I was recently coaching a CEO through a complicated analysis of a potential acquisition. An acquisition should make a company more valuable, but it introduces risk and a host of other variables. The calculus involves a broad range of constituents that need to be considered. In addition to all of the financial and legal diligence, it gave me the idea to construct a roadmap, or checklist of softer items to evaluate prior to pulling the trigger on an acquisition.
The first order problem is the decision to move forward or not. From a deal structure perspective, this is pretty well understood territory. There are many good references for diligence checklists, and models to understand the financial implications of an acquisition. However, it is nearly impossible to cover all of potential variables and gotchas in an acquisition. The buyer has to determine what they know with certainty vs what they have been told, what they suspect but need to confirm, and what the likely traps or points of failure are. The unknowns all contribute risk to the deal.
Historic financial performance of the target is fairly easy to interpret, but past performance is not always a great indicator of future performance under new ownership. The seller did not build their business to fit hand-in-glove with the buyer’s business, so there will be rough edges and overlaps that need to be be smoothed out or eliminated. Acquirers look for “synergies,” which is a euphemism for cost savings. The buyer needs to consider the soft side of removing these edges, and how it will impact future performance. Assuming some of the seller’s employees will be reassigned or eliminated as a result of the ‘smoothing,’ what will be the impact on the culture and retention of the remaining employees? Are the effected employees cultural leaders with influence beyond their functional roles, and is there a risk that their exit will destabilize the remaining employee base? It is important to consider the flight risks and the cultural impacts of the synergies.
There are always different ways to structure an acquisition, and each approach will impact various constituents differently. The mix of cash up front, earn out, equity, debt, and timing will lead to different sensitivities. Buyers want to put the risks on the seller, and the seller wants to put the risks on the buyer, so it is a balancing act. If the seller has institutional investors, the buyer ought to be aware of the investor’s fund dynamics. Are they at the end of their fund lifecycle and looking to get out, or is this an under performing asset? Are they open to rolling their investment into the acquirer’s equity stack, or do they want a clean break? I am not a fan of earn outs, particularly as a seller. I view earn outs as a recognition that the two sides do not really agree on price, so they are kicking the can down the road. My frequent quote has been “an earn out is setting up a later fight.” However, as a buyer I recognize that it is a powerful tool to de-risk a deal. It basically means the buyer is unconvinced of the value the seller is claiming, so the seller gets to prove it by performing. The problem is that the buyer will make changes once they own the company, so the business trajectory will not remain the same. Typically the argument will be “you screwed up my company, so we could not earn the earn out.” My advice is to be VERY clear about the buyer’s intentions, the terms of the earn out, and the measures of success, and keep the duration short.
Often, buyers consider the needs of the seller’s employees, but under value the implications for their own employees. Successful acquisitions will typically result in a blending of executives and employees from both companies. There will be overlaps, and there will be winners and losers on both teams. The process will be unsettling for the acquirer’s employees as well as the seller’s. I have a firm rule that the acquirer has to answer four key questions on day-one for every one of the seller’s employees, and any effected employees of the buyer:
What is my job in the new company? Job descriptions are ideal, but at a minimum a clear statement of duties going forward is required.
Who will I report to? There cannot be any ambiguity of reporting structure. The direct manager is the most important influence on employee retention, so it is vital to set this relationship on the right footing from the start.
What is my compensation package? This is a comprehensive topic that includes base pay, variable pay and bonus opportunities, as well as benefits, equity compensation, and vacation or PTO policies.
What do I need to do to succeed? Employees need to understand their performance metrics and measures, and they have to believe they are attainable.
One of the most important constituencies is the customer base. The seller’s customers are likely to be unsettled, and if any of them were shaky to begin with, churn can become a huge issue. The seller’s leaders need to be active participants to calm down the base, and the buyer has to allocate senior resources to meet the customers and welcome them. Welcoming means listening, not just talking. Customers want to have a voice and a home with the buyer. Listening will uncover underlying satisfaction issues, and should focus on understanding the value the customers perceive in staying with the new company. It will highlight areas the product team needs to preserve or enhance going forward. This is particularly important if the acquirer intends to retire and replace the seller’s existing product. It is easy to think your product is superior so customers will love it, when in fact there may be some key capability your team overlooked.
The same care needs to be applied to the buyer’s customer base. Often the intention of the acquisition is to broaden the buyer’s product line or capabilities. However, existing customers may see it as deemphasizing the current product and react negatively, or look for a replacement vendor that offers more of a pure-play, where their needs are the only focus for the vendor. Churn is the absolute enemy of acquisitions, so it is paramount to focus on the customers of both companies to ensure the revenue stream is uninterrupted.
There are many other considerations, but the last one I want to address is the need to look into the value of the buyer’s business in the future. Assuming the buyer will either go to market to be acquired, or to raise incremental capital in the future. How will this acquisition impact the timing and the potential universe of future investors? Will it make the company a more desirable target, or will it complicate the future investment landscape? How long will it take to prove value from the acquisition, and is that within the investment horizon of the current owners? Institutional fund dynamics play a role in this decision process. If current investors want to get out in the next couple of years, but the acquisition will result in a short-term downturn while the company builds for a future upturn, will it play out in the timeframe of the current investors? This is particularly true if the acquisition will adversely impact near-term profitability, growth, and churn. It may actually lower the value of the buyer before it raises the value. Current investors may prefer a steady growth path to realize their exit value sooner, and therefore will view the deal unfavorably, or impose performance metrics that change the operating equation post-acquisition. All of the existing investors may not be in it for the long haul.
The bottom line is that the CEO, executive team, and the board need to be aware of all of the implications of an acquisition, and avoid focusing solely on the financial and diligence elements of the transaction. To apply a military analogy, there is the action (doing the deal), the reaction (post-deal fallout), and counter action (what has to happen to make sure things go as planned). As Colin Powell said, “you break it, you own it.”