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How to evaluate an acquisition: Part I

A guide through the due diligence process by bob Cronin of Open Approach

The highly competitive M&A market has resulted in fewer ‘slam dunk’ label and packaging transactions. Top performers are often scooped up by strategic and private equity investors before they go to market, making it tougher to find – and confirm – good acquisitions.

This four-part series will guide you through the essentials of evaluating prospects, a process known as due diligence. Due diligence encompasses the activities performed during a transaction to find out the issues or to present the most favorable position to the acquirer. While your organization will have additional considerations, this series will cover those factors most important to any situation. 

This includes: Part I – Ownership structure and financials; Part II – Sales organization, compensation, and customers; Part III – Product mix and markets, buildings and leases, and geographic locations; Part IV – Laws and issues, culture, and management team.

So let’s look at Part I. Ownership structure can be an LLC, S-Corp, ESOP, or other. Private businesses choose ownership structures that 1) align with the people/ entities invested, and 2) provide for the greatest tax advantages. It’s important to know structure, as each type of ownership creates different challenges in taxation – and thus in valuation. Some things benefit the buyer and some the seller. Enlist the expertise of a tax advisor to ensure that the true dollar return works for you.

Knowing structure, you can then review financials. These are the documents used for recording results. Print as an industry uses many special financial techniques because of the customized nature of products. As you review, answer these questions:

Do the results conform to generally accepted accounting rules, and have they been validated by an outside auditor?
The ‘quality’ of a business’s financials says a lot about its character. Sloppiness, omissions, oddities, or questionable financial practices can raise red flags. While some owner add-backs are expected, poor investments can signify the company is running off target. Sellers should have their financials in order long before going to market. And buyers should be ready to dig deep.

How timely are the books closed each month and quarter? 
A strong revenue recognition policy is based on sound accounting principles and strict adherence by all segments of the company. Timely reporting of results is key to understanding sales and profitability issues when they occur. If a company lags or is inconsistent in reporting, it will be difficult to gauge true performance. If you want to be taken seriously as a seller, get your books in peak condition at least a year before you sell.

Do the numbers show significant customer concentration either in sales or margins?
While having a few really big customers may seem attractive, it can pose risk. Because of the ‘relationship’ nature of our business, management changes can cause attrition. Losing a client that represents 20+ percent of sales or margins can wipe out the value of a deal. If an owner’s exit affects long-term loyalty, consider constructing the transaction as an earnout or providing an advisory position so the customer retains a familiar point of entry. 

What do the last five years look like? 
History can tell you about an entity’s future potential. While most companies are accustomed to showing three years’ performance, make sure to evaluate (or provide) at least the last five. It’s critical to see how a business performs in good economies and bad, and how it has responded to both negative and positive sales cycles.

What’s the trending of work in process (WIP)? 
WIP can tell you about various parts of a company and their activity. It’s a look at what can cause significant value swings quarter to quarter – and thus variations in cash flow. Seasonality is a reality in labels and packaging. It’s good to know where gaps exist and whether the seller’s available capacity may be able to support a buyer’s other workflows. Likewise, if a buyer and seller struggle with similar seasonal times, a transaction could be arduous. This may also be an issue with your banker and could nix the deal before it happens. 

Remember that in most cases the sale will require some type of new financial leverage. So it’s important that your deal can get approved by your banker. As a buyer, you need to understand your balance sheet and that of the seller to know what your leverage ratios will look like posttransaction. The banking industry has norms that it conforms to within certain market segments. Anything outside those will require funding other than traditional debt. 

With financial assessments and plans in hand, you can better conduct the rest of your due diligence – and examine it in true context. Part II will look at the sales organization, compensation and customers and how various aspects of each should enter into consideration. 

Analysis in Part I due diligence is crucial, and should be conducted to exacting measures. I’ve been involved in many acquisitions where the sale either didn’t occur or was revalued based on findings. Be meticulous and clarify any questions and discrepancies. And don’t be afraid to walk away. A sale is never final until the money changes hands. Use your due diligence wisely, and make sure that what you see will actually be what you get. 


Bob Cronin is a regular columnist in Labels & Labeling, writing about M&A activity in the industry.

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