Corporate mergers and acquisitions are typically announced in a press release that expresses the enthusiasm of both the purchaser and the target. Like any wedding, a deal is an event that results in a great deal of excitement on the part of both participants, as well as a great deal of speculation on the part of those familiar with the union about whether or not it is a wise decision. And, like many marriages between a man and a woman, a significant number of corporate marriages result in disappointment for all involved.
It is this disappointment to which we are referring when we talk about “bad deals”. A bad deal is a deal that does not meet the expectations of the parties due to an avoidable failure of pre-closing due diligence. While there are some deals that go bad due to some unavoidable or unforeseeable event, these are not the situations that this article will addresses.
So why do deals fail to meet the expectations of the parties? One of the big reasons is that in many cases, neither party goes into a deal with clear expectations about how it will work. This is an important but often overlooked aspect of the decision to buy or sell a business. While the parties to the transaction invariably have some expectations about what will happen after the deal, it is more rare for either party to have spent some time writing down a detailed list of post-deal expectations.
Formulating a detailed list of post-closing expectations allows the parties to the deal to expand the due diligence phase to test the likelihood that those expectations will be met. An example will help illustrate this point.
Suppose that Company P and Company T are distributors of competing products. Company T decides to buy Company P in order to expand its geographic coverage, increase its customer base, and realize cost synergies associated with a reduction in the size of T’s sales force and the elimination of T’s warehouse facility. While just this sentence gives us some idea of P’s expectations in the deal, it is best if the management of P specifically quantifies the anticipated benefits of the deal and tests those expectations in due diligence.
If P does not quantify those expectations and test them in due diligence, there is a great deal of room for things to go wrong. T’s customers, for example, might have a strong preference for the products that T currently distributes and might be unwilling to purchase the products that P distributes. T might be in a long-term lease on the warehouse facility that will result in significant cost should P wish to break the lease after the deal. T’s customers might be closely tied to T’s salespeople, some of whom P expects to eliminate, and others of whom might leave, taking customers with them. In addition, it could be the case that part of T’s competitive advantage came by offering quick delivery times, and the elimination of the T facility and the larger delivery area serviced by P results in those customers finding an alternate vendor.
So in just this very simple example, we see that there are several areas where our hypothetical merger might go bad. The key to a good deal here is for P to determine, to the extent possible, whether its post-deal expectations are realizable before closing the deal. This would include expanding the traditional due diligence process to include talking to salespeople and possibly customers in an attempt to determine realistically what will happen after the deal.
While the example above focused on the buyer, it is just as important for the seller to form concrete expectations about how the deal will work. If a seller receives an offer of $10.0 million for the business, that seller might think that the offer means that he will walk away from the deal with $10.0 million in cash in his pocket. That expectation needs to be tested very carefully by hiring experienced legal, accounting and tax advisors. The $10.0 million offer may well have been an offer for substantially all of the assets of the business and none of the liabilities of the business. Paying off the liabilities that are left behind, paying the corporate tax on any gains realized in the asset sale, and paying any income taxes that result from moving the cash from the deal from the corporate balance sheet to the personal balance sheet of the owner could take a significant bite out of the deal proceeds. Clearly, a seller who expects to walk away with $10.0 million only to find that the actual net proceeds from the deal are less than half that amount will be disappointed.
Too often, the parties to a deal press forward with a transaction without having formulated or discussed a clear picture of how things will work after the deal. If both sides just fill in any blanks with favorable assumptions, and this starts the deal down the road to failure. When we assist our clients in a transaction, we try to pin down their expectations, and we encourage them to test those expectations to the extent possible in due diligence. It is dangerous to assume that certain expenses will go away or that a selling shareholder will have a certain amount of influence over the operations of the combined company. These types of issues must be explored well before the closing in order to avoid post-closing disappointment.
Reprinted from Mercer Capital’s Transaction Advisor – Vol. 3, No. 3, 2000.