Mergers & Acquisitions (M&A) 101

Thanks, everyone for your encouragement to my maiden attempt last week.

As you all know, Mergers and Acquisitions (M&A) is a vast subject.  I intend to pass some knowledge gained to beginners & share some unique experiences with people passionate about M&A pursuits.

Sept 5th is Teachers' Day in India. I would like to thank my gurus on this subject Surjeet Singh , Ex- CFO of Patni Computers Ltd., and Manoranjan (Mao) Mohapatra , ex- CEO of Comviva Technologies Ltd. They both immensely helped me in my learning during my career journey. I also acknowledge Satish Babu 's significant contribution to all M&A pursuits. We learned something new in every deal.

Basic steps in M&A deals

There is enough material in the public domain on the various stages of M&A. So, I am just sharing some tips for beginners who may be operating with tight budgets.

1. M&A strategy:  Your management might have directionally set up an M&A strategy. The mandate may be to fill the gaps in your company’s service offerings, market consolidation, geo expansion, new customers, etc. If you do not have one, make sure that there is an alignment with all decision-makers (say the Board/M&A Committee). Create a scorecard with items that you want in a target asset. We may not always find a perfect fit, but we need to get a high score if we map the target asset against the scorecard. This may avoid wasting a lot of time, effort, and money. You may like to also decide on integration strategy and synergy operationally and culturally. We may tweak it later, but create a default plan.

2. Investment banker: It is important to have an investment banker as an intermediary. Targets may be more comfortable interacting with them in the initial stages of the deal until we develop mutual trust. Choose one who specializes in your focus area. If you are on a tight budget, you may consider signing up for outcome-based fees (and no monthly retainer-ship fees). You can consider limiting exclusivity to targets proposed/ introduced by the investment banker. This may be a tough negotiation but may be feasible and a win-win. Once a target is shortlisted you have to be quick in your decision-making process to close. Targets may be talking to multiple parties. At times you may have to open the purse more to be the best bidder or drop it. You may like to negotiate an exclusivity period to give you time to make a decision.

If you are comfortable, share your M&A focus areas (in the public domain) through Press interviews, LinkedIn posts, CEO communication, etc. You may also connect with some Investment bankers with a Sell-side mandate. There may be some great assets available in the market and they will reach you voluntarily. You can then introduce your investment banker to take the process ahead. 

3. Initial Information request: Develop a basic information request template yourself and make sure that you have all the items to do your scorecard for the initial scan. This may help you to decide Go vs. No-Go for key parameters much before the Due diligence stage. Analyzing trends and getting insights into the initial information on Key customers/ Profitability by Business vertical, monthly/quarterly trends, etc. It is important to remember that the value we pay is for future trends.  So, a good past trend is just a data point. Focus on the Pitch deck and future strategy. Make sure you have all the information (incl. possible synergy benefits that you can achieve) to complete your evaluation. This holistic picture will help you complete your scorecard and complete your initial view of your offer price. Carefully analyze the data presented in this stage. Items like R&D / IP Capitalized, Adjusted EBITDA, Revenue Recognition policy, headcount, etc. may require very close review.

4. Cultural fit and Goal alignment: While the regular diligence is on, you will get enough face time with the key management and employees.  Find time to discuss your key expectations (say. post-M&A integration plan, broad working framework, etc.) at a high level. Make sure that you evaluate the alignment in thought process and cultural fit. This is very critical. It is important to get the stakeholders of the Sellers and key management interested. If you like the management, give them comfort so that they would like to stick around post-closing. This is the phase when they make initial decisions. Engage with them and develop a joint business case, if you can. Then buy-in will be better. Such interaction may get a good feel about the level of interest in the deal from the Sellers.

5. Letter of Intent: This is the first stage where you will make a formal non-binding offer to sellers. You may get help from the Investment Banker on market multiples. However, do your research and see if you will be able to justify the valuation based on the DCF model. In addition to your offer, please make sure that you add key terms and conditions that you will have in your MSA (non-negotiable terms) here. We used to list the pricing assumptions and key terms. Three key terms you should consider covering are given below:

(i) Working Capital & CAPEX: 90-day working capital to remain in the business. We will use the past trend to evaluate the same. We ask for the $ value of CAPEX needed for Technology refresh to run the business for the next year to meet their forecast and add that to the money to be left behind.

(ii) Representation and Warranty: The data provided during diligence will be part of Representation on Warranty terms in SPA/APA as we will rely on that information for making our decision.

(iii) Key assumptions: Key assumptions that we used to come up with the price based on their initial information. Could be related to the customer, Revenue, Cost, Margin, Order book, working capital (good collectible debtors and good saleable inventory), etc.

Make sure that you discuss these and agree at this stage. This can avoid potential issues later in the final negotiation. This can help us re-adjust the price if some assumptions change during diligence.

 6. Due Diligence:  Appoint the right firm for Accounting/ Tax / Legal diligence. In parallel continue with business diligence using your internal team (SMEs). Break this into logical threads viz. Business, Finance & Tax, HR, IT, etc. Each team should review the possible synergies. Customer discussion, key contract review- employee/customers/suppliers, etc). This can help you save costs if you can get internal SMEs for the review. These SMEs can help you create an operating plan for integration. Use a risk-based approach. Use the knowledge gained from the data you received in the initial phase and decide the focus areas where you may need a deeper diligence review

7. Meeting Key employees: Most of them ideally should be presented to you during the Diligence phase. This should help us to get an initial view of the operating model/ Organization structure post the deal. It may be good to understand group/team dynamics. During the evaluation check if they are process-driven or if outcomes are significantly dependent on some key employees. All these inputs have to be considered when you fill the roles in the new org. structure. Use the networking opportunity to build trust and excitement. They can be your torchbearers when you reach out to the larger employee base later.

8. Negotiation of Stock/ Asset Purchase agreement (SPA/APA) : We adopted a strategy of negotiating the business / commercial terms with Sellers before formal SPA/APA discussions with attorneys from both sides. Since we agreed to many key terms during the initial Letter of Intent stage, it was easy to agree to other terms. Make sure that all your key risks and requirements are covered in such meetings. We also agreed to some Representations & Warranty terms (that were critical for closing) before engaging the attorneys. This saved us a lot of legal team time (external Counsel) once we agreed to all business terms (and key principles). Negotiating business terms in the presence of attorneys (both sides) makes it more complex. As we all know it is a zero-sum game there. We just left legal/ tax terms and observations/ exceptions that came out of diligence to the legal team. It saved a lot of time and cost both sides.

The most important item that you need to focus on is the value of working capital that will be left behind. We looked at the cash conversion cycle and invariably negotiated 90-day working capital as part of the price. We defined these in the Letter of Intent.

9.  Closing: This is the legal formality. We ensured that the HR team was engaged on both sides and that all communication, FAQ, Press release were completed. The teams also were ready for items where we planned integration from Day 1 (Eg: IT network, HR, etc).

Some learning & Best practices

Unique experience in 2 deals where we made the right decision to walk away

 Deal 1: Foreign exchange exposure was a key risk – The Deal fell off

 -  A US-listed company decided to sell its subsidiary in Brazil and exit the LatAm region. This entity was on the market as its strategy changed after its new CEO took office.

-  The Seller wanted one USD check at the time of sale (100% upfront). We offered our standard structure – 50% upfront payment and a 3-year earn-out. This was a hard negotiation during the Letter of Intent stage. Finally, seller agreed to our terms but wanted the payout in USD.

-  It was a “Go decision” post the diligence on all factors except one issue. There was Forex risk in Purchase consideration.

-  The Brazil subsidiary had all revenue in local currency and the Seller wanted Sale consideration in USD. The currency was stable (1 USD = BRL 3.26). It was in a narrow band from 2016 to Feb/Mar 2018 when we were negotiating this deal initially.

-  Before final deal negotiation the currency moved from 3.26 (Feb 2018 – DD stage) to 3.40 (Apr 2018 _Final negotiation). There were reports that there could be currency depreciation. The Sellers were OK with up to a 5% depreciation adjustment as currency had moved down 5% between these two dates.

-  We asked for Earnout (computed as a % of future revenue for Year 1 to Year 3) to be fixed in local currency. We said we would pay in USD but based on the market exchange rate on the date of payment. The Sellers refused and we pulled out of the deal as we were worried about the currency exposure

Fast forward: 

By Sept 2018 the BRL depreciated by 25% (1 USD =4.06) and the business became unviable. They had a lot of Opex cost in the US which we may have corrected had we bought this business. They shut down the business by the end of Dec 2018. We made the right decision walking off this deal which looked great in Mar 2018.

 Deal 2: Carve out of LatAm business of a very reputed listed company based in Europe

This was a very large deal. The company decided to hive off and exit the LatAm market. Since it was a listed company there were constraints on data that they were able to share (other than publicly available information). The initial claim back by their management reports indicated that it was a very profitable business.

After legal formalities to secure confidential information, we were able to get a small team (2-3 members) to the Sellers facility for business diligence. After two weeks of deep dive review, we realized that the initial hypothesis that it was a profitable business was incorrect. We used a risk-based approach. The devil is in details (review forecast, headcount, cost allocation, common cost borne by corporate, etc. Do not just go with printed reports but triangulate it with other data to validate the same.

Fast forward: They never sold that unit. Their reported business revenue showed a continuous decline from 2015.  Their revenue in 2023 was 33% of 2015 levels (they list 67% topline in 8 years).

"All that glitters are not gold". Our, Business diligence is critical.

Other Best Practices

i. Earn-out: 

 We always negotiated Purchase consideration as Upfront plus. Earn out for 3 years. We linked the future earn-out to the performance committed by them in their forecast. We linked both Revenue and EBITDA forecasts achievement to the Earn-out dollars.

ii. Audit: 

Financials were always audited before closing and Accounting teams were integrated on Day 1 as we were a subsidiary of a listed company.

iii. Cost optimization

We always plan the support team integration between 0-90 days of closing. We were razor-focused and achieved the SGA savings within the planned timeframe. Since EBITDA was linked to earn-out, we invariably had good support from the CEO of the acquired entity and Sellers. We created the plan before closing and the execution plan kicked off on Day 1 post-closing.

iv. Org. Structuring

We plan the future integration of legal entities before closing. The purchase transaction takes into account the future Org. structure. For example, if we have a local entity in that country, the purchase consideration for that entity will be paid out of that local subsidiary so that we can easily collapse the entities in the future without significant tax costs.

v.  Contingency cover – Hold back from Purchase consideration

Based on the risks identified in the Diligence, we negotiated some Contingent amounts for unknown risks. This was help back from the Purchase consideration and was paid along with the earn-out after adjusting any pre-closing liabilities that were not known/recorded in the books. Recovery through legal suit is a lengthy process. This will make it easy. Eg: Open tax assessment/ customer dispute

 Hope this is useful. Please share your experience and feedback too.

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