Common Misperceptions and Myths in Mergers & Acquisitions

The volume of unsolicited acquisition inquiries made to privately-owned companies is staggering. Some owners are confronted with two to three inquiries each week. One company owner recently informed me that he evaluates the M&A environment by tracking the monthly inquiries from would-be suitors. There is, however, no correlation. Another owner shared that he gauges valuation trends by monitoring what multiples such solicitors indicate they are looking to pay these days. Again, not a good barometer. 

Consolidation in the orthopedic industry is indeed rising, driven in part by owners’ concerns about impending wealth-eating tax rate hikes (capital gains, ordinary income, and estate taxes) and bleak macro-economic conditions, about OEMs looking to streamline their supply chains, and about competitive and pricing dynamics within the orthopedic industry. Such consolidation activity may sustain valuations for a time. For those owners contemplating a sale or recapitalization (to diversify some of their wealth away from the business), a reactive approach to value maximization is fraught with danger.

Solicitations come from business brokers trying to whimsically connect buyers and sellers for a commission and boiler rooms of new MBA grads hired by private equity firms hunting for the extremely small percentage of interested potential sellers that match their specific criteria (which vary widely across thousands of firms). In addition, while strategic buyers often undertake proactive buy-side searches, they too are fishing above the water from where it is difficult to distinguish size, quality and attributes of potential acquisition “keepers” simply from websites, exhibit booth displays or comments from OEMs shared in common. Because business owners are prudently reluctant to discuss selling their companies with an industry competitor or peer, strategic buyers often utilize a buy-side search firm who may or may not truly understand the merits of a potential fit. Combined with easier access to company-owner contact information (the web contains everything now), such intense solicitation activity creates challenges for interested sellers, where any legitimate approach gets lost in the noise.

Nevertheless, many owners contemplating an exit limit discussions to parties with whom they are familiar and/or by whom they have been approached. It might seem that a sequential process of engaging with those who express genuine and knowledgeable interest might reduce market exposure and lead to maximum value. However, market exposure is far more a function of time than number, so exposure increases as the process is extended for each additional buyer.

Buyers know when they’re negotiating against themselves, and an owner’s prerogative not to sell is not leverage during negotiations. Even if a familiar suitor offers an attractive price in a letter of intent, the probability of a deal getting re-priced is substantially higher and a seller’s position on all other key terms is severely weakened without negotiating leverage. While customary, granting a period of exclusivity should be postponed until parties have reached specific deal-related milestones. The buyer must believe a seller has options with other buyers in order to close at the price initially agreed upon and under favorable terms and conditions surviving definitive documentation. The mere fact that other logical buyers likely exist provides little, if any, leverage. Real leverage comes from running a highly organized process that leaves no doubt in any buyer’s mind that other qualified acquirers have also completed their evaluation of identical key information and negotiated the same opportunity. How would an owner have any confidence that, of the myriad terms and conditions in a transaction, the “best” was obtained if companies were considered sequentially? What buyers know that sellers rarely appreciate is how substantial the opportunity, transaction and emotional costs are for an owner deep into a transaction process that gets aborted.

Many sellers believe a buyer values his or her business by applying a multiple to a profit or cash flow metric (e.g., EBITDA). Purchase price multiples are a post-mortem account, where the multiple is generally by-product of the deal price. While conceptually complex, valuation multiples reflect a required return on investment and confidence in the growth of that multiple parameter—the greater the risk, the higher the required rate of return, the lower the multiple and so on. While an EBITDA multiple or range may be used in early negotiations, buyers should examine the facts and circumstances surrounding the company and transaction to determine ultimate price.

In many instances, the value of a business in simplified terms is equal to the future free cash flows discounted back at a risk-adjusted rate. The value may be higher (i.e., a premium) to a different owner because synergies arising from the combination lead to greater free cash flows and/or because a lower discount rate is justified. Because future cash flows are subjective, valuation is a blend of both quantitative and qualitative factors, and all companies are valued differently based on different attributes, many of which can be reasonably quantified. Value is derived from the business’s perceived opportunity for expansion and cash flow growth, reinforced by specific technologies, capabilities, competencies, cost synergies, customers and/or capacity that can be utilized across a buyer’s business. Valuation is also based on the risk associated with the business’s prospects. While many risk factors in the orthopedic industry—such as reimbursement, the regulatory climate, raw material prices or threatening new technologies—cannot be controlled, several factors remain within the owner's control. In addition to having strong financial and operational controls, owners can minimize risk with an optimal product mix, diversified/repeat customer base and solid, deep management capabilities.

How such valuation analyses translate into offers in the real world of M&A is what’s important. A fundamental principle of corporate finance is that a company needs to create economic value in excess of its cost of capital in order to increase shareholder value. Consequently, buyers generally have a benchmark level of return they seek on deployed capital (which can be quite different across public and private companies). Such benchmark return is applied to an analysis of the specific target company involving an assessment of the various value drivers of the particular company. In evaluating the financial prospects of the business, a buyer’s financial modeling frequently incorporates a quantification of synergies expected to be enjoyed from the acquisition along with growth and/or profit “haircuts” commensurate with the perceived risks. In the end, if too large a purchase price is offered, then the return on invested capital will not meet the benchmark return (oftentimes compared to other acquisition or investment opportunities). Conversely, low acquisition prices that produce returns beyond the benchmark threshold provide an incremental, surplus of greater value for the buyer.

Consequently, a buyer’s valuation assessment will be based upon: (i) the benchmark return the buyer expects on the purchase of the business, (ii) the buyer’s expectation of an acquired business’s future performance, (iii) the buyer’s assessment of how a seller’s business expands, strengthens (i.e., reduces risks) or accelerates the growth and strategic objectives of the buyer’s business, and (iv) the economic factors affecting the M&A market (e.g., cost and
availability of capital and industry economic cycle). While the first (benchmark return) and last (M&A market environment) determinants are beyond the control of the seller and do not differ significantly among buyers, the remaining key factors (how a buyer perceives the opportunity and risks associated with the acquired business) are not and do. This explains why valuation in the context of an M&A transaction is part science and a whole lot of art. Because its return on investment is inversely related to the purchase price, a buyer will strive to secure the deal at the lowest price possible, hoping to greatly exceed their benchmark return. Every buyer is unique, basing their decisions on their own perceived opportunities and risks of an acquisition. A seller can shape such perceptions through effective positioning and an orchestrated process to positively influence the ultimate determinant of value—what a buyer is willing to pay.

In responding to unsolicited approaches, a seller lacks the opportunity to shape such perceptions or to have negotiating leverage to sustain them. An attractively positioned confidential information memorandum and well-prepared data room are critical in managing expectations, enhancing valuation, facilitating negotiation of definitive documentation and schedules, and avoiding surprises. Proper positioning, or re-casting, of the historical and projected financial performance of the business is essential in maximizing value. Pro forma financials can include a variety of arcane accounting and other legitimate adjustments that have substantial impact. On the one hand, overlooked items can lead to understating financial potential substantially. On the other, inflated or unsubstantiated items can jeopardize a transaction by compromising credibility.

Even well-run businesses in highly regulated industries rarely are in a position to undergo a buyer’s due diligence process or to present the opportunities and risks of their companies in a manner familiar to the audience. A seller forfeits the opportunity to inspire trust and confidence if it approaches the due diligence process on an ad hoc basis. A buyer is entitled to responses to legitimate questions or to have real issues resolved, neither of which should a seller be dealing with in the midst of a negotiation or closing process. Delays caused by the seller lead to good faith requests for exclusivity extensions, and time is a seller’s worst enemy. However, it is dangerous to rush forward once a price is agreed upon, assuming the details can wait. If the key details are not negotiated up front, not only does it become very difficult to compare one offer to another, but significant leverage on open key terms may be lost. In negotiating a transaction, the variables are extensive, including valuation, form of consideration, earn-outs, structure, timing, financing contingencies, closing working capital adjustments, representations and warranties, indemnification, holdbacks/escrows, employee matters, covenants, conditions precedent, due diligence process, etc. For example, it is customary for M&A transactions to contain post-closing adjustments to protect both the buyer and seller from any material differences between the expected levels of adjusted net working capital and the actual level at closing. This frequently becomes a major point of contention when acceptable formulas are not negotiated at the outset.

Given the intensity of the process and the anxiety associated with selling, owners frequently become distracted from operations. Underperforming between LOI and closing can raise concerns over credibility of the forecast on which valuation was based and lead to renegotiation. The company’s management must remain focused on advancing the business, ensuring that operations will perform during the process. Owners contemplating a transaction should be prepared and utilize M&A advisory expertise; this will likely be the most important wealth transformation event of their lifetime. Accountants, lawyers, wealth managers and commercial bankers are trusted advisors for entrepreneurs and their families, but all possess different skill sets from M&A advisors. In addition to being schooled in and devoted to corporate finance, M&A advisors know the universe of qualified prospective buyers, the rationale making them so and how to position a business and run a process in a manner to extract optimal terms. While they initiate and negotiate transactions with motivated transaction parties on behalf of sellers, they also act as quarterback with the company’s legal and accounting teams to the benefit of its owners. Entrepreneurs create valuable companies; M&A advisors can substantially help harness the value entrepreneurs create.

There is indeed an optimal time to sell a business, and it is not when solicitation interest seems high. As I’m asked frequently, I tell owners that three criteria dictate the optimal time to maximize value, and each evolves, requiring constant monitoring. The first is lifestyle priorities, when financial value trumps personal or emotional value. The second is the state of the capital markets and the industry-specific mergers-and-acquisitions environment, because a business’s value changes with market conditions and M&A supply/demand forces. The third is the business’s specific position on its growth curve (best not to be at the peak). Lastly, buyers do not ascribe increased value to effort or sacrifices—only successful execution of a plan poised for significant growth potential.

David Reilly is a managing director of Viant Capital LLC, an investment banking firm that specializes in mergers and acquisitions, private placements and financial advisory services. He leads the firm’s healthcare practice and can be reached at (203) 682 – 1880 or DReilly@ViantGroup.com.

Jean-Paul Burtin is a valued thought leader to Viant Capital’s orthopedics practice. He is a 20-year veteran of the orthopedic industry having experience with both OEMs and suppliers.

Author’s Note: Nothing contained in this article is to be considered the rendering of financial, investment or professional advice for specific circumstances. Readers are responsible for obtaining such advice from professional advisors and are encouraged to do so.