Merger Beware

Due diligence for buying and selling in today's market

Back Longreads Apr 1, 2011 By Robert Celaschi

Buy enough businesses and eventually you learn what to expect from the process.

Ron Mittelstaedt has completed more than 300 acquisitions since starting Waste Connections Inc. in Folsom back in 1997.

“Probably 90 to 95 percent have gone equal to or better than our expectations,” he says. So when he says this is a risky time to buy, it’s worth listening.

“You have to be a lot more careful doing acquisitions coming out of a recession,” he says. “You are trying to judge exactly what the trajectory is of the business you are buying. You’ve got to be leery of why sellers are selling.”

A recession creates two large hurdles. First, capital tends to be scarcer. Secondly, a buyer will have to wade through more marginal candidates before finding a keeper. “Probably two to three times the amount you would do in a robust economy,” Mittelstaedt says. Last year Waste Connections looked at about 150 companies and bought 15.

VSP Global, the Rancho Cordova-based vision benefits and services company, looked at a couple of dozen investment opportunities last year, eight of which ended up with a formal term sheet or letter of intent, says Thomas Fessler, chief legal officer and general counsel. The company closed on five.

Being careful doesn’t mean avoiding deals entirely. In fact, the market is heating up, says Aron Culver, managing director of business brokerage BTI of Northern California, based in ¨Roseville. The recession has helped weed out many marginal players.

“If a company looking to sell has stabilized or increased their?¨earnings — depending on the sector they are in — it still can be a seller’s market,” Culver says.

Tech companies are pretty hot right now, he says, along with health care firms, thanks to baby boomers. Retail and restaurants, on the other hand, have taken a big hit.

Like many other parts of the business world, mergers and acquisitions rise and fall with the certainty of the economy, says Curt Rocca, managing partner of DCA Partners, a strategic advisory firm in Roseville. Few people want to swing a deal when they aren’t sure how much longer the economy is going to slide downward.

Sellers, meanwhile, start out a recession hoping it’ll be short, and thus figure it’s a lousy time to put the company on the market, he says.

In 2011 the economy may not yet be great, but it feels a little more predictable.

“People feel that they can get their arms around what the downside potential is like,” Rocca says. “People want to know that they will get at least what they pay for, and if they get more it is â?¨a bonus.”

On the buyer side, a lot of companies have spent the past few years downsizing, and many are sitting on a lot of cash, says attorney Michelle Rowe Hallsten, a shareholder in Greenberg Traurig LLP in Sacramento. Private equity firms also need to deploy cash before their commitments to investors expire.

For a company with cash, buying or merging with another firm is a quick way to add top-line growth. And it has the potential to yield much better returns than sitting in a bank.

Put all the factors together, and the next couple of years could get busy for mergers and acquisitions. The tough part is separating the good candidates from the bad.

Mittelstaedt likes to take his time, keeping an eye on potential acquisitions for years before making a deal. And those companies typically have decades of financial performance to measure. He doesn’t like fixer-uppers. Marginal companies looking for a â?¨bailout don’t get a warm reception at Waste Connections.

One good tactic of due diligence is to simply hang out at the target company’s office for a while, Rocca says. Does it look like a scene out of “Dilbert,” or are people at ease with one another? How does the company handle things like work-life balance and flex time? What are management’s views on employee incentives?

Look at employee tenure and turnover, Mittelstaedt says. If people want to stick around, that implies a good culture. If they have competitive wages and benefits, it says something about how good the employees are — or at least how they are perceived. The condition of the facilities can tell a lot about whether the employees have pride in what they do.

“It’s very hard to have those things be all in the right direction and have a poor culture,” Mittelstaedt says.

One of the most important intangibles for VSP Global is talent retention.

“One of the lessons learned is that when you make a significant investment and six months later you start seeing deterioration, that is a doomed transaction,” Fessler says.

And buyers need to take their time.

“The surprises tend to be very often people-oriented,” Rocca says. “People are sweet when you are dating them, and once the honeymoon is over you see who you really married.”

For companies like Waste Connections and VSP, mergers and acquisitions are part of normal business. For the seller, it may be the first time through the mill.

“I think it is very important at an early stage to sit down and have a heart-to-heart conversation with the sellers,” Fessler says. Buyers need to explain their expectations and find out what the seller is expecting.

Sellers likewise need to prep before they go under the microscope, Hallsten says.

“In due diligence, things come up. And if the buyer has to point them out to you, that’s not a good thing,” she says. Buyers typically have holdbacks, clauses in the purchase contract that set aside money to cover potential problems. That could mean tying up money in escrow for the full statute of limitations on a potential problem. Good planning minimizes them.

“They usually have unrealistic expectations of what their business is worth. It’s usually a big number with a lot of zeros.”

Aron Culver, managing director, BTI of Northern California

Getting ready starts with preparing an outside audit of financial statements. Sellers need to make sure they have all the proper financial controls in place and complete records of contracts.

“You wouldn’t believe how many companies can’t locate copies of fully executed contracts,” Hallsten says.

If a buyer sees the seller’s staff running around and trying to clean things up, it makes a bad impression. If a potential buyer gets nervous, that could mean more holdbacks, a lower sales price and slower negotiations. It might even kill the deal, she says.

Buyers should always make the sellers put themselves on the line, Mittelstaedt says. Sellers know their own business better than anyone, so make them warrantee what they are selling: financials, operations, liabilities, asset conditions and any pending legal issues.

Both buyers and sellers also need to explore the best form of merger, Hallsten says. If it’s a sale of stock or equity interest, each stockholder becomes a party to the deal. That could increase the risk of a holdout. A straight sale of assets is usually better for the buyer.

Another option is the reverse triangular merger, where the buyer forms a subsidiary that swaps its stock with the target company.

“I think most of the mergers I have done on the sell side are reverse triangular,” Hallsten says. “That way all the contracts of the target are preserved.” If the selling entity ceases to exist, then so do its contractual obligations.

Price is always the central issue. It’s not as easy as selling a house, where the local Realtor association has lots of comparable sales on file. But organizations such as ValuSource, Pratt’s Stats and Institute of Business Appraisers have databases that can provide anonymous examples, Culver says.

The toughest part about price can be convincing a seller who has put a lot of sweat equity into a company. “They usually have unrealistic expectations of what their business is worth. It’s usually a big number with a lot of zeros,” Culver says.

Sellers do best when they get a good attorney, tax accountant and mergers-and-acquisitions adviser to stay on track while traversing unfamiliar territory. It’s not a time for the do-it-yourselfer.

“For most of them it is the largest single transaction that they are going to be involved in,” he says. “It’s the single greatest opportunity they have to create wealth. The concept of trusting that process to anybody to the absolute best is typically not wise.”

Perhaps the hardest part about a merger or acquisition is calling a halt if it looks like the buyer and seller will be a poor match. It takes a lot of courage to walk away, Fessler says.

He continues: “I very much like to sit down with a team of mine who is looking at an investment, say an optical lab or maybe to acquire some software. I look across the desk and say, ‘If this was your money, if I tapped into your 401(k), would you do this deal with me?’”

More than once, the team members have sat back and reconsidered.

“A lot of times the best deal we do is the deal we don’t do,” Mittelstaedt says. When a merger goes bad, it can take a lot of time and money to salvage it.

“The prudent buyer establishes a time frame where they will turn the operation around or do something different with it,” Mittelstaedt says. Once the time is up, the buyer should become a seller, trade the acquisition to another company where it might be a better fit or close the doors.

“We’ve done all three,” he says.

Sealing the deal doesn’t end the process. There’s still the matter of integrating the acquisition. Based on his own successes and mistakes, Mittelstaedt urges a quick transition to wipe away any uncertainties in the minds of the newly acquired employees. In the world of waste disposal, it means having new uniforms, identification cards and other basics ready to hand out right away. Operational changes should come in the first month.

“Uncertainty breeds complacency, then disgruntlement,” he says. “We have found that people react much better to a rapid change and [are] able to say, ‘We’re done, now let’s move forward.’”

He’s seen some companies take as long as two years to bring two companies’ systems into line.

“What you find is terrible morale, typically terrible customer service and typically an eroding market share,” he says.

VSP takes a more flexible approach, in part because its mergers and acquisitions have been across a wider variety of businesses. Since 2007 it has bought Marchon Eyewear Inc. and Capitol Optical Corp., among others.

“I think every deal stands on its own in terms of what integration plan you have,” Fessler says. If the new company is part of the core business, such as an optical lab, VSP goes about integration more aggressively. If the new company is in a different line of business that broadens VSP Global, it may not push as hard.

No matter what the approach, don’t jump the gun, Hallsten says.

“What we get concerned about is pre-closure integration, which is risky. What happens if the deal doesn’t close or gets substantially delayed? We think you should at least have a signed agreement before you start mapping out integration issues,” she says.

The most important lesson is to follow through on the original plan, Fessler says.

“I’ve had so many clients that have done good acquisitions, but once the deal is closed they get the leather-bound deal books and they are never looked at again,” he says. All the provisions in those deals are designed to protect the buyer, and it’s important to make sure someone looks after the legal warrantees and indemnifications.

One last tip from the experts: Don’t get hung up on whether it’s truly a merger or more of an acquisition. True mergers are less common than most people think, Rocca says, no matter how the deal might be described in a press release. But that’s not necessarily a bad thing.

No matter what the deal is called, it’s all about who ends up with the money, the assets and the control.

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