In our last post we discussed where accountability for synergies should rest. Here we pick up the discussion with the next logical step, the do’s and don’ts of synergy measurement and reporting.
Do align synergy measurement with synergy accountability. This seems like a no-brainer; however, over the years I’ve seen several companies mis-align synergy accountability, measurement, and span of control over synergy achievement, so it is worth a call-out here. A common way this plays out is to have Finance be held accountable for not being tough enough in the budgeting and forecasting process while simultaneously holding Corporate Development accountable for the published deal metrics being missed, all while the acquiring business unit exercising span of control is either not held accountable, or is allowed to obscure results with clever reporting tactics. Align accountability with span of control and then put measures and metrics in accordingly.
Do tie non-transformational operating metrics into your company’s existing measurement framework. There is no need to re-invent the wheel when it comes to measuring results of operations; furthermore, it is counter-productive to have multiple measures for the same items. Simple operating metrics that don’t require large transformational projects should transition to run-the-business measurement approaches soon after change of control. Accretive revenue would fall into this category, as would ongoing cost synergies that can be achieved in the first 90 days and have few dependencies. Day 1 headcount reductions and simple integration items such as standardizing on a common payroll platform could be two examples of the latter.
If you utilize a lot of comparative or long-term measures, carve out one-time items such as costs to achieve that might create distortion. Ideally these one-time costs will be captured in your synergy business cases prepared during deal valuation anyway (See November, 2019 post Deal Valuation: Inclusion of Costs to Achieve Part 3) and can easily be tracked as program costs instead of operating items, preventing distortion in future comparative measures.
Do measure transformational items centrally until most dependencies have cleared. One of the more common, and damaging, mistakes that I’ve seen is to incentivize an acquiring business to achieve dramatic transformation in an acquired business while simultaneously trying to get through an earn-out period or other deal contingency that’s managed outside of the BU, i.e. by Corporate Development. This usually will also occur while Finance, IT, and HR have their own extensive transformation/integration programs underway, with lots of dependencies to go around for all sides.
On truly transformational programs it is better to centralize synergy accountability and measurement until most of the dependencies have cleared. The PMO can then reinforce near-term synergy priorities with incentives, balancing any contingencies such as earn-out arrangements via interaction with the executive steering committee, and create a step-plan that recognizes the timing, costs, and dependencies of synergy realization. When enough dependencies have cleared so that the span of control over outcomes can be dispersed, transition the program to a run-the-business model and follow the approach described above, using existing measurement frameworks for ongoing operational results.
Don’t apply a traditional framework to a “blue sky” acquisition. Recall from our target operating model series that acquisitions to boost innovation and/or creativity usually optimize at lower levels of integration; furthermore, there is usually neither a prescribed timeline nor a pre-determined value defining the desired outcome of the transaction. As such, traditional measurement frameworks are inappropriate and may even be detrimental. Leave golden-egg-laying geese alone in the near run, until the business has progressed to the point where measurable outcomes can be defined for measurement. At that point determine the appropriate metrics, ensuring they are aligned with span of control as always.
Don’t forget to include qualitative and/or macro-level measures. Identify, define, and subsequently track qualitative items that you expect to be key to value capture. These often include employee engagement and/or retention, measures of influence such as social media followers, gains in customer awareness and/or perception favorability, etc. The acquiring business is usually the appropriate accountable party for these metrics and, while they are often overlooked, they are also vital to ensuring that synergy capture is approached holistically.
Don’t forget to adjust for new realities. Static measures soon become stagnant measures whose disconnect from reality leads to a lack of engagement or worse. Markets change, competitors and customers make moves. Pandemics happen. If something irreversible transpires and impacts a previously determined metric, then adjust it accordingly.
Overall, remember that what gets measured gets managed, and what gets managed gets accomplished. The goal of measuring synergy realization is to create an environment of accountability and corresponding incentives that gets results. Measurement is not an end in itself, but rather a means to a desired end. For this reason, it is important to balance the rigor of the measurement approach with its corresponding administrative burden. Keeping synergy measures simple, aligned, and balanced as described above helps companies both achieve the synergies from completed transactions and ascertain strengths and weaknesses in their overall M&A approach for use on future deals.
How the world has changed since my last post in February! Now that 2020 craziness has finally leveled off (knock wood) we can continue with our series on synergies. As promised this edition will focus on establishing accountability for synergy realization.
3 general rules should be applied when determine who should be held accountable for synergy realization. The first general rule is as follows:
1. Accountability for synergies should align with span of control over the synergy realization efforts and the majority of all corresponding dependencies.
Revisiting some content from our April, 2018 posts will be helpful in understanding how this rule applies to various deal types:
Deal Rationale Considerations and TOM Selection
Recall from February’s post that we identified 2 basic categories of deals:
Complimentary deals have much greater variability in optimal TOMs, but there is a general rule that can be applied:
The greater the level of innovation or creativity implicit in the revenue synergies, the lower the level of optimal integration
The table below provides a general outline of where most complementary deals will optimize:
As recalled above, complimentary deals have a wider array of target operating models than do overlapping transactions and the optimal accountability structure also varies accordingly. A second general rule of synergy accountability can be applied as follows:
2. The greater the reliance on extra-accretive revenue synergies, the more accountability and control should (usually) rest with the acquiring business unit and centralized management should be minimized.
The key here is the phrase "extra-accretive", indicating that the revenue is to come from new innovations, not just the addition of mature markets, offers, etc. that result in a one-plus-one-equals-two sum. Often such synergies require careful attention to talent retention and a focus on creativity, innovation, and speed to market. The acquiring business should focus on the required portfolio and/or talent activities that will result in value capture. An IMO will still be very useful in the diligence to first 100 days phases of the transaction to ensure coordination, smooth onboarding, clear communications, capture of lessons learned, etc.; however, centralized program management should usually be discontinued after the first post-close phase and the business unit can assume responsibility- and synergy accountability- thereafter.
This rule also highlights why serial acquirers should always have an established “minimum TOM” that defines the minimum integration to meet legal, regulatory, and “must-have” corporate policy requirements. Up-front agreement on a minimum TOM will allow BU leadership maximum flexibility. For instance they may choose to leave many back-office processes in an as-is state or even outsource some activities to free up additional bandwidth. Regardless, being unshackled from the constraints of a highly-structured and standardized back office allows leaders to focus on the desired revenue growth unencumbered by the workload and distraction of a large integration program.
The third general rule can be applied to nearly all overlapping deals as well as many complementary deals where the synergies are primarily accretive:
3. The broader the synergy model, the narrower the ideal accountability should be, or the more comprehensive the synergy model, the greater the degree of centralization for deal outcome accountability
Dependencies are a key driver when applying this rule. A heavy or full integration that reaches across much of the business will require extensive planning, communications, coordination, and stakeholder management. The absence of a robust, well-sponsored, and centralized IMO foments discord and undermines value capture. The acquiring BU has no desire to learn the intricacies of the ERP tax data model for instance, and the inevitable “but we do this today” or “can’t we do this manually” will equally frustrate administrative staff. And there are even more complexities if back office activities are outsourced, as it is almost certain that the negotiators of those contracts aren’t in the acquiring business unit. As such what often happens is blaming, undermining, rework, and a loss of focus on deal outcomes. Setting up a centralized program office not only ensures a balanced approach to addressing dependencies across the business but can also create a "lightning rod" effect, centralizing any tensions and helping to maintain a spirit of cooperation between teams with differing priorities.
Effective governance is critical when centralizing complex, broad-reaching programs. The executive sponsor should ideally be a member of the C-suite, or at least have a substantial span of control and ultimate accountability for all outcomes, ensuring that Rule 1 above isn't violated. While this may seem like common sense, neglecting sponsorship while leaving accountability with the IMO is a surprisingly common error on transactions that fail to achieve value capture. Furthermore, the executive sponsor should have the authority to align performance and incentive structures to value capture objectives to facilitate focus and cooperation and to prevent conflicting goals from hampering progress.
On such complex integrations the level of dependencies will remain high for some time and early synergy targets are often planned for realization during this time. Centralized program management via an IMO (integration management office) is the best way to ensure that all milestones required to meet these objectives are achieved. To be more blunt, and IMO helps produce more value capture with less finger-pointing. As dependencies are cleared centralized management can be scaled back if desired, and synergy accountability transitioned to the business along with any remaining tasks.
Synergy Series: Getting Real
This post kicks off a series on synergy accountability, management and tracking. Worthwhile synergy programs always start with realistic synergy assumptions, well-vetted against market realities and substantiated with data where possible. Unrealistic expectations produce a toxic slurry of maladaptive behaviors and ultimately result in the loss of both top talent and shareholder value. We’ve discussed several keys to proper deal valuation and synergy expectation-setting in prior posts and as a refresher links are provided below:
Another key to realistic expectations lies in the preparation of the target operating model or TOM (see Apr-Nov 2018 for our extensive series on this topic). Careful TOM preparation will highlight what your business will need to do in order to realize the value of your acquisition.
Note that if you have a highly structured environment- one that features a high level of outsourcing, automation, complex metadata designs, etc.- it is likely that you will have higher integration costs than less structured companies. This is due to the need for the target to conform to your structure via a full, or nearly full, integration, in order for your existing structure to properly accommodate the target’s business needs. It follows that in order to pay the same multiple for the deal, you must also have superior operating margin capabilities that compensate for this cost differential. If superior revenue-generating capabilities are present, i.e. a superior distribution network, access to additional markets, etc. then the cost differential might be overcome in the near term; however, if a low-cost back office is expected to generate this additional operating margin on its own, a longer time horizon is often needed. So, when defining synergy expectations, be sure to consider not just the calculations, but also the horizon and time value of money.
Once your synergy business cases have been created, with the corresponding costs and benefits quantified and the time horizon projected, consider whether they should undergo an additional validation process. As with business case creation itself, there is a cost/benefit tradeoff to consider before commencing a validation exercise. Deals where the acquirer already has significant insight into the applicable business case inputs and deals that are minor investments may not warrant this additional level or rigor; however, substantial investments and deals where the acquirer has a less expertise generally benefit. Validation may include processes such as:
Each of these approaches has different advantages and drawbacks. Personally, I find the cross-functional business case reviews and the benchmarking to be the most useful in providing net new insights. Benchmarking and the use of strategy consultants to re-evaluate topline assumptions both have the advantage of being “arms-length” to the transaction; however, it is important to make sure that there is enough relevant data available. If your business relies heavily on a new technology such as blockchain, it isn’t clear that there is either enough data for benchmarking to be useful as yet, not that such data- from the very emerging stages of a new industry- is free of noise caused simply by industry growing pains.
Once you are comfortable that your synergies have been properly identified, properly valued, and that the timing horizon is realistic, you can begin to address accountability. This is where we will pick up in the next installment.
Happy New Year from Nearco and best wishes for a happy and prosperous 2020! While we will continue to offer training content in this blog, I wanted to start off the year with a review of the excellent new M&A book “Agile M&A” by Kison Patel (https://www.agilema.com/agile-m-a-book) and a discussion of how it ties in to what we have discussed so far.
The book proposes that Agile program practices, which have been proven successful in software development and many other areas, be adopted by M&A practitioners. Contrasting Agile with traditional program management techniques, it does a great job of providing the reader with an understanding of both approaches and why Agile has received such widespread adoption.
Core tenets of the approach to M&A advocated by this blog are reinforced throughout the book. These include active participation in due diligence by the integration team, tighter collaboration and accountability between the “deal team” and integration teams, the need for flexibility in governance and team structures, and the criticality of keeping the deal strategy and rationale in the forefront at all times.
Target operating model development
While the purpose of the book precludes the discussion of target operating models (TOMS) at length, the book’s key messages are applicable to this step. TOM definition lends itself well to an Agile “Sprint” and teams benefit from the daily standups that highlight collaboration areas. Approaching TOM development in this way provides built in dependency identification and validation, potentially saving a great deal of time and re-work. These efficiencies would then carry forward into planning, as the understanding of the overall program and approach across the organization would both be established and have broad buy-in and support.
Program structure and governance
A challenge often faced by IMO leaders is that not all integration is created equal. Some tasks, such as email setup or creating a new node in the companywide ledger, are often routine and lend themselves well to a checklist executed by low-cost resources. Others, particularly go-to-market activities such as offer design, pricing, marketing strategy, etc. vary greatly from deal to deal and require highly skilled resources and frequent executive interaction and decision-making. Still others, such as designing a data structure, require a great deal of time and skill but not necessarily as much managerial involvement in the details. Agile’s flexibility and low-overhead structure accommodate both activities well by allowing the IMO to “split” the program into teams that focus their efforts on different sprint backlogs, maximizing productivity. Practicing Agile alongside an MBE (management by exception) philosophy minimizes distractions and helps leaders maintain sufficient governance while keeping their focus on the deal strategy and value capture.
I found the book to be both on-point and right on time. Traditional M&A approaches were largely designed to accommodate multinational transactions undertaken by companies with highly structured back offices in a time when mobile collaboration technologies were inferior. Mega-deals, where the parties have high degrees of outsourcing, automation, and customized ERP systems, may still need to modify Agile practices and/or blend them with other methods; however, there are benefits to be gained from even partial adoptions. Certainly, the deal and diligence processes should benefit greatly! As the book states, there is no single Agile methodology and continuous improvement is part of the process.
Taking Stock of Where We've Been
In our final blog post for 2019 we will take a touchpoint and review some of the topics we have covered thus far, taking stock of where we are in the overall deal process.
Deciding to Acquire
We began this training blog with a review of the key factors to consider when deciding whether to acquire. This included the following:
Target Operating Models
Deal Valuation and CTA
Our goal for this blog is to create both a teaching tool and a useful reference guide that can be re-visited as needed along your M&A journey. We enjoy hearing from you and wish everyone the very best transition into 2020!
This post concludes our valuation section with a discussion of business cases. Business cases are by far the more common approach to CTA calculation, as most clients do not have an acquisition pipeline robust enough to warrant the creation of standard TOMs (see June 2018 post). Not surprisingly, the method for developing business cases is determined by the deal rationale, since the underlying objective is to model the cost to achieve the key deal value drivers.
Cost Synergy, Business Cases
If the primary value drivers of your deal result from cost synergies, you might consider a twofold approach. Most cost synergy deals realize much of their value through personnel reductions. If this is applicable ask yourself which of the following applies:
If item 1 applies to your deal, then you may be able to forgo the business case process altogether, or you may be able to streamline the scope of the business cases, and still obtain an accurate estimate of costs to achieve. This is because personnel reduction, absent of dependent integration requirements, can often be easily estimated without the need for business cases. Just ensure that Human Resources is involved, and that the following items are included to the extent applicable:
If item 2 more accurately describes your situation, I recommend creating business cases to support CTA for at least 80% of the total cost synergies included in the deal valuation model.
Besides personnel reduction, the most common areas for cost synergies are:
Of these the first 3 generally contribute the greatest operating (non-personnel) cost synergies and the first 2 also generally have the highest costs to achieve; however, if input cost reduction requires renegotiation of purchasing agreements, this can be time-consuming and costly as well. Whether you decide to do business cases only for the first two, the first three, or all the above is a matter of judgement. Remember, the goal is to get accurate CTA estimates supporting at least 80% of your projected cost savings to substantiate the deal valuation.
Note that if your situation does call for business cases, you will need to provide a framework for analyzing the benefits of personnel reduction. If you are going to account for these benefits with a simple analysis- as described earlier in this chapter- ensure that all operational business cases omit such benefits to avoid double-counting. Alternatively, you can have each functional team coordinate with Human Resources to accurately estimate the personnel reduction benefits and one-time costs to achieve, including these in the functional models. Either approach will work.
Using this layout, a cost synergy initiative business case will usually run from 4 to 10 pages, depending on the level of detail provided. Note that not all initiatives will have new recurring costs, but if a new process or operating model, i.e. outsourcing, is being deployed this will apply and should be included.
Once the business cases are drafted, review them for the following:
I find it is useful to bring the various teams together to discuss their drafts and findings at least once prior to submission of the final cases for review. This simple step often eliminates a great deal of overlap and confusion, while providing the teams with insights and encouraging collaboration. It is perfectly acceptable to begin stress-testing certain assumptions during this interim readout. For example, can teams share resources? Or can resources be procured more affordably if sourced under a shared contract? Can additional savings be realized by breaking dependent tasks down into smaller increments, allowing dependent teams to start more quickly? These early conversations begin to flesh out the TOM realization process and will benefit the team as the planning process develops.
Revenue Synergy Business Cases
For stand-alone or minimal integration transactions with revenue synergy value drivers, costs to achieve should be minimal. After all, the presumption is that you are leaving the target largely as-is, and any revenue benefits are coming from accretion and perhaps organic revenue growth, not from combined operations. These deals will likely not require CTA business cases.
For deals with extra-accretive revenue value drivers, the business cases are more complex. You will need to carefully rationalize your selected TOM to determine the integration initiatives required to achieve the level of joint operations necessary to realize your synergy projections. One useful approach to this is to create a forward-looking joint product roadmap; however, note that detailed competitive information is still likely under gun-jumping restrictions, so you will need to rely on carefully documented assumptions in creating a roadmap that supports your conclusions.
Once the roadmap is prepared, you can then conduct an addressable market analysis, and evaluate your projected share capture. Combined with your pricing assumptions- and a price elasticity analysis-, this approach should substantiate the viability of the revenue synergies in your deal model. At this point you can proceed with the CTA business cases using nearly the same approach as described above for cost synergy value drivers, with a few key differences. The template for an extra-accretive revenue cost-to-achieve business case should include the following:
Note the key differences in the cost and revenue synergy business cases. Cost synergies, and accretive revenue synergies, typically have a defined start date, after which benefits are recurring. Extra-accretive revenue synergies tend to require a ramp-up period, reflecting the gradual release and penetration of joint market offers.
While assumptions are required in all cases, extra-accretive revenue business cases rely on assumptions that are more subjective. As such, it is critical to include a robust analysis of TAM, market share, and pricing to document and substantiate your conclusions. Sensitivity analysis is also more critical for these business cases due to the reliance on these assumptions.
It’s common for deal models to have both revenue and cost synergy projections. In this case, you would simply combine the business case methods above to get total CTA, taking care not to double-count any costs. If using both interim and end-state TOMs, remember to factor in timing.
Business cases are the most common method of analyzing costs to achieve modeled deal synergies. Personnel costs can often be estimated without resorting to the preparation of full business cases; however, if business cases are being prepared while a simpler analysis is being used to calculate personnel reduction savings, take care not to double-count costs and benefits.
Overall, remember that the purpose of including costs to achieve in the deal models is to accurately calculate the return from the transaction, and to validate the deal valuation. This objective should guide you in determining which deal value drivers should have CTA business cases, with the goal being to substantiate at least 80% of the projected deal value.
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.
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:
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.
Just as there are differing perspectives on which valuation method yields the best results, there are also different perspectives on whether costs to achieve belong in the valuation models. In this post we will present arguments for both inclusion and exclusion of costs to achieve.
Arguments for Excluding CTA
Proponents of glossing over or omitting costs to achieve will point out, often correctly, that accurate estimates of such costs are too difficult to calculate. They also correctly argue that taking time to calculate and include these costs will “bog down” the process, and potentially cause the loss of the deal.
The latter argument has merit. You will spend more time on valuation if you attempt to include realistic CTA; furthermore, if the deal is competitive (meaning there are other interested buyers) you may be including costs that reduce your valuation relative to other bidders. This will almost certainly be true if you are a publicly traded or otherwise highly regulated company with heavy compliance requirements that finds itself bidding against privately held enterprises and/or private equity. If you are assuming a full integration target operating model, your CTA will also certainly be higher than a bidder that plans to leave the acquisition alone, even if they are also including CTA in their models.
What happens, then, is that costs to achieve are commonly either omitted from deal models altogether or else they are vaguely alluded to with some very high-level estimates. Often existing run-rate costs are used, with perhaps a few small one-time cost numbers associated with simple items such as separation costs for redundant staff. Regardless of anticipated post-close target operating model, it has been my experience that full CTA inclusion is uncommon outside of best-in-class acquirers.
Arguments for Including CTA
The most obvious argument for including CTA in the deal models is, of course, to get a better picture of the projected return on the investment. Including these costs, with their anticipated timing, allows you to estimate cash flows, calculate returns, and determine if the fully costed deal clears your internal capital hurdle rate. It also provides some defense against shareholder litigation, showing that you applied sober diligence to your investment of their capital.
But capital stewardship is not the only reason to consider inclusion of CTA. A fully costed estimation process helps to validate your target operating model selection and to also identify key dependencies on your integration critical path while there is still time to consider these factors in your overall evaluation of the deal as a strategic move. It can help set realistic expectations as to the timing of joint operations. The latter may suggest that while an acquisition is appropriate, there is not enough time to adequately integrate in response to a particular market dynamic, indicating that another strategic move is required in the near term.
Since I am a former accountant it probably comes as no surprise that I am a big proponent of including CTA in the deal models whenever feasible. This not only provides the opportunity for better investment evaluation, but also forces the team to slow down enough to consider whether the desired timing of synergy realization is practical and meets the strategic needs of the acquirer.
Last month we discussed the importance of re-grounding ourselves in strategic fundamentals prior to calculating our deal valuation, and we also discussed the EBITDA multiple approach to those calculations. This month we’ll discuss the cash flow approach, as well as a few other considerations for calculating estimated deal value.
Stream of unlevered cash flows
A common valuation approach is to calculate the target company’s projected future cash flows- often over a period of the next 5 to 10 years. The cash flows are usually first “unlevered’, meaning that interest expense is added back for the purpose of valuation. Now it’s time for a trip back to our college finance classes. Don’t worry, we’ll make it quick.
Recall that our basic formula for the present value of something is:
Future value=present value *[ (1+rate)^number of periods]
Present values are calculated using the company’s cost of capital, or the required hurdle rate (as set by leadership/board of directors) if higher. An example assuming a 10 year horizon and 18% hurdle rate:
Note that there are a few wrinkles with this approach. First, we are assuming that our ability to forecast out 10 years is solid. Second, we need a relatively near-term positive cash flow stream to make the calculations useful. Third, we are essentially valuing anything beyond our horizon at zero.
It is in part to address this problem that investment bankers will often convert the net present value to an internal rate of return (IRR). The IRR is a fancy way of saying what hurdle rate would we need to use in the NPV formula to give us a net present value of $0? Once calculated, this IRR rate is then applied to future projected cash flows in the assumption that reinvestment would be available at that rate.
Real-World Example: Bad Sport
I was recently asked to assist a CFO in the preparation of a valuation model for an acquisition. The projected unlevered cash flows, along with forecasted financial statements, had been provided by the investment banking team. The small target company had a single product, which they sold only domestically via their website, at a fixed price of $25. For purposes of this discussion let’s just say that the product was a sporting goods item. Thus, you would only need one of these if you participated in that sport, and even so the useful life should be between 5-10 years once purchased.
In looking at the sales figures, I noticed something didn’t look right. I quickly ran a US population analysis, and did some quick total addressable market calculations. To sum up the results, every man, woman, and child in the United States would have needed to purchase 1.32 of these items every 5 years in order to reach sales numbers in the financial projections.
Obviously, this didn’t seem realistic to me, so I checked in with the bankers. Were prices expected to rise? Were new products on the horizon? Markets being expanded? Distribution increasing? Nope, nope, nope, and nope. They had simply applied the growth rate of the last 2 years to the next 5 years, without taking into account the actual constraints of the market itself!
Bottom line, always check the financial models. Make sure all assumptions are stated, and run market analysis on any projections. Be prepared to explain what market share capture is assumed, and why that is realistic.
This solves one problem but creates a few more. First, there can mathematically be more than one IRR- i.e. more than 1 hurdle rate that causes the net present value of future cash flows to be zero- particularly if cash flows fluctuate between positive and negative values. Second, IRR valuations tend to be on the high side, because they treat investment in the target the same as they would treat putting money in a bank account at that rate of compound interest. Since we know that all companies experience a lifecycle of growth, stabilization, and decline, that is a fairly optimistic viewpoint- particularly in highly competitive industries or those subject to higher than average risks.
Note that all of the methods we have discussed thus far are highly dependent on the company’s results of operations. Normally this is appropriate; however, a lot of time can be saved by taking a closer look at what assets the company may have.
I was recently asked by a small, privately-held company to evaluate a potential acquisition. We had some really good comps to use, which yielded an enterprise value of $7 million for the target. NPV analysis suggested a value of about $6.2 million; however, the company had just achieved profitability, after accumulating over $100 million in losses during prior years. Assuming a 30% tax rate, that means that there could be upwards of $30 million of tax reduction value to the company that acquires this target! This suggests a valuation far beyond what my client could afford, and one that would bear no resemblance to the comps or NPV of cash flows. Luckily, we caught this prior to the CEO calling in the Board to review the acquisition, and he was able to save face!
Most acquirers will study the income and cash flow statements carefully, but remember to also look at the balance sheet, and to consider the actual market value of any tax benefits, real estate, or other assets, getting the appropriate experts in to value these as needed.
This is a good time to mention tax considerations. In general, it is highly critical to have skilled tax personnel involved in the evaluation and calculation of the value of any proposed deal. The example above is just one of many I could name. For instance, I once worked on an acquisition with a value in excess of $15 billion, much of which was actually paid for via careful tax planning regarding the legal entity structure of the deal. On the flip side, I also worked on a deal where tax had been left out of the discussion to date, and we discovered a potential loss of several million in value resulting from ignoring tax considerations in the deal structure. As we discussed in our due diligence chapters, make sure tax is at the table, and that they have sufficient time and funding to avoid any unnecessary value seepage!
There is no “perfect” valuation method. Comparisons rely heavily on the judgement of others, and are often apples to oranges. NPV overlooks the value generated beyond the consideration horizon. IRR tends to over-value the company’s long-term contribution to the bottom line. Both NPV and IRR rely heavily on the ability to accurately estimate the future cash flows, which is no easy task in itself. In mature industries I personally prefer to use the median of at least 7 good comps paired with a 10-year NPV to provide a valuation range, with an understanding that am likely to be looking at lower valuations than my competitors that are using IRR. Overall, remember that more than half of acquisitions have historically failed to deliver on their projected value, so our skepticism bias is certainly warranted.
Last year we published our first “Tales from the Trenches” blog post, where we examine real-world acquisition blunders. In one of these examples, “Double Trouble”, we described an acquisition where the buyer made 3 key errors. In this post we look back and evaluate what the company’s performance looks like in the years since the deal. But first a refresher:
Company A had historically enjoyed high profitability on their subscription-based market offer; however, other companies had developed or acquired similar products, and were providing free subscriptions to these substitutes as part of their overall go-to-market strategy. With viable free substitutes flooding the market, Company A's revenue was declining, and the future of the business in doubt.
Company A decided that the solution was to purchase another product line that sold subscription services to a similar customer base, bundle the products into a new offer, and thus compete effectively with the freeware by offering a combined value proposition. Given the difference in the offer attributes, Company A knew it was unlikely that any significant administrative cost synergies could be realized; however, they were convinced that the revenue synergies from the new combined market offer would be sufficient to turn this into a fantastic investment. After all the target- Company B- had similar customer demographics, so fantastic cross-selling opportunities seemed likely, correct?
Company A paid a significant EBITDA premium to acquire Company B, and post-deal integration consultants were hired to evaluate Company B in preparation for integration planning. These consultants soon discovered that Company B's biggest challenge had been…wait for it… adjacent companies had developed similar products and were giving away subscriptions as gifts to their customers! To make matters worse, Company B had gathered most of the addressable market share by promising customers a lifetime subscription with no increase in price. And for the icing on the cake, more than 80% of Company B customers were existing customers of Company A. This meant that the only way to increase revenue would be to raise the price of the combined offer to be higher than the price existing customers were paying to buy each separately, with the added wrinkle that the price of Company B’s products could not legally be increased for existing subscribers, and of course the original problem of readily available free substitutes for both.
So, what were the 3 key mis-steps that Company A made in the deal above?
1). Neglecting Strategy Fundamentals
If Company A had taken the time to use the strategic frameworks some significant red flags should have been obvious. Porter’s Five Forces would have highlighted the availability of substitutes for both Companies A and B as a significant strategic hurdle, along with high customer bargaining power, and a competitive business environment. SWOT analysis would have shown similar concerns, while an elasticity study would have pointed out the inability to raise prices. Finally, a proper TAM and share study might have uncovered the pre-existing customer overlap, indicating that cross-selling would not be a profitable effort in an environment of price inelasticity. To be blunt, when you have negative margins it is a really bad idea to try to make that up with volume!
2). Forgetting the Deal Rationale in Due Diligence
Company A did a good job of combing through Company B’s audited financial statements, double-checking the previously audited numbers and carefully evaluating revenue recognition. They evaluated the exposure to major customer groups, sales channels, and the like. They reviewed the valuation against sales trends. What they never did was ask the 2 key questions demanded by the deal rationale, questions that strategic analysis would have highlighted:
3). Overlooking Deal Alternatives
I state frequently (at the risk of putting myself out of work) that deals are a very costly way to achieve strategic objectives. Acquisitions can absolutely make sense; however, alternatives should always be considered. In the case of Companies A and B, their markets were stable-to-declining. The structure of their back offices made achieving administrative cost synergies unlikely. The companies were in no wise competitors. Finally, the stated goal was a combined market offer to a joint customer base. These facts cry out for some type of joint marketing arrangement, not an acquisition!
In conclusion, we can observe the following 2 years post-acquisition:
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