While investment banks and other capital-markets players like to see large public companies feed on each other, blockbuster tie-ups rarely produce giant returns for shareholders. Acquirers’ cumulative returns for such deals were -1.6% in 2011 and the average return since 1990 is -0.8%, according to The Boston Consulting Group. There were an unusually large number of public-to-public transactions last year that produced large losses, the BCG said in a recent report.

Private-company acquisitions have only a slightly better history of returns. But at least it’s a positive one: 1.4% since 1990. And in a slow M&A market, the dollar volume of private-company acquisitions in North America has risen slightly this year as of August 31: $284 billion, compared with $251 billion year-to-date in 2011, according to data provider mergermarket.

Deals with private-company targets have some inherent advantages over large ones — or at least are thought to. Small targets more often sell at a discount or at least a more reasonable premium, for example, because of less competition among buyers. The private-company target may also be in an early stage of its life cycle: a stage prior to robust growth in its product or service in which the acquirer reaps the rewards of after-buying. And the integration of a large buyer and a small privately held target company can be less taxing for the buyer’s management team and its employees.

But buying a small, privately held company can be a messy proposition that’s sometimes worlds away from other kinds of M&A and certainly a less familiar experience for a buyer’s in-house mergers team. And the pitfalls are just as numerous: just think of Microsoft’s $6.3 billion acquisition of aQuantive, nearly 100% of which was written off this year. If such deals are improperly managed by the buyer, as Microsoft’s experience shows, their value can be easily wiped out.

Wading Through the Financials
The state of a small private company’s finances can be a shock to a finance chief used to working with large companies. The small-business owner is unlikely to walk into the room clutching five-year pro forma financial projections and market research substantiating the future potential of the business, says Michael Nall, founder of the Alliance of Merger & Acquisition Advisors, an organization of middle-market M&A professionals.

That’s because business owners rarely think of an exit plan or prepare formal projections. “Owners often have a lifestyle sort of business that they pass on to their kids,” Nall says. “They never give [an exit] a thought until they hit retirement age and then the kids don’t want to take it over. Then they realize they have a problem,” he says.

Just trying to figure out the value of the prospective target company can be difficult. The sellers usually don’t know the value themselves and, for many private firms, historical financial statements often don’t reflect reality, says Nall. The financial reports of a target company “often have to be restated to show what it would have been like run as a public company,” he says, “eliminating things like personal discretionary and nonrecurring expenses that are so prevalent in a private company.”

Many business owners simply report earnings to minimize the tax bite instead of to show true earnings, and “that is where a translation is needed,” Nall says.

Small businesses don’t intentionally calculate things incorrectly or present false data, says Mark Albert, a partner in Perkins Coie’s emerging companies and private-equity practices. “It’s just that a lot of them use cash-basis accounting instead of [an accrual basis] and they may not be recognizing or declaring expenses the way they need to from the IRS’s perspective,” he says.

Although the buyer must adjust the target’s historical financial statements to account for all this, the adjustments are not always straightforward. For example, some private companies pay a salary to family members who are not fulfilling any function in the business, so the buyer must decide whether to add back those expenses to the company’s profit line. “Is this a valid add-back, or do you need to replace those people at a percentage of current market compensation?” Nall asks of those situations.

On the management side, business owners may be paid a hefty salary although they’re not involved in operations and indeed claim they’re not essential to the business. But “a savvy buyer might say, ‘Wait a minute, I have to replace you,’” says Nall, and thus declare an add-back invalid.

Price Differences
Given the difficulty of coming up with a valuation, it’s not surprising that many buyers run into problems when negotiating price with the seller. The biggest hang-up for small-company deals is often in the price. Often the longtime owner may have a highly subjective price in mind, while the buyer, based on the numbers, may come to a wholly different conclusion of the target’s value, says Albert.

Sellers may dwell on the company’s past performance and project that forward without taking into account any changes in the business’s prospects, for example. Or the seller may have wildly optimistic expectations of how much the business is going to grow and what the owners should be paid for. But “the buyers don’t want to pay the sellers for future potential” because that’s exactly where buyers expect to earn their profits on the deal, Albert says.

To bridge the gap, many such deals include earn-outs, which give the seller added consideration if the company hits performance milestones over time. There are also escrows, which are hold-backs of a portion of the purchase price to indemnify the buyer if it discovers errors or problems — like a hidden tax liability — in the target company after the close. In a study of private target transactions last year, Shareholder Representative Services found earn-outs being used in 25% of all deals. Escrow periods are also lengthening, giving buyers more time to identify hidden problems.

Kinder, Gentler Integration
Earn-outs and hold-backs are not only keys to reaching a price, however. They are tools used to retain a privately owned start-up’s founder and key management, which can be critical to the success of a merger with a small, closely held firm.

Tom Herd, head of the North American mergers and acquisitions practice at Accenture, recently worked with a health-care technology company on this very issue. “If the founder had decided to walk away, all of his plans to develop this leading-edge technology [further] and his customer contacts would have left with him,” he says. “The customers who had installed this breakthrough technology were relying on him to guide the installation and make it work.”

The incumbents of a target firm really count, believes John Quinn, CFO of LKQ, a $3.7 billion supplier of replacement parts and systems for automobiles and trucks that closed four acquisitions in 2011. He says that if the buyer doesn’t manage to keep the right people, “sometimes the customers will be more faithful to the employees that leave than to the company. Companies pay a lot for goodwill, and a lot of that goodwill is tied up in the people, the process, and the customers. A poorly executed integration will destroy that value.”

Retaining people is all about cultural fit, according to Quinn. During due diligence, LKQ often has target-company management visit its facilities to ensure the sellers see a cultural fit, he says. “Once we get these people on board, we try to get them with a compensation package that is appropriate and may include some equity, so that they have a vested interest in the company and will want to stay,” he says.

Further, executives of the acquired company retain enough authority over their area to feel like they’re part of the newly combined company, according to the finance chief. At the same time, it’s crucial for them to retain the entrepreneurial spirit that made the target company successful before it was purchased, says Quinn.

The first rule of acquiring a small company is “don’t fix what isn’t broken,” echoes Accenture’s Herd. The CFO of the buyer must understand the original hypothesis of the deal and not destroy the growth potential that drove it in the first place, he says. Translation: don’t use the formal merger-integration frameworks and methodologies that you normally would on larger transactions.

“Unfortunately, we see clients who are determined to squeeze these small companies on to their existing operations or technology templates, and they end up burdening them with so much overhead and process that they end up [killing] the golden goose,” says Herd.

He recommends “parachuting” one of the purchasing company’s high-level executives into the target’s operations to be a guiding hand to the seller’s management team during integration. “The executive acts as an advocate on behalf of the target company’s management to keep all the integration teams and centralized functions [of the buyer] at bay,” he says.

Second, despite investor pressures for short-term results from the deal, the buyer must resist focusing on cost reduction and quick-hit successes. “There’s always a perception that the buyer paid a significant premium for this small, hard-to-value company, so investors want to see quick synergies to justify the premium,” Herd says. As with a large transaction, a buyer might think it prudent to move quickly to reduce back-office head count, cut manufacturing inefficiencies, or shut down redundant distribution networks, for example.

But buyers need to handle small acquisitions in a gentler manner, focusing on things like growth, talent retention, and a product-development road map first. In the past three years, there has been a movement toward buyers taking a collaborative posture with small-company acquisitions. “The buyer collaborates with the target’s management to understand how its resources can help fund the target company’s growth,” Herd says, asking them questions like, “‘How can we help you overcome obstacles that you yourself couldn’t?’ and ‘Where are the undeveloped opportunities in your market?’”

In the course of an M&A deal with a small target, it’s tempting for the larger acquirer to step in and fiddle with the target company’s operations and management because the acquirer’s executives think they know better. But a lighter hand may yield a better return.

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