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Are acquisitions part of your company’s growth plan?

Harvard Business Review Blog Network

by Ron Ashkenas  |  10:00 AM February  6, 2013

Odds are the answer is yes. In the first half of 2012, thousands of merger and acquisition deals were announced globally, worth more than $900 billion. And this was a slow year. Predictions are that 2013 will be even more active as companies that have stockpiled cash look to invest in new growth opportunities.

But acquisitions can be risky business. Studies show that as many as two out of three deals do not realize their originally stated goals. And of course some of these fail spectacularly and end up hurting more than helping. HP’s acquisition of Autonomy is a recent case in point in which a transaction that was supposed to be transformative ended up in a multi-billion dollar write-off and messy accusations of fraud.

Given the fact that acquisitions and mergers are critical pathways to growth, companies will continue to pursue them, no matter what the potential downsides. To reduce the risks however, there are two steps that managers can take to make sure their firms are ready for the challenges of integration before committing to an actual deal. So if you and your colleagues are contemplating an acquisition, here’s a possible game plan.

First, create a high-level picture of what you want a combined company ideally to look like one year after a successful integration — not just in terms of finances, but also in regard to operational practices, strategic initiatives, organizational structure, and culture. This thought-process will smoke out your assumptions about how much change you think the company needs. More importantly, it will give you a basis for dialogue with other managers about their expectations for change, which might be different than yours. In fact, one of the reasons that integrations falter is the lack of alignment among managers about what will actually happen.

In a certain integration at a healthcare services organization, for example, senior leaders were ambivalent about whether they wanted to allow the newly acquired company to continue its own care standards or adopt their more stringent policies. In the absence of a clear decision from above, product managers and caregivers all made their own choices, which led to quality and compliance problems. The real issue was the extent to which the management team was willing to devote time and resources for training, documentation, communication, and all the other aspects of a major change effort. Knowing this ahead of time would have made the leaders think twice about what they were getting into.

Once you have a picture of the combined company, the second step is to do what we might call “backward resource planning.” This means starting with the vision and then working backwards to see what will it take to achieve it — what resources will be needed (e.g. teams, leaders, investments), what oversight and governance might be required, what skills would be essential.

One of the fundamentally flawed assumptions that companies make about integrating acquisitions is that managerial and professional time is infinitely expandable. The reality is that the best people — the ones that need to be assigned to diligence and integration teams — already have full-time and important jobs. So when they are asked to also take on integration assignments, they end up making choices about what not to do. When that happens, all sorts of other things start falling through the cracks, which is why we often see, during integrations, a degradation of customer service, increases in cycle time, and other performance shortfalls.

Some executives deal with this problem by hiring armies of consultants to do the heavy lifting. What they don’t realize is that managers still need to work with these consultants, give them direction, share information, and make sure that the work is being done properly. More importantly, unless managers are deeply involved, they won’t own the eventual outcomes of the integration process. So there’s no getting around the resource issues. What you as a manager can do, however, is prepare. Go into the integration process with a clear sense of the tradeoffs: Given the resources needed, what else can be stopped or delayed? What priorities can be reset? What goals need to be deferred? What work can be eliminated? What managers can be freed up to contribute to the integration projects? And will the eventual outcome be worth the effort?

Combining all or parts of two companies will always be challenging and entail a certain amount of risk. But before chasing the shiny new deal, it’s important to take a hard look at what it will take to succeed, and what it will take to get ready.

For more advice from Ron Ashkenas and others on this topic, read The Merger Dividend and Integration Managers: Special Leaders for Special Times.

 

The Anatomy of a Deal

The following might be a subtitle for this true account of how one deal was put together: “In spite of everything, you need only one buyer – the right one!” (Although the transaction is factual, names, financial data and other details are fictional.)

The company (let’s call it IndustrialTech) has carved a niche in a billion dollar industry. It manufactures proprietary electronic products and is owned by a private equity firm that wants to sell it for liquidity reasons. At the beginning of 2010, the private equity group retained Forbes Mergers & Acquisitions to take the company to market. The goal was to have it sold by the end of the year.

IndustrialTech had annual sales of about $12 million, gross margins of 50 percent, an EBITDA of $1.8 million (15 percent) and a reconstructed EBITDA of $2 million. It also had been growing over the past ten years at a 10 percent rate and had always been profitable. It had a diverse customer base split about equally between end-users and OEM accounts. However, the seller wanted to set a very aggressive full price, with all-cash in a not-so-vibrant M&A market.

On the plus side, however, the seller was cooperative and provided any information that Forbes needed. It also had audited statements, conservative accounting and instant monthly statements. IndustrialTech was, in addition to these factors, on the verge of getting a substantial amount of new business.

In preparing to take the business to market, Forbes came up with a basic game plan. For confidentiality reasons, certain direct competitors were eliminated from the buyer search. Synergistic buyers were targeted-either because they served similar markets or utilized similar manufacturing methods. Forbes also elected to contact selected private equity groups and other intermediary firms.

More specifically, Forbes planned on creating a list of 100 potential buyers. A buyer was defined as an entity that had signed a Confidentiality Agreement, had been pre-approved by the seller, and therefore, had been sent an Offering Memorandum. Forbes anticipated 15 written Term Sheets leading to five Letters of Intent which, hopefully, would lead to the best deal. Forbes advised IndustrialTech that the market was currently below the multiples asked by the seller. However, they succeeded in getting the seller’s premium valuation, and that success was to be based on the following:

  • Preparing a thorough and compelling Offering Memorandum and detailing out the positive future prospects. This required the complete cooperation of IndustrialTech’s management team.
  • Developing a complete list of possible buyers both in the U.S. and abroad.
  • Contacting the buyers to see if they would be interested in the company, but still maintaining confidentiality.
  • Administering all of the potential buyer activity and sending the Offering Memorandum to the appropriate parties.
  • Following up with all of the prospects who received the Offering memorandum and arranging tours of the facilities with the serious prospects.
  • Setting time frames for expressions of interest and term sheets, and fielding questions from the serious prospects.
  • Holding the deal together in spite of fall out from the global recession, which resulted in a two-month delay that could have been much longer.
  • Making sure that complete confidentiality was maintained and making sure that any future confidentiality leaks did not occur.
  • Constantly reminding IndustrialTech’s management to stay focused on maintaining sales and profit goals.
  • Maintaining communications with both the buyers and IndustrialTech’s lawyers and other outside advisors.

Forbes was able to develop a list of 85 possible acquirers; however, five would not sign the Confidentiality Agreement. Here is a breakdown of the 85 possible buyers:

  • Strategic – 45
  • Some Synergy – 20
  • Private Equity Groups – 20

Of the 85 possible buyers, 15 were companies or divisions of firms with annual revenues of $1 billion or more. 12 of these 15 were foreign or owned by foreign companies. IndustrialTech chose not to deal with four of the buyer firms due to negative industry knowledge. Two of the buyers were individuals that had financial backers. Four buyers were just “bottom fishing.” Three of the 85 decided not to move forward due to the credit crisis. One buyer only wanted to acquire assets, not the stock, of IndustrialTech. Interestingly, eight of the 85 firms had previously talked to IndustrialTech about a possible merger or acquisition.

Of the buyers who elected not to proceed or move forward, the majority felt that acquiring IndustrialTech was just not a good fit. Some of the other reasons why other buyers decided not to continue were:

  • Management was too thin
  • Since IndustrialTech was a good company, the price would most likely be too high
  • Buyer purchased another firm
  • One potential acquirer was acquired itself
  • Buying company was having its own internal problems
  • Buyer wanted to move company – this was unacceptable to the seller

After all of this, Forbes arranged five visits for acceptable buyers – the target number. Overall, Forbes received:

  • Term Sheets 4
  • Verbal Offers 2
  • Letters of Intent 4

Of the five buyers who visited the business and met with IndustrialTech’s management, two wanted to acquire the company. These were the best prospects. There were also two other firms, held in abeyance, in case one of the other two didn’t work out.

One of the original two and IndustrialTech’s preferred acquirers competed for the business and ultimately offered the desired price and terms. The buyer was:

  • A public company that wanted to grow through acquisition.
  • One with a synergistic product line.
  • Unlike some of the private equity groups, not totally focused on the financial aspects.
  • One with an appreciation of IndustrialTech’s product lines, its technology and the company’s potential.

Forbes started with 85 possible buyers. The final list came down to just a few and global recession certainly did not help in the sales efforts. IndustrialTech was not a company for just anyone. Despite all of this, Forbes got the deal done – proving once again, that you need only one buyer – the right one!

Business Valuation: Do the Financials Tell the Whole Story?

Many experts say no! These experts believe that only half of the business valuation should be based on the financials (the number-crunching), with the other half of the business valuation based on non-financial information (the subjective factors).

What subjective factors are they referring to?  SWOT is an acronym for Strengths, Weaknesses, Opportunities and Threats – the primary factors that make up the subjective, or non-financial, analysis. Below you will find a more detailed look at the areas that help us evaluate a company’s SWOT.

Industry Status – A company’s value increases when its associated industry is expanding, and its value decreases in any of the following situations:  its industry is constantly fighting technical obsolescence; its industry involves a commodity subject to ongoing price wars; its industry is severely impacted by foreign competition; or its industry is negatively impacted by governmental policies, controls, or pricing.

Geographic Location – A company is worth more if it is located in states or countries that have a favorable infrastructure, advantageous tax rates, or higher reimbursement rates.  A company with access to an ample educated and competitive work force will also enjoy increased value.

Management – A company with low turnover in management and a solid second-tier management team comprised of different age levels is also worth more.

Facilities – A company operating profitably at 70 percent capacity is worth more than a company currently near capacity. Equipment should be up to date and any leases – either equipment or real estate – renewable at reasonable rates.

Products or Services – A company is worth more if its products or services are proprietary, are diversified with some pricing power, and have, preferably, a recognizable brand name. In addition, new products or services should be introduced on a regular basis.

Customers – A company is worth more if there is not heavy customer concentration, but rather recurring revenue from long-time, loyal customers, as well as from new customers created through a regular and systematic sales process.

Competition – A company not contending head to head with powerful competitors such as Microsoft or Wal-Mart will rate a higher value.

Suppliers – Finally, a company is worth more if it is not dependent on single sourced key items or items available from only a limited number of suppliers.

Do You Have an Exit Plan?

“Exit strategies may allow you to get out before the bottom falls out of your industry. Well-planned exits allow you to get a better price for your business.”

From: Selling Your Business by Russ Robb, published by Adams Media Corporation

Whether you plan to sell out in one year, five years, or never, you need an exit strategy. As the term suggests, an exit strategy is a plan for leaving your business, and every business should have one, if not two. The first is useful as a guide to a smooth exit from your business. The second is for emergencies that could come about due to poor health or partnership problems. You may never plan to sell, but you never know!

The first step in creating an exit plan is to develop what is basically an exit policy and procedure manual. It may end up being only on a few sheets of paper, but it should outline your thoughts on how to exit the business when the time comes. There are some important questions to wrestle with in creating a basic plan and procedures.

The plan should start with outlining the circumstances under which a sale or merger might occur, other than the obvious financial difficulties or other economic pressures. The reason for selling or merging might then be the obvious one – retirement – or another non-emergency situation. Competition issues might be a reason – or perhaps there is a merger under consideration to grow the company. No matter what the circumstance, an exit plan or procedure is something that should be developed even if a reason is not immediately on the horizon.

Next, any existing agreements with other partners or shareholders that could influence any exit plans should be reviewed. If there are partners or shareholders, there should be buy-sell agreements in place. If not, these should be prepared. Any subsequent acquisition of the company will most likely be for the entire business. Everyone involved in the decision to sell, legally or otherwise, should be involved in the exit procedures. This group can then determine under what circumstances the company might be offered for sale.

The next step to consider is which, if any, of the partners, shareholders or key managers will play an actual part in any exit strategy and who will handle what. A legal advisor can be called upon to answer any of the legal issues, and the company’s financial officer or outside accounting firm can develop and resolve any financial issues. Obviously, no one can predict the future, but basic legal and accounting “what-ifs” can be anticipated and answered in advance.

A similar issue to consider is who will be responsible for representing the company in negotiations. It is generally best if one key manager or owner represents the company in the sale process and is accountable for the execution of the procedures in place in the exit plan. This might also be a good time to talk to Forbes M&A for advice about the process itself. Forbes M&A can provide samples of the documents that will most likely be executed as part of the sale process; e.g., confidentiality agreements, term sheets, letters of intent, and typical closing documents. We can also answer questions relating to fees and charges.

One of the most important tasks is determining how to value the company. Certainly, an appraisal done today will not reflect the value of the company in the future. However, a plan of how the company will be valued for sale purposes should be outlined. For example, tax implications can be considered: Who should do the valuation?  Are any synergistic benefits outlined that might impact the value?  How would a potential buyer look at the value of the company?

An integral part of the plan is to address the due diligence issues that will be a critical part of any sale. The time to address the due diligence process and possible contentious issues is before a sale plan is formalized. The best way to address the potential “skeletons in the closet” is to shake them at this point and resolve the problems. What are the key problems or issues that could cause concern to a potential acquirer? Are agreements with large customers and suppliers in writing? Are there contracts with key employees? Are the leases, if any, on equipment and real estate current and long enough to meet an acquirer’s requirements?

The time to address selling the company is now. Creating the basic procedures that will be followed makes good business sense and, although they may not be put into action for a long time, they should be in place and updated periodically.

Why Do Deals Fall Apart?

In many cases, the buyer and seller reach a tentative agreement on the sale of the business, only to have it fall apart. There are reasons this happens, and, once understood, many of the worst deal-smashers can be avoided. Understanding is the key word. Both the buyer and the seller must develop an awareness of what the sale involves–and such an awareness should include facing potential problems before they swell into floodwaters and “sink” the sale.

What keeps a sale from closing successfully? In a survey of business brokers across the United States, similar reasons were cited so often that a pattern of causality began to emerge. The following is a compilation of situations and factors affecting the sale of a business.

The Seller Fails To Reveal Problems 
When a seller is not up-front about problems of the business, this does not mean the problems will go away. They are bound to turn up later, usually sometime after a tentative agreement has been reached. The buyer then gets cold feet–hardly anyone in this situation likes surprises–and the deal promptly falls apart. Even though this may seem a tall order, sellers must be as open about the minuses of their business as they are about the pluses. Again and again, business brokers surveyed said: \”We can handle most problems . . . if we know about them at the start of the selling process.

The Buyer Has Second Thoughts About the Price 
In some cases, the buyer agrees on a price, only to discover that the business will not, in his or her opinion, support that price. Whether this “discovery” is based on gut reaction or a second look at the figures, it impacts seriously on the transaction at hand. The deal is in serious jeopardy when the seller wants more than the buyer feels the business is worth. It is of prime importance that the business be fairly priced. Once that price has been established, the documentation must support the seller\’s claims so that buyers can see the “real” facts for themselves.

Both the Buyer and the Seller Grow Impatient 
During the course of the selling process, it\’s easy–in the case of both parties–for impatience to set in. Buyers continue to want increasing varieties and volumes of information, and sellers grow weary of it all. Both sides need to understand that the closing process takes time. However, it shouldn’t take so much time that the deal is endangered. It is important that both parties, if they are using outside professionals, should use only those knowledgeable in the business closing process. Most are not. A business broker is aware of most of the competent outside professionals in a given business area, and these should be given strong consideration in putting together the “team.” Seller and buyer may be inclined to use an attorney or accountant with whom they are familiar, but these people may not have the experience to bring the sale to a successful conclusion.

The Buyer and the Seller Are Not (Never Were) in Agreement 
How does this situation happen? Unfortunately, there are business sale transactions wherein the buyer and the seller realize belatedly that they have not been in agreement all along–they just thought they were. Cases of communications failure are often fatal to the successful closing. A professional business broker is skilled in making sure that both sides know exactly what the deal entails, and can reduce the chance that such misunderstandings will occur.

The Seller Doesn\’t Really Want To Sell 
In all too many instances, the seller does not really want to sell the business. The idea had sounded so good at the outset, but now that things have come down to the wire, the fire to sell has all but gone out. Selling a business has many emotional ramifications; a business often represents the seller\’s life work. Therefore, it is key that prospective sellers make a firm decision to sell prior to going to market with the business. If there are doubts, these should quelled or resolved. Some sellers enter the marketplace just to test the waters; to see if they could get their “price,” should they ever get really serious. This type of seller is the bane of business brokers and buyers alike. Business brokers generally can tell when they encounter the casual (as opposed to serious) category of seller. However, an inexperienced buyer may not recognize the difference until it\’s too late. Most business brokers will agree that a willing seller is a good seller.

Or…the Buyer Doesn’t Really Want To Buy 
What\’s true for the mixed-emotion seller can be turned right around and applied to the buyer as well. Buyers can enter the sale process full of excitement and optimism, and then begin to drag their feet as they draw closer to the “altar.”

And None of the Above 
The situations detailed above are the main reasons why deals fall apart. However, there can be problems beyond anyone’s control, such as Acts of God, and unforeseen environmental problems. However, many potential deal-breakers can be handled or dealt with prior to the marketing of the business, to help ensure that the sale will close successfully.

A Final Note 
Remember these components in working toward the success of the business sale:

  • Good chemistry between the parties involved.
  • A mutual understanding of the agreement.
  • A mutual understanding of the emotions of both buyer and seller.
  • The belief, on the part of both buyer and seller, that they are involved in a good deal

What is a Company Worth?

This question can only be answered by addressing other related questions, specifically: Who’s asking and for what purpose?

From the perspective of the owner, prospective buyers, the IRS, lenders and divorce & bankruptcy courts, the value of a business for purposes of a sale, estate planning, orderly or forced liquidation, gifting, divorce, etc. can be vastly different.

[restrict …]Intrinsically tied to the various purposes of valuation are numerous definitions of “value.” Here are a few examples:

Investment Value – The value an acquirer places on a business based on a future return on investment determined by assessing past and current performance, future prospects, and other opportunities and risk factors involving the business.

Liquidation Value – The value derived from the sale of the assets of a business that is closed or expected to be closed following the sale.

Book Value – Book value is the difference between the total assets and total liabilities as accounted for on the company’s balance sheet.

Going Concern Value – Used to define the intangible value which may exist as a result of a business having such attributes as an established, trained and knowledgeable workforce, a loyal customer base, in-place operating systems, etc.

Fair Market Value
For the purpose of this article, the focus will be on transaction related valuations. Fair Market Value (“FMV”) is the most relevant definition of “value” and is of the most interest to business owners. The more knowledge business owners and prospective buyers have about the valuation process, the more likely they will come to an agreement on a purchase price.

FMV is the measure of value most used by business appraisers, as well as the Internal Revenue Service (IRS) and the courts. FMV is essentially defined as “the value for which a business would sell assuming the buyer is under no compulsion to buy and the seller is under no compulsion to sell, and both parties are aware of all of the relevant facts of the transaction.” IRS Revenue Rule 59-60 lists the following factors to consider in establishing estimates of FMV:

1. The nature and history of the business.
2. The general economic outlook and its relation to the specific industry of the business under review.
3. The earnings capacity of the business.
4. The financial condition of the business and the book value of the ownership interest.
5. The ability of the business to distribute earnings to owners.
6. Whether or not the business has goodwill and other intangible assets.
7. Previous sales of ownership interests in the business and the size of ownership interests to be valued.
8. The market price of ownership interests in similar businesses that are actively traded in a free and open market, either on an exchange or over-the-counter.

What is Goodwill?
An important element of value, when it exists, is goodwill. The IRS defines goodwill in its Revenue Rule 59-60, stating, “In the final analysis, goodwill is based upon earning capacity. The presence of goodwill and its value, therefore, rests upon the excess of net earnings over and above a fair return on the net tangible assets. While the element of goodwill may be based primarily on earnings, such factors as the prestige and renown of the business, the ownership of a trade or brand name, and a record of successful operation over a prolonged period in a particular locality, also may furnish support for the inclusion of intangible value. In some instances it may not be possible to make a separate appraisal of the tangible and intangible assets of the business. The enterprise has a value as an entity. Whatever intangible value there is, which is supportable by the facts, may be measured by the amount by which the appraised value for the tangible assets exceeds the net book value of such assets.”

Valuation Approaches and Methods
Exploring valuation techniques requires an understanding of the tools available. Which tools are utilized depends in part on the purpose of the valuation and the circumstances of the subject company. Generally there are several approaches to valuing a business. Within these approaches, there are several different methods. Listed below are the three major approaches along with some examples of specific methods that fall under each category.

• Income Approach
Discounted Cash Flow Method
Single Period Capitalization of Earnings Method
• Market Approach
Comparable Publicly Traded Company Analysis
Comparable Merger & Acquisition Analysis
• Asset-Based Approach
Adjusted Net Asset Method
Excess Earnings Method

All of the above methods and approaches are frequently used in business valuations.

Normalizing the Financial Statements
Before the approaches and methods above can be applied, it is necessary to analyze and normalize both the income statement and balance sheet of the business for the current and past periods selected to form the basis of the valuation.

• Normalizing the Income Statement

Normalizing the Income Statement generally entails adding back to earnings certain personal expenses, non-recurring and non-cash items. Examples of these “add-backs” could include depreciation, amortization, auto, boat and airplane expenses, one-time extraordinary expenses and other excess expenses such as owner’s salaries and family member’s salaries that are above fair market value, travel and entertainment, bonuses, etc. Owners usually tend to be extremely liberal when normalizing the income statement in order to bolster earnings, which can artificially inflate valuation. Each item must be carefully analyzed and scrutinized to insure that the normalization process is credible.

• Normalizing the Balance Sheet

Normalizing the Balance Sheet includes adjustments that eliminate non-operating assets and other assets and liabilities that are not included in the proposed transaction, and therefore the valuation. The book value of the assets will be adjusted up or down to reflect their fair market value. Inter-company charges will also be eliminated. Inventory may be adjusted upward or downward based on prior accounting procedures and/or obsolescence. Accounts receivable may also require an adjustment based on an analysis of collectibility.

Relevant Terminology:

EBIT – An acronym for earnings before interest and taxes

EBITDA – An acronym for earnings before interest, taxes, depreciation and amortization.

Capitalization Rate – Any divisor that is used to convert income into value. This is generally expressed as a percentage.

Discount Rate – The rate of return that is used to convert any future monetary gain into present value.

(Note: when determining FMV, the earnings stream selected to be capitalized or discounted should be normalized.)

Summary
Even with all the terminology and definitions discussed above, the answer to the original question has not yet completely been answered: What is the company worth?

The value driver of a business is the ability of the entity to generate future cash flow or earnings. Business appraisers will assign an appropriate capitalization rate (or multiple) to a selected earnings stream to derive an overall value for a business. The value of the net assets of the business will be compared to the cash flow valuation and may be adjusted upward or downward. For example: if the earnings based valuation is less than the net asset value, an upward adjustment may be in order. Conversely, if the net assets are negligible, a downward adjustment is more likely to occur.

Many appraisers typically use a common range of multiples to arrive at a “ballpark” indication of value (for example, 4 to 6 times EBITDA). While this approach is commonplace, an in-depth valuation of the subject company will produce a more accurate result. There are too many intangible factors to be considered to rely solely on the capitalization of earnings. Of course, the ultimate value of a company will be determined by the marketplace, which can greatly differ from a seller’s expectation, as well as the expectations of potential acquirers.

It is not uncommon for business owners to have an inflated sense of value of their company. This could be due to a variety of factors including emotional attachment to the business, unwillingness to accept the impact of the risk factors of the business, outside influence from previous market conditions, incorrect conclusion of normalized earnings, comparable transactions, etc. Conversely, acquirers often undervalue businesses. In their quest to “buy right” they often end up paying a lower multiple for a company with serious negative factors, while passing up on higher multiple opportunities, which, due to the quality, are actually better buys.

Valuation is a complex process. Owners and buyers will be well served if they rely on professional advisors such as their accountants, business appraisers, intermediaries or investment bankers.[/restrict]