Lining up a business for takeover is fraught with danger. Avoid the elephant traps and you can achieve rapid growth. But make one risky move and you'll burn cash quickly

Bob Woodland, chief executive of training company Redtray, is an old hand at mergers and acquisitions. He's made nine of them, including two last year during the depths of the recession. It's one of the reasons why £15m-turnover Redtray is ranked in the latest Deloitte Technology Fast 50 of rapidly growing companies.

Mergers and acquisitions are a good way to turbo-charge a company's growth when the economy is in the doldrums. It's also a time when more businesses come up for sale, either because they're under financial pressure or their directors want to give up the struggle to keep them going. But buying a business—or merging with another—poses danger for directors who may be tempted but have never done it before. The starting point of any successful merger or acquisition is that there must be a business logic to it.

When Woodland is searching for acquisition targets he has two criteria in mind. The first is to expand the scope of his business's capability. The second is what he calls "filling in a piece of the jigsaw"—essentially acquiring a business without taking on its management, so that Redtray can merge the target's revenue stream into its own.

Entering a new market can be a compelling reason for a merger or acquisition. Last year, building facilities management provider Incentive FM took over QAS cleaning services. Incentive managing director Jeremy Waud explains: "Our business is mostly focused on the private sector whereas QAS has a lot of public sector clients. So this was a good move for us because it broadens our scope."

Developing an international dimension is another good reason for a merger. Last year, UK-headquartered marketing agency Gyro International merged with US-based HSR to create GyroHSR, which now has 17 offices in 10 countries. "It was led by what would work for our clients and our ability to generate new business," says Richard Glasson, chief executive of the new £100m-turnover company.

The ability to acquire products that enable a company to enter an off-limits market is a strong reason for an M&A. In February, £25m-turnover Access Technology Group acquired Select Software, an HR software provider that complemented Access's specialist field of manufacturing and supply chains. "Wherever possible, a guiding star in making acquisitions is getting us into new industries," says Alistair O'Reilly, chief executive at Access.

Yet finding a suitable target isn't always easy. ILX Group, a £15m-turnover, AIM-listed training company, has made six acquisitions since Ken Scott became chief executive. He recalls: "The first one we found was advertised in the FT. The second we found through an introduction by an acquaintance. The third was through a straightforward reference from a business colleague. The fourth and sixth were from a professional introducer. And the fifth was through a friend of a friend."

When an opportunity arrives, one of the key decisions to take is whether to acquire the company or the business's assets. "As a general matter, the assets will not carry with it liability for the obligations of the company which sells them, save where a liability attaches to the asset being transferred," says Peter Borrowdale, a partner at law firm Reed Smith. One important exception is any liabilities listed under Tupe (the Transfer of Undertakings, Protection of Employment) regulations, which preserve employees' terms and conditions when a business, or part of one, is switched to a new employer. "The acquisition of the shares in a company will simply transfer the ownership of that company to the buyer complete with all the obligations and liabilities that the company has at the time of the sale," Borrowdale adds.

This means that it is important to conduct thorough due diligence (see panel) on all aspects of the company's business before completing the purchase. O'Reilly at Access says: "We do as much due diligence as we can and we tend to do it ourselves, rather than through third parties, because we think we have a greater vested interest and perhaps a greater expertise in spotting and recognising what we are looking for."

And Redtray's Woodland adds: "We look at the balance sheet closely to make sure there are no poison pills. We look closely at the work they do and the people. The key decision for me is whether the people will fit with Redtray. Will I get on with them or am I going to be sitting here in four or five months' time with a big fallout, disagreeing with them over policy and how we implement things?"

Scott believes the lack of cultural fit is the biggest reason why many M&As fail. "But you really take your chances because it's like meeting anyone who has a vested interest—they will be on their best behaviour. Some of them we got spectacularly right and others we got wrong."

The key to success is how the acquisition is integrated. Scott urges the owners to stay on for a period to help the business settle into its new home. Woodland makes a point of calling all his acquisitions, mergers. "It's a softer way of describing what we have done," he explains. "Employees don't like their businesses being acquired. They have worked hard and grown up with their companies. So because there is a high dependence on the new people, I woo them."

For this reason, Woodland deliberately adopts a slow integration process. Acquired companies keep their own names, sometimes for years, a factor which also helps to reassure customers they are going to continue to get the service they expect. "I keep the company independent for as long as I can and then one day the people there call me and say that, as they are working so closely with Redtray, they could drop their old name," he says.

To make sure they integrated smoothly, Gyro and HSR set up a 25-person integration team. They divided into four working groups dealing with external communications to clients, deliverables (such as the new website), finance and legal work, and internal communications (explaining the deal to Gyro's 400 staff and HSR's 200 employees).
"We talked about what we wanted to achieve and the key areas we had to get right to make the merger work," says Glasson.

When Access Technology took over Select Software, O'Reilly and senior colleagues visited Select's Canterbury offices to spend a day with the staff. "We talked to them about the Access Group and what we felt the opportunities were. And we encouraged them to tell us about their part in the business and what their aspirations were."

One of the toughest issues is how to finance deals. The problem hasn't been any easier during the recession as bank lending to business has nosedived. Waud at Incentive wanted to finance his £3m acquisition of QAS partly with debt and partially with equity. But dealing with banks proved a "frustration". Incentive's own bankers, Barclays, "didn't have the appetite" for it, he says. So the company's accountants introduced him to RBS. "They said they were really interested, but the more time they spent looking at it, the more modest their offer became," Waud explains. He needed £2m to finance the cash part of the acquisition, but RBS initially offered a fully secured loan of only £250,000. Later, the bank raised this to £500,000, using the government's Enterprise Finance Guarantee scheme. "But even this wasn't particularly helpful," says Waud.

After much negotiation between Waud, the vendor and the bank, a deal was put together which included the £500,000, with the balance being raised through invoice discounting. But even that arrangement collapsed at the 11th hour because the bank wanted a blanket clause preventing Incentive making payments if banking convenants were breached.

"After a lengthy discussion with all sorts of lawyers and experts, it became clear the bank could stop a payment for whatever reason they wanted," says Waud. In the end, he agreed with the vendor to pay a first instalment immediately from the merged companies' cashflow and the rest in deferred payments against a defined schedule over the next two years. But he remains far from happy at the near £100,000 he's spent on due diligence and arrangement fees to complete the acquisition.

When Redtray's Woodland acquires a new business, he prefers to pay cash rather than use equity in the business. "I just use bank debt," he says. "It's the most beneficial way to acquire and grow a business through acquisition without diluting shareholders."

O'Reilly's acquisitions at Access have been financed by cash. But he does give shares in the group to reward future performance after the deal. "The cash we pay for the business is the owner's reward and recognition for where they've got it today."

Business academics have warned that mergers and acquisitions are as likely to destroy the combined value of the enlarged company as enhance it. But Glasson at GyroHSR reckons that as much as $15m of new revenue could be attributed to the improved strength of the company following the merger.

Incentive's Waud is equally upbeat: the combined business should make around £750,000 profit this year. "We are generating good cashflow, making a good profit and we don't borrow any money at all," he points out. But Redtray's Woodland sounds a note of warning for other directors going on the acquisition trail. "As debt becomes easier to acquire, prices will go up."

Look before you leap

Before you start work on due diligence, make sure the deal is agreed in principle, advises Paul Osborne, head of corporate at law firm Fox Williams.

"A purchaser should seek buy-in from shareholders and confirmation that all are on board," he says. "An understanding on price and who will give warranties is crucial."

Peter Weiss, a partner at law firm Davenport Lyons, advises directors to make sure that all parties have signed a protective confidentiality agreement. He says: "Always obtain full legal and tax advice at an early stage as key issues, such as how to deal with or consult employees, how to address key customers, how to manage any press or leaks about the proposed plans, need to be addressed before the process starts."

The precise scope of due diligence will vary, but it could include any, or all, of the following areas:
Financial
• Examine the target company's accounting policies and decide whether they are reasonable for the industry in which it operates.
• Look at the accounts for "exceptional items" that may have distorted value.
• Determine whether there are contingent liabilities that could affect future value.

Commercial
• Explore the target's unique selling propositions and whether these will be of value in the enlarged company.
• Look at customer and supplier contracts and assess how well they are documented.
• Check what intellectual property the target owns and whether the IP is licensed.
• Review the target's future prospects and decide whether its revenue projections are realistic.

Cultural
• Decide whether there will be a cultural fit from both business and geographical viewpoints.
• Assess the target's management style and gauge whether it will fit into the new organisation.
• Size up the demographic profile of the target's staff and decide whether this will sit comfortably alongside existing workers.
• Gauge how the target company communicates with staff, customers and suppliers.
• Conduct a brand audit to identify synergies, conflicts and potential gaps.

Legal
• Verify legal title to all the target's key assets.
• Examine key contracts to see whether any contain "change of control" clauses that might affect future revenues.
• Check that the target meets all regulatory requirements.
• Confirm whether the business is involved in any unresolved litigation.

Management
• Review whether key managers intend to stay or leave after a takeover.
• Look at management synergies between the buyer and the target, and review how these can be developed.

Environmental
• Determine whether the target has complied with all environmental permits.
• Investigate whether its site is on contaminated land or subject to flooding.
• Weigh up whether future environmental legislation is likely to affect the target company's business.

With thanks to Melissa Needham and Eleanor Mumford Smith at Davies Arnold Cooper LLP, and Terry Tyrrell at The Brand Union