Acquisition Challenges: Why Acquisitions are Unsuccessful
The stock market enjoyed one of its best quarters in almost a decade during the first quarter of this year with the Dow Jones Industrial Average, the S&P 500 and the Nasdaq Composite Index all posting solid double-digit gains. The gains almost recouped all the stock market losses suffered during the brutal fourth quarter of last year.
Of course, a strong stock market is good news for most investors, but it could also be a precursor for a big year for initial public offerings (IPOs) and mergers and acquisitions (M&As). A recent Wall Street Journal article noted that “the market’s turnaround has helped whet investors’ appetite for what many believe could be one of the biggest years ever for IPOs.”1
Preparing for Acquisition Challenges
If your company is thinking about a merger or acquisition this year, there are some things you should keep in mind as you prepare for the acquisition challenges that accompany a transaction. Here are five common reasons why M&As are unsuccessful, along with links to articles we’ve written that address these acquisition challenges in more detail:
1. The acquired company is overvalued in the selling price.
When valuing a business, sellers and acquirers usually use a measurement of earnings known as Earnings Before Interest, Taxes, Depreciation and Amortization, or EBITDA. However, further adjustments beyond EBITDA are often necessary to provide a better look at the business’ true earnings and determine whether or not it is overvalued.
The goal is to determine the quality of the company’s earnings. High-quality earnings are earnings generated from core operating activities, not external events and internal accounting practices. This is accomplished by adjusting earnings to account for things like excess accounts receivable that are unlikely to be collected, dead inventory unlikely to be sold, unrecorded and under-recorded liabilities, one-time expenses and accounting errors.
For a more detailed review, see our quality of earnings article.
2. The acquired company is undervalued in the selling price.
Another adjustment should be made to EBITDA to determine whether an acquired business is undervalued. This adjustment adds one more letter to the EBITDA acronym: M, which stands for Management excesses. These are things like the owner’s personal luxury autos, boats and airplanes; exotic vacations taken by the owner; and season tickets enjoyed by the owner.
The business acquirer will not be expensing excess items like these, so they should be removed from EBITDA. Doing so will give sellers and acquirers a better picture of the business’ true profitability — and most importantly, whether or not the sale price being negotiated is too low.
For a more detailed review, see our EBITDAM article.
3. The financial projections presented by the seller are not accurate.
A common mistake made in acquisitions is confusing financial projections with forecasts. Projections are generally considered to be less-reliable than forecasts because they present future financial results based on hypothetical assumptions, instead of expectations. A forecast, meanwhile, is based on the future economic and business conditions that are expected to exist, which makes it generally more accurate.
Here’s another way to view the difference: Projection assumptions are based on what owners believe will happen in the future, and they sometimes tend to be overly optimistic. However, forecast assumptions are based on past history and realistic future expectations. Therefore, forecasts should generally be used instead of projections in most M&A transactions.
For a more detailed review, see our financial forecast vs. financial projection article.
4. Reported financial data is not accurate or timely.
Acquirers will scrutinize a wide range of reports when performing due diligence on companies they’re considering acquiring. These include balance sheets, cash flow statements and income statements. If these reports aren’t accurate and timely, and if they’re not interpreted correctly, this will eventually lead to problems with the merger or acquisition.
More specifically, the data should allow for clear and actionable decision making; be forward-looking and leverage accurate historical data; be driven by GAAP best practices; be customizable and fully integrated; and provide greater clarity on the past, present and future financial status of the business.
For a more detailed review, see our best-practice financial data article.
5. Undesirable market positions.
Acquirers are usually looking for specific characteristics in the companies they’re considering buying. These typically include outstanding growth opportunities, strong competitive advantages, minimal customer concentrations and a deep management bench. If a business doesn’t possess these characteristics, a buyer is going to expect concessions from the seller, including a lower sales price.
For a more detailed review, see our article on value drivers acquirers are looking for.
The first quarter’s strong stock market performance could be a precursor for a big year for initial public offerings (IPOs) and mergers and acquisitions (M&As). If you and your team are thinking about a merger or acquisition this year, there are acquisition challenges that you should keep in mind and address early. A project CFO or part-time CFO from a CFO services firm can help you determine whether a merger or acquisition is the right course of action for your business, as well as help you plan for meeting the biggest acquisition challenges that will be encountered.
1 U.S. Stocks Rise, Notching Best Quarter Since the Crisis; Akane Otani; WSJ.com; March 29, 2019
Arthur F. Rothberg, Managing Director, CFO Edge, LLC