There are as many answers to the question posed above as there are players—buyers and sellers—involved each year with the process. The answer most frequently heard from buyers is "strategy." When asking sellers, the answer is often the same—with widely differing interpretations of what is meant by the term. Business combinations should always be planned with strategic goals in mind—and they should follow carefully worked out plans for the successful achievement of these goals. In this article we will discuss many of the specific reasons expressed by buyers and sellers, and evaluate them from the viewpoint of an objective third party.
Unfortunately, a very large proportion of completed transactions ultimately fail to achieve the goals for which they were originally initiated. Within this group of unsuccessful deals there are many which fail completely, finally ending with complete or partial divestiture at realized prices far below acquisition cost, following months or years of operating losses attributable to the new subsidiary. This is generally due to poor pre-acquisition planning, sometimes followed by a lack of sufficient post-closing attention on the part of acquiring management.
From buyer's perspective, the prime reason for acquisition is growth, in one form or another. Growth can be accelerated by geographic expansion; product or market diversification; the addition of management strength; technological expansion; and usually by a combination of the foregoing. Whatever its form, "growth" is the operative word.
We have known a number of CEOs who purchased candidates with revenue accretion as their sole strategic benefit. In cases such as these, we could not level any criticism at the CEO for buying revenue and potential profit, unless this was done in contravention of a predetermined strategic plan for product and market diversification. Incremental revenue is an absolutely valid reason for acquisition but must be only one part of an overall strategic plan for growth.
All experienced managers will admit the validity of at least one universal truism: objectively viewed, there is no such thing as a truly "win/win" situation. They must therefore make every effort to evaluate each new project from all sides, to ensure the highest degree of eventual success. Merger and acquisition efforts represent the most lethal of the many "two-edged swords" which are encountered by management. Strategic growth by diversification, in any of its forms, is probably the deadliest of the deadly.
Diversification may be broken into three broad major categories: product line; marketplace; and diversification of a company's basic type of business. In our present context, the latter type of diversification is defined as a major change of business direction—probably the most difficult to accomplish. Examples would be transitions from manufacturing to distribution; from OEM to consumer or end-user products; from "hard copy" to electronic publishing; or from "service" to "product" orientation. No approach to diversification should be taken lightly, although product line and/or marketplace changes can generally be viewed as somewhat less complex—and potentially less dangerous—than changes to a company's basic direction. All types of diversification can usually be accomplished through merger, acquisition, partnering or joint venture. With proper planning and execution, an appropriate business combination may speed the process and make it easier to accomplish. On the other hand, a poorly planned, reviewed, or executed business combination could be damaging and possibly fatal to any company's diversification efforts.
Specifically, bad diversification moves can also prove fatal to the ongoing basic business success of the company involved. More than one otherwise successful management group has found itself deeply involved with problems introduced by a newly acquired entity. When "deep" involvement becomes "total" involvement, there is every likelihood that the old business as well as the new venture will suffer. If this situation continues for too long, the resulting negative impact could cause complete failure of both business segments. Proper evaluation of every aspect of the candidate company prior to acquisition can indicate potential problems and permit preparation of contingency plans to deal with them. Such evaluation may be done in parallel with, or as part of the normal due diligence review. It must be completed in every possible detail prior to close of the transaction.
Geographic expansion is a natural function of business combinations. Perhaps somewhat less fraught with danger than some reasons for purchase, territorial moves can provide as many unknowns as those faced by 15th century world navigators. Companies planning moves from one area to another within the same geographic region will usually encounter a minimal set of problems, as opposed to moves from one state to another, coast to coast, or country to country.
First will be the problem of management in the new region, something which must be considered in any business combination. Then there are problems such as maintaining levels of customer satisfaction; adapting to slightly differing ways of doing business; distributing products or services over a larger area than previously encountered; and communicating company image to a larger and possibly more diverse customer base.
Problems caused by geographic expansion will generally increase exponentially as distances grow larger, both in number and complexity, reaching their ultimate level of difficulty in moves from country to country. In this situation, the expanding company must address a multiplicity of basic cultural differences relating to management, employees, and customers. Most important is the fact that no single one of these problem groups can or should be more dominant than the other two, and any one of them can seriously impact the success of the venture.
Although some planners think of them as vaguely similar, in this article I differentiate "market" from "geographic" diversification, by stating that a company can move into a new marketplace simply by addressing a different group of customers with an established product line. The classic question of "make or buy" is addressed in this instance by the issue of whether the company's existing sales force can sell economically and effectively into the new market. If it cannot, perhaps acquisition of a company with an allied product or service, sold to a basically different base of customers, would be the answer.
A somewhat timeworn but nevertheless classic illustration of such market diversification was acquisition of a newly created, high-level computerized income tax preparation service by a well established publisher of income tax information for the legal and accounting professions. In this instance an existing sales force was able to introduce the new product and move it quickly into the marketplace. Separate sales organizations were ultimately established but product acceptance was accelerated by months, if not years.
While movement from one marketplace to another is never simple to accomplish, it is usually easier than product diversification. Within the context of this article, this is defined as the decision to add new and/or different products or services, generally for sale to existing customers/clients. To illustrate, consider a manufacturer of personal computers that makes the strategic decision to build and sell a "horizontal" line of PC-oriented printers. In an example of "vertical" product diversification, the same manufacturer, which traditionally has purchased printed circuit boards from outside vendors, could decide to acquire an OEM source to meet its own needs, while selling surplus manufacturing capacity to other board customers.
In yet another vein, the enhancement of management through merger or acquisition is generally a very complex and difficult task, although one which is eminently capable of accomplishment. Acquisition of a company in order to strengthen a buyer's management is a strategic step commonly found in service industries, although it can occur in other business sectors as well. There have been cases where the technical or marketing groups of one company were so well organized and widely respected as to attract the interest of a buyer. This will occur considerably more often where both parties are somewhat equal in size, as opposed to a very much larger company acquiring a smaller entity.
Merger or acquisition for the primary purpose of management enhancement can be a logical step with a large buyer and a small seller—where seller candidate has a highly reputed technical or other type of niche management required by buyer. In this instance, however, both parties must be particularly attentive to the integration of management from a small organization into one of considerably larger size.
Both parties must pay very careful attention to the potential fit of corporate cultures and other employee oriented factors, as they should do with management in any type of business combination. We will cover management evaluation more deeply in later articles. For the present, we must stress the obvious. If personnel are a primary reason for the business combination, both buyer and seller should carefully evaluate the probability of buyer retaining seller's employees over a period of time acceptable to both parties.
In the context of this article, "technological expansion" is broadly defined to include such things as more productive or more efficient manufacturing processes or service offerings; movement from other, older means of production or distribution, to more modern means; classical interest in more advanced types of pure high technology; or, more simply, any expansion where the strategy is based upon improvement in the creation and/or delivery of products or services offered by the acquiring company.
As characterized herein, technological expansion is one of the more prevalent reasons for acquisition—and is obviously not restricted to those market segments commonly thought of as "high-tech," or even "technologically oriented."
From the strategic point of view, the process of embarking on a technological acquisition should always start with the traditional make or buy decision. Companies desiring to enhance existing technological qualifications should review their technical "inventory" before beginning a search for acquisition candidates. The pool to be reviewed should include current methodology, as well as personnel. A company lacking specific technical expertise in its current applications may well have a fully qualified group of individuals working with allied but slightly dissimilar capabilities. If such people exist, the strategic plan might be amended to consider a temporary move away from acquisition. The alternative ("make") could be formation of a new group, made up of current employees who are well grounded in, and capable of working with the desired techniques.
It is often the case that a company in search of new technology might well be the owner of something quite similar to that which they are seeking—requiring only some degree of modification to serve the desired purpose. Lacking either the personnel or the methodology required to create the desired new approach, the company could then consider some form of business combination to obtain the missing ingredients.
The search for a technologically oriented acquisition requires great care on the part of a buyer. Having made the decision to buy, companies in this mode must be certain they can recognize that which they seek. This may appear to be an obvious statement but more than one company has sought technological improvement by acquisition—only to learn that it was no further ahead after the deal than before.
Buyer must have qualified employees on staff; be willing to hire one or more experts to establish the core of its technological expansion effort; or locate and retain a highly respected and capable consulting organization, well able to recognize and evaluate the new product. Such capability should include not only full and complete knowledge of the potential techniques involved, but also the ability to make effective judgements concerning the people necessary to make the necessary technology transfer to buyer. In order to be reasonably certain of success, buyer should start with at least two out of three of: qualified employees, appropriate experts, or a retained consulting organization.
Once the seller candidate has been located, and the technology and personnel have been fully reviewed, it is crucial to determine with absolute certainty that buyer's corporate culture will absorb the desired technique. New technology may also require new methods of production, new means of distribution, and new marketing techniques. All of these can be created within the buyer's organization in a reasonably short period of time—provided that basic cultural differences do not interfere.
A buyer company which has traditionally dealt with "small run," "short term," or "job shop" methods may find the transition to large scale production systems difficult, if not impossible, to accomplish. In a similar vein, companies comfortable with assembly of purchased components in order to create finished product may find manufacturing such components a difficult step to manage.
Buyers must also take great care not to overwhelm or smother newly acquired technology by creating an impossible atmosphere in which its creators will have to perform. During the early days of software development, creative people were granted certain flexibility in work practices, dress code, organizational practices and definition of responsibilities. Today, many companies continue to maintain practices such as informal dress days or flexible work hours for technical groups. "Synergism" will occasionally require commingling of new and old employees. Buyer must consider that its original intent was to obtain the valuable techniques offered by the new employees and exercise restraint in attempting to mold them to its traditional form.
When acquiring technology, many buyer companies view acquired personnel as necessary for only a transitional period—until such time as their technological expertise has been transmitted to existing company employees. Under this assumption, many buyers feel obliged to respond to the needs of new employees for only a short period of time. This is inevitably a short sighted approach, since acquired personnel—in both management and lower ranks—are quite capable of sensing such an attitude. Newly integrated employees must be made quite comfortable within the buyer's environment. Feelings of potentially short employment with the new company, whether actual or simply perceived, must be kept to an absolute minimum. The individual who considers himself to be only a transitional aid may withhold vital—and often undocumented details—a fact discovered only following the employee's premature departure from buyer's employ.
Periodically we are accosted by a merger and acquisition "Age of Profligacy," typically characterized by a much larger than normal number of transactions, many of which seemingly have no strategic foundation at all. At the opposite end of the business pendulum, certain segments of the economy occasionally become very sluggish. Does either of these economic situations create a buyers' or sellers' market, with nothing but problems for the respective counterpart company? Even worse do they portend an end to mergers and acquisitions? Must buyers and sellers assume hopeful attitudes of "wait and see?" In our opinion the answer to all of these questions is a qualified "no!" There is little doubt that over inflated prices will trend downward rapidly in slow growth business segments, but those seller companies which represent true value to prospective buyers can and should continue to formulate their plans for sale.
Viewed with only a little hindsight, evidence of a slowdown in merger and acquisition activity was becoming apparent in the third quarter of 2000, during the wildest of the more recent merger and acquisition feeding frenzies involving publicly traded companies. At that time, many people enmeshed with highflying deal making were beginning to bemoan the fact that the merger and acquisition business was no longer profitable, and had little future. Some law firms and many large investment banking houses, geared to the fast pace and extremely high fees of merger mania for several years, found themselves with grossly inflated staff levels, large segments of which were extremely overpaid, in keeping with the unusually high fee levels prevalent at the time. The inevitable failure of high yield bonds and similar instruments made the decline of deals based solely on publicly funded financial considerations equally inevitable. As the deal making trend continued to diminish and corporate governance came under close scrutiny, the press was filled with articles concerning the crash in the merger and acquisitions market. These stories were part of larger articles describing the "hard times" which had befallen Wall Street in general, and a number of large, well-known investment banking firms in particular. A great many sellers were concerned over the effect that such decline would have on their plans to locate a large corporate partner.
There is little question that there was considerable decline of M&A activity in certain industry segments. We must, however, point out that cycles are certainly not unheard of in this, as in other aspects of business in general. In June 2000, we spoke with the individual responsible for corporate development in a very large defense oriented corporation. This person recognizes the advantages of any slow-down in his segment. He planned to wait only long enough for those who had paid highly inflated acquisition prices to realize this fact, at which point he was going back into the market. For those corporate managers who are in the business of business, such declines should be accepted, applauded—and viewed as an indicator of good things for the future.
We spoke recently with the owner of a mid-sized financial services company. The company is profitable, with only those problems that arise from continued successful growth. The owner has been contemplating sale for some time. During the conversation he complained bitterly about the manner in which the stock market has been "beating up" some of the largest companies in his industry.
Given the rather wild market escalation of recent years, we continue to discount the stock market's "valuations" of most industries. From a much more practical point of view, however, there are reasons why principals of mid-sized banking, leasing, and other financial services companies might be well served to wait a bit before proceeding with a search for a corporate partner. The banking industry has been under a considerable cloud for several years. Trends for near- and intermediate-term interest rates remain seriously in doubt. Banking institutions continue to talk merger, largely for purposes of survival. A mid-sized leasing or similar financial services company could experience considerable difficulty in attaining any premium in excess of net book value, and might even have difficulty achieving book.
Owners of companies with current or impending problems might have to move ahead with partnering plans despite poor market conditions. They must recognize that they will probably not achieve a price that meets prior expectations.
What about other types of small- to mid-size companies that have been considering some form of corporate partnering? Is there an economically feasible way to continue this process in an apparently depressed market? We believe that most companies seeking a larger partner generally need not put such plans away until "better times."
There are a number of factors which could cause buyers to pay prices in excess of those that could be "normally" calculated for a target company. These include, but are certainly not limited to, a market that has been "pumped up" by any recently concluded buying frenzy; buyers' clearly defined needs for a unique entity to round out a strategic plan; or simply the auction mentality which takes hold when two buyers compete for the same seller company.
We do not believe we will ever see the last of artificially inflated prices brought about by merger mania cycles. We do continually look forward to those periodic tempering of market excitement which permit companies, both buyers and sellers, to function in a fair but moderate environment.
While we continue to preach the doctrines of planning, some proportion of all sales is initiated through serendipity. We heard recently of such a situation, not yet accomplished but certainly having some probability of completion. Seller has considered sale for a number of years, even starting an organized sale process at one point. Some degree of doubt exists as to whether management really intended sale, or was merely pushed in this direction by its bank. The sale effort was discontinued after a period of management ennui concerning potential buyers. In recent years, seller's business has declined considerably, to the point of serious financial difficulty.
Seller and its potential corporate partner were introduced as part of the formal sale process several years ago. Buyer's then-CEO rejected the transaction as being non-strategic. Seller met buyer's current CEO at a recent trade show, and dialogue commenced. Seller falls within buyer's current strategic requirements. Unfortunately, seller has lost almost all of its bargaining power due to business reverses and financial declines. Any transaction will most certainly result in minimal proceeds for selling shareholders.
When management takes the decision to seek a partner, it must do so with the clear understanding that it is embarking on a process no less time consuming than any major company effort. As one which is quite new to most management groups, a company sale program could represent a significantly more strenuous effort than those "comparable" programs with which management is familiar. Unless the company is large enough to have an experienced corporate development officer—one who has sold, as well as bought—management must retain competent outside assistance. Such assistance may come from the company's legal counsel, but ideally should take the form of a dedicated professional in the M&A field.
Companies seeking corporate partners should begin by making a close and objective introspective examination. As with any sale, proper "positioning" is essential to a successful transaction. The product must be made to appear as attractive as possible, always within the absolute bounds of proprietary and ethical considerations. Each attribute of seller's appearance that can be made more attractive represents one less item of concern to a potential buyer, and relieves the parties from one less item of possibly uncomfortable negotiation at a later time.
If financial statements are not audited, the company must consider retaining the services of a CPA firm to render an opinion on its balance sheet and income statement. Despite recent problems in the accounting profession, a major national firm generally appears more attractive to buyers, although size is not an absolute requirement. The right accounting firm must have the attitude that it has a degree of responsibility for the transaction, at least insofar as it must react quickly to the financial reporting requirements of both parties. This step should be taken immediately following a decision to sell and the audit process should continually be brought up to date until a transaction is completed.
Management must ensure that it has access to the best legal counsel, either inside or retained. Legal counsel should have had extensive prior involvement with corporate partnering transactions. Counsel should be aware of its responsibility to achieve the best possible deal for seller, without "protecting" client to the extent that the parties discontinue negotiations and go their separate ways.
Although properly accomplished on a routine basis, seller should carefully review its organization, and management structure. This review should determine whether or not key functions are correctly managed and staffed. Most important is the determination that no key function is under manned, or can be perceived as improperly controlled. We do not recommend commencement of a management hiring program. We do stress the fact that seller's organizational structure be complete, which can be accomplished by the assignment of functional responsibility, as opposed to enhancement of staff.
Seller's overall operation should be examined in an objective manner. This should include product line profitability; sales and marketing effectiveness; customer and vendor relations; shareholder relations, if appropriate; employee relations; "production" strengths and weaknesses; and any other factors which could impact profitability and capability for growth.
Budgets and business plans should be reviewed, updated, and maintained on a current basis. Very few sophisticated buyers will hesitate to inquire about future plans for market enhancement and growth at a first meeting, if not earlier.
Consideration must also be given to physical appearances. Sellers should look around and attend to those housekeeping items known to be sub-standard. The "skunk works" effect is appropriate in certain types of companies—restricted to correct locations and clearly identified.
A banker friend told us years ago that stories concerning negative changes in a business plan were "explanations" as revenue continued to grow, and "excuses" as revenue began to decline. While this little homily may contain some degree of truth it does not preclude sellers from entering the market successfully after one or more years of revenue decline, assuming the presence of other factors. (To be continued.)