Mergers and acquisitions

There are many good reasons for growing your business through an acquisition or merger. These include:

• Obtaining quality staff or additional skills, knowledge of your industry or sector and other business intelligence. For instance, a business with good management and process systems will be useful to a buyer who wants to improve their own. Ideally, the business you choose should have systems that complement your own and that will adapt to running a larger business.
• Accessing funds or valuable assets for new development. Better production or distribution facilities are often less expensive to buy than to build. Look for target businesses that are only marginally profitable and have large unused capacity which can be bought at a small premium to net asset value.
• Your business underperforming. For example, if you are struggling with regional or national growth it may well be less expensive to buy an existing business than to expand internally.
• Accessing a wider customer base and increasing your market share. Your target business may have distribution channels and systems you can use for your own offers.
• Diversification of the products, services and long-term prospects of your business. A target business may be able to offer you products or services which you can sell through your own distribution channels.
• Reducing your costs and overheads through shared marketing budgets, increased purchasing power and lower costs.
• Reducing competition. Buying up new intellectual property, products or services may be cheaper than developing these yourself.
• Organic growth, ie the existing business plan for growth, needs to be accelerated. Businesses in the same sector or location can combine resources to reduce costs, eliminate duplicated facilities or departments and increase revenue.

However, a merger or acquisition can also create its own problems.

If you are thinking of growing your business through a merger or an acquisition you must consider if your business is ready for expansion. You should:

• Carry out a SWOT (strengths, weaknesses, opportunities and threats) analysis to assess your business. Analysing your results carefully will show you how to build on strengths, resolve weaknesses, exploit opportunities and avoid threats.
• Assess external factors, especially the impact of the economic climate, on the price of a deal.
• Ensure that you have - or have access to - the necessary finances.

Assess the deal objectively

Be clear about what you expect from the deal. Any merger or acquisition must be consistent with the strategic direction of the business. Once you have assessed your own business and its finances, you should be confident the deal produces a higher return than investing the same amount of money internally or, if not, that other reasons justify the deal.

Consider a gap analysis

Another strategy technique is a gap analysis. This involves detailed analysis of where your business is now and where you want it to be in the future. By analysing the gap between the two, you can find ways to bridge it.

Remember that apart from paying for the business you acquire, you will have extra expenses to take into account. These will consist of professional adviser fees and the cost of the internal resources that will be taken up by the acquisition process.

There are several ways to find the right firm for a merger or acquisition before you approach the owners.

Making a target shortlist

First, develop a profile of the sort of firm you want. Gather and review as much relevant information as you can on the markets, companies, products and services you need. Once you have developed the target profile, you can:

• Consider firms you sell to, or buy from, already. Many acquisitions and mergers take place between companies that have an existing commercial relationship.
• Encourage senior staff to use their networks to gather information about likely prospects in your sector.
• Circulate the details of what you are looking for. Use investment banks or corporate finance firms who sell similar companies, if appropriate.

The most effective way to find a target is usually through using a professional adviser in your sector. They should be experienced in handling deals similar to the size of both yours and the target business. Although you should typically ask for a shortlist of ten potential businesses, you would normally pay the bulk of the adviser's fee when you have successfully completed business with the final target.

Opportunities to grow by merger or acquisition may exist where the target business:

• is undervalued
• does not use its assets to maximum effect
• would benefit from relocation
• has poor management
• has managers who want to leave or retire
• has complementary products or services which, when combined with yours, will enhance the offering to customers

Approaching a target business

When you have identified a suitable target business to acquire or merge with, you will need to register your interest in doing so with the owners or management of that business.

Make sure the target understands why you are interested in a deal and how you intend to finance it. Prepare the questions you would like answered. This is also your opportunity to explain your business and your future plans.

If you are planning an acquisition, find out if the owner of your target business already has plans to sell and, if so, whether they intend to remain involved in it. Consider their motives for selling.

When planning a merger, consider whether you could work well with the target company's managers and staff. Personality differences can lead to mergers failing.

Many businesses get professional advice from solicitors or accountants to help them decide. If you have not been through this process before, it is strongly recommended that you instruct an adviser at the outset.

If you are considering a merger or acquisition, you should assess your target business. Talk to those who regularly interact with it - the customers and suppliers.

Consider asking customers about:

• the business' products or services
• the comparison with competitors in terms of payments
• who their main contacts are
• how much their relationship with the business relies on dealing with the owner

Ask your target business for:

• Financial information. If you have to rely on unaudited financial accounts, get warranties from the seller.
• Details about their customer base.
• Trends in sales and profit margins.
• Future forecasts. Consider whether forecasts are realistic and tally with your knowledge of the market and its prospects.
• Stock levels and debt collection trends, investments and the business' debts.
• Information about its marketing.
• Information about key employees and their plans - in particular, the extent of the involvement of the owner.
• Information about its systems, suppliers and legal and contract issues.

How the Data Protection Act (DPA) affects business buyers and sellers

The DPA applies to anyone holding information about living individuals in electronic format - and in some cases on paper - from which they can be identified, or information that expresses an opinion about an individual such as appraisal forms. Sensitive personal data includes information about sexuality, race, religion, politics, criminal record etc.

Without the consent of a target business you should confine your information gathering to generic data that cannot be linked to an individual. With the consent of the target business you have more scope, but the target business will need the data subject's permission - if the data subject can be identified from the information - before the information can be passed on to you.

Businesses can amend their data protection notices, contracts and employment contracts to address specifically the possibility of transferring personal data for the purposes of a corporate sale or restructure.

What the industry expert can do

You can carry out much of the assessment of your target company yourself, but you will find it invaluable to get some advice from an industry expert.

Ask their views on:

• market conditions and changes
• factors affecting market prices and margins
• the business' outlook and health
• others in the market

Buying anything for the best price is a matter of skilful negotiation. But if you are considering an acquisition, it is advisable to apply one of the following methods of valuing the target business. Even if you are only considering a merger, you should be aware of how much the other business is worth.

Net asset value

This is the value of the business' assets as stated in the audited accounts, minus outstanding liabilities to creditors or tax authorities, bank borrowings and redundancy payments due. It provides a baseline from which to start the valuation process.

Entry costs versus cost of acquisition

Compare the cost of acquisition with the cost of starting up a similar business, which might include the assets, product development, employment and marketing costs. Include any savings you can foresee by merging the business with your own.

Cashflow

Forecast the target's cashflow for a number of years and discount these numbers to obtain a net present value. If you are unfamiliar with this method, an industry expert will be able to advise on how to choose and apply discount factors.

Price/earnings ratio (P/E)

A P/E ratio is calculated by dividing the company's share price by its earnings per share. If the company's share price is £30 and it is earning £3 per share, its P/E ratio is ten.

To use P/Es to value an unquoted (ie privately-held) business, look up the P/E ratio for the relevant sector in the financial press, eg the Financial Times, then typically apply a discount because the target business is not on the stock market - shares in a public company are much more liquid and seen as more valuable.

A business run by one person is generally valued at around half the value of a comparable private company run by a team of three or more experienced managers. Customers are probably loyal to the owner-manager and may not remain with any new owner.

The economic cycle also affects private business valuations. During a downturn - small private companies sell on multiples of between six and eight on average whilst during a boom - the same companies may sell for between ten and 12 plus.

Accountants, lawyers and tax advisers often have extensive experience in valuations - using their experience will reduce the danger of you paying too much or owning unforeseen debts.

The extent and quality of the planning and research you do before a merger or acquisition deal will largely determine the outcome. Sometimes situations outside your control will arise and you may find it useful to consider and prepare for these risks.

An acquisition could become expensive if you end up in a bidding war where other parties are equally determined to buy the target business.

A merger could become expensive if you cannot agree terms such as who will run the combined business or how long the other owner will remain involved in the business.

Both mergers and acquisitions can damage your own business performance because of time spent on the deal and a mood of uncertainty.

You may also face pitfalls following a deal such as:

• the target business does not do as well as expected
• the costs you expected to save do not materialise
• key people leave
• incompatible business cultures
• resources being diverted from your business' main aims

Get expert advice from professionals, such as management accountants and solicitors, with experience in similar deals to help forecast potential pitfalls and to address any that arise.

Different legal issues can arise at different stages of the acquisition process and require separate and sequential treatment.

Due diligence stage

Due diligence is the process of uncovering all liabilities associated with the purchase. It is also the process of verifying that claims made by the vendors are correct. Directors of companies are answerable to their shareholders for ensuring that this process is properly carried out.

For legal purposes, make sure you:

• obtain proof that the target business owns key assets such as property, equipment, intellectual property, copyright and patents
• obtain details of past, current or pending legal cases
• look at the detail in the business' current and possible future contractual obligations with its employees (including pension obligations), customers and suppliers
• consider the impact of a change in the business' ownership on existing contracts

Always use a lawyer to conduct legal due diligence.

Deal stage

When you are considering general terms of a potential deal you will probably seek certain confirmations and commitments from the seller of the target business. These will provide a level of assurance and comfort about the deal and are indications of the seller's own confidence in their business.

A written statement from the seller that confirms a key fact about the business is known as a warranty. You may require warranties on the business' assets, the order book, debtors and creditors, employees, legal claims and the business' audited accounts.

A commitment from the seller to reimburse you in full in certain situations is known as an indemnity. You might seek indemnities for unreported tax liabilities, for example.

Your professional adviser can assist in reviewing the content and adequacy of warranties and indemnities.

Cross-border mergers

The Companies (Cross-Border Mergers) Regulations 2007 govern mergers between UK and overseas companies. The regulations introduced a framework which removed legislative barriers and made it easier for UK companies to engage in mergers with other companies from within the European Economic Area.

Every UK company involved in a cross-border merger must file the following documents with Companies House:

• a copy of the draft terms of merger
• a copy of any court order summoning a meeting of members or creditors
• a completed cross-border mergers form CB01

These documents must be delivered to the Registrar at least two months before the first meeting of the members.

If the company resulting from the merger is a UK company, an order is made from the High Court or Court of Sessions approving the completion of the merger. Every UK company involved must deliver a copy of this order to Companies House within seven days.

Upon receipt of this order, Companies House will:

• send notification of the order to the register of each company involved from another European Economic Area (EEA) state
• dissolve any UK company that is transferring to another EEA state and place a note in the register stating that as from the date on which the merger took effect the assets and liabilities of the UK company were transferred to the transferee company in the relevant EEA state

If the company resulting from the merger is in another EEA state, an order is made by the relevant competent authority to approve the completion of the merger. Every UK transferor company must deliver to Companies House a copy of the order, not more than 14 days after the date on which it was made. Any order in a foreign language must be accompanied by a certified translation.

When Companies House receives notice of an order from the registry of another EEA state approving the completion of a cross-border merger, it will dissolve any UK company transferring out to it and place a note in the Companies House register. This note will state that, as from the date on which the merger took effect, the assets and liabilities of the UK company were transferred to the transferee company in the relevant EEA state.

If you are contemplating a cross-border merger, make sure you take appropriate professional advice from the start.

After you have registered interest in doing a deal with another business you will probably follow a process that includes the following steps:

• appointing professional advisers - legal and financial
• carrying out due diligence
• valuing the business
• negotiating financing of the acquisition/merger
• making an initial offer subject to contract
• agreeing the main terms of the deal including a payment schedule, warranties and indemnities from the other business
• updating due diligence based on access to the target business
• finalising the terms of the deal - including restructuring of the shareholding, if appropriate
• announcing the deal and communicating it to staff

In the case of a merger, you will need to integrate key aspects of the two businesses, specifically:

• management
• staff
• technology
• communications
• processes, policies and procedures
• payroll
• training
• personnel policies
• invoicing and purchasing systems

The role of professionals

It is important for you to seek professional advice when considering a deal. You may use bankers, accountants, lawyers, surveyors and valuers for different matters. Advisers with experience in deals will help you make the right choice, pay a reasonable price and avoid pitfalls during and after a deal.

Advisers can provide valuable guidance in areas such as valuing the business, financing the deal, terms and contracts, reviewing legal aspects and specialist valuation of specific areas of the business.

Make sure you agree clear terms of reference and how the work of different advisers will be co-ordinated. Advisers may charge fees on an hourly, fixed or contingent - no deal, no fee - basis.

One of the main attractions for a merger or acquisition can be increased efficiency, so you may need to make some staff cuts or changes.

A merger or acquisition will often go more smoothly if the staff in your business and the target business are protected from uncertainty and involved in the process.

Before the deal begins, consider how you can:

• keep key staff informed - bear in mind that some information may need to remain confidential
• retain key staff - eg through bonuses or other incentives
• involve key staff in the due diligence
• get senior staff to take on more responsibilities while you negotiate the deal
• get to know key staff to help you assess abilities and skill levels

Consulting staff

The Information and Consultation of Employees (ICE) Regulations may require you to inform and consult employees on certain aspects of the merger. If you have 50 or more employees you are obliged to agree a procedure for informing and consulting employees if more than 10 per cent of employees request a system.

Where an employer has a pre-existing procedure for informing and fails to consult, employees can complain to the Central Arbitration Committee, who may impose a fine of up to £75,000.

Your professional adviser should be able to guide you as to who needs to know what.

After the deal you may find it useful to see staff individually or in small groups to explain future plans and to answer questions.

Staff issues

Think about staff matters while you are considering a merger or acquisition. These may include:

• skills gaps and how to fill them
• which posts will be filled by staff either from your business or the target business
• pay differentials between the two companies
• how to get staff from both businesses to build working relationships
• how to share knowledge between staff
• appropriate policies and procedures for the combined business
• relocation issues
• trade union matters

It is important to get expert advice to help with staff issues such as new employee terms (including pension provision), changes in employment contracts and your responsibilities to employee rights after a merger or acquisition.

Business Gateway can give you advice on managing your business. Call us on 0300 013 4753.