Studies consistently show that in about two-thirds of corporate acquisitions shareholder value is destroyed, which means that companies either paid too much or what they bought did not perform as planned. This is not because the concept of putting two businesses together is flawed; it is a result of user error. In other words, most bad deals can be avoided.
Despite the high failure rate, a recent study conducted by the Boston Consulting Group concluded that companies growing through acquisitions generated greater shareholder returns than those expanding via organic growth. When you combine these two observations, the conclusion is that it makes sense to pursue acquisitions, but only if you do it right.
What makes for a successful acquisition? Obviously, the first screen when contemplating an acquisition should be whether the target company has strategic merit for the buyer. The era of conglomerates in the 1950s and 1960s taught us that, unless you are Jack Welch or Warren Buffet, simply owning a portfolio of disparate businesses that operate autonomously with no operating synergies is not an effective corporate strategy. Before acquiring a company a business owner should ask whether the target has strategic qualities that could be more economically purchased than organically grown. Simply put, does your company lack the capability or the time to build what you are attempting to acquire or can you buy it cheaper than you can build it?
As an example, last year I sold Lawrenceville-based Inter-American Data to Agilysys (NASDAQ: AGYS). IAD was the leading provider of software to casinos and highend resorts. IAD software operated on an IBM platform because of the requirements for reliability demanded by the multi-million dollar enterprises running its products. Agilysys was a $1.5 billion dollar reseller of hardware, much of it IBM. With the commoditization of hardware and resultant shrinking margins, Agilysys felt it needed to provide software applications that were sold in the same markets where it was the leading provider of hardware in order to remain relevant to its customers. Agilysys had neither the skills nor the time to build a software company from scratch. Acquisitions were the only logical way to go.
Some of the strategic reasons why an acquisition might make more sense than organic growth include the following:
Most businesses get the “strategy” part right. The deal makes sense on paper. But there is a lot more to a successful acquisition than strategic merit.
Studies show that the number one reason deals fail is poor cultural fit. As America’s economy shifts to knowledge based industries, most companies’ key asset is their people. If the acquirer assimilates the target into a culture that is anathema to the leaders and workers of the company they are buying, the good people will leave or, at a minimum, they will not be fully productive. Then the acquired company will have difficulty achieving the performance the buyer anticipated.
Sellers who are reticent to introduce their key executives to a prospective buyer prior to closing the deal out of a fear that employees might leave if they know the company is for sale make evaluating cultural fit nearly impossible. Consequently, a buyer should insist on interviewing key executives prior to consummating the transaction. Ask them about the firm’s culture, how it evolved, and what actions are needed to preserve it. While it is important to use employment agreements, bonus programs or non-competes to influence future employee behavior, these legalistic approaches do not compensate for a poor cultural fit.
Another major challenge for the acquiring company is to integrate the new business effectively. A formal plan should be in place prior to closing the deal that addresses key organizational changes, system integrations and customer announcements. The plan may call for a gradual integration, but it needs to be in place nonetheless.
If the acquired business will continue to be run by the prior owner, failure to properly integrate that individual is tantamount to failure. Most entrepreneurs are entrepreneurs for a reason: they don’t like working for someone else. Figure out how they are wired emotionally before you structure the deal. An all-cash offer that makes the CEO independently wealthy is not a good idea if you expect the same motivation going forward that got the company to where it is. In many cases putting a meaningful portion of the purchase price into an earn-out preserves the entrepreneurial bent of the prior owner. If you use an earn-out, just be sure to establish a formula that motivates behavior that is consistent with your integration plan, or you will have fits trying to assimilate the new business.
Another reason deals do not work out as planned is a failure on the part of the buyer to thoroughly do their homework. The process of differentiating what the seller has told you from reality is called due diligence. Companies that do not have the requisite skills in house should hire a good lawyer and CPA to perform the legal and financial due diligence. Hire specialists with extensive deal experience! Do not use your divorce lawyer or the person who completes your tax return just because you trust them.
Unfortunately, many companies never go beyond legal and financial due diligence. Effective due diligence includes speaking with key customers and suppliers, performing background checks on key employees and possibly having consultants examine industry trends and the competitive landscape if the company being acquired is in a business sector with which the buyer is not intimately familiar.
Yet another frequent reason deals fail is that the buyer pays too much. Ironically, it is not uncommon for the buyer to overpay because they tried to minimize transaction expenses and they cut corners on doing the deal properly — the proverbial “penny wise, pound foolish” syndrome. Inexperienced buyers who refuse to hire professionals to help them value the company, structure the deal and assist with due diligence are asking for trouble.
Many first-time acquirers do not have a firm grasp on value when they make their offer. If you are using an industry “rule of thumb,” such as X times sales or so much per customer, you also are likely to get into trouble. At the end of the day, the only metric that matters is cash. A discounted cash flow analysis must be performed to make sure the target’s cash flow covers the buyer’s cost of capital.
Even when the proper analysis is performed, often the assumptions are too aggressive. And even if they are realistic, it is possible to overpay if you lack fiscal discipline. There are two concepts in business valuation that are relevant when making an acquisition. The first is fair market value, which is the value of a business on a standalone basis. The second is investment value, which is what the target company is worth to the buyer given all the synergies between the two companies. Most successful deals are priced somewhere between these two measures of value. Bottom fishers who are unwilling to pay at least fair market value often lose out to other bidders. And buyers who pay at or near investment value have absolutely no upside. If they integrate the two businesses perfectly and achieve all of the projected financial benefits, they simply break even on the deal because they have already paid a price assuming that would occur. The reason to do the deal in the first place is to acquire capabilities at less than investment value so that the buyer can create shareholder value by doing the deal.
Finally, buyers have a tendency to fall in love with their deals. Don’t be afraid to walk away—at any point in the process! The bride who turns and runs from the church is better off than the one who walks down the aisle with serious reservations. You may get stuck with the bill for the reception, but that is a lot cheaper than a failed marriage.
Along the same vein, the sooner you figure out whether you really have a deal the better. When the buyer and seller go too far down the road without a common understanding of the terms of the transaction, it opens up the door for a lot of wasted time and energy. I generally encourage a buyer to lay out the agreed upon deal terms in writing in the form of a letter of intent (subject to due diligence) as soon as they have a handle on the value of the company. State in the letter what assumptions the offer is predicated upon and that there will be adjustments made if those assumptions prove to be inaccurate. When contemplating an acquisition, proceed with caution, but don’t analyze the deal to death before discussing and agreeing on major deal points. Otherwise, you may discover in five minutes that you have wasted five months.
A lot of business owners fear acquisitions, often because they have never taken on a management task in which they weren’t fully in control of the outcome, and rightfully so. Consummating a successful acquisition is not easy. That is why two-thirds of them fail. But very few companies achieve great success without making prudent acquisitions. So it is worth it to pursue transactions that add capabilities more effectively or efficiently than you could create them in-house.
Improve Your Chances for a Successful Acquisition
Michael Jacobs, Author
Michael Jacobs is the CEO of Jacobs Capital and Professor of the Practice of Finance at The University of North Carolina at Chapel Hill. He's the author of several books and a certified speaker.
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