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Evaluating Acquisition Targets
Evaluating a Company for Purchase
There are three aspects to evaluating acquisition targets, the financial aspects, the non-financial aspects, and the company's future prospects. Each aspect is discussed in more detail below:
Financial Aspects
Determining the financial value of a business can be done via a variety of methods, which are covered in detail on our flagship website Guide To Selling A Business. As a buyer you can use these techniques and our free online calculator at FreeValuationsOnline.com to determine the value of an acquisition target.
As a buyer, you will be provided with the information needed to value the business by the seller (or the seller's business broker). When you get that information there are a few items that you need to watch out for, because there are assumptions used to derive the information that you may not agree with. These items that you need to question when valuing a potential acquisition are:
Fair Market Value of Inventory — The seller will provide you with a fair market value of the inventory (or they may just use the book value). However, inventory may be obsolete or the market price may have changed since that value was obtained. If the inventory value is material you need to independently verify the value of the inventory.
Fair Market Value of PP&E Just like inventory, the fair market value of property plant and equipment is something that buyer and seller may not agree on. Sellers may want to value Property Plant and Equipment at cost or replacement value. As a buyer, however, you'll want to value based on liquidation value (what you could sell it for today).
Extraordinary events that should be discounted If the business invested in Lottery tickets last year and won, they'll want to include that income in the valuation. As a buyer, you want to discount one time extraordinary events, since they are unlikely to happen again.
Add Backs — A business owner may want to add back expenses that were for their benefit but that you are unlikely to incur. For example, the corporate jet, the company yacht, and the $100,000 donation to their alma mater, are all legitimate add-backs. R & D is a legitimate add-back if the company is in the rope business and tried to develop a rope made of hamster hair that never produced any revenue (though how much they actually spent on the R&D may be impossible to determine). However, a software company developing the next version of their software has no legitimate reason to add back R & D — it is just a cost of being in the software business.
Fair Owner Compensation — Owners may often try to subtract their own salary and benefits from expenses. You will, however, either need to hire someone to replace the owner or do the work yourself. In either case, the labor that they owner is doing has value and you need to determine a fair salary for the owner, not let the owner claim that their time is worthless or worth very little.
Recent changes — If there have been recent changes that will affect the ongoing performance you may want to project back what would have happened if those changes had happened earlier. For example, I had a client that was buying a non-emergency medical transportation provider that had a long term contract with a state government. However, the price of gasoline went up sharply and the contract did not allow fuel costs to be passed through, so the business's future was not as bright as the past.
Pipeline stuffing — Be wary of large sales just before closing. You don't need all of your customers sitting on warehouses full of your new product because they got a discount to buy in bulk just before closing.