Accounting, Financial, Taxation

Financial professionals play a critically important part in all M&A activities. Often CFOs, controllers, and their functional equivalents (throughout this chapter referred to as financial officers) are logical candidates to play a central role in the acquisition process, and invariably should be involved in the transaction from beginning to end.

Although executed for strategic purposes, acquisitions are essentially financial transactions. As such, a fundamentally sound acquisition process typically draws on these skills and expertise of the financial manager:

1. The ability to apply rigorous financial analysis to ensure sound decision making
2. An understanding of the tax implications associated with the various forms a transaction may take
3. An understanding of the applicable regulatory requirements
4. The ability to model and/or critically evaluate business valuations
5. Familiarity with the various financing options available as well as the ability to take a leadership role in structuring a financing package, if necessary
6. Familiarity with the principles of acquisition accounting and their application
7. The ability to plan, coordinate, and execute an efficient and effective due diligence review

In addition to these financial/accounting capabilities, the senior financial officer involved in the acquisition process should also have strong leadership, organizational, and communication skills. A successful acquisition requires a substantial amount of cooperation and coordination among professionals and experts, both financial and non-financial, within and outside the acquiring company. It is imperative that those providing leadership ensure that the process is rationally structured (i.e., that the steps in the process are properly sequenced) and that the efforts of all those involved are not compartmentalized (i.e., that individual efforts are integrated and that all valid inputs are synthesized).

Coordination

As a member of the core team managing an acquisition, the financial officer will have responsibility for coordinating much of the planning and execution of internal and external team members. This includes various line managers within the acquiring organization, as well as accounting, tax, and legal and other specialists who may reside outside the organization and/or in corporate headquarters in the case of larger, multilayered organizations.

1. Internal Coordination. The financial officer within the acquiring organization will generally be a co-equal partner with the business executives tasked with evaluating the merits of a transaction, making recommendations whether or not to proceed, and developing a plan of action, if the transaction is to be pursued. Additionally, he or she would play an important role in determining what internal resources would be needed to further evaluate the target company, to perform due diligence and, ultimately, to execute the transaction.
2. Coordination of External Experts. The financial officer is the logical point of contact in dealing with a wide range of accounting, tax, legal, and regulatory issues and processes. Outside accounting and auditing resources may be accessed to conduct preliminary assessments and financial due diligence. The financial officer must also interface with the target company’s internal and outside accountants. And, he or she will have responsibility for ensuring that acquisition accounting is properly implemented. The financial officer is also the logical coordinator of input from internal tax professionals or external tax advisors. Tax expertise is drawn on early in the acquisition process to determine the tax ramifications in structuring the transaction and is involved in the post–due diligence stage to ensure optimal tax treatment prospectively. Financial and legal considerations intersect frequently throughout the acquisition process. The financial officer is the logical individual to coordinate with legal counsel to ensure compliance with regulatory requirements and coordination of tax and legal issues, including the drafting of the Letter of Intent, ensuring compliance with SEC regulations, state law, and antitrust statutes, and negotiation of the final Purchase Agreement. The financial officer also has a role to play in the financing process. This can range from the simplest type of involvement for a large company, such as notifying the corporate treasury function that money has to be wired to the bank of the sellers at closing date, to very complex negotiations with those funding the acquisition for a smaller organization.

Financial Analysis

Not surprisingly, the financial officer plays an important role in analyzing the transaction and modeling the target company’s business. This includes, among other things, evaluating the target company’s business model and financial dynamics in the context of the acquirer’s investment objectives and establishing the value of the target company.

1. Financial Criteria and Metrics. The financial officer provides critical input on the appropriateness of strategic fit, the reasonableness of projections of growth and profitability and assumed synergies and efficiencies, as well as comparisons of the acquiring company’s projected performance before and after the proposed acquisition (to measure such things as potential accretion and dilution). These are important judgments and measurements for establishing a basis for a preliminary decision to proceed with a transaction.
2. Valuation. Establishing a preliminary view of value and updating that view as additional information becomes available is a major role of the finance function in the evaluation of an acquisition. There is a variety of valuation methods used in the acquisition process, but larger, acquisitive organizations generally have a standard approach and models that are used to determine value, returns on invested capital, and other investment hurdles. Smaller, less acquisitive organizations may engage a valuation expert on a consulting basis. In either case, development of a credible valuation model requires a detailed understanding of the financial dynamics of both the acquiring and target companies and how synergies and efficiencies can be realized (and quantified) by the two. The financial officer is, unquestionably, in the best position to make these determinations.

Determination Of Deal Structure

The financial officer is a key player in determining how the transaction can optimally be structured. Some of the major aspects of the potential structure he or she would consider are:

1. Assets versus Stock. Almost invariably, the buyer will prefer to buy specific assets (vs. the stock) of the target company, because it enables the buyer to be selective about which assets are purchased and reduces the buyer’s exposure to hidden liabilities and generally reduces its tax liabilities. Conversely, the seller will prefer a sale of stock, so that unfavorable tax treatment can be avoided and all assets and all liabilities are included in the transaction. There are special situations in which the seller can treat a stock sale as an asset sale and the buyer can realize some of the benefits of an asset sale. The financial officer, often in combination with tax specialists, can determine the range of acceptable options and quantify their costs and benefits.
2. Earn-Outs. Earn-outs are an approach to risk sharing between the buyer and the seller. They provide the seller with upside potential in the form of additional consideration tied to company’s post-acquisition performance above a defined level (usually measured by revenue and/or profit). The financial officer is in the best position to determine if the use of an earn-out makes strategic and economic sense and, if so, how the earn-out should be structured.
3. Working Capital Adjustments. Letters of Intent will frequently require that sufficient working capital is left in the business at the point of the acquisition to fund ongoing requirements. In such cases, if the working capital falls below that level, then the purchase price would be adjusted downward accordingly. These adjustments are designed to offset any unusual removals of cash from the business. An analysis of the working capital dynamics over time by the financial officer is necessary to determine a fair and suitable working capital target, if a working capital adjustment is contemplated.

Due Diligence

Clearly, the lead financial officer involved in the acquisition should have responsibility for financial due diligence. This would include establishing due diligence objectives, managing the process, and reporting on its results. These functions are briefly discussed below:

1. Establishing Due Diligence Objectives. Although the due diligence process varies from transaction to transaction, there are some aspects of the process that are standard, regardless of the size and nature of the transaction. This includes the overarching objectives of the review, which are to verify historical results and to validate forecasts and key assumptions (such as synergies, growth rates, and anticipated efficiencies) related to the valuation that the acquirer has established. The financial officer should be the primary architect in establishing these objectives.
2. Managing the Due Diligence Process. By virtue of expertise and experience, the finance function is a logical one to take a lead role in structuring the due diligence program and process. A due diligence review is by no means the same as an audit. Constraints on time and resources limit the depth of the evaluations conducted. However, a due diligence review is analogous to an audit, and the types of procedures that should be reflected in the program are not unlike what one would find in an audit program. The financial officer and his or her staff will generally have the experience and expertise to shape the program and coach non-accountants in performing the review.
3. Reporting on Results. Finance professionals are co-equal commentators, along with the business managers involved in the process, on the results of the due diligence.

Because an acquisition is fundamentally an investment decision, recommendations to proceed or to disengage will largely be based on whether due diligence supports or contradicts the valuation that has been established. The financial officer is clearly in the best position to make such determinations.

Further worth reading about merger and acquisition:

Managing Merger and Acquisition (M&A)

Central Role Of Strategic Planning In The Merger And Acquisition Process

Types Of Merger and Acquisition (M&A) Activity

Merger & Acquisition (M&A) - Acquisition Process

Merger and Acquisition (M&A) - Sales Process

Merger and Acquisition (M&A) - Divestiture Process

Divestitures are sales of a segment of a company’s business, such as a business unit, a product line, or even an individual product. Divestitures historically have accounted for a sizable percentage of all M&A transactions executed (estimated to be about 25% in recent years). Decisions to divest or dispose of a segment of a business generally originate once it becomes evident that the unit in question is no longer compatible with the strategic direction of the parent company. Divestitures are generally proactive initiatives that lend themselves to detailed planning and execution. Management of these transactions can be broken down into three distinct phases:

Divestiture Planning

Divestiture planning begins with the development of a paper that lays out the rationale for disposal. That document becomes the basis for corporate approval (from the CEO or the board), which is the trigger event for launching the initiative. Approval will be followed by the development of a retention plan (with incentives) for key personnel associated with the property being divested, to minimize business disruption and loss of productivity. At about the same time, a team charged with responsibility for the transaction should be assembled. The first priority of that team should be to develop a detailed divestiture plan that would identify objectives, assign responsibilities, outline the sales process, and establish a timeline for implementation. The final element of the planning process should be the creation of a communication plan for announcing the prospective sale and its rationale to the employee populations (those of the parent company and those of the business being divested) and external constituencies, such as customers, suppliers, contractors, and, if appropriate, shareholders and the investment community.

Transaction Preparation

The vast majority of divestitures are made by large businesses, frequently publicly traded companies. These companies usually opt to use a business broker or investment banker to assist in the sale. In these situations, the first step in this phase of the process will be to engage the broker or banker. If the business unit to be sold is of substantial size and is integrated into the infrastructure of the parent company, the seller might also engage an accounting firm to “carve out” dedicated financial statements that fairly represent the historical performance of the unit being sold.
With assistance of the broker or banker, and under the direction of the divestiture team, the key managers of the business being divested would develop an offering memorandum or prospectus that would eventually be sent to possible buyers. In a similar manner, management presentations would be developed to be used by the management team to describe the business to a limited number of qualified, potential buyers after the field is pared down. Concurrently, business, legal, and financial documents of interest to a buyer would be assembled in a data room, a location where the information would be stored and indexed awaiting buyer review. During this phase, a list of potential buyers would be created by the broker or banker and vetted by the divestiture team. Once all of these tasks have been completed, the process would be ready to move to the execution stage.

Transaction Execution

The execution phase of the process begins with the announcement of the prospective sale. This announcement is essentially the implementation of the communication plan. Shortly thereafter, the seller would solicit initial bids from the list of potential buyers. Generally, a limited number of qualified buyers would be invited to participate in due diligence, and, ultimately, the field would be narrowed down to the final buyer. The parties would then proceed to contract and close.

Importance Of Proper Planning And Disciplined Implementation

The transactions just outlined are generally of a material nature and entail significant risk for the participants. Although proper planning and disciplined execution cannot eliminate the risk inherent in such transactions, attention to preparation and execution can serve to substantially mitigate that risk. Although there is tremendous variability among and within the types of transactions described, several principles worth noting should be adhered to by those who manage M&A activities. They are:

1. Leave as little as possible to chance. Establish clear objectives and develop detailed plans to attain them.
2. Ensure that transactions are properly resourced. Draw on internal and external capabilities as needed and consider them investments, not expenses.
3. Respect the importance of staging and event sequencing within a transaction. Transactions may differ in many respects, but they all follow a logical and natural process. Remember the adage, “Nine women can’t make a baby in a month.”
4. Do not be afraid to walk away from a transaction. Do not give in to the temptation to salvage a transaction that does not make strategic or financial sense. At any point in time, the costs—both financial and psychological—should be considered sunk costs.

Further reading about Merger and acquisition (M&A):

Central Role Of Strategic Planning In The Merger And Acquisition Process

Types Of Merger and Acquisition (M&A) Activity

Merger & Acquisition (M&A) - Acquisition Process

Merger and Acquisition (M&A) - Sales Process

Role Of The Financial Manager In Mergers And Acquisitions

In contrast to an acquisition, the process associated with selling a business is considerably more reactive. However, it too can be broken down into several distinct phases, specifically:

Pre-negotiation Preparation

The seller of a private company often has no prior experience in navigating the issues encountered in such a sale. Once serious discussions with a prospective buyer begin, the seller should enlist the assistance of a number of advisors. This should include an attorney with M&A experience and some combination of business, tax, and financial professionals who are skilled in the M&A field. The primary area of focus for the inexperienced seller should be an understanding of the value of the business being sold, the tax impact of the terms of the sale, and how the transaction will unfold. Accordingly, the professionals engaged should provide expertise in these areas. In addition, the seller will want to mobilize a limited number of internal managers to assist in early-stage discussion and data assembly. To minimize the potential for business disruption and reduced productivity, it is generally advisable to keep this group small and to impress upon them the importance of strict confidentiality. One other potential member of the seller’s team may be a business broker or investment banker.

Their understanding of the market and the sales process can be of significant value. However, the seller must determine whether that value is likely to be in excess of the commissions paid for their services.

Public company sales, as noted earlier, are considerably more complex than private sales. Similar to the private seller, the management of a public company will seek out M&A expertise. However, at this stage of the process, management will also maintain an ongoing dialogue with its board as the transaction takes shape.

Negotiation

There are a number of major elements to be considered in structuring the transaction: price, the form of the sale (stock or assets), the form of the consideration (cash, debt, stock, or a combination), tax implications, the ongoing role of the seller (if any), and, possibly, the impact of the sale on the seller’s employees. As a result, the negotiation process can be expected to be iterative and protracted. Expert input in the areas of greatest importance and an understanding of interrelationships (e.g., tax and valuation implications on the form of the transaction) are critical. From a strategic perspective, the seller, with the assistance of his or her team, should identify deal breakers and establish a walkaway position and be prepared to discontinue discussions if issues critical to the seller cannot be resolved.

The negotiation process is not necessarily different in concept for a publicly traded company. The major difference lies with the number of individuals involved in the process. A public company will enlist a substantial number of advisors and will involve the close participation of board members as well as the most senior members of its management team. In sharp contrast to a smaller transaction, especially one in which there is owner management, the communication and decision-making process can be quite Byzantine.

Due Diligence

The parameters of due diligence are negotiable but, under any circumstances, preparation for and administration of due diligence requires the dedication of a substantial amount of company resources. Due diligence consists of extensive document review and analysis, management presentations, interviews of key personnel, and tours of facilities. Creation of a data room (the locus of document review) is a labor-intensive activity, and preparation of management presentations can be expected to tie up key managers and their staffs for substantial periods of time.

The length of the formal on-site due diligence process varies but will generally span several days to several weeks, depending on the size and complexity of the company being reviewed. Clearly, review of large public companies with multiple locations will require more time and staff power than review of small closely held businesses. In addition, there is a vast amount of historical financial and business information available in the public domain for publicly traded companies. In the broadest terms, due diligence includes analysis of such information outside the framework of formal on-site diligence.

Although these activities have no impact on seller’s resources, it is worth noting that, from the buyer’s perspective, they may in fact dwarf the efforts associated with the formal, on-site due diligence review.

Contract and Close

Negotiation of the final contract (or definitive agreement) can be a lengthy, iterative process. Even for small deals, the final contract may take in excess of a month to negotiate. Typically, the seller is supported by his or her M&A attorney, a financial advisor, and/or the company’s chief financial officer (CFO). This is the point in the process where the attorney is of greatest assistance and value. Negotiation of the granular detail of the transaction requires someone who is intimately familiar with the process, the associated documents, and the issues. By virtue of training and experience, a good M&A attorney will have mastered the first two of these items.

Participation in the acquisition process from the beginning will have provided the attorney with the basis for dealing with the issues. That said, the active participation of the seller and his or her financial advisor is critical to ensure that business and financial issues are quickly and properly resolved.

In the case of private companies, contract and close can occur simultaneously, unless there has to be an HSR filing. As noted earlier, closing on public company acquisitions is more complex, and the time from contact to close is substantial and requires an affirmative vote by the board and, ultimately, the approval of the stockholders.
Further reading about Merger and acquisition (M&A):

Central Role Of Strategic Planning In The Merger And Acquisition Process

Types Of Merger and Acquisition (M&A) Activity

Merger & Acquisition (M&A) - Acquisition Process

Merger and Acquisition (M&A) - Divestiture Process

Role Of The Financial Manager In Mergers And Acquisitions