In part 1 of this text we presented the process of buying an IT company in Serbia:
In this part, we shall cover the latter three phases of buying an IT company: M&A analysis, Acquisition agreement, and Post-acquisition integration.
M&A is tiresome work. You invest a lot of your own money, time, and energy. Many things can go wrong: the transaction may be stopped at the eleventh hour or the acquisition may not meet your expectation. In order to make sure you will make a solid return on investment, you should get as much information as possible on your target IT Company.
You should engage different types of consultants along the way: financial consultants, tax consultants, auditors, lawyers, etc.
In M&A analysis, there are two important aspects, which are usually complementary and are done simultaneously:
- Due Diligence
Due diligence is a process of detailed analysis of the target company, in order to check if the information presented to you by the target company’s management is accurate and if there are any ‘’hidden’’ problems in the target company’s business. Due diligence may impact your willingness to pay for a target company or you may decide not to acquire the company at all.
On the basis of the aspect of business it covers, we divide due diligence into three parts:
- Tax and Finance Due diligence
- Legal Due diligence
- Commercial Due diligence (Commercial analysis)
Perform Tax and Finance Due diligence
Tax and Finance Due diligence include the following activities, but is not limited to:
- Is Company’s profit presented in a fair amount?
- Is the Company’s financial position (mainly level of debt) presented properly?
- Are Company’s assets valued properly?
- Does Company pay an adequate amount of taxes (corporate income tax, personal tax, value added tax, etc.)?
- What are the most significant Company’s tax risks?
- Are there any opportunities for tax optimization?
- Presentation of main tax and accounting rules regarding your Target IT company
If you are interested in these services, please contact our Tax and Finance Due diligence consultant.
Legal Due diligence
Legal Due diligence is the process of checking key legal issues of your target IT Company that may impact your willingness to buy a company:
- Relationship between the owners: let’s say you want to buy a part of the ownership of your target IT Company and you will have partners. How do current partners regulate their relations, would such conditions be acceptable for you?
- Agreements with customers (clients): are there any risks resulting from these agreements? Is the scope of work precisely defined? Can customers sue your target IT Company for damages done?
- Labor agreements with key employees: will key employees leave the IT Company after acquisition and become your competitors? Are there risks of legal proceedings with employees? Are business secrets well kept?
- Agreements with suppliers: are there any risks resulting from these agreements? Is the scope of work precisely defined?
- Intellectual property regulation: are key products, technology, and brand and Company name protected?
- Legal compliance: are Company’s operations comply with GDPR, environmental regulation, consumer protection, etc.? Are there any risks coming from new regulations?
Commercial Due diligence or Commercial analysis is based on the data generated through Finance Due diligence and Legal Due diligence. The goal of Commercial analysis is to identify key business risks:
- What would be the consequences of losing the IT Company’s largest client?
- What would be the consequences of losing the IT Company’s largest supplier?
- Is the company prone to risks of key employees (key employees leaving the IT company)?
- What are other key operating risks?
- Analysis of IT company’s profitability
- Analysis of IT company’s financial position
Perform targeted IT company valuation
What price is acceptable for acquiring a company? That answer is replied to by the process of valuation.
Generally, there are three approaches to valuing a company:
- Cost approach: the value of the company is simply total assets minus total liabilities from business books. This approach is rarely applied to IT companies since the cost approach is used for companies with large assets and in financial difficulties
- Market approach: the value of the company is estimated on the basis of transactions of similar companies or their market quotations. If comparable companies are valued as 6 times net profit, the value of the company is 6 times net profit. Since M&A transactions are not as common in the Serbian tech industry as in developed countries and since the Serbian stock exchange market is not developed, the market approach is not so appropriate for valuing Serbian IT companies
- Income approach: the value of the company is estimated as the present value of its projected cash flows in the future. The most common valuation method under the income approach is discounted cash flow method. This is the most appropriate method when valuing Serbian IT companies. Therefore, in the following paragraphs, we will write about valuation when discounted cash flow method is used
Generally, our clients ask us for two types of valuations:
- Indicative valuation: quick analysis of the Company’s cash flows
- Full valuation: an in-depth analysis of the Company’s business model in order to estimate the value of the Company in accordance with the International Valuation Standards
An indicative valuation can be done before full valuation or can be used for very small M&A transactions. Value estimated in indicative valuation cannot be deemed fair value of equity, in accordance with the International Valuation Standards.
How valuation is technically done as described in our separate text covering valuation services. For valuation services, please contact our valuation consultant. In this text, we will cover something different: how to understand the numbers you get from the valuation.
As we discussed before in the first part of this text, from a financial perspective, there are three main reasons to acquire a company:
- Buying an undervalued company: buying a company for a lower amount than its value
- Better management: you are able to manage the company in a better way and therefore to increase the value of the company (lower financing costs, higher sales – new clients and new projects, lower costs – higher efficiency)
- Synergy: your company and the acquired company value more together than separately (better efficiency, higher sales, lower financing costs…)
Buying an undervalued IT company
Let’s say that we did a valuation of the target IT Company and we got 310.000 EUR. You agreed with the IT Company’s management to buy it for 190.000 EUR. Is it a good deal? Of course, it is. You are buying an undervalued company.
As Warren Buffett famously put it:
‘’Price is what you pay. Value is what you get.’’
In this example, you are buying something worth 310.000 EUR for just 190.000 EUR.
Buying an IT company which you would manage better
However, things are not always that simple. Let’s say that you believe you will run a target IT company better than current owners. In that case, you need to calculate the control premium. That would be the difference between values estimated from two valuations:
- Status quo valuation (Vsq): valuation of IT company ‘’as – is’’, under current management, in following years
- Valuation with control (Vc): valuation of IT Company with your management. In comparison to status quo valuation, you should present what would you do better (lower financing costs, higher revenue, lower costs…)
What is the maximum amount of control premium (CP) above the company’s current value you should pay?:
Let’s say that Vsq is 350.000 EUR and Vc is 400.000 EUR. CP is 50.000 EUR. In that case, you should not pay more than 400.000 EUR (Vsq + CP) for this company.
Buying an IT company for synergy
Synergies are the most complicated to estimate. First of all, you would need to value your own company (Va). Then you do a status quo valuation of your target IT Company or valuation of your target IT Company with your management if you believe you would manage it better (Vb). To calculate the value of synergies (S), you should value both companies on a consolidated basis, as one entity (Vc), and include a planned increase in revenue, a decrease in expenses, etc. because companies operate better when they work together.
The synergy premium (S) is the maximum amount you should pay above the value of your target IT Company (Vb):
If Vc is 1.000.000 EUR, Va is 700.000 EUR and Vb is 200.000 EUR, then S is 100.000 EUR. The maximum price for the target IT Company should then be 200.000 EUR (Vb) plus S (100.000 EUR), which is 300.000 EUR in total.
Valuation and M&A – summary
To get a better understanding of implementing valuation in mergers and acquisitions and summarize what we have written, we shall present one graph. Let’s assume that you are acquiring an undervalued company (for the amount we shall name transaction value). How do you create value from such transactions?
The Blue area is what you pay for. The red area is what you got (or you at least try to achieve). As long as there is some red area (for example, transaction value can be higher than presented in this graph and include some of the presented premiums), your acquisition makes sense.
Final Agreement of company share purchase
After an M&A analysis, if everything goes fine and well, it is time to conclude the transaction. The transaction is concluded with the Agreement of company share purchase. Do not focus solely on the value of the deal only, but also on agreement terms.
Organizing notary, administration, translators
To get the deal through, you should do some administration work: translate the agreement in Serbian, certify it at the notary’s office, etc. WTS Serbia can help you with all the paperwork and cut through red tape.
The most delicate segment of M&A is post-acquisition integration. Most mergers and acquisitions do not meet expected benefits (mainly synergies and better control), because of poor executions. Having in that mind, our consulting firm stays at your disposal for the last phase. We can help you control the acquired firm, as well as provide you with feedback regarding the company’s performance and compliance with legislation on a periodical basis.
WTS Serbia is a consulting firm that can help with any type of tax, finance, and legal issue you have.