Best Practices: Mergers & Acquisitions

Is an Acquisition Right for You?

These days, it seems, everybody wants to make a deal. Mergers, acquisitions and rollups are taking place at a record clip. But just because deals seem to be going down on every corner does not mean that everyone should pursue an acquisition. According to TEC speakers and M&A experts Terry Gambill and Bill Hodge, acquisitions carry a high degree of risk. When properly planned and implemented, acquisitions offer a legitimate growth strategy for companies of all sizes. But when they fail, they generally fail big-time.

According to Gambill and Hodge, there are many legitimate reasons for acquiring another company. These include:

• Expanding your markets
  
  
• Acquiring people, systems or processes
  
  
• Acquiring new products, services or customers
  
  
• Achieving economies of scale
  
  
• Reducing expenses
  
  
• Creating opportunities for cross-selling
  
  
• Acquiring new distribution systems
  
  
• Eliminating competition

Ultimately, however, all legitimate reasons for contemplating an acquisition fall under one all-encompassing umbrella -- the desire or need for quick and substantial growth.

"When you get down to it, the only real reason to acquire a company is to create significant growth," states Gambill. "If you want to grow incrementally, don't bother with an acquisition."

To tell if an acquisition makes sense for your business, ask three simple questions:

• What are the different ways I could grow my business?
  
  
• Could an acquisition help me achieve that growth?
  
  
• What larger, strategic goals will that growth help me accomplish?

What makes for a good acquisition? According to Gambill:

• Having a solid foundation in place, meaning your people, systems and resources are sufficient to handle integrating another company
  
  
• A well-planned acquisition strategy
  
  
• Realistic plans in terms of expectations and time schedules
  
  
• Appropriate price and terms, with a "realistic" debt load
  
  
• Clear and well-executed people/transition plans
  
  
• Reasonable additional capital investment requirements
  
  
• Having clarity around your personal and professional expectations for the deal

Before making any M&A deals, ask yourself:

• Will this acquisition increase our profits?
  
  
• Will it improve the balance sheet?
  
  
• Is the risk acceptable?

If you can't answer "yes" to each question, say our experts, don't do the deal.

How to Do Successful Acquisitions

To ensure a successful acquisition, say Gambill and Hodge, get your strategy right first. Formulating an acquisition strategy requires four basic steps:

1. Identify your goals.
   
   
2. Consider other alternatives.
   
   
3. Establish key parameters for the deal.
   
   
4. Create a one-page acquisition criteria sheet.

Once you have completed these steps, you're ready to start looking for a company to acquire. Before diving head-first into an acquisition, however, make sure you have the right foundation in place in your own business. This includes:

• Computer and information management systems
  
  
• Management teams
  
  
• Financial planning and reporting
  
  
• Human resources

According to Hodge, potential buyers should answer four sets of strategic questions before making an acquisition:

1. Does the company to be acquired clearly fit into my growth strategy? Will the acquisition increase my competitive position or my profits, either through growth in revenues, efficiency gains, breakthroughs in technology or some other quantifiable measure?
   
   
2. Will the transition work smoothly? Will the two companies integrate well, physically and culturally?
   
   
   
3. Am I paying the right price? Do I have the right deal structure? Does the present value of the cash I expect to receive from the deal exceed what I will pay for the business?
   
   
4. What synergies -- either in terms of revenue enhancements or cost reductions -- do we intend to achieve? How and when will we achieve them?

One of the primary concerns in any acquisition is how to control the risks. The first step in this process involves developing a good acquisition strategy. Other risk-management strategies include:

• Conducting effective due diligence
  
  
• Using the terms of the deal to get the seller to share in the risk
  
  
• Having a written transition plan
  
  
• Assembling an experienced acquisition team to consummate the deal.

If at any time during the deal the risk level exceeds the expected return, walk away.

Finding the Right Acquisition Candidate

To guide your search for qualified candidates, Gambill recommends developing a one-page "acquisition criteria sheet" that outlines:

• Who you are, what you do and where you do it
  
  
• Your company's core competencies
  
  
• How you are financed
  
  
• What you're looking for, including:
  
  
• Type of business
  
  
• Size of the business
  
  
• Where it could or should be located
  
  
• Whether you want to buy all or part of the business
  
  
• Whether you want people, places or things, or stand-alone business units
  
  
• Examples of what the deal could look like (if you have already done similar deals)
  
  
• The contact person at your company.

Keep your criteria short and to the point. If you can't fit the information onto one sheet of paper, you haven't defined your criteria clearly enough.

With acquisition criteria sheet in hand, you can now start looking for companies to acquire. Acquisition candidates can turn up in many different places, including:

• Related companies
  
  
• Customers or distributors
  
  
• Vendors
  
  
• Trade shows and industry association groups
  
  
• Salespeople
  
  
• The Internet

Once a candidate meets your initial deal criteria, the next step involves assessing the potential synergies in the deal. Hodge states that synergies come in two categories -- performance breakthroughs and revenue enhancements. Without synergy in at least one of these areas, the deal will likely fall flat on its face.

In addition to assessing the potential synergy, ask the following questions:

• Does the acquisition candidate clearly fit in with our growth strategy?
  
  
• Will the company integrate well (operationally) with our business?
  
  
• Can the two cultures be integrated?
  
  
• How will acquiring this company increase our competitive position?

Successful buyers, say our experts, share four essential traits -- discipline, persistence, patience and timing. Figure out what you want, stick with your criteria, take the time to initiate and develop relationships with potential candidates, and be ready to take advantage of opportunities when they arise.

Due Diligence: Checking Out the Deal

How do you know whether a potential deal will really work? Do your homework, say our experts.

According to Hodge, anyone acquiring another business should do in-depth due diligence in three critical areas: marketing, financial and legal (which includes environmental concerns). Marketing due diligence involves taking a hard look at your assumptions regarding the company's future revenue growth and profitability assumptions, as well as assessing the market's key leverage points and how those might be changing. Financial and legal due diligence can be covered by examining four key areas -- assets, liabilities, cash flow and revenue and growth rate.

In addition to these areas, Gambill points out a fourth equally important area -- cultural due diligence. This requires researching how the organization is run, how management reviews, evaluates and rewards employees, and how management sets performance expectations.

To conclude the due diligence process, Gambill recommends creating financial projections using different scenarios. To "pro forma" the deal:

• List all your assumptions (in detail) regarding the deal.
  
  
• Re-examine the potential synergies.
  
  
• Do two three-year cash flow pro formas.
  
  
• Determine whether the projections indicate a workable deal.

To enhance your overall due diligence efforts, say Gambill and Hodge:

• Create a cross-functional due diligence team.
  
  
• Have every member of your due diligence team ask people at all levels in the company to be acquired: What are the three biggest problems in this business? What are the three biggest opportunities in this business?
  
  
• Avoid the two biggest due diligence mistakes -- over-confidence in the company's future revenue growth and profitability, and misunderstanding the business you intend to acquire.
  
  
• Keep your B.S. detector turned on high and avoid surprises.

Determining Value

Before attempting to place a value on the company you want to buy, it helps to understand three fundamental principles:

1. The method used by a buyer to value a seller candidate is unique to acquisitions.
   
   
2. Valuation is seller candidate-specific.
   
   
3. Price and value are not the same thing.

According to Hodge, the value of a business is a reflection of four key elements -- assets, technology, cash flow and synergy. Together, the first three represent the "stand-alone value" (SAV) of the business, which equals the value a professional valuator will place on the seller's business. Business valuators do not include synergy in their calculations of the seller's value; synergy can only be calculated by the buyer.

The "buyer's economic value" (BEV) establishes the maximum price you can pay and still have a successful deal. To determine BEV, subtract the pre-acquisition SAV value of your business from the value of the combined companies on a post-acquisition basis. Your BEV represents the high end of the price negotiating range.

The SAV of the seller-candidate sets the minimum price the seller will ask (a rational seller will not sell his company below his SAV.) The final price agreed to during negotiations will fall somewhere in between the SAV of the seller-candidate and the BEV.

To avoid losing value in the deal, keep a close eye on the premium -- the amount you pay above SAV. When calculating value, suggests Hodge, keep the following in mind:

• Synergy drives everything in an acquisition. Don't get involved in a deal that can't generate synergy.
  
  
• Never try to force the numbers. If you have checked the numbers several times and the synergy isn't there, rethink your acquisition strategy.
  
  
• Even if the numbers work, don't consider the synergy as a given. Creating the synergy is always harder than it looks on paper.
  
  
• Recognize that price out the door does not represent the entire price. As the buyer, price equals the cash you pay for the business plus any debt you assume.

"Successful deals involve finding the right seller at the right price with the right approach," concludes Hodge. "If you do these three things right, you can do a lot of other things wrong and it won't matter that much. But if you do even one of these wrong -- especially paying too high a price -- you can do everything else right and still have a lousy deal."

Negotiating the Deal

To get the best deal, says Gambill, let the seller set the price as long as you get to set the terms. In many cases, creative use of terms will allow you to meet the seller's price without paying more than you want.

For example, suppose a business owner wants $2 million for his company but you value it at $1 million. By structuring the deal as $100,000 down, $400,000 in five one-year, no-interest notes, and $1.5 million as five percent of sales, the owner gets his asking price, while you will pay only slightly more than $1 million (based on present net value of the five-year payments). Equally as important, you get the seller to share the risk. If the business goes into the tank over the next five years, you only pay five percent of whatever the business ends up being worth.

When negotiating terms, says Gambill:

• Pay as little cash as possible.
  
  
• Use contingent payments that have a finite cutoff date.
  
  
• Include any consulting agreements with the owner as part of the deal, not as an add-on.
  
  
• Buy inventory on consignment, so that you pay for it as you use it over time.

"It's always easier to reduce risk through creative terms than through lowering price," explains Gambill. "The more you can use terms to get the seller to share the future, the more you share the risk of the acquisition."

In terms of the overall negotiations, keep the following in mind:

• You can't negotiate a good deal unless you're willing to walk away.
  
  
• Probe on price but don't react to the answer.
  
  
• Early in the relationship, look for ways to softly say "no."
  
  
• Keep your ego in your pocket. Ego kills a lot of otherwise good deals.
  
  
• Limit your attorney's role to helping you document the deal and making sure all your decisions are properly and legally implemented.
  
  
• Hire a professional negotiator.
  
  
• Go slow and build the relationship with the seller.
  
  
• Avoid an auction situation.
  
  
• Keep asking why the company is for sale until you feel comfortable with the answer.

"In order to negotiate a good deal, be prepared to walk away at any time," advises Gambill. "Constantly ask yourself, 'What will cause me to walk away, and am I there yet? Knowing your walk-away points and sticking to them will save you a lot of grief in the long run.".

Managing Transition: Seeing the Deal Through

Every acquisition has a "hard" and a "soft" side. The hard side represents the numbers -- the cash flows, revenue streams, cost savings, valuation, price and terms. The soft side represents the people side of the equation. While most CEOs focus the majority of their time and attention on the numbers, the people issues often make or break a deal.

The CEO of the acquiring company needs to take a very active, hands-on role during the transition period. In particular, he or she must:

• Set crystal-clear performance expectations
  
  
• Communicate those expectations to all levels of both organizations
  
  
• Lay out what the transition will look like
  
  
• Address the WIIFM (what's in it for me?) factor

"Acquisition creates change, especially for people in the company being acquired," explains Gambill. "And as we all know, people tend to resist change. Unless you address their issues in a forthright manner, the transition effort can quickly grind to a halt."

According to Hodge, a good transition plan addresses the following areas:

• Who will do what, by when?
  
  
• How will decisions be made?
  
  
• What will the new reporting structure look like?
  
  
• Do you intend to integrate the new people into your physical facility or keep them in theirs?
  
  
• How will everything fit together?
  
  
• Will the current systems support the planned changes? If not, what changes need to take place so they can?

A transition plan needn't be overly complex or detail-oriented. In fact, the shorter, simpler ones often work better -- as long as they conceptually integrate all the key parts and players. To enhance your transition efforts:

• Create the transition plan before you sign the deal.
  
  
• Get involved and be visible.
  
  
• Hit the ground running and make quick decisions.
  
  
• Be honest.
  
  
• Don't confuse cultural differences with political maneuvering.
  
  
• Avoid unplanned turnover.
  
  
• Keep the best of the best.
  
  
• Don't put new people in new jobs.

Above all, transition requires a team effort. To succeed, get the managers in both companies working together early on and keep them involved throughout the transition.

Avoiding the Deal-Killers

According to Gambill and Hodge, only about one out every three acquisitions actually achieve their stated pre-merger goals. They identify the following as some of the most common (and lethal) culprits:

• Bad strategy
  
  
• Failure to properly analyze the deal synergies
  
  
• Bad chemistry and cultural conflicts
  
  
• Unrealistic expectations
  
  
• Failure to consider the potential impact on your core business
  
  
• Lack of or poorly implemented transition plan
  
  
• Sloppy due diligence/ignoring red flags
  
  
• Emotional buying
  
  
• Unrealistic debt load
  
  
• Failure to spend money on professionals

"Remember, this represents only a partial list of everything that can go wrong," advises Hodge. "No matter how you look at it, acquiring another company is risky business. Go into them with your eyes open and know that a lot of things have to go right in order for you to succeed.".

Contributing Experts:

Terry Gambill

Terry Gambill is the founder and president of TEGAM, Inc. which manufactures electronic test and measurement equipment for global metrology, calibration and production test applications. During his career, he has founded five companies and has acquired or sold more than 20 companies and product lines. He speaks frequently about business issues, including growth by acquisition, and has contributed to articles on acquisition strategies in journals such as M&A Today. A former TEC member, he addresses TEC groups on "How to Plan and Execute Successful Acquisitions" and "The CEO as Dealmaker."

Bill Hodge

Bill Hodge is an investment banker and CPA who specializes in mergers and acquisitions of small to mid-sized companies. In his 27 years of business experience, he has owned four companies and completed countless M&A deals for corporate clients. For the past seven years he has bought and sold companies for his own account and has provided business development expertise (M&A strategy, finding, negotiating and implementing acquisitions and divestitures) for those companies too small to afford this function in-house. A TEC member and entrepreneur, Hodge speaks to TEC groups on the subject of "How to Grow Through Acquisitions."

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