Deal Valuation: Inclusion of Costs to Achieve_Part 2

This month we continue our discussion of whether costs to achieve (CTA) should be included in deal models.  In last month’s installment we discussed some of the challenges that arise when these costs are included, as well as a few high-level benefits of doing so.  In this month’s installment we will discuss the use of a Target Operating Model approach to determine CTA for inclusion.

A Target Operating Model Approach to CTA Inclusion

If you have been following this blog, you will be familiar with the concept of target operating models and their relationship to deal rationales.  (April-November 2018 posts).  In short, the deal rationale determines the proper level of integration.  Deals where most of the synergies will come from revenue, particularly if the drivers include innovation or creativity, will optimize at lower levels of integration.  Deals where cost synergies play a larger part and/or there is a greater degree of overlap between acquirer and target will optimize at higher levels of integration.  The target operating model for the deal describes the integrated “5 W’s” or the Who (personnel) will do What (business processes and policies) from Where (geography and facilities) on Which (IT, telephony, networks, etc.) tools, and When (timing).
If you have chosen a minimal integration model, it is likely that most of your deal value drivers come from revenue.  In this case you will want to evaluate whether any personnel, facilities, or toolset integration are required to achieve the desired revenue synergies.  If the synergies are primarily accretive in nature – or if you are purchasing innovation or R&D-then little integration is needed, and you have chosen the correct TOM.  In this instance, you probably don’t miss much by using high-level CTA estimates, and forgoing a more extensive process.

Complementary deals that derive their value from revenue synergies that are not merely accretive, i.e. deals where you expect to combine customer bases, co-develop new offers, or otherwise extensively combine go-to-market operations will require some level of integration to reach synergy realization.  Overlapping deals where the value comes from combining operations for cost synergy purposes will require a high degree of integration.  Vertical deals will vary, depending on the extent to which integration is required for achievement of your business goals.
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Hopefully, you have already thought thru this in your TOM selection and have a “5 W’s” analysis that describes any interim and/or end-state TOMs.  In cases such as these, taking the time to prepare a CTA for each integration workstream is well worth the effort.  You may learn, for example, that regardless of cost/benefit, additional, ancillary projects are required to achieve your goals due to operational dependencies.  This will add to your overall cost of the deal and should be taken into consideration.  Or perhaps you learn that certain efforts will take longer than anticipated, lengthening the critical path to synergy realization.  Regardless, you can expect the CTA estimation process to generate the following outcomes:

1. It will provide insight into the actual return on investment
2. It will inform your valuation process
3. It will illuminate dependencies, and provide insight into the critical path
4. It will identify “excess scope”, activities that are not on the critical path and do not add sufficient synergy value

All four of the above are worthwhile and support the idea that adding CTA to deal models is a good practice when medium to high levels of integration are anticipated.

Conclusion, and a Warning
Beware of the temptation to change your TOM based solely on CTA.  It is completely appropriate to jettison integration activities that are off the critical path and provide insufficient synergy benefits; however, the deal rationale should still drive the TOM.  Remember that we chose the deal rationale because of its alignment with the core business problem we are trying to address; therefore, any TOM changes must be scrutinized to ensure that the deal retains those problem-solving attributes.  It seems obvious, but you might be surprised how deal fever can affect reason.  What starts out as an overlapping deal with cost synergies can suddenly morph into a stand-alone deal that is done for revenue synergies, which inevitably are only accretive and fail to provide return in excess of the hurdle rate.