Risk vs. value in mergers and acquisitions
Risk is perceived – and it is subjective.
Value is simply an estimated, financial quantification of the risk associated with a stream of cash flows (with risk being the key component). As business owners, we typically underestimate the risk in our businesses relative to the way a third party views risk. This makes sense because we understand the challenges inherent in the day-to-day operations of the business.
We’ve been living with these risks for years or even decades. In an acquisition, finding the right fit (a buyer who understands and is comfortable with the risks in the business) yields the best results.
When a buyer makes an offer to acquire or merge with a business, the buyer has only a preliminary understanding of the risks in a particular business. These risks can be categorized in to five different factors we call ValueDriverssm : Financial Value; Organizational Value; Customer Value; Employee Value; and, Strategic Value. As a deal moves forward, both before and after the letter of intent, the buyer will be continuously searching within these ValueDriverssm for risk that can drive value lower.
Each buyer that evaluates a company isn’t just testing the financial statements for integrity; they are also trying to assess the quality and depth of management and the customer base, as well as market and strategic implications of the acquisition. While much of the conversation may center around the strategic fit, don’t be surprised to find out that the buyer is sniffing for ways to protect themselves in the deal. Some of these conversations may appear innocuous enough, but may result in value deterioration. It takes a well heeled person to spot, and hopefully anticipate, these issues in advance. If the seller can get to the potential “issue” and present it to a buyer well before it is uncovered, the seller can help protect value and the confidential nature of the business.
To illustrate this point, let’s use a real world example. The Seller of ABC Co has a customer concentration issue; that is to say, roughly 35% of its revenue comes from one customer. As the seller is talking to multiple buyers, the seller would benefit by presenting this information immediately, as opposed to later in the process. In so doing, some of the buyers may back away – which is actually a good thing!
The buyer(s) that do move forward, are buyers that understand this issue and may not be 100% comfortable with it, but at least they understand it and have determined that it isn’t a deal killer for them. If the seller waited until well into due diligence to reveal this information, she would have most likely “surprised” the buyer. Generally speaking, this is not a good thing to do if you want to maximize value.
By presenting this issue immediately, the seller maintains credibility with the buyer. For those parties that viewed this issue as a deal killer, the seller has protected confidential information by not allowing unqualified parties to take a deep look into their business.
Other issues may arise along the way and deal structure (as opposed to valuation) can be used to help balance the scales of risk. Through mechanisms such as earn outs or other contingent payments, transition services or consulting agreements, working capital provisions, escrow amounts, caps and baskets, and representations and warranties, buyers and sellers mitigate risk in a transaction.
Some of these issues should be outlined in the letter of intent, but many of them will be negotiated in due diligence as the buyer gets deeper under the hood of the company in an effort to uncover and understand such risks. The more risk the buyer sees, the more the seller can expect to meet with heavy pressure to negotiate away from the agreed upon terms of the letter of intent.
Sellers should be evaluating risk through the due diligence period as well.
Further qualification of the buyer including financial due diligence, an analysis of the buyer’s history of acquisitions, post closing integration strategies particularly geared towards customers and employees are essential to discuss during this time period. While many of these issues can and should be discussed in advance of a letter of intent, the due diligence period is a time that the seller can use to further identify any issues and use deal structure to minimize his or her risk in the transaction as well.
In summary, where there is good fit, there are good valuations. Identifying buyers who understand the risks in your business is not easy and takes work, but it typically can lead to higher multiples and more satisfying transactions.