Author Richard Solomon is a conflicts and crisis management lawyer with 50 years of experience in business development, antitrust and franchise law, management counseling and dispute resolution including trials and crisis management.
I have worked with several situations where the expectations of success in merger, teaming, joint venture transactions were frustrated by failure to harmonize how the resulting enterprise is to be run and how performance is to be measured post closing.
Often the negotiators' expectations of reward is in the execution of the final closing documents rather than in post closing issues. Where the acquisition team is not going to be the heart and soul of the management team post closing, this frequently arises.
Of those I have worked with, the issues range from culture to sheer ego to accounting - especially in earn out agreements - to the inability to accommodate pre closing management practices with the acquirer's methods of management. Often this is fatal and divestiture results. Often the previous owners will be able to repurchase the company at a rather substantial discount. At least one such company went through several such circular ownership changes, and the original owners made more off the sale/repurchase difference than they previously did from normal operations. Recently a well known company was repurchased at a $146,000,000 discount from the sale price not that long ago.
If this misfortune does arise, the project can be salvaged and the purpose of the transaction achieved in good order through negotiations and counselling. However, there is so much "self defense" involved when those closely involved with the project try to accomplish this that the potential often is not realized.
When the problem is that how the venture is to be managed does not conform to the culture and rules of the other company, and are sometimes even thought of as lacking in the requisite level of integrity, that is the most difficult hurdle to overcome. The reason for that is that disparagement of style/method is about the most likely influence in killing any relationship. No one should be expected to stay the course after being denigrated as a shady operator.
Most often the shady operator judgment is simply not justified. If competent thought had been given to the issue pre closing it would have been realized that the seller/opposite parties have made the company successful because they know what is called for in their markets. In many instances the lead company will impose its regulations and cause the failure of the venture.
Whether it is the installation of additional levels of management upon a previously lean business model, opportunistic accounting changes - think charging that company interest on its working capital post closing as just one example, and many more predatory impositions when there is a post closing earn out price determinant. That is but one of many unusual changes in financial management. Adding the acquirer's corporate overhead (by allocation of course) to the new enterprise's financial statement is another. The list goes on and on. Allocation techniques, by the way, include everything from straight percentage of gross sales allocation to comparative margin/contribution dollars, to anything beyond or in between - all to the benefit of the acquirer, of course.
The former owners managers, especially if they stick around, are never given a say in decisions to do this because it is certain they would always say no because it changes the financial profile of what was acquired from what it was pre closing. Had it been so configured before the transaction the transaction would not have taken place, says that argument.
In another direction and dimension, however, in one acquisition I am personally aware of, a not very successful professional basketball team was "artfully" non disclosed as an owned asset, and the team's expenses were on the books as operating expenses of the acquired company. This was found post closing to have been a personal interest of the former owner carried on the company's books. To be sure, this was an acquisition in a country where it is the ubiquitous practice to keep at least four sets of books. Had it been a USA acquisition, USA level records and pre investment forensic due diligence might have caught that.
In one I personally dealt with post closing, an earn out price multiple of net earnings increases agreement, the sellers were also the owners of the land and buildings, leasing it to the company. When the decision was made to sell the company, new leases were entered into pre closing that put the rent at a small fraction of market rents. That difference went straight into the post closing operating statement, multiplied by four. The leases by their terms expired when the earn out period expired, and rents on renewal would go back up to market rates. The pre investment due diligence team failed to note the aberrations and a huge dispute arose when this was eventually discovered. The due diligence folks also missed the fact that the owners began not submitting/charging their expense reports during the post closing year. The company looked like it was on a real march to profit enhancement post closing because of these tactics. When the artifice, and others, were discovered, my handling it taught me many lessons about due diligence as well as tough renegotiating.
These issue variations have many configurations that are often extremely enlightening. Most of these expense deferral tactics are frequently used and it is a wonder that due diligence teams so often still miss them. They are often part of the package in IPOs as well. In one IPO situation with that kind of manipulation, the managers got caught. It was a franchising company, and the well publicized enforcement and private litigation situation allowed the franchisees to improve their side of the relationship substantially. Franchisees always, when competently counselled, capitalize on franchisor choke points.
Not infrequently what looks like a financially desirable acquisition, venture or teaming arrangement is not realized due to "cultural" issues. Yes, cultural issues - things like background, nationality, religion, race and the actual way people from various backgrounds behave or perceive relationships.
People of different nationalities often view others with distrust because they recall in their early life that the other nationality was portrayed as dishonest, opportunistic, stingy and selfish, crude, you name it. Crossing religious borders also brings these feelings forth. Not even Ivy League family background suffices to overcome such negative attitudes and reactions.
I have worked in projects in which good opportunities from financial and functional perspectives have failed to come together because the undesirable seller would not take cash (mostly for tax purposes), and the buyers did not want their kind to have a substantial position in the company where they (or they and their friends) might represent a dissident shareholder movement or insist upon board representation. In one of those it was suggested that the acquisition go through because if the working relationships failed to work out it could be spun off in a public offering at a much higher price. No thanks was the response. The company eventually did go public at an enormously higher valuation.
One issue that is almost always overlooked in pre investment due diligence is an inquiry concerning the impact going forward of the fact that the acquiring company is much larger and publicly held. That company undergoes much more intense scrutiny from several perspectives than some smaller privately or closely held company. What the smaller company regularly got away with avoiding any problems at all may well, when done by an affiliate of the larger company be a magnet for enforcement or litigation. This was hardly ever a consideration even back in the 1960s when antitrust enforcement was rampant. I spent a lot of time on this issue back in the 60s.
Inharmonious distribution channels not infrequently prevent all sorts of teaming and venture arrangements. There are certainly ways to overcome this issue, which is much easier to reconcile than naked prejudices. The stories behind these seeming impasses are often mired in one company's operating history, matters that are ancient and forgotten by almost all save the opponent of the deal. Often it is just that one company used brokers while the other used its internal sales force and the brokerage firms were believed to be wary of functionally mixed companies - the brokers fear that when the market penetration positions have been well established by brokers, the firm will switch those products over to its own sales force and the brokers will not have had a future prospect over long term success. Even problems as deep seated as this yield to harmonization given the ability to find channels for opening minds.
One of the things that many companies fail to account for in teaming and tolling agreements with other companies is the question of competition between them and what the impact of that can be if not resolved before contract signing.
Illustratively, where one company is to produce for the other and the scale of the work does not account for 100 % of available output, it is unrealistic to expect the producing company to allow the additional production capacity to lie idle. You are in that situation financing your competitor. No matter the arrangements, the producer will know the price(s) at which the other company is selling the product. To the producer that price is a windfall, and the producer can afford to undercut the customer's resale price. That alone can make the entire project unsustainable for the customer company.
Add to that an overlay of the producer also handling shipment to the end user, and the producer also has the customer list of its client company. I don't have to explain the value and impact of that fact.
These and other similar deal killing issues must be accounted for prior to signing the foundational agreement. That requires serious harmonization capability not usually within the range of abilities of the negotiators of the deal. It also involves questions of legality of the arrangement, at least leaving the client company with nothing more than a right to terminate the arrangement. Sometimes the ultimate intent is that the client company would acquire the teaming agreement producing company. The least that will result will be the scuttling of that aspect of the planning. While one might expect the prospective acquiree to be circumspect about its operations, looking to the prospect of being acquired, few people are willing to defer profit opportunity now for some future prospect that may or may not happen and is certainly not a provision of the teaming agreement itself.
Where the teaming agreement is a door opening gambit of the client company into a new business segment, that business plan will collapse to the embarrassment of its promoters when the obvious temptations inherent in the operation take effect.
It is usually the situation when a franchise company is acquired, that slight due diligence is done on the issue of the value of the acquired company's franchisee relationships. The biggest and most critical asset in any franchising company is its portfolio of enforceable franchise agreements. I strongly suspect that due diligence teams have been taught that it should be assumed these contracts are worth the assumption that a certain percentage of them will be fully performed; a certain percentage will be resold to a new franchisee; some will fail of their own weight and some few will be terminated - based upon some gestalt assessment of Item 20 information in the acquired company's FDD.
My experience on these surprise post closing value collapse instances has been that there was little or no actual forensic examination of the franchisee relationship itself. Franchisees are rarely interviewed. Individual operating files get maybe spot check examinations, and they are rarely kept all in one place. There are operating files, advertising files and compliance/enforcement files somewhere on the "premises". I strongly believe the seller company is fearful of a close look and that the buyers know that. The due diligence team is instructed not to look into chastity issues because this groom really has the hots for this bride.
This is especially so for over the hill companies that buy other over the hill companies in the same business to make it appear that they are still growing even though the industry itself is shrinking. The shrinkage is often due to technological changes, a buggy whip effect. All the ones who see it coming sell to those who want to stretch the appearance of continued substantial unit growth even in the decay stage of the industry's life cycle.
Faking countercyclical force will work for a while, because the Item 20 information is never viewed in light of the reasons for the apparent counter cyclicality. Most of the time the franchisee investors are incapable of that level of due diligence sophistication anyway, so there is no need to worry about them linking up the acquisition history's impact upon Item 20. There are many other franchisee file issues reflecting upon valuing them at par. Taking an actuarial approach in evaluating them is OK if you are ready for and expect the surprises.
I strongly suspect that the surprise depreciation in value post acquisition may be due to the manner if its evaluation. Without forensic due diligence on the actual franchisee relationships themselves; with a gestalt assessment of historical Item 20 information; and with a triage approach to franchisee gross revenue analysis, a more reliable prospect may be available. After all, the company is worth some function of the gross sales of its franchisees because the franchisor's expectation of revenue is a direct function of that stream. It is how that stream is evaluated, the formula if you will, that determines the likelihood that the price will reflect a closer approach to its fair value.
To be sure, the price arrived at through that approach may well not be acceptable to the seller. Those are the situations in which earn out variable pricing can sort out the issues. The acquiring company does not pay for value that is not there, and the seller gets his price if his estimation of value is correct. Of course, in a declining market, the result will be somewhere in the middle.
This could go on for at least several chapters, but this should suffice to highlight the fact that often under examined issues arise to prevent or obstruct achievement of the goals of very attractive, positive transactions. No company keeps resources in house to deal with these kinds of issues.
Few, if any, of the major consulting/financial management firms are tuned up on this either. It deserves serious consideration; perhaps greater scope education regarding how these major transactions are planned and implemented; and perhaps simply adding to the vetting team someone with the experience and insights to present them in a form which enables them to be dealt with timely and constructively.
Hart, Scott, Rodino registration and negotiation processes are beyond the scope of his article, although the potential impact of resistance to the transaction by the government on any of numerous grounds must always be addressed specifically in any agreement.