M&A Mistake #6: Avoidable Surprises
There are many reasons M&A deals fail to close. Macro factors, like changes in tax laws, an economic slowdown, or an unexpected rise in interest rates, can cause a transaction to fall apart. Likewise, a sharp decline in the buyer’s stock price, a change in strategic direction from their Board of Directors, a shortfall in their bank financing, or some other shift in the buyer’s world may lead to them walk away from a deal. In my over twenty years of leading M&A transactions, however, I’ve seen fully three-quarters of failed M&A deals happen because of an unexpected seller-related development, revelation, or discovery. Something comes to light about the target company that the buyer wasn’t expecting. To a buyer evaluating an acquisition, surprises from the seller mean uncertainty, and uncertainty means risk. In the deal-making world, an increase in the perceived risk of a transaction without something to offset it, usually a purchase price reduction, upsets the risk/reward balance in the buyer’s mind. They may still like the business and want to buy it, but they will pay less for a business that has more risk. On the other hand, sellers don’t typically believe that the surprising event warrants lowering the purchase price because, from their perspective, the value of the business itself hasn’t changed. Being closer to the business than the buyer, sellers aren’t alarmed by surprises in their own company as easily. They see it as part of the normal course of business, its regular ups and downs. Therein lies the root of most failed M&A deals. When a negative surprise leads a buyer to believe a business is riskier than they had thought and the sellers offer no offsetting concessions, buyers will often walk away from a deal. Such is the case with this real-life story from Chapter 10.
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I’ve seen many examples of avoidable surprises in my deal-making career, most of which led to a lower purchase price, and a few that outright killed the deal. One of the most dramatic and memorable examples is the surprising news that the CEO of the business my team was selling was a convicted felon, as revealed by a routine background check that the buyer performed just prior to closing. In the weeks leading up to closing a transaction, there are usually a number of routine, check-the-box-type diligence steps that buyers will take to cover their bases and make their risk-management department happy. One of these is ordering background checks on the executive management team of the company being acquired. Next to nothing is ever revealed in these exercises, and the uninteresting results are inevitably stashed away in a deal file somewhere, never to be heard of or thought about again. I assured the buyer that I was as surprised to learn of Rick’s criminal past as they were, while also asking myself how Rick could have failed to mention this to me over the past nine months that we’d been working together. “It says here in this report that Rick served seven years in federal prison in the 1980s for felony larceny,” the buyer continued. “That doesn’t sound like a person we would want to partner with.” Until they received that report, the buyer’s opinion of Rick had been overwhelmingly positive. Rick would continue leading the company post-closing under the buyer’s ownership, and suddenly, they were losing faith in him. After collecting myself, I pushed back. “Rick has paid his debt to society and has put that part of his life behind him. He has created a very successful business career, without so much as a parking ticket in the past thirty years and is still the same dynamic CEO you know him to be. How is this relevant?” Though it took some time, the buyer finally admitted that the issue was not the decades-old felony conviction itself. “We are about to invest $130 million into buying Winterfield Supply in partnership with Rick, and that requires a high level of trust,” the buyer explained. “I can’t believe that Rick wasn’t upfront about this issue earlier in the process or, at the very least, when he consented to the background check. If he didn’t voluntarily disclose this to us, what else is he hiding?” Some buyers would view a past criminal conviction by a key member of the target’s management team as justifiable grounds for walking away from a deal. Others may be less concerned, believing a second chance was warranted. Neither type of buyer, however, appreciates the surprise of uncovering such a fact on their own without warning. The relationship between a potential buyer and the target’s management team, which is incredibly important to the deal’s ultimate success, starts to form when both sides meet for the first time, and it slowly builds during the months leading up to closing. A known but undisclosed issue that comes to light pre-closing will cast doubt on the trust that the buyer has placed in the seller, often killing the transaction. In the case of Winterfield Supply, Rick’s credibility with the buyer was irreparably damaged because of his mishandling of the background check, and the buyer soon walked away from the deal.
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In this article series, I share excerpts and stories from my book, The $100 Million Exit. I hope you enjoyed this post — if you did and want to connect, you can reach me via email at email@example.com or connect with me at https://www.linkedin.com/in/jbrabrand/. Also, you can find my book on Amazon here: https://www.amazon.com/dp/1641375175