UK: SME - Buyers beware.

UK: SME - Buyers beware. - Acquisitions may appear a short-cut to growth, but they can easily go wrong. There is no guarantee that incoming executives will have the same style as the existing team.

by Sarah Perrin.
Last Updated: 31 Aug 2010

Acquisitions may appear a short-cut to growth, but they can easily go wrong. There is no guarantee that incoming executives will have the same style as the existing team.

Many small businesses think that acquiring another company is an easy route to rapid growth. It can be, but making that first acquisition is much harder than it appears and too many companies ignore the dictum caveat emptor, or buyer beware.

'I've seen acquisitions fail more often than they succeed,' says Colin Barrow, head of the enterprise group at Cranfield School of Management.

'It's probably a good idea not to do it,' he adds discouragingly.

So what can go wrong? An acquisition can distract management from running the existing business and subsequently lose good customers. It can over-stretch the management team as they attempt to integrate the two businesses into an enlarged one. It can also cost too much and drain working capital resources.

Yet there are many reasons why buying another company may make sense.

The owner may want to grow the existing business rapidly in order to float it before they become too old.

By joining the two businesses, significant economies of scale may be made, or a company may simply need critical mass to deal with customers on an equal footing.

It is essential to establish a sound business strategy from the outset if the newly merged business is to succeed. Seizing a chance opportunity may prove to be the predator's downfall. 'It is important that acquirers set out the criteria for the acquisition - why they are doing it,' says Jeff Ward, corporate finance partner at BDO Stoy Hayward. 'If they have not justified the move prior to the acquisition, problems are more likely to emerge.'

Once they know why they want to buy another business, the management need to ask themselves some searching questions about timing, capability and corporate culture.

Acquiring another company is a major drain on management time. The team should consider whether they have the ability and drive to handle the challenges of running a newly acquired company, particularly if the business will then be split across several locations. If the existing management are not up to the task, they should either abandon the acquisition strategy or strengthen the team through recruitment prior to making any acquisition.

More importantly, while the acquisition may bring fresh management skills, there is no guarantee that incoming executives will have the same management style as the existing executive team. If the corporate culture of the target business is too different, integrating the two businesses and achieving a united whole will be difficult. Chances of success are increased greatly where the purchaser seeks an acquisition target with a similar or, at least, complementary culture (see box, page 97).

The management team need to identify the characteristics of the company they want to buy, from the sector it operates in to the attitude of its management.

They should consider how the target business will be absorbed into their corporate structure and how it will subsequently be developed. As David Buckley, a Leeds-based corporate finance partner at Ernst & Young, points out: 'Problems can arise after an acquisition if the owner goes back to running the original business and no one has planned what to do with the new business on day one, month one, year one. The management just ends up fire-fighting.'

Timescales should be realistic. Companies are bound to need a period to settle in, however well-matched and successful the takeover or merger is likely to be. TeleAdapt, a £7.5 million turnover company providing laptop internet adapters and technical support, bought a small telecoms software developer, AND Computing Solutions, last November. Gordon Brown, managing director of TeleAdapt, is happy to see that the customers remain loyal but admits: 'There are always teething problems with people who have done things their own way, then join a larger organisation and realise that the product that was their be-all-and-end-all is now just one product among many.'

People are important, not least the number of employees who are being taken on and their prospective roles within the business. Sorting out personnel issues can be a major headache. Before the deal goes ahead, the purchaser should clarify details of all the incoming staff's employment terms and conditions, not forgetting those on long-term sickness or maternity leave. Incoming staff are legally protected under the Transfer of Undertakings (protection of employment) Regulations.

But it is not just what is written down that is important. 'The vendor may forget to tell the purchaser about verbal contracts,' says Paula Cole, an employment law partner at Garretts solicitors. Staff may be accustomed to receiving a £100 bonus each Christmas. When next Christmas comes round, staff could still claim the bonus, even if the right is undocumented.

It makes sense to harmonise employment contracts to avoid administrative complexity and to counter bad feelings, where incoming or existing staff enjoy better terms and conditions. There are two main options. The employer can reach a compromise agreement, in which employees waive their rights under their old contracts in return for a lump sum payment.

The drawback to such agreements is that they may not be watertight, explains Cole, who expects them to be challenged in the courts.

The alternative is to introduce a flexible (or flex) remuneration system where staff can choose the elements of their pay and benefits that suit them. 'In this way, the reason for changing the terms and conditions is not the transfer (of the business), but the introduction of flex,' says Cole. 'That's a legitimate solution.'

Terms and conditions are not the only employment law pitfalls. In any acquisition, some staff become surplus to requirements, particularly where there is duplication such as in accounts or personnel. To avoid claims for unfair dismissal, the employer will need to select candidates for redundancy from existing and incoming staff, using appropriate criteria such as measurable skills rather than age, sex or race. Employees have a legal right to be consulted and are protected by legal remedies if the employer fails to consult with them in the correct way. Getting professional and legal advice is really a must in this situation.

Administration systems may also need to be streamlined. Running two accounting or purchasing systems is inefficient and could lead to costly errors, so time and money should be allocated for harmonisation. Also, check that the IT systems of the acquired company are Year 2000-compliant. If not, they may need replacing.

Having assessed all the hurdles and still decided that acquisition is the right course, how do purchasers find target companies? Purchasers can use their own market knowledge of competitors and suppliers to draw up a list of potential acquisitions. The corporate finance departments of large accountancy firms or other professional advisers often have a database of businesses for sale or may know of appropriate businesses that are not officially on the market. The more specific the company is about the type of the business it wants to buy, the better. The purchaser may wish to keep its identity hidden until the target business has expressed initial interest by using external advisers to make the first approach.

The purchaser needs to find out as much as possible about the target business. Lawyers, accountants and actuaries can perform due diligence work, reviewing the acquisition for hidden legal and financial problems.

Issues such as outstanding legal claims against the target company, unprovided tax liabilities and underfunded pension schemes should be addressed.

Specialist valuers can assess the value of any property or brand names acquired. The cost of these services varies, depending on the complexity of the work. 'If a purchaser pays £10 million for a business, and due diligence costs £10,000, that should not be seen as costly if the advice has been helpful for the future development of the business,' says Buckley.

The purchaser must keep a cool head as talks on price get underway. 'In the heady atmosphere of the negotiations, the owner can get sucked into paying a higher price than expected. It's a recipe for disaster where the purchaser goes into the deal unwilling to walk away if the vendor demands too much,' warns Buckley.

Different methods of funding the purchase are available. Increasing existing bank borrowings may appear the most obvious option, but may not be the best. Using up the overdraft could constrict working capital. The funding should also cover future expansion plans. A mix of equity and debt funding may be more appropriate if further acquisitions are to be made.

Tactical planning is the key to making a successful first acquisition.

Even with the best plans, however, it will be a learning experience.

'The more you do it, the better you get at it,' says Barrow.

A PRESCRIPTION FOR MANAGING GLOBAL GROWTH

Barrie Haigh built Innovex into a successful UK-based pharmaceutical research business. Since 1979, it had conducted clinical trials on an outsourced basis for global pharmaceutical companies. The business only served the UK market, however, and its overseas rivals also operated on a national basis. This struck Haigh as an opportunity.

By acquiring a number of competitors, Haigh realised he could turn Innovex into a global business which would be of sufficient size to deal with the manufacturing giants on a more equal basis.

The acquisitions had to be made quickly before his global strategy became obvious, but Innovex was selective about its purchases. Haigh wanted to be sure that target businesses were a good cultural fit.

Working with change management specialist Liz Clarke of Clarke Consultants, Innovex developed a model to determine the compatibility of corporate cultures. Managers in target companies had to answer a series of questions on issues such as innovation, atmosphere and customer focus. Subsequent analysis generated a picture of the key cultural characteristics of the business, such as whether it was more people-centred, profit-driven or growth-oriented.

'Cultural fit is important. Most acquisitions fail because of people reasons,' says Clarke. 'If the cultures are fundamentally different, then you have a hell of a job bringing them together.' Innovex's acquisition strategy has been successful for Haigh. In 1996, he sold the £80-million turnover business to Quintiles, a Californian contract research group, for £550 million. He made about £300 million from the deal.

CALL CENTRE HEAD DISCOVERS THE VALUE OF EQUITY

Two acquisitions have enabled the Telecom Potential Group to grow from a £300,000 turnover business, specialising in telephone calls and cost analysis, to a £5 million telecoms consultancy and telemarketing and call centre provider with 200 employees. It has not been a trouble-free ride, however.

Four years after its formation in 1981, Telecom Potential made its first acquisition. Its chairman and managing director Peter McCarthy came across a consultancy operating in a complementary field. The purchase of the £100,000 turnover business, he reasoned, would boost the growth of his own company. The consultancy's owner, who joined McCarthy's team, received a paper payment consisting of a 6% equity stake in Telecom Potential, a golden hello and the option to purchase a further 18%. 'Without the equity stake, the consultancy's owner would not have joined,' says McCarthy.

All went well initially and Telecom Potential began to expand into the then emerging call centre business. In 1993, the 24% shareholder decided to leave the business for personal reasons. Although the future of the business wasn't threatened, valuing the 24% stake turned out to be more difficult than expected.

A shareholders' agreement had been drawn up at the time of the acquisition - which covered the eventuality of a break-up - but the document had not been updated and a key element concerning valuation had expired.

The valuation process proved stressful, but McCarthy still backs his decision to acquire the consultancy since it helped Telecom Potential to grow more quickly with more professional management. With hindsight, he recommends that, early on, purchasers should consider non-equity methods to reward the skills of those joining the business. 'Think about giving them value without putting them in a shareholder position immediately. That way, the purchaser can retain greater control over the business.'.

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