Strategies to Avoid the Overpayment Trap

The Overpayment Trap explored how the M&A process is oriented toward getting sellers top dollar for their companies. Becoming mindful of the overpayment trap and deciding to take proactive measures to avoid it are essential first steps. This article provides specific strategies and techniques that you can use to avoid overpaying for a friendly acquisition.

Obviously, a buyer may overpay by miscalculating their relative negotiating position
and offering a price that is significantly more than the amount a seller would accept. In addition, a buyer may overpay when the price paid does not provide for an adequate return on investment.

Why is one buyer willing to pay more than the others? Two reasons come to mind. First, a buyer may want the company because of the role the acquisition will play in fulfilling its strategic mission. Such a buyer may pay a significant premium over Fair Market Value if they are under a compulsion to act, unlike the hypothetical buyer in the definition of Fair Market Value who is not under a compulsion to act. Secondly, a given buyer may be better positioned to maximize returns from a particular acquisition.

Avoiding the overpayment traps involves four essential business arts: strategy, negotiation, due diligence and pricing. These four arts work together. Clear strategy, skillful negotiating, careful strategic due diligence and disciplined pricing are all hallmarks of sensible dealmaking. On the other hand, weaknesses in strategy, negotiating, due diligence or pricing can lead to overpayment.

The Art of Strategy

Acquisitions should be driven by a company’s business and growth plans. A company’s strategy is based upon its present position, where it is going and how it plans to get there. The key question is, “will the company’s strategy be best achieved through organic growth or by means of M&A?”

Strategy is the cart and acquisitions are the horse. Whether you are seeking a single
acquisition or several, your acquisition program should advance your company toward its growth objectives. However, your growth objectives and strategy should define your acquisition program.

The basic reasons for making an acquisition are to:

Leverage existing assets and capacity.
Acquire needed or desired capacity.
Acquire a platform company.
Acquire a business position (an immediate entry and/or dominant position).

Establish acquisition criteria in writing. Once established, acquisition objectives should be prioritized and formalized in writing. Of course, the objectives can be updated and modified to reflect your current strategic thinking, but they should be in writing. The human brain and ego are powerful forces. Emotion, executive hubris, and groupthink can obscure reason and result in shoddy decision making. Pursuing the deal-of-the-moment can waste precious time and resources.

Before entering price negotiations have a “not-to-exceed” amount and a starting price in mind.
Build a relationship with the seller(s).
Learn more about the specific needs of the seller so you can use that information to add value to your offer.
Manage expectations and set boundaries early in the process. Flexibility is helpful along with a problem-solving approach to negotiations. However, unless you establish boundaries, the seller may push for concessions until the edge of the metaphorical envelope has been reached.
Adopt an educative approach when discussing price and valuation issues with the seller.
Be wary of auctions.
Don’t negotiate blindly. Plug deal price, terms and other key assumptions into your financial model to make sure the numbers meet the investment portion of your acquisition
criteria.
Be mindful of the power of “No!” and don’t be afraid to use it to keep your company out of a bad deal.
Don’t underestimate your strength as a buyer and don’t fail to convey strength to the sellers and their representatives. The degree of assertiveness in negotiations is dependent upon each party’s perception of their bargaining power, a largely psychological process.

The Art of Strategic Due Diligence

In a typical transaction, buyer and seller indicate their general agreement on price, terms, deadlines and other basic conditions in a Letter of Intent or Term Sheet. A standard condition is the completion of a due diligence review to the satisfaction of the buyer. Due diligence requires disclosure by the seller and provides the buyer with an opportunity to verify the completeness, accuracy and business significance of the disclosed information.

From a legal perspective, this review is required under the doctrine of the prudent man.
In addition to the legal standard of care, due diligence is a buyer’s last opportunity to avoid the overpayment trap by thoroughly examining the reasonableness and completeness of the assumptions that are being relied upon to value and price the acquisition. In reality, due diligence is about fact-finding and truth-seeking.

Due diligence is a complex and multi-disciplined undertaking that encompasses the entirety of the acquisition target and the buyer’s plans for the company after the deal is completed. Here are several due diligence strategies you can use to avoid the overpayment trap:

Approach due diligence as an opportunity and spare no effort to thoroughly understand the company, how it will fit into your plans, and the best way to capture maximum value while minimizing risk.
Trust, but verify. Trust in your strategic vision, negotiating acumen, and valuation instincts and then take a step back to verify everything. The anticipated economic benefits rest upon myriad of assumptions. It doesn’t matter if you have a high IQ. If your assumptions are false, your ROI will suffer.
Adopt a cool, analytical and objective approach toward due diligence and the issues that are uncovered during the process. Every analyst has their own set of biases. It comes with being human. Avoid spin, overreaction, and the tendency to fit the findings into a preconceived picture. Use the findings to reach an informed decision as opposed to using them to rationalize a decision that has already been made.
Evaluate the implications of all findings that may affect price and related negotiations. Does the finding have an impact upon such critical areas as:
- Markets, customers, and revenues.
- Assumed cost savings and operating expenses.
- Demands upon cash and credit capacities.
- Reserves and contingent expenses.
- Planned assimilation or integration costs.
- Anything that materially changes your perception of the overall risk of the investment.
Whenever possible, quantify the impact of all findings that relate to valuation and pricing decisions.
Negotiate with the seller to mitigate the impact of any findings that materially lower anticipated returns.
Adapt your assimilation and integration plans based upon your findings.
Don’t “stove-pipe” the findings. Make sure that all of the appropriate people in your organization receive the data and encourage them to carefully evaluate its significance and adjust plans and expectations as needed.

The Art of Valuation and Pricing

Every business buyer should adopt a formal, disciplined and standardized approach to valuing and pricing an acquisition target. Models can be internally developed spreadsheets or can be complete third-party or external systems like MoneySoft’s DealSense Plus. The main disadvantage of spreadsheets is that there can be any number of models prepared by different people, which can lead to inconsistent and incomplete results unless a standard is set and tested.

When considering models, forecasts and valuations, keep a few things in mind:

Numbers are not the business. Get beyond the numbers. When analyzing historic financial statements, numbers represent the accounting treatment of transactions. Keep in mind that every line item is comprised of many individual transactions. Each individual transaction started with an intention, was then implemented, produced a result and was then reported according to the company’s accounting policies and competence.
Models can be elegant and simulate the calculated results of a large number of assumptions and variables. When it comes to valuation and pricing, there are a number of key assumptions and variables that can be manipulated with dramatic results. An analyst needs a high degree of intellectual honesty and moral backbone to simulate numbers that are of true value to the organization.
Numbers should be used as part of the fact finding, planning and negotiation process and never manipulated to rationalize or justify an otherwise non-sensible price.

An acquisition is a major business event. Each deal presents a set a unique challenges and risks. Some risks can be identified and managed. Some risks can catch a buyer by surprise. These risks and challenges are best faced without the added burden of overpayment.

By adopting a deal philosophy that integrates strategy, negotiating and due diligence along with a disciplined approach to valuation and pricing, a buyer can side-step the overpayment trap.