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How Mergers and Acquisitions Create Value

Recent merger and acquisition activity, especially in the core middle market manufacturing base, appears to be driven by the realization that well-managed business combinations can create value. "Synergy" refers to the phenomenon that occurs when the value of the combined enterprise exceeds the value of the companies taken separately. Synergies have a real impact on many transactions. The question for buyers and sellers is: "How much value will be created by the proposed transaction, and how do I ensure that I am appropriately compensated for such value?"

Common synergies include:

Elimination of duplicate staffing, particularly in administration, accounting, and human resources
Sale of excess plants, property, and equipment by combining manufacturing facilities. This may also lead to additional reductions in labor and overhead
Reduced risk management, benefit, and compensation costs
Economies of scale and expanded opportunities in purchasing, marketing, distribution, and research and development
Greater access to capital, at a lower cost
Increased market power

The remainder of this article discusses how potential synergies should be addressed by buyers and sellers.

Buyers

Although a buyer should have ample opportunity to quantify potential synergistic benefits during due diligence, in most cases the purchase price is agreed to in advance. The buyer should make high-level assumptions regarding available synergies and request supporting data from the seller. In addition, the letter of intent should provide the buyer with an exit strategy should due diligence indicate that the projected cash flow is materially less than originally anticipated.

In general, when synergies are expected to create significant value, the buyer should:

Assemble its internal and external due diligence teams well in advance
Identify additional experts required for specific due diligence areas, such as environmental, pensions and benefits, and risk insurance
Outline reporting formats, assign responsibilities, and set deadlines
Prepare detailed projections of synergistic benefits for each operational and administrative area
Consolidate operating projections and develop cash flow forecasts to determine the appropriate value and capital structure
Receive "buy-in" from those charged with implementation
This is essential in order to maximize the likelihood of capturing all available synergies

Sellers

The seller should design its marketing strategy to create a competitive atmosphere among potential buyers. In addition to presenting the company's key attributes in the customary selling memorandum, the seller should highlight the synergies available to key classes of strategic buyers. Among other things, the seller should:

Adjust operating income and cash flow for any unusual or nonrecurring items such as excess owners' compensation or one-time capital expenditures
Prepare pro forma projections that consider the benefits available to strategic buyers
Develop a list of prospective actions that can result in additional cash flow

The seller should be actively involved in managing the due diligence process and should request regular meetings with the buyer's due diligence team to ensure that information is being interpreted correctly and potential synergies are recognized. In addition, key managers should be given proper incentives to represent the company in the most favorable manner possible.

How Much Will a Buyer Pay?

Sellers can enhance their chances of receiving maximum credit for potential synergies by creating a competitive atmosphere during the selling process. Here are a few tips:

Approach financial as well as strategic buyers. Even if financial buyers cannot compete because of the synergies available to strategic buyers, they can help set a floor for the valuation and create a competitive atmosphere
Make sure all interested parties have all relevant information and are interpreting it correctly
Research individual potential buyers. Try to quantify the benefits they could derive from the proposed transaction
Manage the process by keeping all potential buyers on the same schedule and controlling access to key information and employees
When soliciting bids, request a discussion of the buyers' valuation methods
Be creative when negotiating payment for the value created by the synergies
Most important, be prepared to help potential buyers analyze the benefits of the transaction. Too often, sellers leave money on the table by failing to communicate to buyers the value of available synergies.

Conclusion

Transactions being contemplated primarily for potential synergies present challenges to both buyers and sellers. The buyer's challenge is to identify and quantify all benefits of the business combination so it can accurately project cash flows and value the business. The seller's challenge is to create a competitive atmosphere and effectively negotiate for the synergistic value.

By Fred Rock

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