THE EVALUATION PROCESS: AN OVERVIEW: (8th article in the series on M&A)

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Evaluation of the business deal is an on-going process that begins the moment you obtain a lead from a broker and continues through closing of the deal.  Think of the evaluation process as a filtering of your flow of leads through successive screens, as you obtain more information about each lead, until you have narrowed your leads down to one final choice.

Based on actions you take, there are typically five discrete stages of information acquisition that will help you in narrowing down your leads. As you obtain more information, you are able to filter or screen out those leads that are less likely to meet your criteria and to provide you with the results you desire. These stages or filters, are as follows:

Filter 1:   Initial information provided by your broker (Filters initial lead pool from hundreds or thousands to about 50 leads)

Filter 2:   Initial data from the broker after a confidentiality agreement is signed (allows you to weed out all but about 25-30 leads, approximately speaking)

Filter 3:   Information obtained from visit to the company and preliminary due diligence (provides you with means to reduce lead pool further to about a dozen target companies)

Filter 4:   Response to your letter of intent by the seller (provides you with means to reduce leads further to about 3-5 target companies)

Filter 5:   Results of Formal Due Diligence and final negotiations for the purchase agreement (Narrows your search from several down to the one company you actually buy).



When you first obtain a lead from a broker, the information is likely to be limited to total revenues, profitability of the company, and possibly, the industry and some product information.  Sometimes you will not even obtain this much information.

If you have followed the suggestions we have provided you about lead flow, you will eventually received hundreds, if not thousands of leads. At this stage, you will be lucky to have sufficient information to compare against your initial acquisition criteria.  Most leads can be quickly weeded out because they are either much too large or small, are in the wrong industry or do not meet your profitability criteria or, perhaps, are in the wrong region. You won’t collect these leads all at one time, but in the course of a year or two, it is quite possible that you will screen this many leads, especially if you include the books of leads that some organizations might send to you.

You may be tempted to investigate leads that don’t fit your broad criteria.  Try to resist this temptation.  If a lead does not match your size, profitability and industry criteria, you should reply quickly to the broker sending you a lead so that he or she can send it on to a more appropriate buyer.  Sticking to your criteria will help you to respond quickly to brokers, and in turn, keeping your network active.  And you don’t have the time to pursue every prospect in detail.

Handling situations with incomplete information

What do you do if you have incomplete information on a lead  — such as a lack of industry information?

If the lead interests you, try to obtain whatever information the broker is willing to extend to you.  However, the broker is likely to ask you to sign a confidentiality agreement and in the case of a buyer broker, a fee agreement, before you are given much more information to go on.  Signing a confidentiality agreement is typically the next step in obtaining more detailed information about companies for which you have an interest.  You may sign a confidentiality agreement for as many as fifty leads over time, if you stick to your initial criteria.

In sum, until you have enough information to reject a lead, i.e., when it doesn’t match your initial criteria, don’t ignore it.  The lead could turn out to be the company best suited to your criteria, then you know to pursue the lead.  Even if you don’t know the broker, you may want to pursue it anyway but reject his or her offer the next time you pursue a lead if the company proved a waste of your time.




The second key filter is after the confidentiality agreement is signed and returned to the broker.  The amount of information you are going to receive once you sign a confidentiality agreement depends upon the sophistication and type of broker you are working with.  You may expect to receive a rather thick binder or “book” where the broker is an investment banker working for the seller.  You may receive only a few pages of additional information and a financial report from a professional broker, possibly even less from the informal intermediary.  The most informal intermediaries may simply provide you with the seller’s address and phone number and suggest that you call to set up a meeting.

Based on the additional information you receive at this point, you should be able to narrow your active leads even further, typically by as much as fifty percent. Thus, assuming that you sign approximately fifty confidentiality agreements over a two year period, you may eliminate 25 or 30 companies on the basis of the materials you are provided by the broker once you sign the confidentiality agreement.  For instance, you may judge that the company size, profitability, industry, specific product or service or location is inappropriate to your needs.

The letter of interest – the ticket to a company visit

An investment banker is likely to send much more detailed information at this stage than a buyer broker is likely to send.  You will be asked for a letter of interest upon receipt of a book or binder of information about the company, before you are allowed to visit the company and meet with the seller.  The letter of interest must state a price you estimate that you are willing to pay for the company.  Although the price you propose is not legally binding, it is the key criterion for determining whether you are chosen to visit the company as a prospective buyer.  You are advised to consult an attorney before signing the letter of interest.



Data collected in the preliminary due diligence is the next filter in the evaluation process.  For the few dozen companies that you find particularly attractive, based on the initial information provided by the broker, it is helpful to carry out preliminary due diligence and to meet the seller, before proceeding to formal due diligence.

Why conduct a preliminary due diligence?

The distinction between preliminary and formal due diligence is an essential aspect of the efficient evaluation process. During preliminary due diligence, your goal is to obtain enough information on a low-cost basis about the company to determine whether or not it is worth carrying out formal due diligence.  To keep costs down, and to increase your opportunities for direct contact with the seller, preliminary due diligence should be conducted by yourself and your management team.  If you come across information in preliminary due diligence that clearly rules out this prospect, you have saved a lot of needless expense during the formal due diligence process.  Furthermore, the rapport that you build with the seller during a properly executed preliminary due diligence process may surface information that event he most exhaustive analysis of documentation may fail to uncover.

Failure by the seller to reveal important information may lead to re-negotiation of the price or even a cancellation of the purchase agreement, but rarely provides reimbursement to the buyer of the expense of formal due diligence.  A business acquaintance recently purchased a company in England in an arrangement where ownership was transferred with no money down.  The arrangement seemed almost too good to be true, and it was.  The day after closing, the new owners discovered a drawer full of unpaid bills that the previous owner had failed to disclose; in essence, bankrupting the firm.  Although the new owners were able to get out of the deal, they are still out of a lot of money due to legal and due diligence expenses for evaluating the company and negotiating the closing and even more, if one considers the time lost and other business opportunities missed in the process.  The experience also underscores the need for direct contact with the owner.  If a situation seems to good to be true, follow your intuition and pursue the situation personally until you have all the answers.  Trust your own instincts.   In this case, a well respected consulting firm that performed the formal due diligence missed any cues that trouble was brewing.

Questions to ask during preliminary due diligence

You will want to be particularly attentive to the following key aspects at this stage:

1.          Why is the seller selling his or her business?

2.          What is the overall financial condition of the company?

3.          Is the company in an acceptable and desirable location, to meet your personal and company needs and to be successful?

4.          Is the seller likely to sell within a price range that you are willing to pay?  (In the case of the investment banker, presumably if you have been selected based on your letter of interest you have already determined this).

5.          Has the company been kept up pretty well or is it run down to the point it would be difficult to make successful?

6.          Are there any glaring problems at this stage–environmental, legal suits, etc., that might make it undesirable to buy this business?

You will probably come up with your own additional questions but you should be able to gather information to move you toward an approximate answer to these questions before investing in costly consultants to review documents in more detail.

Depending once again on the nature of the broker handling the deal, the amount of information you are likely to have prior to your first visit to the prospective company will vary enormously.  In either event, you will want to arrange a visit directly with the seller as early in the evaluation process as possible.  At this point, you should already have determined that the company meets your initial criteria, and is also located in a suitable location for your needs.

You need to find out why the seller is selling as early in the process as possible.  Some sellers are prodded into showing their company by an insistent broker, but are not very motivated to sell, except perhaps at an unreasonably high price.  Or you may have a seller motivated by the wrong reasons.  Perhaps business has not been handled well in recent months or years, and has deteriorated to the point it would be a bad purchase at any price.  In a case where the company has developed a bad reputation among customers, this is particularly difficult to correct.  Assuming that the company meets the initial criteria laid out in your acquisition plan, you have identified a serious seller, and the company has a good reputation, then you are likely to proceed to formal due diligence.



Due to the high cost of formal due diligence, it is very important that you sign a letter of intent and negotiate an exclusivity clause before proceeding.  The exclusivity clause in the letter of intent is supposed to prevent the seller from selling to another buyer during the period the period that you conduct formal due diligence.  Without such a clause negotiated and signed by both buyer and seller, you may invest several thousands of dollars evaluating a company only to lose the deal to another buyer.

If you have been thorough at the preliminary due diligence stage, you are likely to submit a letter of intent for about a dozen of the 25 or 30 of the active leads for which you performed preliminary due diligence — again estimating roughly over a two year period. However, since not all letters of intent are accepted by the seller, anticipate that only about three to five of these are actually worked out and signed by both seller and buyer.  For this small subgroup of leads, you are finally ready to proceed with formal due diligence.

Formal due diligence involves a thorough investigation of all aspects of the business: legal, marketing, financial, environmental and managerial. Formal due diligence is the most costly part of the deal-making process.  Do not be in too big a rush to proceed to this stage or you could waste a lot of valuable money and time. Worse, you might use up the initial investment that you had set aside for due diligence on the wrong companies.


Although, again, each deal is unique, it is typical to complete some level of formal due diligence for four or five companies to every one that you actually close. At any point in the evaluation process, even during formal due diligence, you might uncover problems or issues with the company that make it undesirable for you to purchase.  These problems might relate to environmental pollution, a pending product liability lawsuit or perhaps falsified financial records that inflated the company’s performance.  It is never too late to back out of a deal, prior to closing, although once you sign a letter of intent, you may have to pay a penalty if you back out of the deal.  However, this is far better than purchasing a company that will not work out for you. Even seasoned executives often get too absorbed in the deal at this point to look at it objectively.  Psychologists refer to this phenomenon as escalating commitment. It is important to have enough of an initial investment that you can go through the formal due diligence several times, if need be, rather than feel that you are running out of time and money and must go through with the deal.  Keeping your lead flow going until a deal actually closes also reduces the urge to close on the wrong deal.


Reference: “How to Acquire the Right Business”

John Psarouthakis & Lorraine Uhlaner

Published by Xlibris, 2009


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