Key factors to evaluate in an acquisition

• By Sabrina Barker
• Aug 01, 2000

Once a company decides to proceed with an acquisition strategy and has identified a potential target company, it should begin to gather information. This information should allow the buyer to evaluate the marketing, financial, operational and overall strategic situation of the company. This process is often referred to as the "due diligence" period. It is equally as important for the buyer to concentrate on specific issues in his or her evaluation as for the potential seller to be prepared to answer specific questions.

Sustainable client base. The prime driver behind many transactions in the environmental industry today is simply the acquisition of a "book of business," i.e., buying the firm's existing revenue and customer relationships. Hence, one of the first things that most buyers evaluate is the current strength and the likely future sustainability of the target's customer base. Will the acquiring company be able to retain the bulk of the business, even if some projects need to be managed from a different locale or if some of the faces on the professional staff change? When the target entity is a subsidiary unit of a broader environmental services firm, a key negotiating point is usually the retention of "captive" parent company revenues after the deal.

Making your case with compelling economics and service

A buyer needs to be convinced that a potential deal makes economic sense given his or her view of likely market growth and competitive change. Recent yearly income statements, pro forma estimates and the current balance sheets are usually scrutinized in detail by the buyers (or their certified public accountants) in order to verify the historical trends, current financial strength and the potential future profitability of the company.

Many small firms fail because they try to do more than their resources allow. They may be enamored with geographical growth or new business opportunities beyond their means, often at the expense of the core business where they may excel.

Most successful consolidators and acquirers have a pretty sharp pencil when it comes to identifying areas where overhead costs can be reduced once the transaction is finalized and analyze the general and administrative expenses closely. In addition, most sophisticated buyers have detailed cashflow modeling capabilities and will run a number of different projections and sensitivity analyses in order to determine likely financial performance after the two companies are put together.

A proprietary market edge, or a differentiable service. A potential target company will be proportionately more attractive to a buyer if it has a definitive proprietary technical and competitive advantage relative to the competition. In the current environmental services field, such proprietary advantages are increasingly difficult to develop and maintain. However, some firms have a stronger competitive position than others in terms of certain disciplinary skills, market expertise (for example, strong hydrogeological capabilities or an expertise and reputation in the mining industry) a certain geographic coverage or a strong reputation among certain end users or market sectors. These are typically the types of service or geographic gaps that the buyer is trying to correct.

Objective proof of service claims. Buyers obviously look for objective and independent proof that the company's technical or service claims can be verified. The thorough buyer will typically ask to contact a number of existing and past customers who have had both good and bad experiences with the company to confirm the company's service claims. Simple assertions by the company that its service is superior, that it is the low-cost provider or that it has no effective competition will not be convincing to most buyers.

Critical management strength

A strong and experienced management team is often the single most critical determining factor in a successful transaction, particularly in professional services industries. It is even more important if the target company is in a new geographic area or in a specific market niche about which the buyer knows little. There are typically a number of different management issues that a buyer assesses; these can be broken down into the following important categories:

• Entrepreneurial and business expertise. It goes without saying that the management team should have good general business and financial management skills as well as a strong background within the industry. Acquirers in today's environmental industry look for more than a strong technical background and resume;
• Passion for success and a good internal "chemistry." Management should complement one another in terms of their skills and temperament. Acquirers prefer teams that have a strong and demonstrated passion for success and the desire for economic reward that comes from having invested significant amounts of their own funds in the venture;
• Marketing expertise. In an increasingly competitive environmental marketplace, it is essential that the managers have a clear vision of the markets they serve and a customer-driven orientation in the day-to-day operation of their business. Many companies in the environmental field claim to be "market driven" but few actually are;
• Objectivity and realism. The principals of the selling company must strive to retain perspective and objectivity regarding their business and what it is really worth, even though it may be a "baby" that the company has spent years building. Wildly unrealistic expectations on the part of the selling shareholders are one of the most common causes for the breakdown of acquisition negotiations; and
• Basic traits. While it may seem obvious, buyers often base their judgments and the ultimate investment on their gut feel of the management team's basic personality traits, such as honesty, integrity, intelligence and persistence. Poor "chemistry" or a bad feeling about future compatibility between management teams is also a prime reason behind many deal breakdowns.

Finding the competitive advantage

The buyer also needs to determine barriers to potential competition and the degree of proprietary advantage offered by the target company. How well and for how long can an existing proprietary advantage be maintained? Will the company enjoy any type of natural marketing or distribution advantage in relation to its key competitors? These types of issues are key factors in a mature and over-supplied service industry such as environmental business.

Distinct and definable markets. A company is a more attractive acquisition if it has a clearly identified and timely market for its service. In other words, assuming the company provides a decent service or product, will anybody buy it? A thorough buyer will assess the size and growth characteristics of the specific market, local customer buying habits and the potential for critical changes or trends that may impact the future characteristics of the market. If the firm has some existing large and reputable customers, or strong contracts and commitments, its market forecasts will be a good deal more credible. Several large customers can be a very positive factor, although extreme dependence on a single client is usually negatively perceived.

Too many deals go sour because of a single-minded desire to "do the deal" at all costs, haste and incomplete due diligence up front and a generally poor understanding of the specific strengths and weaknesses of the target company.

Assessing the competition

Experienced buyers conduct a thorough competitive analysis for the target company's service in terms of cost and market applicability. If a company asserts that there is no competition for its product or service, it probably either doesn't recognize and understand the various true forms of its potential competition or it may be attempting to address a non-existent market. The thorough buyer may also commission an independent survey of the industry to get a better understanding of the competitive environment and where the target firm stands in the industry.

Many basics are taken for granted in acquisition discussions, but the buyer should confirm everything, such as the existence of claimed state or regulatory certifications, the technical qualifications and training of key professional staff and the company's past legal concerns. Thoroughness in these types of "bread and butter" issues will usually uncover any past problems or uncomfortable issues that the buyer should know about before real negotiations begin.

From a more general and perhaps less quantifiable perspective, the typical buyer will also look at more intangible factors.

A strong focus on the core business. This is a critical intangible for most buyers. Many small firms fail because they try to do more than their limited resources allow. They may become enamored with geographical growth or new business opportunities beyond their means, often at the expense of the core business where they may really excel. Small firms should very carefully tread this hazy line between maintaining focus and investigating diversification opportunities.

A substantial differentiating factor. After getting familiar with the specific attributes of the company and the general characteristics of the marketplace in which it operates, the concerns of most investors can often be reduced to a single factor - what is different about this firm? Why is it more likely to succeed than all of its competitors? How will it be able to differentiate itself in a competitive marketplace?

General compatibility. When most of the attributes mentioned above are generally positive, it is likely that the company offers the potential to provide a high economic return. There obviously must be a strong potential for long-term profitability if the deal is to work. In addition, the buyer needs to have a good gut feeling that the company will be compatible with the existing organization, in terms of people, "culture," end markets and so forth.

While this is a somewhat idealized list of attributes, it is a worthy target to strive for in the due diligence process. If the buyer is truly serious about (and financially capable of) making the purchase — sellers should keep in mind that many "buyers" today are not — he or she needs to find out everything there is to know about the company. Too many deals go sour because of a single-minded desire to "do the deal" at all costs, hasty and incomplete due diligence up front and a generally poor understanding of the specific strengths and weaknesses of the target company. This inevitably leads to disappointment and distractions on both sides of the deal, oftentimes costly and ineffective legal wrangling and poor economic performance. Any acquisition is a bit of a gamble, but thorough up-front analysis can avoid a lot of problems later.

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This article appeared in Environmental Protection magazine, August 2000, Vol. 11, No. 8, p. 50.

This article originally appeared in the 08/01/2000 issue of Environmental Protection.