Mighty Tools Chapter 4 Assessment

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Fumbled strategic acquisitions was identified as one of seven growth killers targeting midsized firms in Robert Sher’s book, Mighty Midsized Companies: How Leaders Overcome 7 Silent Growth Killers (Bibliomotion, September 16, 2014)

Chapter 4 describes the silent growth killer and examines the problems of midsized firms that make acquisitions that cause massive headaches and deplete value. But it doesn’t have to be that way. Determine the headache quotient BEFORE you make an acquisitions. Then make an informed judgment.

What follows is an assessment rubric that works effectively for all types of operating business acquisitions (not asset acquisitions). Caution is advised on deals with a high complexity rating (which will generate low scores on this assessment): such deals must possess similarly high strategic rationale and have high integration costs built into the decision making model.

We find there are twelve important underlying factors in every business acquisition. This rubric should be used before any acquisition process begins, helping to create criteria for selecting acquisitions, then employed again before signing a terms sheet, and finally, as due diligence is progressing. Ideally the assessment should be done as a team, involving the entire leadership group on the acquisitions team.

Before starting the assessment, please have a specific acquisition in mind. It could be a past acquisition, or one that is currently being negotiated.

You may take this assessment as many times as you like, assessing different acquisitions.

Factor #1: M&A skills and experience

How much acquisitions experience is on your leadership team, and how long have those leaders been with your company? *

We have lots of acquisitions experience on our leadership team and they’ve been at the company for more than three years.

We have a small amount of acquisitions experience, but the leadership team has been at the company for more than three years.

We just hired one or two very experienced acquisition executives in the past six months.

We’re a newly formed executive team without acquisitions experience.

Firms in which the executives don’t have a background including acquisitions experience and/or are newly hired will have a much more difficult time with any acquisition, experiencing many more surprises and problems. It is critical that you know how to integrate an acquisition and know the acquirers people, including their culture, strengths and weaknesses. Thus, outsourcing the acquisition to consulting firms may help to some degree, but they generally don’t wield any authority inside the acquirer, and don’t intimately know the business.

Factor #2: Cultural Differences

We’ve done a careful assessment, and our teams have gotten to know each other, and both sides seem to feel like our cultures and values are similar.*

Somewhat

Mostly True

Completely true

Many varieties of corporate cultures can work well together and produce excellent results. But when there is a vast difference between acquirer and target, integration gets complicated fast and these “human” problems are slow to resolve. Of course even attempting to rate this factor assumes that appropriate due diligence is done on the culture of the target. Sadly this is seldom the case.

Factor #3: Relative size of acquisition

What is the relative size of the acquisition?*

The acquisition is 5% of our size

The acquisition is 16-15% of our size

The acquisition is 16-35% of our size

The acquisition is 36-75% of our size

The acquisition/merger is >75% of our size.

Compare the revenues of the acquirer to the revenues of the target: this percentage forms one of your key factors. (Note: In some cases comparing headcount can be more valid than comparing revenues.)

Factor #4: Amount of integration required

How much integration is required?*

We must integrate everything (and the people) fairly quickly.

We will integrate some of the operations and the back end.

We will only integrate the back end. Operations people will be mostly separate.

We will not integrate them at all. They will operate separately, with some oversight.

Integration is hard work. The act of buying a company doesn’t always mean the teams and operations are fully integrated. Some companies are purchased and left to run on their own. They make only periodic financial reports to the parent, and the new ownership structure may not be publicized. This is almost no integration at all. On the other hand, a merger of equals, in which factories and teams are merged into one, is a massive integration challenge.

Factor #5: Earn-outs

Choose the answer that most closely reflects the deal earn-out.*

There will be no earn-out.

There will be an earn out of less than 5% of the sale price, earned in the first year, not longer, based on a really easily measured/calculated metric like revenues.

There will be an earn out of less than 10% of the sale price, earned in the first 18 months, not longer, based on a really easily measured/calculated metric like revenues.

There will be an earn out of 10% or more of the sale price, earned in the first two years or longer, based on a really easily measured/calculated metric like revenues.

The earn out (of any length time) is based on net or gross profit, or some other measure subject to interpretation.

In negotiations, earn-outs seem like a great way to bridge the gaps in price/value perception. If the business performs well, the seller gets more, since the business has proven the seller’s assertion that it is healthy. In practice however, earn-outs are hard to manage, and bad feelings, litigation, and conflicts of interest abound. One problem that occurs when earn-outs are in place is that team leaders avoid making prudent strategic shifts, since they would adversely affect the earn-out. For example, a US firm bought a company in China, and put an earn-out in place for the founder of the Chinese firm, rewarding him for hitting sales targets. The founder began withholding information from the CEO of the acquiring firm about new opportunities, then “ambushing him” at the last minute for signatures on deals that were far too low in margin. This caused a large, high-risk conflict, since the founder had interpersonal and leadership control of the team in China. In another case, the selling CEO’s earn-out was contingent on gross margin contributions from his personal sales, and he was failing to deliver. The buyer was reticent to fire him from the sales team for fear of getting a reputation as a “bad acquirer” in their small industry, hindering future deal flow. Yet not firing him meant allowing a poor performer to stay on the sales team (at a high salary), threatening the overall sales performance culture of the company.

Factor #6: Operating team’s involvement

Choose the one that fits best:*

We either a) have a small leadership team who is involved as soon as were serious about a deal and helps assess that deal, and if we buy they do the integration, or b) our corporate development team gets our ops leadership involved early.

Our corporate development team or CEO does most of the assessing and buying, giving the operating execs only high level involvement 2-4 weeks before the deal is closed.

CEO/Corp Dev buys, and for the most part, the operating teams get involved as the deal is signed.

In some companies, the CEO and/or the corporate development department finds, assesses and buys businesses largely on their own. Once they’ve done the deal, they hand it over to the operating executives to integrate and operate. This approach adds to the complexity of integration and operation, dramatically increasing the risk of failure. In contrast, some companies require their operating executives to be involved from start to finish. Assuming that these executives are interested, enthusiastic, and have the time and energy to devote to an acquisition, the risk is decreased, and on average, outcomes improve.

Factor #7: Murky due diligence

Choose the one that fits best:*

We completed industry due diligence before the deal negotiations began, and we have plenty of time and access to do deep due diligence, and know the line of business well enough to know how to find where most of the bodies are buried.

We have the time and resources to get to most of what we’d like to look at, but there are some restricted access issues (like can’t talk to some personnel to be acquired or customers, or the target is public), and we have to hustle to get it done.

We can only tackle the high priority items. There are multiple bidders or time pressure, or some sizable restrictions on access.

We will not, or cannot do much due diligence. We trust them, or there is no time, or it is so confidential that any significant due diligence is impossible.

The purpose of due diligence is to gain clarity on what you’re acquiring, and what the prospects for the future will be. Acquisitions in which due diligence is hard to execute (or isn’t executed at all) make for more surprises down the road, adding to complexity and risk. Due diligence is much more than legal and financial. It includes an assessment of culture (on both sides), operations and the potential marketplace. In many cases, the buyer is too rushed or too undisciplined, failing to pursue due diligence on all fronts to the point of clarity. In other cases, no matter how hard you try, there are unknowns or untested assumptions that put the deal at risk. Regardless of the reason, the less clarity you achieve through due diligence, the bumpier the ride after you close.

Factor #8: Unpopular Actions Required

Choose one of the following:*

We are a) buying a well-enough-run company and we won’t have to take any unpopular actions or b) not planning on using any of the acquired company’s people, so we won’t be affected if they’re unhappy.

We will have to take a few unpopular actions, but they are very limited in scope (like closing the accounting department and HR only at the seller’s HQ).

We must take some unpopular actions, but it is not widespread. For example, we just have to close one of four factories, plus some back office functions.

This is more like a turnaround. We must take many unpopular actions, like benefits reductions, layoffs, plant closures, or other adjustments that will hurt morale company wide.

Some acquisitions, especially of distressed companies, require the acquirer to make harsh, even drastic changes. Layoffs, plant closures and cancellation of projects are some examples. These unpopular actions have a chilling effect on the morale of the acquired company. Acquired employees are already uncomfortable with the change in ownership, and when unpopular acts are added, the collective morale of the acquired talent can plummet, taking months or even years to recover. Of course this entire process occurs at a very vulnerable time for a company—during integration.

Factor #9: Change required of acquirer

Choose the one that comes closest:*

We (the buyer) are much bigger than them—their systems may change but ours won’t hardly change at all.

We will have to change in a few areas, in particular, since our systems will now interface with the acquired company, or there may be a few areas where what they do is better than what we do, so we’ll adopt their approach.

We might end up changing about half our systems. They are a sizable company and we are each going to change some, going with a best of breed kind of approach.

Most of our systems will change. We are essentially forming a new company, with new branding, new scaled up systems, and more. When we’re done, very little will resemble the pre-merger days.

Many acquisitions are made to effect change in the combined organization. The biggest of these are called transformational acquisitions—often mergers of equals. In these kinds of acquisitions, not only the target company but the acquirer must endure large and rapid change. The risk is that each structure is disrupted, attitudes are affected everywhere and productivity drops company wide. In a merger of equals, often employees on both sides get pink slips. Sometimes the best of breed approach means that process or system changes affect both sides. On the other extreme, many acquisitions are “bolt-on” acquisitions, in which many people and processes in the acquirer are unaffected.

Factor #10: Visibility of change to customer base

How visible will the change be to customers?*

The marketplace will hardly notice any change. We intend to keep it low key, as this is almost more of an investment for us.

Products, services, the customer facing team and the price points will all remain the same. Any change in brand or shipping locations will happen gradually, after the acquisition is old news.

In order to achieve the synergies in this deal, we’ve got to make some changes that the customers will feel. We’re rationalizing some product lines, re-branding, changing our sales approaches and more.

The acquired customers will all come over to our platform and will have to adjust. We’ll help them, but they will not be a customer of “oldco”, they will be a customer of the acquired firm.

The greater the extent of the change in brand image of the entity, the greater the complexity and risk. In a merger of equals, often the new company is re-branded, a complex process. The more broadly pricing, products and services are changed, the more complexity increases. For example, in my second acquisition, we created a new umbrella brand, making sub-brands of the original company I’d founded along with the two I’d acquired. This was a complex process, requiring the sales team to tell the story, with marketing support. In another example, a firm bought a competitor and raised the target firm’s pricing significantly. The market resisted, blaming the acquirer, and sales dropped. Eventually the acquisition review board reversed the decision and put the old pricing back in place.

Factor #11: Expertise in acquired business

How similar is the acquired business?*

The company we are acquiring is just like ours. We know how to run all aspects of it right at acquisition time.

The seller’s business is similar to ours, but not identical. Likely ONE aspect is different, like the vendor set, the customer type, or the technology isn’t quite the same.

There are significant differences. While we’re in the same sector (like manufacturing, or professional services) and in the same geography (USA, or US and the UK), there are areas where we don’t have the competencies we need, and are significantly dependent on acquired personnel to run the business.

The acquired business has little similarity to our current business, and few or none of our executives has similar experience. We’re going to “school”, and need to keep the acquired team happy while we go through basic training.

Many businesses choose to acquire companies they fully understand. Often these are direct competitors, or companies in the same industry. In a worst case scenario, if all the employees of the acquired firm leave, the company can still be managed by the acquirer. This makes the complexity and risk lower, and was true of all my acquisitions. But many acquisitions are in other industries, where the core competencies are different, where customer relationships are new, where marketplace dynamics and the competitive set are different. These deals are much more complex and risky. The acquirer has much to learn before they can confidently make changes, and they must also placate the acquired management team until the acquirer has learned enough to run the business.

Factor #12: Cash available to manage complexity

Choose one that best resembles your situation:*

We’re stretching to make/borrow the purchase price. We’ll pull the rest out of working capital.

We’ve got what we need to buy it and to fix it up (capital expenditures), but we’ll need our management team to step it up to run the integrations.

We have budgeted for the capital expenditures we know we need, and have allowed some budget to integrate it, so long as things go pretty much as expected. But we don’t have more reserves to throw at it if things don’t go well.

We have all the cash to do the deal, make planned capital expenditures and do the integration, plus a cushion of 20-30% (of the investment) to pay for surprises.

Acquirers who spend all their available cash on the purchase price of the target have little or no cash available to manage the integration. Specifically, the expected return must be compared with the investment, meeting or exceeding the firm’s hurdle rate (minimum ROI). The investment is the sum of (a) the purchase price, (b) any additional capital infusion required by the acquisition target, and (c) the costs of integration. If an acquisition can support a two million dollar investment, and the purchase price and capital infusion together are 2 million, then nothing is left over for the integration—a high risk situation. But if the deal were priced at 1.2 million with a 300K capital infusion, then 500K would be available for the integration, reducing risk.