So, you are the chief financial officer (CFO) and today’s the day you are meeting senior colleagues to brainstorm on how to grow the company. You enter the room thinking about the myriad of proposals that you expect would come up during the discussion. As the meeting progresses over coffee and biscuits, a colleague finally proposes taking the inorganic route for growth. You were not only expecting this, but had come prepared with 10 questions. The answers, of course, are critical to evaluate before embarking on a merger and acquisition (M&A) process. You pose these questions to your colleagues, and, unsurprisingly, an epic discussion, probably rivalling those from your MBA days, takes place. Now that a context has been set, let’s examine these 10 questions and what makes them important.
- What are your motivations for turning to an inorganic strategy?
Is there an important piece of the growth puzzle missing, such as a key customer, technology, market, etc., that you are trying to acquire? In such cases, an acquisition strategy may make sense. Or is this merely a shortcut to revenue growth? While consolidation stories do make sense in certain scenarios, in most cases, one needs to consider that the investors invested in the company and thus appointed the current management team. If they wanted to invest in another business, they would have done so directly– after all, money is the ultimate fungible and free to move commodity.
- The Build vs Buy argument
Have you evaluated other reasonable alternatives to an inorganic strategy? Often people would like to acquire certain readymade technologies, distribution networks, etc., which can be replicated internally, but may take time for the company to achieve. However, in the face of limited resources, the build vs buy equation becomes very important. Further, one should also evaluate if a partnership route brings about the same set of benefits without incurring a large price premium involved in acquisitions and the huge management bandwidth that is involved in acquiring and integrating a target company.
- Is this the right time?
Do you think the stars are aligned? Planetary motions aside, is this stage appropriate in the company’s lifecycle to look for growth through inorganic means? It’s extremely important to ensure the right set of circumstances exist for one to roll out an inorganic strategy. A few pertinent questions that one needs to answer to decide whether the time is right are as follows: (a) Is it too early to look out for an inorganic route?
(b) doe the correct market circumstances exist, i.e. whether the market is in a consolidation phase or a growth phase,
(c) whether an acquisition will add to the enterprise value,
(d) are targets in the industry reasonably priced or whether there are unrealistic valuation expectations which mean that any inorganic acquisition will never reach any kind of financial payback,
(e) do you have the right balance sheet strength to not just be able to finance the transaction but also be ready to bear a hit if your bet goes wrong in spite of the best possible due diligence and analysis ,
(f) whether you have your investor and board support to go for aggressive growth, (g) whether you have the right team in place or do you think you will be able to get the right team in place soon enough to be able to execute and take forward any target that is acquired.
- Formulating an M&A Strategy:
Formulating an M&A strategy is critical. It needs to be complementary to the corporate strategy and vision. It is not restricted to just target selection criteria (industry, size of target, target maturity, geo etc.), but also includes the process, the team, the right partners and finally financing the deal.
The target selection criteria are the most common place aspect of the strategy and is dictated by the essential motivations for executing the inorganic strategy. The process, especially how you will identify targets (whether brought by bankers, whether through own research), creating and managing internal investment gating mechanisms, putting in a review mechanism etc., are very important. Also important is getting the right team mix – with the process requiring a set of senior resources comprising strategy, sales leadership, finance, legal, HR and active participation by the CXO team. This multi-function team will play a key role in the execution and should be thought of ahead of the actual acquisition kickoff. The right partners comprising experienced bankers with the right connect and a motivated set of lawyers and accountants for diligence are very important. The quality of output of the external partners is directly proportional to the right pointers from the M&A team in terms of what critical areas to focus on, negotiation points with targets and adequate reviews.
One of the areas where somewhat less innovation happens is in terms of financing the transaction. While there are a large set of possibilities comprising debt, cash, stock etc., one should also value significant strategic benefits one brings to the table and use the same as a currency for acquisition. For instance, a certain portion of purchase consideration may be exclusive distribution, access to customers and sales networks etc.
- Your valuation framework:
What element in a target should you value and how? This is driven primarily by the purpose of your acquisition. In case of a consolidation exercise or buying out of competition it will strictly be driven by the financial return or IRR. In case it’s a market entry or enter a high growth segment, then a traditional DCF / IRR method may not be workable. In that case, you may need to open your purse strings for a high price (several multiples of revenue usually). Are you therefore clear in your mind on what it is that you are willing to pay in case of the right target coming your way? Similarly, just like investors apply a stop loss in the equity markets for trading do you have in mind a purchase price beyond which you will not pay and simply walk away. This is often easier said than done as managers become very involved in a process and do not want to throw away the time and efforts that have been invested in the process. However, you need to keep in mind that M&A is also equally about walking away from bad deals.
- Target Selection criteria:
While the usual selection criteria of the segment, industry, scale (enterprise, SMB, startup etc.), geography etc. are important selection criteria, at the brass tacks, it is also important to understand who is the seller you would like to deal with and what is the seller’s motivation to sell?
Should you talk to a bootstrapped entrepreneur who wants to cash out? Should you talk to a venture capital or private equity backed company where the investor bought a stake in the company at crazy valuations and now expect even crazier valuations at exit? Or should you talk to a major corporation who is maybe looking to divest a business and may have more reasonable expectations?
The seller and the motivation for sale are extremely important from a target selection and pricing point of view because it will highlight whether an asset is a good or damaged one and whether it will be fairly priced or overvalued. In fact, two signs from the seller are very important to note (at the right time, of course). First, if the seller feels that the growth and profitability potential of particular company is exhausted and they’re trying to exit at the peak. Or, secondly, if the seller has held on to the asset for too long and now is trying to get the best price and cut his losses. Rest assured, then, you are going to inherit a business which is in a downward trajectory and thus all precautions and checks are sorely required. Even if the price is right.
Often when the seller is a private equity or venture capital backed company, then irrespective of financial theory, the psychological impact of sunk cost comes in. When people think that they have invested at a certain valuation and thus cannot exit the company below said valuation, unrealistic and irrational price expectations often come into play.
At times, one will realize during the evaluation process the sellers do not have the skill set to scale up and are therefore exiting the business. Such finds may, of course, be very attractive because one knows that one may be able to run it better and grow the business better than the incumbent management. However, it is important not to fall in the trap where one thinks that the business can be turned around magically.
- Did you consider the non-monetary resource cost that you will incur to make a transaction successful?
Monetary considerations like price, cost of funds are the obvious resource constraints that people often think of. However what people do not think of is whether there is adequate management bandwidth to be able to bite off an inorganic project and process it and integrate it and run it successfully in future. Often, even a successful or a very promising transaction may not fructify because it was left on its own without adequate management oversight by the buyer. So one of the items that any prospective acquirer needs to think of is whether they have the right amount of talent internally to manage the company especially when the founders are not expected to continue for long. Failing which, the buyer needs to assess whether the incumbent management that is going to come in as part of the company have the right mindset, skills and capabilities to grow the business and work towards retaining them.
- Alignment – Goals, Incentives, Structure and Policies:
Getting a buy-in on a common goal from internal stakeholders as well as the target management (including continuing sellers) is very important. Often, running an acquired business on its own can lead to internal competition and silos in operations. It becomes imperative to align both internal and external teams on a joint business plan and assign roles and responsibilities as well as incentives to make the joint business plan succeed. Therefore, getting the important internal stakeholders ready prior to a transaction and keeping the goal alignment in mind as a pre-requisite for designing any deal structures (earn-outs for instance) needs to be ensured while approaching targets.
Structure probably gets less mental bandwidth than it generally should. A convoluted holding structure (often for tax or currency reasons and often involving tax havens) that the seller creates is not something that the buyer needs to spend time on unwinding. It is reasonable to insist on unwinding the structure as part of the transaction to ease one’s own operations and more importantly to avoid undue regulatory challenges. This is something that the buyer needs to address fairly early in the game, probably at the time of the LOI itself.
At the operational level, it is important to harmonize the policies and processes of the target with the parent organization as long as the harmonization is not done as a cookie cutter solution. For instance, bringing up salaries and benefits up to par in a newly acquired company may be important. However, accounting for difference in resource quality, complexity of work, geo differences etc., are important. Else there is a risk of raising operating costs needlessly. To make this work seamlessly, the buyer needs to have a cross-functional post-merger integration team pre-identified to make sure this is done in a seamless manner during the deal process.
- Mitigating customer risks –
(a) retention: how will one ensure that the customers of the target company will continue with you post a transaction? It is extremely important to understand customer stickiness and satisfaction during the DD process as well as assure the customers of continued support, post the transaction. Also, it’s extremely important to understand why a particular company has the customers that it has and if one sees that in the recent past the company has lost customers, well, heads up! This is a worrying trend and it is something that needs to be very carefully evaluated if at all you want to proceed further.
(b) Non-Compete / Poaching – it is also possible that a particular company has been able to acquire a set of customers because of some special relationship with a particular key person (founder or owner or senior management personnel) and it is quite possible that once that person moves out he takes the relationship of those customers with him. Therefore, stickiness of customers and customer contracts needs to be evaluated very carefully during the DD process. Further safeguards may need to be built through appropriate non-compete and non-poaching agreements.
(c) Tech consolidation – This consideration becomes especially important in the situation where the buyer and the target both have a significant installed base of customers on similar compatible technologies and moving customers from one set of products to the next set of products (either through combination or selection of the best of breed or elimination of one parallel product line) involves a significant disruption faced by the customer. There is also a significant cost when one must move the customer from one technology base to another. These are costs that need to be estimated, especially at the pricing stage.
- Ability to drive synergies –
Often times a price premium paid for acquisition is justified as being capable of set off against future synergies. While premium is upfront and typically in cash, synergy benefits are often temporary and theoretical. There is significant risk that if the target is well amalgamated within the company, then after a while it all becomes business as usual and the costs and luxuries pile up and expected synergies evaporate.
Driving synergies often requires taking up a very di-associated and dispassionate view of the business. A non-nonsense PE-like mindset towards driving costs and operational performance is needed. Very often, it may require an outside person to be brought in to drive the process as it requires a very different DNA than an operating manager. In operating managers, logical decision making is typically hardwired through education and experience, whereas cost control requires at times ruthlessness and the ability to turn a deaf ear to other people’s logic.
As part of this initiative, several challenging decisions need to be made. For instance, if the newly acquired management talent can run the business better than the incumbent buyer’s management personnel, will you be ready to replace your own people with better talent? Will you be decisive enough to take tough calls, especially regarding people? How will you assimilate technology especially in this situation where both companies have an established product with significant customer installations?
These are, in a nutshell, the top 10 questions that come entailed with chalking and executing an inorganic strategy. Of course, your mileage may vary, given the fact that different industries, different companies and different kinds of buyers and sellers exist. So tell us, when it comes to embarking on the M&A journey, what’s on your mind?