Acquisition deal breakers
Why is the failure rate for M&A deals so high and how can you maximise your chances of success? Growing Business investigates
Get it right, and this is as good a time as any to grow your business by acquiring or merging with another company. So why is the failure rate for such deals so high and what can you do to maximise your chances of success?
When Jeremy Waud decided that it was time for his facilities management company Incentive FM to strengthen its office cleaning capabilities, the ideal partner was staring him in the face. Waud had worked with Herts-based Quality Assured Services (QAS) over a number of years, knew and respected its founder and chairman Steve Wright, and was keen to get access to its public sector clients. What’s more, Wright was ready to ally his company to a group that could go after broader facilities management contracts and provide a London office.
Risk takers and haters
The acquisition was completed in 2009, no thanks to the banks, according to Waud. “The sale consideration was £30m, of which we needed to raise £2m in cash,” he explains. “Our own bank, Barclays, was lukewarm, so we went to RBS. They were encouraging at first, then dragged their feet before offering us £250,000, which was no help at all, even when that was doubled using the government’s Enterprise Finance Guarantee (EFG) scheme.”
After much frustration, a complex deal was hammered out using invoice financing. However, Waud pulled the plug when RBS insisted on a clause giving it a veto on payments. “It put the bank into a position where it could stop us making a payment if it thought our cashflow was under pressure at some future date,” he says.
That was a deal breaker from the vendor’s point of view, so the two companies went away and came to an agreement based on a lower upfront payment, a deferred consideration plus equity. Six months down the line, the expanded group reports £20m turnover and 57% sales growth in the year to March 2010, while projecting £25m sales during the current year. Crucially, Wright is on Incentive FM’s board. “The banks were stunned that we did the deal without them, but we were delighted,” says Waud, although the experience cost him £100,000 in upfront costs.
Incentive FM’s story neatly illustrates some of the problems facing purchasers in the present market. Everyone knows it’s harder to get credit these days, yet it remains unclear how that may change under the new UK government. Prime minister David Cameron promised to review the EFG, but as it stands, the scheme can be used as another way to control lending rather than free it up.
Merger and acquisition activity has dropped this year, according to Experian Corpfin. “At the start of 2010, feedback from the corporate finance community was more optimistic and talked of a more realistic approach to valuations among vendors,” recalls Experian’s business development manager Wendy Smith. “However, the lower number of deals tells us that the market is still very fragile.
Although funding has been available where strong risk-free businesses have been involved, there is a still a funding gap. This is proving to be the key barrier to getting deals off the ground.”
Risk-free is the key phrase here. Earlier this year, Chris Steel, a director of First Flight Placements, was retained by a client to acquire an engineering-based manufacturing business with an enterprise value of £2.1m. “It was generating an adjusted EBITDA [earnings before interest, taxes, depreciation and amortisation] of around £450,000, and has excellent growth opportunities, both in the UK and overseas,” he explains.
The cash on a completion target of £1.6m was to be funded by £450,000 in equity, £350,000 invoice finance and a four-year loan of £900,000, including fees. Most banks declined the lending proposal quickly, with one offering support initially based on a 50% level of securitisation on the cashflow lend element. However, the bank’s final decision stated that this had to be fully securitised, and that the directors had to provide additional guarantees of £100,000. “In other words, the bank was unwilling to take any risk at all to facilitate the deal,” says Steel.
Extra mile due diligence
The banks’ reluctance to lend was entirely based on their perception of risk. “We have seen clients borrowing to make a string of acquisitions they couldn’t fund when the company had a lean period a year or two down the line,” says Natasha Frangos, partner at corporate finance specialists haysmacintyre.
“It’s easy to get beguiled by benefits such as cost savings or an increased customer base, and not think about the negative synergies and risks.”
Assessing the risks and avoiding nasty surprises is the job of the due diligence teams, and that should always involve visiting the target company. A good practitioner will not just be content to go over the books, the contracts, licences and employment agreements. The most beneficial information comes out of discussions with the directors, the financial controller and senior salespeople, according to Frangos. “Without personal contact, you can’t get a feel for less tangible aspects of the business, such as morale, its flexibility in changing markets and its attitude to future risk,” she says.
It follows that financial and legal due diligence isn’t a formality. Don’t view the report as something to be glanced at, posted to your bank and kept in a file, stresses Frangos. “Sit down with the due diligence team and discuss the findings and the actions that are suggested,” she advises. “To get the benefit out of the process, you need to talk through the risk areas and points that can be used in negotiation and factored into the agreement.”
As Incentive FM showed, money isn’t the only factor that can threaten an acquisition. If you’re healthy financially, this can be a good time to buy a company that is an appropriate fit and the motivation of both parties is right, says Jeremy Furniss, partner at ’boutique’ finance firm Livingstone Partners. “What acquirers get consistently wrong, often causing them to withdraw quite late in the process, is not going through a deep enough analysis of why they are acquiring a business,” he points out. “Kissing frogs is a waste of time and money.”
Bad reasons for going on the hunt include doing it because group HQ says that this is how you must expand, or because your company is going downhill. “Solving problems in your own business is never a good enough reason for going out and buying another,” says Furniss. “Legitimate reasons for wanting to acquire a business include: organic growth not being fast enough; to achieve scale and critical mass in the market; or to gain access to critical technology.”
Conversely, Furniss recommends making sure you clearly understand precisely why the target company is on the market. “When acting for purchasers, I’ve frequently found that the sellers have been rehearsed: ‘Please pay me £10m and I promise to be just as interested in putting in the hours with that in my pocket as I was before,'” he says. “If the management team is about to retire, then that is often an absolute obstacle to getting the deal done.” What acquirers want to hear is that the target business has been taken as far as it will go under private ownership and now wants to move to the next level as part of a bigger group with more resources, infrastructure and a strengthened management structure.
Simon Barrow is the chair of People in Business and co-author of Employee Communications during Mergers and Acquisitions. He has worked for bidders and targets on the cultural and people aspects of merger and acquisition deals for over 18 years. He says dealmakers didn’t used to be interested in whether or not lasting success was delivered. “Their job was to achieve the deal and the substantial rewards for doing so,” he recalls.
Unlike the entrepreneurs we spoke to, though, Barrow sees signs of change and a new breed of talented bankers who want to be associated with success beyond the deal itself.
“They do not wish to be glorified estate agents,” he says. “They want established clients who will trust them to think of their overall interests. Being able to refer clients to ‘soft issue’ experts outside their field is now on their radar. A long record of dismal research reports indicate that between 38% and 80% of transactions fail to achieve their objectives. This has helped to change boardroom attitudes among some chief executives and non-executive directors, who know that people issues are so often the cause of failure.”
Evidence shows that more than double the number of executives leave in the years that follow a merger, compared to the rate for non-merged companies, and replacing them is not just expensive in recruitment costs, but also in lost expertise, Barrow argues. “You can smell failure or success in the behaviours of a business long before the results,” he says. “Relevant human resources metrics should be studied as intently as finance and sales figures.”
That’s a view supported by Furniss, who experienced the frenzy of corporate finance activity just before 2008, with buyers competing for assets and, typically, not even meeting the principals of the companies they were targeting until late in the process. “That bond, trust and understanding between the two principals was never kindled,” he says. “It was not until the buyer had expended massive time and effort getting to the front of the pack in this miserable investment banking process, which the big investment banks run, that they realised they couldn’t deal with the guys on the other side of the table.”
Furniss, however, seems to not have come across Barrow’s ‘new breed’ of bankers just yet. “A prime reason why deals don’t happen is that the process by which the company is being sold – typically because there’s an investment banking advisor involved – is not conducive to you, the buyer, and learning about the basic motivations behind the people trying to sell,” he says. “It only becomes apparent later in the process, at which point your confidence has gone. And, of course, you have egg on your face, because you have incurred substantial professional fees.”
The pre-deal stuff may be complex, but it is routine for experienced people like Frangos and Donald Stewart, corporate partner at Faegre & Benson LLP’s London office. For a lawyer, some would say Stewart has sensitive antennae. “The contracts are either sound or they aren’t,” he says, “but when markets start to fall, the benign environment disappears and you can see who is swimming naked. That’s when it really matters that people are good at the things that make deals work.”
The biggest problem that most businesses face is in post-acquisition integration. While times of great economic change bring opportunities as well as challenges, Stewart believes that few people have the courage to embrace the opportunities. “People like to think they know what is going on,” he says, “communication is key.”
There’s surprising agreement about why acquisitions fail: unrealistic price expectations, blind enthusiasm resulting in failure to see the elephant traps, and above all, not involving every individual who will be affected as early as you can. Plus the key to success post acquisition is considering who’s going to manage the business once you have bought it? Perhaps the team you’re inheriting is great, but if not, who are you going to parachute in? A real danger is tying up talent needed in the core business. If you’re not experienced, you may ruin the deal, as well as neglect your original business.
Arguably, the greatest risk of not doing a deal lies in the cost of the lost opportunity of not securing the agreement you should have. And, of course, there’s also the financial hit of pursuing an acquisition, only to find that the business you’re interested in is not what you thought it was, resulting in you pulling out having spent a lot on due diligence.
Evan Rudowski, co-founder and director of SubHub, on an acquisition that simply didn’t come off
Before he launched SubHub, a technology platform for anyone wanting to build a money-making membership site, Evan Rudowski tried to acquire the then leading solution in this space in the US.
“We intended to buy the company and relocate to the US,” he explains. “We went far down the path with the sellers, a husband-and-wife team, even signing heads-of-terms, agreeing the price, and more.
But when we moved towards the final agreement, it fell apart.
“We hired a top law firm to draft the deal, and they had it reviewed by a divorce lawyer! We felt the terms were normal and standard; they felt they were aggressive and onerous.
“We lost trust. Because we were back in the UK and corresponding via email, we weren’t on the scene to be able to restore trust. They pulled out of the deal. So instead, we set up SubHub as a competitor. We now surpass them by all measures, but we lost time and money with the failed acquisition.”
Rudowski advises: “Preserve trust by dealing with people at their level. Stay on the scene to get the deal done – don’t do it long-distance. Find positive ways to describe the protections you need rather than punitive contractual language. Try to make it happen quickly, so that deal creep doesn’t open the door to reconsideration and recrimination.”
Askar Sheibani is well-versed in the trials of acquisitions. He urges business owners to bear one thing in mind above all else: always expect the unexpected
It’s no wonder Askar Sheibani’s company Comtek won Green Business of the Year in this year’s Growing Business Fast Growth Business Awards. It’s the leading pan-European IT equipment repair service with a turnover of £10m, and keeps network and telecoms equipment out of landfill. In 1997, Sheibani successfully acquired IT equipment manufacturer Gandalf Netherlands out of administration, despite some legacy problems. “It brought us an excellent customer base, 28 great staff speaking 15 languages, and premises next to Schiphol airport,” explains Sheibani.
His next foray was into Germany and France to pick up the repair businesses Vanco Euronet, divested following its initial public offering in 2001. Frankfurt went well, but Paris was a disaster mainly due to a combination of red tape and working practices. “From day one we had a problem with staff – they wouldn’t work for more than 35 hours a week and would only do their designated jobs,” he says. “There were also legal and regulatory problems. It took three months to register for VAT, which would take just 24 hours in the UK.”
After three months, Sheibani had to concede that the operation was not economically viable – the office was closed.
Sheibani advises: “Treat each acquisition individually. Take time to understand the culture and expectations of the workforce.”