What are the key issues to consider in the early stages of M&A process?

Introduction

• M&A process is extremely complex and costly for both buyers and sellers.In addition to involvement of key resources from both buyers and sellers, both parties also engage the professional services of attorneys, investment bankers and third party consultants to assist them in closing the transaction. This involves huge payments which results in high transaction costs.In many cases, risks are identified late in the M&A process and buyers/sellers after having invested huge amount of time and costs overlook these risks and focus only on getting the transactions closed.This will result in issues when integrating the target with buyer.Due to this, synergies targets will not be realized.The entire deal is a failure for both buyers and sellers.No wonder 60-70% of M&A deals fail in realizing their synergies and strategic goals.
• The above problems can be prevented by identifying the red flags very early in the M&A transaction, much before the due diligence phase.By identifying these red flags earlier, considerable amount of time, costs and efforts can be saved.

Key red flags to be identified early in the deal

Penalties on termination of Supplier Contracts
Most target companies have close relationship with their vendors and suppliers.In some cases, the target companies enter into a long contractual commitment with the supplier that spans for around 6-7 years.These contracts have a penalty for early termination provisions and penalties for this range from 5-10% of the total contract value.During acquisition, the buyer needs to enter into detailed negotiations with suppliers on the rationale behind structuring these termination costs and how to minimize penalties in event of an acquisition.In most of the deals, there would be supplier consolidations or replacement of target suppliers by buyer post acquisition.If the termination fee is high, then the buyer need to evaluate if it is necessary to proceed further.

Change of Control clauses
Change of control clauses and corresponding payments needs to be looked into detail by the buyer.These clauses apply for Customer and Employee contracts.

In case of key customer contracts where customer outsources majority of its services to the target, the contracts come with a condition that any change in ownership requires the consent of customer.If this is not followed then there is a risk of customer moving to competitor.This will be a huge risk to buyer as the value of proposed M&A deal reduces when the key customers do not approve or terminate the relationship with target due to the proposed deal.The buyer can persuade the customer on the benefits of the proposed acquisition and how this deal can benefit the customer in terms of the services rendered.If the buyer fails to persuade the customer, then it is a red flag and the buyer should abort the deal.

In case of key employees, the buyer would look to retain them post acquisition by entering into employment agreements. These agreements can be structured favorably by the buyer by granting stocks, joining bonus and in some cases retention payments to key employees to prevent them getting poached by competitors. The target in many cases enters into a agreements with Directors and the key employees which states that parties would be compensated or can vest their stocks immediately on the trigger of change of ownership conditions.In other cases, such employees are required to be paid huge severance costs by the employer on termination of their services.Hence the buyer needs to analyse these agreements in detail especially on the change of control provisions before entering into an employment agreement with key employees.

Unfavourable feedback by Customers on Target
Customers are one of the key factors for getting into M&A deals and the buyer would ensure that all the customer relationships from the target are transferred without any issues to buyer post acquisition. The buyer needs to have a 1 on 1 discussion with key customers about their experience with Target and on the quality of services provided by Target to them.In many cases, the buyer would look at the CSAT rating of the target given by every customer.This would give an idea to the buyer about the quality and scope of services offered by the target.The buyer would also want to retain the target client partners/relationship managers for all its customers as these client partners would be useful to transition the relationships smoothly from the target to customer post acquisition.
If the buyer does not receive favorable feedback about Target from its customers, then it is a red flag for the buyer not to proceed further with the transaction.

Clash of culture between buyer and seller
Culture integration between the buyer and seller is key for the deal to be successful. Rather than waiting till integration to identify the risks and cultural gaps between buyers and seller, the buyer needs to evaluate its culture with the target and whether they are compatible.There are websites like glassdoor which give a feedback on the Working culture of companies.If the buyer feels that there is a cultural misfit and this could result in either employee churn or be an obstacle to realize synergies post integration, then the buyer should abort the deal.
Quality of Target Management
Most of the deals specifically in the technology space require the founders and target management to continue even post acquisition. The quality and passion of target management and how they run their business is a key factor for the buyer to evaluate. If the buyer evaluates the target management to be passionate in adding value as against waiting for his earn outs to be vested soon, then the buyer should look to retain them by offering lucrative positions in buyer organization by providing additional responsibilities. On the other hand, if the management is seen to be arrogant and not transparent in their business operations, then it would be better for buyer not to continue forward.

Evaluating the Target IT infrastructure
IT due diligence is either neglected or not given high importance by the buyer as Financial and Commercial Due Diligence.

In many cases the buyer looks to integrate the target IT landscape post integration thus finding out duplicate systems as well as issues in migrating target sales and financials data to buyer platform.Hence the buyer needs to evaluate the target IT landscape and risks that accompany due to disparate systems along with list of applications that is needed to be integrated or retired from the overall application portfolio.

Evaluating Target Balance sheet
Target balance sheet needs to be evaluated in detail especially the liabilities section.The buyer needs to look at debts and accrued interest payments that it may need to absorb after the deal.The buyer would also get a fair assessment of how Working capital requirements are managed.The buyer should also request for audited balance sheet as this would eliminate accounting mismatch and also how the target recognizes revenues and if all transactions happen at the same time periods.

Data Privacy issues
Post GDPR, it is very important that target is compliant on how it uses its customers and marketing data.This has become a critical factor for buyer in M&A, as buyers do not want to enter into costly litigations post acquisition. The buyer needs to evaluate how the target uses its marketing database for its campaigns and other promotional purposes and if target has provided opt-in feature to its prospects to access its campaigns.

With many companies including Google requiring to pay huge fines for the way they use customer data and push advertisements to customers without their permissions, buyer needs to evaluate the data Privacy issues of target to decide if it wants to move forward with the transaction.

Conclusion

As M&A transactions involve huge time and costs, it is better to identify key red flags upfront and decide not to pursue the transaction further.

In some cases both parties hire a clean team who has access to confidential information of both the parties in the data room.The clean teams are generally third party professional services firms who after analyzing in detail the data of both parties arrives at conclusion whether the transaction will generate synergies and what would be the synergies targets to look at for this deal.