
15/07/2024 6 min Read
Mergers and Acquisitions: Frequently Unasked Questions
‘Mergers and acquisitions’ or M&A, conjures up images of glamourous, obscenely-priced deals. But in real life, the reasons for transactions appear unjustified in hindsight while others seem to pull it off successfully. A lot of the deals in the private space, don’t make it to the public domain and some obvious, yet valuable lessons are lost to the world.
As practitioners working with small and medium enterprises (SME), we felt it would be useful to follow the story of one such entrepreneur and, hopefully, learn from his experiences.
Mr. Daredevil was a worried man. He sat, staring at the performance indicators of Redeye Infotech Private Limited, (RIP) the IT company that his family business, Goodluck Building Materials Private Limited (GBM) had acquired a year ago. Almost the same time last year, he had sat triumphantly at the head of the table in the plush board room of RIP while its vanquished executive team cowered in front of him. And now, his financial statements looked like a dog’s dinner.
“Who can I speak to that will understand my problem?” thought Mr. Daredevil. Mr. Killjoy, he said to himself, he will have some light to throw on this. He was a dry witted accountant, who would have Mr. Daredevil’s welfare in mind.
Mr. Killjoy smiled as Mr. Daredevil narrated his woes. “There is only one question you should have asked yourself. Why are we doing this?”
“Of course I know the answer,” Mr. Daredevil sounded confident.
Thus began the volley of questions that Mr. Daredevil wished he had asked himself a year ago.
KJ: Then I’m asking you now– why did you do this?
DD: Because I wanted to grow our business.
KJ: What do you mean by growth? Sales, profits, cash flows or valuation?
DD: Sales, of course.
KJ: Why did you not think of investing in new products or developing your business in new markets or to a new set of customers?
DD: Because that would take much more time and effort. But it would have costed only 20% of the acquisition price.
KJ: Did you do a financial evaluation of both options?
DD: No it seemed obvious to me. A non-executive director, did ask this question. But I was too excited to bother to answer.
KJ: But this company develops software. Why get into something you are not connected with?
DD: They do software for the construction industry.
KJ: Are your customers or suppliers the same? Are the skillsets required to run the business the same?
DD: Well, not really, but then, we can learn. Also we can access a new territory with head office in Bangalore.
KJ: Can’t you just set up an office in Bangalore? Why pay so much for access to an office there?
DD: Yes, you are right. But then…. We want to become a big name….
KJ: Why did the previous owners sell?
DD: I was not really sure till after we closed the transaction, they were doing quite well. But we later realised that their main customer was a relative who owned a construction business in Singapore. They ran into difficulty and had to close down recently.
KJ: Why didn’t your due diligence throw this up?
DD: But then their financials were pretty healthy. We just projected a modest growth on their current actuals. Isn’t that conservative?
KJ: Hmmm… now I understand what went wrong. But more importantly, do you understand?
DD: Yes, but then, I was also planning to use their skilled team to sell our building materials. They are all civil engineers you know.
KJ: But why would you need civil engineers to sell to your distributors?
DD: Well, no need but it’s impressive to have so many qualified people.
KJ: Do you think they will be happy just selling to distributors? And having less qualified people as their superiors?
DD: Well, now I understand why half the team resigned after we took over.
KJ: By the way, do you have a lot of free cash flow in GBM? How did you finance the acquisition?
DD: No, on the contrary, we are cash strapped because of high inventory and receivables. We had a term loan for an expansion project which we used for the acquisition.
KJ: How do you intend to repay?
DD: We are starting to delay payments to our suppliers. I don’t know how we will manage going forward.
KJ: You are hurtling down the path of disaster, Mr. Daredevil. But I may have some good news for you. One of my friends, in the design software business in the US, is looking for a captive development centre in India. If you wish, I can speak to him to look at RIP.
DD: That would be great. When can we sign the agreement?
KJ: Hang on…. He would first need to convince his board that there is a compelling business case. He would also need to work out the financing aspect and its impact on his existing organization. He will need to get preliminary information to do his valuation workings. Once he has agreed a price range internally, he will negotiate a term sheet proposing an enterprise and equity valuation subject to certain conditions. Then a due diligence review – operational, financial and legal, would follow. This would involve both insiders and outside advisers, looking at all the company’s operations, assets and liabilities including staff. Once they have kicked all the tires, they will enter into definitive agreements specifying various pre-closing and post-closing conditions and structuring the deal for tax efficiency and financing. Once the pre-conditions are satisfied, a closing balance sheet would need to be drawn up after which working capital adjustments would be made to the purchase price. Then they would form a cross-functional team for integration and synergy realisation with representatives from both organisations and draw up a 100- day plan. The integration process will be closely monitored by the board and corrections made as necessary.
DD: Oh… I didn’t realise it’s so complicated.
KJ: Not really, everything will fall in place automatically once have asked yourself the question – “Why are we doing this?” and kept validating your answers till you are absolutely convinced you are doing the right thing.
Mr. Daredevil thanked Mr. Killjoy and drove back to his office pensively. At least, now as a seller, he knew what to expect.