Mergers and Acquisitions: A Condensed Practitioner's Guide

Chapter 1

The Acquisition Process

An acquisition occurs when a buyer acquires all or part of the assets or business of a selling entity, and where both parties are actively assisting in the purchase transaction. If the buyer is doing so despite the active resistance of the other party, this is known as a hostile takeover. A merger occurs when two companies combine into one entity. The vast majority of all business combinations are handled as an acquisition, where one entity clearly takes over the operations of the other.

In this chapter, we will address the basics of the acquisition process—why buyers acquire, why sellers have an interest in selling, and the process flow for both a basic acquisition and one conducted through an auction process. The chapter also addresses a variety of other issues, including acquisition strategy, risks, target criteria, and hostile takeovers.

WHY WE ACQUIRE

Why do companies feel compelled to acquire other businesses? After all, the typical buyer knows its own market niche quite well, and can safely increase its revenues over time by continual, careful attention to internal organic growth. Nonetheless, thousands of acquisitions occur every year. Here are some reasons for doing so:

• Business model. The target’s business model may be different from that of the buyer, and so generates more profits. For example, a target may operate without labor unions, or have a substantially less burdensome benefits plan. The buyer may not be able to re-create this business model in-house without suffering significant unrest, but can readily buy into it through an acquisition.

• Cyclicality reduction. A buyer may be trapped in a cyclical or seasonal industry, where profitability fluctuates on a recurring basis. It may deliberately acquire a company outside this industry with the goal of offsetting the business cycle to yield more consistent financial results.

• Defensive. Some acquisitions take place because the buyer is itself the target of another company, and simply wants to make itself less attractive through an acquisition. This is particularly effective when the buyer already has a large market share, and buying another entity in the same market gives it such a large share that it cannot be bought by anyone else within the industry without anti-trust charges being brought.

• Executive compensation. A buyer’s management team may be in favor of an acquisition for the simple reason that a larger company generally pays higher salaries. The greater heft of the resulting organization is frequently viewed as being valid grounds for a significant pay boost among the surviving management team. This is not a good reason for an acquisition, but it is a common one.

• Intellectual property. This is a defensible knowledge base that gives a company a competitive advantage, and is one of the best reasons to acquire a company. Intellectual property can include patents, trademarks, production processes, databases that are difficult to re-create, and research and development labs with a history of successful product development.

• Internal development alternative. A company may have an extremely difficult time creating new products, and so looks elsewhere to find replacement products. This issue is especially likely to trigger an acquisition if a company has just decided to cancel an in-house development project, and needs a replacement immediately.

• Local market expertise. In some industries, effective entry into a local market requires the gradual accumulation of reputation through a long process of building contacts and correct business practices. A company can follow this path through internal expansion, and gain success over a long period of time—or do it at once through an acquisition. Local market expertise is especially valuable in international situations, where a buyer has minimal knowledge of local customs, not to mention the inevitable obstacles posed by a different language.

• Market growth. No matter how hard a buyer may push itself, it simply cannot grow revenues very fast in a slow-growth market, because there are so few sales to be made. Conversely, a target company may be situated in a market that is growing much faster than that of the buyer, so the buyer sees an avenue to more rapid growth.

• Market share. Companies generally strive toward a high market share, because this generally allows them to enjoy a cost advantage over their competitors, who must spread their overhead costs over smaller production volumes. The acquisition of a large competitor is a reasonable way to quickly attain significant market share.

• Production capacity. Though not a common acquisition justification, the buyer may have excess production capacity available, from which it can readily manufacture the target’s products. Usually, tooling differences between the companies make this a difficult endeavor.

• Products. The target may have an excellent product that the buyer can use to fill a hole in its own product line. This is an especially important reason when the market is expanding rapidly, and the buyer does not have sufficient time to develop the product internally before other competing products take over the market. Also, acquired products tend to have fewer bugs than ones just emerging from in-house development, since they have been through more field testing, and possibly through several build cycles. However, considerable additional effort may be needed to integrate the acquired products into the buyer’s product line, so factor this issue into the purchase decision.

• Regulatory environment. The buyer may be burdened by a suffocating regulatory environment, such as is imposed on utilities, airlines, and government contractors. If a target operates in an area subject to less regulation, the buyer may be more inclined to buy into that environment.

• Sales channels. A target may have an unusually effective sales channel that the buyer thinks it can use to distribute its own products. Examples of such sales channels are as varied as door-to-door sales, electronic downloads, telemarketing, or a well-trained in-house sales staff. Also, the target’s sales staff might be especially effective—in some industries, the sales department is considered the bottleneck operation, and so may be the prime reason for an acquisition offer.

• Vertical integration. To use a military term, a company may want to secure its supply lines by acquiring selected suppliers. This is especially important if there is considerable demand for key supplies, and a supplier has control over a large proportion of them. This is especially important when other suppliers are located in politically volatile areas, leaving few reliable suppliers. In addition to this backward integration, a company can also engage in forward integration by acquiring a distributor or customer. This most commonly occurs with distributors, especially if they have unusually excellent relationships with the ultimate set of customers. A company can also use its ownership of a distributor from a defensive perspective, so that competitors must shift their sales to other distributors.

No matter which of the reasons previously mentioned are central to a buyer’s acquisition decision, it ultimately involves enhancing the price per share of the buyer’s stock. This may not be immediately apparent, especially for smaller acquisitions where resulting share price changes are trifling, but a long-term acquisition strategy should gradually build a company’s price per share.

WHY A TARGET SELLS

The general assumption is that a target’s shareholders are willing to sell strictly so that they can be paid the maximum price. This is not necessarily the case. A target may have a strong preference for remaining independent, but a variety of factors may require it to search for a new owner. The buyer should be aware of the principal reason for a sale, so that it can tailor its bid accordingly. Here are some reasons why a target may be interested in selling:

• Anemic profits. If a target has minimal or no profits, it cannot sustain itself. In this scenario, a buyer may complete an acquisition for a low price, but also find itself having to restructure the acquiree in order to dredge up a profit.

• Competitive environment. The number and aggressiveness of a target’s competitors may have increased substantially, resulting in a current or impending revenue and profit decline. While a buyer can certainly obtain such a business for a small price, it must also question whether it wants to enter into such a difficult environment.

• Estate taxes. The owner of a target may have died, and his estate must sell the business in order to pay estate taxes. The deceased owner’s relatives may not have a clear idea of the value of the business, so a prospective buyer may have a relatively easy time negotiating with an inexperienced counterpart.

• Patent expiration. A target may be selling in a protected environment, using a key patent that keeps competitors at bay. However, that patent is now close to expiration, and the target is not sure if it will be able to compete effectively. Due to the increased competitive environment, the target may lose a great deal of value, and the buyer can acquire it for a low price.

• Rapid growth. A target may be growing so fast that it cannot obtain sufficient working capital to support the growth. This scenario is a good one for the target, since it has proof of strong growth, and so may be able to negotiate a high price.

• Retirement. The target’s owner wants to retire, and needs to cash out in order to do so. If the owner has established a long timeline for the sale, he can sort through a variety of offers and negotiate at length, resulting in a higher price. Conversely, a rushed retirement timeline can force down the price.

• Shareholder pressure. If the target is privately held, then its shareholders will have a difficult time selling their stock. A buyer can provide complete liquidity to these shareholders, either through an all-cash offer, or by issuing shares that can be registered for sale to other investors. This is an especially common reason when the management team does not hold majority ownership of the target’s shares, and so cannot control its direction.

• Stalled growth. A target may find that its growth has stalled, for any number of reasons. Maximized revenue is a logical point at which to sell, so the target puts itself up for sale, on the assumption that a buyer can re-invigorate growth.

• Technological obsolescence. The target may have based its core business on a technology that is now becoming obsolete, and it cannot afford the massive overhaul required for replacement. If the buyer is already operating under newer technology, it may be able to snap up such a target for a low price, and quickly convert it to the new systems.

All of the points above make it appear that sellers want to do a deal because of external forces that are not under their control, and which result in decreased value to them. However, a canny seller will have the sale transaction in mind for a number of years in advance of the actual event, and will position his company for sale at the time when its value is properly maximized, and he has stripped out as many risks as possible. For example, the seller should settle lawsuits and any government regulatory actions in advance, shorten the terms of any asset leases, and avoid launching any major, capital-intensive activities. These actions yield a clean, profitable enterprise for which a buyer would willingly pay top dollar.

Knowing why a target wants to sell is not just an input into the pricing process—it is also a very good question for the acquisition team to ponder. If the target’s management is essentially giving up, and they are the ones most knowledgeable about their company, then why should the buyer want to acquire it? In many cases, examining the issue from the perspective of the seller may cause the buyer to back out of a prospective deal.

ACQUISITION STRATEGY

A surprising number of buyers do not consider the total corporate strategy within which they conduct acquisition activities, if indeed they use any formal strategy at all. Instead, they simply look for modest extensions of their current core business. Given the large investment of funds and management time needed to buy and acquire another company, a buyer should instead spend a great deal of time formally pondering why it wants to make acquisitions in a particular market niche, and of an identified target in particular. The details of this analysis will vary considerably by company; several of the more common strategic issues are noted in this section.

The single most important strategic consideration is the size of an acquisition. It is much better to complete a series of small acquisitions than one or two large ones. By doing so, a buyer learns a great deal from each successive acquisition, so that it develops a significant experience base. If it buys a number of these smaller firms, a buyer can hone its acquisition skills remarkably. Conversely, if it only acquires large companies, it will not have such a skill set, and will therefore have a higher risk of failure. Also, a buyer can impose its own systems more readily on a small acquisition, whereas it may have a substantial tussle on its hands with a larger one. Finally, some acquisition efforts will fail, so it is better to have one or two small deals fail than one large one.

The buyer should always acquire a business that supplements its strongest business segment, and ignore acquisitions that would bolster its weakest segment. By doing so, it is concentrating its management efforts on that part of its business that generates the highest revenue or profit growth, and so builds the most long-term value. The buyer would be better off divesting a weak segment than adding to it.

A bolt-on acquisition is a direct add-on to the buyer’s existing business; it is very similar to the operations the buyer already has. In this case, the buyer should have an excellent idea of what synergies can be obtained, so the acquisition is more of a mundane, tactical nature than a strategic one. However, the buyer must give a great deal more thought to strategy if it is contemplating an acquisition located in an entirely new business area. Since the level of uncertainty over a bolt-on acquisition is greatly increased, the buyer must be prepared for a broad range of outcomes, from serious losses to outsized gains. The buyer should also factor into its planning a proper retention plan for the target’s management team, since it cannot reasonably expect to manage a business itself in an entirely new business arena.

One of the more likely strategic issues faced by a buyer is the reactions of its competitors to an acquisition. They may buy a company themselves, or jump into a bidding war for the buyer’s current acquisition foray, or file an anti-trust lawsuit, or enter into a protective alliance with other competitors—the list of possible reactions is substantial. This does not mean that the buyer should back away from an acquisition because of its fears of competitor reactions, but simply that it must be aware of how the deal will lead to a restructuring of the competitive environment in its industry. There may even be cases where the buyer deliberately backs away from an acquisition, leaving it to a competitor to acquire. This can be an excellent ploy when the target has several known flaws, and there is a strong possibility that the competitor may stumble in its integration of the target.

Another strategic concern is the avoidance of competitors. If a buyer has thus far subsisted in areas away from ferocious competitors, then it would do well to continue down the same path, and find unexploited niches that those competitors have not addressed. The worst possible strategy in a great many cases is to make an acquisition that places the buyer squarely in the path of large, well-run competitor; the result is usually an acquisition whose results rapidly head downhill.

If a buyer is publicly held, it may report in its quarterly and annual financial statements the key metrics upon which it relies (such as changes in revenue or backlog). If these metrics are properly communicated, the investment community also will focus on them, which means that changes in the buyer’s stock price will be tied to those specific metrics. Thus, the buyer should focus on acquisitions that can help it improve those key metrics. For example, if the investment community focuses on increases in a company’s revenue growth, then it should focus more on target companies with the same characteristic, rather than entities that perform better under other metrics.

If a buyer intends to pay for an acquisition with stock, then it should be mindful of the impact that a group of new shareholders may have on its ability to conduct business in the future. For example, this new voting block could interfere with the buyer’s intent to sell off pieces of the newly acquired company. It could also contest director elections and oppose a variety of actions requiring shareholder approval, such as the creation of a new class of stock. Thus, a buyer may prefer to pay cash for an acquisition, strictly to avoid activist shareholders.

The strategic issues noted here include the size of the target, business segments to support, industry niches to invest in, and the reactions of both competitors and the investment community. None of them directly involve the purchase of a specific company, but rather the framework within which the buyer competes. A buyer should constantly test acquisition targets against this framework, and also test the veracity of the framework itself on a regular basis.

THE BASIC ACQUISITION PROCESS FLOW

The buyer usually initiates contact with the target company. The best method for doing so is a direct call between the presidents of the two companies. This allows for a brief expression of interest, which can be discreetly broken off if the target’s president is not interested. If there is some interest, then the presidents should meet for an informal discussion, after which their management teams can become involved in more detailed negotiations. If the buyer’s president has difficulty obtaining access to his counterpart, then it is best to only leave a message regarding a strategic transaction or strategic alliance, and wait for a response. Offering to buy someone’s company through a lengthy voice mail may not be considered a serious offer, and will be discarded. A formal letter containing a purchase offer can be misconstrued as notice of a hostile acquisition, and so is to be avoided.

If the buyer wishes to contact a target but does not want to reveal its identity, it can use an intermediary to make the initial contact. This can be an investment banker, consultant, attorney, or some similar individual who can discreetly represent the buyer. The intent behind using an intermediary is to see if the target has any interest in a potential buyout. If not, the buyer can quietly depart the scene, with no one learning of its acquisitive desires. This is a useful ploy when the buyer is scouting out an industry for possible acquisitions.

If there is an agreement to exchange information, then both companies must sign a non-disclosure agreement (NDA). Under the agreement, they are obligated to treat all exchanged information as confidential, not distribute it to the public, and to return it upon request. Otherwise, even if the acquisition does not occur, the buyer will retain all information about the target, and could use it for a variety of purposes in the future. In a worst-case scenario for the target, its confidential information could be spread around the industry, with adverse consequences. There are occasional cases of one-way NDAs, where the buyer signs it but the target does not. This is to be avoided, since there is an increased chance that the target is simply trying to publicize the deal, in hopes of attracting other bidders.

The target may hire a professional negotiator, or proxy, to represent it in any discussions with the buyer. Though expensive, the proxy allows the target to create a buffer between itself and any of the more strident negotiation disputes. This allows relations between the buyer and target to remain cordial, with any ire being deflected onto the proxy.

A reasonable way to begin discussions between the parties is to avoid any mention of the target’s financial or operational condition. This information will shortly become almost the sole topic of conversation, in order to see if the target meets the buyer’s purchasing criteria. However, buyer’s initial objective is to foster a sense of trust among the target’s executives. Not only does this sometimes result in more willingness by the target to divulge information, but it may also mean that the target will be more likely to sell to the buyer, rather than some other bidder who has taken less time to build relations. Consequently, a good first step is complete avoidance of numbers, in favor of softer discussions about the needs, concerns, and operating styles of both companies.

In general, the target has more negotiating power at the beginning of the acquisition process, while the buyer has more control at the end. This is because the buyer has inadequate information about the target until it has completed the due diligence process, after which it will use that information to attempt to lower the proposed purchase price. Thus, a common scenario is for the buyer to initially agree to a high proposed price by the target, and then gradually whittle that number down through a variety of adjustments. The target is more likely to agree to these changes near the end of the negotiations, when it has become more firmly committed to concluding the sale.

If the buyer makes an offer, the target may be tempted to shop that offer among other potential bidders in hopes of attracting a better offer. Though common, this practice represents a considerable breach of good faith with the original buyer. Thus, the target should first consider the adverse impact of losing the original bid from a now-irate buyer before engaging in bid shopping.

Irrespective of how the two parties position themselves in regard to pricing, the ultimate price paid will be founded upon a detailed valuation analysis that is conducted by the buyer. As a baseline, this valuation uses a five-year discounted cash flow analysis, as well as an estimated termination value for the selling entity at the end of that period. However, it is best to supplement the analysis with a low-end breakup valuation, as well as a valuation that is based on prices recently paid for comparable companies. The later valuation works best for a high-growth target that has minimal cash flows. By creating and comparing a range of these valuations, a buyer can derive a reasonable price range within which it can negotiate with the target. This topic is covered in more depth in the Valuing an Acquisition Target chapter.

Under no circumstances should the buyer allow the target access to its valuation models. If it were to do so, the target would likely alter its figures for the numerous variables and assumptions in the models, resulting in a significantly higher price. Instead, the buyer should consider this to be a closely guarded secret, and only offer the target a final price, with no supporting documentation.

As an interesting sidelight, the buyer can estimate in advance the selling president’s reaction to a purchase price by estimating its impact on the president’s outstanding stock options. If the president’s options will not be exercisable at the offered price, then a certain amount of indifference can be anticipated. However, if the exercise price is greatly below the offer price, the buyer may find itself with an inordinately cooperative counterparty.

Alternatively, there are situations where the buyer is not likely to meet with a favorable reception. For example, if the target has just obtained significant funding or brought in a new president, it may have major growth expectations, and would prefer to wait until a later date, when it will presumably have a higher valuation.

The target may insist on an excessively high purchase price, or else it will not proceed with the acquisition. The buyer can work around this problem in two ways. One is through an earnout provision, where the target has the opportunity to be paid substantially more if it can generate significant revenue or profit increases in the near future. Alternatively, the buyer can offer to pay at least a portion of the price with a long-term, low-interest note. The face value of the note makes it appear that the buyer is paying full price, but the low-interest nature of the instrument actually results in a substantial discount over its term.

The buyer can depress the purchase price by making it clear that it is evaluating several alternatives to the target company. By doing so, the negotiating power shifts to the buyer, who is now in a better position to obtain a more reasonable price. Also, many negotiations fall through, for any number of reasons. Because of these pricing and closing problems, it is extremely important for a buyer to constantly be searching the industry for targets, and to always have a number of potential deals in various stages of completion.

After the parties have discussed the acquisition and arrived at the general terms of a deal, the buyer issues a term sheet (also known as a letter of intent), which is a non-binding summary of the primary terms of what will eventually become a purchase agreement. The term sheet is discussed later in the Term Sheet chapter.

Many buyers do not have access to sufficient funds to complete an acquisition, but wish to continue with acquisition talks in hopes of obtaining the necessary funding prior to closing the deal. They can make the seller aware of this difficulty with a financing out condition, which allows them to abandon the deal in the absence of funding. The point at which this condition is brought up is a delicate issue. The