The difficulty when it comes to mergers and acquisitions, especially within the SME sector, is that both parties run the risk of drastically under-estimating the cost and amount of management time and effort involved in achieving a smooth takeover.
This was shown by the recent poor financial results of Electronics Boutique (EB). It found that the integration costs of its acquisition of former rival, Game, crushed its profit. The high street retailer's profit plunged into the red to the tune of £3.3 million for the six months ended 31 July. In the same period last year, EB had posted a profit of £1.5 million.
The loss was purely down to bringing the two chains together and updating Game's distribution infrastructure. EB's business model continued to be sound during the period despite PlayStation price erosion - proved by the 19.3 per cent rise in turnover to £63.8 million.
Peter Lewis, chairman of EB, was clear as to where the blame for the loss lay - "In the integration of Game, which had grown rapidly from 65 to 92 stores in the preceding 12 months, without the necessary investment in infrastructure. A great deal of effort has been put into ensuring these weaknesses are rectified."
The perils of being a predator
It is tempting in the increasingly competitive business climate for companies to see their way forward as by becoming a corporate predator and expanding rapidly.
A successful merger can lead to increased profit and new market penetration. But an ill-considered, poorly executed acquisition can cost a great deal of money, reduce profit, lose customers, damage a hard-won reputation and lead to redundancies. The latter can be particularly expensive if they are a direct result of the takeover: the acquisitor must pick up the tab for unfair dismissals or redundancies.
So the reason for running this risk is to increase profit? The DTi research concludes: "Acquisition appears to lead, on average, to reduced profitability, although this deterioration is apparently reduced after five years. The more profitable a company before acquisition, the sharpest decline in profit post-acquisition."
If that doesn't justify a note of caution, nothing will. Acquiring SMEs cite capturing market share and diversification as their most important considerations. The acquired firms see takeover as an exit route, a means of realising capital gains, or even a method of sorting out management succession.
Overvaluing the target
These ideals are fine, but a common mistake by acquiring firms is overvaluing the target business. This is because they don't carry out the necessary due diligence, and make a bid on a price based on a net asset value.
This is usually misleading and may include items such as pension scheme surpluses or cash they thought was being transferred in the deal, but is not. There can also be undisclosed liabilities, such as outstanding litigation, patent disputes or cash in the bank, which the target company has agreed will be distributed before sale.
The acquisitors must also check what infrastructure is owned and what is leased: what may appear to be an asset may be a liability.
Another common error is identifying the wrong target. Acquisitors often assume the target will automatically add, possibly double, its business, but this is generally not the case. The purchase of one reseller by another does not necessarily make the buyer twice as big.
If they are in competition, there is likely to be overlapping business and, instead of increasing profit, the deal may simply increase costs. A high street with a Game store located 100 metres from an EB store is still sharing the same customer stream, but with double the staff and premises.
Another difficult judgement to make is knowing when the time is right to make a move. Mergers and acquisitions are expensive and time consuming both when carrying out due diligence and managing with post-acquisition integration.
The danger is for businesses to spread themselves too thinly during these two important stages, so that 'doing business' actually suffers. Before considering a takeover, the acquiring company must guarantee it is firmly established in terms of management and financial strength.
The huge workload associated with mergers and acquisitions means company directors will have to temporarily take their eye off the ball. This may be beforehand, which could reduce cash flow, or after the deal, when they have to manage the integration of new staff and a bigger enterprise which could involve offices in new locations, serving different market sectors and providing training to a raft of new employees.
Acquisitors must ensure they are financially secure and that they have the management strength in depth to deal with all these complex issues. Post-acquisition, businesses must put their efforts into stabilising and consolidating.
Currently, the market is picking up. Although many manufacturing sectors have suffered because of the high value of the pound that has affected exports, the UK has so far emerged from the threatened recession relatively unscathed. Mergers and acquisitions among companies of all sizes that were on hold are now going ahead.
However, not everybody has survived: vendors, resellers and even certain distributors have collapsed. This has led to an increase in acquisitions via insolvency. For those companies looking for a bargain, this sector is the basement.
The lessons, therefore, are: if you are considering an acquisition, make sure you are doing it for the right reasons and following the right procedures. Never be panicked into acquisition, and do not let your usually clear judgement be clouded by business machismo, or you may have plenty of time to regret it.
Ensure you have the right management team in place and are financially solid, and be certain to seek the right professional advice. In addition, be absolutely certain that the management team has targeted the right business. What will the acquired company really add to your own?
Then ensure that you carry out the correct due diligence before firming up your bid. Although that process will cost you money, it is likely to save you far more in the long run.
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