Mergers and acquisitions are headline-grabbing events that are often the pinnacle of a CEO’s career. But they also often fail to generate value, as numerous studies over the years have shown.
With over 15 years of experience doing M&A deals, Toptal Finance Expert Javier Enrile shows that the main reason for disappointing results is simple: Most people think M&A is merely an exercise of agreeing on a price for the deal. What they fail to understand is that there is a science to doing M&A that often makes the difference between a deal being successful or not.
In this article, Enrile runs through three key tactics for ensuring your company can get the most value out of an M&A transaction.
In the professional life of a CEO, a merger or acquisition can be one of the most exciting events that take place, if not the pinnacle of one’s career. M&A deals are headline-grabbing events that can propel companies to levels that organic growth alone would otherwise never have been able to reach. But as many studies show, M&A deals often don’t pan out quite the way they were planned. A recent study by S&P Global Market Intelligence, for instance, showed that share prices of firms in the Russell 3000 index that had acquired a company between January 2001 and August 2017 tended to underperform the broader index. As for the reasons for this disappointing performance, the same study found that relative to the peer group, acquiring company net profit margins tended to fall, as did the returns on capital and equity. Earnings per share also grew less quickly, and debt and interest expense figures tended to increase.
The Fineprint Matters: Using Legal Documentation to Manage Risk in the Negotiation Process Effectively
In 20 years of working on M&A deals, I’ve heard the following sentence from both buyers and sellers far too many times: “Javier, thank you for getting the purchase price agreed and term sheet done; let’s send it to the lawyers to put it in writing and call it a day.” Or even more problematic, “These contracts are a maze of mumbo-jumbo which I don’t care about; the relationship is what matters.” The M&A negotiation process is often misperceived as simply a process of striking an agreement on the purchase price, forgetting the just-as-important risk allocation exercise that occurs in the negotiation of definitive contracts. Some market participants have not gone through a bad experience (e.g., when the target firm is not what it was supposed to be) in an M&A transaction and, therefore, lack the tacit knowledge of the importance of having well-negotiated definitive contracts. This is often the difference between losing all the capital at risk or recovering 80% or 90% of it.
The legal framework creates the structural edifice of the negotiation process. It serves four main purposes: (1) to memorialize in detailed legal language the business understanding between the parties, (2) to allocate risks, (3) to gather more information, and (4) to set out the consequences to each party when things go wrong.
The legal framework can be divided into two main phases: the first phase encompasses the Letter of Intent (LOI) (also called a Term Sheet or Memorandum of Understanding), and the second phase includes the definitive contracts and the due diligence process, which aims to transform data into intelligence to guide the negotiation process.
Before arriving at the Letter of Intent, the two sides have little to show but a degree of conviction that the potential transaction meets their respective strategic objectives and some sense of the level of chemistry between the management teams. The purpose of the LOI is to set the key terms of the deal: the price, form of payment, and structure. It also serves as a means to confirm the understanding, express commitment to the transaction, and set the ground rules for future negotiations. While in some cases, practitioners opt to skip this phase and move directly into phase II on the grounds that it saves time and cost, I always recommend taking the time and effort to draft and negotiate an LOI to ensure that there is agreement on the main terms before diving into the lengthy and costly process of performing due diligence and negotiating definitive contracts.
Sample Term Sheet
The use of negotiating leverage at different phases of the deal to increase negotiating strength is a perfect example of how having expert advice ensures effective negotiations. A key point in negotiating an LOI is to understand how negotiating leverage shifts as the deal cycle moves along. The seller achieves the maximum leverage right when the LOI is being arranged, as they can exploit the competitive tension created by having many buyers interested. From that point on in the deal cycle, the seller’s leverage declines while the buyer’s leverage increases. After the LOI has been signed, typically, the seller will be in exclusive negotiations with one buyer (or, at most, two), which decreases the competitive tension mentioned above. In addition, with time, one or more of these circumstances could arise: (1) the content and terms of the LOI could be leaked, potentially causing several complications (e.g., employees could get nervous and start seeking other jobs or customers may become concerned about whether the new owner will increase prices or fail to provide the same level of service which may lead them to look for another provider), (2) a seller can also get emotionally attached to the idea of the sale and begin thinking about ways of spending or investing the proceeds, or, if they are owner-executives, moving on to other activities (including retirement). All of these circumstances reduce the seller’s leverage as it makes it harder for a seller to resist demands from the buyer after the LOI is signed. The phrase “becoming wedded to the deal” is an apt one.
Practitioners have unique insight into how the leverage shifts at each step of the negotiation process and use this insight to obtain the best possible outcome. For example, buyers should attempt to keep the LOI short and more general, deferring negotiating key issues in the definitive contracts phase where their leverage level has increased. Conversely, sellers should attempt to have the LOI as detailed and comprehensive as possible so that it takes advantage of its optimal bargaining positions.