Wednesday, June 6, 2007

When You Think You’re Buying Low, The Seller Thinks He’s Selling High

I used to do mergers and acquisition work on a regular basis. At that time, I would frequently get from investment bankers books describing companies that were for sale. One time, I got a book on a franchise retailer who had number of stores in a couple of major markets in the United States. I opened up the book and quickly built a simple computer spreadsheet to roughly see how profitable this company was. It looked outstandingly profitable!

If you added the potential for national and international expansion, it looked even better. If we paid for it based on normal pricing multiples, we would make a fortune! This looked like a “can’t miss” deal—a no-brainer, as we called them. Any fool could see how good of a deal this was. It looked so positive, that I was tempted not to do a more detailed analysis—even if my assumptions were off by quite a bit, it would still look good. I got very excited, because you rarely see a deal that looked this exceptional.

But then I started thinking. If this was such a good business model, why is the owner selling? I went back to the book. It claimed that the business was for sale because the owners felt that its greatest value lay in its expansion potential. The book went on to say that the current owners believed that if the company was put into the hands of someone who was better capitalized, they could achieve that expansion potential better than the current owners. That sounded reasonable to me…until I looked up who the owners were.

One of the largest owners was a major investment banking company. In fact, it was the same company that had been contracted to sell the company. This investment banking company had full-time investment professionals and access to far more capital than the people it was trying to sell the company to. Something here didn’t smell right. If wealthy professional investors could not (or would not) fund this company, why should I? I was reminded of an old saying, “If a deal appears too good to be true, it probably is.”

So I investigated further. Buried deep into the book was a comment that most of the franchise agreements with the company were expiring over the next few years and that a significant percentage were refusing to renew their franchise. These franchisees claimed that they saw no benefit to being associated with this franchisor and were going to operate stores independently. This caused some concern. If the current franchisees were dissatisfied and not renewing, why would I think I could expand this concept nationally with new franchisees? Perhaps this chain is contracting, rather than expanding.

So I investigated further. Way back in the small footnotes was a comment that most of the store leases were coming to an end over the next few years and would have to be renegotiated. That didn’t bother me until I remembered that about 50 pages earlier in the book, the company bragged that one of its benefits was the unusually low rents it paid on its properties. In fact, it claimed that its leases were at only about 25% of current market rates. That got me thinking. When those leases get renegotiated, they will probably move a lot closer to market rates.

This caused me to go back and rerun the model on my spreadsheet, putting in less expansion and higher rents. This time, the model was highly unprofitable. You’d have to have been a fool to want to buy this company. The more you expanded it, the worse it looked. Suddenly, I understood why these professional investment bankers wanted to sell the company right away. Its current profitability was going to disappear in a couple of years. They were hoping to find a fool who would buy the company based on its current position rather than its future position. And I was nearly that fool.

One of the key roles of strategic planning is to find ways to grow a company. Acquisitions are a popular tool for creating that growth. Therefore, it is very common to see acquisitions put into a company’s strategic plan.

Although it looks wonderful to put acquisitions into a planning document, it is a lot more difficult to actually make the acquisitions happen. First of all, acquisitions rarely come according to your schedule. For example, you may put in your plan that you will do a $20 million acquisition in the first half of the second year of your plan. But what if the deal really happens in year four? Or year one? Or not at all? What if the deal happens to be significantly larger or smaller than $20 million?

This brings us to the second major problem with putting acquisitions into strategic plans—most are failures. Depending on what study you look at, approximately 70% to 80% of acquisitions, on average, are failures. Had the company I worked for acquired that franchiser mentioned above, I am certain it would have been a failure. If so many acquisitions fail, then why do strategic plans typically assume that every acquisition in the plan are wildly profitable?

It is a lot like the stock market. Every day millions of shares trade hands. Nearly all the sellers are assuming that the price of the stock is going down while nearly all of the buyers are assuming that the price of the stock is going up. At least one of the two parties has to be wrong on every one of these millions of transactions.

I was initially excited about that franchise retailer, because I thought at first I was buying it at the bottom. It looked highly profitable and highly expandable. I thought I was getting in at the beginning of an upward ride to great wealth. However, as I examined it further, I realized that the sellers thought they were selling it at the top. They could see that rising costs and fewer franchisees were just around the corner and that everything was getting worse. The great ride was over and things were trending down. In this case, if a deal had occurred, I think the buyer would have been wrong and the seller right.

Most aggressive companies have a gap between the goal of how large they want to be and how large the combination of their current businesses can get. To fill that gap, I have seen companies use unknown, miscellaneous acquisitions as a plug in their planning document.

In many cases, this can be a cowardly approach to planning. Rather than doing the hard work of detailing a specific path to fill the growth gap, these companies ignore the problem. They convince themselves that some mysterious acquisitions will solve all of their growth problems, so they don’t need to worry about it. Trust me…any growth gap should be worried about, because they are rarely easy to fill, even if you are filling them with acquisitions.

Because doing acquisitions well is so difficult, I have listed below four principles of acquisitions that I have learned over the years. Keep these in mind as you plan for and as you do acquisitions.

1. Have an answer for the 30% question
If you are acquiring a publicly traded company, a rule of thumb is that you will probably end up paying around a 20 to 30% premium over its current trading market value in order to get the deal done. In general, the current market value of a widely traded stock is a fair approximation of what a company is worth in the hands of its current management. Therefore, if you acquire a public company, you typically need to have a plan to operate the acquired company about 30% better than the current owners just to break even on your investment. If you want to create significant growth beyond breakeven, you need to do even better. Since privately held companies have access to sophisticated consultants, the astute ones will probably want a similar type of premium.

With such a high level of performance needed to make a typical acquisition work, it is no wonder that so many acquisitions fail. It is highly unlikely that you can manage their company under their strategy and do it 30% better than they can. The only way you can cover the 30% gap is if you can do something meaningfully different with the assets as you combine them with your assets. And that requires good up-front planning.

For most acquisitions to cover the 30% premium, there need to be significant synergies between the acquiring company and the acquired company. These synergies can come in many forms:

• Transfer of core competency, management, or operational strengths between companies (in either direction);
• Access to new products, services, technologies, patents, customers, distribution channels or geographies that can be improved by assets or competencies already owned by the acquiring company.
• Access to missing elements needed to reach your strategic direction faster or cheaper than creating it from scratch.

Strategic planning can help determine which types of synergies are most valuable to your company and thereby help direct your search to the acquisition targets where you are most likely able to cover the 30% premium.

Without synergies between the companies, you are nothing more than investment capital. The only value you bring is your money. It is hard to think that just by putting in your money, you can make the company 30% better. Besides, there are professional investment capital companies that do that type of investment on a full-time basis and are very good at it. They are probably the smartest pure money investors. If the deal is good enough on a pure money basis, they will probably get to the deal before you do. Beware of pure money deals that have been rejected by professional investment bankers.

2. Look for companies that are not for sale first
When an owner is actively trying to sell a company, he or she is sending a message of no longer wanting to be associated with company. That should make you suspicious of why you would want to be associated with that company.

Also, when a company is actively being sold, it is more likely that the company is being operated in a way that optimizes its salability, rather than longevity. For example, in order to make a company look good to a potential buyer, a company may do things to increase sales or profits in the immediate term. However, these activities may obligate the company to do things that are detrimental in the long-term. Be suspicious of any rapid recent improvements.

By contrast, if owners are not actively considering selling, then they are showing a commitment to the company. In addition, they are less likely to be operating the company in a way that compromises the company’s future.

3. Always ask the owner why they are willing to sell their company
You have a right to be suspicious whenever a company is willing to sell at the price you are willing to pay. After all, they know their company better than you do. And, as mentioned earlier, sellers want to sell at the top, not the bottom. So don’t be afraid to ask why they are willing to sell.

Some answers to this question are quite acceptable. For example, an older owner who has most of his or her assets tied to the company for sale may want to make his or her assets more diversified and more liquid for retirement or transfer of assets to children by selling to get cash or get stock in a larger company that is easier to sell in the market.

Another good answer would be if a company for sale is at a transition stage and the current owners feel that they are not best suited to operate during or after the transition. For example, some people may feel comfortable starting small companies, but not at running them when they become larger.

4. Unlink the goal from the path
Acquisitions are not the only way to achieve strategic synergies. One can often achieve the same goal via strategic partnerships, alliances, coalitions, consortia, joint ventures, internal start-ups, strategic hiring, or outsourcing. Often, these alternatives can be a more cost effective or less risky way to achieve these goals as compared to acquisitions. By unlinking the goal (the strategic synergy) from the path (acquisition) one is freed up to look at more alternatives. Don’t automatically assume that acquisitions are your only alternative.

Success in acquisitions is difficult. When you think you are buying low, the seller thinks he or she is selling high. To reduce the risk of failure in acquisitions, keep in mind the following principles:

1. Have an answer for the 30% question
2. Look for companies that are not for sale first
3. Always ask the owner why they are willing to sell their company
4. Unlink the goal from the path

Just because about 75% of all acquisitions fail does not mean you should completely avoid them. Consider your alternatives. Studies show that alliances have a similar failure rate, and new business start-ups fail about 80-90% of the time. If you do nothing, the effects of the changing environment will make your current strategic initiative eventually fail 100% of the time. Suddenly, acquisitions don’t look as bad an alternative.

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