Diligence and Integration: Five Focal Points to Guide Corporate Growth
Many businesses seeking to grow through acquisitions are finding it increasingly difficult to ensure accurate valuations, validate a promising investment thesis, and prioritize sound diligence processes that pave the way for a successful integration. Despite ongoing labor disruption and supply chain constraints—many of the recommended diligence and acquisition strategies remain unchanged, although the pandemic continues to shape the lens through which these strategies are viewed.
Drawing from the best practices highlighted in a study and recent panel discussion, corporate development teams can benefit from five key focus areas that range from questioning the new normal to ensuring human capital considerations are not overlooked. Here are several go-to strategies that corporate development leaders should keep in mind:
1) Integrated diligence efforts are paramount.
Most M&A scenarios present a lot of interplay between functions such as finance and operations. Each team needs to be aware of other teams’ findings throughout the diligence process, and sharing this information is essential to ensure valuations are on point. The stakes are higher in the current competitive deal market where corporations are competing with private equity firms, and 10x multiples can be commonplace.
Depending on the size of the deal, or in cases involving programmatic acquisitions, success can depend on having a central party overseeing project management to coordinate across all workstreams and functions.
2) In today’s market, effective valuations require scrutiny of the “new normal.”
When evaluating target acquisitions, one distracting factor can be the perception that an organization’s business climate has settled into a so-called new normal. Now, as the pandemic continues into its third year, corporate development leaders must determine the validity of heightened valuations. Here, some acquisition analysts might assume that a major uptick in a company’s growth (for instance, a 25% jump when compared to a moderate 5% annual climb over the prior five years) represents a new baseline, but this accelerated pace may continue to be an anomaly. If a high valuation is proposed based on pandemic-driven factors (sometimes called the “COVID pop”), it may present a somewhat wishfully inflated value, and corporate development leaders need to avoid accepting such valuations too readily.
Experts suggest that additional caution should be exercised—especially when evaluating private, founder-led organizations— by scrutinizing the COVID pop and paying closer attention to the likely business climate over the next 18 to 24 months. Specifically, this analysis becomes paramount in the pre-LOI and pre-diligence stages, in which corporate development teams have found it helpful to quantify revenue and EBITDA impacts, examining profit & loss (P&L) statements and quality of earnings. Equipped with this information, buy-side diligence teams should determine any COVID impacts and validate or adjust the valuation using projections for the coming 18 to 24 months.
During diligence and pre-diligence phases, it is of particular importance for buy-side teams to determine whether a target company’s increased sales revenues are related to higher demand for products versus higher pricing that has been passed along to customers due to an increase in commodity prices (resulting from supply chain realities). Conversely, analyses should address whether higher prices that have been passed along to customers have negatively impacted demand in the short term. This information can also shed light on a target company’s current ability to navigate commodity pricing, manage customer relationships, and address shifting demand patterns in the future.
3) After the diligence phase, tax-related considerations are often overlooked.
When it comes to successfully integrating businesses post-acquisition, companies often overlook that the tax position of the newly combined business often differs from the position of each individual entity prior to acquisition. Although pre-acquisition tax diligence is beneficial in identifying potential historical tax exposures of the target entity, failing to engage tax professionals to assess the tax position of the newly combined business can be a costly pitfall.
It is important to first understand if changes in ownership resulting from an acquisition impact the tax classification of the acquired entity or force changes in tax methods. For example, during the acquisition of an S Corporation by a C Corporation, having an ineligible S Corporation shareholder may result in termination of the S Corporation election, and this would force the newly purchased entity to be subject to entity-level taxation.
Going forward, to ensure successful tax compliance, the combined business will likely need to undergo a nexus analysis to consider the footprint of the newly combined business. The analysis can be used to modify existing, or create new, processes for compliance. Involving trusted tax professionals in this process will allow the company’s management to understand the impact that the business’s plans for expansion and growth will have on its tax compliance requirements. It also allows opportunity for tax planning—and ultimately tax savings.
4) Human capital considerations are also an important aspect of any deal.
Matters related to people come up frequently in diligence and acquisitions. It is important to fully understand the management team and the post-deal incentives for employees to remain at a company. This heavily influences any investment thesis because often the most compelling part of any deal is the people, and their expertise—providing continued access to the nuances of existing intellectual capital—can matter more so than assets. Regulatory and compliance issues must be adequately addressed, and human capital matters can also have financial impacts if a deal causes compensation to change.
When considering the success of an acquisition and integration, it is important to identify and assess commitment likelihood from people early in the process. To the extent possible, diligence should “pulse-check” desirable management and key deputy personnel to determine their intent to remain with an organization post acquisition and participate in its continued success. Pulse-check efforts may include preliminary conversations regarding equity or other incentives. If key personnel do not indicate an interest in remaining with the organization, it can be a good indicator that an acquisition is not a feasible next step. In past cycles, replacing personnel may not have been as critical of a concern; however, today’s market presents hiring and retention challenges across some sectors that may make personnel retention a more heavily weighted issue in the present market.
Some experts also suggest that personnel facing a merger or acquisition scenario often do not want to be tied to earnout incentives that occur over a long period. Even if they are interested and incentivized, employees who continue to remain with an organization post deal often prefer those incentives to provide shorter runways or greater flexibility to transition out of the organization without penalty, provided an amenable relationship exists and basic targets are achieved. Teams looking to remain competitive in today’s complex market can use this to their advantage.
5) Thorough diligence can shape overarching strategies as well as ensure better post-deal operations
Conducting thorough diligence can help investors move beyond validating whether a target organization is healthy; proper diligence can reveal the necessary strategies for an integration to ensure sound financial, operational, and technological functions exist and thrive after the deal.
By questioning the new normal and validating an investment thesis, companies can apply deeper levels of investigative rigor to determine whether gaps exist in their current portfolio of offerings. A refined and comprehensive approach to diligence can provide better clarity regarding whether a specific acquisition can accelerate competencies and competitive advantages.