
stock. Barbary earned $250,000 in its most recent year of operations. Just prior to the
acquisition, High Noon had 2,000,000 shares outstanding, and earned $1,500,000 in its most
recent year of operations. The before-and-after earnings per share of High Noon are
calculated as follows:

Before Acquisition After Acquisition

$1,500,000 profit ÷ 2,000,000 shares $1,750,000 profit ÷ 2,250,000 shares
= $0.75 earnings per share = $0.78 earnings per share

Earnings per share have increased as a result of the acquisition transaction, which is received
favorably by the investment community.

In any acquisition where the resulting changes in profits and shares outstanding
results in a decline in earnings per share, the acquisition is said to be dilutive to

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earnings. When the reverse situation occurs, the acquisition is said to be accretive to
earnings.

The Earnout Payment

We addressed the concept of the earnout in the Valuation of the Target chapter. An
earnout is a payment that occurs after the purchase transaction has closed, and which
is based on the future performance of the acquiree. It is used when the seller believes
the future performance of the acquiree is greater than what the acquirer is willing to
incorporate into its offer price. Thus, the earnout bridges the expectations gap
between the two parties.
The earnout is useful from a taxation perspective, since the seller’s shareholders
only pay taxes on it when they receive cash, which could be spread over several
years.
To avoid confusion, the deal structure should state the exact terms under which
the earnout is to be paid. Consider the following points when designing the terms:
• Allowed changes to business. State the extent to which the acquirer can alter
the acquiree’s business model during the earnout period.
• Basis of calculation. Only pay an earnout based on revenue generated. If the
calculation is based on profits, the seller can complain that post-acquisition
actions taken by the acquirer (such as allocating corporate overhead to the
acquiree) reduced profits.
• Definitions. The agreement should contain precise definitions of any terms
used in the calculation of the earnout. If there is even a hint of a possible
difference of opinion concerning a definition, it could result in a legal dis-
pute over the amount of payment owed.
• Duration. Keep the earnout period as short as possible. Having a longer
period that spans multiple years makes it difficult for the acquirer to proper-
ly integrate the acquiree into its operations. If the acquirer had been plan-
ning to dismember the acquiree as an operating entity, it cannot do so until
the earnout period has been completed.
• Examples. It is useful to include sample exhibits in the agreement, showing
exactly how the earnout would be calculated. This provides clarity when
there are disputes over earnout calculation issues.
• Graduated payout. The seller should earn a percentage of any gain above a
certain minimum level of performance. This is much better than setting a
large payout only if a specific hurdle is reached, since not reaching that hur-
dle is bound to involve hard feelings and a possible lawsuit.

The earnout is theoretically based on the ability of the acquiree to generate

additional cash flow in the future, so this means that the conditions underlying the
earnout should increase the cash available to the acquirer. Thus, the acquirer should
pay for earnouts in cash, rather than in stock or debt.

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Practical Considerations
Much of the preceding discussion has addressed a number of theoretical
considerations of the benefits of various types of deal structures. In reality, the type
of payment will be driven by that entity having the most power in an arrangement.
Here are several scenarios to consider:
• Bankruptcy. The acquirer may be required by the bankruptcy court to pay in
cash, and would be more likely to do so in any event, since it is likely buy-
ing at a low price and wants the residual value to accrue to its shareholders.
• Controlling acquirer shareholder. If there is a controlling shareholder of the
acquirer, that individual or business may want to avoid having its share
holdings watered down by the issuance of stock to a seller.
• Controlling seller shareholder. Whoever owns the controller interest in the
seller can dictate the terms of the deal structure, as long as there are multiple
bidders.
• Hostile bid. If an acquirer is making an unwelcome bid, it will likely need to
offer cash in order to win over the shareholders of the target company.
• Management ownership of seller. If the managers of the seller own a large
part of its shares, they are more likely to demand a stock-for-stock deal, on
the grounds that they will then become large shareholders of the acquirer,
and so may be able to influence their continuing employment by the acquir-
er.
• Multiple bidders. In a multi-bidder environment, the bid with the largest
proportion of cash usually wins.
• Sole bidder. If the seller is motivated to sell and there is only one bidder,
then the bidder can adopt a take-it-or-leave-it attitude and impose a range of
possible deal structures.

Thus, the key determinant of the deal structure can swing between the acquirer and
the seller, depending on the circumstances.

Summary
When negotiating a deal structure, the two parties must take into account their
respective financial positions, expectations for future gains, and tax requirements.
The following table shows the respective issues of both parties:

Deal Structure Acquirer Acquiree

Stock • Shares future stock gains • No immediate liquidity
• Preserves cash • Defers income taxes
• May dilute EPS
Debt • Takes all future stock gains • No share of future stock gains
• Preserves cash • At risk of non-payment
• Accepts liens on some assets • Defers income taxes
• Does not dilute EPS

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Deal Structure Acquirer Acquiree

Cash • Takes all future stock gains • Gains liquidity
• More likely to win in bidding • No share of future stock gains
war • Immediate tax liability
• At risk of not having
sufficient cash
• Requires more discipline
• Does not dilute EPS

However, if there is only one possible buyer, and that buyer is having trouble
obtaining financing for the deal, then all of the various permutations just noted do
not factor into the deal structure. Instead, the acquirer simply assembles the only
available funding package and presents it to the seller for approval; there is no
negotiation of structure, for the acquirer cannot negotiate. Instead, the seller is faced
with a binary solution – to either accept or reject the deal as offered.
This chapter has discussed the structure of a deal, but only from the perspective
of the type of payment offered. In the next chapter, Legal Structure of the
Acquisition, we address the tax implications of an acquisition, and how taxes impact
the legal structure of the deal.

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 Chapter 11
Legal Structure of the Acquisition
Introduction
There are a number of legal structures available for combining the businesses of the
acquirer and the acquiree. The structure chosen will have a direct impact on whether
the income tax on the seller’s gain can be deferred, on the ability of the acquirer to
avoid liabilities, on the types of payment made, and several other factors.
Consequently, both parties must be cognizant of the advantages and shortfalls of the
legal structure they select. This chapter discusses the merits and failings of the most
common legal structures for an acquisition.

Related Podcast Episode: Episode 88 of the Accounting Best Practices Podcast

discusses types of acquisitions. You can listen to it at: accounting-
tools.com/podcasts

Tax Issues in an Acquisition

There are significant taxation issues related to acquisitions that can allow an astute
seller to defer the recognition of income taxes for many years, or create an
immediate (and large) tax liability for an uninformed seller. There are lesser, though
still important, tax issues that impact the acquirer. The central tax issues related to
an acquisition are noted in the following sub-sections.

Tax Issues for the Seller

The seller wants to delay the taxation of any gains it may realize through an
acquisition transaction. Delaying taxes has value, since income taxes paid in the
future have a smaller present value than taxes paid now. The tax treatments of the
various forms of compensation are as follows:
• Stock-for-stock. In a stock-for-stock exchange, income taxes are deferred
until such time as the recipient of the stock of the acquirer sells that stock
(which could be years in the future). If the recipient waits for a sufficiently
long time to sell the stock (typically one year), the transaction is recognized
as a long-term capital gain, for which a much lower tax rate is paid.
• Cash. A cash payment requires the immediate recognition of income taxes.
• Debt. Debt payments are taxable when received. Thus, there is a tax deferral
aspect to this type of payment.
• Other consideration. If some other form of consideration is paid, the
recipient is likely to owe income taxes at once if the recipient realizes a gain
 Legal Structure of the Acquisition

on the difference between the value of the consideration received and the
cost basis of the stock given up.

If the consideration received in an acquisition is a combination of the preceding

elements, then some elements will be taxable and others will have deferred taxation.

Note: There are instances where the tax basis of the seller is higher than the price to
be paid, in which case there is no gain on which income taxes would be paid. In this
situation, the seller is much more likely to want a cash payment.

Tax Issues for the Acquirer

Tax issues have a much smaller impact on the acquirer than the acquiree.
Nonetheless, the acquirer should certainly be aware of the following issues:
• Asset step up. The acquirer wants to step up the recorded value of any assets
it acquires to their fair market values, which allows it to use a higher level of
depreciation expense to shield more profits from taxation. This is allowable
in a taxable transaction, and not allowed in a tax-free transaction. However,
if the fair market value of acquired assets is less than their net book values,
the acquirer has no opportunity to engage in a step up transaction.
• Net operating loss carry forwards. The acquirer can gain access to unused
net operating losses (NOLs) incurred by the seller, which the acquirer can
use to shield the profits of the acquiree. However, these losses can only be
recognized over lengthy periods, and so do not play a major role in the ac-
quisition decision or how it is structured. Ultimately, an acquisition should
be based primarily on other factors than the use of an NOL.

The tax issues pointed out in this section are not minor; in some acquisitions, the
seller will be so insistent upon a particular legal structure to take advantage of a tax
situation that the deal will fail without it. The reason is that income taxes can cut
deeply into the gains of selling shareholders.

Issues with Stock Purchases

Most of the legal structures described in the following sections are based on a desire
to purchase the shares of the seller, rather than its assets. Buying shares means that
the acquirer will then own the seller’s business entity, rather than just its assets. This
has the following ramifications:
• Contracts. Since the seller’s business is presumably going to continue in
operation as a subsidiary of the acquirer, the acquirer also obtains both the
customer and supplier contracts of the seller. This can be useful if the seller
has a large backlog of customer orders. However, some business partners
include a “change of control” clause in their contracts, under which they
have the option to terminate a contract if there is a change of control of the
business. This does not necessarily mean that those business partners will

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terminate the contracts, but the acquirer will probably have to negotiate new
ones.
• Liabilities. The downside of purchasing an entire business is that the
acquirer is now responsible for all of its liabilities, even those that are not
documented. It may have the right to obtain reimbursement from the seller
for undocumented liabilities, but nonetheless, this presents a risk to the ac-
quirer.
• Net operating loss carry forwards. Since a stock purchase shifts ownership
of the seller entity to the acquirer, the acquirer also gains any NOLs owned
by the seller.
• Goodwill amortization. Goodwill is the difference between the purchase
price of an acquisition and the amount of the price not assigned to the assets
and liabilities obtained in the acquisition. When the acquirer buys the stock
of the seller, it cannot amortize any goodwill associated with the transaction
for tax purposes. Since goodwill can comprise a large part of the amount
paid, this can substantially increase the amount of income taxes that the
acquirer pays.

General IRS Requirements to Avoid Gain Recognition

The Internal Revenue Service (IRS) stipulates in its Internal Revenue Code (IRC) a
number of acquisition structures that can allow the deferral of gain recognition. A
proposed transaction must incorporate all three of the following concepts into an
IRS-approved acquisition structure before gain deferral will be allowed:
• Bona fide purpose. The proposed transaction must have a genuine business
purpose other than the deferral or complete avoidance of taxes.
• Continuity of business enterprise. The acquirer must continue to operate the
acquired entity, or at least use a large proportion of the acquired assets in a
business.
• Continuity of interest. The shareholders of an acquired business must
receive a sufficient amount of stock in the acquiring entity (generally con-
sidered to be at least 50% of the purchase price) to have a continuing finan-
cial interest in it.

It is possible to circumvent the continuity of interest rule to some extent by issuing

the minimum stock requirement to the seller in the form of preferred stock. Doing so
gives recipients a periodic dividend, so that they receive some cash flow in the short
term.
The IRS acquisition models that can be used to defer income taxes are called
Type A, B, C, or D reorganizations (we will refer to them as acquisition types, rather
than reorganization types). The IRS requirements for these acquisition structures are
described in the following four sections.

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The Type “A” Acquisition

An acquisition transaction can be designed to follow the IRS guidelines for a Type
“A” acquisition, which are stated in Section 368(a)(1) of the IRC (paragraph A).
This acquisition has the following characteristics:
• At least 50% of the payment must be in the stock of the acquirer
• The selling entity is liquidated
• The acquirer acquires all assets and liabilities of the seller
• It must meet the bona fide purpose rule
• It must meet the continuity of business enterprise rule
• It must meet the continuity of interest rule
• It must be approved by the boards of directors of both entities, plus the
shareholders of the selling entity

This transaction type is among the more flexible alternatives available, since it
allows for a mix of payment types. It also allows selling shareholders to defer the
recognition of income taxes related to those shares exchanged for acquirer stock.
However, shareholders must recognize income on all non-equity payments made to
them. Also, because the acquired entity is liquidated, this terminates any acquiree
contracts that had not yet expired, which could cause problems for the acquirer.
The Type “A” acquisition is most useful in situations where the seller wants to
receive a mix of cash and stock from the acquirer, which allows it to defer a portion
of the related taxable income. Acquirers tend to be less enamored of this approach,
since they run the risk of losing any contracts held by the acquired entity when it is
liquidated.

The Type “B” Acquisition

An acquisition transaction can be designed to follow the IRS guidelines for a Type
“B” acquisition. This acquisition is defined as follows in Section 368(a)(1) of the
IRC (paragraph B):

“The acquisition by one corporation, in exchange solely for all or a part of its voting
stock (or in exchange solely for all or a part of the voting stock of a corporation
which is in control of the acquiring corporation), of stock of another corporation if,
immediately after the acquisition, the acquiring corporation has control of such
other corporation (whether or not such acquiring corporation had control immedi-
ately before the acquisition).”

The transaction has the following characteristics:

• Cash cannot exceed 20% of the total consideration
• At least 80% of the acquiree’s stock must be acquired with the acquirer’s
voting stock
• The acquirer must buy at least 80% of the acquiree’s outstanding stock

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• Acquiree shareholders cannot be given the option of being paid in cash

instead of stock, if the result could potentially be that less than 80% of the
acquiree’s stock is acquired with the acquirer’s voting stock; even having
this option available disallows the use of the Type “B” acquisition
• The selling entity becomes a subsidiary of the acquirer
• It must meet the bona fide purpose rule
• It must meet the continuity of business enterprise rule
• It must meet the continuity of interest rule
• It must be approved by the boards of directors of both entities, plus the
shareholders of the selling entity

It is possible to have a creeping Type “B” acquisition, if the stock of the acquiree is
purchased within a 12-month period and there is a plan to acquire it as a result of
these transactions. There are two additional rules related to a creeping acquisition,
which are:
• The acquirer can only use stock-for-stock purchases; cash is not allowed
• The acquirer could have used cash to buy shares in the acquiree at some
point in the past, as long as those purchases were not part of a plan to ac-
quire the business at that time

The Type “B” acquisition is most useful when the seller needs to keep operating the
seller’s business and its contracts. However, it forces the seller to accept nearly all
acquirer stock in payment for the acquisition.

The Type “C” Acquisition

An acquisition transaction can be designed to follow the IRS guidelines for a Type
“C” acquisition. This acquisition is defined as follows in Section 368(a)(1) of the
IRC (paragraph C):

“The acquisition by one corporation, in exchange solely for all or a part of its voting
stock (or in exchange solely for all or a part of the voting stock of a corporation
which is in control of the acquiring corporation), of substantially all of the
properties of another corporation, but in determining whether the exchange is solely
for stock the assumption by the acquiring corporation of a liability of the other shall
be disregarded.”

In essence, this is the transfer of the assets of the seller to the acquirer in exchange
for the voting stock of the acquirer. This acquisition has the following characteris-
tics:
• The acquirer must buy at least 80% of the fair market value of the acquiree’s
assets
• The acquirer can use cash only if it uses its voting stock to buy at least 80%
of the fair market value of the acquiree’s assets
• The selling entity must be liquidated

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• It must meet the bona fide purpose rule

• It must meet the continuity of business enterprise rule
• It must meet the continuity of interest rule
• The acquirer may not have to gain the approval of its shareholders for the
transaction, since this is an asset purchase. The acquired entity must gain the
approval of its shareholders for the transaction.

A problem with the Type “C” acquisition is that dissenting shareholders can demand
that their shares be appraised and paid for in cash. If the resulting cash payments are
more than 20% of the total compensation paid, this violates the Type “C”
requirements and invalidates its use as a tax-deferral method for those shareholders
receiving stock.
The Type “C” acquisition is most useful when the acquirer wants to treat the
transaction as an asset purchase, and the seller wants to be paid primarily in stock in
order to defer the recognition of income taxes.

The Type “D” Acquisition

A Type “D” acquisition is defined as follows in Section 368(a)(1) of the IRC
(paragraph D):

“A transfer by a corporation of all or a part of its assets to another corporation if

immediately after the transfer the transferor, or one or more of its shareholders
(including persons who were shareholders immediately before the transfer), or any
combination thereof, is in control of the corporation to which the assets are
transferred; but only if, in pursuance of the plan, stock or securities of the corpora-
tion to which the assets are transferred are distributed in a transaction which
qualifies under [Sections 354, 355, or 356].”

This transaction is designed primarily to subdivide a business into smaller

components, which are then spun off to shareholders. The following are variations
on the type “D” concept:
• Spin-off. A company is divided into at least two entities, and existing
shareholders receive shares in the new entities.
• Split-off. A company is split into different entities, with some shareholders
only retaining their shares in the original entity, while others turn in their
shares in exchange for shares in the new entity.
• Split-up. A company creates several new entities, transfers its assets and
liabilities to them, and liquidates itself. Shareholder interests transfer to the
new entities.

All of the variations noted here are designed for the internal restructuring of a
business, rather than the acquisition of an outside entity.

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Triangular Mergers
All of the preceding acquisition arrangements suffer from a potential problem,
which is that there may be some dissenting shareholders who disagree with the deal,
and refuse to participate in it. If so, they may elect to continue as minority
shareholders, or demand appraisal rights, or vote against the deal in the stockholder
vote that is required for most types of acquisitions. In addition, it can be hard to
contact the many shareholders of a public company to obtain their votes.
Appraisal rights are the legal right of dissenting shareholders to not accept an
offer to buy their shares, but instead to have their shares appraised and purchased –
typically in cash. Appraisal rights may not be allowed, depending upon the state of
incorporation of the selling entity. Appraisal rights can cause trouble in some types
of acquisitions, since the amount of cash paid for these shares may invalidate the
type of acquisition structure being used.
It is possible to get around the problems posed by dissenting shareholders, as
well as the sheer volume of shareholders in a public company, through the use of a
merger transaction, rather than an acquisition transaction. In a merger, all
shareholders are required to accept the price offered by the acquirer, if the seller’s
board of directors approves the deal. In this section, we present two types of mergers
– the triangular merger and the reverse triangular merger.

The Triangular Merger

In a triangular merger, the acquirer creates a wholly-owned subsidiary, which in turn
merges with the selling entity. The selling entity then liquidates. The acquirer is the
sole remaining shareholder of the subsidiary. The characteristics of the transaction
are the same as those for a Type “A” acquisition, which are:
• At least 50% of the payment must be in the stock of the acquirer
• The selling entity is liquidated
• The acquirer acquires all assets and liabilities of the seller
• It must meet the bona fide purpose rule
• It must meet the continuity of business enterprise rule
• It must meet the continuity of interest rule
• It must be approved by the boards of directors of both entities

The Reverse Triangular Merger

A reverse triangular merger is the same as a triangular merger, except that the
subsidiary created by the acquirer merges into the selling entity and then liquidates,
leaving the selling entity as the surviving entity, and a subsidiary of the acquirer. Its
characteristics are:
• At least 50% of the payment must be in the stock of the acquirer
• The subsidiary created by the acquirer is liquidated
• The acquirer acquires all assets and liabilities of the seller
• It must meet the bona fide purpose rule
• It must meet the continuity of business enterprise rule

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• It must meet the continuity of interest rule

• It must be approved by the boards of directors of both entities

The reverse triangular merger is used much more frequently than the triangular
merger, because the reverse version retains the seller entity, along with any business
contracts it may have. It is also useful when there are a large number of shareholders
and it is too difficult to acquire their shares through a Type “A” acquisition.

The Asset Acquisition

The preceding legal structures were based on the assumption that the acquirer wants
to control the business entity of the seller. What if that is not the case, and the
acquirer only wants to purchase the assets of the seller? Doing so has the following
ramifications:
• Contracts. If the acquirer only buys the assets of the seller, it is not acquir-
ing any contracts with the business partners of the seller. This can cause
havoc if the acquirer intends to continue doing business with the customers
and suppliers of the seller, since all contracts will have to be renegotiated.
• Liabilities. An asset acquisition actually means that the acquirer buys only
those assets and liabilities specifically stated in the purchase agreement.
Thus, there may be a transfer of liabilities. However, it will not include un-
documented or contingent liabilities; this is the main reason for an asset
acquisition.
• Asset step-up. The acquirer records any assets acquired at their fair market
values, and depreciates these (presumably) stepped-up values for tax pur-
poses. If the fair market value of the assets acquired is less than their net
book values, then there is no tax benefit. In addition, the acquirer can amor-
tize any goodwill associated with the acquisition for tax purposes.
• Net operating loss carry forwards. Since the acquirer is not purchasing the
seller’s business entity, it does not obtain the NOLs associated with that
entity.

Note: If an acquirer elects to purchase the assets of an acquiree, this means that it
must obtain the title to each individual asset that it purchases – which can involve a
substantial amount of legal work if there are many fixed assets. Also, it may be
necessary to have liens removed from the acquired assets, which may call for
negotiations with the creditors of the acquiree.

It may not be possible to disassociate the liability for environmental cleanup from an
asset purchase. In some situations, environmental regulations state that the cost of
future hazardous waste remediation can attach to assets, as well as legal entities.
Consequently, if the acquirer is planning to buy real estate as part of an asset
purchase, it should engage in considerable due diligence for environmental
problems.

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In summary, an acquirer may insist on an asset acquisition if it believes that the

risk of acquiring additional liabilities is too great. It may also be a useful method if
the acquirer only wants to pluck a specific “crown jewel” asset out of the seller, such
as a key patent.
The shareholders of the seller are opposed to asset acquisitions, for the follow-
ing reasons:
• Remainders. They end up owning any residual parts of the seller (usually its
liabilities).
• Double taxation. The seller must pay income taxes on any gains realized
from the sale of its assets. Then, if the entity chooses to pass through these
gains to its shareholders, it does so with a dividend, which is taxed again. To
make matters worse, if the seller had previously claimed an investment tax
credit on the assets it is now selling, it may have to give back some of the
credit, which increases its tax liability. Double taxation does not occur if the
selling entity is organized as a subchapter “S” or similar organization (see
the next section).

The asset acquisition can be useful when the acquirer only wants to buy a small
piece of the selling entity, such as a specific product line. If so, the only way to
complete the transaction will probably be an asset sale, because there is no entity
that owns just the desired assets and no others.

Impact of the Acquiree Organizational Form

There is a difference in the value of an acquiree, depending on whether it has been
organized as an “S” Corporation or a “C” Corporation. The key difference is that the
acquirer can more readily step up the recorded cost of the assets acquired from an
“S” corporation.
The regulation that applies to this situation is Internal Revenue Code Section
338(h)(10). In essence, this section of the IRC allows the acquirer to purchase the
shares of an “S” corporation while treating the transaction from a tax perspective as
the purchase of its assets. This has two ramifications:
• The acquirer can step up the value of the acquiree’s assets
• The acquiree entity is not terminated, so its contractual arrangements are
now owned by the acquirer (though the contracts may still be subject to
change of control clauses that terminate the contracts)

This means that the price an acquirer is willing to pay for an “S” corporation is
likely to be higher than if the same entity were organized as a “C” corporation. The
increase in price is based on the present value of the tax savings that the acquirer
will generate from the incremental increase in the asset depreciation and goodwill
amortization of the stepped-up assets it acquired in the transaction.
Thus, organizing a selling business as a subchapter “S” corporation increases its
value to an acquirer, and so should raise the price paid for it.

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The same situation applies to a limited liability corporation and a limited

partnership, though the applicable text in the IRC is in Section 754.

Summary
There are many types of legal structures available to the buyer and seller, each
offering a different mix of features. The legal structure selected will be the result of
negotiations between the parties, and perhaps an alteration of the mix and amount of
compensation paid in order to match the structure selected. The following bullet
points note the key features of each legal structure described in this chapter:
• Type “A” acquisition. Allows for a mix of payment types, and deferred tax
recognition on stock payments. However, the selling entity is liquidated,
which may terminate key contracts to which the seller was a party.
• Type “B” acquisition. Requires payment mostly in stock, so there is little
liquidity for the seller. However, the selling entity is retained, so the acquir-
er does not lose any contracts held by the seller. This is a popular legal
structure.
• Type “C” acquisition. Requires payment mostly in stock, so there is little
liquidity for the seller. This is essentially an asset sale. Dissenting share-
holders who are paid cash can keep this type of deal from being completed.
• Type “D” acquisition. Ideal for splitting apart a company; rarely used for
acquisitions.
• Triangular merger. Useful for avoiding dissenting shareholders. Also allows
for a mix of payment types, and deferred tax recognition on stock payments.
However, the selling entity is liquidated, which may terminate key contracts
to which the seller was a party.
• Reverse triangular merger. Useful for avoiding dissenting shareholders.
Also allows for a mix of payment types, and deferred tax recognition on
stock payments. The selling entity is retained, so the acquirer does not lose
any contracts held by the seller. This is a popular legal structure.
• Asset purchase. Mostly of interest to the acquirer, which only buys the
assets it wants, thereby reducing its risk of incurring undocumented liabili-
ties. Also allows for the step-up of assets to their fair market values. In-
volves double taxation to the shareholders of the seller, who therefore gen-
erally oppose this method.

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 Chapter 12
Acquisition Documents
Introduction
Several documents are used in the acquisition process, one to set the initial
boundaries of what the parties hope to accomplish, one to act as the purchase
contract, and possibly another to document the circumstances under which the
contract was assembled. In this chapter, we discuss the contents of these documents
– the letter of intent (or a smaller variation called the term sheet), the purchase
agreement, and the closing memorandum.

Related Podcast Episode: Episode 85 of the Accounting Best Practices Podcast

discusses the acquisition term sheet. You can listen to it at: accounting-
tools.com/podcasts

The Letter of Intent

The letter of intent (LOI) is a brief document submitted by the acquirer to the target
company, in which it states the price and conditions under which it offers to acquire
the company. A draft of the LOI is usually circulated among the parties and their
attorneys for changes to be negotiated before a final version is signed. The key
elements of an LOI are:
• Binding. The LOI will state whether the terms in the document are binding.
Usually, they are not, and the LOI will go on to state that the terms are sub-
ject to the eventual negotiation of a purchase agreement. For example:

The terms of this document are not legally binding on either party. The
term sheet is only intended to reflect the intentions of the parties, who will
use this document as the basis for the subsequent good faith negotiation of
a legally binding definitive purchase agreement.

• Parties. This states the names of the acquirer and the target company. For
example:

ABC Corporation, a Colorado corporation (“Buyer”), and DEF Incorpo-

rated, an Iowa corporation (“Seller”).

• Price. This is the total amount of consideration to be paid to the seller.

There should be a statement that the stated price will vary, depending upon
information uncovered during the due diligence process. For example:
 Acquisition Documents

Buyer anticipates paying the shareholders of Seller $1.2465 per share for
all tendered common stock of Seller. This price is calculated based on the
financial results and representations of Seller. If contrary information is
uncovered during the due diligence process, the parties may agree to an ad-
justed price per share.

• Form of payment. This states whether the price will be paid in cash, debt,
stock, or some mix of these elements. For example:

Buyer will pay the shareholders of Seller a mix of cash and the common
stock of Buyer. This mix shall be 40% of the price in cash and 60% in
common stock. The amount of common stock issued shall be based on a
conversion ratio of 2.0 shares of Seller common stock for 1.0 shares of
Buyer common stock. The price shall be paid on the closing date.

• Earnout. If there is to be an earnout, this clause states how the earnout is to

be calculated. For example:

An additional payment of $1,000,000 in cash shall be paid to the Seller

shareholders if the audited financial statements of the Seller entity for the
year 20X1 reveal an increase in operating net income from 20X0 of at least
$1,500,000. The payment shall be made no later than five business days
following the release of the audited financial statements for the year ended
20X1.

• Working capital adjustment. This states any changes in the purchase price
that will be triggered if the seller’s working capital varies from a certain
predetermined amount as of the closing date. For example:

If the aggregate amount of Buyer working capital is less than the base
amount of working capital, the difference shall be treated as a reduction of
the purchase price. If the aggregate amount of Buyer working capital is
more than the base amount of working capital, the difference shall be treat-
ed as an increase in the purchase price.

Tip: The working capital adjustment must be included in the purchase agreement, so
it should be stated early, in the letter of intent, to ensure that both parties are aware
of the adjustment that will later be made to the purchase price. This can come as
quite a surprise, usually to the seller, which has less experience with acquisitions.

• Legal structure. This states the form of the legal structure to be used, such
as a triangular merger or an asset purchase. The legal structure can have
profound tax implications for the seller, so this item may require considera-
ble negotiation. See the Legal Structure of the Acquisition chapter for more
information. For example:

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Buyer will acquire those assets of Seller listed in Exhibit A. Buyer will al-
so assume the trade accounts payable of Seller, as noted in Exhibit B. No
other assets will be purchased or liabilities assumed, other than the items
noted in Exhibits A and B. The Seller entity will continue in existence fol-
lowing the transaction, under the control of its existing shareholders.

• Escrow. This states the proportion of the price that will be held in escrow,
and for how long. For example:

Twenty percent of the purchase price shall be held in escrow for a period
of six months from the purchase date. Buyer has until this date to claim
any adjustments to the purchase price. If there are still uncontested funds
remaining in escrow at the end of the six-month period, they shall be dis-
tributed to the shareholders of Seller.

• Due diligence. This states that the acquirer intends to conduct due diligence,
and may state the approximate dates when this will occur. For example:

Buyer intends to begin due diligence in regard to Seller’s operations and

finances on or about February 1, 20X1, and anticipates this process to be
concluded within four weeks. The actual amount of time required for due
diligence shall depend upon the availability of documents and the assis-
tance of Seller’s employees and its advisors.

• Responsibility for expenses. This states that each party is responsible for any
legal, accounting, and other expenses related to the acquisition transaction.
For example:

Both parties agree that they are individually responsible for any expenses
they incur associated with this proposed transaction. Examples of such
expenses are for legal advice, investment banking fees, and accounting
charges.

• Closing. This states the approximate date when the acquirer expects that the
purchase transaction will close. For example:

The parties anticipate that the closing date for this transaction shall be
March 31, 20X1.

• Acceptance period. This states the time period during which the terms stated
in the LOI are being offered. The recipient must sign the LOI within the
acceptance period to indicate approval of the terms. Limiting the term of the
offer allows the acquirer to later offer a different (usually reduced) set of
terms if the circumstances change. For example:

The terms of this letter of intent shall expire if not accepted in writing by
Seller and received by Buyer no later than [date].

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 Acquisition Documents

The letter of intent may go no further than the preceding points, or it may include a
number of additional clauses, such as:
• No shop provision. The seller agrees not to shop the price given in the LOI
to other prospective bidders in an effort to find a higher price. This clause
can be legally binding. For example:

Seller will not contact or enter into negotiations with any other entity or
person regarding the sale of its assets or stock for a period of 90 days, be-
ginning on the date of Seller’s written acceptance of these terms.

• Termination fee. This is a fee paid by one party to the other if the acquisition
is cancelled. If paid by the seller to the acquirer, this can help to prevent the
seller from shopping the deal to other prospective bidders. For example:

If Seller terminates this agreement, Seller shall pay a termination fee of

$10,000,000 to Buyer no later than three business days following the clos-
ing date.

• Financing out condition. The acquirer may not have sufficient financing at
the moment to pay the owners of the target company, and so wants a way
out of the prospective deal if it cannot secure financing by the closing date.
The preceding termination fee clause is not usually found in the letter of
intent when there is also a financing out condition. For example:

Buyer may terminate this agreement at any time prior to and including the
closing date, if Buyer cannot obtain sufficient financing to pay the agreed
per-share amount to the owners of Seller.

• Stock registration. If payment is to be in the stock of the acquirer, there may

be a clause requiring the acquirer to register the stock within a certain period
of time (though few acquirers will voluntarily include this information in the
LOI). For example:

Those parties receiving Buyer shares shall receive registration rights, under
which Buyer is obligated to make reasonable efforts to register the shares
with the Securities and Exchange Commission. If Buyer cannot obtain
such registration within six months of the closing date, Buyer shall issue an
additional 100,000 shares to those parties originally receiving Buyer
shares, in proportion to the original number of shares issued to them. The
delivery of these additional shares does not fulfill Buyer’s obligation to
pursue registration of the original shares issued.

• True up. If payment is to be in stock, there may be a clause stating that the
acquirer will issue additional shares if the value of the stock drops below a
certain point. Again, the seller will have to demand this clause, since the
acquirer will rarely offer it. For example:

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Three months following the closing date, Buyer will calculate the average
closing price of Buyer’s stock for the ten preceding business days. If this
average closing price is at least five percent less than the price at which
shares were originally issued to Seller, Buyer shall issue sufficient addi-
tional shares to return the value of the shares paid to the original closing
price. This issuance shall occur no later than four months following the
closing date.

• Stock options. The selling entity may have issued stock options to its
employees. There can be a clause stating how these options are to be treated
as part of the acquisition. For example:

All outstanding Seller options shall be converted into Buyer options, using
the stock-for-stock exchange ratio on the closing date. All vesting periods
associated with the original options shall be rolled forward into the re-
placement Buyer options.

• Stock restriction. If payment is to be in stock, the acquirer will likely require

that the seller cannot sell the shares within a certain period of time, such as
six or 12 months. For example:

The shares issued by Buyer to the shareholders of Seller shall contain a re-
striction clause that prevents the shares from being sold to any third party
for a period of six months following the closing date.

• Management incentive plan. There may be a bonus plan, stock grants, stock
option plan, or some similar arrangement for the management team of the
seller. This clause is intended to quell any nervousness among the managers,
and may gain their support for the deal. For example:

Upon completion of the purchase transaction, Buyer shall issue a total of

500,000 Buyer stock options to the management team of Seller, to be ap-
portioned based on years in service and position title. The exercise price of
these options shall be based on the average closing price of Buyer’s com-
mon stock for the five business days immediately prior to and following
the closing date. The members of the Seller management team are stated in
Exhibit A [included as an attachment].

• Retention. A clause may state the intentions of the acquirer regarding the
employees of the seller, such as a commitment not to conduct any layoffs
for the first year. For example:

Buyer does not intend to lay off the employees of Seller, other than for
normal performance-related reasons. To encourage employees to remain in
the employ of Seller, Buyer intends to issue 100 shares to each Seller em-
ployee for each year of employment already completed. These shares shall
vest over a five-year period.

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• Announcements. Either party may feel that it would be damaging to

announce the LOI to the general public or news media, so this clause states
that doing so must have the prior approval of both parties. For example:

Buyer and Seller mutually agree to withhold public disclosures regarding

this transaction to any third parties unless both parties agree to the disclo-
sure in writing, in advance. This prohibition does not include contacts with
those parties actively assisting in the consummation of this transaction.

• Conditions precedent. This states the requirements that must take place
before the acquirer will agree to complete the purchase transaction. Exam-
ples of conditions precedent are having several years of audited financial
statements, the completion of due diligence, the approval of regulatory
agencies, the completion of any financing by the acquirer to obtain the funds
to pay for the transaction, and/or the condition of the seller being substan-
tially as represented to it. The acquirer includes these items in the LOI to
give itself a reasonable excuse to extricate itself. For example:

The transaction referenced in this document is subject to the existence of

the following conditions:
• Approval of all government entities regulating the activities of
Seller and Buyer.
• Approval of lenders in regard to financing Seller in the amount of
the debt component of the purchase price.
• Approval of the transaction by the boards of directors of Buyer
and Seller.
• Approval of third-party advisors regarding the tax-free nature of
the transaction.
• Audited financial statements for the past two years.
• Successful completion of a final purchase agreement between
Buyer and Seller.
• The information presented to Buyer as part of due diligence is
substantially the same as was initially represented to Buyer. This
determination is to be made solely by Buyer.

• Representations and warranties. This is a short statement that the acquirer

will want representations and warranties from the seller in the purchase
agreement, under which the seller essentially creates a warranty that the
business it is selling is as represented to the acquirer. This clause technically
applies to both parties equally, but the real legal burden is on the seller. For
example:

The purchase agreement shall contain representations and warranties of the

Buyer and Seller, as well as covenants concerning the provisions of the
agreement.

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• Pre-closing covenants. This clause is an attempt to prevent the seller from

substantially altering its business arrangements or ownership structure prior
to the transfer of ownership without first notifying the acquirer. This can
involve such matters as taking on debt, selling stock, and selling operating
units. For example:

Seller will preserve its existing business arrangements and ownership

structure prior to closing. Seller will not complete any transactions prior to
closing that will alter its existing debt or equity, nor will it acquire or di-
vest significant assets without first issuing a written notification to Buyer.

Of the preceding clauses, the seller wants to be particularly careful about signing off
on a no shop provision, since it closes down the seller’s options to obtain a better
price elsewhere. The clause may be acceptable if the acquirer is offering a price so
high that other bidders are unlikely to overtop it. However, a rock-bottom price
combined with a no shop provision should be grounds for rejection of an LOI. A no
shop provision is particularly dangerous for the seller when the LOI does not contain
some key provisions, such as the form of payment or the legal structure. When such
clauses are missing, the seller has already agreed to be subject to the no shop clause,
but has not negotiated items that can seriously impact the amount and timing of
compensation received.
It is possible that the acquirer may be intent upon closing the deal with the seller
as soon as possible. If so, the LOI can be designed to be quite restrictive, with few
excuses allowed for either party to back out of the arrangement. However, such a
level of restrictiveness is not usually found, since the acquirer has not yet conducted
its due diligence, and so does not have a concrete idea of what type of business it is
buying.

Tip: The seller should not get overly excited about the price listed on the LOI. The
acquirer will inevitably find some issues during the due diligence review and use
them as bargaining chips to reduce the price – sometimes by quite a large amount.

In short, the LOI is an initial concept statement for what the purchase agreement will
eventually look like. By stating the broad outlines of the deal fairly early in the
acquisition process, there is less room for misunderstandings when the purchase
agreement is eventually negotiated. Though most parts of an LOI are not legally
binding, having both parties sign it creates a general commitment to work through
the remaining acquisition steps and complete the deal.
In larger organizations, the signed letter of intent is handed over to an acquisi-
tions team, which is responsible for due diligence, completing a purchase agreement,
and integrating the organizations. When handed an LOI, this group is likely to
consider the acquisition a “done deal,” and so will grind through the various
remaining steps to ensure that the deal is completed. They may recommend changes
in the price of the deal, based on what they find during due diligence, but they are
not likely to recommend deal cancellation, unless an unusually dangerous issue is

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found. Thus, the LOI can trigger a bureaucratic steamroller that will lead to a
completed deal. This is not the case in smaller organizations, where there are fewer
people involved in the process, and where the negative opinion of just one person
can cancel a prospective acquisition.

The Term Sheet

A variation on the LOI is the term sheet. A term sheet contains approximately the
same information listed in an LOI, except that each clause is highly abbreviated, and
it may not even be signed by the parties. The term sheet is more useful for smaller
and simpler acquisitions where the two parties want to move quickly to a purchase
agreement, and so use the term sheet as an outline from which the purchase
agreement is constructed.
The term sheet is also useful in an auction environment, where bidders are
required to use it to submit their terms before being allowed to proceed further with
the auction process. Thus, it can be used to narrow the field of potential bidders.
Some serial acquirers may issue quite a large number of term sheets to various
target companies. This type of acquirer likes to make brief contact with many
companies in a target area, and make a number of low-end offers. It then proceeds
into due diligence with those few companies willing to discuss a deal at the low
price point. In this situation, the term sheet is essentially being used to troll for low-
cost deals.

The Purchase Agreement

The purchase agreement governs the final sale of the acquiree to the acquirer. It may
be hundreds of pages long, especially when appendices are included, and so requires
a massive amount of detailed review by both parties to ensure that its terms are
acceptable. The acquirer and seller generally hand off the review of this document to
their attorneys, who work on clarifying the terms of the agreement. Periodically,
they approach their principals with summaries of the remaining points to be
negotiated, along with their recommendations for how to proceed. Then, with their
instructions in hand, the attorneys assemble for another round of discussions.
This separation between the principals and their attorneys is useful, for it allows
the attorneys to fight out the details while the principals can remain cordial with
each other (which may be a critical point if the owner of the acquiree intends to
work for the acquirer after the deal has closed).
The contents of the purchase agreement can vary significantly, depending on the
legal structure of the deal (such as an asset purchase or a stock purchase) and other
factors. The following clauses are usually found in a standard purchase agreement:
• Business combination. This states the legal structure of the transaction, and
when it will occur. The wording will be different for each type of legal
structure, or if the transaction only involves the purchase of selected assets.
• Stock payment. If the payment is to be in the stock of the acquirer, the
exchange ratio at which the seller’s shareholders will swap their shares for

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the shares of the acquirer will be stated. The seller’s stock is then cancelled,
along with all treasury stock held by the seller. The procedure for exchang-
ing shares may be stated.
• Cash payment. If the payment is to be in cash, this clause states how the
funds are to be transferred (usually by wire transfer or certified check).
• Debt payment. If the payment is to be in debt, this clause states the terms of
the promissory note, and may include reference to a security agreement that
states the secured position of the seller in the assets of the acquirer. The
detailed debt documents are included in the accompanying exhibits.
• Option and warrant termination. The acquirer does not want to inherit any
unexercised stock options or warrants, so this clause states that all options
and warrants will be exercised or terminated prior to the acquisition, leaving
no residual obligation for the acquirer.
• Representations and warranties. This is a cluster of representations that the
information provided by each party to the other is true. There can be a con-
siderable amount of dickering between the attorneys working for each side
in determining which items are included and excluded from this section, as
well as the extent of the associated liabilities if the representations turn out
to be false. Here are a number of the items usually included in the represen-
tations and warranties section:
o Accounts receivable. The accounts receivable are fairly stated in the
accounts receivable aging report listed in the exhibits, and the bad
debt reserve is a reasonable estimation of receivables that will not
be paid.
o Approval. The board of directors has approved the purchase transac-
tion.
o Bribes and kickbacks. The acquiree has not made bribe or kickback
payments to other parties. This clause is useful if the acquirer is lat-
er sued by the government for such activities, since the acquirer can
pursue reimbursement for any fines and penalties from the seller.
o Capitalization. The acquiree affirms the number of shares author-
ized and outstanding, as well as the existence of any convertible in-
struments.
o Contracts. There are no contracts that will be terminated as a result
of the transaction, other than those stated in the exhibits. Also, there
are no material contracts other than those stated in the exhibits.
o Employees. The acquiree affirms that there is no collective bargain-
ing agreement with a union, and that there are no union representa-
tion petitions or other union recognition activities.
o Employee benefits. The acquiree affirms that the benefits listed in a
supporting schedule constitute all of the benefits paid to employees.
o Environmental compliance. The acquiree is in full compliance with
all environmental regulations, and has current permits where need-
ed.

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o Fees. There are no unpaid broker’s or finder’s fees, other than those
stated in the exhibits.
o Financial statements. The financial statements fairly present the re-
sults, financial position, and cash flows of the acquiree.
o Good standing. The selling entity is in good standing with the state
in which it is incorporated.
o Insurance. The disclosure schedule summarizes all current insur-
ance policies, including agent contact information, names of insur-
ers, coverage periods, and scope.
o Inventory. The acquiree affirms that the inventory is in sellable con-
dition, and that slow-moving or obsolete inventory has been proper-
ly reflected in the inventory reserve account.
o Lawsuits. There are no outstanding lawsuits or actions that may re-
sult in lawsuits, other than those stated in the exhibits.
o Options and warrants. There are no outstanding options and war-
rants other than those stated in the exhibits.
o Patents and trademarks. The acquiree affirms that it owns the pa-
tents and trademarks stated in the exhibits. Also, its business opera-
tions do not conflict with patents or trademarks held by other par-
ties, other than those it already licenses.
o Real property. The acquiree confirms the address and description of
each parcel of land it owns, affirms that it has clear title to each
property, and that there are no options or rights of first refusal relat-
ed to them.
o Regulatory approvals. There are no additional regulatory approvals
required for the transaction.
o Shares. The numbers of shares outstanding are as stated. The share-
holder list may be included in the exhibits.
o Subsequent changes. Since the last reported balance sheet date,
there have been no subsequent changes to the business, other than
those arising from the ordinary course of business. This clause may
be quite specific about the absence of changes in such areas as the
sale of assets, new debt incurred, stock or dividends issued, or con-
tractual changes.
o Subsidiaries. The acquiree confirms the name, jurisdiction, and cap-
italization of each listed subsidiary, and affirms that there are no
other shares or convertible instruments outstanding for each one.
o Taxes. Taxes have been appropriately calculated and paid, except
for the unpaid taxes noted in the exhibits. All taxes collected on be-
half of government entities have been remitted, except for those
noted in the exhibits.
o Title to property. The seller has title to all assets, except for those
noted in the exhibits.
o Undisclosed liabilities. There are no material undisclosed liabilities.

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The representations and warranties section may end with a blanket statement that the
seller has disclosed all material items to the acquirer concerning its financial results,
financial position, operations, and future projections. This clause provides some
additional protection to the seller in case some outlier event occurs that was not
addressed in one of the more specific representations and warranties.

Tip: The acquirer should insist on a comprehensive set of representations and

warranties. If the seller refuses to provide them, then the acquirer is taking a large
acquisition risk if it plans to buy the entire business entity, and so should consider
terminating the acquisition discussions.

There may be additional clauses that deal with circumstances specific to the
purchase transaction. Here are several such clauses:
• Basket. This clause sets a fixed dollar amount of losses that the acquirer
must record from the acquiree before it can pursue damages from the seller
under the indemnification provisions of the purchase agreement. For exam-
ple, a basket of $100,000 prevents the acquirer from claiming reimburse-
ment for the first $100,000 of losses.
• Collar. If payment to the seller is made in stock, it is set at a certain
exchange ratio of the acquirer’s to the seller’s stock. The collar clause states
that the exchange ratio will be reset to maintain the intended total purchase
price if the acquirer’s stock price changes beyond a certain amount. This
clause reduces the risk to the seller of suffering a reduction in the price paid.
• Earnout. This clause describes the calculation to be used to determine
additional payments to the seller, as well as the form and timing of those
payments.
• Material adverse change clause. This clause allows the acquirer to exit from
the purchase transaction if the condition of the target company declines to a
significant extent prior to closing the deal.
• True up provision. This clause entitles the seller to additional acquirer stock
if it was originally paid in stock, and the market price of that stock subse-
quently declines. This clause is not normally used unless the acquirer is
publicly-held, where there is a market for its stock that can be referenced.
This is not quite the same as the collar provision, for a true up can occur
many months after an acquisition has been completed.

Tip: It is quite difficult to pursue anyone for payments related to representations and
warranties when the selling entity is a public company, because ownership is
diffused across such a large number of shareholders.

Another element of the representations and warranties section is the amount of the
indemnifications to be paid if there are breaches of the representations.
The representations and warranties section is almost entirely designed for the
protection of the acquirer, so there will likely be arguing by the acquirer’s attorneys

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to expand its scope, while the seller’s attorneys attempt to reduce or even eliminate
it. In particular, the seller will want to limit the time period over which it may owe
payments to the acquirer for any breaches, as well as the total amount that it may be
obligated to pay.

Tip: If the seller is paid in stock, then it should negotiate to pay the acquirer back in
its choice of stock or cash if there is a subsequent breach of its representations that
requires payment. This can be a useful clause if it is difficult to sell the stock.

If there will be an interval between the signing date of the purchase agreement and
its effective date, there is a chance that the management of the acquiree could take
actions not beneficial to the acquirer, such as selling assets, acquiring debt, or
paying last-minute bonuses. In this case, there should be a conduct of business
clause that limits management to just those activities in which it would normally
engage in the ordinary course of business. The clause may specifically prohibit
certain activities in order to preserve the business in its condition as of the signing
date.
Depending on the circumstances, the parties may want to include a termination
clause that allows the parties to exit from the transaction. This could be a simple
written notification to the other party, or it could be more restrictive, only being
allowed under certain circumstances, such as:
• Material breaches of representations and warranties
• A court injunction prohibiting the purchase transaction
• A delayed transaction that is not completed by a certain date

There may also be a larger number of exhibits linked to the purchase agreement,
containing the detail for items referred to within the main body of the purchase
agreement. Examples of such exhibits are:

Accounts receivable aging report Lease obligations

Bank accounts and authorized signers Letters of credit outstanding
Broker and finder fee arrangements Liabilities
Consents Material contracts
Debts outstanding Patents, trademarks, and domain names
Employee benefits Pending lawsuits
Employee salaries Pension plans
Encumbered assets Permits and licenses
Excluded assets Promissory note to seller
Financial statements Property leases
Fixed asset register Related party contracts
Intellectual property Shareholder list
Key employee arrangements Stock options and warrants
Insurance policies Title to property
Labor agreements

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The purchase price stated in the LOI or term sheet may not be the same one stated in
the purchase agreement, because the terms of the deal will change as part of the
negotiation process, with various alterations to the agreement correspondingly
modifying the value of the deal. For example, a shift to an all-cash purchase may be
so valuable to the seller that it accepts a price reduction in exchange. Similarly, the
legal structure of the deal could have profound tax implications for the seller, which
could also alter the price.

Note: With the exception of auction situations, the acquirer controls the purchase
agreement, since it presents the initial version of the document to the seller. This
level of control allows the acquirer to introduce a variety of clauses to the agreement
that are in its favor, and which the seller must negotiate to have modified or
withdrawn. Thus, control of the document gives the acquirer an inherent negotiating
advantage.

Positions of the Parties

Implicit in the preceding discussion of legal documents is the vast amount of
haggling by the parties that occurs before the purchase agreement is signed. The
acquirer and the seller obviously have different objectives, and so want to
incorporate different clauses into the purchase agreement. Following is a listing of
the positions either side is most likely to take:

Acquirer Interests
• Debt payment. As noted in the Payment Structure of the Acquisition chapter,
the least useful form of payment from the perspective of the seller is to ac-
cept a series of debt payments. The reverse is true for the acquirer, since
offering debt preserves its on-hand cash balance and avoids the use of stock.
In many cases, the acquirer will want to include at least some portion of debt
in the purchase price.
• Escrow. The acquirer will want to set aside some portion of the purchase
price in an escrow fund, from which it can withhold funds if certain post-
closing issues arise. The parties will dicker over the size of the escrow and
its duration. Expect the escrow to be about 15% of the total price, and to
expire in 12 to 18 months.
• Basket. The acquirer wants the smallest basket possible, so that it can be
indemnified after absorbing only a small amount of losses from indemnified
items. The amount is usually set somewhere in the range of 1-2% of the total
purchase price.
• Earnout. If the seller is basing estimated future results on a high price, the
acquirer will likely respond with an earnout clause (see the Valuation of the
Target chapter), which reduces the risk of overpayment by the acquirer.
• No shop. A serial acquirer is likely to be tired of making unsolicited offers,
only to have the target companies immediately shop their offers around for a

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higher bid. These acquirers are particularly likely to demand a no shop

clause.
• Representations and warranties. Reps and warranties should be a major
point of concern for the seller, who should hold out for a complete suite of
them. A seller who tries to shortchange reps and warranties is likely to be
offered a much lower price or find that the acquirer is no longer interested.

Of the points noted here, the acquirer is most interested in representations and
warranties, an escrow, and a no shop provision, probably in that order.

Seller Interests
• Legal structure. As noted in the Legal Structure of the Acquisition chapter,
the legal structure of the deal can have a large impact on the amount of taxes
paid by the seller. The impact of the legal structure is usually greater on the
seller than the acquirer, so the seller should bargain hard for its preferred
format.
• No shop. The seller almost certainly wants to avoid a no shop provision, and
should avoid it in particular if the offer price appears to be too low.
• Cash. In some situations, usually involving the retirement of the seller, the
winning bid will go to the largest cash offer, even if other offers involving
stock, debt, or earnouts are higher.
• Escrow. A seller who wants to totally cash out of his or her business might
accept a somewhat lower purchase price in exchange for the elimination of
the escrow.
• Responsibility for expenses. The seller may attempt to have the acquirer pay
for any audits of its financial statements. This position may work if the ac-
quirer made an unsolicited offer, since the seller may not have been plan-
ning a sale, and therefore might not otherwise need an audit.
• Stock registration. If the seller is being offered stock, it should absolutely
demand registration rights; otherwise, it will not be possible to sell the
shares.
• True up. If the acquirer is paying with stock and its stock price has been
highly variable, the seller might demand a true up provision or a collar. This
may involve hard negotiation, since the acquirer could be required to pay a
substantial additional stock issuance.
• Material adverse change clause. The seller does not want this clause, since
a near-term decline in its condition can cancel the acquisition. At a mini-
mum, the seller wants to restrict the conditions under which the clause can
be triggered.

Of the points noted here, the seller is most interested in the legal structure, followed
by the stock registration and true up or collar provisions (if stock is offered).

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It is useful to be aware of these differing positions as the two sides craft the final
version of the purchase agreement, so that each side can be prepared for the
demands of the other party.

The Closing Memorandum

The parties to an acquisition may want to revisit the terms of the agreement for
several years after the deal has closed, if only to understand why certain terms were
included in the agreement. However, a purchase agreement is essentially a collection
of clauses involving such matters as payment terms and assertions – it does not
provide a narrative regarding why certain clauses were included or excluded. Such
additional documentation can be useful for interpreting the intent behind the
wording used in the agreement.
This additional documentation can be assembled into a closing memorandum,
which documents general background information on the transaction, including
descriptions of any unusual issues that were addressed, decisions made, and why
they were stated in a certain way in the purchase agreement.

Note: The closing memorandum is usually written by the attorneys working for the
acquirer, since the acquirer usually controls updates to the purchase agreement.
Thus, the memorandum is written from the perspective of the acquirer, not the seller.
This viewpoint may exclude additional information that might have put a different
slant on the statements made in the closing memorandum.

Following are sample notes that might be included in a closing memorandum, and
which give some idea of the type of narrative to include in it:

Stock compensation provisions: The three owners of Armadillo Security Armor

(“Armadillo”) were concerned about the variability of High Noon’s stock price,
since changes in the price over the past three months could have altered the stock
consideration paid to them by as much as 30%. The parties included the following
features in the purchase agreement to allay these concerns:
• The number of shares issued on the purchase date was based on the
weighted-average price of the stock during the 20 preceding business days.
• A true up provision was included, under which the number of shares would
be adjusted upward as of six months after the effective date of the agree-
ment, but only if the weighted average stock price for the five business
days prior to the adjustment date was at least 10% lower than the price
used for the initial issuance of stock. Thus, any change in the stock price of
less than 10% would not trigger the true up provision.
• The owners of Armadillo were granted a put provision for 10% of their
shares in High Noon, which they could exercise at any time after one year
from the effective date of the agreement, which High Noon would have to
purchase in cash, based on the weighted average share price for the five
business days preceding the put date.

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Warrants: Armadillo had issued a large number of warrants to its suppliers, which
it considered necessary in order to secure capacity during peak demand periods. The
parties agreed to convert these warrants into High Noon warrants, using an
exchange ratio of 3:1 (Armadillo warrants to High Noon warrants). The exercise
price for each warrant was set at the weighted average market price of High Noon
stock for the five business days immediately prior to the purchase date, which was
$11.80.

Representations and warranties: The owners of Armadillo refused to indemnify

High Noon for the outcome of any legal proceedings, on the grounds that the three
legal actions currently in progress were so recent that it was impossible to quantify
their results. High Noon elected to proceed with the purchase agreement despite this
issue.

The closing memorandum can be included in the closing binder, along with the more
formal purchase agreement; it is more readily accessible in that location. However,
being adjacent to a formal legal agreement does not mean that the closing
memorandum can be construed as a legal document that is in any way binding.
Instead, it is only useful as a narrative that may be used as background information
for an amicable settlement of differences over the interpretation of the purchase
agreement. As such, the closing memorandum is not by any means a required part of
the acquisition documents, but it can be useful.

Summary
This chapter has described a two-stage process, beginning with either an LOI or
term sheet, and progressing to a legally binding purchase agreement that transfers
ownership of the selling entity to the acquirer.
Only the general outlines of the LOI, term sheet, and purchase agreement have
been noted in this chapter. The purchase agreement in particular is a lengthy
document that requires the active participation of a law firm with considerable
experience in the formulation of such documents. Consequently, both the acquirer
and seller should retain top talent to create these documents for them, and thereby
mitigate the risks associated with an acquisition transaction.

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 Chapter 13
Acquisition Integration
Introduction
Once the acquirer has decided to buy a company and its offer has been accepted, the
next step is to integrate the two organizations. This can be a difficult process, for the
acquirer needs to enact all of the synergies that it already identified in order to make
the acquisition a financial success. Depending upon the extent of the synergies, this
may result in a considerable amount of upheaval within the acquired business,
though proper management of the integration team can mitigate problems to some
degree. In this chapter, we discuss general integration topics and then delve into
many specific integration issues.

General Integration Topics

When a company has just been acquired, the productivity of its employees will
nosedive, and is not likely to recover until the integration process has been
completed. In addition, any employee interested in self-preservation is likely to test
the employment market; the departures of multiple employees are likely, if not
certain. The acquirer can mitigate both issues by following these two rules:
• Integrate fast
• Inform employees fully

Fast Integration
The integration process must begin the moment the purchase has been completed,
and should progress as hard and fast as possible. By doing so, the integration team
has a better chance of completing its integration goals and achieving the synergies
needed to make the acquisition a financial and operational success. The longer the
integration takes, the more likely it is that the simple passage of time, combined with
resistance from the acquiree’s employees, will eventually halt the integration effort
before all of its goals have been achieved.
A determination to complete a fast integration may meet with varying degrees of
success. The team will likely find that some “low hanging fruit” can be completed
within a few weeks. However, there are several areas in which the integration task is
so large that it may require more than a year to complete. Here are several areas
where integration is lengthy:
• Accounting systems. One of the more difficult integration areas, this
involves the transition of the accounting software to the system used by the
acquirer, usually one module at a time.
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• Hedging positions. The company may have entered into any number of
transactions to hedge its risk, usually on the payment or receipt of foreign
exchange. Hedges may no longer be needed if the combined entity has off-
setting cash flows, but it may take months for all of the hedges to be re-
solved.
• Long-term investments. An acquiree with excess funds may have placed
some of it in illiquid, long-term investments. If so, the acquirer may have to
wait upwards of a year before it can extract the funds.
• Materials planning systems. If the acquirer wants all locations to operate a
common materials planning system (of either the push or pull variety), it can
require a remarkably involved process, since it calls for swapping out a sys-
tem that is already enmeshed in every aspect of the purchasing, production,
and warehouse management departments. This process is not only lengthy,
but also risks a serious interruption of the acquiree’s operations.
• Payroll systems. When combining payroll systems, it is usually best to do so
as of the beginning of the calendar year, so that tax records can be accumu-
lated on a single system for the entire year. Thus, there is a great deal of
payroll conversion work at year-end.

The longer-term integration efforts noted here usually involve the work of
specialists, who can operate independently from the integration team. This allows
the team to complete its shorter-term work and move on to other projects, while the
specialists remain on-site for as long as it takes to complete their jobs.

Employee Communications
There is no point in hiding any layoffs from employees. If the integration effort goes
as fast as it should, everyone will know about the layoffs within a few weeks or
months – so tell them as soon as the integration team has decided which positions
are redundant. If subsequent events alter the integration plans, then keep employees
apprised of the changes as soon as there is some certainty concerning future actions.

Tip: If the integration team is still contemplating different options regarding the
status of employees, do not tell employees about it yet. Doing so gives them no
additional information regarding their job security, and it only looks as though the
acquirer is indecisive. Wait until there is a firm decision, and then communicate it.

Achieving an adequate level of employee communication is a key goal in any

acquisition integration. There should be someone on the integration team whose
primary concern is communications. This can take a variety of forms, such as group
meetings, conference calls, webcasts, newsletters, and one-on-one meetings – and
preferably a mix of several of these methods. The worst type of communication is an
e-mail or memo that is not supported by some type of in-person communications;
the reason is that e-mails and memos are easily misconstrued, and so can lead to
additional confusion.

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Team Composition
The integration team is likely to be composed almost entirely of the employees of
the acquirer. This is particularly true if the acquirer engages in a large number of
acquisitions, for it needs people who are experienced in completing the integration
process as quickly and thoroughly as possible, and then moving on to the next
acquisition.
Though the bulk of the integration team comes from the acquirer, it is still of
considerable importance to include at least one person on the team from the acquired
company. This person should be an influential member of the acquiree. This
individual is then in a position to act as a bridge between the integration team and
the acquiree employees who are being impacted by them. If employees have
concerns about the integration, they can funnel them through their representative on
the team.
There must be a full-time manager for the integration team. This person is
responsible for the following items:
• Create and update the integration plan
• Ensure that the team has sufficient resources to complete its work in a
timely manner
• Report to the managements of both the acquirer and acquiree concerning the
status of the work
• Resolve disputes arising from integration issues
• Act as a bridge between employees within the two companies

Depending on the size of the integration effort, this manager must be prepared to
live near the acquiree for the duration of the integration, or at least travel there and
remain on-site during most work weeks. Since the role requires considerable
coordination with the headquarters staff and senior management, the integration
manager will likely commute between the two companies on a regular basis.
The integration manager is usually a mid-level manager from the acquirer’s
organization who is comfortable working with little oversight. This person should
have significant tenure within the organization, so that he has had sufficient time to
build up a strong network within the company. This network is extremely useful
when the integration manager uncovers a knotty problem with an acquiree, and
needs to reach deep into the acquirer’s organization to find the person most capable
of resolving the issue.

Tip: It is imperative that the integration manager be an employee of the acquirer, not
the acquiree. While the acquiree should have representation on the integration team,
these people may be more concerned with preserving the acquiree organization than
in rigorously implementing all identified synergies.

The team must work with those functional managers who will eventually be
responsible for the operations of the acquired business. These managers will assume
responsibility once the integration team has completed its work, and so have a

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vested interest in the types of synergies that the team intends to implement. For
example, if the corporate IT manager is scheduled to take over the IT operations of a
new acquisition, he may not be too thrilled to find that the integration team just
terminated a number of key employees that he will need to operate the legacy
systems of that business. Thus, there must be a continuous flow of communication
between the team and their eventual successors, to determine which synergies to
implement and which to modify in order to leave the acquired business in good
condition for ongoing operations.

Integration Planning
The integration team inherits the foundation for its integration plan from two
sources:
• The due diligence team, which formulated an initial set of possible synergies
that will need to be implemented; and
• The acquirer’s standard integration activity list, which may incorporate a
number of standard synergies, such as shifting certain activities to the corpo-
rate entity.

Any serial acquirer has a standard integration list for every business that it
purchases. The contents of a typical integration list are spread through the following
sections in this chapter.
The integration manager inserts those synergies specific to the acquiree into the
standard integration activity list, which becomes the initial integration plan. Based
on the requirements of this list, the manager arranges staffing for the team, and
reserves their time for the expected duration of the integration project.
The plan will likely undergo revisions on a daily basis, as the team encounters
issues and incorporates them into the plan. Also, the designated long-term managers
of the various functions of the acquiree will weigh in with their requirements, which
will also alter the plan. Finally, an analysis team from corporate headquarters will
likely examine the results achieved by the integration team at various milestone
dates, to see if it has completed anticipated synergies. All of these issues result in a
fluid planning environment that calls for constant attention by the integration
manager, as well as the continual reshuffling of resources to match any plan
modifications.

Competitor Reactions
When planning the acquisition integration, incorporate into your thinking the
reactions of competitors. It is absurd to think that competitors will do nothing in
response to an acquisition, unless the parties are so small that the event is beneath
their notice. Here are several common reactions, and how to deal with them:
• Employee poaching. Key employees probably already have contacts within
competing firms, and will receive employment offers from them. To avoid

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employee defections, have compensation packages ready as soon as the deal

is announced, and communicate them one-on-one.
• Customer poaching. A standard rule of acquisitions is that the sales of the
acquiree initially suffer a decline immediately following the announcement
of an acquisition. Part of this decline comes from turmoil in the sales de-
partment, but some of it also comes from customer poaching by competitors.
The competitors will play upon customer fears of increased prices, reduced
service, or declines in product quality, and will likely lure away some cus-
tomers. To reduce the number of defections, call or visit the larger custom-
ers as soon as possible to discuss the acquisition, as well as any changes
likely to occur.

Tip: Initiate a sales incentive plan, such as a sales discount, which roughly coincides
with the acquisition date. This makes it more difficult for competitors to lure away
customers, and shows that the buyer is committed to providing value to its customer
base.

Tip: If there is a trade show scheduled in the near future, attend it as a combined
entity, and treat it as an opportunity to meet with customers and suppliers, and
address any issues they may have with the acquisition.

Consider hiring a public relations firm to handle information in the media about the
acquisition. This firm can use a variety of communication channels to emphasize the
financial strength and general probity of the acquirer, and how this will strengthen
the combined businesses. The intent is to reassure all business partners and
employees regarding the outcome of the purchase.

Tip: If negotiations have been a closely guarded secret, a possibility is to quietly

announce to employees the recapitalization of the business by a new investor, and
make no other move to indicate that ownership has changed. This option keeps
competitors at bay, because they are not sure what happened. It is a particularly
useful option if the existing CEO remains in charge of the company, so there is no
visible change in its operations.

The only thing faster than the speed of light is the rumor mill, so you can be assured
that news of loosely-guarded acquisition talks will have reached competitors before
the transaction has been completed. This means that some competitors will be ready
for action as soon as the deal is announced. This brings us back to the earlier point
about integrating as fast as possible; you must settle any initial employee turmoil
quickly, thereby giving competitors fewer issues to attack.
We now proceed to a series of discussions of integration topics by functional
area, presented in alphabetical order.

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Accounting Integration
The accounting function can be one of the more difficult integration tasks. If the
acquirer prefers to have a well-integrated accounting system, then all of the
following integration steps must be followed. However, if the acquirer is willing to
leave it alone and just asks for a trial balance that it can record in the consolidated
records of the parent company, then few of the following items need to be
addressed.
Thus, the extent of accounting integration work depends on the organizational
structure of the acquirer. The more important integration tasks are as follows:
• Account definitions. It is quite possible for two organizations to store
different information in the same account, because they define the account
differently. This problem can arise between a parent company and an ac-
quiree, so the team must meet with the general ledger accountant to precise-
ly define which transactions are recorded in which accounts. The result may
be a change in the default accounts used for certain transactions in the ac-
counting software.
• Accounting policies. Even if the acquirer plans to leave its acquiree alone in
most respects, it should impose a standard set of accounting policies. Exam-
ples of such policies are a uniform capitalization limit and a variety of reve-
nue recognition rules. Otherwise, the acquiree might report financial results
that are entirely inconsistent with those produced by other subsidiaries of the
parent company.
• Accounts payable. If payments are to be processed from a central location,
contact all suppliers to notify them of the new remittance address to which
they should send their invoices.
• Bank accounts. Does the acquirer want to retain existing bank accounts?
Many acquirers have preferred banking relationships, and so will want to
shift over to new accounts at those banks. The conversion process can be
lengthy, and typically includes the following steps:
o Open new accounts
o Order check stock for the new accounts
o Record the new account number in the accounts payable software
module
o Shred the check stock for the old accounts
o Move recurring ACH debits from the old accounts to the new ac-
counts
o Wait for checks outstanding to clear the old accounts
o Close the old accounts

• Best practices. Investigate the practices of the department and extract unique
best practices for use elsewhere in the organization. Also, implement the
acquirer’s standard set of best practices.
• Budget. If the acquirer requires the use of a budget, oversee the budgeting
process to create a budget for the remainder of the current year.

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• Capitalization limit. Assign the acquirer’s capitalization limit to the

company. This may be easier if handled on a go-forward basis, rather than
applying it retrospectively to existing fixed assets.
• Chart of accounts. The acquirer’s controller will probably want to impose a
standard chart of accounts to assist in more rapidly closing the books of the
parent company. This means that the company’s old chart of accounts must
be transitioned to the new one. This can involve a significant amount of
work, such as:
o Reset the default expense account in each vendor master file record
o Reset the default sales account in each customer master file record
o Reset the cash account used in the accounts payable module
o Reset the account numbers in all journal entry templates
o Reset the account numbers in recurring journal entries
o Deactivate the old account numbers
o Reset the account number ranges in all financial reports generated
by the accounting software

• Closing schedule. The controller of the parent company very likely operates
under a tight schedule when closing the books, and so will impose a specific
set of due dates on the acquiree, stating the dates and times by which certain
reports (primarily its final trial balance) are to be delivered.
• Collections. Investigate collection procedures and the state of the aged
receivables report to see if collection activities are adequate. If not, impose
additional procedures to accelerate collections. If the acquirer sends all seri-
ously overdue accounts to a single collection agency, then it should route the
same types of accounts from this acquiree to the same agency.
• Common paymaster rule. If there is an expectation that employees may be
paid by different subsidiaries of the parent company, then the acquirer
should designate a single entity within its business infrastructure to pay
those employees. This entity becomes the “common paymaster.” Doing so
avoids the duplicate withholding of payroll taxes beyond their maximum
annual levels. This saves money for the organization as a whole, since it
would otherwise be matching the excess amount of payroll taxes.
• Controls. Compare the controls used by the company to those required by
the acquirer, and implement any missing controls. The team could also make
inquiries about fraud that has happened in the past, in order to gain some
idea of process weaknesses that may require particular attention. If the ac-
quirer is publicly-held, it may be necessary to conduct a full controls review,
to see if the acquiree is compliant with the provisions of Section 404 of the
Sarbanes-Oxley Act.

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Tip: There are more likely to be control breaches if the acquiree was run by the
founder, using a top-down management hierarchy. The founder would have been
able to circumvent any controls, so the control analysis should be especially
comprehensive.

There are also likely to be weak controls in small businesses, which have not yet
grown to the point where they would have found it necessary to enact more
comprehensive controls.

• Inventory costing. The acquirer may require a standard inventory costing

method, such as the first in, first out method. If so, it can be quite difficult to
impose the system on an acquiree that does not have the necessary historical
records. In such cases, it is better to treat a standardized inventory costing
system as a longer-term objective.
• Metrics. The acquirer likely uses a somewhat different set of operational and
financial metrics, and will want the acquiree to use them, as well. The ac-
counting department is usually tasked with compiling this information. Do-
ing so involves imposing standard calculation methods for the metrics –
otherwise, the acquiree may adopt alternative calculation methods that skew
the results.

Tip: Do not throw out the acquiree’s metrics without some consideration of why
they were used. It is possible that the business environment and operations of the
company mandated the use of certain metrics, whose use should be continued.

• Payroll cycles. If the acquirer wants to standardize payroll, it will probably

demand standardized payroll cycles (which is the length of time between
payrolls), such as paying employees on a biweekly basis. It is not especially
difficult to change the length of the payroll cycle, but does
• Payroll systems. If the acquirer wants to operate a single, centralized payroll
system, consider converting to the corporate system only at the beginning of
the calendar year; by doing so, the company can accumulate annual pay
information within a single system and issue a single tax withholding report
to employees for the full year. Centralizing payroll calls for the transfer of
the following information (and more) to the corporate system:
o Annual salary and hourly wage information
o Tax withholdings taken
o Garnishments
o Tax levies
o Insurance deductions
o Pension deductions
o Direct deposit information

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• Processes (general). The theoretically most logical way to integrate the

accounting processes of an acquiree is to compare its systems to those of the
acquirer, and devise the most efficient combination of the two. In reality, the
integration team is in a hurry, and so only has two options, which are:
o Impose standard systems. If the acquirer is expanding fast, it needs
to apply the same, standardized system everywhere. This means that
potentially excellent local systems may be thrown out in favor of
“cookie cutter” processes.
o Retain existing systems. The acquirer may not care what systems the
acquiree has, as long as it submits monthly summary-level reports
on a timely basis. In this case, the integration team will probably
verify that sufficient controls are in place, and take no further ac-
tion.

• Public reporting. If the acquirer is a publicly-held company, it has four

business days in which to file a Form 8-K with the Securities and Exchange
Commission, in which it announces the acquisition.
• Reports. Rewrite all financial reports so that they match the standard report
template used elsewhere in the organization. This may include the addition
of entirely new reports.

Tip: If the acquisition takes place near the end of the acquirer’s fiscal year, it may
be more cost-effective to let the company continue to operate its own systems, and
make most changes effective as of the beginning of the new fiscal year. This avoids
the need for any retrospective alteration of financial reports from earlier in the year.

• Software. A potentially massive project is to switch to the accounting

software used by the acquirer. The level of devastation imposed on the ac-
counting staff will depend upon how thoroughly the existing accounting
software is integrated into the company; ripping it out and imposing a new
system will likely overwhelm any other project that the accounting employ-
ees may be tasked with for many months.
• Signatories. Does the acquirer want to retain the current set of check signers
and wire transfer authorizers? If not, the team should notify the company’s
bank of the change in control, cancel the current list of authorizers, and re-
place them with a new set of names.
• Training. If the acquirer is intent on installing new systems and procedures
within the acquiree, then it must support these changes with an appropriate
level of training. Even if there are few systemic changes, training may still
be needed because of the need to report information to the parent company.
For example, what if the acquirer is located in a different country? Currency
translation issues now arise that had never previously been a concern. In
such cases, training will be needed to avoid the risk of having business
transactions either being ignored or incorrectly accounted for.

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Once all changes have been made, have the acquirer’s internal audit team schedule a
series of reviews of the accounting operations, to ensure that standard practices have
been properly installed and are operational.
The preceding points about integrating the accounting function are based on the
assumption that the acquirer will retain at least some local accounting functions.
However, if it wants to centralize all accounting at the corporate level, the
integration process is substantially different. In that case, the key steps are more
likely to include the following:
• Retention plans. The acquiree’s accounting staff is told that the department
will be closed. Retention bonuses are promised to keep the staff on-site
through the conversion process.
• Vendor master file transfer. The vendor master file from the acquiree’s
accounts payable system is converted into the format used for the same file
in the acquirer’s accounting system, and transferred to that file.
• Payables transfer. All open accounts payable are shifted to the acquirer’s
accounts payable system. The historical records for paid payables are also
transferred.
• Supplier contacts. Suppliers are contacted and asked to forward their
invoices to the central corporate accounts payable function.
• Expense report inputting. If the corporate parent uses a centralized employ-
ee expense reporting system, the acquiree’s employees must be contacted
and instructed in how to use the system to submit their expense reports.
• Payment method transfer. If payments to suppliers and employees are made
by ACH direct deposit, shift the direct deposit information to the corporate
payment system.
• Customer master file transfer. The customer master file from the acquiree’s
accounts receivable system is converted into the format used for the same
file in the acquirer’s accounting system, and transferred to that file.
• Receivables transfer. All open accounts receivable are shifted to the
acquirer’s accounts receivable system. The historical records for paid re-
ceivables are also forwarded.
• Customer contacts. Customers are contacted and asked to forward their
invoice payments to the central corporate cash receipts function, or to a des-
ignated lockbox or bank account.
• Collections database. All accumulated information related to customer
collection activities is forwarded to the central corporate collections group,
along with contact information for each customer.
• Fixed assets transfer. All fixed assets listed in the fixed assets register, as
well as all related accumulated depreciation amounts, are shifted to the ac-
quirer’s fixed assets system.
• Mapping. All general ledger accounts used by the acquiree are mapped to
those used by the acquirer.
• General ledger transfer. At a minimum, all general ledger summary totals
are shifted to the corporate general ledger system. A better alternative,

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though more complex to transfer, is to shift over the supporting detail as

well, for all periods used in the financial statements.
• Reconciliation documentation. The accounting staff of the acquiree should
complete any remaining reconciliations of general ledger accounts, and for-
ward the reconciliations to the corporate staff.

The preceding steps only indicate the major actions needed to move an entire
accounting department into the central corporate system, but should give an idea of
the large amount of work required to effect a comprehensive transfer.
It may be necessary to keep some accounting clerical staff on-site at the
acquiree, irrespective of the determination to centralize, since some information
(such as timekeeping data) is best accumulated locally. It may also be useful to
retain an on-site financial analyst, to investigate variances from expectations and
report findings back to corporate headquarters.

Culture Integration
We describe this section as “culture integration,” because integration is the topic of
this chapter, but in reality it may not be possible to “integrate” the cultures of the
two businesses at all. If the acquirer buys a business whose cultural norms are
fundamentally different from its own, then it may be necessary to leave the culture
of the acquiree essentially intact, or else face a sharp decline in performance. With
that issue in mind, we proceed to the process of learning about culture, and
modifying the integration plan to accommodate it:
1. Collect information. Gaining an understanding of a company’s culture takes
more than a few brisk interviews with the human resources manager. While
that certainly is a starting point, the team should also have discussions with
those employees who have been with the acquiree the longest, and so have
the best knowledge of the inner workings of the business. Their view of how
the organization really operates is probably more accurate than that of the
senior managers who may be somewhat divorced from day-to-day opera-
tions.
2. Differences analysis. How does the culture of the acquiree differ from that
of the acquirer, and what can be changed to bring the culture of the acquiree
more into alignment with that of the parent? The team should consult with
its team member who is a local representative, as well as its original inter-
viewees, to determine the impact of any prospective changes.
3. Give and take. Do not scrap all of the component parts of the acquiree’s
culture. Even if corporate management decides that it cannot allow the ac-
quiree’s culture to remain untouched, it may be possible to continue some
aspects that are important to local employees, and which do not impact the
rest of the company. There may even be some features of the local culture
that it would be worthwhile to spread across other subsidiaries. For example,
the local management may have built a culture that dotes on customers; if

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the rest of the company suffers from poor customer ratings, then a dose of
that culture may be just what the rest of the company needs.
4. Communicate. If there are to be any culture changes, be sure to communi-
cate them multiple times to employees. A memo is not sufficient. Where
possible, a significant change warrants a series of group meetings to address
any modifications, why they are being implemented, and when they will
begin.

In short, the integration team needs to have an open mind about how the culture of
an acquiree impacts how it operates, and alter its integration objectives to
accommodate key elements of that culture.

Tip: It is particularly dangerous to unilaterally impose changes on a business that is

accustomed to a collaborative decision-making process, since employees will take a
dim view of changes that are proceeding without their input. In such cases, the
integration team needs to take the extra time to discuss matters with employees. This
is not a matter of engaging in a ceremony to appease the natives; if employees bring
up good points against a change, then by all means work with them to arrive at a
better solution.

Customer Service Integration

There are some integration opportunities in customer service, but only if the
underlying products are approximately the same. For example, the acquirer may sell
high-end products that are supported by intensive field service operations, while the
acquiree sells low-end products that are simply replaced if they break. In such a
situation, there is little room for integration. Here are some integration areas to
consider:
• Call center integration. If both companies operate inbound call centers to
support their products, it may be possible to combine them. However, given
the labor-intensive nature of call centers, it may be difficult to manufacture
enough additional profits to make it worthwhile. Consequently, this is a task
sometimes skipped by integration teams, and instead handed to the customer
service manager for long-term implementation.
• Field service consolidation. If both companies have products that require
periodic field servicing, and their products have approximately the same
geographic distribution, it is possible that their field service operations can
be combined. If so, this brings up such issues as where the regional field
service coordination centers will be situated, rebranding field service vehi-
cles, using common field service procedures and forms, cross-training em-
ployees on products, and consolidating the staffs. Since this is a labor-
intensive activity, it is possible that no field service positions will be elimi-
nated. However, it may be possible to eliminate some positions in the ad-
ministrative overhead associated with field service, if administrative duties
are consolidated.

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Divestment Issues
If the acquirer is purchasing a business that has been spun off from another
company, the divested operations are probably making use of some services
provided by its erstwhile parent. Examples of such services are accounting and
production computer systems, common facilities, and shared staff in such areas as
accounting and human resources. The integration team must address these shared
resources at once, for the former owner probably wants to extricate itself from its
former operations as soon as possible.
The integration team has to ascertain how long it has before shared services will
be eliminated, and schedule for replacement staff, services, and facilities before that
date. If replacements cannot be found prior to the termination date, then the
integration manager should negotiate with the seller for a longer conversion period.

Employee Integration
In most integration efforts, the acquirer simply leaves most employees in their
current jobs, because they do not have sufficient time to evaluate everyone. This is
perfectly acceptable for many positions. However, what about senior positions and
opinion leaders where the quality and attitude of the employee can have a profound
impact on the performance of the acquiree? The following issues are targeted
primarily at those key positions:
• Evaluate employees. It is dangerous to base the retention of a senior
manager on a single interview (or none at all). Instead, the team should
schedule a round of interviews with each senior manager, and have the in-
terviewers fill out an evaluation form that is then aggregated to arrive at a
group opinion. These interviews should involve a common set of questions,
as well as mandatory scoring in such areas as leadership, technical skills,
and communications, so that all interviewers can evaluate based on the same
information. The team itself may not be the best group to conduct the inter-
views; it may be better to fly each interviewee back to corporate headquar-
ters, so that the managers with whom they will interact can be involved.
• Founder disposition. The acquirer has probably just made the founder of the
acquiree a wealthy person, so job retention will be unlikely, unless there is a
way to pique his or her interest. Here are several possibilities:
o Advisor status. The founder may have an interest in advising the ac-
quirer in exchange for a stipend. This is more likely if the founder
plans to retire, and so has time available for such activities.
o Invest in new venture. The founder is probably an entrepreneur and
so has no interest in being managed, but might consider accepting
an investment in a new venture. This may be a good approach for
the acquirer, if only to maintain relations with the founder.
o Run R&D unit. If the founder has an engineering mindset, there may
be some interest in putting him in charge of a special research and
development group that allows him to focus solely on new products.

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• Opinion leader relations. There are typically a small number of longer-term

employees whose opinions are listened to by others within the organization.
The team needs to locate these people and work with them in crafting its
integration plan. The result may not be their active support, but it may be
possible to keep them from engaging in active resistance to the integration
team.
• Relocate positions. If the acquirer is truly interested in retaining employees,
but needs to move them to new locations, then it must pay 100% of the relo-
cation costs, as well as provide sufficient monetary incentives.

Tip: Many families are unwilling to relocate, so only a small percentage of

employees will consent to a relocation. However, employees may be willing to work
at the new location for a short time in exchange for a retention bonus. This allows
the acquirer more time to hire their replacements, and also gives it time to persuade
employees that moving to the new facility is not so bad.

• Retention analysis. The team should create a report for the acquirer’s senior
management team, detailing the impact if certain key employees leave the
business, and also describing the team’s retention plans for them. Retention
should involve whatever is needed to keep an employee, such as a change in
title, responsibilities, job content, or location – the issue is not always com-
pensation. Senior managers need to decide if they are willing to support the
recommended actions, after which the team works with the targeted em-
ployees to keep them with the company.

Tip: If the acquirer elects to give stock options to key employees, be sure to use
fairly lengthy or staggered vesting periods, to keep them from leaving in the near
term.

• Settle roles. Most employees in an acquiree are not going to be laid off as a
result of the acquisition – but they do not know that until told. Consequent-
ly, the integration team should decide as soon as possible which employees
will be retained, and to whom they will report. Waiting to complete this step
is dangerous, for it introduces uncertainty into the work force, which will at
least result in reduced productivity, and which may extend to some people
finding jobs elsewhere.

Tip: Some employees will leave their jobs as a result of an acquisition. Be sure to
treat these people extremely well, since they may not like their new employers, and
can be lured back. If they come back, this may be seen by other employees as a sign
of corporate stability.

The points noted in this section appear to be a relatively scientific and passionless
set of activities. In reality, the integration effort can involve some tense moments, as

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some employees are shuffled out of positions that they may have occupied for years.
The worst case is when there is considerable ambivalence against the acquirer, and
this attitude is rampant in the work force. If so, the integration team may have no
choice other than to replace a large part of the acquiree’s work force, probably
starting with the opinion leaders and cutting as deeply into the organization as
necessary to root out those causing trouble.

Tip: The acquirer should never be parsimonious with its severance packages.
Instead, it should provide generous severance. Departing employees will certainly
discuss the amount of severance they received with the remaining staff. This gives
remaining employees an entirely different opinion of the quality of their new
employer.

Human Resources Integration

The human resources area is a prime focus of the integration effort, for it is at the
center of those activities needed to keep the workforce as productive as possible,
even while some disruptive integration activities are underway. Several integration
considerations are:
• Benefits. If the acquirer has a large number of employees, it can probably
command the lowest possible rates for benefits. If so, it should take over the
acquiree’s benefit plans. If the existing plans span a contractually-mandated
time period, this integration may have to wait until the existing plans have
expired.
• Bonus plans. An acquirer may want to standardize the structure and payouts
associated with bonus plans throughout its subsidiaries, and may instruct its
integration team to do so. However, it is unwise to interfere in any way with
the current bonus plans of a newly acquired company, especially if it ap-
pears that employees will earn their bonuses. Instead, assign the task to the
human resources staff, and address the issue as of the beginning of the next
bonus period.

Tip: If the acquirer wants to reorient an acquiree at once to push for the completion
of integration goals, it can either set up an additional bonus plan for those activities,
or buy out the existing bonus plans based on accomplishments achieved to date, and
replace them with its own plans.

• Compensation parity. If the acquirer and the acquiree operate businesses

that are in approximately the same industries and geographical regions, there
will be a need to eventually achieve some degree of compensation parity
between the organizations. Achieving parity may require gradual multi-year
increases in some areas, combined with a reduction in the rate of pay growth
in others. This is not a short-term job for the integration team, but rather a
long-term one for the human resources department.

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Tip: Compensation parity may not be possible or even desirable when the
underlying businesses are fundamentally different. The same issue applies to
benefits. For example, if a business competes based on its low cost structure, it
would be foolish to apply the parent company’s rich benefits package to it and
destroy its profitability. Thus, some variation in compensation and benefits may be
required in different subsidiaries.

• Contact list. If the acquirer maintains a company-wide contact list (at least
for certain positions), then the human resources staff should forward this
information to whomever maintains the list, as well as install a procedure for
adjusting the list over time.
• Defined-benefit plan integration. If the employees of the acquirer are
enrolled in a defined benefit plan and the acquirer intends to roll the em-
ployees of the acquiree into it, the team needs to arrive at a formula for cred-
iting the years of service of these employees into the plan. This is an expen-
sive point, for more years of service translates into higher benefit levels.
• E-mail centralization. If the acquirer chooses to administer e-mail for all of
its subsidiaries, then the human resources staff should forward the employee
list to the e-mail administrator, as well as install a procedure for adjusting
the list over time.
• Employee agreements. Some employees may have had employment
agreements with the acquiree, under which they were guaranteed bonuses or
severance pay. If so, these agreements may need to be rewritten. Alterna-
tively, it may be possible to leave the existing agreements in place until their
termination dates, and then replace them with agreements more consistent
with the standards of the corporate parent.
• Employee manual. Many acquirers prefer to have a standard set of employ-
ment practices, which can include a standard medical insurance package, a
single pension plan, standardized vacation allowance, vacation accruals, and
so forth. These practices should be thoroughly documented in an employee
manual. Even when the acquirer tailors its employment practices to local
conditions, this will still probably call for some changes in the employee
manual. The integration team should have employee manuals prepared and
ready for distribution as close to the start of the integration as possible. Also,
the team should schedule an employee meeting to walk through these manu-
als, pointing out key changes from the prior employee manual and answer-
ing questions. This is an important topic for employees, so spend as much
time as necessary in the meeting.
• Human resources database. A sophisticated acquirer will maintain a
company-wide human resources system, in which it tracks benefits, training,
skills, and other information for all employees. This must be installed local-
ly and the local staff trained in its use.
• Pension plan. If the acquiree has a defined benefit plan, this presents a
significant risk of incurring additional expenses in the future, depending

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upon the interest rate that invested funds can earn (and other assumptions).
The acquirer can eliminate this risk by switching the acquiree’s employees
to a defined contribution plan, though doing so presents some legal obsta-
cles and may annoy employees to a considerable extent. The least compli-
cated way to switch plans is usually for the acquiree to terminate its pension
plan prior to the change in control, after which the acquirer introduces its
pension plan.

Tip: If the acquiree has a union, examine the union agreement to see if the union
must agree to a switch from a defined benefit to a defined contribution pension plan.

• Personnel search. The team may be on the lookout for personnel whom it
can promote into the parent company. It is certainly useful to offer promo-
tions to the best and brightest. However, there are two problems with inte-
grating a talent search into a standard integration process, which are:
o Time required. It may take quite a long time to locate promotable
prospects, which means that this task may more appropriately be
scheduled as a longer-term, ongoing process of sifting through the
employees.
o Cookie cutter integrations. When an acquirer is intent on complet-
ing a large number of acquisitions in short order, it cannot spend the
time on personnel identification. Instead, the integration teams are
more likely to install a required set of systems and procedures, and
move on to their next projects.

A key issue associated with the human resources function during an acquisition is
the termination of employees. If layoffs are planned, do not engage in a prolonged
series of layoffs; all that does is crush the morale of the remaining employees.
Instead, there should be two layoffs, which are scheduled as follows:
• Redundant position layoffs. Examine all of the short-term projects involving
synergies to be gained by eliminating positions, and lay off these employees
at the same time. If there is a small difference in the time periods during
which some positions must be retained, it may make sense to continue pay-
ing some employees a few weeks longer, so that the layoffs can be consoli-
dated into a single event.
• Retention-bonused layoffs. This layoff is usually much smaller in size, and is
well after the earlier layoff. This involves the people who are needed to
transition their tasks for some period of time, after which they are paid a
bonus and terminated. These terminations may not occur on the same date,
since some transitions take longer than others. However, if properly com-
municated to employees, there should be no question that these layoffs were
scheduled from the beginning, and so do not represent a new set of layoffs.

When engaged in any type of compensation normalization between the employees of

the acquirer and the acquiree, consider deriving the effective net income of the

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employees, both before and after any proposed changes. This means aggregating net
after-tax income from pay, bonuses, and benefits. It is entirely possible that the
human resources staff may be advocating a much richer benefits package for the
employees of the acquiree, but does not realize that a proposed cutback in the bonus
plan more than offsets the increased benefits. This effective net income calculation
should at least be completed for all key employees whose retention is critical. In
some cases, the differences in compensation systems will be so radically different
that management would be well advised to proceed with considerable care, as noted
in the following example.

EXAMPLE

Red Herring Corporation acquires the Icelandic Cod Company. Both organizations operate
fish canning facilities that are located just a few miles apart, on the coast of Maine. Given
their proximity to each other, there should be no regional differences in pay or benefits.
However, the two organizations have taken radically different approaches to pay and
benefits. Red Herring pays 100% of all benefits, but does not have any meaningful bonus
plans, and pays employees the median wage for the area. Icelandic Cod takes the alternative
approach of paying high wages and performance bonuses, but does not offer any benefits at
all. The result of these alternative compensation systems has been the retention of older
employees with families at Red Herring, versus the retention of a younger workforce at
Iceland Cod that tends to be single and healthy, and so in less need of benefits.

If the managers of Red Herring enforce their compensation package on the employees of
Icelandic Cod, a likely result will be the departure of a significant part of the Icelandic work
force. Consequently, the managers elect to retain separate compensation systems for the next
year, and explore a very gradual equalization of systems over the following five years.

Information Technology Integration

There can be a number of opportunities for improvement in consolidating IT
systems. However, many acquirers only treat them as opportunities, and never take
the time to complete any of the more in-depth synergy projects. This is caused by
the great difficulty of standardizing on the same technology platforms, which is not
only expensive, but may also require several years to complete. Nonetheless, the
results can be rewarding, so the acquirer should at least consider the following
integration options:
• Operational integration. How are the IT operations of the acquiree to be
integrated into the IT structure of the rest of the company? Also, are some of
the systems used by the acquiree of such excellence that they should be
rolled out throughout the rest of the company? Further, does the addition of
the acquiree place the acquirer’s IT systems at a larger capacity level that
now requires rethinking of the entire IT infrastructure of the business?
• Organizational structure. How is the IT organization as a whole to be
structured? Does the new acquisition call for a reshuffling of the manage-

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ment structure? Should any portions of the IT system be outsourced? Should

there be changes in favor of centralizing or dispersing IT operations?
• Duplicate staffing. There may be overlap in the services provided by IT
employees in the acquired business and those in the acquirer’s business.
Duplication is most prevalent in the areas of help desks, desktop and laptop
support, and network monitoring. However, there may be few initial savings
in this area unless the software, hardware, and network infrastructures of all
subsidiaries have already been standardized.
• System diversity. Every time an acquirer buys another company, the IT
department must deal with the maintenance of a new set of software pack-
ages being operated by the acquiree. In general, it is less expensive to oper-
ate the same software (and software versions) throughout the company, and
decommission any duplicate systems. Cost savings from using fewer soft-
ware packages include reduced software maintenance charges, data center
costs, and in-house software support labor. In particular, it is no longer nec-
essary to maintain small groups of experts to service each software package;
instead, a smaller and more centralized group is used to support the few
remaining systems that are used throughout the company. Thus, the IT man-
ager needs to decide if expenses will be reduced over the long term by re-
quiring the acquired business to adopt the software used elsewhere in the
company.
• Software supplier centralization. It is particularly important to shift business
to the smallest number of software suppliers. By doing so, the acquirer can
“wield a big stick” in negotiating software purchase prices and follow-on
annual maintenance charges. Even if maintenance charges do not drop, it is
quite possible that the number of employees authorized to use each package
will decline, which reduces costs. For example, a supplier may charge a
fixed annual maintenance fee for a range of 100-250 users. If the acquirer
and the acquired entity each had 101 users and were both paying this fee,
then the user base can be combined under a single maintenance fee that still
falls within the range of a single 100-250 user license.
• Data center consolidation. In a larger organization, it usually makes sense to
consolidate data centers. Each data center is very expensive to maintain, so
eliminating even one of them usually results in savings in the million-dollar
range. In global enterprises, it may not be possible or prudent (from a risk
management perspective) to have just one data center, but it is generally safe
to centralize data centers at a regional level.
• Disaster recovery planning. If the acquiree does not have a system in place
to recover from IT system disasters, then install one as soon as possible.
This may involve backup procedures, offsite data storage, and the use of
backup computing facilities. The amount of disaster planning will depend
upon the extent to which IT systems have been integrated into the compa-
ny’s operations.

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• Security review. An IT security specialist should examine the acquiree’s

systems and recommend the imposition of whatever controls are needed to
reduce the risk of unauthorized access to the company’s databases.
• Equipment purchases. It is always less expensive to maintain a single type
of IT equipment, so the acquirer usually mandates that specific types of
equipment be purchased for all subsidiaries, or at least that equipment only
be purchased from certain suppliers. In the latter case, this may mean that
the company as a whole can benefit from bulk purchase discounts.

The main goal for IT should be to reduce its aggregate cost following an acquisition.
This goal is possible for IT, because it can be extremely scalable: a certain
expenditure can be used to service the IT needs of a broad range of users. Therefore,
by adding the revenue of an acquired business while eliminating some portion of its
IT expenses, the acquirer can achieve an increase in profits.
However, the inherent profit-enhancing capabilities of the IT area do not come
without a cost. It can be extremely difficult to consolidate data centers, standardize
on certain types of hardware, centralize IT staff, eliminate redundant positions, and
(especially) standardize on specific types of software. These issues are made
particularly difficult in light of the need to also implement new controls, backups,
and disaster recovery plans for acquired entities. It requires excellent management
skills to realize the potential benefits of IT integration.
If an acquirer is engaged in a continuing series of acquisitions, it is entirely
likely that the IT organization will be inundated with those integration tasks needed
to realize efficiencies from the acquisitions. If so, it will have great difficulty in also
rolling out new technologies or making changes to existing systems. To avoid these
issues, the IT manager should consider creating a separate IT group that is solely
concerned with non-acquisition issues. Doing so improves the odds of achieving
more advanced IT capabilities for the company as a whole. Otherwise, the
department may be so focused on integration activities that the technological
prowess of the business falls behind that of competitors.

Legal Integration and Issues

This section describes both integration issues and legal issues, since there is a
chance that some legal problems will arise as part of the integration process. The
topics are:

Legal Integration
• Advance pricing agreements. If the acquirer plans to sell goods between
subsidiaries, this will require the establishment of a transfer price at which
the goods are sold between subsidiaries. Transfer prices can be used to re-
duce the overall corporate tax liability, so the tax and legal staffs might con-
sider applying to the relevant tax authorities for advance approval of the
pricing methodologies the company plans to use for these transfer prices.

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• Contract management. If the legal department of the acquirer maintains a

contract administration database, then the acquiree should forward copies of
its contracts to the corporate legal staff. If not, then contracts will probably
be maintained locally.
• Liens. If the acquiree’s debts were paid off as part of the acquisition (as is
usually the case), there should no longer be any liens against company as-
sets. The team should conduct a search for liens and have any remaining
ones removed.
• Trademark administration. The acquirer should centralize the administration
of trademarks, so that no trademarks are inadvertently allowed to lapse.
Thus, the authorization to administer trademarks must be shifted from the
attorney of the acquiree to the attorney of the acquirer.
• Trademark extensions. If the acquirer plans to market the acquiree’s name
and products in other markets, it should apply for trademarks in those re-
gions. Otherwise, someone else could take the trademarks, thereby requiring
the acquirer to market the products under a different name.

Legal Issues
• Discrimination lawsuits. In the likely event of layoffs, some employees may
claim that they were discriminated against. To mitigate this risk, a labor
attorney should review all prospective terminations in advance, as well as
the methodologies used to determine layoffs, to see if there will be any ar-
guable claims of discrimination arising from them.
• Layoff notification. In the United States, a company must be in compliance
with the Worker Adjustment and Retraining Notification Act (WARN). This
Act requires 60 days’ notice when an employer plans to close a facility or
conduct a mass layoff. The provisions of WARN apply to situations where:
o The employer has at least 100 employees
o A facility closure will result in an employment loss for at least 50
employees
o A mass layoff will result in employment loss for at least 500 em-
ployees at an employment site, or for at least 50 employees if they
make up at least one-third of the active workforce

Management Structure Integration

Managers are the prickliest of all employees, particularly in regard to their spans of
control and reporting relationships. Thus, the team should be particularly careful
about implementation issues involving managers. For some of the following issues,
it may be necessary to call in the acquirer’s senior managers:
• Authorization levels. The acquirer may allow a certain level of transaction
authorization to its employees at a subsidiary. If so, the team should com-
municate these authorization levels. Authorizations may include:
o Check signing authority up to a certain dollar level
o Wire transfer authority up to a certain dollar level

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o Hiring and firing authority for certain positions

o Fixed asset sales and disposals
o Contract signing authorizations
• Redundant managers. If the acquirer plans for an extensive amount of
centralization, then there will likely be too many managers for too few posi-
tions. The human resources staff will need to arrange for retention bonuses
through whatever period is needed by the company, followed by appropriate
severance packages for those managers considered to be redundant.
• Reporting relationships. Any acquisition involves a certain amount of
reshuffling of responsibilities. The team should settle these responsibilities
as soon as possible, formalize them in a new organizational structure chart,
and communicate them throughout the entire company.
• Specialist positions. An acquiree may have been too small to afford
specialists in certain areas, such as treasurers, credit managers, risk manag-
ers, and taxation specialists. If so, the parent company (which presumably
does have these positions) may want to shift some reporting relationships so
that local employees report to these specialists. For example, the local credit
clerks may now report to a credit manager at corporate headquarters.

In short, there is almost certainly going to be some change in every manager’s job, if
only because the normal management span of control guarantees that some
integration issue is bound to have an impact. This means that managers in particular
will have great interest in the proceedings of the integration team, and so will require
a higher-than-usual level of communication.

Marketing Integration
Marketing is sometimes ignored by acquirers, on the grounds that its activities are so
specific that they cannot be easily aggregated at the parent company level to reduce
costs. This is not entirely the case, as shown in some of the following points:
• Consolidate advertising spend. The team might consider shifting the
acquiree’s advertising to the same ad suppliers used by the parent company,
which increases the aggregate amount of advertising spend, and thereby
allows the company to negotiate volume discounts.
• Consolidate campaigns. If the acquirer plans to roll the acquiree’s products
into its own product lines, it can terminate some or all product-specific ad-
vertising campaigns and instead include them in its existing campaigns.
• Consolidate catalogues and price lists. If the intent is to sell the product
lines of the two entities on a combined basis, then their catalogues and price
lists must be revised and re-issued to customers.
• Name placement. If the acquirer wants to alter the name of the acquiree or
insert the parent company name in its branding, then the acquiree should
revise not only its letterhead, but also all business cards, branding on Pow-
erPoint presentations, and so forth.

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• Product termination. The product lines of the two companies may involve
some overlap, so the team needs to decide which products will be terminat-
ed. This is not a minor decision, for it may also involve the elimination of
production equipment (or entire facilities). Further, it may make sense to
first draw down the finished goods inventory levels for products before ter-
minating them.
• Standardize packaging. If the acquirer plans to insert the acquiree’s products
into its own product line, it needs to redesign product packaging to make it
consistent for the entire product lineup. This also means that the packaging
materials can probably be sole-sourced to a single supplier in exchange for a
volume discount.
• Redirect web site. The acquirer may want to eliminate the acquiree’s web
site, in which case it should be set to redirect to the web site of the acquirer.
Alternatively, the acquirer may elect to maintain the site, but adjust its look
and feel to more closely adhere to that of the corporate site.
• Trade shows. If the two companies have historically attended the same trade
shows, they may be able to combine their show attendance in the future.
This can require an initial increase in costs, since they may need to replace
their portable trade show booths with a new one that is rebranded and capa-
ble of displaying their combined wares.

Materials Management Integration

Depending upon the level of integration that the acquirer wants to achieve, the
integration team may find itself completely ignoring the materials management
function, or engaging in a massive systems replacement and upgrade. The latter is
usually the case if the acquirer believes that it can achieve a major reduction in the
inventory investment of the acquiree. Possible integration steps include:
• Distribution system. The acquirer may want to consolidate distribution
systems. This may involve closing some warehouses and shifting stored
items elsewhere. Given the length of some warehouse leases, these changes
may require a number of years to complete.
• Inventory record accuracy. The inventory records of the acquiree must be at
a sufficiently high accuracy level to give the acquirer confidence in the ac-
curacy of its reported inventory levels. Consequently, the team should en-
sure that the warehouse staff is operating an inventory tracking system that
yields high record accuracy levels, or upgrade the procedure to ensure that
accuracy levels will be higher in the future.
• Inventory security. The team should verify the existence of barriers around
inventory storage areas, and require the construction of fencing and the in-
stallation of input/output transactions to improve the accuracy of inventory
records.
• Obsolete inventory. If inventory is a significant asset, the team should insist
on the installation of an ongoing system for ferreting out and disposing of
obsolete inventory. The point is not to actually find obsolete inventory right

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now, but rather to set up the process for doing so. A robust process will
mitigate the risk that the acquiree will have undocumented obsolete invento-
ry in the future, which gives the acquirer more confidence in its financial
statements.
• Purchasing consolidation. It may be standard practice for the acquirer to
require the use of certain suppliers by all acquirees. Doing so increases the
purchasing volume with each of these suppliers, allowing the parent compa-
ny to negotiate larger volume discounts. This also involves the installation
of a monitoring system, to see if anyone is purchasing outside of the author-
ized supplier list.

Note: The level of potential purchasing consolidation increases with a function of

geographical proximity to each other and the commonality of parts. The engineering
departments of the two companies can eventually cooperate in the design of
products that use common parts, but this is a multi-year endeavor.

• Purchasing terms. The acquirer may assign different priorities to the

purchasing terms that it allows suppliers. For example, it may emphasize 60
or 90-day payment terms in order to reduce its working capital require-
ments, and is willing to accept somewhat higher materials prices in ex-
change. If so, the purchasing staff will need to negotiate new terms with its
suppliers, which can be a protracted affair.
• Supplier certification. The acquirer may require that the quality of supplier
products be certified. If so, the acquiree may not be accustomed to the certi-
fication process, and must work with the acquirer’s employees to set up the
requisite certification system.

An acquiree may have invested a large amount in the creation of a unique brand for
its products. If so, customers have come to expect a specific look and feel for these
products, which it may have taken the acquiree years to create. If the acquirer were
to consolidate the sourcing and production of the acquiree, it may find that the look
and feel characteristics of these unique products have slipped away, resulting in a
gradual decline in customer loyalty, sales, and profits.

EXAMPLE

Artisan’s Delight uses a group of home-based weavers to create hand-crafted shopping bags
made of home-spun wool, which it markets as an all-natural alternative to plastic shopping
bags. The company is acquired by International Bag, whose strategy is to be the low-cost
producer in every market it enters. The materials management staff at International Bag
promptly terminates the contracts with every weaver used by Artisan’s Delight, and shifts the
work to an automated manufacturing facility in Indonesia.
Customers immediately notice that the material used in the shopping bags has changed to a
wool-rayon blend. Also, the slight imperfections in the woven products that are indicative of

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home production have vanished. Given these issues, customer acceptance of Artisan’s high
price points vanishes, resulting in a catastrophic decline in sales.

Production Integration
It can be difficult to successfully engage in any integration activities in the
production area, for an acquiree’s production facilities are designed specifically for
the manufacture of its own products; thus, moving production elsewhere is not
always an option, at least in the short-term. Nonetheless, the integration team might
engage in the following activities:
• Constraint analysis. Have a constraint specialist review the production
facilities and see if the flow of work can be revised to match the concepts of
constraint analysis and throughput maximization. With proper retraining of
the production staff, this can result in more reliable production flows, a re-
duced need for fixed assets, and improved profitability.
• Excess capacity. In those rare cases where production can be shifted among
facilities, the team might analyze the acquiree’s facilities to see if there is
any excess capacity available, and move more work into the company to
take advantage of it. Conversely, if the facilities are overworked, it may be
possible to shift production to another of the acquirer’s network of manufac-
turing plants.
• Fixed asset moves. If production equipment is not needed in one facility, the
most cost-effective use of it may be to move it to another facility.
• Outsourcing. An identified synergy may be that an acquiree’s production
facilities are so inefficient that they can be most easily improved by shutting
them down and outsourcing the production. This requires the participation
of the acquirer’s production management staff to select a supplier and out-
source production.

Selling Integration
The following points assume that the acquirer feels there is some advantage to be
gained from combining the sales forces of the two companies. However, this is not
always a wise choice. The typical company targets a very specific slice of the
market, and trains its sales force to deal with that niche. If the two sales departments
have different training, deal with different customers, and use different selling
strategies, then combining them may fail. Consider the following situations:
• High price point. Probably requires multiple contacts and presentations,
with contractual negotiations. Usually involves a sales team.
• Low price point. Probably involves a single contact and standard brochures.
Likely to involve a single salesperson.
• Long selling cycle. Probably involves a high-priced product or service for
which a request for proposals has been issued, and for which a formal sales
proposal is expected. Usually involves a sales team.

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• Technical sale. Probably involves a mid- to high-priced product or service,

where a presentation by a sales technician is required.
• Commodity sale. Usually for a lower-priced product, possibly in high
volume. Sales require minimal salesperson involvement.

Consider what the impact would be if the sales efforts of two companies were
combined, where each one followed a different selling strategy? As you can see
from the preceding list of selling situations, the result would be similar to mixing oil
with water. With that warning in mind, here are several integration issues to
consider:
• Cross-training. If the two companies are to handle each other’s customers,
this calls for immediate cross-training in the characteristics of major cus-
tomers, as well as the procedures used to deal with them.
• Customer contacts. Meet with the major customers to discuss the acquisi-
tion, and answer any questions they may have. The goal is to avoid customer
defections. A great deal of face-to-face communications as part of the acqui-
sition can also be used to improve overall customer relations, though it is
expensive and time-consuming to keep up this level of communication for
long.
• New customer identification. In a few situations, the combined entities will
have an expanded mass and production line that allows it to sell to custom-
ers who would not have previously deigned to notice them. These new cus-
tomers are potentially massive ones, with a potential for equally large or-
ders, and so are well worth the sales effort. The integration team is not re-
sponsible for identifying or approaching new customers, but it should re-
mind the sales team of this opportunity.
• Redundant positions. If the acquirer plans to have its existing sales staff
handle sales for the acquiree’s products, it will likely review both its exist-
ing salespeople and those of the acquiree, prune out the lowest performers,
and retain the top ones. The result is likely to be terminations at both the
acquirer and the acquiree.
• Price change authorization. There may be different levels of authorization
required in the two organizations for allowing changes from the standard
product prices. If so, the team may need to standardize the authorization
levels. This can cause difficulties when the acquiree’s sales staff was not
monitored on this issue.
• Recertification. In some cases, a customer may require that a supplier that
has gone through a change in ownership must be recertified to do business
with it. If so, the integration team should monitor the recertification process
for each customer. This issue can negatively impact short-term sales.
• Territory integration. If the acquirer apportions its sales staff among various
sales territories, it may want to reshuffle the acquiree’s sales staff into those
same territories, especially if it wants the combined sales forces to sell a
combined product line. This can be a difficult situation, since redundant

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positions may be eliminated and the remaining sales staffs must be trained
on each other’s products. For this level of integration, expect an initial de-
cline in sales and a considerable amount of initial turmoil in the sales de-
partment.

Acquirers commonly try to have their newly-combined sales forces sell a broader
array of products derived from both companies. However, this does not always
result in a greater level of selling efficiency. There is a short-term problem, where
the sales staff must be pulled from the field to learn about their new products. There
is also a longer-term issue, where presenting more products to customers takes more
time, which reduces the total number of sales calls. These issues are only of
importance if there are face-to-face sales contacts; there is little or no impact on
other distribution channels.

Treasury and Risk Management Integration

If the acquiree has a treasury department, it is usually shifted in its entirety into the
corporate treasury department. The reason is that the corporate treasury staff can
generate more interest income, hedge more effectively, and obtain lower-cost debt if
it can manage the cash flows of the entire organization. Issues to consider are:

Treasury Integration
• Credit policy. The acquirer may want to alter the credit policy of the
acquiree, if it feels that a looser or tighter credit policy will result in a profit
enhancement. Credit may be administered locally, since doing so places the
credit staff closer to the collections and sales staffs.
• Debt payoff. It is extremely common for lenders to exercise the debt
acceleration clauses in their loan agreements when a company is acquired,
which means that the treasury group must pay off loans when the acquisition
is completed. The corporate treasury group may arrange for replacement
financing with a new lender, or it may have sufficient cash to avoid the need
for additional lending.
• Hedging. The various subsidiaries of a parent company can net their
combined cash flows to hedge against the risks inherent in foreign currency
trades. A central treasury group can examine these cash flows and obtain
hedges to mitigate the risks associated with any net foreign currency posi-
tions. The team can arrange to include the cash flows of the acquiree in this
hedging system.
• Sweep accounts. If the acquirer invests cash from a central location, arrange
to have the cash in the acquiree’s bank accounts be included in a daily cash
sweep or notional pooling program. Cash sweeping is when a company’s
bank automatically moves cash out of a bank account and into a cash con-
centration account. Notional pooling is a mechanism for calculating interest
on the combined credit and debit balances of bank accounts that a corporate
parent chooses to cluster together, without actually transferring any funds.

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Risk Management Integration

• Insurance policy integration. If the acquirer is sufficiently large, it probably
has both low-cost insurance policies and a risk manager to administer them.
It will probably want to consolidate any policies held by the acquiree into its
own policies, though it may have to wait for the acquiree’s existing policies
to expire before it can do so.

Post-Integration Analysis
Once the integration effort is judged to be largely complete, an analyst should
compare the initial expectations for synergies to those actually achieved. This is
useful for the following reasons:
• Feedback loop. Any areas in which expected synergies have failed are ones
that are more likely to fail again in future acquisitions. This means that the
acquirer should modify its expectations for the same synergies in the future,
which in turn may impact the prices it is willing to pay for other acquisi-
tions.
• Obstreperous management. If a synergy failed to materialize, it may very
well be due to the resistance of managers at the acquiree. If failed synergies
represent a significant reduction in expected profits, it may be time to con-
duct a cost-benefit analysis on those people getting in the way of the integra-
tion effort. The result may be the replacement of certain managers.
• Replication. If a particular synergy was a new one that worked out well,
management can include it on the standard due diligence list of items to
review. Thus, it could be applied to future acquisitions.

The post-integration analysis may result in the determination by the acquirer to try
again on some failed synergies. The integration team may be called back for this
second effort.

Integration for the Serial Acquirer

The strategies of some businesses are built around the ongoing acquisition and
integration of other businesses. If so, they likely have full-time integration teams
who move from one acquisition to the next. These teams have developed a standard
set of integration topics to address, which are based on their experience with similar
acquirees in the same industry. Assuming that most acquirees are roughly similar,
this means that the teams have a good idea not only of what issues they will find, but
also which synergies will work, and how long it will take to complete the bulk of the
integration tasks.
A well-managed serial acquirer realizes that it can only acquire companies at a
certain pace, because its integration teams are only able to complete their integration
activities at a certain pace. If the acquirer were to buy companies at an excessively
fast pace, the most recent acquisitions would receive little management attention
until an integration team became available; this means that no synergies or other

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integration activities would be completed in the meantime. From the perspective of

an outside observer, this pacing issue should highlight those businesses acquiring at
a torrid pace, for they are unlikely to achieve outsized profits from their acquisition
activities. If anything, the sheer weight of the problems introduced by their
undigested acquisitions may very well bring them down over the long term.
Acquisitions are, by their nature, unpredictable – you cannot determine exactly
when a purchase will be completed, or if it will fall through. Thus, it is impossible to
have a perfectly-timed series of acquisitions to which integration teams can be
neatly assigned. Given this issue, it is better to schedule excess “free” time for
integration teams than to over-schedule them. Doing so gives them more time to tie
up loose ends on their current projects before moving to the next one.

Summary
The acquisition integration process is a difficult one, which calls for the services of a
full-time, committed integration team that works on-site for as long as it takes to
achieve the primary integration goals. It is of great importance for this group to
complete its tasks as rapidly as possible, while communicating its changes to all and
sundry. However, the team should not leave behind an outraged workforce; it also
requires considerable delicacy to negotiate through the maze of local relationships
and viewpoints to make changes function properly.
Consideration of a company’s culture is of great importance when enacting
changes. If the employee linkage to culture is so strong as to be almost palpable, the
integration team will probably run into problems so severe that its integration tasks
are delayed or cannot be completed at all. If the team has tried to force its integration
schedule on the acquiree for a prolonged period, it is likely that relations with the
business are irreparably damaged, and the acquisition will never achieve its
proposed synergies.
Finally, acquisition integration always meets with some degree of resistance.
The manager of the integration team needs to determine the extent to which he is
willing to modify the integration plan to mitigate resistance. However, it never
makes sense to alter the plan to a massive extent (thereby foregoing valuable
synergies) in order to please everyone. Instead, the manager needs to understand that
there will be a disaffected minority who cannot be placated unless the bulk of the
integration efforts are abandoned. Thus, there is a continuum of trade-offs, with the
achievement of all integration objectives at one end and a happy workforce at the
other. The integration manager needs to select a spot on that continuum that
represents a reasonable tradeoff between the two extremes.

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 Chapter 14
Accounting for Acquisitions
Introduction
This chapter describes the basic steps required to account for an acquisition under
Generally Accepted Accounting Principles (GAAP), with a brief discussion of how
international accounting standards vary from GAAP in this area. The centerpiece of
accounting for acquisitions is the acquisition method, which details a series of steps
to be completed to arrive at the acquisition journal entry. Consideration must also be
given to the subsequent review of any goodwill arising from an acquisition, to see if
it has been impaired. The goodwill impairment testing process is described in this
chapter.

Note: In GAAP, acquisitions are referred to as business combinations, so that phrase

is used throughout this chapter.

Overview of Business Combinations

A business combination has occurred when a group of assets acquired and liabilities
assumed constitute a business. A business exists when processes are applied to
inputs to create outputs. Examples of inputs are fixed assets, intellectual property,
inventory, and employees. An output is considered to have the ability to generate a
return to investors.
A business combination must be accounted for using the acquisition method.
This method requires the following steps:
1. Identify the acquirer. The entity that gains control of the acquiree is the
acquirer. This is typically the entity that pays assets or incurs liabilities as a
result of a transaction, or whose owners receive the largest portion of the
voting rights in the combined entity. If a variable interest entity is acquired,
the main beneficiary of that entity is the acquirer. One of the combining
entities must be the acquirer.
2. Determine the acquisition date. The acquisition date is when the acquirer
gains control of the acquiree, which is typically the closing date.
3. Recognize and measure all assets acquired and liabilities assumed. These
measurements should be at the fair values of the acquired assets and liabili-
ties as of the acquisition date.
4. Recognize any noncontrolling interest in the acquiree. The amount recog-
nized should be the fair value of the noncontrolling interest.
5. Recognize and measure any goodwill or gain from a bargain purchase. See
the Goodwill or Gain from Bargain Purchase section for a discussion of
goodwill and bargain purchases.
 Accounting for Acquisitions

There are two types of business combinations that can result in some modification of
the preceding accounting treatment. These types are:
• Step acquisition. A business may already own a minority interest in another
entity, and then acquires an additional equity interest at a later date that re-
sults in an acquisition event. In this situation, the acquirer measures the fair
value of its existing equity interest in the acquiree at the acquisition date,
and recognizes a gain or loss in earnings at that time. If some of this gain or
loss had previously been recognized in other comprehensive income, reclas-
sify it into earnings.
• No transfer of consideration. There are rare cases where no consideration is
paid while gaining control of an acquiree, such as when the acquiree repur-
chases enough of its own shares to raise an existing investor into a majority
ownership position. In this situation, recognize and measure the noncontrol-
ling interest(s) in the acquiree.

There are a number of additional issues that can affect the accounting for a business
combination, as outlined below:
• Contingent consideration. Some portion of the consideration paid to the
owners of the acquiree may be contingent upon future events or circum-
stances. If an event occurs after the acquisition date that alters the amount of
consideration paid, such as meeting a profit or cash flow target, the account-
ing varies depending on the type of underlying consideration paid, as noted
next:
o Asset or liability consideration. If the consideration paid is with as-
sets or liabilities, remeasure these items at their fair values until
such time as the related consideration has been fully resolved, and
recognize the related gains or losses in earnings.
o Equity consideration. If the consideration paid is in equity, do not
remeasure the amount of equity paid.
• Provisional accounting. If the accounting for a business combination is
incomplete at the end of a reporting period, report provisional amounts, and
later adjust these amounts to reflect information that existed as of the acqui-
sition date.
• New information. If new information becomes available about issues that
existed at the acquisition date concerning the acquiree, adjust the re-
cordation of assets and liabilities, as appropriate.

EXAMPLE

Armadillo Industries acquires Cleveland Container on December 31, 20X3. Armadillo hires
an independent appraiser to value Cleveland, but does not expect a valuation report for three
months. In the meantime, Armadillo issues its December 31 financial statements with a
provisional fair value of $4,500,000 for the acquisition. Three months later, the appraiser
reports a valuation of $4,750,000 as of the acquisition date, based on an unexpectedly high
valuation for a number of fixed assets.

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In Armadillo’s March 31 financial statements, it retrospectively adjusts the prior-year

information to increase the carrying amount of fixed assets by $250,000, as well as to reduce
the amount of goodwill by the same amount.

Any changes to the initial accounting for an acquisition must be offset against the
recorded amount of goodwill. These changes to the initial provisional amounts
should be recorded retrospectively, as though all accounting for the acquisition had
been finalized at the acquisition date.
The measurement period during which the recordation of an acquisition may be
adjusted ends as soon as the acquirer receives all remaining information concerning
issues existing as of the acquisition date, not to exceed one year from the acquisition
date.
The acquirer will probably incur a number of costs related to an acquisition,
such as fees for valuations, legal advice, accounting services, and finder’s fees.
These costs are to be charged to expense as incurred.

Identifiable Assets and Liabilities, and Noncontrolling Interests

When the acquirer recognizes an acquisition transaction, it should recognize
identifiable assets and liabilities separately from goodwill, and at their fair values as
of the acquisition date. The following special situations also apply:
• No asset or liability is recognized in relation to an acquired operating lease
in which the acquiree is the lessee, except to the extent of any favorable or
unfavorable lease feature relative to market terms, or the willingness of third
parties to acquire a lease even at market rates.
• Do not include any costs that the acquirer expects to incur in the future, but
is not obligated to incur in relation to the acquiree, such as possible employ-
ee relocation costs.

It is entirely possible that the acquirer will recognize assets and liabilities that the
acquiree had never recorded in its own accounting records. In particular, the acquirer
will likely assign value to a variety of intangible assets that the acquiree may have
developed internally, and so was constrained by GAAP from recognizing as assets.
Examples of intangible assets are:

Broadcast rights Internet domain names Noncompetition agreements

Computer software Lease agreements Order backlog
Customer lists Licensing agreements Patented technology
Customer relationships Literary works Pictures
Employment contracts Motion pictures Service contracts
Franchise agreements Musical works Trademarks

A key intangible asset for which GAAP does not allow separate recognition is the
concept of the assembled workforce, which is the collected knowledge and

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experience of company employees. This intangible must be included in the goodwill

asset.
The accounting treatment for special cases related to the recognition of assets
and liabilities is as follows:
• Contingency fair value not determinable. It is quite common for a contin-
gent asset or liability to not be measurable on the acquisition date, since
these items have not yet been resolved. If so, only recognize them if the
amount can be reasonably estimated, and events during the measurement
period confirm that an asset or liability existed at the acquisition date.
• Defined benefit pension plan. If the acquiree sponsored a defined benefit
pension plan, the acquirer should recognize an asset or liability that reflects
the funding status of that plan.
• Indemnification clause. The seller of the acquiree may agree to an indemni-
fication clause in the acquisition agreement, whereby it will indemnify the
acquirer for changes in the value of certain assets or liabilities, such as for
unusual bad debt losses from receivables in existence at the acquisition date.
In these cases, the seller recognizes an indemnification asset when it recog-
nizes a loss on an item to be indemnified; this should be retrospectively
applied as of the acquisition date.

Tip: Realistically, if you are still attempting to establish a valuation for assets and
liabilities more than a few months after an acquisition, they probably had no value at
the acquisition date, and so should not be recognized as part of the acquisition.

Acquired assets and liabilities are supposed to be measured at their fair values as of
the acquisition date. Fair value measurement can be quite difficult, and may call for
different valuation approaches, as noted below:
• Alternative use assets. Even if the acquirer does not intend to apply an asset
to its best use (or use the asset at all), the fair value of the asset should still
be derived as though it were being applied to its best use. This guidance also
applies to situations where an asset is acquired simply to prevent it from
being used by competitors.
• Assets where acquiree is the lessor. If the acquiree owns assets that it leases
to a third party (such as a building lease), derive fair values for these assets
in the normal manner, irrespective of the existence of the lease.
• Fair value exceptions. There are exceptions to the general rule of recogniz-
ing acquired assets and liabilities at their fair values. The GAAP related to
the recognition of income taxes, employee benefits, indemnification assets,
reacquired rights, share-based awards, assets held for sale, and certain con-
tingency situations overrides the use of fair value.
• Noncontrolling interest. The best way to measure the fair value of a
noncontrolling interest is based on the market price of the acquiree’s stock.
However, this information is not available for privately-held companies, so
alternative valuation methods are allowed. This valuation may differ from

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the valuation assigned to the acquirer, since the acquirer also benefits from
gaining control over the entity, which results in a control premium.
• Valuation allowances. Some assets, such as receivables and inventory, are
normally paired with a valuation allowance. The valuation allowance is not
used when deriving fair values for these assets, since the fair value should
already incorporate a valuation allowance.

A few assets and liabilities that are initially measured as part of an acquisition
require special accounting during subsequent periods. These items are:
• Contingencies. If an asset or liability was originally recognized as part of an
acquisition, derive a systematic and consistently-applied approach to meas-
uring it in future periods.
• Indemnifications. Reassess all indemnification assets and the loss items with
which they are paired in each subsequent reporting period, and adjust the
recorded amounts as necessary until the indemnifications are resolved.
• Reacquired rights. An acquirer may regain control over a legal right that it
had extended to the acquiree prior to the acquisition date. If these reacquired
rights were initially recognized as an intangible asset as part of the acquisi-
tion accounting, amortize the asset over the remaining period of the contract
that the acquiree had with the acquirer.
• Leasehold improvements. If the acquirer acquires leasehold improvement
assets as part of an acquisition, amortize them over the lesser of the useful
life of the assets or the remaining reasonably assured lease periods and re-
newals.

Tip: The amortization period for leasehold improvements may be a significant issue
for the acquirer, if it intends to shut down acquiree leases as soon as practicable.
Doing so may accelerate the recognition of leasehold improvement assets.

The Securities and Exchange Commission (SEC) does not allow use of the residual
method in deriving the value of intangible assets. The residual method is the two-
step process of first assigning the purchase price to all identifiable assets, and then
allocating the remaining residual amount to other intangible assets. This SEC
guidance only applies to publicly-held companies.

Goodwill or Gain from Bargain Purchase

This section addresses the almost inevitable calculation of goodwill that is
associated with most acquisitions. It also addresses the considerably less common
recognition of a bargain purchase.

Goodwill Calculation
Goodwill is an intangible asset that represents the future benefits arising from assets
acquired in a business combination that are not otherwise identified. Goodwill is a

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common element in most acquisition transactions, since the owners of acquirees

generally do not part with their companies unless they are paid a premium.
The acquirer must recognize goodwill as an asset as of the acquisition date. The
goodwill calculation is as follows:

Goodwill = (Consideration paid + Fair value of noncontrolling interest) – (Assets acquired –

Liabilities assumed)

If no consideration is transferred in an acquisition transaction, use a valuation

method to determine the fair value of the acquirer’s interest in the acquiree as a
replacement value.
When calculating the total amount of consideration paid as part of the derivation
of goodwill, consider the following additional factors:
• Fair value of assets paid. When the acquirer transfers its assets to the
owners of the acquiree as payment for the acquiree, measure this considera-
tion at its fair value. If there is a difference between the fair value and carry-
ing amount of these assets as of the acquisition date, record a gain or loss in
earnings to reflect the difference. However, if these assets are simply being
transferred to the acquiree entity (which the acquirer now controls), then do
not restate these assets to their fair value; this means there is no recognition
of a gain or loss.
• Share-based payment awards. The acquirer may agree to swap the share-
based payment awards granted to employees of the acquiree for payment
awards based on the shares of the acquirer. If the acquirer must replace
awards made by the acquiree, include the fair value of these awards in the
consideration paid by the acquirer, where the portion attributable to pre-
acquisition employee service is considered consideration paid for the ac-
quiree. If the acquirer is not obligated to replace these awards but does so
anyways, record the cost of the replacement awards as compensation ex-
pense.

Bargain Purchase
When an acquirer gains control of an acquiree whose fair value is greater than the
consideration paid for it, the acquirer is said to have completed a bargain purchase.
A bargain purchase transaction most commonly arises when a business must be sold
due to a liquidity crisis, where the short-term nature of the sale tends to result in a
less-than-optimum sale price from the perspective of the owners of the acquiree. To
account for a bargain purchase, follow these steps:
1. Record all assets and liabilities at their fair values.
2. Reassess whether all assets and liabilities have been recorded.
3. Determine and record the fair value of any contingent consideration to be
paid to the owners of the acquiree.
4. Record any remaining difference between these fair values and the consid-
eration paid as a gain in earnings. You should record this gain as of the ac-
quisition date.

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EXAMPLE

The owners of Failsafe Containment have to rush the sale of the business in order to obtain
funds for estate taxes, and so agree to a below-market sale to Armadillo Industries for
$5,000,000 in cash of a 75% interest in Failsafe. Armadillo hires a valuation firm to analyze
the assets and liabilities of Failsafe, and concludes that the fair value of its net assets is
$7,000,000 (of which $8,000,000 is assets and $1,000,000 is liabilities), and the fair value of
the 25% of Failsafe still retained by its original owners has a fair value of $1,500,000.

Since the fair value of the net assets of Failsafe exceeds the consideration paid and the fair
value of the noncontrolling interest in the company, Armadillo must recognize a gain in
earnings, which is calculated as follows:

$7,000,000 Net assets - $5,000,000 Consideration - $1,500,000 Noncontrolling interest

= $500,000 Gain on bargain purchase

Armadillo records the transaction with the following entry:

Debit Credit
Assets acquired 8,000,000
Cash 5,000,000
Liabilities assumed 1,000,000
Gain on bargain purchase 500,000
Equity – noncontrolling interest in Failsafe 1,500,000

Reverse Acquisitions
A reverse acquisition occurs when the legal acquirer is actually the acquiree for
accounting purposes. The reverse acquisition concept is most commonly used when
a privately-held business buys a public shell company for the purposes of rolling
itself into the shell and thereby becoming a publicly-held company. This approach is
used to avoid the expense of engaging in an initial public offering.
To conduct a reverse acquisition, the legal acquirer issues its shares to the
owners of the legal acquiree (which is the accounting acquirer). The fair value of
this consideration is derived from the fair value amount of equity the legal acquiree
would have had to issue to the legal acquirer to give the owners of the legal acquirer
an equivalent percentage ownership in the combined entity.
When a reverse acquisition occurs, the legal acquiree may have owners who do
not choose to exchange their shares in the legal acquiree for shares in the legal
acquirer. These owners are considered a noncontrolling interest in the consolidated
financial statements of the legal acquirer. The carrying amount of this noncontrol-
ling interest is based on the proportionate interest of the noncontrolling shareholders
in the net asset carrying amounts of the legal acquiree prior to the business
combination.

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EXAMPLE

The management of High Noon Armaments wants to take their company public through a
reverse acquisition transaction with a public shell company, Peaceful Pottery. The
transaction is completed on January 1, 20X4. The balance sheets of the two entities on the
acquisition date are as follows:

Peaceful High Noon

(Legal Acquirer, (Legal Subsidiary,
Accounting Acquiree) Accounting Acquirer)
Total assets $100 $8,000

Total liabilities $0 $4,500

Shareholders’ equity
Retained earnings 10 3,000
Common stock
100 shares 90
1,000 shares 500
Total shareholders’ equity 100 3,500
Total liabilities and shareholders’ equity $100 $8,000

On January 1, Peaceful issues 0.5 shares in exchange for each share of High Noon. All of
High Noon’s shareholders exchange their holdings in High Noon for the new Peaceful
shares. Thus, Peaceful issues 500 shares in exchange for all of the outstanding shares in High
Noon.

The quoted market price of Peaceful shares on January 1 is $10, while the fair value of each
common share of High Noon shares is $20. The fair values of Peaceful’s few assets and
liabilities on January 1 are the same as their carrying amounts.

As a result of the stock issuance to High Noon investors, those investors now own 5/6ths of
Peaceful shares, or 83.3% of the total number of shares. To arrive at the same ratio, High
Noon would have had to issue 200 shares to the shareholders of Peaceful. Thus, the fair value
of the consideration transferred is $4,000 (calculated as 200 shares × $20 fair value per
share).

Goodwill for the acquisition is the excess of the consideration transferred over the amount of
Peaceful’s assets and liabilities, which is $3,900 (calculated as $4,000 consideration - $100
of Peaceful net assets).

Based on the preceding information, the consolidated balance sheet of the two companies
immediately following the acquisition transaction is:

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Peaceful High Noon Adjustments Consolidated

Total assets $100 $8,000 $3,900 $12,000

Total liabilities $0 $4,500 -- $4,500

Shareholders’ equity
Retained earnings 10 3,000 -10 3,000
Common stock
100 shares 90 -90 --
1,000 shares 500 500
600 shares 4,000 4,000
Total shareholders’ equity 100 3,500 3,900 7,500
Total liabilities and shareholders’ equity $100 $8,000 $3,900 $12,000

Related Issues
This section addresses several issues that are similar to business combinations, but
which are not treated in the same manner as business combinations.

Acquisition of Assets
A common form of acquisition is to acquire only selected assets and liabilities of an
acquiree. This approach is used to avoid any undocumented liabilities that may be
associated with the acquiree. The accounting for asset acquisitions encompasses the
following situations:
• Cash consideration paid. When cash is paid for assets, recognize the assets
at the amount of cash paid for them.
• Noncash assets paid. Measure assets acquired at the fair value of the
consideration paid or the fair value of the assets acquired, whichever is more
reliably measurable. Do not recognize a gain or loss on an asset acquisition,
unless the fair value of any noncash assets used by the acquirer to pay for
the assets differs from the carrying amounts of these assets.
• Cost allocation. If assets and liabilities are acquired in a group, allocate the
cost of the entire group to the individual components of that group based on
their relative fair values.

EXAMPLE

Armadillo Industries acquires the sheet metal stamping facility of a competitor, which
includes production equipment, a manufacturing facility, and the real estate on which the
facility is located. The total purchase price of this group of assets was $800,000. Armadillo
allocates the purchase price to the individual assets in the following manner:

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Percent of
Fair Total Fair Purchase Cost
Asset Value Value Price Allocation
Production equipment $325,000 35% × $800,000 = $280,000
Manufacturing facility 400,000 43% × 800,000 = 344,000
Real estate 200,000 22% × 800,000 = 176,000
$925,000 100% $800,000

Transactions between Entities under Control of Same Parent

When two or more entities are owned by a common parent, it is relatively common
for them to enter into a variety of business transactions with each other, such as the
transfer of assets or the sale of goods or services. Other examples of these
transactions are shifting assets to a new entity, shifting assets into the parent, and the
parent shifting its ownership interest in partially-owned subsidiaries into a new
subsidiary.
When transferring assets or exchanging shares between entities under common
control, the entity receiving the assets or equity interests should recognize the
transferred items at their carrying amounts as stated in the records of the transferring
entity on the transfer date. If these carrying amounts have been altered due to
pushdown accounting (see next), then the entity receiving the assets or equity
interests should instead recognize the transferred items at the historical cost of the
parent entity.
If the sending and receiving entities use different accounting methods to account
for similar types of assets and liabilities, it is permissible to adjust the carrying
amounts of transferred items to the accounting method used by the recipient, if
doing so represents a preferable treatment. If there is a change in accounting method,
it must be applied retrospectively to the transferred items for all prior periods for
which financial statements are presented, unless it is impracticable to do so.

Pushdown Accounting
Pushdown accounting involves requiring the acquiree to adopt a new basis of
accounting for its assets and liabilities. This approach is used when a master limited
partnership is formed from the assets of existing businesses (though usage is
restricted), as well as when there is a step-up in the tax basis of a subsidiary. The
SEC has stated that it believes pushdown accounting should be used in purchase
transactions where the acquiree becomes substantially wholly owned. Pushdown
accounting is not required if a business is not publicly-held.

Income Taxes
The nature of an acquisition transaction represents a balance of the taxation goals of
the acquirer and the owners of the acquiree. The likely result of the acquisition
structure is that some deferred tax liabilities and deferred tax assets should be
recognized. Specifically, the following tax-related accounting may be required:

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• Goodwill. The amortization of goodwill is allowed as a tax deduction in

some tax jurisdictions, but not in others. The result may be a difference in
the book and tax basis for goodwill in future years, for which a deferred tax
asset or liability should be recorded.
• Replacement awards. If the acquirer issues replacement awards to the
employees of the acquiree, and those awards are classified as equity and
eligible to be tax deductions, recognize a deferred tax asset for the deducti-
ble temporary difference relating to that portion of the award relating to the
precombination service of the awardee. The deduction may exceed the fair
value of the award; if so, record the excess as additional paid-in capital.
• Tax allocation to acquired entity. If the acquirer retains the historical basis
for the financial reporting of an acquiree in conjunction with a step-up in the
tax basis of acquired assets, it is allowable to use any of the following meth-
ods to allocate the consolidated tax provision:
o Allocate taxes to the acquiree on a preacquisition tax basis
o When realized, credit the tax benefit caused by the step-up in tax
basis to the additional paid-in capital account of the acquiree
o When realized, credit the tax benefit caused by the step-up in tax
basis to the income of the acquiree
• Temporary differences. If there are temporary differences related to deferred
tax liabilities or assets related to a business combination, recognize them at
the acquisition date.
• Valuation allowance or tax position change. If there is a change in the
valuation allowance or tax position of an acquiree that occurs during the
post-acquisition measurement period, and which results from new infor-
mation about issues in existence at the acquisition date, record the offset to
the change as an adjustment to goodwill. If goodwill has been reduced to
zero, the offset is then recorded as a bargain purchase. All other changes in
the acquiree’s allowance or tax position are recognized as a change in in-
come tax expense.
• Valuation allowance. Assess the need for a valuation allowance that offsets
any deferred tax asset for which there is uncertainty about the recoverability
of the asset. If the acquirer has already established a valuation allowance, it
may be necessary to alter the allowance based on tax laws that may restrict
the future use of deductible temporary differences or carryforwards of either
the acquirer or the acquiree.

Goodwill
Goodwill is a common byproduct of a business combination, where the purchase
price paid for the acquiree is higher than the fair values of the identifiable assets
acquired. After goodwill has initially been recorded as an asset, you should not
amortize it. Instead, test it for impairment at the reporting unit level. Impairment
exists when the carrying amount of the goodwill is greater than its implied fair
value.

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A reporting unit is defined as an operating segment or one level below an

operating segment. At a more practical level, a reporting unit is a separate business
for which the parent compiles financial information, and for which management
reviews the results. If several components of an operating segment have similar
economic characteristics, they can be combined into a reporting unit. In a smaller
business, it is entirely possible that one reporting unit could be an entire operating
segment, or even the entire entity.
The examination of goodwill for the possible existence of impairment involves a
multi-step process, which is:
1. Assess qualitative factors. Review the situation to see if it is necessary to
conduct further impairment testing, which is considered to be a likelihood of
more than 50% that impairment has occurred, based on an assessment of
relevant events and circumstances. Examples of relevant events and circum-
stances that make it more likely that impairment is present are the deteriora-
tion of macroeconomic conditions, increased costs, declining cash flows,
possible bankruptcy, a change in management, and a sustained decrease in
share price. If impairment appears to be likely, continue with the impairment
testing process. You can choose to bypass this step and proceed straight to
the next step.
2. Identify potential impairment. Compare the fair value of the reporting unit to
its carrying amount. Be sure to include goodwill in the carrying amount of
the reporting unit, and also consider the presence of any significant unrec-
ognized intangible assets. If the fair value is greater than the carrying
amount of the reporting unit, there is no goodwill impairment, and there is
no need to proceed to the next step. If the carrying amount exceeds the fair
value of the reporting unit, proceed to the next step to calculate the amount
of the impairment loss.
3. Calculate impairment loss. Compare the implied fair value of the goodwill
associated with the reporting unit to the carrying amount of that goodwill. If
the carrying amount is greater than the implied fair value, recognize an im-
pairment loss in the amount of the difference, up to a maximum of the entire
carrying amount (i.e., the carrying amount of goodwill can only be reduced
to zero).

These steps are illustrated in the following flowchart.

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Goodwill Impairment Decision Steps

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To calculate the implied fair value of goodwill, assign the fair value of the reporting
unit with which it is associated to all of the assets and liabilities of that reporting unit
(including research and development assets). The excess amount (if any) of the fair
value of the reporting unit over the amounts assigned to its assets and liabilities is
the implied fair value of the associated goodwill. The fair value of the reporting unit
is assumed to be the price that the company would receive if it were to sell the unit
in an orderly transaction (i.e., not a rushed sale) between market participants. Other
alternatives to the quoted market price for a reporting unit may be acceptable, such
as a valuation based on multiples of earnings or revenue.
The following additional issues are associated with goodwill impairment testing:
• Asset and liability assignment. Assign acquired assets and liabilities to a
reporting unit if they relate to the operations of the unit and they will be
considered in the determination of reporting unit fair value. If these criteria
can be met, even corporate-level assets and liabilities can be assigned to a
reporting unit. If some assets and liabilities could be assigned to multiple
reporting units, assign them in a reasonable manner (such as an allocation
based on the relative fair values of the reporting units), consistently applied.
• Asset recognition. It is not allowable to recognize an additional intangible
asset as part of the process of evaluating goodwill impairment.
• Goodwill assignment. All of the goodwill acquired in a business combina-
tion must be assigned to one or several reporting units as of the acquisition
date, and not shifted among the reporting units thereafter. The assignment
should be in a reasonable manner, consistently applied. If goodwill is to be
assigned to a reporting unit that has not been assigned any acquired assets or
liabilities, the assignment could be based on the difference between the fair
value of the reporting unit before and after the acquisition, which represents
the improvement in value caused by goodwill.
• Impairment estimation. If it is probable that there is goodwill impairment
and the amount can be reasonably estimated, despite the testing process not
being complete when financial statements are issued, recognize the estimat-
ed amount of the impairment. The estimate should be adjusted to the final
impairment amount in the following reporting period.
• No reversal. Once impairment of goodwill has been recorded, it cannot be
reversed, even if the condition originally causing the impairment is no long-
er present.
• Reporting structure reorganization. If a company reorganizes its reporting
units, reassign assets and liabilities to the new reporting units based on a
reasonable methodology, consistently applied. Goodwill should be reas-
signed based on the relative fair values of the portions of the old reporting
unit to be integrated into the new reporting units.
• Reporting unit disposal. If a reporting unit is disposed of, include the
goodwill associated with that unit in determining any gain or loss on the
transaction. If only a portion of a reporting unit is disposed of, you must
associate some of the goodwill linked to the reporting unit to the portion
being disposed of, based on the relative fair values of the portions being

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disposed of and retained. You should then test the remaining amount of
goodwill assigned to the residual portion of the reporting unit for impair-
ment.

EXAMPLE

Armadillo Industries is selling off a portion of a reporting unit for $500,000. The remaining
portion of the unit, which Armadillo is retaining, has a fair value of $1,500,000. Based on
these values, 25% of the goodwill associated with the reporting unit should be included in the
carrying amount of the portion being sold.

• Reporting unit disposal, minority owner. If a company has less than

complete ownership of a reporting unit, attribute any impairment losses to
the parent entity and the noncontrolling interest in the reporting unit on a
rational basis. However, if the reporting unit includes goodwill that is at-
tributable to the parent entity, then attribute the loss entirely to the parent,
not the noncontrolling interest.
• Subsidiary goodwill impairment testing. Any goodwill recognized by a
corporate subsidiary should be dealt with in the same manner described
elsewhere in this section for the impairment of goodwill. If there is a good-
will impairment loss at the subsidiary level, you must also test the reporting
unit of which that subsidiary is a part for goodwill impairment, if the trig-
gering event is more likely than not to have also reduced the fair value of
that reporting unit below its carrying amount.
• Taxable transaction. As part of the fair value estimation, determine whether
the reporting unit could be bought or sold in a taxable or non-taxable trans-
action, since this affects its fair value.

Tip: From a practical perspective, it is almost always easier to estimate the fair
value of the reporting unit based on a multiple of its earnings or revenues, though
this should only be done when there are comparable operations whose fair values
and related multiples are known, and which can therefore be used as the basis for a
fair value estimate of the reporting unit.

Impairment testing is to be conducted at annual intervals. You may conduct the

impairment test at any time of the year, provided that the test is conducted thereafter
at the same time of the year. If the company is comprised of different reporting
units, there is no need to test them all at the same time.

Tip: Each reporting unit is probably subject to a certain amount of seasonal activity.
If so, select a period when activity levels are at their lowest to conduct impairment
testing, so it does not conflict with other activities. Impairment testing should not
coincide with the annual audit.

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It may be necessary to conduct more frequent impairment testing if there is an event

that makes it more likely than not that the fair value of a reporting unit has been
reduced below its carrying amount. Examples of triggering events are lawsuits,
regulatory changes, the loss of key employees, and the expectation that a reporting
unit will be sold.
The information used for an impairment test can be quite detailed. To improve
the efficiency of the testing process, it is permissible to carry forward this
information to the next year, as long as the following criteria have been met:
• There has been no significant change in the assets and liabilities comprising
the reporting unit.
• There was a substantial excess of fair value over the carrying amount in the
last impairment test.
• The likelihood of the fair value being less than the carrying amount is
remote.

As an additional note for publicly-held companies that report segment information,

the asset, liability, and goodwill allocations used for goodwill impairment testing do
not have to be the same as the amounts stated in segment reports. However, aligning
the two sets of information will make it easier to conduct both impairment testing
and segment reporting.

Variations under IFRS

The Financial Accounting Standards Board and International Accounting Standards
Board have been jointly working on reducing the differences between GAAP
accounting and International Financial Reporting Standards (IFRS). While there are
still notable differences between GAAP and IFRS in some areas of accounting,
business combinations is not one of them. The key aspects of acquisition accounting
are essentially identical under both accounting frameworks.

Summary
Accounting for acquisitions is considered one of the more complex areas of
accounting. However, when broken down into its constituent parts, it is apparent that
the concepts are not that difficult; the accountant simply has to plow through an
established series of work steps to arrive at the proper journal entry to record an
acquisition. This does not necessarily mean that two accountants independently
compiling the accounting information for an acquisition will arrive at identical
journal entries; the valuation of assets and liabilities is a key part of acquisition
accounting, and valuation is judgmental to some degree. Thus, the risk of improperly
accounting for an acquisition is most likely to arise in the area of asset and liability
valuations. This means the accountant should pay particular attention to valuations,
and document them thoroughly for the inevitable year-end review by auditors.

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 Chapter 15
Acquisition Personnel
Introduction
The acquisition process involves skills that are not usually present in a company,
because those skills are not needed in the day-to-day operations of the business.
Instead, the acquirer or seller typically employs outside experts who handle various
aspects of an acquisition. The services of specialists are absolutely necessary in
many acquisition situations, but they come at a substantial cost. In this chapter, we
discuss the types of specialists who are usually involved in acquisitions, and how a
serial acquirer can reduce their cost by bringing some acquisition functions in-house.

The Acquisitions Attorney

It is vital for both parties to retain the services of attorneys having in-depth
knowledge of acquisitions. Their assistance is required at every step of the
acquisitions process, including the development of letters of intent, non-disclosure
agreements, due diligence, and purchase agreements. They also create a number of
related agreements, such as employment agreements for the employees of the
acquiree and debt documents for any debt payable to the seller.
The acquisitions attorney is involved in a specialized field, where one must have
an in-depth knowledge of how deals are structured and understand the impact of
varying the terms of the basic agreements. Given this level of specialization, it is not
a good idea to simply retain the company’s general counsel for this work. Instead,
look for a specialist who has considerable experience in the field. The best
specialists typically work within larger law firms, so that they have access to an
ongoing stream of acquisition transactions.
The relationship between the seller and its attorney is particularly important,
since that attorney needs to know in advance if there are any current or potential
legal issues, so that he can engage in mitigation activities in advance. This may
involve a complete examination of all legal issues prior to putting a company up for
sale, including a review of board minutes, the corporate bylaws, key contracts, and
so forth for any potential problems. Otherwise, legal issues may crop up in due
diligence that could scuttle the deal, which could have been avoided if the attorney
had known about them sooner.
Attorneys are paid by the hour, typically in the range of $200 to $500 per hour.
This means that their compensation is not tied to the success of the acquisition –
they will be paid even if the acquisition transaction fails. Despite the high cost per
hour, this payment arrangement actually works quite well for both the acquirer and
seller, since the attorneys are more likely to spend time digging through due
diligence issues and the purchase agreement, looking for any items that might
 Acquisition Personnel

interfere with the best interests of their principals. This pay structure makes it more
likely that attorneys will provide more conservative, protective advice to their
principals, which nicely offsets the more optimistic advice of the investment bankers
– whose compensation is mostly tied to completing the deal.

Tip: Some attorneys dig into the details too much, which results in excessive legal
fees. You can direct their attention to certain areas of concern and restrict their
activities in other areas, if you want to reduce their fees. Also, if a law firm persists
in engaging in an excessive amount of review work, switch to other firms to assist
with the next acquisition deal.

The best attorneys have the capability to not just spot every conceivable legal issue
that could arise, but also to suggest workarounds that can still complete the deal.
Too often, an inexperienced attorney will feel that he is earning his pay simply by
presenting a list of all the potential problems in a purchase agreement, which can go
a long ways toward terminating the entire deal. Thus, the ability to use his
knowledge of the legal system to craft a reasonable agreement for both parties is the
hallmark of a great attorney.
Another aspect of an excellent attorney is one who can provide advice to his
client regarding which issues are negotiable, and the impact of various legal clauses
on the acquirer and seller. In some situations, an inexperienced seller may not realize
that (for example) certain representations and warranties are totally customary
within the industry, and must be included in the purchase agreement. This is a
valuable skill that can keep an acquisition on track.
The completion of the purchase agreement is particularly burdensome for the
attorneys representing both parties, since there are usually a number of changes to
the document that are caused by information unearthed during the due diligence
process, as well as changes caused by dickering over individual clauses.
Consequently, the attorneys put in many hours at the end of the acquisition process,
and so can present some quite startling bills for their services. Nonetheless, their
work is absolutely essential, since a poorly constructed purchase agreement could be
far more expensive for the acquirer and seller than the corresponding amount of
legal fees.
There are also some legal specialists who may be brought in to investigate
certain aspects of an acquisition. For example, a patent or trademark attorney can
investigate the intellectual property filings of the acquiree to make sure that they are
valid, while a tax attorney can assist in creating a legal structure for the deal that has
the most beneficial tax effects for the parties involved.
Of all the personnel who may become involved in an acquisition, it is most
important to find an attorney with vast experience in the field, an excellent
knowledge of workarounds to acquisition problems, and the ability to act as an
advisor. This person will come at a high cost, which is insignificant when compared
to the value that he provides.

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The Investment Banker

An investment banker is particularly useful to the seller of a business. As was
mentioned in the Acquisition Process chapter, the investment banker provides the
following services to a seller:
• Provides an approximate valuation of the business
• Recommends the proper sale timing to maximize the sale price
• Preps the business for sale, based on a knowledge of which features will
bring a higher price
• Contacts those entities most likely to bid for the business
• Advises on the construction of an offering memorandum
• Manages the auction process
• Arranges for all meetings between bidders and the seller
• Assists with negotiations regarding the terms in the purchase agreement

In addition, the banker acts as a buffer between bidders and the seller. This means
that the banker can contact possible bidders while keeping the identity of the seller
secret, as well as answer the more routine bidder questions without bothering the
seller, while also handling the more difficult negotiating points without getting the
principals in a transaction angry with each other. Handling these tasks on behalf of
the seller allows the management team to continue running the business with
minimal interruptions. This buffer role is a crucial one, and can be of great
assistance to the seller.
The ideal investment banker is one who has an excellent knowledge of the
industry in which the seller’s business is located, particularly in terms of contacts
with buyers and knowing the prices at which acquisition deals have been completed
recently.
A good investment banker comes at a high price. Expect to pay a monthly
retainer of anywhere from $5,000 to $25,000, as well as a percentage of the final
sale price. If the business is not expected to sell for a large amount, then the banker
may impose a minimum fee, such as $500,000, if the business is sold. The
percentage of the sale price that a banker charges used to follow the Lehman
formula, which is:

5% Of the first million dollars price paid

4% Of the second million dollars price paid
3% Of the third million dollars price paid
2% Of the fourth million dollars price paid
1% Of all remaining dollars price paid

This formula was originally designed in the 1960s, so subsequent inflation has made
its basic terms unprofitable for investment bankers. Instead, bankers like to propose
variations on the general concept, such as:

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5% Of the first 10 million dollars price paid

4% Of the second 10 million dollars price paid
3% Of the third 10 million dollars price paid
2% Of the fourth 10 million dollars price paid
1% Of all remaining dollars price paid

It is also common for a banker not to propose the lower percentages inherent in the
Lehman formula. Instead, they may offer a descending percentage only until 3% is
reached, after which 3% applies to all remaining dollars paid to the seller. Thus, the
investment banker can earn massive fees from the sale of a business.
The investment banker has been presented here as being primarily associated
with the seller, but they may also work for acquirers, especially if they are needed to
raise funds to pay for the transaction. In this case, the banker earns a large fee based
on the amount of money raised on behalf of the acquirer. Bankers may also earn a
smaller fee when acting in an advisory role to the acquirer.
In short, the investment banker can bring considerable value to the selling
process, but this value comes at a high price. Bankers are very highly paid, but if a
seller has little practice in selling businesses, a qualified investment banker can be of
great assistance in managing the sale process and obtaining a good price.

The Valuation Specialist

There are many valuation companies available who use a variety of techniques to
derive a valuation for an entire business or for specific assets. Valuation experts are
very useful for acquirers, particularly in regard to the recordation of a completed
acquisition. Accounting standards require that the assets and liabilities of an
acquiree be recorded on the books of the acquirer at their fair market values;
valuation firms can provide this information. In addition, valuation specialists can
provide estimates of the fair value of a reporting unit in subsequent years, when an
acquirer must test its goodwill asset for impairment. Also, auditors use valuation
reports as independent evidence that the valuations at which an acquirer records an
acquisition are reasonable.
The compensation model of the valuation specialist is typically a fixed fee,
possibly with an additional billing related to any problems encountered. They also
like to substantially increase their fees if a client wants a report within a very short
time period (as is usually the case in an acquisition). Thus, an acquirer may find that
meeting a short deadline could double its valuation-related expenditure.

Other Consultants
It may be necessary to bring in other consultants to assist with an acquisition
transaction, depending on the circumstances. In this section, we note the situations in
which specialists may be needed for actuarial, environmental, human resources,
public relations, regulatory, and public company issues. They are:
• Actuarial. It may be useful to obtain the services of an actuarial firm to
determine the amount of any overfunding or underfunding of an acquiree’s

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pension plan. This information may already have been calculated by the
actuaries working for the acquiree, but another actuary should work for the
acquirer to test the assumptions used to estimate pension funding levels. In
some cases, estimated reinvestment rates and payout levels may be unrealis-
tic, and could misstate the amount of liability that the acquirer will be taking
on.
• Environmental. An environmental testing and mitigation firm may be
needed if there is even a hint of possible environmental trouble. Given the
extremely high liability associated with environmental issues, it would be
foolish not to employ this consultant. Environmental firms typically charge
by the hour, and ratchet up their rates if an analysis must be completed in
short order (as is usually the case for an acquisition).
• Human resources. If the acquiree has been sued by its employees for various
human resources-related issues, or has had troubled relations with unions,
then the acquirer could hire a labor attorney to investigate the issues and
report back with summarizations of the issues and estimates of contingent
liabilities. This is a particularly useful consultant when a target company is
located in a foreign country, and the acquirer has little knowledge of the
labor laws of that area. For example, another country may require that a very
long notice period be given to employees before a facility can be shuttered,
as well as substantial termination payouts to employees.
• Proxy solicitation. If the acquirer is attempting to buy another publicly-held
firm and it elects to go straight to the shareholders with its offer, it should
hire a proxy solicitation firm. These businesses solicit proxies from the
shareholders, which they then use to vote the shares of those shareholders to
replace the board of directors. The proxy solicitation process involves direct
contact with the larger shareholders, which is both labor-intensive and ex-
pensive.
• Public relations. For a larger transaction, it can be useful to employ the
services of a public relations firm. This advisor can be used to craft messag-
es to the public regarding the acquirer’s intentions regarding an acquiree. A
public relations firm is particularly useful for issuing statements intended for
competitors, such as the acquirer’s commitment to buying a company, irre-
spective of the price paid. These messages may prevent competing offers
from surfacing.
• Investor relations. If the acquirer is publicly-held, the senior management
team may periodically engage in conference calls and road show meetings
with investors. If so, an investor relations advisor should be retained who
can formulate the official company responses to expected questions regard-
ing an acquisition. Otherwise, investors will be on the lookout for trouble-
some statements, and could drive down the company’s stock price as a re-
sult.
• Regulatory. If the acquirer is buying into a regulated industry, it should
retain the services of an advisor who is familiar with the regulations im-
posed on companies in that industry, as well as the issues that may cause a

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key license to be revoked. This advisor should examine the operations of the
acquiree to see if there may be any problems pending that could result in
license revocation. This person may also offer advice on how the acquisition
itself may alter the view of the regulatory agency towards the acquiree.
• SEC filings. If an acquirer is publicly-held, it already has an attorney who
either writes or at least reviews its filings with the Securities and Exchange
Commission. Larger acquisitions must be reported in the Form 8-K within a
few days of the completion of an acquisition. The public company attorney
is closely involved in the writing of this notification.

The In-House Acquisitions Department

A serial acquirer may have assembled a large in-house acquisitions team, perhaps to
avoid outside fees, or perhaps because it needs continuity in its analysis and
handling of multiple deals. This group is mostly comprised of people who might
otherwise work for the company in independent advisory roles, such as attorneys
and investment bankers. Outside of this core group, there are also several experts
who are called upon as needed to conduct due diligence on acquisition candidates. It
is common to find the following people on these due diligence review teams:
• Attorney
• Human resources manager
• Controller or assistant controller
• Engineering manager
• Material management supervisor
• Production manager
• Sales manager

There is a second group of employees who are brought in as needed to integrate

acquired businesses into the parent company or its other subsidiaries. This group is
usually pulled from all of the major departments, such as accounting, engineering,
production, purchasing, and sales. These people do not report directly to the
acquisitions department, though the integration team leaders may do so.
There may also be one or more financial analysts on staff who review the
financial and operating results of candidate companies and render opinions on
whether a target company should be bought, and at what price.
It is less likely to find valuation specialists on an in-house team, since the skill
they provide is not needed on a regular basis, and the fees charged by outside
valuation firms are usually not excessive.
The in-house acquisition team is responsible for industry research, locating
acquisition candidates, meeting with them to discuss acquisition possibilities, and
uncovering potential synergies. If there appears to be the possibility of a deal, the in-
house team presents their recommendations to senior management. If approved, the
team then engages in due diligence, valuation, and purchase agreement negotiations
with the target company. If successful, the in-house team sends in an integration
team, which will probably be on-site for a number of months to complete any

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targeted synergies and merge the operations of the two businesses to whatever extent
is considered reasonable.
Despite the indicated range of activities that the acquisitions department engages
in, the number of full-time people it employs may not be that large. The core group
is usually comprised of a small number of highly educated and experienced people
with considerable acquisitions experience. The more successful departments are
those that have strong networks within the company, so that they can draw upon the
expertise of other people to assist with due diligence and integration activities.

Summary
Only rarely and for very small companies is it possible to conclude an acquisition
without the input of a variety of advisors. There are so many pitfalls in the
acquisition process that it behooves both the acquirer and seller to engage the
services of as many experts as needed, both to mitigate risk and to obtain the best
possible deal for themselves. At a minimum, both sides should employ competent
attorneys with acquisition-specific experience. Next, it is generally advisable for the
seller to hire an investment banker, since sellers rarely have the expertise needed to
properly market their businesses. There will also be a number of other consultants
whose services may be used as the situation warrants.
The cost of these advisors is considerable, so a company that is continually
buying other businesses might consider hiring some of these advisors into its own
full-time acquisitions department.

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 Chapter 16
Reverse Mergers
Introduction
A normal acquisition is intended to buy some attribute of another business, such as
its customer base, intellectual property, or real estate. The reason for a reverse
merger is much more focused – to take advantage of the publicly-held status of the
target company. In most cases, the target is simply a shell company that used to have
active business operations in the past, but which has been stripped down to a single
attribute – it is a public company. In this chapter, we will explore the reverse merger
concept, its legal structure, due diligence issues, and other items of concern to
anyone contemplating a reverse merger.

The Reverse Merger Concept

A company uses a reverse merger when it wants to avoid the expense of an initial
public offering, and instead buys a company that is already publicly-held. In most
cases, the company being purchased is nothing more than a shell company that has
been inactive for several years. A shell company is a company with minimal
operations or assets, or assets that are solely in cash. By owning the public company,
the buyer can register stock for sale to the public, though it must now have its
financial statements audited and issue regular reports to the Securities and Exchange
Commission (SEC). Its shares will probably initially be available for trading on the
over-the-counter (OTC) market, though it can apply to have its shares traded on a
formal stock exchange.
The basic transaction flow for a reverse merger is that a private company gains
control of a public shell company, with the shell structured to be the parent company
and the buyer’s company becoming its subsidiary. The owners of the private
company exchange their shares in the private company for shares in the public
company. They have now gained control over a majority of the stock of the shell.
The legal structure used for this merger is called a reverse triangular merger (see
the Legal Structure of the Acquisition chapter). The process flow for a reverse
triangular merger is:
1. The shell company creates a subsidiary entity.
2. The newly-formed subsidiary merges into the private company that is
buying the shell.
3. The newly-formed subsidiary has now disappeared, so the private company
becomes a subsidiary of the shell company.

The reverse triangular merger is used to avoid the cumbersome shareholder approval
process that is normally required for an acquisition. Though the shareholders of the
 Reverse Mergers

private company must still approve the deal, it is only the shareholder of the new
subsidiary that must approve the deal on behalf of the shell company – and the only
shareholder of the new subsidiary is its parent company.
The reverse triangular concept is particularly useful, because it allows a private
company to continue operating as a going concern and without a change in control
of the entity. Otherwise, the business might suffer from the loss of any contracts that
would automatically expire if either of those events were to occur.

Note: It is easier to complete a reverse merger with a shell company whose shares
only trade on the over-the-counter market, rather than on a formal exchange. The
reason is that stock exchange rules typically require the approval of the shareholders
of the shell company. Thus, it may make sense for a shell company to delist from an
exchange prior to engaging in a reverse merger.

Other than the use of the reverse triangular merger concept, the reverse merger
follows the normal set of steps used for any acquisition. The acquirer conducts due
diligence on the shell, and the attorneys for both sides negotiate a purchase
agreement. However, there is one additional requirement, and it is an onerous one –
the filing of a Form 8-K with the SEC within four business days of the reverse
merger. This filing contains many of the items found in a full-scale prospectus for an
initial public offering, and so is a major production. It includes several years of
audited financial statements, a comparative analysis of results over several periods,
related party transactions, and so forth. This Form 8-K filing should be a source of
considerable dread for the CFO of the acquiring business, since the four-day filing
requirement makes it difficult to issue this document with the complete suite of
required information.

Advantages and Disadvantages of the Reverse Merger

There are a number of advantages associated with the reverse merger concept, which
are:
• Speed. A reverse merger can be completed in just a few months.
• Time commitment. If a company were to follow the tortuous path of an
initial public offering, the management team would be so distracted that
there would be little time left to run the business. Conversely, a reverse
merger can be accomplished with such minimal effort that management
barely notices the change.
• Timing. If the buyer is not immediately intending to use the shell to raise
money from the public, it can take the reverse merger path even in weak
stock market conditions.
• Tradable currency. Being public means that the stock issued by the
combined entity is a more tradable form of currency than the stock of a pri-
vate company, which makes it easier for an acquirer to engage in stock-for-
stock transactions (see the Payment Structure of the Acquisition chapter).
Also, the shares of a public company are frequently valued higher than those

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of a private one (because the stock is more tradable), so the public company
that engages in stock-for-stock purchases can do so with fewer shares. How-
ever, issued shares must still be registered if the recipient wants to sell them,
which can be an involved process. Also, if the market for the company’s
stock is not large, it may be difficult for the recipients of its shares to sell
them over a relatively short period of time.
• Liquidity. The reverse merger path is sometimes pushed by the current
shareholders of a business, because they want to have an avenue for selling
their shares. This is a particular concern for those shareholders who have
been unable to liquidate their shares by other means, such as selling them
back to the company or selling the entire business.
• Dilution. In an IPO, the underwriter wants the company to sell more stock
than it really needs to, since the underwriter earns more money by collecting
more cash from stock sales on behalf of the company. This dilutes the own-
ership of the original shareholders. In a reverse merger situation, the compa-
ny typically raises only the amount of cash it needs, thereby limiting the
amount of shareholder dilution.
• Stock options. Being public makes the issuance of stock options much more
attractive to the recipients. If they elect to exercise their options, they can
then sell the shares to the general public, while also obtaining enough cash
to pay for taxes on any gains generated from the options.

Against these advantages are arrayed a considerable number of disadvantages, which

are sufficiently onerous to make many companies take themselves private again.
They are:
• Cash. A company may not achieve an immediate cash inflow from the sale
of its stock, as would be the case if it had taken the path of an initial public
offering. Instead, a stock offering may be delayed until a later date.
• Cost. Even the lower-cost reverse merger approach still requires a large
ongoing expenditure to meet the requirements of being public. It is difficult
for an active business to spend less than $500,000 per year for the auditors,
attorneys, controls, filing fees, investor relations, and other costs needed to
be a public entity. In the author’s experience, the actual figure is closer to
$800,000 for the first year of operations, after which annual costs can be
reduced into the $400,000 to $500,000 range.

Tip: Do not engage in a reverse merger unless senior management is fully

committed to making the necessary expenditures needed for a public company, such
as extra accounting staff and more attention to control systems. Otherwise, the CFO
and controller will be so harried that they will be rendered ineffective for all normal
activities.

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• Competitive stance. The company will be required to reveal a great deal of

information about itself, which can be used by its competitors to ascertain
performance levels, major contracts, larger customers, and the like.
• Lawsuits. A public company may be sued on the basis of a sudden decline in
its stock price. Some law firms make it their business to file lawsuits over
these stock declines.
• Liabilities. There is a risk associated with buying the liabilities that still
attach to the old public company shell. This risk can be ameliorated by ac-
quiring only a shell that has been inactive for a number of years. The seller
is rarely willing to personally commit to any representations and warranties
regarding liabilities, so the acquirer is taking on these risks.
• Results orientation. If the company wants the investment community to buy
its stock, then it needs to report increasing revenue and profit results over
time. This places considerable pressure on the company to perform, which
may not have been the case when the business was privately held.
• SEC filings. The company must file its annual financial results on the Form
10-K, its quarterly results on the Form 10-Q, selected events on the Form 8-
K, and other filings, depending on the circumstances. Many of these filings
require auditor participation and a legal review, which increase the costs of
the company.
• Stock price. When a company goes public through a reverse merger, the
sudden rush of selling shareholders puts immediate downward pressure on
the price of the stock, since there are more sellers than buyers. When the
stock price drops, this makes any stock options issued to employees less
effective, since they will not profit from exercising the options. Also, if the
company intends to use its stock to make acquisitions, it will now have to
issue more shares to do so.
• Thinly traded. There is usually only a minimal amount of trading volume in
the stock of a public shell company – after all, it has been sitting quietly for
several years with no operational activity, so why should anyone trade its
stock? Also, immediately following the purchase of the shell, the only stock
that is trading is the original stock of the business, since no other shares
have yet been registered with the SEC. It takes time to build trading volume,
which may require an active public relations and investor relations cam-
paign, as well as the ongoing registration of additional stock (see the Trad-
ing Volume section).

Tip: A good way to keep too much downward pressure from impacting the stock
price is to impose waiting periods on the holders of company stock, so that there are
no surges of sell orders hitting the market as soon as the company becomes publicly-
held.

This lengthy list of problems with reverse mergers keeps many companies from
engaging in them. In particular, take note of the annual cost of being public, and the

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issue with thinly-traded stock. The cost should completely block smaller companies
from taking this path, while the lack of a market for the stock offsets the main reason
for begin public, which is having tradable stock.

The Price of a Shell

If a company wishes to purchase a public shell company, it should contact the local
legal community to determine who has shells for sale. Shell companies are
frequently acquired or fronted by attorneys who are responsible for maintaining
them, usually for a number of years.
The price of a shell will certainly vary based on supply and demand, but the
following factors also impact its price:
• Assets. Most shells have a small cash balance to pay for accounting and
legal fees, but some have larger cash balances that will boost the price.
• Liabilities. If there are liabilities on the books of the shell, the buyer needs
to take them into account. Some are valid, and will reduce the purchase
price. Other liabilities are so old that no one is actively trying to collect
them.
• Legal and other issues. If there have been legal issues in the past or other
unresolved liabilities, and especially environmental liability problems, then
these issues will seriously impact the price. However, a price reduction is
not worth the risk associated with these issues, so a buyer would be better
served by spending more to buy a cleaner shell.
• Reporting status. If the shell has continued to report its results to the SEC on
a regular basis, this calls for less work by the acquirer to bring the reporting
status of the entity up-to-date, so current reporting yields a more valuable
shell.
• Shareholders. The foundation of an active market in a company’s stock is a
large number of shareholders, so if the shell has several thousand sharehold-
ers, it is considered more valuable than one with just a few. However, de-
pending on the age of the shell, many of these shareholders may be inactive
or have bad addresses, which makes them less valuable to the buyer.

Tip: If there are potential legal issues or liabilities, the buyer can ask for an
indemnification clause in the purchase agreement, so that the seller must reimburse
the buyer for any liabilities settled after the purchase date.

These factors make it difficult to pin down a price for a shell. Generally, most shells
sell for well under $1,000,000, with some clean shells selling for less than half that
amount. The seller usually wants some stock in the acquiring company, as well.

Shell Due Diligence

Even though there may appear to be nothing about a shell company to review, the
acquirer must always engage in due diligence, especially if there are to be no

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representations and warranties associated with the deal. There are admittedly fewer
due diligence tasks to pursue than in a normal acquisition, since the shell has no
operations. Nonetheless, the acquirer should investigate the following items:
• Assets. Though unlikely, there may be some non-cash assets still owned by
the shell. If so, review them to see if they have any value, or can be profita-
bly disposed of.
• Auditors. Have the financial statements of the shell been audited, and has
the audit been conducted by auditors who are registered with the Public
Company Accounting Oversight Board?
• Board minutes. Review the board minutes to search for any issues that may
require additional investigation.
• Contracts. Are there any contracts that the company entered into when it
was an operating entity that are still in force?
• Historical business. What was the original business of the company
underlying the shell? Is there any reason to believe that the nature of the
business makes it more likely that there will be undocumented liabilities?
• Liabilities. Search for any undocumented liabilities of the shell.
• Litigation. Have any lawsuits been filed against the shell, or has anyone
threatened to do so?
• Personnel. Review the histories of anyone currently involved with the
management or sale of the shell. Any prior lawsuit relating to shells is a
major red flag.
• SEC filings. Review the shell’s most recent filings with the SEC to see if it
is a current filer.
• SEC investigations. See if the SEC has ever conducted investigations of the
company, and the results of those investigations.
• Shareholders. Review the list of current shareholders. If there are many
small shareholders, the acquirer may need to engage in a reverse stock split
to flush them out of the shareholder records.
• Shares. Pay particular attention to the records of stock issuances and
repurchases, and verify that the net amount outstanding matches the detailed
stockholder list.
• Structure. Examine the certificate of incorporation and bylaws.
• Trading patterns. Has there been much trading volume recently in the
shell’s tradable stock? If so, it may indicate the presence of insider trading
in anticipation of selling the shell to the acquirer.

This list is far shorter than the due diligence list needed for an operating entity,
because it is targeted at those few aspects of a shell company that can cause
problems for the acquirer. The acquirer should investigate all of the items noted
here, since any one of them could uncover a serious issue.
Nearly every item in this due diligence list is related to legal issues. Therefore, it
would be appropriate to have an all-lawyer team conduct the due diligence. These
attorneys should have specific experience in due diligence investigations. Also, give

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the team sufficient time to investigate the shell thoroughly; mandating a one-day
investigation presents a considerable risk of missing a problem.
A strong indicator of problems in a shell is missing documentation. This could
simply be sloppy record keeping by the shell administrator, but a true professional
understands that there has been plenty of time to “scrub” the shell and have
everything laid out perfectly for an acquirer. Consequently, if contracts, shareholder
votes, board minutes, and so forth are missing, it is time to look at other shells.

Trading Volume
One of the larger problems with a reverse merger is that the acquirer wants to use its
publicly-traded stock to acquire other businesses, but there is only a minimal market
for the stock. The trouble is that the shell company was not reporting its results for
years, so no one has any interest in the stock. Also, the only trading has been in the
shares that were tradable prior to the reverse merger, and there may be few of those
shares in circulation. Further, institutional investors are usually barred by their own
internal investment rules from buying stock in companies that are not listed on a
stock exchange, or which sell below a certain minimum price point. This means that
an acquisition target may not accept a stock payment because it would then be
nearly impossible to sell the shares. In short, an acquirer who has bought a shell
company needs to build the trading volume of its stock in order to make stock-for-
stock purchases attractive to its acquisition targets.
It is not easy to increase trading volume. Here are several techniques for
improving the situation:
• Analyst coverage. It is nearly impossible to gain analyst coverage of a new
reverse merger company. It is possible, however, to pay for such coverage
(as long as the payment is disclosed). The resulting analyst reports may gen-
erate some interest in the stock.
• Investor relations. The company should hire an investor relations firm and
its own investor relations officer. They are both responsible for spreading
news about the company throughout the investor community.
• Road shows. The senior management team should periodically go on road
shows, where they talk about the firm to brokers and investors. If there is no
immediate intention to raise money through these trips, they are called non-
deal road shows.
• Create a message. The investor relations people need to craft a message
about the company that investors understand, and which they are willing to
buy into. This message should be consistently applied over time, with the
company’s actions adhering to its statements.
• Report consistent results. The company does not want to startle the invest-
ment community with unexpected jumps and drops in its reported results.
Instead, the senior management team and its advisors must use all of the
communication tools at its disposal to convey its expectations for the com-
pany’s results in the near term, so that actual reported results are usually

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close to the expectations that the company has established in the market-
place.
• List on an exchange. Gaining a listing on any stock exchange will probably
increase trading volume, with higher volumes being associated with larger
and more reputable stock exchanges. Each exchange has its own listing re-
quirements, which typically involve some mix of shareholder, revenue, prof-
it, and asset volumes that may be difficult for a smaller business to achieve
in the near term. However, if the company has a consistent pattern of
growth, it may eventually gain entry into a stock exchange.

A company may engage heavily in all of the preceding activities and still see little
improvement in its trading volume. This is particularly likely when a company is in
an industry that the investment community does not feel is “hot” at the moment. If
so, the company can elect to either continue on the same path, reposition itself with a
new company strategic direction, or go private. Going private is covered in the next
section.

Other Reverse Merger Issues

If a company engages in a reverse merger, there are a number of issues that it may
be faced with. There is a strong likelihood that investors will want to sell their shares
in the near future, in which case the company’s senior managers should be aware of
the SEC’s Rule 144, which allows investors to make their shares tradable under
certain circumstances. Also, it may be necessary to clean up the shareholder list by
eliminating smaller shareholdings; this can be accomplished with a reverse-forward
split. Finally, if the venture into the world of being a public company proves to be
too difficult, it may be necessary to take the company private. All of these issues are
addressed in this section.

Rule 144
The new owner of a public shell may find that the process of registering shares with
the SEC is cumbersome, expensive, and time-consuming. In some cases, the better
part of a year may pass before the SEC allows stock to be registered. There will be
pressure from shareholders to register their stock, since stock certificates bear a
restrictive legend that prevents their sale until they are registered. If the company
finds the registration process to be too difficult, it can point out to its shareholders
that they can use the SEC’s Rule 144 to register the shares themselves.
Under Rule 144, investors can sell their stock holdings if all of the following
conditions have been met:
• Holding period. A shareholder must hold the shares for at least six months.
• Reporting. The company must be complying with its SEC reporting
requirements.
• Trading volume. If the stockholder is in a control position at the company,
then he or she can only sell the greater of 1% of the outstanding shares of

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the same class being sold or 1% of the average weekly trading volume in the
four weeks preceding a notice to sell shares.
• Trading transaction. The sale of stock must be handled as a routine trading
transaction, with the broker receiving a normal commission.
• Notice of sale. If the stockholder is in a control position at the company, he
or she must file a Form 144 with the SEC, giving notice of intent to sell.
This requirement is not applicable if the sale is for fewer than 5,000 shares
or the aggregate dollar amount will be less than $50,000.

Following completion of the applicable conditions, shareholders must apply to the

company’s stock transfer agent to have any restrictive legends removed from their
stock certificates. The stock transfer agent will only remove the legend with the
written approval of the company’s designated attorney. Once the legend has been
removed, a shareholder can sell the stock.
Though Rule 144 appears to give investors a reasonable means for selling their
stock, its practical application is limited by the volume of trading in the stock. Thus,
even though investors may be allowed to sell their stock, it does not mean that there
will be a sufficient number of interested buyers to allow for their sale.

The Reverse-Forward Split

When a private company acquires a public shell, it may find that the shell has been
operationally inactive for so long that many of its shareholders no longer have valid
addresses. These shareholders tend to have very small stock holdings; this makes
sense, since investors with larger shareholdings will go out of their way to ensure
that the company has the correct contact information for them. There are shareholder
research firms that can locate some of these shareholders, but it may be impossible
to find them all. This can be a problem, because the company is still responsible for
sending annual reports, proxy statements, and dividends to them, and this cost will
accumulate over time.
A possible method for eliminating some of these shareholders is the reverse-
forward stock split. Under this approach, the company declares a hefty reverse stock
split, such as 100 current shares for one new share, and then immediately flips this
around and declares the reverse of the first split. Thus, to extend the example, a
reverse stock split of 100 to 1 is followed by a forward split of 1 to 100. The end
result of these gyrations is that the larger shareholders see no change at all, while the
smaller shareholders are eliminated. Thus, if a shareholder holds 99 shares of
company stock, and the company declares a 100 to 1 reverse-forward stock split,
then the shareholder ends up with less than one share as part of the reverse stock
split, and is sent a payment for that partial share.
While it may appear excessively convoluted, the reverse-forward stock split is
an effective way to clean up the shareholder records and eliminate those
shareholders who are most likely to be inactive.

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Going Private
It is quite likely that a smaller business that has gone public through a reverse
merger will find that the cost of doing so is too great, and so wants to take the
company private. If there are no more than 300 shareholders of record, going private
only involves filing the very simple Form 15 with the SEC. Thus, if senior
management is uncertain of the company’s ability to continue as a public company,
it should try to keep the number of shareholders as low as possible.

Note: A shareholder of record is a person or entity listed in the shareholder records

of a business as owning its stock. A brokerage can be the shareholder of record on
behalf of its clients. Thus, it is possible to have many more actual shareholders than
is indicated by the number of shareholders of record.

If there are more than 300 shareholders, the company will have to find a way to
reduce the number of shareholders, such as through a stock buyback program or a
reverse stock split. It then documents its intentions in the much more elaborate
Schedule 13e-3, which it files with the SEC. The SEC may review and comment on
this Schedule, possibly several times, so there can be a multi-month delay between
filing the form and taking any of the actions noted in it. Once the company then
takes steps to reduce the number of shareholders, it can file a Form 15 and take itself
private.

Note: A company that has gone private needs to continually monitor the number of
shareholders of record. If the number ever exceeds the 300-person limit, the
company must resume its public company filings with the SEC.

Summary
We have included the concept of reverse mergers in this book because it involves
the combination of two separate businesses. However, the intent behind this
combination is quite different from the normal reason for an acquisition. The
acquirer is solely interested in one attribute of the shell company – its status as a
public entity. Thus, the underlying historical business of the shell is probably of no
concern at all to the buyer.
In leaving this topic, we must interject a note of caution regarding the use of
reverse mergers. This approach is typically used by smaller companies that cannot
afford to go public by the traditional IPO route. These smaller businesses now find
themselves subject to the onerous reporting requirements of a public company. A
common long-term outcome is that these smaller businesses find that the costs of
being public outweigh the benefits, so they either collapse or take themselves
private. Thus, be sure of the company’s reasons for being publicly-held before
engaging in a reverse merger; there may be other alternatives that are more cost-
effective and less risky for the business.

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Glossary
A
Advance pricing agreement. An agreement between a taxpayer and a taxing
authority regarding the transfer pricing methodology to be used for certain types of
transactions between business entities.
Appraisal rights. The legal right of dissenting shareholders to not accept an offer to
buy their shares, but instead to have their shares appraised and purchased, usually
for cash.
B
Bargain purchase. A situation where the amount paid for an acquisition is lower
than the valuations assigned to its assets and liabilities.
Bear hug. An offer to buy the shares of a target company at a price clearly higher
than what the target is currently worth.
Bolt-on acquisition. The acquisition of a business closely-related to that of the
acquirer.
Breakeven point. The sales level at which a company earns a zero profit. It is
computed by dividing all fixed expenses by the gross margin percentage.
C
Carrying amount. The original cost of an asset, minus accumulated depreciation and
any accumulated impairment.
Cash sweep. When a company’s bank automatically moves cash out of a bank
account and into a cash concentration account.
Collar agreement. An agreement to adjust the number of shares paid to the
shareholders of the acquiree if the market price of the acquirer’s shares trade above
or below certain predetermined levels.
Comparison analysis. The derivation of the value of a business by comparing it to
similar acquisition transactions that were completed recently.
Contribution margin. The margin that results when variable production costs are
subtracted from revenue.
Control premium. The additional value associated with shares that will give the
purchaser control over a business.
Cost of capital. The cost of the debt and equity used by a business. It is comprised of
debt, preferred stock, and common stock.
 Glossary

Creeping tender offer. The gradual accumulation of the shares of a company, with
the intention of acquiring control over the business or obtaining a significant voting
bloc within the company.
Cycle counting. The process of counting a small proportion of the total inventory on
a daily basis, as well as investigating and correcting any errors found.
D
Data room. A physical or electronic storage area in which documents and files are
stored for review by bidders.
Discounted cash flows. A valuation method under which the future expected cash
flows of a business are discounted to their present value.
Diseconomies of scale. A situation where a series of acquisitions results in larger
total expenses than any gains caused by synergies.
Due diligence. The investigation of the financial, operational, legal, and other
aspects of a target company, prior to purchasing the business.
E
Earnout. An additional payment made to the shareholders of an acquired company if
it can meet certain performance objectives.
EBITDA. Earnings before interest, taxes, depreciation, and amortization. It is a
rough measure of the cash flows of a business.
Employee stock ownership plan. When the company contributes funds to a plan,
which uses the cash to buy shares of company stock. The plan is owned by
employees.
Enterprise value. The market value of the shares of a business, plus its outstanding
debt, less its cash balance.
Exchange ratio. The number of shares of the acquirer that it is offering to exchange
for each share of the seller.
F
Factoring. The sale of receivables to a finance company. Under this arrangement,
the customer is notified that it should now remit payments to the factor. The factor
assumes collection risk.
Failing company doctrine. The concept that a failing company can be acquired, even
if it results in the further consolidation of an industry.
Fairness opinion. A detailed analysis of a purchase offer by a valuation firm or
investment bank, stating its belief that an offer made to acquire a target company is
fair.
Fair price provision. A provision in a corporate charter, requiring an acquirer to pay
for the shares of minority shareholders at a fair price.

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 Glossary

Financial buyer. An acquirer that is more likely to investment in a business to

improve it, and then sell it for a profit.
Fixed-exchange collar. A collar agreement under which the exchange ratio is locked
between the collar boundaries, and the price is fixed outside of the collar boundaries.
Fixed-price collar. A collar agreement under which the price is fixed within the
collar boundaries, and is based on an exchange ratio outside of the collar boundaries.
Forward EBITDA. The use of projected EBITDA information for the next 12
months to derive the valuation of a business.
Forward revenue. The use of projected revenue information for the next 12 months
to derive the valuation of a business.
G
Generally Accepted Accounting Principles. A set of authoritative accounting
standards issued by several standard-setting bodies, which entities should follow in
preparing their financial statements.
Golden parachute. A large payment made to an employee in the event of a change in
control of a company.
Goodwill. The difference between the purchase price of an acquisition and the
amount of the price not assigned to the assets and liabilities obtained in the
acquisition.
Greenmail. The repurchase of shares from a potential acquirer at a premium, usually
accompanied by a promise from the acquirer to discontinue its activities to acquire
the company.
Gross margin. Revenues minus the cost of goods sold.
H
Hart-Scott-Rodino Act. An Act mandating the review of certain acquisitions to see if
they cause antitrust issues.
I
Indemnification provision. A clause in a purchase agreement, stating that the
acquirer is protected from any unfavorable resolution of a contingency in the
acquiree’s business.
International Financial Reporting Standards. A set of authoritative standards set by
the International Accounting Standards Board, which an entity must comply with if
it wishes to create financial statements that are accepted in those countries
mandating the use of IFRS.
IPO valuation. The derivation of a company’s valuation by initiating the process of
taking the company public and determining the price at which its shares are expected
to sell.

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 Glossary

L
Lehman formula. A compensation plan for paying an investment banker that is based
on the size of the transaction.
Letter of intent. A document submitted by an acquirer to a target company, in which
it states the price and conditions under which it offers to acquire the company.
Leveraged buyout. The purchase of a business using a large proportion of debt, and
usually involving the existing management team.
Liquidation value. The amount of funds that would be collected if all assets and
liabilities of a company were sold off or settled.
M
Material adverse change clause. A clause in a purchase agreement, under which the
acquirer can back out of an acquisition prior to the closing date if certain events
occur, such as a decline in the financial results of the acquiree.
Mini-tender offer. A tender offer in which the entity initiating a tender offer will end
up owning less than five percent of a class of stock of the publicly-held business that
is the subject of the tender offer.
N
Net book value. The original cost of an asset, less any accumulated depreciation,
accumulated amortization, and accumulated impairment.
No shop clause. A requirement in a letter of intent that a target company cannot shop
the offer made to it by an acquirer to other prospective bidders.
Non-deal road show. Presentations by company managers to the investment
community, where the company is not raising funds.
Notional pooling. A mechanism for calculating interest on the combined credit and
debit balances of bank accounts that a corporate parent chooses to cluster together,
without actually transferring any funds.
O
Offering memorandum. A document used to summarize the main features of a
business to a prospective buyer. It is used as part of the auction process to sell a
company.
Organic growth. The growth generated internally by a business.
P
Partial tender offer. A tender offer for less than the full amount of a class of shares
of a company.
Payroll cycle. The length of time between payrolls. Thus, if a business pays its
employees every Friday, this is a one-week payroll cycle.

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 Glossary

Pro forma financial statements. A set of financial statements issued by an entity,

incorporating assumptions or hypothetical conditions about events that may have
occurred in the past or which may occur in the future.
Proxy. The authorization of shareholders to vote their shares for them at a
shareholders meeting.
Proxy fight. An attempt by those not in control of a business to use the proxy method
of voting to obtain a sufficient number of shareholder votes to gain control of the
board of directors of a company.
Purchase agreement. A legal document used to govern the final sale of an acquiree
to an acquirer.
R
Registration rights. The obligation by the issuer of shares to have them registered
with the Securities and Exchange Commission.
Relief-from-royalty method. The assignment of value to an intangible asset, based on
the royalty that would have been paid for the rights to use the asset if it were
licensed from a third party.
Replication value. A valuation technique that involves estimating the cost to
replicate a target company.
Reverse-forward split. A technique used to eliminate small shareholdings by first
engaging in a reverse stock split, followed immediately by a forward stock split.
Road show. Presentations by the senior management of a company to the investment
community.
Roll up strategy. The practice of buying multiple smaller businesses within the same
industry, in order to achieve a significant market position.
Rule 144. An SEC rule under which the holder of stock can sell the shares on the
open market after an initial holding period has been completed. There are
restrictions on the number of shares that can be sold per period.
S
Schedule TO. A schedule filed with the SEC when one makes a tender offer and
accumulates more than five percent of a class of the shares of a publicly-held
business.
Shareholder of record. A person or entity listed in the shareholder records of a
business as owning its stock. A brokerage can be the shareholder of record on behalf
of its clients.
Shareholder rights plan. Rights issued to existing shareholders, under which they
can acquire additional shares if anyone acquires more than a certain amount of the
company’s shares.

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 Glossary

Shelf registration. The registration of a new issuance of securities with the Securities
and Exchange Commission in advance of their distribution.
Shell company. A company with minimal operations or assets, or assets that are
solely in cash.
Standstill agreement. A payment to an acquirer in exchange for an agreement not to
increase the number of shares of the target company that it holds during a specific
time period.
Step acquisition. The purchase of an acquiree in several tranches of stock purchases.
Strategic purchase. The purchase of a business for strategic reasons, rather than
being based on a more quantitative valuation model.
Supermajority. When more than a simple majority of shareholder votes is needed to
approve certain actions.
Sustaining expense. An expense incurred on a regular basis in order to keep a
business competitive. Examples are equipment maintenance, training, and branding.
Synergy analysis. The review of the operations of an acquirer and a target company
to determine where revenue enhancements and cost reductions can be achieved by
combining the two entities.
T
Teaser letter. A letter to prospective bidders, enumerating the features of a business
that is for sale. An interested party can then contact the seller for more information.
Tender offer. A broad solicitation to purchase a substantial percentage of a
company’s shares for a limited period of time. The offer is at a fixed price, usually at
a premium over the current market price, and is customarily contingent on
shareholders tendering a fixed number of their shares.
Term sheet. This is a document similar to a letter of intent, except that the terms
offered by the acquirer to the target company are more likely to be abbreviated in
size, and there may be no intent to have either party sign it.
Trailing EBITDA. The use of historical EBITDA information for the last 12 months
to derive the valuation of a business.
Trailing revenue. The use of historical revenue information for the last 12 months to
derive the valuation of a business.
Transfer price. The price at which one part of an entity sells a product or service to
another part of the same entity.
Trial balance. A report listing the ending debit and credit balances in all accounts at
the end of a reporting period.

281
 Glossary

True up provision. A clause in a purchase agreement, under which the number of

shares issued to the seller can be adjusted at a later date if the market price of the
stock of the acquirer declines below a certain point.
Two-tiered tender offer. A tender offer where the acquirer offers a better deal for a
limited number of shares in order to gain control over the target company, followed
by a reduced offer for an additional group of shares at a later date.
U
Useful economic life. The time period over which an asset is expected to contribute
to the cash flows of a business.
V
Vertical integration. The strategy of buying both the suppliers and distributors of a
business, in order to control all key aspects of its supply and distribution chains.

W
White knight. An entity that makes a friendly offer to acquire a business that is the
subject of a hostile takeover attempt by a third party.
Worker Adjustment and Retraining Notification Act. A federal Act requiring 60
days’ notice when an employer plans to close a facility or conduct a mass layoff.

282
 Index

Index
Compensation parity ........................... 228
52 week high, as valuation basis .......... 85 Competitor reactions ........................... 217
Complexity analysis .............................. 55
Accelerated vesting ............................ 120 Conditions precedent........................... 203
Accounting integration ....................... 219 Conflicts of interest ....................... 56, 138
Accounts payable, review of ........ 51, 148 Consignment inventory ....................... 161
Accounts receivable, analysis of .......... 49 Constraint analysis .............................. 238
Accrued liabilities, review of................ 51 Consulting contract ............................. 184
Acquisition size ...................................... 9 Contingent shares ................................ 178
Actuary, role of................................... 262 Continuity of business enterprise ........ 190
Adjacent industry strategy ...................... 4 Continuity of interest .......................... 190
Adjusting entries................................. 141 Contract management ......................... 234
Advance pricing agreements ...... 169, 233 Contracts review ........................... 84, 166
After-market sales .............................. 143 Control premium ................................... 87
Alternatives to selling ........................... 46 Conversion rights ................................ 150
Anti-greenmail provision.................... 120 Core expenses ..................................... 145
Antitrust acquisition ........................... 120 Corporate culture................................. 132
Appraisal rights .................................. 194 Cost of capital ....................................... 77
Asset acquisition......................... 195, 251 Credit granting policy ......................... 163
Asset step up ....................................... 189 Creeping tender offer .......................... 117
Attorney, role of ................................. 259 Culture integration .............................. 224
Auction process .............................. 23, 29 Customer poaching ............................. 218
Audit committee minutes ................... 166 Customer service integration............... 225
Cycle counting ...................................... 50
Bankruptcy acquisitions ....................... 31
Bargain purchase ................................ 248 Data center consolidation .................... 232
Basket clause ...................................... 208 Data room
Bear hug ............................................. 112 Electronic .......................................... 63
Bid bonds............................................ 164 Physical............................................. 62
Board minutes, review of ................... 166 Debt, review of.............................. 52, 149
Board of directors liability.................... 66 Depreciation analysis .......................... 154
Bona fide purpose rule........................ 190 Disaster recovery plan ......................... 163
Book value analysis .............................. 69 Discount rate ......................................... 77
Breakeven point .................................. 146 Discounted cash flows analysis ............. 75
Business combinations Diversification strategy ...........................5
Income taxes .................................. 252 Divestment issues ................................ 226
Overview of ................................... 243 Dividends, unpaid ............................... 150
Double taxation ................................... 196
Call center integration ........................ 225 Due diligence
Cash forecast ...................................... 163 Accounting policies ........................ 153
Cash sweeping .................................... 240 Corporate culture ............................ 132
CERCLA ............................................ 167 Cost ................................................. 129
Clean Water Act ................................. 168 Employee benefits .......................... 139
Closing bonus ....................................... 59 Employees ...................................... 136
Closing memorandum ........................ 212 Equity ............................................. 150
Collar agreement ................................ 180 Expectations.................................... 129
Collateral, review of ........................... 150 Financial statements ....................... 139
Comparison analysis ............................. 83 Fixed assets ..................................... 147

283
 Index

Hedging .......................................... 164 Fixed-exchange collar ......................... 181

Information technology .................. 162 Fixed-price collar ................................ 181
Insurance ........................................ 164 Franchises ........................................... 144
Intellectual property ....................... 146 Full service strategy ................................3
International issues ......................... 169
Legal issues .................................... 165 Geographic growth strategy ....................2
Liabilities ....................................... 148 Going private ...................................... 275
Management issues ........................ 133 Golden parachute ................................ 121
Marketing ....................................... 157 Goodwill
Materials management ................... 160 Amortization ................................... 190
Preparation for................................ 128 Calculation of ................................. 247
Product development...................... 155 From business combination ............ 247
Production ...................................... 158 Overview of .................................... 253
Regulatory compliance................... 167 Greenmail ............................................ 124
Report............................................. 170 Gross margin analysis ........................... 54
Revenue.......................................... 143
Selling activities ............................. 156 Hart-Scott-Rodino Act .......................... 35
Service companies.......................... 168 Hedging strategies ............................... 164
Taxes .............................................. 151 Herfindahl-Hirschman Index ................ 39
Treasury ......................................... 163 Horizontal merger guidelines ................ 38
Hostile takeover defenses .................... 119
Earnings per share, impact on............. 184 Human resources integration............... 228
Earnout payment........................... 88, 185
Employee benefits .............................. 139 Incremental borrowing rate ................... 79
Employee communications ................ 215 Influencer price point ............................ 86
Employee integration.......................... 226 Information sharing ............................... 58
Employee loans .................................. 146 Information technology department .... 162
Employee poaching ............................ 217 Information technology integration ..... 231
Employee stock ownership plan ......... 151 Insider loans ........................................ 164
Employment contracts .......................... 59 Insurance policy integration ................ 241
Enterprise value .................................... 71 Integration
Environment issues, reduction of ......... 47 Accounting ..................................... 219
Equity, review of .................................. 52 Culture ............................................ 224
Estimating systems ............................... 55 Customer service ............................ 225
Exchange ratio .................................... 177 Employees ...................................... 226
Expense trends .................................... 145 For the serial acquirer ..................... 241
Expenses, review of .............................. 54 Information technology .................. 231
Legal ............................................... 233
Factoring, review of............................ 149 Managers ........................................ 234
Failing company doctrine ..................... 41 Marketing ....................................... 235
Fair price provision..................... 116, 120 Materials management .................... 236
Fairness opinion ................................... 92 Planning .......................................... 217
Field service consolidation ................. 225 Production....................................... 238
Financial buyer ..................................... 21 Selling ............................................. 238
Financial statements Team ............................................... 216
Audited ............................................. 49 Treasury .......................................... 240
Review of ....................................... 139 Integration speed ................................. 214
Fixed assets, review of ................. 50, 147 Intellectual property, review of ..... 56, 146
Fixed price .......................................... 180 Inventory
Fixed share count ................................ 180 Analysis of ........................................ 50

284
 Index

Obsolescence review ........................ 50 Integration....................................... 229

Record accuracy ....................... 50, 236 Review of.......................................... 52
Turnover ........................................... 50 Percentage of completion method ....... 154
Investment banker, role of ............ 19, 261 Performance bonds .............................. 164
Investment policy ............................... 164 Personal expenses ................................. 54
Investments, analysis of........................ 49 Post-acquisition review ......................... 18
IPO valuation ........................................ 86 Post-integration analysis ..................... 241
Prepaids, analysis of .............................. 50
Joint ventures ........................................ 15 Presentation by management................. 27
Pricing philosophy .............................. 143
Leases, review of .......................... 51, 148 Product
Legacy systems................................... 163 Development ................................... 155
Legal integration................................. 233 Recalls ............................................ 155
Legal issues ........................................ 165 Supplementation strategy....................2
Legal issues, mitigation of .................... 48 Production department activities ......... 158
Letter of intent .............................. 16, 198 Production integration ......................... 238
Leveraged buyout ............................... 124 Proxy fight .......................................... 118
Liabilities, unrecorded .......................... 52 Proxy solicitation ................................ 263
Liquidation value .................................. 68 Purchase agreement............................. 205
Low-cost strategy ................................... 8 Pushdown accounting ......................... 252

Manager integration............................ 234 R&D expenditures............................... 155

Margin analysis .................................. 142 Real estate value ................................... 68
Market window strategy ......................... 6 Reasons to sell....................................... 43
Marketing department activities ......... 157 Receivable write-off method ............... 154
Marketing integration ......................... 235 Redemption rights ............................... 116
Marketing, review of ............................ 53 Registration rights ............................... 175
Material adverse change clause .......... 208 Regulatory compliance ....................... 167
Materials management........................ 160 Relief from royalty method ................... 69
Materials management integration ..... 236 Replication value................................... 82
Merger Regulation ................................ 41 Representations and warranties ........... 206
Mini-tender offer ................................ 117 Restructuring charges .......................... 141
Multiples analysis ................................. 72 Retainer fees........................................ 145
Retention analysis ............................... 227
Nepotism ...................................... 55, 138 Revenue
Net operating loss carryforwards ........ 189 Gross vs. net ................................... 153
No action letter ................................... 123 Recognition ..................................... 154
No shop provision .............................. 204 Review of.......................................... 53
Noncontrolling interest ....................... 245 Trend reporting ................................. 53
Non-disclosure agreement .................... 16 Reverse acquisition ............................. 249
Notional pooling ................................. 240 Reverse merger
Advantages and disadvantages ....... 267
Offering memorandum ......................... 25 Concept ........................................... 266
Opinion leader relations ..................... 227 Due diligence .................................. 270
Organic growth ....................................... 1 Rule 144.......................................... 273
Shell price ....................................... 270
Partial tender offer .............................. 115 Trading volume............................... 272
Patent analysis ................................ 14, 56 Reverse triangular merger ................... 194
Pension plan Reverse-forward split .......................... 274
Funding .......................................... 139 Risk adjustment ..................................... 79

285
 Index

Roll-up strategy ...................................... 8 Certification .................................... 161

Rule 144 ..................................... 176, 273 Contracts ......................................... 160
Supplier certification ........................... 237
Safety issues ......................................... 56 Sustaining expenses .............................. 54
Sales backlog ........................................ 53 Synergy analysis ................................... 95
Sales department activities ................. 156 Synergy strategy......................................6
Sales growth strategy.............................. 1
Sales integration ................................. 238 Takeover defenses, reduction of ........... 49
Sales multiples analysis ........................ 83 Target costing........................ 55, 145, 155
Schedule TO ....................................... 109 Target research ...................................... 13
Second request ...................................... 37 Taxation issues .................................... 188
Securities Exchange Act ..................... 108 Taxes payable, review of ...................... 51
Share repurchase................................... 46 Taxes, review of .................................. 151
Shareholder meeting minutes ............. 166 Teaser letter........................................... 23
Shareholder of record ......................... 275 Tender offer ........................................ 112
Shareholder rights plan ....................... 121 Term sheet ........................................... 205
Size of person test ................................. 36 Territory integration ............................ 239
Size of transaction test .......................... 36 Timing of the sale ................................. 57
Special meeting limitation .................. 121 Totality of circumstances test.............. 113
Special voting rights ........................... 121 Toxic Substances Control Act ............. 168
Spend management ............................. 160 Trademark administration ................... 234
Staggered board of directors ............... 121 Transfer pricing ........................... 154, 169
Standstill agreement ........................... 124 Transitory revenue ................................ 75
Step acquisition .................................. 244 Treasury integration ............................ 240
Stock buyback .................................... 124 Triangular merger ............................... 194
Stock options ........................................ 60 True up provision ................................ 208
Stock-for-stock exchange ................... 175 Two-tiered tender offer ....................... 116
Strategic buyer ...................................... 21 Type “A” acquisition .......................... 191
Strategic purchase ................................. 87 Type “B” acquisition ........................... 191
Strategy Type “C” acquisition ........................... 192
Adjacent industry ............................... 4 Type “D” acquisition .......................... 193
Diversification.................................... 5
Failings of ........................................ 11 Uninsured risks ................................... 165
Full service ......................................... 3 Unrecorded liabilities .......................... 150
Geographic growth ............................. 2
Low-cost ............................................ 8 Valuation floor and ceiling.................... 90
Market window .................................. 6 Valuation specialist, role of................. 262
Product supplementation .................... 2 Vertical integration strategy ....................4
Roll-up ............................................... 8
Sales growth ....................................... 1 Warranties, review of .......................... 149
Synergy .............................................. 6 Warranty claims .................................. 155
Vertical integration ............................ 4 White knight................................ 110, 124
Supermajority voting .......................... 121 Williams Act ....................................... 108
Supplier Working capital adjustment ................ 199

286