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588 Making Key Strategic Decisions must be budgeted as they can have a significant impact on postmerger cash flows. The detailed plan must start at the highest levels of the organization. If executives from the two firms are going to lead the transition, they must be confident of their future roles and comfortable with their compensation plans. In the Daimler-Benz-Chrysler deal, there was a good deal of animosity be- tween executives as the German managers watched their American counter- parts walk away with multimillion-dollar payoffs from their Chrysler stock options while simultaneously receiving equity in the newly merged firm. A fair incentive system must be in place at the corporation’s executive suite before any implementation plan begins. Once the key managers have been identified, retained, and given the proper incentives, they must carry the vision of the merger to the rest of the organization. To combat the productivity problems discussed above, managers have two critical weapons, speed and communication. Remember that the enemy from the employee’s perspective is uncertainty, and absent timely infor- mation from above, they will usually assume the worst. Executives must move quickly to convey the vision for the merged entity and to assure key employees of their role in executing this vision. While all employees should be part of this process, those that deal with the firms’ customers should receive special attention. We saw how Cisco moves quickly to retain key salespeople and reassure important customers that the merger will only improve product offerings and services. In contrast, the 1997 merger between Franklin Planner and Covey Systems failed to heed this ad- vice. Combining sales forces was seen as a key source of synergy, but the com- pany was unsuccessful in merging the two compensation programs. Divisions were especially strong within the company’s 1,700-person sales force, which marketed its seminars and training sessions. Former Covey salespeople got higher bonuses than Franklin staffers. Covey employees also kept their free medical coverage, while Franklin’s had to pay part of their premiums. 19 This situation created such sniping by sales reps on both sides that productivity plunged. The implementation plan must focus management resources on those areas at the root of the deal’s synergies. If value is going to be created, it will only be by executing on those aspects of the deal that were the original rationale for merging. Without a plan, it is too easy for managers to get bogged down in de- tails of the implementation that have little marginal impact on shareholder wealth. In the failed AT&T-NCR merger, the hoped-for technological synergies between telecommunications and computers never materialized as managers worried more about creating a team environment. In many cases, the disappointing performance of mergers can be traced to a failure to account for cultural differences between organizations. These differences can be based in corporate culture or national culture in the case of cross-border deals. In many transactions, both corporate and national cultural Profitable Growth by Acquisition 589 differences are present. Because they are difficult to measure and to some ex- tent intangible, cultural differences are often ignored in the pre-acquisition due diligence. This is unfortunate since they can ultimately be the most costly aspect of the implementation process. In mergers where the firms have similar cultures, the rapid combination of the two organizations can actually be easier. However, where there are large cultural differences, executives should con- sider keeping the entities separate for some time period. This allows each to operate comfortably within its own culture while at the same time learning to appreciate the strengths and weaknesses of the cultural differences between the organizations. Such an arrangement may delay the realization of certain synergies but, in the end, is the most rationale plan. The key is that culture can have a huge impact on value (both positive and negative), and therefore needs to be part of the planning process from the very beginning—even before any acquisition offer is made. To ensure success, the postmerger implementation process must be care- fully planned and executed. Even when this is done, there will undoubtedly be surprises and unanticipated problems. However, a well-thought-out plan should minimize their negative impact. The most important parts of the plan are speed and communication, which are critical weapons in the fight against suc- cessful implementation’s main enemies—uncertainty, anxiety, and an in- evitable drop in productivity. A plan conceived and implemented swiftly by the firms’ executives, with their full and active leadership, improves the chances for a successful transition. As always, we urge acquirers to seek the ad- vice of knowledgeable experts on the implementation process. SUMMARY AND CONCLUSIONS Mergers and acquisitions are a popular way for firms to grow, and as economic globalization continues, there is every reason to believe their size and fre- quency will increase. However, it is not that case that profitable growth by ac- quisition is easy. The empirical data presented in this chapter makes it clear that corporate combinations have historically failed to meet the operational and financial expectations of the acquiring firm’s managers and shareholders. While target firm shareholders typically earn 30% to 40% premiums, M&A transactions do not create value on average for the acquirer’s stockholders. This information should make it clear that a carefully designed acquisition strategy, realistic estimates of the potential synergies, and an efficient imple- mentation plan are critical if the historical odds are to be overcome. Managers must understand that the only source of incremental value in corporate mergers and acquisitions is incremental future cash flows or reduced risk. These cash flows can come from increased revenues, reduced costs, or tax savings. The sum of the potential value created from these incremental cash flows is called synergy. For a deal to be successful financially the premium paid and the costs of the transaction must be less than the deal’s total synergy. 590 Making Key Strategic Decisions Only then will the bidder’s shareholders see their wealth increase. This sounds simple, but in a competitive market for corporate control, there must be a rel- atively unique relationship between the bidder and the target that other firms cannot easily match. The market must perceive the target as worth more as part of your firm than alone or with some other firm. There are many practical details that potentially impact the creation of value in M&A transactions. These include the choice of payment (cash vs. stock), the accounting method (purchase or pooling), tax considerations, and antitrust concerns. Each of these may affect future cash flows and synergies and therefore must be part of the premerger due diligence process. We de- scribe briefly how each factor can impact value creation, but refer potential bidders to investment bankers, professional accountants, tax experts, and attor- neys for the most timely and customized advice. The final and most important part of the process is the postmerger imple- mentation plan. Managers often focus on completing the transaction, which is unfortunate, since the transition to a single organization is where the keys to value creation lie. A detailed implementation plan must be developed before the transaction closes and communicated quickly and effectively to employees by the firm’s new leadership. The plan must focus on the roots of synergy in the deal to ensure the successful creation of the anticipated shareholder value. In deals where there are major cultural differences, special attention must be paid to smoothly integrating these differences. Failure to do so can doom an otherwise sound transaction. In the end, profitable growth by acquisition is possible but difficult. The market for corporate control is competitive and it is easy for bidders to overes- timate potential synergies and therefore overpay for acquisitions. To avoid this, managers must develop and stick to an acquisition plan that makes strategic and financial sense. Only then can they hope to overcome history, human nature, and the odds against successfully creating shareholder value through mergers and acquisitions. Our hope is that this chapter provides the basic in- formation needed to embark on such a course. FOR FURTHER R EADING Morosini, Piero, Managing Cultural Differences (New York: Elsevier, 1997). A com- prehensive discussion of culture’s role in mergers and other corporate alliances. The focus is on cross-border deals, but the strategies for effective implementa- tion can be used by all. Sirower, Mark L., The Synergy Trap: How Companies Lose the Acquisition Game (New York: Free Press, 1997). Focuses on assessing the potential for synergies and value creation in mergers. V lasic, Bill, and Bradley A. Stertz, Taken for a Ride: How Daimler-Benz Drove Off with Chrysler (New York: HarperCollins, 2000). A fascinating behind-the- scenes look Profitable Growth by Acquisition 591 at the Daimler-Benz-Chrysler deal. Clearly shows the roles of culture, human nature, and managerial hubris in M&A transactions. Weston, J. Fred, Kwang S. Chung, and Juan A. Siu, Takeovers, Restructuring, and Corporate Governance (Upper Saddle River, NJ: Prentice-Hall, 1998). An ex- cellent reference for developing and implementing an effective M&A strategy. INTER N ET LINKS www.cnnfn.cnn.com/news/deals Up-to-date stories on deals, all free information www.stern.nyu.edu/∼adamodar Academic site with numerous quantitative examples and spreadsheets that can be used to value potential synergies www.mergerstat.com Comprehensive source of M&A data; some good free information www.webmergers.com Good reports on M&A activity of internet companies NOTES 1. For a concise summary of and more detail on empirical tests of M&A perfor- mance see chapter 7 of J. Fred Weston, Kwang S. Chung, and Juan A. Siu, Takeovers, Restructuring, and Corporate Governance (Upper Saddle River, NJ: Prentice-Hall, 1998). 2. Anup Agrawal, Jeffrey F. Jaffe, and Gershon N. Mandelker, “The Post- Merger Performance of Acquiring Firsms: A Re-examination of an Anomaly,” Journal of Finance 47 (September 1992): 1605–1621. 3. Weston, Chung, and Siu, 133, 140. 4. Business Week, October 30, 1995. 5. Merger & Acquisition Integration Excellence (Chapel Hill, NC: Best Prac- tices, 2000). 6. For a more thorough discussion of this topic, see Weston, Chung, and Siu, chapter 5. 7. The Wall Street Journal, November 30, 2000, B4. 8. Ibid. 9. Business Week, April 20, 1998, 37. 10. Business Week, October 16, 1995, 38. 11. The Wall Street Journal, September 21, 2000, C22. 12. The Wall Street Journal/New England, July 28, 1999, NE3. 13. See Harvard Business School case #285053, Gulf Oil Corp—Takeover, for a complete discussion of this value creation. 592 Making Key Strategic Decisions 14. Adapted from Brian Coyle, Mergers and Acquisitions (Chicago: Glenlake, 2000), 32. 15. J. Fred Weston and Brian Johnson, “What It Takes for a Deal to Win Stock Market Approval,” Mergers and Acquisition 34, no. 2 (September/October 1999): 45. 16. Weston and Johnson, 45. 17. “M&A Time Line,” Mergers & Acquisitions, 35(8) (September 2000): 30. 18. Ira Smolowitz and Clayton Hillyer, Working Paper, 1996, Bureau of Business Research, American International College, Springfield, MA. 19. Business Week, November 8, 1999, 125. 593 18 BUSINESS VALUATION Michael A. Crain It has been said that determining the value of an investment in a closely held business is similar to analyzing securities of public companies. The theories are similar and not overly complex on the surface. There are even Web sites that proclaim to be able to value a private business. But like so many things in the business world, the devil is in the details. The valuation of a closely held busi- ness depends on many variables. While the theories of valuation are not overly complicated, the accuracy of the valuation result is only as good as the vari- ables that go into it. The valuation of closely held businesses is often compli- cated because of the limitations of the underlying information and the way private businesses are operated. Unlike public companies, private businesses often do not have complete and accurate information available. Dollar for dol- lar, the time to accurately value most profitable private companies is out of proportion to the analysis of public-company securities. This is illustrated in the following case study that demonstrates the financial theories of business valuation and the level of information needed for an accurate result. For the past 20 years, Bob has owned and operated a manufacturing business that has grown significantly since its inception. Bob is approaching 60 years of age and his children do not appear capable of taking over the company. He is contemplating the future of the business at a time when he would like to slow down. One of his options is selling his business. Bob’s company, ACME Manu- facturing Inc. is a manufacturer of certain types of adhesives and sealants and has revenues of approximately $50 million. It has six manufacturing locations throughout the country. Bob owns 100% of the company’s common stock. He does not know what the company is worth, nor does he know how its value 594 Making Key Strategic Decisions would be determined. Bob asked his certified public accountant (CPA) about valuing the business. The CPA tells him that it would be most appropriate to engage someone who specializes in business valuations. After interviewing sev- eral candidates, Bob hires Victoria to appraise his business. The valuation date is December 31, 2000, and the standard of value is fair market value. Victoria explains the appraisal process and the scope of her work. THR EE APPROACH ES TO VALUE Victoria tells Bob that the value of a business is determined by considering three approaches. 1. Income approach. 2. Market approach. 3. Asset (or cost) approach. The income approach is a general way of determining the value using a method to convert anticipated financial benefits, such as cash flows, into a present single amount. This approach is based on the concept that the value of something is its expected future benefits expressed in present value dollars. (A simple example of present value is that a dollar received a year from now is worth less than a dollar today.) The market approach is a general way of determining a value comparing the asset to similar assets that have been sold. For example, real estate ap- praisals using the market approach rely on the sales prices of comparable prop- erties. In business valuation, it is sometimes possible to locate similar businesses that have sold and are appropriate to use as guidelines in the appraisal. The asset approach is a general way of determining the value based on the individual values of the assets of that business less its liabilities. The company’s balance sheet serves as a starting point for this approach. The proper applica- tion requires that all of the business’s assets be identified. Often, the balance sheet prepared in accordance with general accepted accounting principals does not include assets that have been created within the company such as goodwill and other intangible assets. Once all the company assets and liabili- ties have been identified, each one is valued separately. DIFFER ENT TYPES OF BUYERS Victoria explains to Bob that buyers have different motives for acquiring busi- nesses and they may be willing to pay different prices for the same business. Most buyer motives can be grouped into these categories: • Financial buyers. These buyers are primarily motivated by getting an ap- propriate rate of return on their investment. Financial buyers generally have a much broader range of investment alternatives than other types of Business Valuation 595 buyers. Also, financial buyers often have an exit strategy to sell their in- vestment at some time in the future. They usually pay fair market value (defined next). • Strategic/investment buyers. These buyers probably already know the company or already operate in its industry. Therefore, the number of strategic buyers for a particular business is typically more limited than the market of financial buyers. A strategic buyer is usually looking at in- tegrating its operations with the purchased business. Most of these buyers will pay a price that reflects certain synergies that are not readily avail- able to financial buyers. This price is called investment value, which is different than fair market value. The smallest of businesses, sometimes called “mom and pop businesses,” often have two other groups of buyers—lifestyle buyers and buyers of employ- ment. A lifestyle buyer is looking to acquire a business that gives him or her a desired lifestyle (e.g., a motel in the mountains). Another group of buyers of small businesses is primarily motivated to provide employment for the buyer and/or the family. Among strategic and financial buyers, strategic buyers will usually pay a higher price because of the anticipated synergies between the two businesses. After explaining the different types of buyers to Bob, Victoria discusses how it applies to ACME. Obviously, Bob would like to obtain the highest price possible if he sold his business. However, Victoria has no way to foresee who that buyer may be or that buyer’s strategic motives for buying ACME. There- fore, she is going to determine what a financial buyer would likely pay—the company’s “fair market value.” Practically, determining the fair market value will assist Bob in establishing a target minimum price to accept when selling ACME. If Bob can locate a particular strategic buyer who would pay a strate- gic price (or investment value), he will try to obtain a higher price. Bob asks Victoria to explain fair market value and how it differs from in- vestment value. She tells him that fair market value is defined as “the price, ex- pressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.” 1 Fair market value contemplates what the “market” will pay. Investment value is the price a specific investor would pay based on individual requirements and expectations. It frequently reflects a higher price for the unique synergies between the buyer and company. AN OVERVIEW OF THE BUSINESS VALUATION PROCESS Victoria explains to Bob that a complete business appraisal is both a quantita- tive and qualitative process involving a risk and investment return analysis. A 596 Making Key Strategic Decisions complete valuation is more than simply analyzing the historic financial state- ments of the business and then making future projections. Valuations that give the most accurate results consider qualitative matters such as technology changes, the company’s competition, and its customers. In addition, other areas that are considered are macro-environment issues such as the industry and the national and local economic factors that affect the particular business. A com- plete business valuation will consider the following areas: • Analysis of the company. • Industry analysis. • Economic analysis. • Analysis of the company’s financial statements. • Application of the appropriate valuation methodologies. • Application of any appropriate valuation discounts or premiums. A large part of valuing a business is the assessment of the investment risk of buying and owning the business. A buyer of the business assumes the risk that he or she will actually receive the anticipated economic benefits. Of course, there is no guarantee of actually receiving the projected income. A fundamental concept in business valuation is the risk-reward relationship in making any kind of investment. Rational individuals and companies make in- vestment decisions regularly by comparing the risk of an investment to the anticipated rewards. For example, a certificate of deposit from a bank that is guaranteed from default may have a rate of return (interest) of 5%. This in- vestment has little or no risk. Investments in large public company (large-cap) stocks have traditionally returned an average of 10% to 12% per year over the long term. Small public company (small-cap) stocks have average historical rates of return in the 15% to 20% range over the long term. These three types of investments illustrate the risk-reward relationship investors have in making decisions. Buying large-cap stocks instead of a certificate of deposit carries more risk and, thus, the market rewards the investor with a higher rate of re- turn. Small-cap stocks over the long term have been more risky than large company stocks and have rewarded investors even more with higher returns. Simplistically, the valuation of a closely held business considers the risk of an investment in the company and compares it to alternative forms of investments. Victoria further explains that valuation concepts are founded in several economic principles. The first is the principle of alternatives that states that each person has alternatives to completing a particular transaction. In the pre- ceding example, the individual has the alternatives of investing funds in a bank certificate of deposit, large-cap stocks, or small-cap stocks. Investing in a busi- ness is yet another alternative. The second economic principle in valuation is the principle of substitution. This states that the value of something tends to be determined by the cost of acquiring an equally desirable substitute. For ex- ample, if a new restaurant offers steak on its menu, it will likely have a price similar to other restaurants selling steak (all things being equal). The first Business Valuation 597 restaurant will probably not sell very many steaks if the price is double what the customer could buy at another restaurant. Likewise, a potential purchaser of a business is not likely to pay significantly more than the price he or she can purchase a similar business. In business valuation, we must remember that buyers/investors have many places to invest their money and they will generally not pay significantly more for a business than the price of comparable investments. Thus, a business valu- ation will generally benchmark the profitable private company against alterna- tive investments. This involves an analysis of the risk of those investments as well as those of the business being valued. INDUSTRY ANALYSIS ACME operates in the adhesive and sealant industry. The U.S. government’s Standard Industrial Classification (SIC) is number 2891. Victoria researches this industry and finds that the segment consists of approximately 1,100 U.S. estab- lishments primarily engaged in manufacturing industrial and household adhe- sives, glues, caulking compounds, sealants, and linoleum, tile, and rubber cements. The annual sales in this industry segment are $16.9 billion, and the in- dustry employs roughly 36,000 people. Also, the industry has grown at an aver- age annual compound rate of 6.7% over the past 10 years. Victoria finds that this industry segment is a large growing global segment. However, the U.S. portion is highly fragmented and a significant majority of the industry participants are small and regional companies. It is expected that the industry will consolidate as companies seek to enhance operating efficiencies and new product development, sales and marketing, distribution, production, and administrative overhead. Victoria concludes that the industry outlook is positive in revenue and earnings expectations but moderated by the level of competition from numer- ous, smaller companies selling similar products. THE FUNDAMENTAL POSITION OF THE COMPANY During Victoria’s management interview, she discovers that Bob founded ACME 20 years ago. The company’s history has been one of relative success. It started in a small garage and grew by expanding the number of products and its customer base. Over the years, ACME acquired new facilities, not only in its hometown but in other cities as well. The company’s growth was primarily funded by reinvesting its profits and with long-term financing when purchasing real estate. During the past five years, ACME’s sales increased from $34 mil- lion to $50 million. ACME currently expects to expand its manufacturing ca- pacity by adding equipment to the existing locations. Victoria’s investigation into ACME’s competitors reveals competition from numerous companies, many of which are small, privately held businesses. . be- tween executives as the German managers watched their American counter- parts walk away with multimillion-dollar payoffs from their Chrysler stock options. employees of their role in executing this vision. While all employees should be part of this process, those that deal with the firms’ customers should receive