Potential Pitfalls With Mergers and Acquisitions


Mergers Photo_HL

I have always been a fan of using mergers & acquisitions as a viable way to quickly scale your business. However, this road is not foolproof by any means. Below are some of things that can go wrong, so do your research and plan accordingly.
The skillsets it takes to grow a small stand-alone business are very different from the skillsets required to grow a larger business through M&A activity. You want to make sure someone inside “Newco” has past experience in dealing with M&A-related issues like merging businesses, teams, financials, etc. and someone 2ho knows how to operate a much bigger company, typically with more procedures and controls for scalability. Remember, the CEO’s role must change as the company scales.
Let’s face it; mergers are very much like marriages.  You are merging people, personalities and cultures.  Also, marriages don’t always go as planned—they often end in divorce. “Divorce” in the M&A sense is much harder to accomplish, meaning you are stuck with these issues, whether you like it or not. So, it is critical you do your homework and make sure the senior management has clear roles and can gel together as a new team. And, that the employees in the trenches will aspire towards a shared collaborative culture of “we”, instead of “us” vs. “them”.
Often times entrepreneurs think that selling to and working for a big company will solve all problems, as big companies have bigger budgets, etc.  But, having lived through two sales to billion-dollar companies, big companies bring as many headaches as they do solutions.  Big companies move like a turtle compared to the light speed of startups, with many layers of bureaucracy and decision- makers. Additionally, the powers located at the top are typically focused on much bigger “fish to fry”.  This means your startup will most likely get “lost” inside a big company unless you have a well-documented agreement in advance detailing its guaranteed support.
Yes, I am sure you tried to ask all the right questions during the due diligence process (as I have previously taught you how to do back in Lesson #66).  But, I guarantee you that even the best advisors and lawyers may miss something that can come back to bite them. Not to mention, let’s face facts; a seller is trying to sell and will always present things from a rose-colored glasses perspective. For this reason, you need proper seller representations and warranties documented in your M&A agreement to protect yourself.
Let’s say you have two $5MM businesses coming together. It is reasonable to estimate that they could make $10MM in revenues together, if not more from cross-selling their products. The reality is, you have a higher chance that revenues are only $7-$8MM once the dust settles. Why is this? Because key employees can become disgruntled by the merger and leave the company. Or, the target was overly optimistic on the health of the sales pipeline, etc. So, build in a cushion for situations like these, and make sure the pro forma economics still work for you.
Earnouts are payments made to selling shareholders at some point down the road, well after closing the deal, after the selling company hits some agreed-upon financial or performance target. Earnouts can work great for buyers, but earnouts very rarely pay sellers as much as they anticipate. Sellers agree to terms thinking the earnout will be achieved, and when it does not, a grim reality sets in. So, if you are a seller, regardless how well-written you think your earnout is, things will most likely not pay out as you hope. So, take more cash upfront when you can, and be happy with the deal even if a zero earnout is achieved.
Getting M&A transactions properly documented for maximum protections in the event something goes wrong down the road is not easy. It requires the skills of experienced lawyers. These people are most likely not your general counsel; they are lawyers with deep M&A experience who have lived through the “negotiation wars” and have the battle scars to prove it.  Do not be cheap here: pay for the best M&A lawyer you can afford, as it could end up saving you millions in capital and hours of heartache down the road.
This is not intended to be a catch-all list of potential pitfalls, but is simply some high level things to keep in mind to protect yourself when going down the M&A road.  Get a good advisor to help you with your negotiations and a good lawyer to make sure it is properly documented.



Reprinted by permission.

Image Credit: CC by Los Angeles District

About the author: George Deeb

George Deeb is a managing partner at Red Rocket Ventures, a Chicago-based startup consulting and fundraising firm with expertise in advising Internet-related businesses. More of George’s startup lessons can be read at “101 Startup Lessons — An Entrepreneur’s Handbook.”

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