Spotting the Bad Deal – Before It’s Too Late

Posted on December 15, 2011

Growing your business through acquisitions is tempting:  the rewards can be great.  But as many as half of all marriages between companies fail to meet expectations.  Here are the key questions to ask before you do the deal.

For many mid-market companies, growing through acquisitions is a tempting and exciting option. The statistics, however, point to a more sobering reality: As many as half of all marriages between companies fail to meet the expectations of either side.

In a 2009 survey of 100 large corporate executives and M&A professionals commissioned by Merrill Corporation, most respondents (44 percent) cited merger success rates of just 26 percent to 50 percent, and 15 percent of the respondents reported success rates below 15 percent. A 2006 study in the British Journal of Management paints a similar picture: The overall failure rate of M&A deals, according to separate research over the past 30 years, ranged between 44 and 50 percent. In other words, the odds of a successful acquisition are roughly the same as a coin toss.

Why is this? Most research on the subject indicates that the leading cause of a failed acquisition is a conflict between the goals, strategies or management styles of the two merging companies. Sadly, these conflicts do not surface until after the deal is complete and the integration process is already under way.

While a large firm can write off most of their bad acquisitions from the profits from their much larger, core business, mid-market firms are particularly vulnerable to bad deals. Most mid-market firms have no corporate development function, and those that do have it thinly staffed. They also typically make and integrate acquisitions using their line executives, which distracts them from core operations. While mid-market M&A activity seems to be improving, the truth is most firms are not in a position to take big risks. Getting it right is critical.

The simple answer to reducing this risk is not to buy companies that you cannot successfully integrate. However, this is easier said than done. Executives love to buy companies, and bankers, lawyers, accountants and M&A consultants all reap their profits the moment the deal closes, regardless of the ultimate success or failure. And hey, let’s face it – deals can be exciting. But the CEO who is able to set aside emotion and walk away from bad deals will be better able to avoid taking an unnecessary risk and endangering the whole enterprise.  That means thoroughly analyzing a deal from all angles, figuring out just how two separate entities will actually fit together, and who will get the job done.

I speak first from experience. As a CEO of an art publishing business, I once considered a deal to acquire a Utah company that would have added a popular genre to our collection of products.   There were red flags, however. The seller was eager, yet put a surprisingly high price on the table. Another thing I noticed about this seller was that he talked in circles. As time progressed and my team and I continued to analyze the deal, we began to see some less-than-ethical business practices that made us feel uncomfortable.

Meanwhile, the seller had visions of taking an important role in our senior management team. To be honest, his selling skills were one of the reasons we wanted to bring him aboard.  But we started to see that the way he treated artists and customers was different than how we treated ours. We walked away from that deal, and as time went on, we knew we had made the right call. We watched as the Utah company infringed on the intellectual property rights of other art publishing firms, including our own, and its reputation suffered as a result. We dodged a bullet.

When companies do not pay attention to the integration process, the results can be truly ugly as well as damaging to everybody involved. Take, for example, the case of a mid-market staffing firm I had once worked with. The firm ran out of money during the recent economic downturn and was bought by a much larger global firm. The cultures of the two businesses could not have been more different. The selling company was comprised of a community of experts who were all partners in the firm and who generated business through networking. The purchasing company had a high-volume, cold calling approach. Basically, polar opposites. To make matters worse, there was a total lack of communication during the integration process. The people with the selling company had no idea what would happen to them, and as a result, they fled in droves. It was a classic example of a horrible integration.

So how does one avoid such debacles? Here are five key questions I encourage CEOs to use to assess deals from an integration standpoint:

1. Does the buyer have sufficient management capacity to take on the integration process?  Are they already stretching to run their existing business?
2. Has the culture of the seller been thoroughly assessed, and is it fairly compatible with the buyer’s culture?
3. Is this deal well aligned with the buyer’s corporate strategy?  (A deal that will deliver on a key strategy will more than offset the cost of a difficult integration.)
4. Is the deal priced at a level so that the buyer can still afford to pour adequate resources into the integration – and still have an ROI that passes the hurdle rate?
5. Is the acquisition – and all the costs and risks associated with it – a better choice than all other alternatives?

If the situation looks weak in any of the five areas, run. These are signs that the integration will stumble. When that happens, the recovery can cost as much time and resources as two or more good acquisitions. And yet, no amount of project management can fix an acquisition that should never have happened to begin with.

Of course, sometimes things aren’t that black and white. A buyer may think they have all the answers, but there are still other factors that could trip up the integration process. Let’s take a closer look at three key barriers to a successful deal, and how they might be overcome:

Deal Fever.  Doing deals can be intoxicating. But this excitement can also cloud everyone’s thinking. Someone on your team needs to be a counterpoint to the excitable, gung-ho types.  Perhaps it is the CFO, or maybe it’s the board. Whoever it is, someone needs to exhibit calm and ask the tough questions.

Poor Bandwidth. If your team is struggling to find the time to perform full due diligence to make a good assessment, your team likely does not have enough time to ensure the integration goes well.  Outsourcing the due diligence may help solve a short term problem only.

Bidding War. If you are being forced to rush into a deal because there are multiple suitors, pour in extra resources if possible. But losing an opportunity to buy in a rushed situation could actually be a blessing. In bidding wars, the winning company often pays too much – and ends up with a bad integration on their hands to boot.

Investment bankers are a primary guide to M&A for many mid-market acquirers.  Won’t they help steer around bad deals?  Not so fast. A colleague of mine, who spent 15 years on the front lines managing deal integrations, recently told me that 99 percent of intermediaries have no experience with integration – in fact, most intermediaries actually avoid talking about it, for fear it will collapse discussions. When integrations are not addressed, my colleague said, it creates a vacuum that is “usually filled with unrealistic expectations on both sides. After the deal is done these expectations surface and create tensions, political  drama, key employee defections, lost customers and poor financial performance.”

I’m not trying to be a stick in the mud here. Good deals still happen 50 percent of the time, according to the stats.  But if you want to increase your odds of success, be sure to meticulously and diligently screen for integration success (in addition to other factors). If you want to grow your business through acquisitions, try using the above questions to assess your deals, and think about how you would mitigate the key barriers. Also, consider the fact that a higher walk-away rate may actually increase your overall ROI on deals you execute.

And if you are unable to do the homework, at least think about those coin-flip odds. Sometimes it’s better to keep the coin in your pocket.