Winning an M & A beauty contest

A friend today related over lunch a choice he's currently facing: which of three competing startups to acquire.  How does he think about this choice?  Here's a great chance to see Design For Exit principles in action.

Let me lay out the scenario.  Bob (I'll call him) is the newly-appointed business development exec for a unit of a Big Company.  His business unit needs a key technology to integrate into their product, and they'd rather buy it than build it.  The business unit's technical evaluation has narrowed the field of many small companies to a short list of three choices.

Having led the process of arriving at these three candidates, Bob then engaged the corporate M&A team, thinking he could more or less hand off to them to do diligence on the three targets and make a recommendation.  But after futzing around for six weeks Corporate came back to Bob and asked him to build a comparative business case -- a spreadsheet model that estimates, for each of the three choices, what the net economic impact would be of acquiring that particular company.  When he's done, Corporate will look at the three bottom lines and pursue the one with the highest number. 

(There are lots of reasons why this is exactly not how Bob's company should be doing this analysis.  The next post will discuss flaws in this approach and give some suggestions for how the buyer should evaluate the choices.  Unfortunately, though, most buyers don't evaluate the way they should; so as a seller, the analysis described below is one of the ones you're most likely to encounter.)

To understand the analysis Bob has been asked to prepare, let's work out an example.  Suppose that target company A can be bought for around $20 million (which happens to be true in Bob's situation).  For this example we'll also suppose the following:

• Bob's business unit sells $200m/year of product at 65% gross margin.
• They believe that having company A's technology will allow them to sell 10% more than they otherwise would.
• The operating expense of the acquired company will be $3m/year after integration.
• Bob's company uses a 5-year economic analysis with zero discount rate.  (Doesn't seem very sophisticated, does it?  In fact, this is exactly how one of the largest tech acquirers does their analysis.)

Then an economic justification would begin with the incremental gross profit from owning the technology: revenue ($200m x 10% x 5 years = $100m) multiplied by gross margin (65%) = $65 million, the leftmost bar below.  From that they will deduct the incremental operating expense ($3m x 5 years = $15m) and the purchase price ($20m).  What's left over, $65m - $15m - $20m = $30m, is the net benefit to the buyer of doing the deal.

Bob will then repeat this same analysis for targets B and C, then present to corporate the three results as his comparative business case.

Lessons for the seller

Here are three important observations from the above:

• First, just like in any sales situation, the buying company includes different people who want different things.  This case is pretty typical, with a business unit constituency and a central corporate function.
• Second, acquirers are slaves to their spreadsheets. This one happens to be an economic analysis.  The other type of spreadsheet you're likely to see is an RFP-style list of questions with a score for each question and some kind of formula to combine the scores.
• Third, the most important numbers in these spreadsheets are often pulled from thin air.  The entire case rests on an assumption of 10% revenue uplift from owning this technology.  Hmmm.

Given these observations, here are some ways you can make the process work to your advantage:

• Understand the form of the analysis.  The acquirer may have a standard spreadsheet model for evaluating target companies.  You need to understand what the drivers are of that model (meaning which inputs have the greatest impact on the outcome).  They will be different for different acquirers, since companies vary in how they value growth vs. profit, short term vs. long term, purchase price vs. operating expense, etc.
• Influence the form if you can.  In my friend Bob's case, Corporate actually didn't give him a template.  They just asked for a comparative business case, leaving him to invent the format.  If your presentation to Bob includes a spreadsheet analysis presented from his point of view, chances are he'll "borrow" it and add columns for the other two targets, who now have to play by your rules.
• Work with the buyer to fill in the analysis.  Once you understand the drivers, help Bob complete his model.  You'll want to do this in person, not by email or over the phone; and you should position yourself physically next to Bob, not across the table from him.  (This is an important negotiating tactic from Getting To Yes.  The message to Bob is that you and he are not adversaries; rather, you're sitting side by side facing the problem.  It's good advice in many situations, but especially so in an acquisition discussion, where you need Bob to start feeling that you're "part of the team" as early in the engagement as possible.)
• Know your competition.  Ask Bob how many companies are in consideration and where you rank among the alternatives.  He may be reluctant to share this information, but you can get it out of him by explaining (for example) that your Board wants you to focus on the business and is skeptical about Bob's level of interest (as they should be).  You need to know that it's worth your time to engage with him in building a thoughtful and robust joint business case.
• Be the emotional favorite.  A spreadsheet model gives the illusion of objectivity, but it's only an illusion.  The person creating the assumptions for the model almost always biases it in the direction of whoever s/he wants to win. 
• Overcome objections.  As in any sales engagement, you need to understand the buyer's objections and respond to them.  There are four things on Bob's mind: a) is your company the best choice for my business, b) will my colleagues in my business unit support me, c) can I convince Corporate, d) can I justify the price.  By having answers prepared for each of these questions you can help him help you.