Judging an M & A beauty contest

Yesterday's post gave advice to sellers on how to improve the odds of winning an evaluation that uses a comparative business case, based on an M&A process my friend Bob is running right now.  The comparative business case is one of the more common tools buyers use to analyze potential deals; unfortunately, in this case at least, it's also one of the less helpful.  This post turns to the question of  how a buyer should be looking at the decision in front of them.

You'll recall that Bob, a business-unit exec, was asked by his Corporate M&A team to estimate the net benefit of acquiring each of three different targets under consideration.  The analysis for target A looked like this:

Fig. 1

The analysis for targets B and C would be similar, and the goal is to compare the "benefit of deal" result for A vs. B vs. C and choose the best one.

The problem with this approach is one of false precision.  Remember that Bob's business unit needs to acquire a technology, not a product or a business.  The justification for the deal relies on how the acquired technology can improve the business unit's sales of its own product.  That's a difficult prediction to make under the best of circumstances; when you add the uncertainty of trying to estimate how well each of three different versions of the acquired technology can be integrated, it's even harder.

To see the nature of the problem, let's look at a slightly more realistic version of the buyer's business case for acquiring target A.

Fig. 2

In this version the business unit still believes that acquiring this technology is likely to improve their revenue by 10%, but they also acknowledge that in the worst case it might be as little as 3%, and in the best case it might be as much as 13%.  Using the same 5-year formula as above, the result is that the incremental gross profit may fall anywhere between +20m and +80m.  The purchase price and the operating expense are unchanged, and the result is that the net benefit of the deal could be as high as +45m or as low as (15m), a net loss.

(You'll almost never see a model that's as honest as this.  Most M&A models don't admit for the possibility of a net loss on the deal.  But they should - especially given that as many as two-thirds of acquisitions end up with the buyer worse off than if they had not done the deal.)

One thing you'll note from Figure 2 is that there's a $60m "swing" between best case and worst case, and that the swing is much larger than the $20m expected purchase price of the company.  That's not unusual.  It illustrates one of my buy-side rules:

For small deals, price matters less than you think.

A small deal here is defined relative to the size of the acquiring company or division - anything less than a few percent of market cap is small.

(In fact, the above is only half of the rule.  The other half is: "and for large deals, price matters more than you think."  I'll take up the second half in a future post.)

Figure 2 above showed a range of possible outcomes from acquiring target A.  We can make the same sort of chart for the other two targets.  Targets B and C will have different purchase prices and operating-expense projections, but most importantly, each will also have its own wide range of projected revenue contribution.

Using these ranges, rather than a single number, might lead to a three-way comparison like that shown here:

Fig. 3

Target A has a net benefit range from +45m down to (15m), and the other targets have their own net-benefit ranges, which here I've set as +55m to (35m) for target B and +25m to (10m) for target C.  These figures are arbitrary, but the exact figures don't matter; what's important is that the ranges are mostly overlapping, which is almost always what you'll see in this kind of analysis.

The main thing we learn from Figure 3 is that, regardless of whether you choose A, B, or C, what matters is that the result come in at the top end of the range.  What the comparative business case doesn't show is that the likelihood of a top-end-of-range result is bound to be very different among the three choices; and what the buyer should be focused on is the factors that make a top-end result more likely.  Which leads to my second buy-side rule:

Employee assimilation is 90% of what matters in a successful transaction.

Assimilation here goes beyond mere retention.  Cash or stock programs can retain employees for a year or two, in the sense of keeping them from leaving; but what those programs can't do is win the employees' engagement and loyalty.

In Bob's situation, the three targets A, B and C all have good enough technology; his engineering team evaluated a much longer set of choices and these three were the ones that made the grade.  Typically the choice among the three would either come from the engineering team's favorite, or from a (flawed) financial analysis like a comparative business case.  A better approach is to focus on the most important employees in each of the three targets and ask yourself which of them will thrive in your organization.  That will tell you which target to go after.