For many years M&A transactions have been a favorite technique for growing business and creating wealth.
At the same time, many business owners are comfortable with the lifestyle their business is providing to them. A key question to ask is, “why grow”?
There are multiple reasons for this.
Large business enterprises enjoy several key advantages. Generally, they’re better capitalized since their choices for finding new equity or debt is wider than smaller businesses. Plus, they’re in a better position to negotiate higher quality transactions with suppliers, vendors and partners. They are better positioned to weather major economic storms. They are viewed as being more able to supply large customer’s needs. They are able to withstand competitive pressure. They can afford better advisers and consultants. There are very attractive to new employees needing training. They can generally offer better benefit packages. And, there are many more reasons.
Larger entities are simply much more valuable. They’re very size makes for excellent economies of scale. This is particularly true when it comes to taking on projects of almost any size. There are generally more profitable and are able to create and maintain large amounts of cash. In addition, this combination of higher revenue and profits allows them to command higher multiples from investors.
Here’s an illustration which underscores the point.
Suppose we have two companies, one doing $10 million with a net profit of $1 million. The other has a top line of $20 million and a bottom line of $2.2 million. Investors might be willing to pay 3 1/2 million dollars for the smaller company and around $7.7 million for the larger company. This assumes that each is worth a multiple of 3.5 times earnings. Both companies earnings are computed before taking in consideration interest, taxes, depreciation; and, amortization. This is commonly referred to as EBITDA. Adding these two numbers together we find that they are worth $11.2 million. That’s the price an investor would be willing to pay to buy each of these two companies separately in two transactions.
However, if these two were combined into one company we would expect some decrease in operating costs. These reductions would come, in part, from the elimination of various redundant departments. These reduction would include physical space, employees, managers and all the other associated costs. Let’s suggest altogether the savings amount to $600,000 on an annualized basis. This means that earnings would increase from $3.2 million to $3.8 million.
Furthermore, it’s likely the multiple will increase as well. They are now a significantly larger company with revenues of $30 million. The multiple could increase from 3.5 to as high as 4.0. This means an investor might be willing to pay as much as $15 million for the newly combined business. Probably the extra $3-$4 million is a pretty attractive reason to enter into an M&A transaction.
The problem with all this mathematical logic is as follows.
Most deals like this take place because of the obvious economic drivers. However, what frequently upsets the whole business is the failure to align the two companies. Even if these companies are more or less the exact same market selling the exact same products they are likely to have significant differences in the following areas:
- Core values.
- Philosophies of doing business.
- Mission statements.
- Systems and procedures.
- Fundamentals and basic practices.
- Compensation systems.
- Owners visions.
- Goals and tactics.
- Sweetheart transactions with related parties.
- And on and on and on.
Of course, the more different these things are between the two companies will make alignment all that much harder. Nonetheless, these differences must be reconciled in order to have a successful outcome. This is the primary reason a large percentage of the mergers end up as failures.
Three major things can be done to increase the likelihood of success.
First, is to understate and the differences prior to entering into an agreement.
Second, is to determine the specific action required to ensure alignment over time. And last, strategic and tactical planning retreats should be held jointly prior to the actual date of execution.
While all of these are excellent things to do, they’re very risky because of the probability of confidential material being released and the deal blowing up. So considerable care and caution needs to be in place prior to any of the three remedies being implemented.