Business Valuation: Key Questions to Ask

By some estimates, roughly 80% of a typical small business owner’s net worth is tied up in her company. Yet, according to experts, most entrepreneurs have not taken the time to formally value their companies.

Financial Planning:

BY: ANN MARSH

FINANCIAL PLANNING

THURSDAY, FEBRUARY 21, 2013

“The value is the amount your business would be worth if you were to sell it to a third party,” says Mark Tepper, the president of Strategic Wealth Partners in Seven Hills, Ohio. Tepper, who specializes in working with small business owners, has devised a multi-step process for doing back-of-the-envelope valuations for his clients.“We put the valuations together as part of our wealth management package,” he says.

English: Figure 13: Break even of costs and revenues; new investment. Belongs to The Organic Business Guide. (Photo credit: Wikipedia)

Given that certified valuations cost between $5,000 and $20,000, Tepper says, many of his clients prefer to use his process at first before making the larger investment. Although he warns that his line of questioning offers only a rough number, he says it can still give clients a preliminary way of thinking about their assets' value. “These are not certified valuations,” he cautions. “You can’t take these to IRS court and challenge a gift tax or estate tax ruling. But we can turn [them ]into a certified valuation in roughly a week’s time” if necessary, he adds.

As part of the process, he says, he asks his clients the following eight questions:

1. Can the company stand on its own two feet and operate independently of the owner?

“A good litmus test is if you don’t have the ability to take a month-long vacation from the business, and shut down email and phone communication for that month, then the business is not independent of you,” according to Tepper. “No acquiring buyer is interested in buying a job. They want to buy an investment.”

2. Does the company have a stable and motivated management team?

“Those are really the biggest assets in an acquisition,” Tepper says. “We want to make sure [the management team] will stick around post sale." To ensure this happens, he says, owners should have some sort of non-qualified deferred compensation in place: Valuable team members "should want to continue working so that their account will vest every single year,” he explains.

3. Are there operating systems in place that can improve the sustainability of cash flows?

To make sure a company is a well-oiled machine, Tepper says, there should be a how-to manual -- so that when somebody acquires the venture, they don’t have to learn everything from scratch. “This also helps to protect you when employees leave,” he says, “even if it’s just a receptionist.”

4. Is there a diversified customer base?

“You don’t want to generate 70% of your revenues from one big company,” he says, “because if they leave, you are out of business.”

5. Are there recurring revenues?

“The greater percentage of your revenues that are recurring, the greater the multiple that you will attract” when selling the firm, Tepper says. Firms are typically sold as a multiple of revenues, such as 10 times earnings or total revenues. “This would be something like a cell phone contract,” he says, “not like buying toothpaste. You want sales on a subscription or contractual basis. The acquiring owner would expect those revenues to continue.”

6. Are the financial statements easy to understand?

Buyers want to make sure your client is not running a lot of lifestyle expenses  -- such as cars, vacations or country club memberships -- through the company. Those would make the company’s tax profile look better than it is in reality, Tepper says.

7. Is the appearance of the facility consistent with the asking price?

There can’t be broken windows or unkempt grounds at  $10 million asking price, Tepper says.

8. Is the cash flow not only good, but improving?

A buyer wants to know he is getting an asset that promises to increase in value, he adds.

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Getting more value from divestitures

Companies often struggle to capture the full value of a separation. Here’s how to do better.

McKinsey Quarterly:

FEBRUARY 2013 • David Fubini, Michael Park, and Kim Thomas

Source: Corporate Finance Practice

Most divestitures start with a strategic decision that a company is no longer the best owner of one of its businesses. ... Indeed, past McKinsey research has shown that companies that more frequently reallocate capital generate higher returns than their peers.¹

But once a company decides to sell, problems can arise. Managers devote their attention to finding a buyer but seldom scope deals from a potential buyer’s point of view, even as they struggle to figure out exactly what should be included in the sale, apart from the productive assets that are its centerpiece. ... Management and the board can get so caught up in the sale that the core business begins to suffer from neglect. All in all, divestiture turns out to be no panacea: sellers can take up to three years to recover from the experience (exhibit). Indeed, some companies are so wary of these pitfalls that they decide to muddle through with businesses of which they are not the natural owners—another unsatisfactory result, as research suggests that these sales can produce significant returns for both the parent company and the divested or spun-off business.²

In our experience, even highly complex divestitures can work well, provided companies follow proven practices, especially in three areas: scoping the deal in detail, addressing the so-called stranded costs left behind when the revenue-generating assets are sold, and managing the expectations and concerns of employees.

... Getting started on these activities quickly, in parallel with the search for a buyer, can unlock enormous value for buyer and seller alike.

Taking the buyer’s point of view

... Admittedly, it’s a bit impractical to define exact deal boundaries before the identity of the buyer and its preferences are known.

To get around that problem, smart sellers define a number of different deal packages—of assets, people, and services—configured to attract interest from a broad spectrum of buyers. These packages not only broaden the field of potential buyers, often in ways that companies cannot envision at the outset, but also help the company cope with the tough questions that buyers inevitably have about what’s in scope, how to separate, the transitional services they can count on, and the financials of the business. ...

English: Diagram of private equity fund structure for Private equity, Private equity fund, Private equity firm (Photo credit: Wikipedia)

Sellers can construct sale packages for a range of buyers. Each buyer is unique and will have more or less need for infrastructure, capabilities, and a geographic presence where the assets for sale are located. To prepare for the wide range of needs, most sellers will want to develop basic packages for at least three types of bidder: a strategic buyer with a local presence, a strategic buyer from another region, and a private-equity firm seeking a stand-alone entity. ...

... And there may also be buyers interested in cherry-picking parts of the core business instead of taking all of it—which, while probably not ideal, should not be discounted out of hand. Sale packages include pro forma financial statements tailored to represent the package being offered to each buyer or class of buyer that highlight the true value of the business, separation and transition plans, and details on proposed management and talent assignments.

When a large industrial company was looking to divest one of its business units in the late 2000s, its managers’ first instinct was to sell to a large strategic buyer. But by conducting a form of due diligence on its prospective buyers ...—including some private-equity firms—the company was able to understand all the potential synergies each would gain by buying the business. That enabled managers to design a specific value proposition for each potential buyer. Eventually, they were able to attract—and sell the business to—a much smaller player ... . Even better, the company got a price 20 percent higher than first expected. In fact, ... the final list of bidders included a private-equity consortium and a few other unanticipated interests.

Rooting out stranded costs

One of the most challenging aspects of a major divestiture is that even sellers that control expenses well are inevitably left with some corporate costs associated with the business but not sold with it. ... Stranded costs essentially can be any type of cost that does not automatically disappear with the transaction, ... . Some of these are fixed, such as the IT system, and cannot be readily reduced regardless of the size of the divestiture. Others are more variable and can contract, for example, with a lower head count—but they can still take years to unwind unless explicitly planned as part of the divestiture. ...

We see three strong practices to reduce overhead. First, ... defining the precise boundaries of potential deal packages early in the deal brings to light the full extent of the subsidiary’s sales, general, and administrative costs. The parent company can make a better attribution of resources to the parent and the subsidiary. That benefits both companies.

Second, successful sellers often use the momentum generated by the divestiture as a catalyst to reduce stranded costs—and to improve the performance of any bloated or inefficient corporate-center activities revealed by the divestiture. (This mirrors a similar effect of transformational acquisitions, in which buyers take advantage of the circumstances of an acquisition as a catalyst to restructure costs more broadly.³) ...

Rooting out stranded costs takes a separation manager with the foresight to rethink the parent company’s cost base and the authority to make it happen—the third good practice. ...

Companies of this size often face a special problem in rooting out stranded costs. For many large multinational companies organized by matrix, the only pragmatic method is for senior management to lead a cross-functional initiative to tackle cross-cutting opportunities such as shared-service and outsourcing operations, as well as the change programs required to support the cost transformations.

Managing employee expectations

The challenges of talent management in a divestiture start at the moment companies begin defining the boundaries of different sale packages and continue right through to the close of the deal. First and foremost, managers struggle to figure out what to say to the people involved. ...  Sometimes company leaders will choose to keep plans for the deal confidential up until signing— as one global CEO and seasoned divestiture veteran told us, “I just deny everything until the deal is signed. It’s easier that way.” This may be true, but it creates a communication challenge. Many employees inevitably will know about the deal because of the massive preparation work that is impossible to conceal. But if management officially denies the reports, it becomes very difficult to put in place communication plans and other measures to minimize the concerns that always arise in such situations—all employees want to know, “What happens to me?”

Some form of short announcement is essential. Once managers make an announcement, they should clearly define and communicate the selection process to keep employees motivated while they wait for news of their fate. ... Ideally, the communication plan should be part of a compelling story that shows not only employees but also investors, analysts, and customers why the divestiture will leave both buyer and seller better off.

Once the word is out, other challenges begin. ... Given the role the exiting managers will play in communicating the business’s value to potential buyers, delay in informing them is undesirable. But once they are informed, they immediately become another party at the negotiating table, bargaining for the talent, assets, and contracts they feel they’ll need to be successful and trying to avoid the ones they don’t want.

Failing to manage the tension between the two groups can be damaging. When a global industrial company divested a multibillion-dollar division, for example, it began to receive a lot of applications for transfers from the entity to be divested back into the parent company—so many, ... that the company was at risk of visibly depleting the divested company ... potentially affecting its value. To discourage the transfers, it aligned the incentives of people in the departing unit to the characteristics of the sale. It decided to reward managers based on earnings before interest, taxes, depreciation, and amortization (EBITDA)—a critical negotiating point with the private-equity firm that ultimately bought it. The emphasis on EBITDA motivated exiting managers to minimize the overhead they took with them; it also reduced transfer requests.

This approach did leave more overhead for parent-company managers to deal with, ... But they made a conscious choice to accept this, believing that the right way to deal with broader cost issues was, ... as part of a thorough change process in the wake of the divestiture. Parent-company managers often lack the incentives that would compel them to take care of the departing entity. ... In our experience, it is important to define and implement a set of performance measures and rewards aligned with value maximization, and to use these with all key people involved in the divestiture process. The most obvious rewards are monetary, but research shows that other incentives (such as recognition and promotions) can be equally if not more important determinants of performance.

Negotiations over talent are particularly sensitive. The first inclination of parent-company managers is to keep the best performers and send the rest with the divested business. That’s not practical, ... the divestor has a moral ... and ... legal [obligation] to make sure the business is a going concern. ... At the same time, the parent company must retain critical resources, and quite often, the exiting managers have the very skills they need. Thus, successful divestors will address the issue of talent early in the process and start building or acquiring the skills needed in both the parent organization and the business to be sold.

Much of the value of a divestiture depends on the effectiveness of the separation process. Defining the right deal, managing talent uncertainty, and rooting out stranded costs can make the difference between a deal that succeeds and one that destroys value. And skill in divestiture is comparatively rare; doing it well can help companies get a competitive edge.

About the Authors

David Fubini is a partner in McKinsey’s Boston office, Michael Park is a partner in the New York office, and Kim Thomas is a senior expert in the Copenhagen office.

Notes

¹ Stephen Hall, Dan Lovallo, and Reinier Musters, “How to put your money where your strategy is,” mckinseyquarterly.com, March 2012.

² Bill Huyett and Tim Koller, “Finding the courage to shrink,” mckinseyquarterly.com, August 2011.

³ Marc Goedhart, Tim Koller, and David Wessels, “The five types of successful acquisitions,” mckinseyquarterly.com, July 2010.

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Get Paid More with a Seller Note

Corporate Finance Associates Newsletter Q2 2012

By John Hammett, Managing Director
Minneapolis Office, Corporate Finance Associates

Private company owners are always interested in maximizing the value of their company when they sell. … Sellers naturally focus on the nominal valuation of the company. But the value to the seller isn’t just in the price that is negotiated, but also in the terms of the deal. Experienced dealmakers know that the terms of the deal can drive the total valuation from the buyer’s perspective.

The natural inclination of sellers is to favor an "all-cash" deal: …However, this perspective overlooks an alternative that can increase the total value of the deal by 10% to 20%.

This alternative is a "seller note". The seller note means that the seller finances part of the buyers purchase with a promissory note or a loan back to the company. The seller agrees that a portion of the purchase price will be paid three to five years down the road, and he will receive interest payments on the face value of the note. Private Equity firms (financial buyers) have a strong preference for including seller notes as part of their deal terms.

Example
The example of this is shown in the attached chart (FIG 1). The example assumes that the company has EBITDA (Earnings Before Interest, Taxes, Depreciation, Amortization) of $2 million and that it would be valued in an all-cash deal at 5 times EBITDA for an Enterprise Value of $10 million (left column). It shows an alternative where the seller finances 20% of the Enterprise Value with a seller note at 9% interest (center column) and the difference in cash to the seller (right column).

Buyer’s Perspective
The immediate difference is that the value multiple for the deal with the seller note is 0.5 times … higher than the Typical deal. … There are two reasons why the buyer will pay a higher multiple for a deal with a seller note.




English: Diagram of DuPont analysis of return on equity. ‪Norsk (bokmål)‬: Diagram over DuPont-analyse av kapitalrentabilitet. (Photo credit: Wikipedia)

The first reason is simple math. The buyer’s balance sheet (FIG 2) is composed of bank debt, the buyer’s equity, and sometime, a seller note. Each tranche of capital has a different cost related to it. Bank debt is relatively cheap, with Prime Rate at 3¼% and commercial loans at 6%. At the other end of the spectrum, financial buyers target a rate of return of greater than 25% on their equity investment. The seller note lets the buyer put in less equity … so the deal is more leveraged but still delivers the target rate of return on the equity. This works because seller note carries a relatively high 9% interest rate, but that is still lower than the equity that it replaces. The math works out so that the equity investor gets an even higher rate of return, even though the price paid is higher.

There is a subjective reason why buyers pay more for a deal with a seller note: comfort. … The seller who is willing to leave a seller note invested in the company gives the buyer great comfort that there are no hidden issues that might show up after the deal is closed. This is reflected in a higher price to the seller.

Seller’s Perspective
In this example, the seller gets a 10% higher enterprise value on the company with the seller note. Just as important, the seller gets an opportunity to invest 20% of the proceeds in a high-yield fixed income investment. … The seller note becomes the fixed income allocation of the portfolio. Its performance should certainly beat the returns from most publicly-traded debt securities.

Bottom Line
The seller is making a wise move by selling a private company that is a concentrated , risky, and illiquid asset, and re-investing the proceeds in a portfolio of other investments to provide for future living expenses and to preserve wealth. The seller note should be managed as a core part of that portfolio.

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Ready to Sell Your Business and Retire?

WSJ.com:

By VERONICA DAGHER

The wealth of many boomers is tied up in businesses they own. And that can be a problem when it comes time to retire.

Advance planning for the sale of a business is more important than ever, ... Even when families transfer ownership to the next generation without a sale, the tax consequences can be huge without proper planning.

Too many owners aren't prepared for the day when they'll need to cash out. Some haven't done their homework to figure out what the business is really worth. Others undermine their company's value with their inability to let go.

Below, financial advisers and exit-planning specialists weigh in on some of the most common mistakes business owners make when they're ready to retire, and how those mistakes can be avoided:

Gary Hovland

The Mistake: Creating a Business That's Too Dependent on the Owner

One of Paul Pagnato's boomer clients spent decades building his company. When he decided to retire, he was not only chief executive, he was handling all key decisions in marketing, sales and client service, despite having hired executives to handle those functions.

WASHINGTON, DC - FEBRUARY 21: Chairman, President, and CEO of the Boeing Company W. James McNerney, Jr . (Image credit: Getty Images via @daylife)

"He was the business," says Mr. Pagnato, a Washington, D.C.-based adviser who works exclusively with entrepreneurs. But Mr. Pagnato says having a business too dependent on the owner or a handful of major customers can dramatically hinder the company's sale price, as buyers are likely to perceive more risk. Indeed, Mr. Pagnato's client ended up selling his business for less than he originally planned and was required to stay on longer to insure a smooth transition.

The Fix: Mr. Pagnato says it's important to delegate responsibility well before the sale to help insure a smoother transition and diversify the company's customer base.

The Mistake: Ignoring the Tax Benefits of Planning Ahead

Enlarge Image

Adam von Poblitz had a client whose 10-year-old business was valued at $20 million two years ago. The owner had always planned to transfer an interest to her son, says the New York City-based estate-planning attorney. But the client procrastinated. Today, the client is ready to transfer a 50% interest in the company to her son, but the company is now valued at $40 million. As a result, she will pay gift tax on a much larger taxable gift.

The Fix: Had the client transferred the half interest two years ago, she would have paid gift tax on only $10 million rather than on $20 million, thus avoiding the tax on the post-gift appreciation attributable to her son's half interest.

Mr. von Poblitz says that if an owner anticipates transferring ownership in the next five years, it may make sense doing it sooner at a lower valuation.

The Mistake: Incorrectly Valuing the Business

Unfinished Business Is it a folly? or has someone run out of money or fallen foul of the planning people? (Photo credit: Wikipedia)

Richard Jackim worked with a client who was the founder of a small but successful consulting firm. The client calculated he'd need to sell his business for $6.25 million to maintain his lifestyle in retirement, says the Chicago-based exit-planning adviser, and figured his business would be worth that much. He was wildly optimistic, however. All too often, owners base retirement plans on faulty valuations, causing drastic overhauls in retirement plans, not to mention blows to self-esteem, says Mr. Jackim.

The Fix: Well in advance of retiring, business owners should get a realistic appraisal of their business, to see if it will fetch what they'll need to retire. If it won't, the owner needs to adjust his or her retirement plans, or come up with a financial strategy to boost their income.

Mr. Jackim says a mergers-and-acquisition adviser can help determine what a business actually might sell for.

Also essential: understanding if there is a market for the company, how liquid the market is for lending and equity, what buyers are paying for similar companies and how they are structuring the deals.

The Mistake: Rushing to Accept a Rich Number

Understanding Financial Leverage (Photo credit: Wikipedia)

Sellers often jump at what appears to be the highest bidder, ignoring other bids, says Fentress Seagroves, an Atlanta-based transaction-services principal. ... The seller doesn't take into account the due diligence that the buyer is undertaking, and how that could change the final number. The seller also ignores other crucial elements of the bid, such as how employees will be treated, or how the buyer will finance the deal. In the end, the seller may have ignored what would have been truly the best deal.

The Fix: Don't fixate on what is superficially the richest offer, Mr. Seagroves says. ...Try to anticipate how the due diligence the buyer is undertaking could change his or her offer at the close. Consider all aspects of the transaction, not just the nominal price.

The Mistake: Hiring Your Brother-in-Law to Do the Deal

Thomas Bonney had a client whose legal counsel's expertise was in general legal matters for small businesses. The lawyer also happened to be the husband of the company's controller, says the Philadelphia-based exit-planning adviser. The lawyer's lack of expertise with merger-and-acquisition transactions and lack of understanding about the time-sensitive nature of the deal resulted in the family's missing the opportunity to sell the business in a strong deal market.

The Fix: Too many family businesses keep everything in the family—including legal services. That can be ... foolhardy when looking to sell. Mr. Bonney advises clients who are considering selling their business to interview three to five separate firms early in the process. He says they should ask the lawyers how they would structure the deal, how they can help with negotiations and ultimately, make a quick close. This process will not only allow the owner to see how an attorney works with them, but they will also have an opportunity to get some good ideas on both legal and personal issues—such as what should a compensation package look like for a family member who wants to continue to work in the business.

The Mistake: Underestimating the Emotional Impact of Selling a Business

John Leonetti, a certified business-exit consultant based in Canton, Mass., has seen all manner of crises erupt when a business owner prepares to sell, causing disastrous moves that wound up hurting the sale and the seller's personal life. ...

Because owners' sense of self and purpose is often wrapped up in their business, letting go is often more difficult then they realize and sometimes causes them to act irrationally, he says.

The Fix: Mr. Leonetti says owners can make their exit easier by mapping out their post-exit lifestyle before the sale. He advises clients to get a calendar and fill in how they are going to spend each day for the six to 12 months after the deal goes through. He's also seen clients do consulting work or start a scaled-down version of their former business, allowing them to stay in the business they love and adjust to a new schedule.

Ms. Dagher is a reporter for Dow Jones Newswires in New York.
She can be reached at veronica.dagher@dowjones.com.

A version of this article appeared April 30, 2012, on page R3 in some U.S. editions of The Wall Street Journal, with the headline: Preparing to Leave.

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Is Financial Leverage Good for Shareholders?

Although high debt levels are touted to be shareholder-friendly, highly levered companies do not deliver higher returns.

CFO Magazine:
Gregory V. Milano, Joseph Theriault

Ever since the 1980s wave of leveraged buyouts, it has been commonplace for investors, 
academics, and commentators to suggest that levering up the balance sheet by taking on more debt financing is beneficial for shareholders. Our capital-market research suggests otherwise....

The appeal of debt originates in university corporate-finance classes where students are taught that an important driver of shareholder value is to minimize the weighted average cost of capital (WACC) based on the proportions and costs of debt and equity capital. The U.S. tax code allows a deduction for interest payments, so WACC tends to be lower for more highly levered companies, as long as the risk of financial default doesn’t become excessive. A lower WACC increases the calculated present value of anticipated future cash flow, which is projected to increase the share price.

Theoretical corporate finance aside, a behavioral argument suggests that debt disciplines the otherwise free-spending ways of management. It is said to reign in capital spending, improve cost efficiency, and lead to superior performance.

...Yet our research shows that highly levered companies tend to deliver lower returns to shareholders.

We started with the 1,000 largest nonfinancial U.S. companies and eliminated those without full financial and market data for 2001 through 2010, which left us with 512 companies. We separately explored two subsets of time to examine different points in the economic and credit cycle.

Simply sorting companies based on leverage seemed to produce industry distortions: some industries tend to use either more or less debt. In fact, some of the industries that deliver the highest total shareholder return (TSR) based on dividends and share price appreciation also happen to be those that tend to use less debt. That is true for food retailing, pharmaceuticals and biotechnology, software, and technology hardware.

Understanding Financial Leverage (Photo credit: Wikipedia)

To avoid any industry distortions, we compared companies within each industry that carried above- and below-industry-average leverage based on three different measures and averaged the results. Those measures were: (1) debt to debt plus equity, (2) debt to market value of equity, and (3) debt to earnings before interest, taxes, depreciation, and amortization (EBITDA). Over the full 10-year period, the companies with above-average leverage within their industry delivered 0.6%lower annualized TSR.

The analysis was repeated for 2008 through 2010, when credit was less available, credit spreads were generally higher, and the use of debt was more highly scrutinized by investors. As expected, highly leveraged companies performed even worse during this tighter credit period by delivering annual TSR 1.7% lower than their less-leveraged peers.

As also expected, during the credit boom from 2004 through 2006, highly levered companies performed better with 1.2% higher TSR per year.

Over the full 10 years, leverage had a negative impact, ... Does this imply the theory behind WACC and its impact on valuation are wrong? We do not think so, but we do question the behavioral implications of carrying higher debt levels.

A close examination of performance shows those with higher debt tend to deliver 3% lower revenue growth per year than the less-leveraged companies in the same industry. ...[We] have demonstrated a strong linkage between revenue growth and TSR for both the market as a whole and for many specific industries, so revenue growth is an important point of differentiation in value creation.

Indeed, the failure of higher leverage to lead to higher TSR may not be due to a misinterpretation of how leverage affects valuation but rather the misconception that managerial behavior is unaffected by leverage. Perhaps at least some companies carrying more debt are more conservative in their strategies and this leads to less revenue growth, and that’s why share-price performance is no better despite the tax benefits that reduce WACC.

... Can leverage be beneficial? We believe it can be in a limited number of cases where desirable reinvestment in the future is not readily available.

English: Diagram of leveraged buyout transaction structure for Private equity, Leveraged buyout (Photo credit: Wikipedia)

We further believe temporary higher debt levels that facilitate the investment in desirable growth opportunities, such as successful acquisitions, can be beneficial as long as the debt level is subsequently reduced.

But for most companies, increasing leverage tends to make management more conservative, which seems to reduce the propensity to be strategically opportunistic ... Leverage constricts revenue growth, which leads to worse share-price performance on average.

Despite the touted benefits of leveraging up the balance sheet, most companies would deliver better share-price performance over time if they were more prudent with the amount of leverage taken on.

Gregory V. Milano, a regular CFO columnist, is the co-founder and chief executive officer of Fortuna Advisors LLC, a value-based strategic advisory firm. Joseph Theriault is an associate at the firm.

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Taking a longer-term look at M&A value creation

Companies that do many small deals can outperform their peers—if they have the right skills. But they need more than skill to succeed in large deals.

McKinsey Quarterly - Corporate Finance - M&A
JANUARY 2012 • Werner Rehm, Robert Uhlaner, and Andy West

Image via Wikipedia

Measuring the value that mergers and acquisitions create is an inexact science. Typical analyses compare share prices before and after a deal is announced, using short-term investor reactions to indicate how much value it would be likely to create. One benefit of this approach is that it provides a measure of expected value unaffected by other variables, such as subsequent acquisitions or changes in leadership.

Yet relying on market reactions to gauge value creation has drawbacks. It skews the results to larger deals, which have the heft to affect share prices, and underrepresents smaller ones—even though they account for a majority of M&A. It can also underestimate the amount of value created by multideal strategies whose real worth develops over the longer term. …

To address those shortcomings, we analyzed the excess shareholder returns¹ of the world’s top 1,000 nonbanking companies, which completed more than 15,000 deals over the past decade. … When we segmented companies by the scope of their M&A programs (Exhibit 1), we found that long-term returns vary significantly by deal pattern and by industry. The implication is that across most industries, companies with the right capabilities can succeed with a pattern of smaller deals, but in large deals industry structure plays as much of a role in success as the capabilities of a company and its leadership.


Exhibit 1: The excess shareholder returns of the world’s top 1,000 nonbanking companies reveal distinct patterns of deal making.

Long-term returns to M&A

Because we look at excess returns over a full decade, we’re better able to correlate longer-term strategies with shareholder returns and company survival rates. The data confirm that the larger companies get, the more they rely on M&A to grow: 75 percent of those that remained in the top 500 used active M&A programs, including 91 percent of those that stayed in the top 100 (Exhibit 2). A majority of these companies complete many smaller deals, with no large ones.² … A correlation of the identified patterns of M&A with long-term excess returns shows that the only companies that had, on average, negative excess returns were those that did large deals (Exhibit 3). …


Exhibit 2: The larger companies get, the more they use M&A to grow.


Exhibit 3: Companies using a programmatic strategy are the most successful.

Companies using any of the other approaches to M&A showed positive excess TRS relative to global industry indices. Those with a more programmatic pattern of M&A (defined as many small deals that over time represented 19 percent or more³ of the acquirer’s market capitalization) on average performed better than companies relying on organic growth. They also had a higher probability of positive excess returns.⁴ Finally, the data suggest that a growth strategy built around a series of small deals can actually be less risky than avoiding M&A altogether. Organic strategies showed the greatest variability in excess TRS between top performers and companies in the lowest quartile, while programmatic and tactical M&A had the smallest range.

The importance of industry specifics

As compelling as these global averages might be, they do not answer the question of whether an individual company in a specific industry at a given time should engage in M&A. … As our previous analysis showed, returns by M&A approach are widely distributed and can obscure individual results.⁵ Consider the data on an industry-by-industry basis (Exhibit 4). The results vary widely but patterns do emerge.


Exhibit 4: Returns by M&A approach are widely distributed and can obscure individual results, but they roughly indicate the top strategies by industry.


Large deals. Companies are more successful with large acquisitions—those worth more than 30 percent of the acquirer’s market capitalization—in slower-growing, mature industries. Here, there is great value in reducing excess industry capacity and improving performance, and a lengthy integration effort is less disruptive.

In contrast, large deals in faster-growing sectors⁶ have been less successful, with –12 percent excess TRS in the five years after such deals, significantly lower than the 4 percent excess TRS for companies in slower-growing industries over a similar period. Why did companies in faster-growing sectors underperform? Many focused inwardly during the lengthy integration required for large deals, missing critical product or upgrade cycles. Others attempted to expand into complementary businesses, where targets had limited overlap in products and technology. In addition, over the period we reviewed, we found that these companies tended to do large deals in years when market valuations were generally high. Tech companies, for example, have fallen into all three of these traps.

Of course, the success of large deals also depends on a company’s strengths and its leadership’s ability to guide it through a year or more of integrating a large acquisition, as well as other factors idiosyncratic to specific deals.⁷


Programmatic deals. Companies across a variety of industries do well using the programmatic approach. … Companies using the strategy completed many acquisitions that together represented a material level of investment as a percentage of market cap.⁸ In addition, we found a volume effect—the more deals a company did, the higher the probability it would earn excess returns.⁹

Evidence shows that executing a high-volume deal program requires certain corporate capabilities but not necessarily a specific industry structure. … For example, IBM’s program of acquiring smaller software firms succeeded because the company could offer acquired businesses access to global markets, which they had lacked. …

… In some cases, big companies are also looking to find new growth opportunities. In the late 1990s, German industrial conglomerate BASF, for example, determined that it could grow more quickly and profitably if it shifted its focus to specialty chemicals—an area in which managers believed they could create value through their technical skills and understanding of customer needs. The company then shed its commodity chemical operations and acquired specialty companies and businesses, which it quickly integrated.

In another series of deals, The Walt Disney Company acquired brands such as Baby Einstein and the Muppets, lending the power of Disney’s global profile to expand their market and reach. Acquisitions of Club Penguin and Marvel Entertainment were similar: the former gave Disney a product in a new distribution channel; the latter allowed it to pick up content that’s popular with teenage males—a relatively tough demographic for the company.


Tactical deals. Companies using a tactical approach to M&A also do numerous small deals, but those deals do not, combined, make up a large portion of the acquirer’s market capitalization. … Tech companies were significantly more successful with this approach than with the others: they used M&A as part of an innovation and capability-building strategy, buying options and adding functions.

Microsoft, for example, has a history of adding features to its core products through M&A to give users incentives to upgrade. Many smaller products acquired by the company found their way to the next release of Excel, and the upgrade cycle provides continued revenue for the franchise. Manufacturer Foxconn Electronics executed more than 20 small strategic and equity outsourcing deals over the decade. Some were intended to expand its capabilities from PC assembly into digital cameras, handsets, and networking equipment, to name a few things. Others eased the company’s vertical integration into components, with the goal of serving end customers better and thus helping the acquired businesses to grow.

Industrial companies in this segment seem to use tactical M&A to fill gaps in products or channels. … Caterpillar, for instance, used M&A to round up its product portfolio by purchasing companies that made diesel engines, railroad and mining equipment, and specialized repair gear. …


Selective deal making. Many companies do deals occasionally but don’t appear to have an M&A capability or a proactive M&A strategy. Most of the companies in this segment spend less than 2 percent of their market cap a year on M&A. Their total shareholder returns are in all likelihood driven more by an organic-growth tailwind than by M&A strategy. The rest of the companies in the segment are individual cases, many stemming from unlucky one-off deals at the end of the 2001 tech bubble. It is therefore hard to conclude that the performance of this group is based on a clear M&A strategy. More likely, these were solid companies that engaged in occasional pragmatic deals to support the growth of the underlying business.
It’s possible to understand M&A performance better by taking a finer-grained look at patterns of deal activity. The success of large deals tends to depend more on the industry where they take place, the success of small ones more on the capabilities of the acquiring companies.

About the Authors

Werner Rehm is a senior expert in McKinsey’s New York office; Robert Uhlaner is a director in the San Francisco office; and Andy West is a principal in the Boston office.

The authors would like to thank Theresa Lorriman for her significant contribution to the research.

Notes

¹ We measure excess TRS by assigning companies to subsectors and tracking the difference between a company’s TRS and an index that follows the sector. In this analysis, we used 11-year excess TRS to avoid some of the issues resulting from the collapse of the high-tech bubble in the early 2000s.
² Defined as a target acquired for at least 30 percent of acquiring company’s market value in the year the deal closed.
³ Among companies completing only small deals, we used the aggregated median acquired market capitalization, or 19 percent, as the cutoff between those with significant M&A programs (programmatic acquirers) and those that acquire small deals opportunistically (tactical acquirers).
⁴ However, the confidence intervals for average returns are overlapping.
⁵ Andres Cottin, Werner Rehm, and Robert Uhlaner, “Growing through deals: A reality check,” mckinseyquarterly.com, April 2011.
⁶ Defined as average annual growth above 7 percent. This data set included 82 deals worth more than 30 percent of the acquirers’ market cap.
⁷ See, for example, Ankur Angrawal, Cristina Ferrer, and Andy West, “When big acquisitions pay off,” mckinseyquarterly.com, May 2011.
⁸ A median of 36 percent of market cap acquired with 33 deals over the time frame.
⁹ As with the other analyses, this is a correlation, not necessarily a causative relationship. Although we feel confident that the deal strategy contributed to the outperformance, it is possible that better-performing companies executed more deals in the wake of their success.