What it means
When a business decides to grow through acquisition, it looks for other enterprises that can help it achieve its strategic goals. The business chosen for potential purchase is called the target company.
Identifying this company involves extensive research, assessing its financial health, understanding its market share, and evaluating its cultural fit. Leaders examine whether buying this enterprise will increase revenue, reduce costs, or eliminate competition more efficiently than building those capabilities from scratch.
Once a target company is selected, the acquiring business initiates contact, often through investment bankers or direct leadership talks, to express interest. This phase involves a careful dance of negotiation regarding price and structure.
The buyer then conducts due diligence, which means thoroughly examining the target company's books, legal contracts, and operations to ensure no hidden liabilities exist. In practice, target companies can range from tiny start-ups bought by tech giants to massive corporations targeted by private equity firms.
The process requires balancing financial metrics with human factors, as employee retention and customer loyalty often dictate whether the acquisition succeeds long after the paperwork is signed. A target company is much like a house you decide to make an offer on.
Before you bid, you inspect the foundation, check the plumbing, and decide if it suits your family before buying.
In practice
Real-world examples
Example 1
TechStart, a growing software developer, identified a smaller local coding firm as a target company to quickly acquire ten skilled engineers and three established enterprise software contracts. Hiring and training ten engineers from scratch would have taken at least a year. The founders judged that buying the firm would be faster and carry less risk.
Example 2
GreenDelivery, a regional courier SME, made a local eco-friendly cycling fleet its target company to expand its service footprint into the city centre without buying new vans. The cycling firm already held the local permits and had loyal customers. GreenDelivery's finance manager built a simple model to check that the purchase price could be recovered from combined profits within five years.
Example 3
A multinational coffee chain set its sights on a regional roaster as a target company to secure a direct supply chain and proprietary bean blends for fifty new retail locations. The roaster's owners were approached privately before any public announcement. The chain's advisers spent weeks comparing the roaster's margins with its published peers before making a first offer.
Think of it
A target company is much like a house you decide to make an offer on. Before you bid, you inspect the foundation, check the plumbing, and decide if it suits your family before buying.
Formula
Calculation
Estimated Value = Target Company Net Profit x Industry Price-to-Earnings Ratio.
Example: if a target company earns $200,000 a year and the industry ratio is 5, the estimated value is $200,000 x 5 = $1,000,000.
The ratio is a judgement, so test how sensitive the answer is. At a ratio of 6, the same company would be valued at $200,000 x 6 = $1,200,000, so every extra point on the ratio adds $200,000 to the price. A buyer would therefore compare the ratios paid for similar businesses and look at whether the $200,000 profit is steady or likely to fall once the current owners leave.Case study
Seen in the real world
This is a fictional, illustrative scenario. BrightView Media, a digital marketing agency with $2 million in annual revenue, wanted to expand into video production. It selected PixelCraft, a boutique video agency turning over $500,000, as its target company. BrightView offered $1.2 million to acquire PixelCraft. Before finalising the deal, BrightView's finance team conducted due diligence and discovered that PixelCraft relied on just two major clients for 80% of its income, which meant $400,000 of its $500,000 revenue depended on two relationships.
Armed with this insight, BrightView renegotiated the purchase price to protect itself if those clients left after the buyout. The deal closed successfully, and within one year the combined business increased its total video revenue by 40% while diversifying its client base. The renegotiation took a specific form: BrightView paid $900,000 at completion and agreed to pay a further $200,000 only if both major clients were still under contract twelve months later. This kept the total at up to $1.1 million, which was $100,000 below the opening offer, and it moved the risk of losing the clients back to the sellers. The structure is a common way of aligning the interests of buyer and seller when the future of a key customer is uncertain.
Watch out
Common mistakes
- Falling in love with the target company's product and ignoring its underlying financial health or debt.
- Failing to plan for how the target company's staff will integrate into the new corporate culture.
- Rushing the due diligence phase and missing critical legal or tax liabilities hidden in the books.
Questions
People also ask
How is a target company different from a buyer?
The target company is the business being looked at for purchase, while the buyer is the organisation initiating and funding the acquisition.
Does a target company always want to be bought?
Not always. Some acquisitions are friendly and welcomed by the target company's board, while others are hostile, meaning the target fights against the takeover.
Who decides which business becomes a target company?
The leadership team and board of directors of the acquiring company, often with the help of financial advisors and market researchers, make this decision.