Why do companies buy other companies? Is it because they can get a positive IRR (internal rate of return) or ROI (return on investment)? Do they do deals because the return may be greater than their WACC (weighted average cost of capital)? No, absolutely not.
Then why are those measurements used to determine if an acquisition was successful? The answer is because the integration wasn’t done properly. Integration wasn’t done properly because the necessary work to identify the specific tasks to be accomplished and the goals to be achieved weren’t defined prior to doing the deal. If the work was done properly and the company was prepared for the integration, they’d be able to measure the success of delivering against the reasons for doing the deal. If it wasn’t done properly, those financial metrics are all that’s available.
Companies buy other companies for the synergies. That’s a highly overused term but what it means in this context is that the buying company is looking for something specific from the acquisition, like increasing the number of customers, increasing the average revenue per customer, lowering the churn rate, decreasing the customer acquisition cost, decreasing the average cost per customer, increasing the average cross- sell or up-sell per customer, etc. These are specific and measurable reasons for buying another company. They need to be measured during integration. It is the delivery against these items that ultimately determines the success or failure or a deal, not the IRR of the deal.
The Synergy Curve
There is a very good article done by A.T. Kearney in March 2013 titled, “What Shape is Your Curve?” It describes a Synergy Curve for M&A deals. Synergy curves reveal the measure of attractiveness of the deal, either up front as part of a due diligence exercise or when evaluating the deal’s ultimate success. A synergy curve shows the accumulation of synergies over time, and it tells a thousand stories. It is the result of months of preparation, planning, and implementation. Its shape is defined by the integration strategy, the speed at which synergies are delivered, and the implementation capabilities of the integration team and the broader organization. It stands as a testament to the quality of the CEO’s vision and execution and will be scrutinized by the board, shareholders, and markets.
Plotting a curve helps clarify the deal’s strategic rationale, which is fundamental to maximizing synergy delivery; once completed, it can be used throughout the integration to benchmark, plan, and track the synergy delivery rate.
The Window of Opportunity
In every merger, there is a window of opportunity when newly merged companies can best engage stakeholders to deliver synergies. During this time, there is a clear case for change, intense top management attention, and significant committed resources. All stakeholders—from suppliers and shareholders to employees and customers—are expecting change, and it is important not to disappoint them. After this window closes, the outlook for delivering synergies is greatly diminished. A synergy curve, which represents the time element of delivery, can provide valuable support to CEOs and other top executives as they assess the merger’s synergy delivery.
When expected synergies are clearly defined and articulated, they can be measured and tracked. This is the real work around integration. It can’t all be done prior to the deal closure but the ground work can be laid and the refinement completed when the deal closes.
So how do you determine the success of an acquisition if you failed to map out the synergies at the start and, as a result, didn’t track them during integration? The default answer is to calculate the IRR or ROI. But there is another way and it involves a set of hypotheses for how the synergy should or would have been delivered. A colleague of mine, Ilan Pragaspathy, illustrated an example of how this can be accomplished:
Let’s say we are dealing with wireless telecom. Metrics common in the industry linked to business drivers would include # subscribers, average revenue per customer, churn rate, customer acquisition cost, average cost per customer, average upgrade rate, average subsidy per handset, etc. We could build a simple model of the business pre and post merger – with *independent drivers* (# customers, fixed costs (network, towers, …), variable costs, etc.).
If the high level rationale is: cost per subscriber will fall due to rationalizing the network… now we can test whether that is borne out by the model. We might find that, yes the fixed cost went down, but the number of subscribers fell as well (another independent variable in the model) as a consequence of the merger. So the recommendation may be that the cost synergy was realized but there were negative revenue consequence due to merger, so focus on that.
What You Want to Know
In this illustration we examined the success of the fundamental justification for doing the deal, which isn’t to deliver a positive IRR. Ultimately, as the CEO, a member of a Board of Directors, or a shareholder, this is what you ultimately want to know. The focus should be on pre-merger planning rather than on post mortems.
If you’re wondering how you build a company that you can sell for a premium in a few years, contact me to discuss the Valuation Amplification Process: email@example.com.
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