What it means
In any acquisition there are two sides: the acquirer, which makes the offer, and the target firm, which is the object of it. The target is usually selected because it fits the buyer's plans, for example by filling a gap in its products or giving it access to new customers.
The buyer then studies the target in detail before making an offer. That study is called due diligence, an investigation of the target's accounts, contracts, legal position and operations.
Its purpose is to confirm that the business is what it appears to be and to uncover hidden problems. Findings can change the price or cause the buyer to walk away.
A key question is how much the target is worth to the buyer. This is its standalone value plus the extra value that the buyer expects to create by combining the businesses, known as synergies.
The buyer should not pay more than that total, or the deal destroys value for its own shareholders. The target firm's board has its own duties.
It must consider whether the offer is fair, whether better offers might exist, and how shareholders, employees and customers will be affected. In a hostile situation, it may use defences to resist the approach.
For a non-specialist, it is worth remembering that being a target is not always a sign of weakness. Strong, well-run companies are often targets because a buyer wants to own them.
The offer price and the terms matter more than the label. People also use the word firm loosely, so a target can be a listed company, a private business or a division that its owner wants to sell.
The steps are similar in each case, although a private target usually involves a negotiated sale with a single seller and no public vote. Payment can be in cash, in the buyer's shares or in a mix of the two.
In practice
Real-world examples.
Example
A large software company identifies a small cybersecurity business as its target firm. The small business has technology the buyer lacks and a loyal group of customers. The buyer pays a premium because it expects to sell the technology to its own client base, which is far larger than the target's own.
Example
A regional supermarket chain targets a competitor that owns a well-located warehouse. After due diligence, the buyer finds that the warehouse needs $4,000,000 of repairs. It lowers its offer by the same amount.
Example
A private equity fund selects a struggling manufacturer as a target firm because its assets are worth more than its share price. The fund plans to improve the management and sell the company after five years. The board of the target agrees to the sale because the offer exceeds the market price.
Formula
Calculation
Maximum price a buyer should pay = standalone value of target + value of synergies
Buyer's gain = maximum price - price actually paid
A buyer values a target firm on its own at $80,000,000 and estimates that cost savings and extra sales are worth $15,000,000 in present value. The maximum price is 80,000,000 + 15,000,000 = $95,000,000. If the buyer agrees to pay $85,000,000, its gain is 95,000,000 - 85,000,000 = $10,000,000. The target's owners receive a premium of 85,000,000 - 80,000,000 = $5,000,000, or 6.25% over standalone value.Case study
Seen in the real world.
Halden Beverages is an illustrative, fictional drinks company that decided to buy a smaller producer of fruit juices, called Fernbrook Juices, which is also fictional. Fernbrook had annual profit of $5,000,000 and strong relationships with grocery chains.
Halden valued Fernbrook at $50,000,000 on its own and expected savings from sharing distribution to add $10,000,000. It offered $55,000,000, leaving $5,000,000 of the synergy value for its own shareholders.
The illustrative deal went ahead after due diligence revealed no major problems. Within two years, savings came in at about $8,000,000 in present value terms, so Halden captured less than it hoped, but it still made a gain over the price paid.
Watch out
Common mistakes.
- Assuming the target firm is always in trouble, when many targets are healthy businesses that fit the buyer's strategy.
- Paying away the full value of the synergies in the price, which leaves nothing for the buyer's shareholders.
- Skipping thorough due diligence and discovering hidden liabilities, such as unpaid taxes or pending lawsuits, only after the purchase has completed.
Questions
People also ask.
What is the difference between an acquirer and a target firm?
The acquirer is the company making the offer, and the target firm is the company being bought.
How does a company choose a target?
It looks for strategic fit, a reasonable price, strong customers or technology and manageable risks, and it screens many candidates before approaching one.
Can the target firm refuse an offer?
Yes, its board and shareholders can reject it, though a hostile bidder may appeal directly to shareholders.
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