Assessing growth opportunities: are you financial or strategic?

Evaluating a potential merger, acquisition or investment opportunity can lead you down an exciting but sometimes perilous path. Some of the best "deals" you make may be the ones you pass on. However, if growth is in your plan, you will no doubt want to consider opportunities.

The due diligence phase of your investigation can help you set a sensible price. First, know what kind of buyer you are: financial or strategic. Financial buyers seek a targeted return on the investment and look to maximize undervalued assets, such as real estate. They usually require exit strategies and timetables for divesting. Strategic buyers search for synergies with their business, valuable employees, relationships or some mixture of these.

The would-be seller will provide potential buyers with masses of information highlighted by the company's financial statements. When looking at the income statement, be sure to calculate EBITDA (earnings before interest, taxes, depreciation and amortization). This gives you a measure of profitability without regard to things likely to change after the acquisition, such as the company's debt structure, its tax status and fixed asset base. EBITDA also lets you compare profitability within the industry.

Perform some ratio analyses on the financial statements, looking for both trends and industry relationships, such as:

* The current ratio. Current assets divided by current liabilities. It should be 1.0 or above; 2 or above is very good. If it's below 1, look deeper.

* Working capital. Current assets less current liabilities gives you working capital.

* Net sales to accounts receivable, which indicates how long it takes to convert receivables into cash.

* Inventory turnover ratio. Divide the cost of goods by average inventory to see how long it takes to sell inventory.

* Debt to equity. Divide shareholders' equity into long-term debt to see a company's leverage and ability to borrow.

* Debt service coverage ratio, which is EBITDA divided by annual principal and interest payments.

Read the notes to the financial statements and the auditor's opinion. You'll see whether the auditors have issued a clean opinion and whether there are any issues about the enterprise's viability. Also, look for other important information in the notes in these areas:

* Related Party Transactions. Any non-arms-length transactions? If so, they should be addressed in the negotiations.

* Off Balance Sheet Obligations. Hidden liabilities and long-term obligations such as lease commitments, employee benefit and retirement obligations, purchase commitments may not appear on the balance sheet.

* Litigation Exposure, Concentrations and Credit Risk. Significant litigation exposure should kill any deal if the risks are not manageable. The company's reliance on sole suppliers or a few large customers can threaten future cash flow.

After studying the financial statements, prepare a pro forma earnings statement of your combined enterprise. Incorporate all potentials for cost savings, sales growth, new product lines and other synergies into your model. This allows you to assess likely returns. Be conservative in preparing this model, since there will likely be unforeseen setbacks.

In considering synergies, think about both horizontal and vertical integration. Horizontal integration includes new markets for existing products, improved penetration of present markets, expanded distribution networks and cross-selling product lines to existing customers. Vertical integration may ease supply-chain expenses, improve access to key services or materials or allow you to utilize resources like warehouses and trucks to their fullest capacity.

Economies of scale and elimination of overhead costs can also improve the return on your investment. Reductions may be realized in overhead in human resources, accounting, technology, marketing, advertising and more. You may also benefit from economies of scale such as reduced per-unit production costs and more powerful negotiating positions with customers and vendors.

Frequently, buyers of closely held companies make the mistake of trying to integrate the business too quickly, without help from the prior owners or management. Lock in key personnel for two to three years, or more, with an incentive-based compensation formula. Effective incentives for integration and growth include employment contracts and earn-out clauses in the purchase agreement.

Do not lose sight of your original goals for the acquisition or investment. Financial investors, who often take significant risks and lock up their money for extended periods, should get returns on investment exceeding 10-12 percent. Strategic buyers should be able to achieve their objectives and not abandon them or switch gears just to get the deal done.

Finally, even if all other factors look good, the culture of the organizations being merged or acquired must be compatible. If not, economics may take a back seat to infighting and, ultimately, failure.

Seth Molod, CPA ([e-mail]) and Robert Sattler, CPA ([e-mail]) are partners in Berdon LLP, a New York and Long Island-based CPA and advisory firm, where they guide clients though acquisitions, mergers, investments and sales.