A comprehensive guide to M&A targets evaluation

A successful merger and acquisition (M&A) deal starts with choosing the right target. Selecting a target company that fails to meet the acquirer’s objectives or is improperly evaluated can land both parties with nothing. About 65% of buyers report that valuation gaps between the acquirer and target often impact the ability to get deals. 

That’s why a comprehensive approach to target evaluation matters. This article describes the principles of target selection and defines the main criteria for assessing potential acquisitions.

Defining M&A strategy and setting the objectives

The beginning of 2024 marked a 24% rise in the strategic deal market. This signals a shift in how companies approach mergers and acquisitions, emphasizing long-term growth and competitive advantage over short-term financial gains. 

Such an approach speaks to the importance of having a clear M&A strategy before proceeding with the target selection. 

A well-defined M&A strategy acts as a compass, guiding the identification, evaluation, and pursuit of acquisition opportunities. Without a solid strategy, companies risk making decisions that:

• Lack alignment with long-term goals
• Fail to create synergies or enhance competitive advantages
• Lead to overpayment or integration challenges

A solid acquisition strategy outlines the main objectives the acquirer wants to achieve with the acquisition deal. Having clear objectives helps to guide the selection of target companies. For instance, if an acquiring company aims to gain access to new geographical markets, it won’t consider potential acquisitions that operate in the same location.

Additional objectives can be:

• Access to technology and intellectual property
• Gaining a bigger market share
• Addition of new product lines or services for diversification
• Cost and revenue synergies
• Competition elimination
• Access to the talent base

Finding the best target for M&A

The process of looking for the best acquisition target consists of three main stages:

1. Market research
   This step involves studying the industry to understand market trends, opportunities, and challenges. The goal is to identify which sectors or areas align with the acquirer’s goals, such as expanding into new markets or gaining access to the target’s customer base. It also helps prioritize industries with high growth potential or strategic importance.
2. Target identification criteria
   Here, you decide what an ideal target looks like. This includes factors like company size, revenue, market position, geography, and compatibility with your business. These criteria ensure the chosen target aligns with business strategy and financial expectations.
3. Sourcing potential targets
   Finally, you search for potential acquisition targets that match your criteria. This can be done using industry databases, professional networks, advisors, or direct outreach. Half of modern dealmakers involve AI technologies at this step. The result is a list of potential targets ready for deeper evaluation.

Key evaluation criteria for M&A targets

Now, let’s list the main criteria for evaluating potential targets.

Financial performance

This examines the target company’s financial health and profitability. The goal here is to understand the financial health and operations of the target.

The main financials to look at are:

• Profit margins
• Revenue
• Cash flow
• Debt levels
• Year-over-year growth
• Earnings before interest, taxes, depreciation, and amortization (EBITDA)

Consistent financial growth or strong performance indicates stability and the potential for long-term value. It’s also important to check if the target’s valuation aligns with the buyer’s budget and expected returns. 

Note: Acquirers often evaluate targets’ financial performance by focusing on metrics such as return on invested capital (ROIC) or return on equity (ROE). However, these indicators make better sense when evaluating mature companies, as they wouldn’t be very illuminating when assessing early-stage, high-growth companies.

Ownership structure

Ownership structure examines how a company is owned and controlled — whether it is a private company, public company, or family-owned company. 

The way the target is owned can affect how easy or hard it is to make a deal. Understanding the ownership also helps avoid conflicts and speeds up the process.

Strategic fit

Strategic fit measures how well the target company aligns with the buyer’s business models and goals. 

This includes evaluating whether the target complements the acquirer’s product portfolio, market presence, or future expansion plans. A strong strategic fit ensures the deal adds value, whether by entering new markets or achieving operational synergies. A mismatch here could make realizing the deal’s benefits challenging.

Cultural compatibility

Cultural alignment between two companies is cited as the top challenge for 20% of dealmakers when it comes to M&A execution. Indeed, cultural clashes can often lead to failure, as it was with the infamous Daimler-Benz and Chrysler merger in 1998. 

This is why it’s important to pay attention to the target’s organizational culture early in the M&A process. 

Cultural compatibility looks at whether the target’s values, work environment, and leadership style align with the buyer’s. A good cultural fit ensures smooth integration and employee cooperation after the deal. Differences in company culture, on the other hand, can lead to conflicts, lower morale, and higher employee turnover.

Leadership

Evaluating the target’s leadership team is crucial, as strong management drives a company’s success. 

Factors to assess include management data such as experience, vision, and track record of key executives. It’s also important to consider whether the leaders are willing to stay after the acquisition or if replacements might be needed. The leadership’s cooperation is often key to achieving a smooth transition.

Reputation

Check the target’s reputation in financial markets and your industry in general.

Reputation reflects how the target is viewed by customers, employees, and industry peers. A strong reputation indicates trust and goodwill, which can be a significant asset. Poor reputation, on the other hand, might bring challenges, such as customer distrust or difficulty retaining employees. 

Buyers must ensure the target’s reputation aligns with their own brand values. 

Legal and regulatory risks

This focuses on identifying potential legal and compliance issues with the target. 

Areas of concern might include unresolved lawsuits, violations of Federal Reserve regulations, or intellectual property disputes. These risks could result in financial penalties or damage to the acquirer’s reputation. That’s why a buyer should be aware of all the possible risks and be ready to address them early to avoid unexpected liabilities post-acquisition.

Additional read: Explore the difference between investment banking and private equity in our dedicated article.

Finalizing the main evaluation steps

Here are the main steps that will lead to finalizing the target evaluation process:

1. Due diligence
   Perform due diligence on the target company to confirm the information provided is correct and uncover any potential risks. This includes reviewing financial records, legal matters, contracts, operations, and other key aspects of the business. This step ensures that there are no surprises after the deal is completed.
2. Risk mitigation
   Risk mitigation involves identifying and addressing potential risks that could affect the success of the deal. This can include legal issues, financial liabilities, or operational challenges. The goal is to reduce these risks by developing strategies to manage them or negotiating terms that protect the buyer.
3. Deal valuation
   Deal valuation determines how much the target company is worth. This involves analyzing financial performance, market conditions, and potential future earnings. The valuation helps the buyer decide if the price aligns with the company’s value and whether it meets their investment goals.
4. Structuring
   Deal structuring involves deciding how the transaction will be organized, including payment terms and the division of responsibilities. It outlines whether the deal will be an all-cash purchase, stock swap, or involve other financial instruments. The structure ensures both parties agree on how the deal will be executed and financed. 

If all the outcomes from every step are satisfactory for the buyer, the deal is most likely to proceed.

Making the final decision

The key factors influencing a buyer’s final decision on the specific target depend on the buyer’s strategic objectives. However, the main factors are typically the following:

• Financial health
  Buyers look for companies that have a strong financial track record, including steady revenue, healthy profit margins, and manageable debt. This shows the target is stable and capable of future growth.
• Strategic fit
  A target company that aligns with the buyer’s business strategy is highly valued. This ensures the deal adds real value and supports long-term growth.
• Company culture
  Buyers consider whether the target’s workplace culture and values match their own. If the cultures are too different, it can cause problems with integration, corporate development, and employee morale after the deal.
• Legal issues and risks
  Any potential legal problems, like ongoing lawsuits or regulatory issues, can make a deal risky. Buyers need to identify and address these risks before moving forward to avoid unexpected costs or complications.
• Price
  Buyers need to ensure that the price of the target company is fair based on its value. They assess financial performance, market conditions, and growth potential to make sure the price is justified and fits their budget.

Key takeaways

• A well-defined M&A strategy guides target selection, ensuring alignment with long-term goals and avoiding overpayment or integration difficulties.
• To find the best M&A target an acquirer should perform market research, outline the main target identification criteria, and initiate target sourcing.
• The key criteria for the target’s evaluation include financial performance, ownership structure, strategic fit, cultural compatibility, leadership, reputation, and legal and regulatory risks.
• The main steps to finalizing the target evaluation are due diligence, risk mitigation, deal valuation, and structuring. 
• When making a final decision on the target, an acquirer should mostly pay attention to financial health, strategic fit, culture, legal issues, and price.

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