Too often company executives driven by expanding their empire or blinded by a "quick fix" for entering a new market end up in an overpriced deal.
Why do acquisitions fail? Start with the price.
An acquisition can provide a successful avenue for growth and obtaining competitive advantage. But many acquisitions end up as failures for the buyer. Why do acquisitions fail? Start with the price.
Acquisitions represent a way for a company to quickly buy its way into a new market, or to stay competitive in an existing market. Such a “quick-fix” approach, however, can cause a management team to overvalue an acquisition target, driven by emotions instead of business logic. The idea of growing your empire can be too enticing to walk away from an overpriced deal. It’s easy to fall in love with a target and overestimate the benefits while ignoring the risks. In an auction situation, some companies may bid up the price to avoid losing out to a competitor.
Overpaying for a company is not always immediately clear, nor does it always mean the acquisition will fail. But the more you pay for a company, obviously, the longer it takes to realize the economic benefits. If you consistently overpay for a series of acquisitions, you will systemically destroy shareholder value.
How can you avoid the pitfalls of overpaying? Begin by developing a thorough understanding of the true worth of the business you’re targeting. The value of a business is theoretically the sum of the net present value of all the future expected free cash flows generated. While it’s impossible to truly predict future cash flows, acquirers can do a more thorough job of understanding the target’s plans for achieving growth and what really drives value for the business.
A robust analysis of which factors have the greatest impact on cash flow, as well as additional investments that will be required to grow the business, can help management identify potential high-risk areas. Ignoring even simple questions on areas such as customer concentration, supplier relationships, or even additional management needs, can lead you to overvalue the target. Sellers will always offer the rosiest of hockey stick projections, so it’s up to the acquirer to make sure they are asking the right questions to hone in on a fair price that reflects the true costs and benefits of a deal.
Material price decisions should be met with questions like:
How will we achieve a reasonable payback on the acquisition price?
What is the most we are willing to pay before we walk away?
What investments will we need to make beyond pure purchase price?
How dependent are we on “synergies” to make the acquisition work?
Can we structure the deal more creatively to reduce our risk of overpaying?
There’s no way to determine the “perfect” price for an acquisition. Various valuation methodologies can provide some guidance, but in the end, price is a negotiation. By thoroughly understanding the risks to achieving projected financial results, and testing price against the costs and benefits, management teams can exercise proper restraint during these negotiations to ensure that the price is right.
KARL STARK AND BILL STEWART are managing directors and co-founders of Avondale, a strategic advisory firm focused on growing companies. Avondale, based in Chicago, is a high-growth company itself and is a two-time Inc. 500 honoree. @karlstark