Merger and acquisition (M&A) activity increased significantly in the fourth quarter of 2023, signaling a hot M&A market for 2024. But there are some potential pitfalls for unwary buyers and sellers. Here are some common mistakes and how a business valuator can help ensure your deal goes as planned.

Reliance on valuation rules-of-thumb

Some M&A participants rely on industry “rules of thumb” and gut instinct, especially in mature industries. Although rules of thumb can provide a reasonable basis for initial M&A discussions, they fail to address important valuation considerations, such as nonoperating assets and changes in market conditions. Therefore, they’re rarely sufficient as the sole basis for a deal.

Before making a formal offer to merge with or acquire another business, it’s important to obtain a comprehensive valuation analysis. Valuation professionals consider three valuation approaches — cost (or asset-based), market and income — before selecting the most appropriate approach to arrive at a reasonable asking or purchase price.

Overpayment

Several factors may cause a buyer to overpay, thus causing the transaction to fall short of expectations. For instance, there may be inaccurate financial assumptions as well as a lack of astute due diligence. A purchase price is only as reasonable as its underlying assumptions. In some cases, buyers forecast unrealistic synergies and economies of scale. Others mistakenly believe they can run the business more efficiently than the previous owner.

Similarly, the buyer may analyze a transaction using unsupported hurdle rates (benchmarks used to evaluate investment decisions). Generally, the hurdle rate should be commensurate with the buyer’s cost of capital. When a buyer uses a hurdle rate that’s below its cost of capital, it’s more likely to overpay.

In addition, industrywide consolidation can sometimes lead to inflated pricing multiples. In some cases, valuation multiples may become detached from economic reality. In the midst of frenetic M&A activity, a buyer may feel compelled to pay overly high acquisition premiums to maintain sufficient market share.

When companies overpay in a merger or an acquisition, the results can have a ripple effect throughout the organization. In some cases, ill-conceived deals can even lead to bankruptcy. Of course, this is an extreme example of the consequences of overpayment. Most companies don’t close their doors just because of one bad deal. More common consequences of overpayment include reduced shareholder value and deteriorated financial ratios.

Due diligence is key

Due diligence refers to the systematic process of vetting a proposed deal. Comprehensive due diligence addresses financial, operational, technology and human resource issues. Beyond looking at financial statements and tax returns, buyers should perform site visits and interview personnel, customers and suppliers if possible.

When due diligence is performed too hastily or its scope is too narrow, buyers are likely to overlook deal-threatening risk factors, such as contingent liabilities, obsolete assets, concentration risks, poor internal controls, unpaid taxes or employee retention issues.

Problems and risk factors unearthed through acquisition due diligence should be investigated and reconciled. In some cases, the buyer may need to renegotiate the deal’s terms. For example, to offset the risk of a significant contingent liability, the buyer may reduce the purchase price or negotiate a seller-funded escrow account.

(This is Blog Post #1561)