All M&A transactions have a lot in common. The acquirer must perform rigorous due diligence to verify the history and quality of the target company’s earnings, the validity of its assets, the collectability of its Accounts Receivable, the extent of current or potential litigation. Risks--such as customer concentration and threats from competitors—must be carefully considered.
But when a transaction involves a middle market company whose value consists largely of its technology and intellectual property (IP), one issue is especially important for due diligence. The acquirer or merger partner must question rigorously the value and relevance of the acquiree company’s technology going forward. My experience as CEO of several middle market companies that produce and sell technology-intensive products has taught me: ignore this step at your peril.
Consider what is at stake in many acquisitions. To satisfy their investors and drive a rising valuation, firms that own a portfolio of niche technology manufacturing companies must deliver top and bottom line growth every quarter. To meet this goal, the parent company or private equity sponsor needs to see its companies achieve consistent organic growth and margin improvement from operational efficiencies. Many such companies also pursue a strategy of strategic acquisitions: bolt on acquisitions and platforms for future roll ups. To justify and sustain the funding for this kind of aggressive growth strategy, their acquisitions must deliver consistently: in the short- and longer-term.
Avoiding M&A Disappointments
Too often the evaluation of a company and its products rests on a forecast of future growth that simply projects past revenue trends forward. No matter how stellar the acquiree’s technology has been in the past or how impressive its past earnings growth, a buyer or merger partner must be prepared to ask some tough questions about whether its core technology will continue to deliver value. If its core technology is in transition or is likely to be soon, the impact on the company’s future product road map must be carefully considered.
5 Questions To Ask
To validate your investment hypothesis, you must ask five key questions:
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Do the CEO and management responsible for R&D and Marketing have a well-grounded conviction about where their technology and products are headed?
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Does the technology deployed in the product have a future life--or is it about to be replaced or significantly modified?
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Does the company have a history of predicting market, product and technology transitions accurately—and developing a road map to plan product transitions?
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Has the company demonstrated the engineering, R&D and marketing capabilities to manage such product transitions?
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Does the company have a record achieving revenue growth from new products?
Only answering these questions in the affirmative will make you confident about the target company’s future earning potential.
Avoid Unpleasant Post-Deal Surprises
Remember that, even in the best of circumstances, the period after an acquisition involves a great deal of distraction—for example, providing information to the acquirer and explaining the business to them. This can lead to a loss of short term focus on the day to day nuts and bolts of markets, customers and operations. Even the best transition creates organizational stress. Discovering that revenues are not growing as forecasted and do not justify the price paid for the company will put the company in immediate turnaround mode. The new owners start to distrust management, compounding the problem.
Seeking rigorous answers to the 5 Questions above before committing to the deal can avoid this scenario. In the second part of this article, I will discuss a real world example of what happens when the questions above are not answered satisfactorily.
About the Author
Mike is an experienced CEO who has a record of achieving sustainable sales and earnings growth with domestic, international, public and private companies, both large and small. Learn more or contact Mike directly here.
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