A Guide Through the Minefields of Building Companies Through Acquisition.
By Bill Wade
The basic premise couldn’t be any simpler. Take a highly fragmented industry facing technological change, customer upheaval or chronic financing difficulties. Add in a few well-healed foreign firms or (worse) a couple of previously unknown competitors from “outside the business”.
Since the industry leaders are probably family run businesses (second or third generation) with limited succession strategies, the next step to protect profit and continue growth is clear: Consolidate.
It can’t miss. The new company will start out life with the best of everything – smart, entrepreneurial ex-owners as key managers … freshly infused capital from public or private equity funds … savvy top management eager to reap the “low hanging fruit” by combining back offices, systems, inventory, purchasing power and expanded customer contact. Regional national or even multi-national market dominance from day one … perfect!
Why then do consolidations (also variously referenced to as roll-ups, MBO’s, buy-ups, build-ups or “poofs”) seem to be faring so poorly in the public markets. Is the recent stock price trace record of these companies simply reflective of a couple of widely publicized problem cases (Waste Management, Republic Industries, Corporate Express, Physicians Resource Group, etc.) or is there a special set of management hurdles facing these hybrid corporate structures?
Both business owners thinking about selling and managers thinking about buying need to realize that the management task upon which they are about to embark is both different and more complex than those faced in typical mergers … somewhat dangerous ground, since more than 60% of these vastly simpler two party transactions are thought to be failures. What can cause dysfunction as these well-funded groups of successful managers – most are proven executives – ply their course to creating a single and focused company?
A study of several consolidations, both successful and disastrous, points time and again to ten POMO’s (Positions of Maximum Occurence) of misunderstanding. Not all are in evidence at all times nor universally prevalent across the organization. However, a little organizational pathology reveals components of these ten in nearly every instance of conflict.
As will become evident, the key to success seems not to be bound up in valuations, EBITDA or financial engineering. Rather, it boils down to a proposition articulated in a classic HBR article by Willard Rockwell, one of the first large scale consolidators, in 1968: “What you acquire, first of all, when you buy a company is its people. They are the precious assets that can keep it imaginative, aggressive, inspired and dynamic. In my view, if you keep this thought well in mind, you will not go wrong.”
This is certainly true, but the permutations of employee misunderstanding and mistrust make the nurturing of this asset a real trial. Let’s now examine ten problems peculiar to consolidation of multiple merger situations:
1. A Consolidation company is a corporation … not a club
Consolidation of an industry is a traumatic time for all involved, and since there is normally more than one consolidator at work when the craze strikes a segment, seller choice often becomes clouded (but rarely overwhelmed by) non-economic factors.
The proposed transaction represents an irrevocable investment decision for both parties. Since the driving force in the sale of a family business is usually the ability to “take some chips off the table”, cash or highly discounted cash equivalents end up ruling the day.
It is interesting to note, however, the language used by sellers and outsiders (vendors, customers, etc.). Typically the terminology revolves around “joining the group”, as though the decision was not equity transfer but membership in a club. All publics need to be reminded of the corporate nature of the new entity and the set of decision-making processes this implies. Buying groups may “vote” on vendors, companies do not. Trade associations may vote on legislative positions, companies do not. Clubs may vote on rules (such as the handling of a trademark), companies do not.
Since this paradigm transformation is so critical, it is imperative to begin creating a cultural basis of shared or common beliefs as soon as possible (even before the closing), and to the greatest organizational depth possible. There is one rule to maximize this crucial process … oversimplify. The basic tenets of the new company’s approach to everything from customer service to human relations has to be covered quickly and concisely … and then has to be restated and summarized over and over. Compounding chaos will do nothing to dissipate it.
Consolidation integration is often likened to “herding cats” … and apt description. Nothing is more important to the pulling-together process than common understanding of short-term direction. Managers should prepare to over lead (not to be confused with over-managing). No nuance can be assumed, and every expectation should be stated as specifically as practical … and in writing if possible.
A major factor in the delineation of the “new deal” should be the introduction of a formalized business planning process – no small change to organizations that may not have even done budgets in prior years. Business planning is an excellent opportunity to involve many levels of many functions, and to forcefully demonstrate the depth of change being anticipated in the organization and the industry within which it competes.
2. There is an enormous difference between “real” business and family business.
A large part of the appeal of smaller family business is the supposed lack of “corporate “BS” necessary to run the enterprise. Once consolidated with others, these simple freestanding organizations find it necessary (and usually difficult) to assimilate the tentacles of a corporate structure into their isolated individual companies.
Formal organizational structure is essential (the plan should be finalized even before closing), as this is the neural network that will guide all future development. Note…it is not enough to simply draft a bunch of reporting relationships … they must be rigorously respected. The possibilities for chaos from continuing informal (and often contradictory) structures can’t be overestimated. Remember that most previous intra-and inter-organizational relationships were never really defined – but here this definition becomes imperative to the success of the new deal.
Often the first real business exercise for the entire new company is the preparation of a budget and annual business plan. Unlike the case in the family setting, budgets are not merely suggestions…they become the critical financial playbook. Most small companies put together a “bank plan”, typically a super conservative annual budget that almost can’t be missed. Now, perhaps for the first time, aggressive targets must be hit.
Managers of individual operations don’t have a history of looking at a larger entity, nor their units’ effect on others. Another common hurdle is the reliance on previous year results as an estimating basis … dangerous since all the previous rules have just been changed. Owners forget that the new investors are looking forward to pro forma cash flows, not backward to see results vs. last year. Zero-base, activity based costing is the most effective (if most painful) solution here.
Two last warnings. Never assume a common level of data quality…it’s not there. Migrations from different charts-of-accounts, part numbering schemes, product or vendor coding structures or process protocols are just too much to overcome on the first pass. Define everything database-wise as intricately and immediately as possible.
Secondly, be prepared for corporate naiveté on a broader scale than anyone would guess. Behavior and communication patterns that seem “normal” to large company veterans are foreign to these new comers.
3. Never assume that purchase price is the only monetary issue.
Most sellers come from a background of extreme corporate frugality – understandable since the company’s money was their money on nearly a direct basis. Two interesting problems spring from this fact. First, every cent will be fought over in post closing cleanup. Even though they may have just received a check for $10 million for the purchase of the business, bruising battles can break out over $100 car allowances. Personal is personal, and no amount is too small to forgo. The best possible defenses against this disruption:
- Detail everything (even though deemed immaterial during negotiations) in writing. No understandings go unclouded in the fog of consolidation activity in the first 12 months, and it is not just mega-bucks items that can paralyze the process later.
- Limit post closing adjustments or any “earn out” types of payment. These “on-the-come” valuations severely limit the ability to consolidate or make cultural changes, and may actually cause a unit’s behavior to be counter to the interests of the new company.
The use of re-investment (or purchase of a unit with the stock of the new company) can be a powerful alignment tool when it comes to commonality issues (vendors, policies, etc.). The expectations of control that accompany the investment can create a minefield, however. Understanding the underlying motivation of sellers is critical. Inclusion of previous owners on boards of directors tends to be dangerous, as most consolidations are built from multiple acquisitions. Inclusion on or exclusion from such boards can be a bone of silent (but very real) contention. Once again, written detailing of mutual expectations is a must to avoid these pseudo-control hiccups.
Executive committees or management / operational committees are often substituted for “real” board seats. Without careful delineation of authority, these can cause management cross currents as well. Remember, under no circumstance can the company become a democracy, and voting, especially showing deference to individual age or organization size, rarely optimizes decision-making. If used at all, consider communication the prime objective of these constructs.
4. Never confuse former owners with communication channels.
In established corporate structure, overall communication patterns evolve over time, but basically follow established “level A to level B to level C” formats. As the consolidation company comes together, it is especially tempting to suppose that similar channels would arrange themselves. Surprise – they won’t.
Regardless of claims of inclusion of employees in the running of the previous company, family management and other entrepreneurial types had made a living (literally) by not telling anyone anything … a practice that probably counts its roots among “whistle blower” tax code provisions. Recognize the fact that in the past owners didn’t tell employees anything, and without a lot of prompting, are not likely to start now.
Mass communication directly to all employees, through paycheck letters or company newsletters, is the only way to be sure that the entire organization hears the same thing the same way – with minimal editorial comment on the side.
On the communications front, feel free to over do it, especially early. Try to get to employee spouses to tell the big picture and alleviate (if appropriate) fears about layoffs, etc. Don’t leave your vendors out of the loop, as they are intimately involved in many aspects of the company’s future. It has been interesting to note that customers seem to be the group with the fewest concerns – perhaps an off shoot of American’s generally over served markets.
It is imperative to recognize the real management players as soon as possible. Family managers may have been out of the day-to-day operations for years, and are therefore questionable sources of real field input. The second tier is often the guts of the asset, so every possible effort should be made to nurture and assure longevity for these key players. Short-term employment agreements in the early stages will tend to tie these managers into the process from the beginning, and help protect this key asset from competitive raiding.
Day one is critical. Be sure to have as complete a “welcome to the new company” package as possible available for all employees. Don’t underestimate the average employee’s interest, knowledge of the industry or curiosity about big picture strategy. Tell as much as you can as soon as you can, but be careful not to leave much open for interpretation. Remember, the entire structure is forming itself and questioning itself … but it may not yet trust itself.
5. Personnel Evaluation … it’s tough to know your real players.
One critical discipline often overlooked by small or family business is in the area of personnel evaluation. Formalized systems are normally non-existent, save some notes in the file regarding last pay raise, etc.
Similarly, records on training accomplishments of selected individuals are also missing. It is difficult-post-deal to determine exactly what the talent pool looks like. Three common hindrances include:
- “My people are great … you should pay them more.” Unfortunately in only rare circumstances were many key second and third level managers included in the distribution of the buyout pie. Often one of the first “crises” encountered will be that of imminent loss of key people because they are under paid. Comparable pay levels (if a deficiency truly exists) should be figured into purchase price adjustments.
- Sort out loyalty vs. ability. Long-term employees are usually valuable, unless this was simply the only job they could get. Watch carefully for undue deference (yes-men) when talking with key managers in the presence of ex-owners. The ability should be evident…and is not to be confused with loyalty.
- Nepotism is not always bad. Evaluate “water tower kids” (their name is up there) with as much fairness as possible … interviewing them alone helps … and find out if they will still be interested in working there when someone else is in charge.
In any employee evaluation, expect to hear what owners think you want to hear. Try to sort out defensive evaluations, as they will create serious roadblocks to true consolidation. Competence may not transfer to new circumstances, nor may compatibility.
6. Estimate the limits of ambition of previous owners.
Anyone receiving a multimillion-dollar check for his business has to take a moment to think what … exactly … the effect will be on his life outlook. True, the experience is markedly different from winning the lottery – you didn’t win the money, you (or your family) earned it. None-the-less, sudden liquidity can have drastic social and psychological effects, especially if the previous owner has most of his net worth tied up in the company (and if he had personally signed for the bank loans).
Two primary business effects have been often noticed in this regard. The first usual reaction is the evaporation (at least temporarily) of the entrepreneurial “Bias Toward Action”. While former owners guided and grew their business through often unbelievable financial and market travails, unfamiliarity with requirements of the consolidation atmosphere may render them afraid of their own shadow. Instant reassurance of management trust in their judgment (while introducing new reporting and authorization forms) will make this nearly universal system pass quickly.
Balance is the key here, for once comfortable with the new rules, many “things we always wanted to try but didn’t have the capital” start to surface like rocks in the spring. The discipline of capital allocation systems must be installed (and enforced) from day one. Capital allocation is an enterprise wide decision set, not simply a prioritizing process for individual units.
One more nearly universal surprise … previous owners unanimously report that they “Haven’t worked this hard – ever”. In a short-term sense, this is probably correct – as most day-to-day operations have often been turned over to second tier managers. Also, since they will tend to try to control all information flow, they find themselves tied up by managing both the questions and the answers. Re-insertion of the family can be very disruptive to the real daily supervisors.
7. Ask for (and share) feedback, but beware of voting.
Multilevel field feedback, from employees, customers, vendors or even competitors can be the most valuable source of research available. There are several caveats regarding this process:
- Be careful of the phrasing or orientation of the question. Don’t ask for information in such a way as to indicate what you expected to hear – or you will hear exactly that. Avoid phraseology that not only indicates ignorance of the facts, but the inability to formulate a plan of action. “What would you suggest?” is far different from “What should we do?”
- Don’t assume answers are complete or that all-relevant information is being volunteered. In this brave new world, information represents the ultimate protective device. Lack of experience and lack of trust really curtail the efficiency of fact finding. Therefore, count on spending days or weeks (but certainly not hours) listening to all levels of input.
- Carefully weigh the value of “the old days”. Since the consolidation is actually changing the face of the industry, antidotes from ten years ago may have limited relevance on a go-forward basis.
- Pick your time to confront sensitive issues. Immediately post-closing, the entire organization will have been rubbed raw, and expectations are disorganized. This superheated sensitivity may be a bad time for decisions that require understanding or trust from employees.
As for overall strategic direction, don’t wait for it to magically appear from field input. Generally, consolidation strategy (and early tactical solutions) can’t possibly come from committee work … but if this hasn’t been pretty well thought out prior to writing checks, it may be academic anyway.
8. Familiarity may breed contempt, especially in the crunch.
One of the most fascinating changes brought on by the formation of a consolidation company is the metamorphosis of pre-existing personal relationships among the principals involved.
Since the majority of these new larger companies is geographically diverse collections of operations in the same base business, the probability is high that many of the managers have known each other from trade groups or advisory councils. There is an unbelievable difference between an association board and being equity/business partners. Cliques and “shadow cabinets” emerge in the new entity that only serve to complicate the true consolidation effort. Friendship may get in the way of candor, and gossip soon is confused with communication.
Large organizations of any type are combinations and interactions of economic, political and social spheres.
The product of these interactions largely determines the success of the combined enterprise, so each should be monitored…and managed if appropriate. To the extent possible, these interactions must be contained within the operating management of the company. Unnecessary or unstructured access to advisors, lenders and investors should be limited, as “back-channel” information can be disruptive to both ongoing operation and strategic development.
9. Consolidation savings only count once you can spend them.
Great ideas are never in short supply when a bunch of entrepreneurs, who all intimately know the industry, get together in a consolidation effort. Operations, sales tactics, tax tricks and training tips all come out quickly once a modicum of trust among the new management team has been established. However, prioritizing which will be the “next great thing” may be the first opportunity for hurt feelings and dissention.
A couple of common problems surface in this effort. Due to the local nature of most small businesses, the fact that many operational innovations will not thrive equally in all geographic or industry sub segments must be considered. Care should be taken, however, as geographical or customer differences are often merely excuses to be sure that “change is what happens to the other guys”.
Consolidation benefits typically count on communization opportunities, which have to be pushed much harder than most anticipate. The tragedy of commons (what is good for the whole may not be good for each component) is the strongest single factor responsible for pulling buying groups and cartels apart…it must be managed closely here.
As previously mentioned, closely held information is the best shield for the status quo. During discussions of emotional points (including selection of vendors), watch for the “secret deal” that is usually revealed only after consensus is reached. Long term, this “gotcha” mentality must be eliminated…and this may require fairly wrenching personnel decisions. Public executions have a way of getting everyone’s attention.
10. Technology should have no personality.
Many areas of operational improvement will be dependent on an examination of “best practices” of the individual units as they are added to the consolidation company. Two that probably shouldn’t be included in this evolutionary process are accounting standards and an overall IT strategy.
Absolutely nothing is as disruptive in the formative stages of a consolidation company as non-common charts-of-accounts. Consolidation of results and analysis of component units (or prospective add-on acquisitions) is nearly impossible without a common lingua franca. Fortunately, newer data mapping and data warehouse tools allow for uniform understanding at the home office level without disrupting branch operations or daily customer service related systems. Use of this solution allows a little breathing room in the field, while providing banks and investors timely and meaningful analysis up front.
Utilization of this all-important accounting short cut depends upon very early adoption of a focused IT strategy. Flexibility must be built in, as no more than three-quarters of any buildup is likely to be operating on the same system (much less same release). While tempting at the corporate level, installation of enterprise wide systems (ERP) within the first two years of company formation is almost certainly a train wreck in search of a crossing.
The ability to manipulate field data … remember our earlier caveat regarding data quality…is critical to control of four pivotal working capital accounts: cash, receivables, payables and inventory. Even extremely similar operations on the same system will have wide variances in coding structure and nomenclature. IT has to be able to deal with this “dirty data” from Day One. Without this capability, forget those heralded, “back office savings” much less any E-commerce capability.
Note also that other “technical” aspects of the transactions – EPA, OSHA, etc. – will be magnified at the time of a sale. Prepare key employees for “due diligence depression” as soon as possible … the questions and document requests will be unbelievable, and not anything most people are used to.
Both the rate of consolidation and the concentration of industries are reaching the highest point in American economic history – some 108 years after the trustbusters chased Rockefeller and his original gang of consolidators. Computer and communication technology is the single driving force, and almost no US industry will escape the consolidation microscope.
Consolidation companies created from multiple acquisitions…either serial or of the “big bang” school of development…require feverish attention to detail. In all spheres (economic, social and political) of the combining enterprise, the challenges extend well beyond those encountered in the two party deals.
It is absolutely essential to pinpoint objectives – operating, financial and personal – as precisely as possible for all involved. Concentrating on ideas that provide two-way payoff (both for buyer and seller) will accelerate the true consolidation.
Once again, it is worth paraphrasing Willard Rockwell’s thoughts from 40 years ago…at which time Mergers and Acquisitions magazine gushed: “If current trends continue, one of every three American companies will merge in the next ten years…”
The merger (or consolidation) route can be all that its most enthusiastic proponents claim it to be – if the reasons for merging are right, if the pre-planning is sound, if major pitfalls are anticipated and if the CEO is a stark realist.
Hopefully, we have provided some insight to eliminate some of these if’s.