Mergers and acquisitions, or M&A, can be very complex processes that may be as risky as they are rewarding. Differences in internal controls, management styles, processes, data volumes and complexity of integrating systems between two organizations looking to a merger or an acquisition can often result in the increase in business risks exponentially. Organizations that are unable to reach a consensus in these aspects of management often fail to achieve the proposed result of combining their business operations together.
Despite these risks, many organizations use mergers and acquisitions as a fast track tool for rapid expansion and growth. In a large number of mergers and acquisitions, a buyer overpays for purchase of a business entity and the merger fails to meet expectations.
Smart Business spoke to Richard Millman, CPA/ABV, CVA, the principal-in-charge of the Forensic Accounting Services Team at Tauber & Balser, P.C., for a look at the risks involved and the common mistakes that happen in mergers and acquisitions.
How can a prospective buyer’s assumptions create differences between expected and actual results?
Financial and business assumptions form the basis of a model underlying a valuation process and the purchase price estimated for buying an entity. Cases where buyers forecast unrealistic synergies and economies of scale often result in high-risk and low-return M&A transactions. One common assumption that leads to wrong and mistaken judgment is that the buyer would run the business more effectively and efficiently than the old owner.
Another common mistake in M&A transactions is the buyer’s assumption of using unrealistic and unsupported industry standards for benchmarks. The result of this could be the buyer using a rate of return less than the cost of his capital or purchase cost. This, on paper, yields good returns but, in reality, would be devastating.
What should a potential buyer do to determine whether a company is worth the asking price?
There are three approaches to valuation known as the cost, market and income approaches. Often, companies follow a rule of thumb rather than a complete analysis for decision-making. In such cases, important considerations, including those impacting nonoperating assets, changes in market dynamics, etc., are ignored.
Before making a formal offer to merge with or acquire another business, management must ensure that a complete analysis using all three approaches should be performed to make the best decision and determine a reasonable offer/purchase price.
Are there special concerns when valuing a company in an industry experiencing a lot of consolidation?
Inflated pricing multiples are often a major problem in the valuation exercise.
Industrywide consolidation often leads to this issue, and, in certain cases, the result becomes unrealistic. Instances where companies have paid unrealistic premiums to maintain market shares are plentiful.
Is due diligence really that big of a deal? What is the worst that can happen?
Due diligence is the systematic process of understanding and evaluating a business proposition. This ideally would cover both strategic and operational areas, including financial and technical aspects and resource-related issues. In many M&A opportunities, incompetent due diligence has lead to overlooking risks, including financial-related risks like unpaid taxes, fines, obsolete assets and organization risks such as employee retention issues, poor management control, etc. The result can be devastating to running the business, even resulting in bankruptcy.
Issues that come up in the due diligence process must be carefully understood and examined, and solutions should be identified. The impact of due diligence may include:
- The potential buyer withdrawing from the deal if information from due diligence makes the investment highly risky;
- Revision of the valuation of investment and adjustment of the potential price that may be offered to the seller; and/or
- Resolution of the problem and revaluation of the investment proposition.
The best way to ensure M&A activities succeed is through due diligence. Valuation analysts play a vital role in helping an organization evaluate mergers and acquisitions transactions. Thus, in reality, it is best suited for an organization to leave the valuation process to the experts than perform it itself.
RICHARD MILLMAN, CPA/ABV, CVA, is the principal-in-charge of the Forensic Accounting Services Team at Tauber & Balser, P.C. During his 40 years of experience, his professional background has spanned both the public and private sectors. He has provided litigation support and expert witness services in cases involving accounting principles, applications of Generally Accepted Accounting Standards and accountant malpractice. He has also consulted in the area of mergers and acquisitions throughout his career. Reach him at firstname.lastname@example.org or (404) 814-4905.