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To further emphasize this point, consider the return of in- vestment implications when one public company pays a pre- mium to buy another public company. When Buyco pays $90 per share to acquire 100% of Sellco, which had been trading for a market price prior to the acquisition of $60 per share, they are paying $30 per share more—a 50% premium—than what their shareholders would have to pay to acquire the same stock on the open market. Implicit in their acquisition decision is the message to their shareholders that they can create value above this pre- mium through the acquisition. Thus, their decision is based on the assumption that it is in the shareholder’s best interest to pay this premium in advance based on management’s ability to de- liver the expected synergies. For shareholders to end up better off in this scenario, management must create substantial returns to justify the premium paid. Success is not impossible, but such lofty goals, in light of investment alternatives, mandate sound ac- quisition valuation and analysis.
In addition to their focus on shareholder value, executives and board members also must recognize that M&A is usually the company’s largest form of discretionary spending. Such a decision often has a greater effect on shareholder value than any other, and few other events in the life of a business can change value so quickly and dramatically. Acquisitions gener- ally commit a company to the selected strategy for a long period of time. As implementation occurs, it becomes increasingly dif- ficult to abandon that commitment, particularly if the market’s initial reaction is negative. Finally, because the company has typically paid a premium over fair market value for the acquisi- tion, it often is aiming to achieve difficult synergies, which cre- ates a heightened level of uncertainty about the success of the investment.
SYNERGY MEASUREMENT PROCESS
These risks in M&A are not presented to discourage making ac- quisitions; rather the point is to impress on buyers the need to fully understand how to evaluate potential acquisitions with value creation as the goal.
Synergy Defined
Achieving synergy begins with a clear understanding of what it is.
Defining synergy as “a combination of businesses that makes two plus two equal five” or “the wonderful integration benefits from combined strategies and economies of scale” is imprecise and misleading.
In his book, The Synergy Trap: How Companies Lose the Acquisi- tion Game, author Mark L. Sirower provides the following defini- tion and discussion of synergy:
Synergy is the increase in performance of the combined firm over what the two firms are already expected or re- quired to accomplish as independent firms.
Where acquirers can achieve the performance that is already expected from the target, the net present value (NPV) of an acquisition strategy then is clearly repre- sented by the following formula:
NPVSynergyPremium
In management terms, synergy means competing better than anyone ever expected. It means gains in com- petitive advantage over and above what firms already need to survive in their competitive markets.1
Thus, the acquiring and target firms already have built into their stock values investor’s expectations of the increase in value that each company can achieve while operating as a stand- alone business. Synergy is the improvement in excess of these anticipated im- provements,which makes success in the acquisition process a much more elusive goal. And the odds of successful achievement of this goal are generally reduced by the size of the acquisition premium paid. If most of the value-creating potential from the acquisition is paid to the sellers in the form of a premium, little potential value creation exists for the acquiring firm.
This fact raises the related issue of identifying which party, the buyer or the seller, creates the synergies. Typically, the buyer
1Mark L. Sirower, The Synergy Trap: How Companies Lose the Acquisition Game(New York:
The Free Press, 1997, 2000), pp. 20, 29.
enables the competitive advantages of the combined enterprise, including revenue enhancements, cost reductions, or technology improvements, over the performance of the individual entities. So the synergy value is usually created by the buyer.
Exceptions do exist. When a target possesses a technology or proprietary process that the buyer can adapt and employ over its larger volume base, this “bounceback” synergy is created primarily by the seller. While the buyer brings the enhanced customer base over which the benefit can be extended, the target creates a bene- fit and value far beyond what it is worth as a stand-alone entity.
Sources of Synergy
Synergistic benefits generally result from four potential sources:
1. Revenue enhancements 2. Cost reductions
3. Practice improvements 4. Financial economies Revenue Enhancements
Revenue enhancements may result from higher unit sales, which usually are achieved by the combined entity serving a broader mar- ket or offering an expanded product line, or both. Selected price increases also may be achieved, particularly when the combined entity creates strategic advantages, such as being the sole supplier for a technology or product.
Forecasted revenue enhancements should be viewed with caution. They are often dependent on many external variables, particularly customer and competitor response. Both may be dif- ficult to predict, and, to a large extent, they are beyond the con- trol of the combined entity. For example, customers may have a policy that prevents excessive reliance on any one source of sup- ply. Competitor reaction also should be anticipated, including new product offerings and price discounts.
Revenue enhancements can be achieved when the combined company offers a broader line of products or services, often by leveraging the distribution system of the new entity. The expanded
or improved product line also may qualify the combined company to compete for business that was not available to either the ac- quirer or the target operating as stand-alone businesses.
Cost Reductions
Estimates of the second synergy source, cost reductions, tend to be more predictable and reliable than revenue improvements.
Through consolidation of functions, positions and related fixed assets and overhead are eliminated. The magnitude of this bene- fit tends to be larger when the target is similar to the acquirer in operations and markets served.
To succeed with cost reductions, particular attention must be paid in advance to job titles and account classifications. Because these tend to vary among companies, identifying which specific functions can be eliminated becomes more difficult. Salaries and wages, in particular, require vigilance because while positions may be cut, the individuals who held them sometimes survive in the new entity in a different department or job title.
Technology and Process Improvements
Process improvements occur when the combined entity adopts the most efficient or effective practices employed by the target or ac- quirer. These enhancements frequently result from technological or process improvements that can be leveraged over the broader base of the combined entity. The improvements can create en- hanced revenues or cost reductions as well as more efficient oper- ations or more effective marketing and distribution.
Financial Economies
The fourth synergy source, financial economies, is often misun- derstood. The target’s cost of capital can be reduced through ac- quisition by a larger company that eliminates many of the risks that exist in the target as a stand-alone business. These financial economies raise the investment value of the target but not its fair market value. The combination also may lower the combined en- tity’s financing costs and may allow for efficiencies in lease terms, cash management, and management of working capital.
The value of a target, however, cannot be enhanced by at- tributing to it a lower cost of capital through use of more debt fi- nancing. Since any acquirer could achieve this benefit, such finan- cial manipulations seldom have genuine value-creating potential.
The combined entity also may create certain tax benefits, such as use of net operating loss carryovers or the ability to incorporate in a jurisdiction that provides favorable tax rates. Acquirers are cau- tioned, however, to recognize that most financial economies can- not materially improve a company’s strategic position and seldom should be the driving force behind a transaction.
KEY VARIABLES IN ASSESSING SYNERGIES
In assessing the potential savings from each of these synergy sources, members of an M&A team should focus relentlessly on three variables that can dramatically influence the accuracy of the estimated synergy and value calculation.
1. Size of synergy benefit.The synergy value should be quantified in a forecast of net cash flows that includes estimates of revenues, expenses, financing and tax costs, and investments in working capital and fixed assets. Each component of the forecast, particularly all estimated improvements, must be challenged rigorously. Acquisition team members must resist the natural inclination to buy into the deal emotionally, which so often leads to overly optimistic revenue and expense estimates. Each element in the forecast must be estimated accurately.
2. Likelihood of achievement.The business combination will project various benefits, some of which have a very high likelihood of success while others may be long shots. For example, the likelihood that the administrative costs associated with the target’s board of directors can be eliminated is about 100%. Conversely, achieving certain sales goals against stiff competition is probably far less definite. These differences must be noted and allowed for in the forecast. Computing the probability of various outcomes, such as optimistic, expected, and pessimistic, or
through a Monte Carlo simulation, helps to quantify the range of possible outcomes. In particular, management should be sensitive to downside projections and their consequences.
3. Timing of benefits.The buyer’s M&A team must recognize that while the acquisition usually occurs as a single
transaction, its benefits accrue over the forecast period that may cover many years. The value of the acquisition and its success are critically tied to achieving the improved cash flows according to the forecasted time schedule. Any delays push cash flows farther into the future and reduce their present value. Temptations to accelerate the timing of revenue enhancements or cost savings must be avoided, with the timing of each assumption challenged just as the amounts are. The history of M&A is littered with stories of how unrealistic acceleration of improvements to enhance the attractiveness of an acquisition led to overestimation of synergy value. The M&A team that succumbs to this
pressure is first and foremost fooling itself.
The clear point here is to stress the importance of objectivity and rigorous due diligence in the examination of forecasted syn- ergies. Investors anticipate improvements in the performance of both the acquirer and the target in the values they establish for each company as stand-alone entities. The synergies related to the acquisition must reflect improvements beyond those already antic- ipated. The value of these synergies must exceed the premium over the acquirer’s fair market value in order to create value. Thus, every forecasted synergy must be challenged aggressively in terms of the estimated amount, the likelihood of achievement, and when that benefit will occur. Companies that overlook this process are invit- ing unpleasant surprises and disappointment in the future.
SYNERGY AND ADVANCED PLANNING
The acquisition planning process described in Chapter 4 empha- sized the need to tie the acquisition plan to the company’s over- all strategic plan. Within this context, each acquisition should be
evaluated in light of the likelihood of achieving the forecasted synergies. Mark L. Sirower describes the “Cornerstones of Syn- ergy” as four elements of an acquisition strategy that must be in place to achieve success with synergies. As shown in Exhibit 5-1, lack of any of the four dooms the project, according to Sirower.
Sirower’s cornerstones include:
• Strategic vision. Represents the goal of the combination, which should be a continuous guide to the operating plan of the acquisition.
• Operating strategy. Represents the specific operational steps required to achieve strategic advantages in the combined entity over competitors.
• Systems integration. Focuses on the implementation of the acquisition while maintaining preexisting performance targets. For success, these should be planned in considerable detail in advance of the acquisition to achieve the timing of synergy improvements.
• Power and culture. With corporate culture changing with the acquisition, the decision-making structure in the combined entity, including procedures for cooperation and conflict Exhibit 5-1 Sirower’s Cornerstones of Synergy
Strategic Vision
Operating Strategy Power &
Culture
Systems Integration
Premium
Competitor Reactions Competitor Reactions
Competitor Reactions
Source: Mark L. Sirower, The Synergy Trap: How Companies Lose the Acquisition Game (New York: The Free Press, 1997, 2000), p. 29.
resolution, must be determined and implemented. Success in the integration requires effectiveness throughout the newly combined organization which forces the need for clarity of purpose.
Synergy has acquired almost a mythical reputation in M&A for the rewards that it reputedly provides. Watch out for these re- wards. They may indeed be a myth.
Business combinations can provide improvements, but these must be in excess of the improvements that investors al- ready anticipate for the acquirer and target as stand-alone com- panies. These anticipated stand-alone improvements are the first hurdle that any combination must surpass. When the acquirer pays a premium to the target’s shareholders, the present value of any benefits provided by the combination must be reduced by this premium. Thus, the higher the premium paid, the lower are the potential benefits to the acquirer. Acquirers also must recog- nize that in handing over initial synergy benefits to the seller in the form of the premium payment, they have left themselves the challenge of achieving the remaining synergies, which are often the most difficult.
Synergies must not be mythical. They must be harshly con- tested, accurately forecasted, and appropriately discounted net cash flows that reflect their probability of success under carefully constructed and reviewed time schedules.
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