The process of M&A starts off with determining the needs of the acquirer and figuring what is needed from a possible merger. Once this has been done, the managers start listing down all possible companies that could be taken over. Detailed, thorough analysis and a screening process are later used to shorten the long list.

M&A: How to Create and Shorten a Long List

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In this article, we look at 1) recognizing the purpose of M&A, 2) creating long list, and 3) screening potential candidates.

RECOGNIZING THE PURPOSE OF M&A

Before a company initiates the process of a merger or acquisition, it is essential to determine what purpose the company hopes to achieve through the merger. A merger or an acquisition is a major strategic decision for any company which must be backed by research and deliberation. All parties that would be affected by a possible M&A should be identified, as well as the impact of the merger on them.

Revisiting vision and mission statement

In order to identify the reason for a possible merger, the company needs to revisit its vision and mission statements, since these provide the general direction in which the company is supposed to go. Vision statements say a lot about a company, since they detail how the entity perceives its existence and how it envisions to change or impact with its operations in the industry. Similarly, a mission statement talks about what the company wants to achieve in the future and how it plans to do so. Reviewing the mission statement will help decision makers get reacquainted with the company’s philosophy before they look into a potential M&A.

Updating and renewing the vision and goals

Reviewing the vision and goal statements will help the company define parameters for a possible merger. Companies need to periodically revise and update their vision and mission statements. It also includes setting new goals and changing policies to accommodate mergers and acquisition.

Determining what the company wants to achieve with M&A

The company needs to determine and pinpoint what it wants to achieve with a particular merger or acquisition, since it would make it easier to shortlist companies. It must also be determined how the merger will impact the business as a whole. If the company plans ahead and knows exactly what it wants to achieve, it would save a lot of time and effort and eventually result in the right decision being made. Listing down all the goals of the company will help managers better strategize mergers and acquisitions. A bad merger could hurt the company and slow down growth, which is why planning is of paramount importance.

Determining how it would impact the business processes

A merger or an acquisition is likely to impact the business operations considerably, especially if the operations of the target company are being integrated with current operations. It is important to plan for these changes ahead of time, so that proper arrangements can be made, which will help with a smooth transition. In order to make the target company part of the running operations, a cultural change has to be initiated, which will involve taking the employees into confidence, recruitment, and training.

CREATING LONG LIST

It is important to be methodical while creating and shortening a list for a possible M&A. Here are some things to consider while searching for the right company.

Listing down companies working in the industry

The first step involves identifying targets for a merger or an acquisition. There are several ways in which a right fit for a merger could be found. First; the managers need to develop a profile of the sort of firm they want to acquire. Managers must also gather information on market condition, industries, products and services being offered. There are several research reports available on industries and their future potential, which can be of great help to the acquirer.

The acquirer needs to look for companies in their vicinity, which means it needs to consider firms it sells to and buys from. Many mergers and acquisitions take place between firms that already have a working relationship. Senior staff and managers must be encouraged to use their contacts and network to look for likely prospects in the industry. Details could be circulating in the industry pertaining to a possible merger and the kind of firm the acquirer is interested in. For this purpose banks and other financial institutions could be used, since they serve similar companies.

Establishing the primary screening or selection criteria

After reviewing and revising the company mission and vision statement, criteria are developed according to which the long list is further shortened. The criteria may include the size of the company, budget, number of employees, area of business, location, value of the company and relevance to the current business area. This would act as the primary screening or selection criteria.

List according to Pre-determined criteria

Once you have a list of companies, and the criteria that will factor into your decision-making, list all the companies down and rate them on each criterion. Creating a table listing each individual factor you are considering and then adding companies to this table will help you clearly see which companies do and do not match your requirements. Should a lot of companies fit the bill, you can use this table to help prioritize a list in the order you will approach the companies. Having data laid out for easy visualization can help speed the process of choosing the right companies for your shortlist.

Developing a search strategy

This process requires a lot of information from primary and secondary sources. The company needs to find information about these companies, so that analysis and decision making is easier. Information can be often found in publications made available to the public, but at times, primary research has to be done in order to acquire insightful information. When a merger or acquisition is being deliberated, information regarding the company can be sought directly from the company as well. Government organizations and regulatory bodies usually have a database containing all the companies in a particular industry, which could be acquired to streamline the process.

All the companies in the long list will be tested on this set of criteria. Another strategy is talking to experts and getting their insightful opinion about various companies in the industry. Alternatively, companies could be categorized according to the area of business they specialize in.

Computerized databases and directory, banking, and accounting firms

The search and organization of these companies could be aided with technology. Databases could be created, especially for industries with a huge number of companies. The computerized data would also help organize the list better and criteria could be set to shortlist the companies in the industries. Moreover, in order to acquire as much as information as possible records can be sought from various financial institutions like banks and accounting firms, which will be able to provide insightful information about the target companies.

Approaching the target company

When a suitable target has been identified, there is a need to register interest. There should be formal and clear communication with the concerned party. The higher management, which is board of directors in most cases, must be directly approached. It must be made sure that the management fully understands as to why the acquirer is interested in the target firm. A list of question should be prepared and presented to the decision makers at the target firm. A formal meeting could help get clear information across in addition to providing an opportunity to explain the business and future plans of the acquirer.

Before the owners or decision makers of the target company are approached it is advisable to find out if the they are already planning to sell the business. If they are already planning to sell, the reasons behind must be determined and investigated. It must also be considered, in case of a merger, whether the acquirer would work well with the target company’s managers and staff, since personal difference could mean the difference between success and failure

SCREENING POTENTIAL CANDIDATES

Once the acquirer has the list of shortlisted companies for a possible merger or takeover, screening potential candidates will further narrow the search. There are ways through which this can be done.

Detailed analysis, valuation and evaluation of the target company

After the initial screening process, all shortlisted companies are put through a detailed and thorough analysis. This process involves going through the company’s financials. These financial statements include an income statement, balance sheet, cash flow statement and capital structure statement. Evaluating these statements would give the acquirer an idea as to how the potential company has performed over the years. Underlying patterns can also be determined through these statements which will give an insightful view of how well the company has progressed over the years. Income statements could be further used to generate various performance ratios, which give an overview about company’s profitability. Some common ratios include, gross profit ratio, net profit ratio and return of capital employed ratio. In the same manner values from the balance sheet can be used to calculate ratios, which summarize the financial standing of a company, commonly include current ratio, acid-test ratio and leverage ratio. Solicitors and accountants could provide valuable insight into the financial standing of the company.

Brief financial due diligence review

All selected companies must also go through the process of due diligence. Usually mergers and acquisition require approvals from central government agencies that are responsible for ensuring a competitive environment in the industry. It is important to make sure that there are no legal disputes concerning the ownership of the potential companies.

Adding more criteria to shorten the list

Once all the relevant information has been collected more criteria could be added to further shorten the list and possibly select a firm for a merger. Conditions may include market size, size of the firm, product line, and degree of leverage. All the shortlisted companies could be tested against these conditions to find the right fit.

Valuation

The next step involves valuation of the company. In order to understand the concept of valuation, it is important to develop familiarity with the concept of cash flows.

Any income a company receives or any expense incurred impacts the cash account over a given period. There are two kinds of cash flow movements: Cash inflows and Cash outflows. Inflows include revenues earned from operations or investments and financing activities. Cash outflows include expenses incurred by the firm for operational activities, investments, and purchase of assets.

Net cash flows can be calculating by combining cash inflows and outflows. A positive net cash flow would mean that the company is receiving more cash than it is spending.

There are several ways to value a company using the cash flow models:

1. Hiring a professional consultancy firm to do the job

Although this method might be costly and time consuming, it usually gives an accurate valuation of the company. Another method to valuate a company involves analyzing the cash flows of the company and placing a value on company’s ability to generate profits.

2. Forecasting using future net cash flows

In some cases, future net cash flows are also calculated and a forecast is created, which provides an important determinant for valuation of the company. As explained above, operating free cash flow is cash generated by operations, which is attributed to all providers of capital in the firm’s capital structure. This also includes debt providers as they provide funds to finance the company. The calculation is done by taking earnings before tax and interest and adjusting for the tax rate. Depreciation is added back, since it is non-cash expense and does not impact the cash account. Capital expenditure is subtracted and any changes in capital structure are also subtracted. All these values are available in the income statement and balance sheet of the company.

3. Looking at Growth Rate

Another model for valuation includes looking at the growth rate, which is the rate at which the company is growing in terms of revenues and profits in a year to year comparison. This value can be difficult to predict at times, but could drastically change the value of the firm. Conventionally, it is calculated by using the return on invested capital value and multiplying it with retention rate. The percent of earning that are held back within the company, hence not paid as dividends, is known as retention rate. Return on investment is the income generated from the operations. This value can be retrieved from the income statement.

4. Using the present value of operating free cash flows

Another popular method to evaluate the value of a company is calculation of the present value of operating free cash flows. The operating free cash flows are calculated as mentioned above, but for this calculation the cash flows are discounted to take into account the cost of financing projects. The discounting is based on the average interest rate in the economy. The weighted average cost of capital is used as the discounted factor. Three potential growth scenarios are taken in account: No growth, constant growth and varying growth.

Creating and shortening a list of potential firms for merger or takeover is a complicated process, which requires a lot of research, due diligence and meticulous calculation. A number of factors, as explained above, need to be taken into account before a decision is made. The acquirer needs to determine a criteria, which would help make the process manageable. The narrower the parameters, the easier it would be for the acquirer to shorten the long list.

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