A Step in the Right Direction
I understand why musicians such as Bruce Springsteen, U2, and the Rolling Stones keep singing the same old songs and producing “Best Of” CDs. In the December issue, I wrote a “Best of the Best” piece on my favorite features during my six years at Leader’s Edge. The feedback from readers was overwhelming. Many asked for the complete set of articles.
Since this is our annual M&A issue, I am presenting my second “Best Of” collection, this time dealing with M&A only. I am confident that any seller or buyer can benefit from a refresher on the key concepts discussed in these articles to help you execute a successful transaction.
ONE—Hire Your Next Acquisition
We’re all familiar with transactions that wind up as failures or disappointments. As a result, buyers have become more sophisticated in their due diligence procedures. Arguably, though, the most important area—due diligence on the seller’s ownership and management team—rarely gets the scrutiny it merits. Most common is the interview process. Even when interviews are performed, they’re often less than comprehensive.
Whether you use an outside consultant or your own due diligence process, consider some basic procedures.
- Include a detailed interview process. Your evaluation of the seller’s management and top people should be just as rigorous as your internal hiring process.
- Include some form of profile testing. Sometimes a review of personnel files will reveal results from previous tests from firms like Caliper, PDP Works or Bigby, Havis & Associates.
- Spring for a consultation. Those profile tests are only as useful as their interpretation. Have a professional interpret the results.
- Add a background check. You never know what you might find.
- Survey employees about the agency. Find out how the rank and file feel about their jobs, the company and its management. Try the Organizational Growing Pains Questionnaire from Growing Pains: Transitioning from an Entrepreneurship to a Professionally Managed Firm, by Eric Flamholtz and Yvonne Randle.
- Follow through on your findings. Once you complete the transaction, use the results of your research to improve the performance of the acquired firm.
- Engaging in due diligence on the seller’s key players will help you decide whether you want them as your business partners and subsequently help you manage a new crop of employees.
TWO—Synergistic Value Creation
To make acquisitions the best strategy for growth, an agency must apply a disciplined approach to evaluating a deal. The reason is simple—many acquisitions do not produce value for the acquiring company’s shareholders.
Let’s focus on the most obvious reason for bad deals: overpaying. How can this be avoided?
The Right Price—Determining the right purchase price seems like a simple equation, but there is no simple answer. The key is to know the highest price that you are willing to pay and that will increase shareholder value.
Synergy Is Not Enough—To determine the right purchase price, a buyer needs to understand the different components of value. All transactions have two value components: intrinsic value and synergistic value.
Most people think only about intrinsic value—an agency’s ability to generate cash flow. When people refer to rules of thumb for estimating value, such as six times EBITDA (earnings before interest, taxes, depreciation and amortization), they are talking about intrinsic value.
Synergistic value is the increase in cash flow from improving operations.
When analyzing the price of a deal, the synergistic value is what results in the premium over the intrinsic value. So, how do you measure synergistic value to make sure you do not overpay? While more of an art than a science, expected synergies can be calculated.
There are five business drivers of value from merging two companies: expense savings, increased revenues, operational efficiencies, financial strategies and tax savings. The first three are primary factors in determining whether synergy is possible.
1. Expense Savings—Perhaps the greatest potential benefit comes from eliminating duplication in merged businesses. That’s often true, but be careful. Most buyers have a hard time eliminating positions or move slowly to make changes; thus, the biggest risk is underestimating the time needed to reach expected expense savings.
2. Increased Revenues—Combining sales forces with complementary products and services is bound to pay dividends, right? If you can draw more customers to a wider range of products, you might have built a better mousetrap; however, cross-selling is often a challenge. Just ask banks that have acquired insurance agencies how their cross-selling penetration compared to expectations.
3. Operational Efficiencies—Under the famous “best practices” theory, an acquisition, combining the brightest of both organizations, yields operational efficiencies that provide both expense savings and increased revenue. Identify only those areas that you can easily quantify or in which you have already achieved operational efficiencies.
While in the midst of a deal, it’s difficult to fully explore the potential value of combined operations. Recognizing that your calculations are a forecast, apply the “best laid plans” factor and work with a conservative estimate. The trick is to understand whether the positive aspects of a deal create enough synergistic value to justify a price above and beyond intrinsic value.
THREE—The Art of Integration
There are hundreds of books on valuation, due diligence and other aspects of managing a successful merger or acquisition, but few of them devote substantial space to describing how the important integration process should work. Surveys of failed acquisitions cite the lack of an integration plan as a primary culprit.
The buyer should approach the integration the way it approaches its overall business plan: purposefully and diligently. It must execute four primary phases of integration.
1. Pre-acquisition Planning—By far the most common struggle is the planning, so consider the following questions:
- What is changing?
- What are the opportunities?
- What are the cultural challenges?
- Where do we cut costs?
- Where are operating differences?
- Where do we gain real synergies?
- What are the real growth opportunities?
- Do we expect employee turnover?
2. Communication—You generally get only one chance to make a profound impact on the employees of an agency being acquired, so it’s crucial to provide a clear message about what will change, how the change will be done and what the expectations will be.
3. Integration Plan—Once the deal is sealed, integration begins. Forming an “integration team” consisting of employees from both companies is often the most effective strategy. Characteristics of a successful team are clarity in its role, responsibility and clear expectations of the integration timetable.
It’s not uncommon for the acquiring firm to have a 100-day integration plan. The entire integration might not be done within that time, but the plan helps keep the integration on track.
Here are the actions you should take during the first 100 days:
- Align the expectations of the acquired agency’s management with yours and stay on track.
- Effectively communicate your goals to everyone in both companies.
- Do not allow “deal fatigue” to set in, whereby critical time slips away without your enacting any meaningful changes. Deal fatigue, quite common in a protracted transaction, can sap the integration energy.
- Focus on the high-priority items critical to integration success and save for later all the great ideas that came up in the transaction process.
- Obtain buy-in to the top strategic items to be accomplished in the first 12 months and develop a schedule for them.
4. Evaluating Integration—How would you measure whether your first 100 days were successful? Here are some benchmarks:
- Did you achieve open, regular communications among management regarding integration issues?
- Have key procedures and processes been blended to create some immediate synergies?
- Have key metrics been developed to measure future success?
- Have both buyer and seller agreed on the key strategic initiatives that will drive shareholder value?
Benchmarks must be devised to see if integration tracks with pre-acquisition planning. If the evaluation reveals that goals are not being reached, make changes fast. It’s not possible to over-communicate, nor is it plausible to gloss over the impact of integrating different cultures.
It is universally agreed that integration is the most difficult part of any M&A transaction. Take a fresh look at your integration process before your next transaction. Both sellers and buyers can use these guidelines as a framework for successful mergers and acquisitions.
FOUR—Navigating Safely Through Murky M&A Waters
Are you seeking to sail toward higher profits, acquiring the talent that everyone in the industry so desperately wants? Are you thinking that mergers and acquisitions will get you there? For the most well prepared buyers, that means having a formal M&A policy. Let’s be clear: An M&A policy is very different from an M&A strategy, and most agencies and brokerages don’t have one.
Simply put, an M&A transaction is a tactical objective to reach a strategic goal. An M&A policy is one of the most crucial components in implementing the tactical objective. Do you have a written policy that is used by all team members involved with the transaction process? Since we all have polices for hiring, accounting, travel—in short, just about every important business process—why not an M&A policy?
- General Policy Guidelines—Commit the policy to paper and ensure that it is used by all team members involved in each transaction. An M&A policy should be tied to your strategic plan.
- Guidelines for Approvals—Designate the structure and process for seeking M&A approvals and state the chain of command.
- Initial Assessment—Specify a process to perform an initial assessment of a target. Develop your process from an objective to address your firm’s greatest needs.
- Deal Structure and Valuation—Create a set of parameters to apply to all potential deals.
- Outside Experts—Third party experts will sometimes be valuable. Set ground rules for their hiring.
- Negotiation—Designate a lead negotiator and stipulate when to bring in an attorney; e.g., when drafting a term sheet, issuing a letter of intent, performing due diligence or creating definitive agreements.
- Due Diligence—Stipulate who performs your due diligence work.
- Integration—The M&A policy will specify who will oversee integration. The process must consider how you identify, plan and communicate the most critical integration issues.
- Agreements—This includes confidentiality agreements, letters of intent, non-compete, non-solicitation, non-piracy and employment agreements. What’s negotiable? What’s not?
FIVE—Beyond the Numbers
When evaluating an acquisition candidate, many buyers rely too much on historical and projected financial information. Only half an agency’s value should be based on an objective financial analysis; the other half should be a subjective non-financial analysis. More important, how does the acquisition candidate meet your financial and non-financial objectives? To help streamline the acquisition process, buyers should develop a clear and detailed acquisition candidate profile.
Here is a list of top 10 criteria for an evaluation matrix:
10 Management/Staff Assessment
9 Future Growth Potential
8 Mix of Business
7 Customer Base
6 Historical Cash Flow/Profitability
5 Ability to Integrate
4 Competitive Position
3 Underwriting Market Relationships
2 Technology and Facilities
1 Location/Geographic Footprint
The acquirer then assesses the target’s status for each of the criteria, giving each element a score of 1 to 10. Here is an example of a fictitious target for the top three criteria:
10—Management /Staff Assessment: The target has an experienced management team, multiple producers and strong support staff. Score: 9 points.
9—Future Growth Potential: Firm has a good sales culture, but new business development has slowed over the past couple of years. Score: 8 points.
8—Mix of Business: The target serves a niche client base, and revenue is concentrated primarily in two property-casualty lines of business. Score: 6 points.
Calculate the results:
Rank x Score Total Score Maximum Possible Percent Score
10 x 9 90 100 90%
9 x 8 72 90 80%
8 x 6 48 80 60%
Totals on top three criteria: 210 270 78%
What does a 78% mean? How does this translate into how a candidate fits into the target profile? Some rules of thumb:
90% to 100%: Revise the assessment. Few candidates rank this high when an assessment is done properly.
80% to 89%: The candidate is a very good match. Synergistic value could justify a premium price.
70% to 79%: A good fit across some key elements. No major weaknesses or drawbacks. This candidate is slightly above average, should be given thorough consideration, and should not command a premium price.
60% to 69%: A reason to pause and reflect. You probably need some overriding qualitative factors to proceed with this transaction.
50% to 59%: Many key areas do not line up with the target profile. At a minimum, the transaction would have to be valued appropriately to justify the risks.
Below 50%: Scoring does not measure up to your pre-defined qualifications. Forget this deal.
Many owners decide to sell or continue running a newly acquired firm without understanding the long-term, cash-flow, after-tax impact. Most closely held businesses make decisions based on short-term analysis rather than long-term financial planning.
Brokerage owners must understand the concept of monetizing the new agency versus continuing its operation. The following assumptions are often critical to both business models:
- Projected growth rates over the next five years
- Cash compensation, including salary, commissions and bonuses, to be received by the shareholders over the next five or 10 years
- Determination of adjusted or normalized EBITDA
- The appropriate market multiple to determine the estimated sales price of the agency both now and at the end of a selected time period
- Projected reinvestment requirement
- The appropriate ordinary income and long-term capital gains tax rates
- Estimated discount rate on future cash flows
- Investment income on proceeds from the sale of the company.
To effectively evaluate the assumptions, several scenarios should be modeled. For instance, assume growth rates of 5%, 10% and 15%. Finally, it is best to model several possible sale dispositions, such as the agency selling for 6.0, 6.5 or 7.0 multiples of EBITDA. These variables will balance the overall impact of market conditions.
In the end, each business model will calculate the present value of the after-tax cash flow that can be earned by the shareholders. The last critical step is to determine the growth rates that are necessary to calculate “break-even points” of free cash flow in both models.
Over the years, owners have found this so-called steady-state analysis an invaluable tool. The analysis is bound to raise questions about existing strategies and the long-term risk and reward of selling the business versus continued operations. Before embarking on either path, make sure that you understand the financial impact.