CHAPTER 1
Winning through Mergers and Acquisitions

Buyers and sellers can create substantial value through merger and acquisition (M&A). Both can win from a transaction. That is the beauty of deal making. And that is much of the allure that has driven the tremendous volume of M&A activity worldwide over the past three decades.1 Despite this volume, most businesses are not salable. M&A advisors disqualify roughly 65% to 75% of prospective sellers and, according to a U.S. Chamber of Commerce study, only 20% of the businesses that are for sale will successfully transfer hands to another owner. This would imply that only 5% to 7% of companies actually get sold!2

This book focuses on private company business value, with particular focus on private (or closely held) companies in the lower end of the middle market (i.e. those generating between $3 million and $250 million in value).3 What creates value? How do we measure it? How does a management team build it? How do they preserve it? How do they maximize it through a transaction? It is this focus that will improve the chances of selling a business. These concepts are equally important to buyers and sellers because both can and should benefit from a deal. But different results frequently occur. Sellers may sell under adverse conditions or accept too low a price due to lack of preparation or knowledge. And every buyer runs the risk of purchasing the wrong business or paying too much. As seen during the Great Recession of 2007–2009, transactions during adverse economic times create their own sets of challenges. That is why understanding value – and what drives it – is critical in mergers and acquisitions.

Wise shareholders and managers do not, however, confine their focus on value to only M&A. They should be building value in their business while still running it. If you do not grow, you will ultimately decline. As Will Rogers famously said, “Even if you're on the right track, you'll get run over if you just sit there.”

Value creation drives the strategic planning of shareholders and managers and, in the process, creates focus and direction for their company. Their M&A strategy supports and complements their broader goal of building shareholder value, and they buy and sell only when a given deal creates value for them.

This brings us back to the purpose of this book. It explains how to create, build, measure, manage, preserve, and maximize value in mergers and acquisitions in the context of the broader business goal of building value. Senior managers in most public companies focus on value every day because it is reflected in the movement of their stock price – the daily scorecard of their performance relative to other investment choices. Private companies, however, lack this market feedback and direction. Their shareholders and executives seldom understand what their company is worth or clearly see what drives its value. For this reason, many private companies – and business segments of public companies as well – lack direction and underperform.

Managing the value of a private company, or a division of a public corporation, is particularly difficult because that value is harder to compute and justify. Yet most business activity – and value creation or destruction – occurs at this operational level.

Being able to accurately measure and manage the value of smaller businesses or business segments is critical in the value‐creation process. And this skill will pay off in M&A as well because most transactions involve smaller entities. Although we read and hear about the big deals that involve large corporations with known stock prices, the median M&A transaction size in the United States between 2012 and 2016 was approximately $43 million. Smaller deals involving closely held companies or segments of public companies are the scene for most M&A activity.

Therefore, every value‐minded shareholder and executive must strive to maximize value at this smaller‐entity level where daily stock prices do not exist. The concepts and techniques that follow explain how to measure and manage value on a daily basis and particularly in M&A. The discussion begins with an understanding of what value is.

Critical Values Shareholders Overlook

When buyers see a potential target, their analysis frequently begins by identifying and quantifying the synergies they could achieve through the acquisition. They prepare a model that forecasts the target's potential revenues if they owned it, the adjusted expense levels under their management, and the resulting income or cash flow that they anticipate. They then discount these future returns by their company's cost of capital to determine the target's value to them. Armed with this estimate of value, they begin negotiations aimed at a deal that is intended to create value.

If the target is not a public company with a known stock price, frequently no one even asks what the target is worth to its present owners. However, the value the business creates for the present owners is all that they really have to sell. Most, and sometimes all, of the potential synergies in the deal are created by the buyer, rather than the seller, so the buyer should not have to pay the seller for most of the value the buyer creates. But in the scenario just described, the buyer is more likely to do so because his or her company does not know what the target is worth as a stand‐alone business. Consequently, the buyer also does not know what the synergies created by his or her company through the acquisition are worth, or what the company's initial offer should be.

Sellers are frequently as uninformed or misinformed as buyers. Many times the owners of the target do not know if they should sell, how to find potential buyers, which buyers can afford to pay the most to acquire them, what they could do to maximize their sale value, or how to go about the sale process. After all, many sellers are involved in only one such transaction in their career. They seldom know what their company is currently worth as a stand‐alone business, what value drivers or risk drivers most influence its value, or how much more, if any, it would be worth to a strategic buyer. Typically none of their team of traditional advisors – their controller, outside accountant, banker, or attorney – is an expert in business valuation. They certainly have not seen as many businesses as an experienced business appraiser. Few of these professionals understand what drives business value or the subtle distinction between the value of a company as a stand‐alone business versus what it could be worth in the hands of a strategic buyer.

The seller could seek advice from an intermediary, most commonly an investment banker or business broker. But these advisors typically are paid a commission – if and only if they achieve a sale. Perhaps current owners could achieve a higher return by improving the business to position it to achieve a greater value before selling. This advice is seldom popular with many intermediaries because it postpones or eliminates their commission.

With sound advice so difficult to find, sellers frequently postpone sale considerations. Delay is often the easier emotional choice for many entrepreneurs who identify personally with their company. But with delay, opportunities are frequently lost. External factors – including economic, industry, and competitive conditions that may dramatically affect value – can change quickly. Consolidation trends, technological innovations, or regulatory and tax reforms also can expand or contract M&A opportunities and value.

Procrastination also can hamper estate planning and tax strategies because delays reduce options. And the bad consequences are particularly acute when value is rapidly increasing.

Thus, buyers and sellers have very strong incentives to understand value, manage what drives it, measure it, and track it to their mutual benefit.

Stand‐Alone Fair Market Value

With a proper focus on maximizing shareholder value, buyers and sellers begin by computing the target company's stand‐alone fair market value, the worth of what the sellers currently own. This value reflects the company's size, access to capital, depth and breadth of products and services, quality of management, market share and customer base, levels of liquidity and financial leverage, and overall profitability and cash flow as a stand‐alone business.

With these characteristics in mind, “fair market value” is defined by Revenue Ruling 59‐60 of the Internal Revenue Service as “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.”

Fair market value includes these assumptions:

• Buyers and sellers are hypothetical, typical of the market, and acting in their own self‐interest.
• The hypothetical buyer is prudent but without synergistic benefit.
• The business will continue as a going concern and not be liquidated.
• The hypothetical sale will be for cash.
• The parties are able as well as willing.
• The hypothetical seller is not forced to sell (i.e. accept an offer that represents a “distress sale”) and a buyer is not compelled to buy (i.e. necessary to earn a...