Mergers and Acquisitions Analysis

Most businesses grow in two ways: by attracting more customers and through the mergers and acquisitions process. A merger occurs when two companies join forces to form a new company, and an acquisition occurs when a company buys one of its competitors.¹ Mergers and acquisitions (M&A) aren’t simply a way to reduce the pool of competitors. They also serve as a good way to diversify product or service offerings, access intellectual property, enter new markets, and gain valuable employees.

There are many reasons a company owner would sell businesses. One owner might want to retire without putting a succession plan into place. Another might be interested in expanding the business but lack the capital to do it. A rival might also create conditions under which it becomes tempting for the owner to sell—or difficult not to.

Keep reading here to explore the processes involved in mergers and acquisitions.

The common types of mergers or acquisitions are vertical and horizontal.² In a vertical merger, a company acquires one of its suppliers. In a horizontal merger, two companies in the same industry merge to form a single, combined company.

In many instances, acquisitions are approved by the leadership of both companies, and each team draws up terms and conditions that benefit both parties. This is known as a friendly takeover.³ If the board of the company being acquired does not agree to the sale and it goes forward anyway, it is known as a hostile takeover or a hostile acquisition. These usually happen when the acquirer purchases more than a 50% share in the target company. Alternately, the company looking to purchase might offer more than its target company is worth to inspire the owners to sell.

If the acquiring company got shareholders to vote on the transaction, their filing with the Securities and Exchanges Commission will reflect this. Called a merger proxy, it makes key information about the deal available.⁴

Acquisitions can also be longer- or shorter-term. Strategic acquisitions occur when one company wants to buy another company to meet its long-term goals. Financial acquisitions occur when a company buys another company, fosters its growth over a limited time, and sells it.

M&A require significant financial investment, so there are important steps to take before completing them.

Before a company chooses to sell, its owners usually prepare a memo of intent to see if there is any purchasing interest in the market.⁵ If there is interest, prospective buyers will typically research the company to set goals and objectives and determine if the acquisition makes sense for them.

If a buyer determines that buying its target company makes sense, then due diligence usually includes conducting a valuation of the company to see if the deal is legally and financially sound. During the financial due diligence process, the buyer gathers information and examines financial statements to determine how much the target company is worth.⁶ This is followed by a business valuation, in which the buyer compares those results to market trends to determine the fair market value of the target company.

Based on due diligence and valuation, the buyer and the seller set an initial price for the acquisition. At this stage, each company’s legal team identifies and manages risks involved with the sale, prioritizes their company’s objectives, and determines how to structure the sale.⁷

During deal structuring, each company identifies concerns and evaluates terms and conditions to make sure the deal benefits both parties. They then make offers and counteroffers until they reach a final purchase agreement.

Following a successful sale, each company's owner must determine how best to integrate its workforce, procedures, intellectual property, and other business aspects into the new company. A company can choose to capture some aspects of the acquired company without disrupting its operations, which is known as targeted integration.

If two companies merge into a new company, they need to collaborate on a name, branding, and other specifics. If one company acquires another, it works with the target business to manage cultural and operational shifts.⁸ Each company also needs to develop a strategy for announcing the merger and marketing new goods and services to the target company’s existing clientele.

You will need to know how to calculate a company's value as part of the mergers and acquisitions process, whether you're working for the buyer or consulting with the companies involved as they consider acquisitions. Financial analysis in M&A supports solid financial planning.

This valuation method involves using the metrics of a similar business to determine your target company’s value.⁹ Doing CCA analysis, you would identify comparable companies and evaluate cash flows and other financial information to assess how the target company stacks up against its peers.

You may calculate these values related to sales, price compared to earnings, and price compared to sales. These calculations can tell you if the target company is overvalued, undervalued or aligned with the market.

The PTA method involves analyzing similar companies that have sold in the past and analyzing the dollar value of each acquisition.¹⁰ This method isn’t as common for M&A valuations, because you have to factor in market conditions and other variables that impact sales price.

To value the target company’s potential future value, use the discounted cash flow analysis. This valuation method involves projecting future cash flow over a set period and discounting the future value to get an accurate idea of the company’s present value.¹¹

For this valuation method to yield useful data, you need to assume that the target company is easily able to increase its cash flow, and you need to estimate its terminal value (the value at the end of the measuring period) accurately.

Financial modeling is important for M&A, because it helps you make strategic decisions instead of buying a company and ending up with a lemon. This process starts with a pro forma financial statement, which consists of reports–such as an income statement or a profit and loss statement–made with projected revenues and expenses over a fiscal year or another defined period.¹²

You can use these pro forma statements to run a sensitivity analysis or engage in scenario planning. In sensitivity analysis, you slightly tweak one value in the pro forma to see its impact. For example, you might make one statement with current values and then another showing how a 5% drop in sales impacts the company’s financials.¹³

Using sensitivity analysis helps you analyze multiple potential scenarios to determine the risk associated with acquiring or merging with a company. If the company is still profitable in multiple scenarios, you might determine that the acquisition deal is a good investment.

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