Chapter 10

Business Mergers and Valuation

A merger is one way we are able to enhance organizational sustainability by expanding operations. Mergers occur when the merging organizations have a mutual interest in joining forces. This is decidedly different from an acquisition, which is a predatory move by one organization on another and is often not welcome resulting in a hostile takeover. Which of these it is may be different in the minds of the parties to the transaction as depicted in Figure 10.1. Mergers and acquisitions of other companies are investment decisions and should be evaluated on essentially the same basis as, say, the purchase of new items of machinery. There are, however, two important differences between this type of activity and many standard investments.

First, because acquisitions are frequently resisted by the target’s managers, instigators often have little or no intelligence about their targets beyond published financial and market data and any inside information they may obtain. Once they have declared their position, the situation changes. When the bid process is underway, the defending board is obliged to provide key information to enable the instigator to conduct due diligence examinations, which are essentially searches for skeletons in the cupboard.

Second, many acquisitions are undertaken for long-term strategic motives, and the benefits are often difficult to quantify. It is not unusual to hear the chairman of the predator talking about an acquisition opening up a strategic window. What they often do not add is that the window not only is usually shut but also has thick curtains drawn across it. To a large extent an acquisition is a shot in the dark, which partly explains why so many organizations that proceed with one suffer greatly afterward. Of course, this is not the only reason for failure. On occasion a target is simply too large in relation to the instigator, so excessive borrowings or unexpected integration problems strangle the parent.

Given that acquisitions have uncertain outcomes, the larger they are the more catastrophic the impact of any adverse events. As a result, it may be more rational and less risky to confine activity to small, uncontested bids. Alternatively, a spread of large acquisitions might confer significant portfolio diversification benefits. The greater the scale of takeover activity, however, the greater the resulting financing burden placed on the instigator and the greater the impact of diverting managerial capacity into solving integration problems.

Clearly, another critical element of mergers and acquisitions is the proposed financing method. Cash has been, and continues to be, a popular medium for financing acquisitions. There was a time, however, when more emphasis was placed on the use of debt as the primary means of such financing. The use of debt to finance acquisitions has declined dramatically with the higher valuations of target enterprises. As a result, shares in the instigator are now routinely used to finance acquisitions. Of course, the total financing package could comprise elements of each of these options. Several considerations guide the selection of the medium of exchange. Among the most important are tax considerations, accounting treatment, managerial control issues, financial returns to owners, and the existence of slack, which is defined as unused financial resources.

Without a doubt, the acquisition decision is a complex one. It involves significant uncertainties, often requires substantial funding, and may pose awkward problems of integration. Yet as some acquisition kings have shown, spectacular payoffs can be achieved.

Why Do Mergers Occur?

Throughout the book I have tried to emphasize that, for virtually every organization other than a not-for-profit or government authority, the major objective must be to maximize value for the current owners. This is absolutely necessary for any one of a number of reasons that include borrowing to diversify, looking to sell the organization, privatizing of public sector entities, or converting from a private to a public organization.

The best way for us to maximize value is to actively manage our resource, liability, and equity bases because if we don’t then somebody else will. Our organization may well be absorbed by another because they believe they will be able to better maximize value for owners. This is the first, and principal, reason for merger and acquisition activity.

There are other reasons for engaging this activity, probably the most common of which is the belief that synergies exist allowing the two organizations to work more efficiently together than either would separately. Such synergies usually result from their combined ability to exploit economies of scale, eliminate duplication in many functional areas, share managerial expertise, and raise larger amounts of capital. If successful, then this is an excellent way of increasing owners’ wealth.

Mergers between organizations operating in the same industry are often motivated by a desire for greater market share. In some cases, tax advantages may be derived from a merger or acquisition, but this is rarely a key consideration in prompting organizations to merge. More often merger or acquisition activity is part of a deliberate strategy of diversification, allowing the predator, or the combined organization, to exploit new markets and spread its risk.

On the other hand, we may instigate an acquisition because we think the target is undervalued. This means that we have found a bargain—a good investment capable of generating an abnormally high return for our owners. Unfortunately, there are also times when acquisitions are simply motivated by the management team’s desire to empire build. Rarely are these acquisitions successful in anything other than promoting certain individuals’ super-egos and boosting their pay packets.

Finally, the owners of an organization may seek a merger or an acquisition when they no longer wish to operate the enterprise themselves. Perhaps in these cases it would be simpler to sell their share of the organization to someone else, but this is likely to result only in a change of ownership without accruing any of the benefits associated with joining forces with another organization.

Who Benefits?

The principal benefit from a merger or an acquisition arises from increased cost efficiency and an increase in market share, which often leads to an increase in value generation. If this is the case, and really it shouldn’t be any other way, then our owners’ wealth after a merger or acquisition should be greater than the sum of the owners’ wealth in each of the participating organizations. Of course, it doesn’t always work out that way, and there are many examples to show that. Shaun Rein¹ suggests that in 70% of merger and acquisition cases the owners would have been better off not getting involved at all.

Any discussion concerning winners and losers in merger and acquisition activity must include the management teams of both the bidding and target organizations. They are important stakeholders in their respective organizations and play a significant role in negotiations. In the case of an acquisition, the management team of the predator will often benefit considerably in that they will manage an enlarged organization, which will, in turn, result in greater status, income, and security. For their counterparts in the acquired organization, the situation is less certain, with some being retained but others being demoted or shown the door. Something similar happens in the case of mergers as the combined organization seeks to exploit synergies from the merger.

It will come as no surprise to many readers that mergers and acquisitions can be very rewarding for the investment advisers and lawyers engaged by each organization. They will receive fees for providing advice and putting together the financing package. In many cases the advisers acting for the target, in the case of an acquisition, receive higher fees to compensate them for the loss of a client.

What Makes a Successful Merger?

Earlier I suggested that in the majority of merger and acquisition cases the owners would have been better off not proceeding. Obviously, there are times where success is achieved. What are the magic ingredients of success? It is generally accepted that there are several factors consistently present in successful mergers and acquisitions, which relate to strategy, fit, integration, motive, price, and ownership.

A merger or acquisition intended to achieve our strategy is the only basis on which we should proceed. If we can’t explain how the deal will help us reach the destination on our long road then it shouldn’t be done. There are quite a few strategic reasons to engage in a merger or acquisition, but the best ones relate to getting our hands on complementary product lines, securing innovative technical skills, accessing new markets and customers, and leveraging existing resources. Just because an organization is available and we can afford it are not good enough reasons to get involved.

Fit, which is another way of describing organizational culture, considers such things as whether the deal will be acceptable to employees of both organizations, whether the new management team is able to speak with one voice, or whether any customers will be alienated by existing reputations. It certainly is an intangible, but nevertheless critical, factor in the success of a merger or an acquisition. It’s unlikely that any deal will provide a perfect fit, so it is essential that both organizations assess these cultural issues in advance and identify the worst-case scenario. If we decide that losing some good people and potentially some customers is bad for the future then we should reconsider our plans.

Successful integration of the two organizations will have an enormous impact on the success of the merger or acquisition. Understanding what will be necessary to achieve a successful integration needs to start at the time a merger or an acquisition is being considered because integration costs have to be taken into consideration when determining the price.

With a merger or acquisition it’s important to understand what each party’s motive is for entering the transaction. If the organization has been offered for sale and you are thinking of buying, then never assume you know the reason why it is being sold. Always ask why, and be skeptical about the answer. There could be a really valid reason, but if there is so much opportunity, why are they selling? What do they know about their organization and its future that they are not telling you? What about you? What are your reasons for thinking about acquiring or merging with that particular organization? Maybe it has something special, such as a strong customer base, a leading-edge product, or a well-known brand name, that will allow you to grow your organization faster than building it up internally. Or maybe you just want to stroke your ego and increase your pay packet by managing a bigger organization. Whatever the motives on either side, understanding them up front will help you structure the right deal for everyone.

The price is always important. Remember, as with any other investment, you must be able to generate a return greater than the cost of financing your organization. The higher the price the greater the returns, in absolute terms, that you need to get from the investment and the smaller cushion you have for unexpected problems. On the other hand, securing a low price does not always equate to a good deal and may be a good indicator that all is not as it seems. In any merger or acquisition there is a pricing range based on different assumptions of future performance. In the case of an acquisition, the predator has to decide what price to offer in that range or how the risk will be divided between the respective owners. In a competitive, strategic situation it is often the case that predators will be forced to pay more than they would like, although they should always know the maximum they are willing to pay and not exceed it even if it means losing the opportunity.

Once the merger or acquisition transaction has been completed, someone, preferably a highly respected individual who was closely associated with the negotiations, needs to take ownership of the new organization. This person needs to be its champion and not simply view the acquisition or merged organization as another project to be delegated. Melding the two organizations is never going to be an easy task, and so while everyone on the integration team needs to focus on the important issues, this one person needs to be given some specific targets and held personally accountable for achieving them.

Valuing a Business

An important aspect of any merger or acquisition negotiation is the value to be placed on the organization to be merged or acquired. There are several methods that can be used to derive an appropriate value of an organization, which are not, of course, used only in the context of merger or acquisition negotiations. They will also be required in other circumstances, although they remain a vital element in this activity.

In theory, the value of an organization may be defined in terms of either the current value of the resources it controls or the future cash flows generated from those resources. In a world of perfect information and perfect certainty, valuing an organization would pose few problems. In the real world, however, measurement and forecasting problems conspire to make the valuation process difficult. Various valuation methods have been developed to deal with these problems, but they often produce quite different results.

The main methods employed to value organizations fall into one of three broad categories. These are methods that are based on the value of an organization’s resources, use stock market information, or predict future cash flows.

Resource-based methods attempt to value an organization by reference to the resources it controls. The simplest way is to use the resources statement that is published by the organization. It will show a value for resources as well as the amount of external claims against those resources, or liabilities. By subtracting the claims from the value of resources we can arrive at one value for the organization. Using this method has the advantage that the valuation process is straightforward and the data are easy to obtain.

The value of an organization obtained in this way, however, is likely to be extremely conservative. This is because a number of resources that the organization controls, such as brand names, internally generated goodwill, and intellectual capital, may not be shown on the resources statement and will be ignored for the purposes of valuation. What is more, many of the items are often shown at their historic cost, which may be well below their current market value. We can try to overcome this particular flaw by using current market values rather than the values shown on the resources statement. These could be based on either net realizable value or replacement cost. In practice, a combination of both valuation approaches may be used.

Use of stock market information is only directly relevant to a company whose shares are listed on one of the many stock exchanges around the world. Since it is generally accepted that share prices react quickly, and in an unbiased manner, to new information that becomes publicly available, the value of a listed company is easily determined. This, of course, doesn’t help when we are looking at other organizations. It doesn’t stop us, however, from using stock market information and ratios to help value an unlisted organization.

The first step is to find a listed company within the same industry that has similar risk and growth characteristics. Stock market ratios relating to the listed company can then be applied to the unlisted organization to approximate its value. The key ratio here is the price to earnings ratio. By simply multiplying the unlisted organization’s earnings by the price to earnings ratio of the listed company we can arrive at an approximate market value for the unlisted organization.

We have already seen that the value of a resource is equivalent to the present value of the cash flow it generates. There are two methods we can use here. The first, the dividend valuation method, was first introduced in chapter 5. This method works on the basis that the valuation of an organization is based on its current dividend, the expected future growth rate of that dividend, and the required rate of return on equity capital. While this method is intuitively appealing, there are practical problems in forecasting future dividend payments and in calculating the required rate of return. On top of this, the use of dividends as a basis for valuation poses a problem because of their discretionary nature. Different organizations will adopt different payout policies thereby affecting valuation calculations. Nowhere is this more evident than in the case of high-growth organizations that choose to plow profit back into their organization rather than make dividend payments.

The second, the free cash flow method, determines an organization’s value by reference to the free cash flow that it generates over a period of time. Free cash flows are those available to investors after any new investments in resources. In other words, they are equivalent to the cash flow from operations after deducting income taxes paid and cash for investment. The valuation process is the same as we have used previously, and that is to discount the future free cash flows over time using the weighted average cost of capital. The present value of these future cash flows, less amounts owing to long-term lenders at current market values, will represent the value of the organization. The major problem with this method is that of accurate forecasting—an endemic problem in every aspect of business life when trying to understand the future.

There are other methods available to us, some of which, such as shareholder value analysis and economic value added, we looked at in some detail in chapter 9. Using any of these methods to value a well-established organization is not without problems, but those problems will appear trivial when struggling with the difficulties of valuing newly established organizations. These organizations have no track record and may be making little or no profit, rendering any of these valuation models impotent. In these situations one way of calculating an organization’s value is to apply an industry multiplier to the gross sales or the gross profit of the organization. The drawback here is that industry multipliers generally represent the industry average, and very few organizations operate at or around, averages, which would overvalue or undervalue an organization if such a rule of thumb is applied. All the same, at least our estimation will serve a purpose, even if that is simply to provide a starting point for negotiations.

Choosing a Valuation Model

When deciding on the valuation model to employ we need to consider the underlying purpose of the merger or acquisition. Different valuation models may be appropriate for different circumstances. Let me give you an example. If the predator is looking to acquire an organization simply to break it up and sell it piece by piece, then it would probably be most interested in the liquidation basis of valuation. On the other hand, where market prices are available these will be used as a basis for negotiation.

In every situation, whichever method is used to value an organization, the result is only going to provide an approximation that will help set the boundaries within which a final price will be determined. This final price will, however, be influenced by various factors, including the negotiating skills and the relative bargaining position of the parties.

Summary

Mergers or acquisitions have a particular place in the commercial world’s circle of life. As I have tried to show with my little case study, business enterprise is a journey—a journey that is dreamed about, planned, carried out, and ultimately finished when the destination is reached. These journeys can be quite short, exceptionally long, or a collection of mixed-length journeys. Each journey in a collection represents an individual circle in the life of an organization. Even those organizations that have existed since what seems to be time immemorial, such as the remarkable ryokan—Hotel Sakan in Sendai, Japan—that has been in existence for more than 1,000 years and, I believe, operated by the same family for more than 25 generations, have been through a succession of these circles as they reach one destination and then start out in search of another.

When a destination is reached, or even just before we get there, we need to think about whether we wish to continue our journey to another place. If we do, then it is simply a matter of starting a new circle in the life of the organization. If we don’t, then we either bring the life of our organization to a close or find someone else who is interested in taking it on its new journey—its next circle of life. This is the role played by merger and acquisition activity.

There is a lot to consider when we are thinking of acquiring or merging with another organization, but nothing is more important than deciding on the price we want to pay. If we don’t get somewhere near the mark with our offer, then the impact on our own existence could be terminal. Determining the amount to pay, in other words valuing the organization, is such a subjective task. However we decide to calculate this amount, it will not be precise but simply an approximation that will allow us to start negotiating.

With any merger or acquisition, understanding what we are getting is the first important step, knowing how much to pay is the second important step, and integrating the two organizations is the third important step. In the end, is it worth the effort? This depends entirely on what is being bought. There are unique merger or acquisition opportunities that can dramatically improve our position in our market, or provide access to new markets. With careful planning, analysis, and hard work by the management team, mergers or acquisitions can be an excellent way to help us reach our destination in this particular circle of life.