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Five Overlooked Due-Diligence Factors for Assessing the Real Market Potential of an Acquisition Target
You are probably as perplexed as I at the repeated difficulty that acquisitions have in delivering on their promises of growth.
The title of a June 2006 survey report from Accenture said it clearly: “Executives Report that Mergers and Acquisitions Fail to Create Adequate Value”. The subtitle, “Deals Often Come Up Short on Delivering Anticipated Revenues, Expected Cost Savings and Successful Integration of Information Technology”, caps the point.
When asking acquirers about the causes of these shortcomings, there are usually a handful of common responses.
Few will admit that the culprit may have really been an inadequate due diligence process - one that failed to reveal fundamental weaknesses in the market position or marketing and sales capabilities of the target company.
The “Dead Man in a Canoe” Model of Acquisition Due Diligence
This model begins with the premise that even a dead man in a canoe will make great progress downstream, if the current is flowing fast enough. In fact, a dead man in a canoe will make even more progress than a live man rowing backwards. Furthermore, if the water level in the stream is so low that the bottom of the canoe is resting on the stream bed, no one - a good rower, a dead man or a backwards rower - will make any progress at all, no matter how much someone paid for the canoe.
The canoe metaphor and due diligence
Five factors can be assessed to determine the reality of the growth potential and the marketing and sales capabilities of an acquisition target. They are:
Few investment analyses dig deeply enough to understand these factors. Yet, they ultimately portend long-term success or failure.
The Five Assessment Factors
1. What process is used for selecting target markets and investments?
Many small acquisition targets simply do not have a good process for selecting markets to target. If the acquisition target is currently successful, it was many times due to the speed, responsiveness and informality in the organization that allowed quick re-focus for survival when a market was not responding. Rapid trial and error eventually resulted in the discovery of a “savior” market before cash ran out.
If the acquisition target has a good process, then it is probably already validated by their growth. If growth is temporarily stalled, no matter how good the sales pipeline report, take it as a red flag. Putting the acquisition’s markets through your own process for identifying lucrative target market opportunities provides a quick sanity check.
If the acquisition target doesn’t have a good market focus selection process, then that upgrade is the first thing to do when, and if, the acquisition is completed. Leaving this process upgrade incomplete after acquisition, assures future stumbles.
A combination of three critical market factors (demographics, economics and legislation) drives market momentum. There isn’t much anyone can do about demographics. Businesses cannot affect shifts in population overnight. However, sometimes simply shifting focus from one segment of the market to another catches demographic sub-currents that can accelerate demand.
For example, the number of hospitals in the U.S. is declining. Philips’ defibrillator business can keep trying to sell into emergency rooms in a saturated hospital market with a declining installed base or move to the high-end consumer/commercial market fueled by the combination of the relentless demographic of aging baby boomers and government promoted and legislated emergency preparedness initiatives.
Economics is more complex. There are macro trends (national and international), micro (market and product specific) and, what I’ll coin, nano-economics (the economics associated with an individual customer sales transaction). If all three are flowing in the same positive direction, the results are outstanding. However, market momentum usually slows down top to bottom. First macro economics fail, then the micro, then nano. For the experienced executive, evaluating the macro and micro level momentum factors affecting the wisdom of an acquisition should be relatively easy
We will get to the nano-economic factor in the next section, but before we do, one final word on market momentum. Too many acquisitions are bought for product reasons (complementary offerings, new technology, brand name et al) vis-à-vis solid market momentum reasons. While it may be nice to complement and flush out your product line with an acquisition, it must not be the primary motivator. Such acquisitions become a burden rather than an asset.
3. How valid are both their value proposition and competitive advantage? (What are the nano-economics?)
Here’s a sad, but not surprising, discovery. At a mini strategy workshop I conducted a group of a dozen CEOs and owners of small-to-mid-sized businesses were given a simple challenge: Imagine your ideal customer prospect and match it to your best product or service offering. Once you have that imagined, calculate a typical five year economic payback the ideal customer would receive from that offering.
Not one person in the room could do it in the 15 or so minutes available. May just have been a bad class.
In an article by this author published in the December 2007 IndUS Business Journal entitled, “The Seven Laws of Performance Excellence”, the first is the Law of Economic Value. It states, “The source of all economic value in any business originates from a customer’s belief that they will receive more favorable economic, emotional or physical value in return for the cash they are willing to spend with your company”.
There must be a significant customer-perceived imbalance in the economic, emotional or physical value equation, in favor of the customer or there will be no deal. It is what drives nano-economic momentum. This is the true nature and reality of the acquisition target firm’s value proposition. It drives new product adoption. How well it is delivered vis-à-vis competitors is the true measure of competitive advantage. All future cash flow starts there.
A number of years ago, during a due-diligence working session, the presenters were asked, “Can you state how the acquisition of this target by your firm will ultimately provide increased economic value to either your, or your acquisition target’s, customer base?” Stunned silence answered the question.
If an acquiring company cannot somehow tie its target acquisition investment to the Law of Economic Value, the natural selection forces of the marketplace will ultimately depreciate the value of that investment. Value to a customer ultimately rules.
4. How healthy is the sales pipeline? Does the acquisition target have, and use, a good disciplined sales process?
Sales opportunity pipelines (or, as some call them, sales funnels) are common support documents in the due diligence process. Rarely does an acquiring firm have a good process for assessing its validity.
Here are six suggested criteria for assessing each major opportunity in the pipeline:
It may seem that this kind of effort for each of the target customer’s sales people and each opportunity in the pipeline is a lot of work. It certainly is not a reasonable thing to do for the acquisition of a huge company with hundreds or thousands of sales people. But, it definitely is for small company targets. And, after all, it is called “diligence”. If you use a process like this, pipeline “fluff” falls away quickly, revealing the real value of the sales opportunity pipeline.
The second part of assessment factor is whether the acquisition target has, and utilizes good sales process discipline. A good sales process is recognizable by its ability to not only win a high percentage of opportunities in the pipeline, but also do the following:
5. How talented and capable are the marketing and sales people?
When embarking on an acquisition and beginning to meet the people at the acquisition target as part of the due-diligence process, the people can usually sort into three types.
The first are the “fearful-skeptics”. These people are simply trying to keep their jobs, stay under the radar and do whatever it is they need to survive the acquisition integration.
The second type are the “hostiles”. They fear loss of power or influence, the coming discomfort associated with an upset of the status-quo, or exposure of incompetence and/or visibility given to their lack of progress.
The final types are the “eager-embracers”. They are the ones that usually say something like, “I’m looking forward to this. I can really see the benefits. I’ve been formulating some innovative ideas for some time. I’d like to share them with you. How can I help?”
These last are the few who will already have developed their own process, who continually want to see things improve and who simply can’t stand ineffectiveness, slowness and inefficiency. This type is critical to have in a good marketing and sales organization.
In assessing the people and talent there should be two key roles represented.
One Good Marketing Strategist: One good, talented marketing strategist can create programs that launch firms into incredibly rapid growth opportunities.
A Few Good (Sales) Men: In sales there should be a few very good and influential sales people that can act as internal opinion leaders. In this role they provide support for the transition with peers and customers, and, through their example, help other sales people learn how to manage the acquisition integration and its incumbent changes.
There are many reasons for acquisition. Venture Capital and private investment firms look to discover and increase value for extraction at some future point. Commercial businesses typically look to acquisitions to accelerate growth, capture IP, open up new channels or gain rapid entrance into a new market.
Independent of the type of acquiring firm or the ultimate purpose of the acquisition, those embarking upon due diligence are encouraged to adhere two basic principles:
One final point: When the good revelations outweigh the bad in this 5-factor analysis and the deal closes, by virtue of having dug deep enough to discover the acquisition target’s weaknesses, the acquiring firm has already laid out before them the roadmap for improvement.
Many more articles in The CFO Refresher in The CEO Refresher Archives