Due diligence: understanding the critical M&A success factors

Acquiring a firm or start-up whose business is driven by technology or software requires specific knowledge and insights into the drivers and risks of such companies. The same often applies to industrial firms operating in niche markets where technical factors provide a competitive edge.

Investors normally possess excellent financial and legal capabilities that enable them to evaluate a merger & acquisition (M&A) target. However, technical and commercial appraisals as part of a due diligence process can be significantly improved using specialist consulting and thereby lead to better investment decisions.

Any valuation of a company needs to be based on a sound understanding of the business and the value creation mechanism of the target. Astonishingly, not all investments follow a due diligence process that provides these essential insights. Investors regularly struggle when technical aspects, technology, or software significantly drive the valuation of a target and the evaluation of business risk. In these cases, industry-specific experience and specialist technical knowledge is necessary to assess the attractiveness, quality, and competitive position of the acquisition target. The benefits, advantages, strengths, risks and protection of the target’s technology, as well as its role in the current and future business, must be understood and appraised. Innovation, sales pipeline, and operations are all gauged as to their effectiveness, efficiency, capabilities, and maturity. All these assessments provide a sound foundation and valuable input for the legal and financial due diligence.

Valuing hidden and intangible technical assets

Do the managers and engineers of the M&A target have the knowledge and capabilities needed to grow the product and service offerings as laid out in the investment scenario? Can staff operate the expensive factory equipment efficiently and safely? How are potentially dangerous goods stored and handled? Does the architecture of the software support the expected growth in customers and users, and can it be maintained and further developed with reasonable effort?

Scrutinising capabilities, product and software architecture, organisational setup, processes, and team expertise with a strong recognition and evaluation of best practices or critical patterns is essential for answering these questions. The results are compared to the financial projections and the legal obligations of the acquisition target. Viability and appropriateness of the sales, cost and investment forecasts get a better and more realistic judgement. Contract risks are linked to market, technical, innovation and operations risks and comprehensively evaluated.

Understanding the inherent risk of a business

The recent, decade-long growth cycle of the economy has covered the risk innate to many businesses. The financial figures of the last few years often don’t show the variation in sales and profits that economic cycles normally cause in the respective industries. For example, while consumer tastes might shift in the food industry, overall demand may remain fairly stable. On the other hand, plant and equipment sales are triggered by new investments, which are heavily dependent on the expansion of capacity by potential customers in their industries. As a case in point, business cycles are especially pronounced in the semiconductor equipment industry.

Investors who are less familiar with the practices and cyclical patterns in the acquisition target’s trade need insider advice to understand the true risk profile of the business, which is poorly reflected in recent years’ financial figures. Too many industries have profited from demand being boosted by government and central bank interventions since the financial crisis in 2008. The latest crash in the car industry shows what happens when artificially stimulated demand suddenly collapses. Mainly financially motivated investors need to make sure that their M&A target meets the criteria of their investment strategy and profile.

Start-ups need more than money

Start-ups need to establish themselves and grow fast. Although there is a need for their products and services, the respective markets still might have to be developed. The products and services of a start-up are normally not mature, may not be ready to scale, or might need to be developed further in order to satisfy customers. Supply chains and operations may be improvised and therefore need optimising and professionalising. Investing in start-ups has become fashionable. Nevertheless, any such investor should ask whether the kind of ecosystem and support needed to foster the start-up’s growth can be provided. After all, start-ups need more than just money to succeed.

Saving time and reducing costs

A blend of business, market, end-customer, and technical knowledge is needed to quickly grasp the fundamental business logic of an acquisition target and reveal critical areas that need to be investigated in more detail. It is important to dive into specific scientific and technical subjects and provide sound advice about their impact on the investment. A mix of business and technology consulting will generally lead to a better evaluation of the value creation ability of the target’s business model and enable investors to challenge the presented business plans and financial projections. By first improving the investor’s fundamental understanding of the target’s business and then evaluating the financial and legal position in more detail, a significant amount of time and money can be saved during the due diligence process. The broader understanding of business and technical challenges also increases the success rate of an M&A transaction and facilitates value-creating investment decisions.

Author: Rolf P. Maisch