Acquisitions enable companies to make significant growth in revenue, market, location, technology, and profitability in a short period and at a lot lower risk than long-term organic investments. Despite these benefits, tales abound of businesses that have made poor acquisition decisions. When committing cash and resources to the lengthy identification and due diligence of a potential acquisition, it is essential to have a high confidence level in the initial target selection.

Even if an acquisition is not completed, this process comes at a considerable expense. While extensive resources are available on the due diligence process, the early selection process remains somewhat of a mystery. This second installment of a three-part series on M&A¹ will demystify the processes and criteria with best practices to help identify potential acquisition targets.

Strategic Acquisition Targets

When looking for strategic acquisitions, targets can fall into two major categories: associated with the original business or independent from the initial business to diversify the company.

Associated With the Original Business

Associated acquisitions are typically when a company acquires a new service business to leverage its current capabilities or add functional abilities, additional skills, or resources to its existing teams and services. These acquisitions are generally most helpful to companies with a robust current market share and a desire to provide complementary services to clients or expand into new markets. This could include an electrical contractor purchasing a mechanical contractor to provide additional value “bundled” services to clients or buying to expand geographical coverage.

Independent From the Initial Business

In comparison, independent acquisitions involve introducing businesses with distinct service markets or critical success criteria to those that are not connected to the company’s existing operations. These “independent” companies may have active corporate management oversight involved in the day-to-day operations or may have the corporate parent participate in company strategy, investment decisions, or shared services.

Developing an Acquisition Strategy

The selection of an acquisition strategy is primarily settled on by determining the path that best uses the acquiring company’s current management team and line-of-business managers. When a business has excess functional skills and resources relevant to its type of work, it should evaluate “associated” acquisitions as a viable strategic target.

Alternatively, a company can capitalize on the potential benefits of unrelated acquisitions if it has the ability and capability to:

• Manage a diverse set of businesses;
• Accommodate different company cultures under one corporate umbrella; and
• Leverage the management and financial resources and utilize economies of scale for shared services.

Evaluation Process

A company should establish a detailed evaluation process for selecting acquisition targets with the most significant potential to provide value to the acquiring company. Economic value is created only when acquisitions result in an increase of a combined company’s cash flow. Successful acquisition identification and screening processes primarily:

1. Contain an objective metrics-based ranking to assess the target company’s ability to generate value for the acquiring company.
2. Are relatively simple to implement and use when identifying potential target acquisitions.
3. Have the capability of reflecting the unique business aspects of any company to “normalize” against other target companies in a like-for-like manner.

Alignment With Company Strategic Goals

A company’s target acquisition evaluation process should be tailored to its unique strategic objectives. For instance, as a part of its strategy, a company that is flush with cash and anticipates significant capital investment requirements in four years may have to invest a portion of their profits into an acquisition to purchase the company. The acquired company should be financially self-sufficient and produce positive cash flow to address company requirements. This strategy lays out a high-level plan for acquisition, a timeline for a return, and the use of the proceeds.

Specifying the worth of each measure spurs managers to examine the acquisition as part of a larger plan for company objectives, available resources, and employee skill sets. Developing these steps as part of a strategic plan may customize general principles frequently found in a target acquisition evaluation process matrix. A statement may even be needed for each metric evaluated as part of the process to define the minimum or maximum value tolerance. For purchasing companies, these metric rating ranges will represent the importance of each issue.