Mergers require ample preparation, the right timing and due diligence on the sides of both seller and buyer.

The State of the Art of the Deal

Mergers and acquisitions can be big successes or major failures, depending on preparation

Back Longreads Jun 6, 2022 By Steven Yoder

This story is part of our June 2022 print issue. To subscribe, click here.

As merger mania rolls on, more investors and firms are looking for businesses to snap up. But many company marriages fail. Is now the time to sell? And how do you pick the right partner and make sure the deal doesn’t blow up?

It could have been a tough transition in 2014 when HUB International acquired independent insurance agency John O. Bronson Co. 

The two firms couldn’t have been more different in history or size. HUB started in 1998 when 11 Canadian brokerages merged, becoming the world’s ninth-largest insurance broker by 2014. John O. Bronson Co. had served the Sacramento region since 1888. 

But the Bronson team did their homework, meeting with five potential buyers to find the right fit, says Robert McVicar, a former vice president at Bronson and now executive vice president at HUB International Sacramento. The Bronson team wasn’t interested in a company that would offer a good price but not be committed to its employees. HUB stood out because the culture of the two firms meshed — both are “entrepreneurial, focused on our people,” says McVicar. Also important: HUB wasn’t looking to change how Bronson operated, which wasn’t true of some other firms they talked to.

Bronson’s sales staff saw the advantages: access to more claims and loss-control resources and to specialized experts. Producers could take that message to clients, which helped keep customers through the transition. No Bronson employees left the company over the ownership change, McVicar says. “Finding a partner that aligned with our goals and objectives and morals was really important,” he says.

Globally, the value of mergers and acquisitions hit an all-time record in 2021. But more deals doesn’t necessarily mean more profitability, satisfied employees or contented customers. According to the Harvard Business Review, 60 percent of mergers and acquisitions destroy shareholder value. That outcome isn’t inevitable though: Area business leaders and M&A experts have lots of wisdom on how to avoid a deal that falls through or causes problems for sellers and buyers months or years later.

When transactions go bad

For healthy companies looking for M&A partners, it’s a seller’s market. Buyers involved in health care transactions paid 20 times earnings in 2021, five times higher than 2019, according to management consulting firm Bain & Company. Elizabeth Leet Jackson, partner at Sacramento law firm Delfino Madden, says the rise in interest rates hasn’t slowed the surge: In 2021 her firm did $1 billion in transactions. In first quarter 2022, it hit $250 million, though it’s the fourth quarter that’s usually its busiest. 

Area experts mostly give similar reasons. Historically low interest rates mean more buyers are looking for returns, especially private equity funds getting into new cash-flow-positive industries like insurance and health care. Target companies look more attractive because they benefited from federal pandemic relief and paid down debt, so their balance sheets are strong. And for sellers borrowing to make a purchase, debt is still cheap by historical standards.

That doesn’t mean inflated prices are the rule everywhere. Software companies get valuations that are many multiples of revenue even when they don’t show a profit, says Jessica Holcombe, founder of the Holcombe Law Group in Auburn. More traditional businesses — home inspection companies, restaurants, service businesses — normally aren’t seeing those price spirals in a sale, she says.

Deal frenzy also means more sellers who aren’t prepared. If a seller has trouble assembling core documents and prolongs the sale process, market conditions can change and the buyer might pull out, says Dan Morash, founder and CEO at California Safe Soil in McClellan Business Park and a former Wall Street investment banker who’s bought and sold numerous projects in the energy sector. 

Sellers also can move too fast. After identifying a buyer and seeing a purchase price they like, an owner might sign a term sheet, which describes the major parts of the deal, without consulting their attorney. Only later do they find out from counsel about unfavorable terms, like a noncompete provision that keeps the owner from working in their own industry for a long period after the sale, says Holcombe. 

Owners also overpromise and underdeliver, which can come back to bite them post sale. In most transactions, a portion of the sales price is withheld and payments toward the agreed price are doled out over time post closing as the company meets agreed milestones, often quarterly profits. This contract provision is called an earnout. Mark C. Lee, a partner at Rimon Law who’s based in Sacramento, says that in more than half the deals he’s been involved in on the sales side, the sellers don’t make their earnouts. 

Real-world disasters abound. BankBoston’s 1998 acquisition of investment bank Robertson Stephens failed in 2002. The Chrysler and Daimler-Benz merger dissolved in 2007. 

AOL and Time Warner disbanded in 2009. Bust-ups have many triggers: Purchased companies don’t perform as projected, company cultures clash, customers or employees flee after the deal closes. “The landscape is littered with those,” says Curt Rocca, managing partner at DCA Partners, a Roseville-based boutique investment bank specializing in M&A advisory services.

The right way

On the flip side, mergers and acquisitions are a great tool for buyers to expand and for sellers to get working capital or exit to retirement. Bay Area-based Bank of Marin’s acquisition of American River Bank last August helped Bank of Marin enter a new market and offer their existing customers new products, says Marin president and CEO Tim Myers. 

For sellers, one of the first steps is figuring out what you’re after, Morash says. It’s not always about retirement — some owners want an infusion of cash by a private equity firm to liquidate debt or get more capital to grow. Others are looking to merge with another company to cut overhead and fuse complementary assets. At this early stage, some companies hire a business consultant to help them define the market opportunities.

The due diligence part of the transaction — such as the buyer’s review of contracts, finances, accounting and governance records — may be the most time consuming. So one of the first steps sellers should take is to get with their CPA and tax advisor to make sure there are no hidden landmines that have to be disclosed or dealt with, Rocca says. So important is the due diligence phase that he suggests sellers hire an M&A advisor to put the company through a dry run of the process before an actual buyer gets involved.

What gets less attention is that due diligence goes in both directions. Lee says sellers need to ask for documentation that the buyer has the cash to pay for the sale or a loan commitment letter if they’re relying on borrowed money. “Most sellers are only thinking about providing a ton of information to the buyer. They’re not really thinking about their side of the ledger,” he says. He’s seen sellers get strung along while the buyers get their finances together.

Equally important, sellers need to assemble a team to run the business while the owner is tied up in the transaction, says Jackson. A sale often requires that the owner treat it as a full-time job. Not doing so can tank a deal: One of Holcombe’s clients decided to take on due diligence without the help of his legal team and got so distracted by the demands that the company’s revenues dropped and the seller lost interest. 

In most sales that Lee has been involved in, sellers hire a broker, especially as the size of the selling company increases. Brokers often have a lot more insight about potential buyers than sellers do. Take a medical practice: “They don’t know who is out there looking to roll up or acquire a bunch of physician offices,” says Lee. “They have no idea — they’re heads-down and taking care of patients.”

Several factors will affect the sale price, and Rocca advises sellers to determine who are likely to be their high-value buyers and to look at the sale as the buyer would. That means assessing with a critical eye which elements of the business will be most valuable to a buyer and which most concerning. Are future revenues highly dependent on the current owner? If so and they plan to exit, the deal may be worth less to a buyer. The same is true for customer concentration: Most of the revenue depending on just a few clients could lower the price, Rocca says.

Company culture matters more than ever to deals. McKinsey & Company M&A partner Rebecca Kaetzler said in a company podcast in 2020 that the consulting firm’s data shows companies that get merged or acquired are more likely to hit their cost and revenue targets if they plan how the two cultures will work together. That means cultural diligence — frank discussions about how the two companies’ management practices and ways of working differ and how those differences will be dealt with — is as important as due diligence. That process might involve bringing in an outside consultant.

​​HUB International has done about 800 mergers, and only a handful of those have failed, says Ryan McManus, vice president of mergers and acquisitions. The number one reason for post-deal company divorces is culture problems, he says. For HUB, an hour-long meeting over video doesn’t cut it; they want to meet with potential target companies in person and have dinner. What’s their business strategy, and what might they need help with? How do they talk about their employees? Who’s sharing in the proceeds of the sale? “We have a funny thing at HUB — the more time we spend with you, the more the price goes up,” says McManus.

He says a main reason cultures so often clash is that the larger company tries to push their culture on the smaller one. HUB does the opposite, he says: “We’re a very bottoms-up organization. The field tells corporate what they need rather than the other way around.” 

Culture also affects whether employees stay after the deal closes. Jackson says she’s seeing a new trend in negotiations that’s likely due to widespread labor shortages: purchase agreements that require a certain percentage of the seller’s workforce to accept employment with the buyer on terms and conditions similar to their current ones.

Sellers considering withholding bad news from a buyer — say, that an employee is thinking of suing or a key team member is planning to leave — should resist the impulse, Holcombe says. Most contracts have holdback provisions that let the buyer keep part of the sales price after the deal closes as insurance against problems that emerge later. The seller has more leverage before the sale than after to negotiate how much money fixing a problem is worth, Jackson says.  

“It’s never too early to start planning for a sale. You just don’t know when someone’s going to come knocking.”

Curt Rocca, Managing partner, DCA Partners

It’s never too early to start planning for a sale. “You just don’t know when someone’s going to come knocking,” Rocca says. Failing that, he advises owners to think three years out since buyers usually want to assess two to three years of performance. That gives sellers time to fix issues with management, customer concentration and more.

Change being hard, there’s another sale involved: telling customers, employees and investors why the deal is good for them. In the Bank of Marin-American River Bank acquisition, Myers says that conversation was important because Bank of Marin was the bigger bank coming into the region from outside. “You have to tell the story. And honestly, one thing we learned is you can never do enough,” he says. “There were times where we felt like we were inundating people with communication and the feedback was, ‘You’re not being transparent enough.’ So you’re toggling between not overwhelming people with updates and not having them feel like we’re not communicating.”

What’s success look like?

It’s possible to measure how well deals worked out. For buyers, it’s whether the target business gets seamlessly integrated into the buyer’s operation, says Lee. That’s often measured in profitability, and some acquiring companies keep a separate cost center for the acquired business. Turnover also matters: Top management usually leaves after a deal, but if the people below them don’t, that’s a sign of success, Lee says.

For sellers, a key measure is whether they were paid what they hoped from the sale, hit their post-sale performance targets and got their earnouts based on making those milestones, says Christopher Russell, a partner at Stoel Rives who handles M&A transactions. Hitting earnouts is a sign that there was a proper transition of the business, he says. 

McManus advises selling companies to pay attention to anything they’re uncomfortable with in negotiations and revisit what they’re trying to achieve with a deal. “Think about what you want the outcome to be. What do you want it to be for your employees? What do you want it to be for your clients? What do you want it to look like five years from now?” 

Eight years after the deal, McVicar says the Bronson team got the outcomes they were after.

“The culture in our office and the culture of HUB, they aligned pretty darn well,” he says. “It was a 10, and that’s not just because my boss might see this. We did good.”

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