STRATEGIC

Challenges Involved in Small Business Mergers and Acquisitions

– a Brief Overview

Li Ou
PhD candidate in Genetics & Biostatistics
University of Minnesota
Minneapolis, MN

Mark J. Komen, President
Kodyne, Inc.
Plymouth, MN

Every acquisition/merger is different in terms of purposes. The motivations for selling a business may include owner retirement/illness, financial goals met, lack of an heir to take over the business, estate planning concerns, partner disputes, profitability or financing issues, access to greater resources from the acquirer and risk reduction to name a few. On the acquirer side, motivations may include achieving operating synergy and economy of scale with their current enterprise, diversifying assets, obtaining products/patents, entering new markets, tax benefits and adding cash flow.

No matter what the motivating reason is, the proper execution of any deal always starts and ends with strategy. It is essential for both sellers and acquirers to consider their strategy to deal with challenges involved in a deal. No one ever plans to enter into a bad deal. Yet, many well-intentioned entrepreneurs and executives enter into acquisitions that they later regret.

Acquisition/merger is a special blend of art and science. While no two deals are identical, there are some essential components for executing a successful acquisition. In this article, we will discuss key challenges in each step of acquisition for both sellers and acquirers.

Seller’s Challenges

Sellers’ main pre-sale challenges lie in a preparation and a due diligence phase. In addition, one can never underestimate the challenges they may fact in a post-sale integration phase.

1.1 Preparation Phase

There is usually a positive correlation between the amount of time sellers spend in preparation for the transaction and the price paid for the acquisition. The main challenge during the preparation process is to make your business saleable and choose the right timing to inform any people involved of this deal.

1.1.1Make Your Business Saleable

To make your business saleable, you need to strike a balance between entertaining the needs of potential acquirers and maintaining the business as an on-going concern. On one hand, sellers must anticipate the specific needs and motivations of different acquirers. For instance, crafting products that can fit well into a potential acquirer’s product line is an effective way to attract acquirers. On the other hand, since each acquirer will have different motivations and needs, it may be a good strategy for sellers to keep some offerings in their present form.

Another thing that a seller should be aware of is try not to leave loose ends. Very few acquirers will be interested in owning a company that still has remaining shareholders who present operational or legal risks. Therefore, it is reasonable to purchase minority shareholders’ interests so that the acquirer won’t have to contend with their demands after the deal. Further, the sellers should make sure that their businesses stick to a variety of legal and financial standards which will make a review of their operations “apples to apples” with an acquirer. In addition, if a company’s compensation and benefit structure is industry-standard and similar to that of potential acquirers, your business will definitely be more attractive.

1.1.2 Conduct a ‘Who Knows What When’ Analysis

During an acquisition, the seller should not overlook the human element. Choosing a good time to inform people involved with or affected by this deal can minimize potential negative effects.

If you inform key employees of a potential sale too early, their performance may be affected in anticipation of losing jobs or from a general fear of the unknown. The best talent will likely find other jobs and leave while the remaining staff is likely to be distracted, resulting in a drop of morale. If you tell employees of a sale at the last minute, they may feel resentment at having been kept out of the loop. The best time to tell staff about the sale of your business is after the deal has closed. Sellers are well-advised to prepare a presentation to staff about the future with the new owners. We will discuss this further in section 2.5.

Suppliers and customers will be also concerned about their own interests. If you wait too long and disclose your news at the last minute, key customers or suppliers may not have time to react and evaluate the impact of the sale or acquisition on their businesses.

1.2 Due Diligence

Most of the time and effort for an acquisition deal are spent on due diligence. Acquirers will be interested in documentation covering everything from past and current financial data, tax filings, corporate minutes, customer lists, vendor lists, employee lists, intellectual property, pending lawsuits (if any) and a host of other information. Sellers are best served by keeping these items up-to-date so they are ready to provide them to prospective buyers.

1.2.1 Provide Accurate and Comprehensive Information for Potential Acquirers

Keep in mind that your credibility is on the line. A loss of trust from a potential acquirer can cause them to pull out of the deal. Worse still, creating bad reputation as a seller may drive away other potential acquirers.

1.2.2 Be Patient

Generally speaking, the due diligence phase takes a long time because the acquirer needs to make sure that the deal is reasonable, the financials make sense and they understand your business and how it fits into their plans. If you seem too anxious to sell, acquirers will take advantage of your impatience and the offer you get may be lower than desired. However, both sides are generally aware that “time is of the essence” and it is in the seller’s favor if there are multiple buyers in the picture.

1.3 Integration Phase

1.3.1 Avoid Sellers’ Remorse and Power Struggles

Sellers sometimes have remorse after the transaction, particularly when they remain as a minority owner or in a temporary consulting capacity. A seller might be so accustomed to managing the business that they may not be open to the changes in strategies or policies implemented by the new owners. The former owner and acquirer need to be in agreement on each person’s roles and responsibilities, decision-making approaches and tolerance for risk as not to undermine the acquirer’s efforts or contradict their authority.

Acquirer’s Challenges

2.1 Preparation Phase

2.1.1 Develop an Acquisition Plan

First of all, acquiring a business without a clear strategy is fraught with risks. This is especially important if the acquirer is not intimately familiar with the target business (or even how to run a business if the situation involves first-time ownership). The acquirer should consider assembling a transition team made up of representatives from finance, marketing, sales, legal and operations, for example, who can advise on preparations and plans. Involving outside advisors is also a common strategy.

Further, the acquirer should draft an acquisition plan that includes objectives, relevant industry trends, criteria for evaluating target companies and a timetable for deal completion. Being able to answer the following questions is crucial for a successful purchase:

• Why are you acquiring a business?
• What are your specific objectives?
• Who are the target companies?
• Who are their competitors?
• How will you finance the deal?
• What are the operational synergies will result from the proposed deal?

2.2 More Due Diligence

2.2.1 Encourage Full and Complete Disclosure

Since a seller will be naturally reluctant to expose potential acquirers to large numbers of its staff, getting access to the right staff is one of the main challenges in due diligence. This is a particular problem in technology-driven companies, where the employees who developed the technology are seen as a valuable asset and the acquiring company may be concerned about those people being hired away or leaving the business if they are concerned about their future employment.

2.2.2 Not Too Hasty or Too Long

Acquirers should be aware that sellers may become defensive, evasive and impatient during the due diligence phase. Few business owners will enjoy having their business policies and decisions examined under a microscope, especially for an extended period of time and by an acquirer who is likely searching for skeletons in the closet. Eventually, the seller may give the prospective acquirer an ultimatum: ‘‘Finish the due diligence soon or the deal is off.’’

In spite of the pressure from sellers, acquirers should resist the temptation to conduct a hasty ‘‘once-over.’’ It is the acquirer who will pay a lot of money and be responsible for the company after the transaction. However, they should keep in mind that due diligence can never be perfect and should not be a tedious fishing expedition. Due diligence overkill can set up an atmosphere of mistrust and terminate a deal in process.

2.2.2 Comprehensive and Customized Checklists

Since every type of business has its own issues and problems, a standard set of due diligence questions will rarely be sufficient. Acquirers need to develop a customized due diligence checklist that align with both the acquisition target’s business and with the acquirer’s established ways of doing things.

2.3 Valuation of Target Companies

No single valuation method will answer the real question what a business is actually worth. Generally speaking, market value is only one indicator. Other valuation factors include capitalization of earnings, discounted cash flow and net return of assets or equity. In addition, one needs to assess what the projected earnings stream under the proposed new ownership would be with considerations such as infused capital, new management and additional resources for example. With a further understanding of customer lists, brands, intellectual property and licenses, one can determine a reasonable price. Particularly challenging for acquiring small, privately held businesses is securing accurate information and documentation. Without these items, making realistic valuations is all the more difficult. In the end, a company’s value is directly determined by what a motivated buyer is willing to pay for it.

2.4 Financing the Deal

Bank financing is often extremely difficult to secure for small business acquisitions. Therefore, it will be essential to anticipate this situation and make early preparation. There are many approaches to financing these deals including cash, earn-outs, stock swaps, government loans, etc. These will not be explored in this paper.

2.5 Integration

Generally speaking, integration is seen as the single biggest source of failed acquisitions. Although we are focusing on the people side of the integration issue in this article, processes and technologies also come into play in a big way as well. Incompatibilities between such things as ERP/MRP systems, financial/accounting systems, CRM packages, design software, capital equipment, quality systems, etc. will create endless stress, frustrations and inefficiencies unless addressed with forethought and good planning.

2.5.1 Employee Retention and Layoffs

A major integration planning challenge is employee retention. It is in the best interests of the new owners to review the seller’s employee base and identify key employees to retain in the new organization and employees that should be let go due to such things as duplication of responsibilities, insufficient skill levels, low performance or poor attitudes. Three important things to remember during the review process: Be objective. Be balanced. Be honest.

Once key employees have been identified, the challenge is to ensure that the acquirer will be able to retain them. If employees perceive a dramatic change in organizational culture, they may flee the company after it is acquired. This can lead to significant financial ramifications due to:

• The high cost of hiring and training new employees
• The loss of customer relationship
• The loss of intellectual capital

To retain key employees, buyers can consider financial actions such as retention bonuses and other incentive pay structures, along with perks, training classes and challenging work assignments. Moreover, buyers should be aware of non-financial actions including reducing uncertainty through credible leadership, leadership-development programs and producing sufficient information about organizational changes [3].

2.5.2 Customer Base and Supplier Relationships

Another post-closing challenge is to determine the profitability of the customer base. Sometimes, the acquired company has legacy customers that it has been unwilling or unable to terminate even though they are unprofitable or difficult to manage. The acquirer should review all customers for profitability and sustainability to optimally manage the customer base. Personally contacting key customers is a good way to establish rapport with the new ownership team. Oftentimes, acquirers will have different requirements for gross margins and customer interactions than the previous owners so establishing open communication with customers will allow those conversations to move forward in a productive manner

Similarly, to ensure that the acquired company is getting the best prices and terms, it is a good idea for the acquirer to conduct a thorough review of the existing suppliers and make personal contact with them to build healthy and fruitful relationships. The same holds true for dealing with any financial institutions who are involved in funding the deal.

2.5.3 Culture Integration

When two companies become one, the first thing that employees will notice will be the difference in the ways the companies do business – especially if the combined company is under the same roof as the original one. A highly dependent organization used to relying on their management chain for making even low-level decisions may not know how to function in one whose culture expects and rewards taking initiative and high levels of personal accountability and achievement. Conversely, changing from a culture that values innovation, risk-taking and employee development to one based on power, empire-building and whoever yells the loudest gets their way will be extremely stressful for staff. Employees are quick to notice any differences in organizational structure, values and philosophies between companies.

More importantly, employees not only see differences but also have a sense of vulnerability over losing their accustomed way of doing business. It is imperative that the new owners clearly establish their expectations about what it takes to fit in and be successful in the new company. This may require redesigning the HR (hiring, compensation, benefits, etc.) and employee development systems to promote alignment with the new culture.

To mitigate the pain during culture mesh process, both buyers and sellers can consider the following several things. First, include consideration of cultural differences when determining the value of the deal. Second, both acquirers and sellers need to figure out how to combine the two cultures in a way that will prevent the deal from failing. It is not in either company’s interest to maintain both cultures unless the organizations will remain autonomous after the deal.

Conclusion

Small business merger and acquisitions face many of the same issues as larger, publicly held companies. Truly understanding the sell/buy process; engaging a team of knowledgeable advisors; having current and accurate records; and paying attention to customer, vendor, financial institution and staff relationships in the post-acquisition world are crucial pieces to secure the best odds for success.

References
[1] Sherman, A. J. (2010). Mergers and Acquisitions from A to Z. AMACOM.
[2] Frankel, M.E.S (2005). Mergers and Acquisitions Basics. The Key Steps of Acquisitions, Divestitures, and Investments. John Wiley & Sons, Inc., Hoboken, New Jersey.
[3] Erickson, R. A. & Roloff, M. E. (2007). Reducing attrition after downsizing: Analyzing the effects of organizational support, supervisor support, and gender on organizational commitment. International Journal of Organizational Analysis, Vol. 15 No. 1, pp. 35-55.