Twelve value drivers: Assessing value in an M&A transaction

Monday, November 1, 2004

In the current security industry M&A marketplace, where some security segment deals are slowing down (e.g. very large company, residential monitoring) and other segments heating up, generally company valuations are relatively low compared to the late 1990’s. This creates opportunities to acquire high growth companies, selected corporate assets, intellectual property or average or under-performing small and middle market firms.

A careful analysis of the following key “Value Drivers” before closing the deal will greatly increase the chance of an efficient and successful integration of the acquired company. The same analysis works for entrepreneurs selling their company as well, by offering a guide on how best to position the company for sale.

The customer base: The customer base of the company to be acquired is extraordinarily important. What is the buying trend over the past five years? Is it possible to extrapolate future revenue based on previous performance? How many new customers are acquired annually? Is the customer base stable? What is the customer profile? Are customers vulnerable to economic fluctuations?

Recurring revenue: One of the top value drivers is recurring monthly revenue. Buyers and investors are particularly interested in “recurring revenue models” and will assign a higher “pre-money value” to these types of companies. Of total revenue, what percentage is recurring? Will the combination from the acquiring and the acquired companies create an opportunity for a higher percentage of recurring revenue?

Product integration: A major reason for making an acquisition is to acquire new and complementary product lines so that the acquiring company can leverage its distribution system and increase gross margins. Pay attention to technical platforms of different products. Analyze whether products are complementary or competitive.

Gross margin: Gross margin is the most important item on the profit and loss statement. It’s vital to conduct an in-depth analysis to determine whether acquiring the target company will ultimately improve or degrade gross margins. Analyze operating processes to accommodate more, presumably complementary, product or service sets.

Intellectual property: Intellectual property is a “catch-all” phrase meaning one thing to one person and something different to another. Intellectual property certainly means trademarks, patents and copyrights but it also can mean a “developed process” such as a unique way to generate sales leads. Can these IP processes be protected? Do employees with impact on certain processes have non-competes and confidentiality agreements in place?

Human capital: During the late 1990s, a common approach was to acquire a company, assume that management would stay for a while and then expect to replace management as employment agreements expired. Today, buyers look for situations where management wants to stay for the long term.

Management experience and expertise: This is closely aligned with the human capital value driver with the following differences: Does the management team of the company to be acquired have substantial knowledge of a specific product, process or a market segment that is a necessary requirement of the buyer?

General and administrative leverage: Almost as important as Gross Margin is the G&A leverage when combining companies. Buyers tend to overestimate the cost savings of combining companies at the G&A line and the costs of transition are often underestimated if not overlooked altogether.

Distribution leverage: Potential buyers frequently say, “I want to buy a company where I can drive the products from the acquired company through my existing distribution system.” While this concept is sound, there are pitfalls. Measure demand through effective market research.

History/reputation and operating tenure: The fact that a company has been in business for some time matters and has real value. That the company has loyal customers and employees with documented history is important.

Sales and marketing effectiveness: One key and a very important element to a successful buy-side, sell-side or investment transaction is to determine whether the company has developed an effective and “least cost” sales and marketing model.

Barriers to competitive entry/competitive differentiation: Barriers to competitive entry are sometimes even more difficult to specify in the security industry as products are often perceived to be the same. Dealers, integrators and monitoring companies are viewed as service providers with no particular competitive edge. Buyers and investors must look for effective barriers to competition when evaluating a potential acquisition.

In today’s M&A environment, it is more important than ever to concentrate on these and other “Value Drivers.” The late 1990s called for buying the company and then making it work. Today’s environment requires careful study and analysis.
Marshall Graham is the founder of Washington, D.C.-based Focus Enterprises, an investment banking and consulting firm. Graham can be reached via email at