Part 2 in Tercera’s series on services M&A
You’ve done it! You’ve found what appears to be “The One”. You’ve found an acquisition target that appears to check all the boxes of your M&A strategy and completes you in some way.
You’ve now gone through the dating phase that we covered in our previous M&A blog, and you’ve come out the other side aligned on high level terms and an agreement to enter into exclusivity. Congratulations!
Now it’s time to REALLY get to know each other. You guessed it, diligence.
In Part 2 of our M&A series, we’ll explore how to make the most out of the due diligence process, what timelines to expect, what data to assess, and how to analyze it. When it works, it can create a winning combination for the acquirer and the target. But it is important to go in with an open mind and follow the right steps to get the best outcome.
How do you make the most of diligence?
As you enter the diligence phase, an information imbalance exists between buyers and sellers. Sellers know far more about their business than the buyer does, and their goal is to ensure their business looks as good as possible. It’s the buyer’s job to rectify that imbalance and learn as much as possible in a relatively short amount of time.
During diligence buyers must temper the excitement of the dating phase, in favor of vigilance and skepticism. It’s important to know what you’re walking into with eyes wide open.
During diligence buyers must temper the excitement of the dating phase, in favor of vigilance and skepticism.
It helps to go into diligence with the question, “Why is this company selling?” Do they know something about their business that makes them want to sell it today? Are they getting pricing pressure that’s driving down their gross margin? Is their largest customer coming to the end of their contract and at risk of leaving?
The last thing you want is a negative surprise rearing its head shortly after close. By digging deep into the data and asking the right questions, you can minimize that risk.
Diligence is also a time for teams to get to know each other, to understand each other’s business, customers, partners, cultures and work styles. Unfortunately we have seen a lot of deals that made a lot of sense on paper, but as the two companies began to work together, the culture and styles clashed, which ultimately made the acquisition fall apart. It’s important to try to recognize that culture fit prior to the deal closing. This is what makes acquisitions particularly tricky in people-based businesses, and is why many M&A “roll-ups” fail over time.
Diligence is also a time for teams to get to know each other, to understand each other’s business, customers, partners, cultures and work styles.
If both firms go in with the mindset of wanting to get to know each other and form a true partnership, post-merger integration (the subject of our next blog in the series) goes a whole lot smoother.
How long should you plan for diligence?
The timeline for an acquisition varies significantly, depending on a variety of dynamics. The timeline below shows a typical 12-week timeline, but this could change based on a number of factors such as whether there’s a banker involved or if it’s a competitive bidding situation.
Don’t underestimate the time it could take to pull together the cuts of data you might need or the time for legal negotiations. No diligence process is exactly the same. Some companies are more sophisticated than others. Some deals are larger and more complex than others and require more scrutiny. And acquiring a partner in an adjacent industry segment is different from acquiring a competitor.
If the company you’re looking to acquire is a competitor, the diligence process can prove to be especially tricky. They need to be reassured that intentions are sincere and an acquirer is not merely fishing for competitive intelligence. After all, you are asking them to air their dirty laundry, customer lists and pricing, and secret sauce. Not surprisingly, they may be reluctant to share this data until very late in the process after you can show conviction in closing the deal in short order. In these instances, NDAs become more important and certain data may need to be redacted to conceal sensitive information.
Diving into the data
Here are some of the most common requests within a diligence process, why they are important, and what pitfalls to look for in the data. This is by no means a comprehensive list, and there are often secondary data requests needed to clarify or confirm trends in the initial data. An experienced investment partner like Tercera will be able to help either an acquirer (or a target) navigate and customize these requests.
Historical financials:
This includes profit and loss (P&L) statements, balance sheets and monthly cash flow statements for at least the last 3 years (ideally more). The P&L lets you assess revenue growth, gross margins, and total operating / profit margins to understand growth trends, areas of over or underinvestment, and allows you to see and verify potential synergies with your company.
It is important to view the trends monthly to understand if recent trends reflect the larger picture. Is the company’s growth slowing down? Is it driven by one service line or is it across the board? If gross margins are trending down, is it because of pricing pressure, rising labor rates or a shift in customer mix? The balance sheet can also show how efficient the company’s billing and collections teams are, as well as any debt that needs to be paid off or refinanced during the acquisition
Projected financials:
This is their budget and forecast, which will lay out the financial plan over the coming year(s) and where and how they plan to grow. Depending on the sophistication of the finance function, these can vary wildly in accuracy and achievability. The only thing we know about a financial forecast is it’s wrong (nobody can truly accurately predict the future), but it is important to understand what management believes to be a best efforts representation of their business in the future. If the company has budget-versus-actual reporting for the historical period, this can help you gain confidence in the target’s budgeting and forecasting abilities.
Backlog and pipeline:
This is about getting comfortable with visibility into future revenue. Analyzing backlog (signed contracts that are yet to be worked on) and pipeline (potential future business, not yet signed) together helps you determine the achievability of the forecasted revenue. We cover additional analysis of revenue visibility in our budgeting and forecasting playbook.
Historical revenue by customer:
Getting this data for the last 3 years (ideally more) is not always easy and can be a touchy subject, so often customer names are left redacted. However, historical revenue by customer allows you to assess customer concentration risk as well as customer retention. You will also want to dig into the work they are performing for each customer, how they won the customer, and the future outlook for retaining and growing the customer.
Historical operational metrics:
This includes bill rates, utilization, goodwill hours, and customer satisfaction (CSAT). Bill rates indicate pricing power with customers. Utilization reveals how effectively a firm keeps its delivery employees billable. Goodwill shows the proportion of hours worked for a client that were not billable. All of which greatly impact gross margin. Customer satisfaction (CSAT) measures how satisfied customers are with the services delivered.
Talent data:
This could include items such as the organization chart, employee mix, and attrition rates. The org chart helps identify key personnel and their roles in the organization. The mix of employees by geography, type (direct versus contractor) and seniority offers insight into the composition of the employee base coming into your organization. The direct-versus-contractor split is important for what it reveals about cost structure and the ability to scale up or down. Attrition measures how quickly employees leave, either voluntarily or involuntarily. It is a critical metric that provides insight into workforce stability and the effectiveness of employee engagement and retention.
Capitalization table:
The cap table details the company’s ownership structure, showing the percentage held by founders, investors, and other stakeholders. This is essential for understanding the stakeholders required to approve an acquisition and how much money each key member will make in the transaction. If their involvement going forward is critical to the success of the transaction, will they have enough money at stake going forward relative to the amount they will receive at close to remain motivated to create a successful business.
From “what” to “why”
Once you have the data, you have the “what”. You know what their historical trends are, what their customer concentration is, what their operational metrics are, etc. But it takes a keen analytical eye and the ability to ask the right questions to answer the key question “why”. Why is revenue growth slowing? Why are operating expenses growing? Why is customer concentration diminishing?
Understanding the “why” allows you to more effectively forecast business performance, which will help determine if you still want to buy this business and if you are paying the right price.
Understanding the “why” allows you to more effectively forecast business performance, which will help determine if you still want to buy this business and if you are paying the right price. No business is perfect, but it’s important to know the “why” behind negative trendlines to understand the impact on a business.
For example, we would feel a lot better about slowing revenue growth if it’s driven by an intentional services shift to a more profitable service line than if they are struggling to sell to new customers.
Some of the “why” can be answered in analyzing the data. You may see, for example, that customer concentration declined because the largest customers remained flat while the company added new customers. Gross margins may have improved because of a mix-shift in geography of their workforce moving to lower-cost delivery centers.
But a critical part of answering “why” comes from meeting with the management team and asking the right questions. Have them walk you through the data that they have put together while you ask “why” along the way. Show them the analyses you have been creating from the data they have sent across.
Raise the concerns that you have throughout the process. If they are not answering questions to a level that makes sense to you, feel free to ask the question a different way. This is not an interrogation, more like an interview. Sometimes teams can’t answer “why” themselves, so a working group might be needed to figure it out together.
These meetings are also a great opportunity to understand the management team of the potential acquisition. For example:
- How do they think and interact with each other? Is the CEO the only one answering questions? That may be a sign that she or he does not empower the team to solve problems and could raise a concern around the effectiveness without that person.
- When your head of sales meets their head of sales, do they see opportunities to work together?
- How would members of their management team fit within your organization? It’s not often the case, but acquisitions could be a perfect tool to fill holes with folks that otherwise would not be available.
Be thoughtful on who you bring into the process and how
As you make your way through diligence, communications should be handled thoughtfully and progressively, bringing more and more stakeholders under the tent as the deal progresses.
Initial discussions may be highly confidential, involving only the CEO, CFO or corporate counsel. However, as things progress, more members of the leadership team – and potentially a layer beneath them – may need to be brought in on both sides. It’s also tough to see the strength of the team you’re bringing on if they’re not involved.
On the flip side, remember they are also evaluating your organization. Being acquired can be an emotional process, so they way you bring them in and delve into the data matters. At the end of the day, people are the asset in technology services, and no acquisition is successful if the people walk away post-close.
At the end of the day, people are the asset in technology services, and no acquisition is successful if the people walk away post-close.
Finally, be conscious of how you use people’s time. Usually the stakeholders involved in these deals are CEOs and management teams who still have to keep the business running well while managing all kinds of different requests. This is why it is beneficial to have a partner (an investor and/or an investment bank) on your journey who has seen M&A before to help you along the way.
An acquisition can often involve bold new strategies, life changing wealth transfers, and big changes in the livelihoods of stakeholders. We always say that there is always one point in every deal where you think it will fall apart, but if you can make it through that, you can emerge with a battle tested partnership and a game changer for your business.
If you think you need a partner to help you navigate this journey, Tercera may be able to help. Reach out to us here.
