9 Reasons Why Mergers Fail (and How to Avoid Them)
by Rachel Boynton, CM&AA
Volume 6 Issue 22, November 5, 2019
At least seven out of 10. That’s on the low end of how many mergers and acquisitions (M&As) are likely to fail. The high end? Nine out of 10. And these are no misprints. It’s the conclusion of research, as referenced by Harvard Business Review and other publications. That means 30% of M&As at most succeed, while only 10% are essentially assured to succeed.
With statistics like that, why would you consider selling your business — especially if you care about the future of the business after your exit? These figures were determined via examination of a large pool of deals in every business sector. Basic reasons frequently cited for such a high failure rate include an uninvolved seller, culture shock at the time of the integration, and poor communications from the beginning to the end of the M&A process.
Based on my experience, M&As can be navigated very successfully if you have the right information and team to work with. It also helps to understand what can go wrong and how to avoid making such mistakes.
Here are nine causes for failed mergers and what I believe is necessary to address such shortcomings.
1. Not knowing the motivations of buyers and sellers
I have met two kinds of sellers: one just looking for the most amount of money for the business and one that needs to find the perfect buyer for the individuals, families, staff, and community related to the business. In human services, the latter is most common. Buyers, on the other hand, come in all shapes and sizes, from strategic buyers that provide the same services to investment bankers looking to build and flip — and many shades in between.
When my husband and I were selling our human services company, we met with a buyer in an ancillary business line that we thought would complement our company well. Our initial meeting with its development lead went great. He seemed to understand our vision and think it would be a strong partnership. As we started performing due diligence, the buyer’s team came for a visit. When the meeting started, all of these strangers started asking about “empty beds” and “patients.” This was alarming as we were not in the medical field and never used this terminology or treated people in such a way. We started to feel insulted by their lack of understanding of our business. They then started discussing future initiatives as if they already owned the business and our people in the room did not matter.
My husband and I left that meeting with the same sick feeling. We killed the deal that night. No amount of money would make that deal ever feel good or right.
I always discuss what is most important to my sellers during our first meeting. I also screen all of the buyers to understand their intention and assess if there is a cultural fit. It’s not a perfect science, but these initial steps can help determine the success of a deal.
2. Unrealistic expectations
I worked with some sellers who had been in the human services industry for about 15 years. They spent tireless hours providing stellar services and were growing aggressively. When we received our first offer for their business, it was a 6x multiple of their adjusted earnings before interest, tax, depreciation, and amortization (EBITDA). I felt pretty good. However, the sellers insisted on receiving at least a specific amount of money — a particularly high amount — because they believed the company was worth that much.
During a lengthy discussion, I explained why the figure they envisioned was unreasonable. The financial analysis showed a ceiling that would be close to impossible to break. Most buyers are unwilling to cross certain thresholds, regardless of how amazing a business may be (or seem to be to a seller).
A seasoned M&A professional can help prepare a seller ahead of time for the selling experience, including what offers to anticipate. Both parties should reach an understanding of the expectations of the sale before going to market.
3. Hidden debt and financial instability
Buyers are well aware that sellers sell for many reasons, including the fear of losing the company because of debt or money stresses. However, no one wants to be halfway through the due diligence process only to learn about the posting of foreclosure notices. This tension on the seller will often lead to poor decisions. Even worse, an aggressive buyer can take advantage of the situation.
Be forthcoming with your M&A advisor. Paint the complete, honest picture of your business — both its successes and struggles. The advisor may have some immediate suggestions to stabilize the situation until the right buyer is found or can help fast-track the process to maximize value. Whatever you do, don’t hide anything!
4. Inaccurate financials
The first step of our process here at VERTESS is to show sellers a financial picture of their organization the way that buyers will be assessing it. We help formalize even the most difficult financial (e.g., QuickBooks) records. We also complete a proforma that projects future earnings and opportunities.
Despite our best efforts, there are ways that these processes can lead to the presenting of incorrect information. How? The numbers we work with are provided by the sellers. If the data shared with us is incorrect, we will then be working with incorrect data (and may not catch all errors). We have seen sellers overinflate growth for future years, underestimate the cost of services, or book revenue incorrectly. We can often secure a great offer with these numbers. However, once under a letter of intent (LOI), the buyer will conduct a quality of earnings review. That’s often when we learn that the numbers that were provided to us are not accurate. The result? The buyer either adjusts the purchase price accordingly or pulls the offer.
5. Change of ownership
It’s very easy to change the name of a company owner. For one reason or another, you might decide to put your spouse or child as the owner. No big deal, right? Depends on your plans to sell the company and the regulatory standards of your payers.
In the eyes of many licensing agencies, such as the Centers for Medicare & Medicaid Services (CMS), any “change of ownership” (CHOW) must be reported to these agencies. That’s pretty straightforward. What you may not know is that CMS, as an example, has a rule preventing organizations from undergoing a CHOW more than once every 36 months. So, if you reported a change 24 months ago, the sale of your company to a new owner will have to wait 12 months. States often have their own set of regulations around the sale of an organization that could greatly affect how the deal should be structured. To ensure a smooth sale, know what guidelines exist before you start the process.
6. Inflated “add-backs”
During the financial valuation process, we calculate a seller’s EBITDA as well as the adjusted EBITDA. Adjusted EBITDA removes expenses that the seller has incurred as a business owner that the next owner will not likely incur, referred to as “add-backs.” These might be a car payment, executive development coach, or membership at the business club. Adjusted EBITDA is often the basis for valuing the company.
Most buyers will agree with such standard add-backs, but if a seller adds items of a questionable nature that the buyer does not agree with, the purchase price can experience a drastic adjustment. It’s important to not only understand each add-back that you list, but be ready to support why it is an expense that the future owner will not need to incur. A seller might receive an initial offer that appears generous, but once add-backs are discredited, the price may not be what was anticipated.
7. Lack of communication
The M&A process is lengthy and can take many months — sometimes even a year or more. Communication begins with how your company is represented to buyers at the time of introductions. It becomes more intense during the negotiations of an LOI and finally during closing. Breakdowns in communication can jeopardize a deal at any of these stages.
Maintaining consistent, transparent communication throughout the due diligence process can support a smoother experience. Expectations should be made clear between the buyer and seller, better ensuring that each of their priorities for the future are aligned. This can help avoid future culture shocks.
Enlisting the expertise of a knowledgeable advisor to communicate the good, bad, and ugly between buyer and seller can help avoid discomfort and allow each party to work comfortably together after the closing. It is important to know that one person is overseeing each step of the process, from introduction to integration.
8. Poor representation
One of my most trusted advisors as a business owner was my corporate lawyer. He represented us for years and was essentially a part of the organization’s family. I knew he had our best interest at heart whenever he reviewed a situation with us. He provided tremendous advice and guidance to us over the years, but one of the most important pieces of advice he shared with us was when he told us not to work with him.
When it was time to sell, he referred us to a lawyer specializing in M&A. I remain grateful to him for this guidance. I have worked with clients who have used their trusted lawyer/friend to represent them during the selling stage. What many of them found was doing so resulted in making the process painfully confusing, time-consuming, and frustrating, often causing the deal to fail.
Let’s face it: Buyers are typically experienced and have gone through the M&A process multiple times. Sellers, most likely, have not, which is why they need a lawyer with experience in this area. The details and language involved in an M&A transaction are often complex. There is often common language and terms that an experienced M&A lawyer will know to look for, so that a seller’s best interest is represented in the deal. Such a lawyer will also not waste time on other common protections for the buyer. If your lawyer is arguing over language or points that are typically standard in a deal, not only are you wasting your time, but you may be frustrating and insulting the buyer.
Make sure that you have someone in your corner who knows the legal pitfalls and vulnerabilities you will come across during the final stages of a deal. This will help ensure you receive the most protection while understanding the nuances of the legal jargon.
9. All eggs in one basket
When it comes time to sell your company, you may be tempted to jump at the first prospective buyer that approaches you with a reasonable offer and good fit from a culture perspective. After all, doing so will seemingly reduce the length and stress of the selling process. This approach can work well, but I have also seen it go south very quickly. The reason: If the buyer knows or believes that it’s in the driver’s seat, it may pay what it thinks is a reasonable price, not necessarily what the seller thinks is fair.
Without competition, a seller loses critical leverage and may be pressured into compromises. I worked with a client who was approached by a buyer directly. This buyer offered an amazing multiple for his company. It was the first offered he received. On paper, it looked like a great deal. Sadly, once the LOI was signed, the buyer quickly pulled apart the financials and discounted so many items that the multiple was no longer desirable. Fortunately, the seller was knowledgeable about what he deserved to receive for the company and quickly pulled out of the deal. Unfortunately, he had not engaged in discussions with other prospective buyers, so he lacked alternative avenues to explore. He then started over with me. If we had started the process together from the beginning, when the initial deal fell through, we could have quickly pivoted to other interested buyers.
Making the Best of a Challenging Situation
I shared the M&A statistics at the beginning of this column not to discourage you from selling your company, but to paint a realistic picture of the marketplace. The good news is that with the proper preparation, open communication and knowledge of the M&A process, and support by a team of competent, skilled advisors, you will greatly increase the likelihood of being in the minority of companies that achieve a successful merger.