The 7-steps investors follow to buy a company efficiently

Steps that save you time and money

Dear Investors,

In this edition we go through the process of acquiring a business efficiently. The perspective we will take is that you are either a private equity investor or are buying a business to operate it.

The benefit to following this acquisition process is that it will save you time and money. If there are deal breakers you want them to come out as early as possible, before the expenses add up.

Take my word on that last one. We lost a deal ten months into the acquisition process, after incurring due diligence and legal costs. That is the worst possible point to lose a deal from a cost and time perspective, but it is significantly better than doing a bad deal.

Best, Raj

Finding the right company

We all want to buy a great business. But if you are only looking to buy great businesses, you’re in trouble. They are rare, hard to find and often not-for-sale. If you do find one, the price is usually sky-high. That is a recipe for low returns. Don’t get me wrong, if you can get your hands on one of these, go for it, but manage your expectations around only looking for great.

Fortunately, you don’t only have to buy great businesses. What you want is a business with a few warts, but lots of potential. That way seller expectations are more reasonable and you won’t have to overpay to get it. Thereafter, if you have an efficiency and value-add plan, you can significantly grow the value of this kind of business.

What you do not want is a fixer-upper or a turnaround. Turnarounds don’t turn and fixer-uppers don’t fix. If you are in private equity or doing M&A, you want a business that has positive cash flow. These ones usually have negative or declining cash flows.

The simplest way to find a business is to look at one industry, preferably the one you know something about. This way you will already have an idea of who the players are and can start putting out feelers on who is looking for an investor or wants to sell.

Assessing the deal

Most people think that the first thing to do when looking at a business is to dig into the financials. Nope, that’s the second thing.

The first thing to do is to find out why the current owners are selling. There can be any number of reasons, such as: owner retirement; people moving; kids don’t want to work; owner wants to cash out; business needs more equity to grow; the business cycle is turning; the owner has a new young wife and things are complicated with the ex-wife; etc.

One that I often see is, the sellers have had one or two extraordinary years and want to cash out while things are hot and they get can get top dollar. Before getting too excited about these companies, remember, there has to be a really fundamental change for a business to have a sudden increase in profitability. The norm for most industries is increasing competition, leading to reduced profitability over time.

The reason you want to find out the seller’s motivation is to make a go, no-go decision as early as possible. Also, you don’t want to be the dumb money i.e. the guys getting in, while everyone else is getting out.

Once you are confident in the seller’s motivations, then look at the financials and the proposed deal. Ensure that there is alignment in the deal. You want the people in the company working toward the same goals that you are. This can usually be achieved by bringing management in on the deal or leaving the owners with a material stake in the business. Generally speaking, if people own shares, they will work to make those shares more valuable.

Negotiate the terms

Once you have assessed the deal and feel that it can work, you can move onto negotiation. Basically, you want to have discussions with the owners and come out with three things:

  1.  How much are you paying?

  2. What shareholding are you getting for that price?

  3. What are the special conditions? Such as the current owners have to stay on for a period of time or maybe payments will take place over time, etc.

Take your time and get all these terms down in writing and signed by both parties. We call this written document a letter of intent (LOI) or a term sheet. It’s not a binding agreement, but it helps to create commitment, clarify thinking and to prevent never ending negotiations during the later stages of the deal (when expenses are mounting).

Due diligence

Due diligence means checking out what you are buying, before you buy it. In car parlance, don’t think of it as kicking the tyres when buying. Think of it as getting a mechanic to look under the hood and tell you in detail what is wrong. You don't want to buy a lemon.

Get help. Most people, even financial people, are not great at due diligence. Definitely find the right people and spend money here if you need to. This is not the time for DIY. This is your last chance to find the hidden deal breakers or gems in the company - use it.

Financing the deal

Financing is situation specific, but mostly you will be financing the deal with a combination of debt and equity. Equity is the cash you put in. Debt is typically a loan from a bank. You can also get fancy with something like mezzanine finance or hybrid instruments. But that is more complicated.

Main tips - keep it simple, do not over-leverage and you should be fine.

You will need a lawyer to draw up legal agreements. The main agreement is called the “share subscription agreement” or “share purchase agreement”. This agreement covers the terms of the acquisition. It is very comprehensive and documents everything that you negotiated. It is based on the LOI.

What kind of lawyer do you need? I’m going to split the legal industry into three sections: big-law (as it is known), medium law (a term I made up) and small law (another term I made up).

Big-law are the biggest law firms around. They have the most professionals and expertise in all fields of law. They often have global reach through international partner firms. These guys are good for large transactions, which have cross-border issues or require deep regulatory knowledge. Needless to say they cost an arm and a leg. You do not need these guys for small and medium sized transactions. They will produce the same documents that other lawyers can, but at 5-times the cost.

Medium law are regional law firms, which have specialised professionals. They can do everything but don’t have the same scale as big-law. They only cost an arm, not an arm and a leg. These are my preferred legal guys (for our target deal size). They have corporate law knowledge and can advise you. It costs a bit but you get quality and you feel confident in their abilities.

Small law are local law firms. Usually with one or two partners. These guys can also produce fabulous agreements. The challenge is if the lawyer is not specialised in corporate law, then you don’t have that specialist knowledge available. That said, recently I was involved in selling two companies where small law was used. I did not pick the firm, but they did a great job. It was very professional. So you can use them, but pick your law firm based on what you need. If you need advice, pay for it.

Post investment

If you are buying a company to run it, you will be there every day and know what is going on. But if managers are running the company you will need regular updates on what is going on. Some key issues to focus on:

  1. Communication: Talk to management often and know what is going on.

  2. Measure: Have clearly defined performance measures in the business, look at them and course-correct constantly.

  3. Verify: Do not only depend on numbers, walk the floor and see for yourself what is happening. Talk to people – they know where all the problems are.

  4. Financial controls: Make sure that money cannot leave the company without proper scrutiny and approval by the financial team. Always have more than one person approve payments - set this up with your bank.

  5. Financial reporting: Study the financial statements monthly. These should be ready within a week of month end.

  6. Publicise: Have internal processes in place to scrutinise expenses. Let everyone know that this happens - it deters fraud.

  7. Carrot: Have a compensation system in the company that measures the behaviours that you want and rewards them.

  8. Stick: Have a disciplinary system that deals with wrongdoing swiftly but fairly.

What did you think of this edition?

Login or Subscribe to participate in polls.

Join the conversation

or to participate.