While investment banks and other capital-markets players like to see large public companies feed on one another, blockbuster acquisitions rarely produce giant returns for shareholders. Acquirers’ cumulative return for public-to-public company deals in 2011 was –1.6%, while the average return since 1990 is –0.8%, according to a recent report by Boston Consulting Group. An unusually large number of public-to-public transactions produced large losses last year, says BCG.
Public-company acquisitions of private companies have only a slightly better history of returns, but at least it’s a positive one: 1.4% since 1990, according to BCG. And in a slow M&A market, the dollar volume of all private-company acquisitions in North America has risen slightly this year, to $284 billion at the end of August, compared with $251 billion for the first eight months of 2011, according to data provider Mergermarket.
Deals with private-company targets are thought to have some inherent advantages over large ones. Small targets more often sell at a discount, or at least a more reasonable premium, for example, because of less competition among buyers. Private-company targets may also be in an early stage of their life cycle — a stage prior to the robust growth of a product or service that allows the acquirer to reap large rewards. And integrating a small, private company can be less taxing for the buyer’s management team and its employees than taking on another large company.
But buying a small, privately held company can also be a messy proposition. Just this year, Microsoft reported its first quarterly loss as a public company when it wrote down $6.2 billion of its $6.3 billion all-cash acquisition of aQuantive, an online advertising company, in 2007. As Microsoft’s experience shows, if such deals are improperly managed by the buyer, their value can easily be wiped out.
The state of a small private company’s finances can be a shock to a finance chief used to working with large companies. The small-business owner is unlikely to walk into the room clutching five-year pro-forma financial projections and market research substantiating the future potential of the business, says Michael Nall, founder of the Alliance of Merger & Acquisition Advisors, an organization of middle-market M&A professionals.
Just trying to figure out the value of the prospective target company can be difficult. The sellers usually don’t know the value themselves, and for many private firms, historical financial statements may not reflect reality, says Nall. As a result, the financial reports of a target company “often have to be restated to show what it would have been like run as a public company,” he says. In practice, this may mean eliminating things like personal discretionary and nonrecurring expenses.
Given the difficulty of coming up with a valuation, it’s not surprising that many buyers run into problems when negotiating price with sellers. Indeed, the biggest hang-up for small-company deals is often in the price. The longtime owner may have one price in mind, while the buyer may run the numbers and come to a wholly different conclusion, says Mark Albert, a partner in Perkins Coie’s emerging-companies and private-equity practices.
To bridge the gap, many such deals include earnouts, which give sellers added consideration if the company hits performance milestones over time. There are also escrows, which are holdbacks of a portion of the purchase price to indemnify the buyer if it discovers errors or problems (like a hidden tax liability) in the target company after the close. Earnouts were used in 25% of 200 private-target transactions in a 2011 study by Shareholder Representative Services. Escrow periods are also lengthening, giving buyers more time to identify hidden problems.
Retaining a privately owned start-up’s founder and key management can also be critical to the success of a merger with a small, closely held firm. If the founder of a high-tech firm decides to leave, for example, “all of his plans to develop this leading-edge technology [further], and his customer contacts, would [leave] with him,” says Tom Herd, head of Accenture’s North American mergers-and-acquisitions practice.
The incumbents of a target firm can be assets to buyers, says John Quinn, CFO of LKQ, a $3.7 billion supplier of automobile replacement parts and systems that closed four acquisitions in 2011. Indeed, if the buyer doesn’t manage to keep the right people, “sometimes the customers will be more faithful to the employees that leave than to the company,” Quinn says.
During due diligence, LKQ often has target-company management visit its facilities to gauge whether the sellers see a cultural fit, says Quinn. LKQ also makes sure executives of the acquired company retain enough authority over their areas to feel like they are part of the newly combined company, according to the CFO. It’s crucial for buyers to retain the entrepreneurial spirit that made the target company successful before it was purchased, he says.
A Light Hand May Be Best
The first rule of acquiring a small company, says Herd, is, “Don’t fix what isn’t broken.” In practice, this means buyers of smaller targets should not use the formal merger integration frameworks and methodologies they normally would for larger transactions, he says. “Unfortunately, we see clients who are determined to squeeze these small companies onto their existing operations or technology templates, and they end up burdening them with so much overhead and process that they end up [killing] the golden goose.”
Despite investor pressures for short-term results from the deal, the buyer must also resist focusing on cost reduction and quick-hit successes. “There’s always a perception that the buyer paid a significant premium for this small, hard-to-value company, so investors want to see quick synergies to justify the premium,” says Herd.
As with a large transaction, a buyer might think it prudent to move quickly to reduce back-office head count, cut manufacturing inefficiencies, or shut down redundant distribution networks, for example. But buyers need to handle small acquisitions in a gentler manner, focusing first on things like growth, talent retention, and a product-development road map. In the last three years there has been a movement toward buyers taking a collaborative posture with small-company acquisitions, says Herd. “The buyer collaborates with the target’s management to understand how its resources can help fund the target company’s growth.”
In the course of an M&A deal with a small target, it’s tempting for the larger acquirer to step in and fiddle with the target company’s operations and management because the acquirer’s executives think they know better. But a lighter hand may yield a better return.