70% of M&A transactions are doomed to fail because of poor preparation and unclear strategies. To help minimize the risks faced by most business buyers and sellers, Domenic Rinaldi talks about seven of the most common M&A pitfalls that must be avoided at all costs. From the ROI targets and due diligence to valuation and integration, he delves into the most important stages of M&A and how to navigate through them effectively. Take note of each one, and you are on a straight, clear path to a successful and rewarding transaction.

For more comprehensive guidance, click here to download our due diligence best practices and checklist resource for free. 

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Common M&A Pitfalls: 7 Mistakes You Must Never Do – Ep. 090

I’m often asked why M&A deals fail. What do we see when things go wrong? I sat down and put together a top seven list of the reasons that deals fail. There are way more than seven reasons that a deal can fail, but these are the ones that we hear about and see more often than not. If you can get an understanding of these and get prepared, you can avoid these in your own transaction. What I’m going to talk about is I’m going to lay out what the seven reasons are, and then things that I think you can do to mitigate falling into these traps. If you’re armed with this knowledge and you put together a great M&A advisory team and a well-thought-out plan, I promise, you’ll increase your odds of success dramatically.

Before we get into this episode, we created the best practices and a checklist for how to conduct diligence. This is a free resource and it’s available on either of our sites, SunAcquisitions.com or K2Adviser.com. Take a minute to download this tremendous resource. It’s a great starting point for you and your advisors when you’re contemplating an acquisition. As always, thanks for being here. I hope you enjoy this episode.

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I’m going to dive into the top seven reasons M&A deals fail. For purposes of this show, let me describe what I mean by failure, and it’s not necessarily what you think. It doesn’t mean that the deal unraveled completely. Surely, that’s the most catastrophic result of an M&A deal. We don’t see that very often where an entire business imploded and went away, unless there were something happening in the economy or completely outside of somebody’s control. More often than not, what we see happen is that a business, when it does fail, reduced in value due to some reason, and then the new owner had to turn around and sell it at a reduced value, or someone took over the business, and faced immediate and significant speed bumps like client or employee defections or vendor issues.

These are the things that cause you to miss your return-on-investment targets. We’ve talked about this before. Every deal, whether you’re an individual investor or you own a company, and you’re growing through acquisition, you should have ROI targets for every acquisition that you’re looking to make because you have to have some measurement of whether or not the deal was successful. ROI doesn’t always have to be a financial metric. We believe that you should have a financial metric all the time, but there might be other metrics that you put in place to determine if a deal was successful or not. Having a metric or metrics is critical and knowing whether or not the deal turned out the way that you were hoping.

Common M&A Pitfalls: The deal size will impact how you will finance the transaction and the debt you will put on the deal.

No Solid Acquisition Plan

Let’s dive into these top seven, talk about what they are and, how you can avoid this. Number one on my list is you didn’t have a solid acquisition plan going into it. We see often that people will launch a search because they wake up one day and they decide they want to either own their first business or they want to grow through acquisition. They didn’t take the time to build a comprehensive strategy. A comprehensive strategy includes a lot of things. It’s taking a step back and deciding what are your goals? What makes the most sense? How are you going to go about sourcing those opportunities? How are you going to finance it?

It has lots of pieces, and you should do this work well in advance of ever hitting the market. When you decide that an acquisition makes sense, here are some of the things that I think you need to do in order to make sure that you don’t fall into this trap and have your M&A deal fail. First off, decide, is this a diversification play or are you looking to grow through acquisition or is it your first acquisition? If it’s your first acquisition, you need to make sure that you do your homework. You need to understand what industry sectors make sense. Once you get into the sectors, peeling the onion back a little bit from there and deciding what types of businesses inside of those sectors make the most sense for you based on your skillset, background, experiences? What you’re trying to do with your company if you own an existing company, and you’re looking to fold something into it? What are your goals? Are you looking to add clients?

Sometimes, maybe you’re looking at technology and it’s a technology play. In that case, maybe you don’t want to buy an entire business. Maybe you want to buy technology and strip it out of an existing business. Maybe you want to go out and grab talent because your current business is lacking talent or you can’t source enough good talent and making an acquisition will help you do that. Maybe it’s a geographic expansion that you’re looking for. You want to open up new geography and expand that way. What size range are you looking for? Understanding the deal size is important because that will have an impact on how you’re going to finance the transaction, what debt you’re going to want to put on the deal. As a part of that plan, it’s understanding what your return on investment model is going to look like for that add acquisition.

You have all these pieces in place, and if you have that plan, now you can go execute against it and you can move swiftly, especially in today’s market. I know that might sound surprising to people, but this market is a seller’s market. There are many buyers in the market today that are looking for acquisitions. You want to have your plan put in place so that when you do hit the market, you can move fast. We can talk about out why is the market active? Why are there many buyers? I’ve covered this in a number of other episodes, but in short, interest rates are at historical lows, money is cheap and organic growth is very hard. Acquiring a business has become one of the primary one’s paths to growing or even for people who are looking to own their own business, finding a job right now is hard, and buying your own business and controlling your own destiny is the path. Tons of buyers in the marketplace have a plan, know what you want to execute against, know what your end goal is, what is success looks like? Then you can go ahead and launch your search.

Overpaying And Valuation Mistakes

The next reason M&A deals fail is people flat out overpay or make valuation mistakes. This may come in as a surprise, but over 70% of M&A deals fail to meet their ROI targets. It doesn’t mean that the deal was a failure. It means that they failed to meet whatever the ROI targets were. That’s a very high percentage. Why does that happen? It happens because either people don’t stick to their model. What is your model of success so that when you’re valuing deals, you know what the benchmarks and you stick within your model, you stick within your comfort zone, or people will allow market pressure to pull them outside of their ROI targets?

We’re seeing that happen a lot. We are seeing where valuations are hitting higher and higher levels, owners are in the driver’s seat when it comes to marketing their businesses and offers. People are being pulled outside of their comfort zone. When you do this and you overpay, or you make valuation mistakes, it could lead to some significant challenges in the business. What are my recommendations here? How do you avoid overpaying? How do you avoid making these valuation mistakes? First off, hire valuation experts. Especially if you’ve only done this a couple of times, and if you’ve never done it, you certainly need to hire valuation experts. These are people who do this day in and day out. They’re going to know what the market’s looking like. They’re going to know what the trends are, but they’re also going to know where the tolerance levels should be.

Common M&A Pitfalls: Most loans are not fixed rates but floating. If you’re not careful, you might have a hard time dealing with your debt obligations.

These experts will help guide you and make sure that you’re not making mistakes that you then can’t recover from later on. The other thing is to make sure that you’re securing comps. In the business for sale marketplace, there is no such thing as comparable in residential real estate, which is the MLS. There is nothing publicly available for you to track. What are other deals selling for? These are usually confidential transactions when it comes to closely privately held companies, but valuation experts and M&A advisors have access to comps. You’re going to want to understand what current deals are selling for and what are the ranges of values so you know that you’re not overpaying, or if you do overpay, you’re not far outside of the normal range that you’re going to put yourself in your deal and risk. The other thing that I mentioned to people in this category of overpaying or making value mistakes, if something doesn’t make sense around the financials or anything in due diligence, follow the trail, don’t give up.

If you don’t feel comfortable, keep asking questions, keep digging, figure it out because this is one area where you can make a small mistake or what seems like a small mistake, and then it’s going to come back to haunt you later on and you realize it was a big deal. Usually, I like to follow my gut. I tell my clients to follow their gut. If something doesn’t seem right, follow the trail, continue to ask questions. The last thing around overpaying and making evaluation mistakes is you have to check your ego at the door. This can become a very emotional process and very competitive process. If you’re a competitive individual and you like to win, it’s easy to make mistakes because you get caught up in the process and the negotiation. Check your ego at the door. Don’t become emotional, look at the facts, make sure you’re not making a mistake that you can’t recover from later on.

Too Much Leverage

The next item on the list is you take on too much leverage. You take on too much debt to acquire a business. In today’s interest rate, it’s easy to do that. You can look at a deal pattern and say, “I can take on this much debt at today’s interest rates, and I can cover this nut.” I understand that, but most loans are not fixed rates. Most loans are floating. While today’s interest rates are at historical lows, if those rates start to notch up a bit, and all of a sudden, your monthly principal and interest payments go up by 10% or 15%, all of a sudden you might have a hard time making those debt obligations. You have to factor that in.

You can’t take a look at what your debt is now based on today’s interest rates, you’ve got a floating debt loan. What could happen? Model that out and make sure that you’ve got enough comfort and enough room in the financials in that business that if that happens, you can weather that. I would be conservative here. I would measure that assuming that you don’t grow the business at all. Assume a steady state, play with the model at different interest rates, and see what happens. The other thing with too much debt is a downturn occurs. I’ve lived through two significant ones. We’ve had the recession of 2008 and COVID. It’s hard to model in these downturns.

These are significant and who could ever imagine these things, but it’s important to try to at least think about that. If there’s a downturn, what happens? Can you make those debt obligations? Can you still take care of yourself, your family, or your employees? Modeling some of that, while I wouldn’t spend a ton of time on it, is important to understand. That will keep you conservative to make sure that you don’t take on too much debt and too much leverage. Usually, when you do this, the result is that you overpaid for the business and perhaps, you didn’t put in enough equity. Those are other things to be looking at. If you overpaid, leverage goes up, or maybe perhaps you were looking to put in a minimum amount of equity, and maybe putting a little bit more equity in upfront will reduce your debt burden and your leverage and give you the runway.

The next item is you overestimated growth or synergies. When it comes to growth and synergies, I have to say I see time and time again, people have the tendency to be very aggressive. We have a famous saying in our business, “People pay owners for what they built, but they buy a business for what they think they can do with it in the future.” It’s natural to think you could take the business to the next level, that you could bring your skills and your experiences to that business. Whether you’re an individual investor and you think you could take that business to the next level, or you own a business, and you’re looking to acquire a business and merge it into yours and you’re going to get some synergies. Synergies like you can reduce some overhead, maybe reduce facility costs because you’re merging that business into your facility. There are models that you can do here.

Time and time again, I see that people overestimate what’s possible. One of the things to remember especially is growth through organic methods has become very hard. It’s hard to grow a business organically. My tendency here, when I look at these models, is to have people be conservative. Take a hard look at it, and sometimes even look at your model and maybe cut it in half. If you’ve got a growth of X, cut it in half and see what that looks like. What you don’t want to do is have an expectation of the business, then fall short and you overpaid, or you took on too much leverage and now you can’t meet your obligations.

Common M&A Pitfalls: If something doesn’t make sense around the financials or anything in due diligence, follow the trail of the M&A deal and don’t give up.

One of the things that happens also in the growth and synergy of phase is you’re going to meet with an existing owner, and the owner’s going to lay it out for you. One of the questions that you should be asking in diligence is if they wound back the clock 10 or 15 years, what would they do to grow the business? Usually, the owner is the best person to tell you how to grow that business, but you want to dig deeper. You don’t want to understand what they think could happen or what methods they would use to grow the business. You want to understand whether or not they tried any of those methods. If they didn’t try any of those methods, why didn’t they try them? If they did try them, what happened? There’s an onion to be peeled back here. Understand what the owner’s knowledge is, what their experiences are. The other thing to understand about growth is what investment is it going to take to grow the business?

Most growth comes with a significant investment. That’s going to be cash out of your pocket post-transaction. There’s another reason why some people can’t meet their targets or deal fails because they didn’t have the capital to meet growth expectations. The same thing comes with synergies. It’s going to cost you money to bring a business and integrate it into yours. You’ve got to move it. You’ve got to move employees. You might be paying state packages for employees. Whatever the case may be, there are always investments to be made, whether it’s for growth in synergies. My overarching comment here is to be conservative, look at it strategically, and be careful so that you don’t miss your targets.

Weak Due Diligence

The next item on the list is that when you conducted due diligence, it wasn’t comprehensive. It was in essence, weak due diligence. Diligence is hard. We’ve done a couple of episodes on this. We’ve tried to go deep into what’s involved. The diligence is something that goes way beyond the financials. Especially during COVID, diligence has taken on a whole new perspective. There is so much more to consider during this COVID environment, especially if you’re buying a business that was impacted by COVID positively or negatively.

There’s a lot to figure out. If it’s negative, is the impact temporary until that business can come back out the other side? If COVID had a positive impact on that business, is that also temporary? Is the business going to come back to its historical levels? This is a cautionary tale right here. You want to make sure that you’re not overpaying for businesses who have experienced growth during COVID, because if we get back to some level of normalization and that business comes back to historical levels, chances are you overpaid and you’re going to have a tough time meeting your debt obligations.

Remember, you’re an outsider. It’s impossible for you to uncover everything in diligence. You couldn’t spend enough time to figure it all out. You don’t want to make sure that you have experts. I don’t mean just one expert, I mean having experts even at the functional level, depending on what type of business you’re buying. While it’s obvious that you would bring in a forensic accountant or a CPA or somebody that can help you with the financials, you may need experts around HR, communication, marketing, whatever it is, you need to think through all of the aspects of that business, and whether or not you should bring in an expert to help you conduct the diligence.

Not Spending Enough Time With Balance Sheets

The other recommendation of the mistake I see people make every now and then, is they don’t spend enough time with the balance sheet. They spend so much time on the P&Ls and the tax returns to figure out what the adjusted EBITDA of a business is going to be post-transaction. They don’t spend enough time with the balance sheet, and the balance sheet will tell you a lot. They will tell you how much cash that business needs to operate with day in and day out, month in and month out, what the seasonality looks like. If it’s an inventory-intensive business, what’s happening with inventory? What do you need to be prepared for there? All of that balance sheet work should get you to an important metric.

The important metric is what is the necessary networking capital of the business in order to sustain the business at its current levels? What’s networking capital? Networking capital very simply is your current assets, plus your current liability. In most deals, unless it’s a stock transaction, you assume that you’re not going to be taking on any of the cash, and you’re not going to be taking on any of the long-term debt of the business. The owner who gets to keep their cash and they have to retire all of the long-term debt. It assumes that you’re taking on things like accounts receivables, inventory, current payables, and any current obligations that the business has. That calculation, those current assets minus those current liabilities, will give you your networking capital and that’s an important number.

Common M&A Pitfalls: Somebody has to be responsible for integration to make sure that it’s a success.

Once you have that, you want to spend a little bit of time modeling that because if you have some growth expectations, you can back into what capital you’re going to need to fuel that growth on the balance sheet. The last thing I recommend around due diligence is to do some modeling for unforeseen events. I wouldn’t spend a ton of time in this area, but I would spend a little bit of time. If you had a downturn in the business, 10%, 15%, 20% downturn top line, what would that mean to your bottom line and what would that mean to your cash position? What would that mean to your networking capital position?

It’s worth spending that time to figure it out so you know that if it happens, you’re going to have the cash, a line of credit, whatever it is to withstand any downturn like that. You can model some other things that go beyond financials like you have a technological breakdown or a data breach, or some other things like that. You need to understand what your backup and contingency plans are. Due diligence, besides the next topic that I’m going to get into integration, is probably the most important thing that you can do, and one of the biggest reasons deals fail. People didn’t do the proper diligence.

Poor Integration

The next item is integration. This is the most critical step in securing the success of an M&A deal. You’ve done the deal, then how do you secure success and how do you meet your ROI targets? It’s a complex process. Integration touches every part of the operation. A detailed plan is required here. Let me talk about integration and what are the best steps and what are my recommendations here. First off, whether it’s you as the acquirer or somebody that you hire, somebody should own the integration process, and that should be their sole job. They’re responsible for making sure that the entire integration process is a success.

Everybody in the process has to report to them. They set the parameters, plan, goals, and do the check-in points, whether that’s daily, weekly, monthly, whatever it is. Somebody has to be responsible for integration to make sure that it’s a success. What you don’t want to do is parse this out to department heads and expect them to operate on their own. While you’re going to give a department head or somebody who’s the head of a functional area, their responsibilities should all funnel back to somebody who owns the entire process. It’s my number one recommendation when it comes to integration, so that you make sure that nothing gets missed, and you have one person that you can go to, that you know owns it.

When you think about integration, it cuts across every phase of the operation. It cuts across clients, vendors, employees, technology, marketing and sales. You need to have a plan for each phase. The number one issue in integration is the people. The people are the number one asset that you’re acquiring more important than the client’s, more important, in many cases, the technology, and the vendors. People are what make the business operate day in and day out. If you take care of the people, if you get that right, mostly everything else will fall into place. You’re going to still have some hiccups along the way and speed bumps, but getting the people right is job number one here.

Don’t shortcut this step. Spend an inordinate amount of time on the people, making sure that you get it right so that they then can turn around and take care of your investment. The next one is culture. Honestly, this is something that you need to figure out in due diligence, culture clashes happen. We’ve seen it. Two companies coming together or even an individual investor taking over a company, and they miscalculated the cultures, they take over and shortly thereafter, they lose a key employee or a key client because the cultures didn’t match. They didn’t have the same underlying foundational beliefs, and something can quickly unravel there. You want to make sure that you spend time in diligence around culture. Then once you understand what the culture is when you’re in integration, make sure you support whatever that culture is. Cultivate it, and make sure that you follow through on what your early findings are so that you can maintain the same culture that you saw early on.

The underlying integration, the foundational piece of integration, which is my last point here, is communication. You need to have a good communication plan for every aspect of the transaction and the integration, internally for your people, externally for clients and vendors. You want to make sure that plan is built even before you have a closing occur. You want to know what you’re going to say hour 1, day 1, week 1, and have that plan build-out at least for the next couple of weeks, so that you’ve got something to follow and you’re showing consistency. You can modify the plan from there. Having a good solid communication plan is the solid foundation for making sure that integration goes smoothly.

Retaining Wrong Advisors

The last piece and the last reason that I see M&A deals fail to meet their ROI targets or fail completely is the owners retain the wrong advisors. If you’ve read other shows at M&A Unplugged, you’ve read professionals speak about how important hiring the right advisors is. To peel back the onion here a bit, you need people surrounding you in your transaction who live and breathe mergers and acquisitions. They know what it takes to get a transaction done. They know what’s happening. What are the current trends? I’ll give you a perfect example. COVID has thrown everybody a curveball, and it’s not just in the operation of their business. We’re now seeing all of the legal documents in a transaction change substantially to accommodate for a post-COVID environment, reps and warranties indemnifications.

Those are some of the simple things. If you don’t have an M&A attorney who specializes in doing transactions, they may not understand what the trends are and what’s happening. They could miss something important. The same goes for accountants. Tons of great accountants out there but then there are people who analyze M&A transactions and take it a step further. They get what it means to integrate a business in, and whether or not synergies that your modeling out make sense. They can even get involved in some of the growth expectations that you’re building, and give you feedback there. They can be very helpful when it comes to calculating networking capital.

M&A advisors like ourselves, when we do hundreds of deals, we see about everything there is to see. We hope people avoid mistakes all day long or get ahead of issues that we know are going to occur. Getting the right team and the right set of advisors can help you avoid the pitfalls and help you from having an M&A deal that fails or misses your ROI targets. In wrapping up here, I’ll say that acquisitions are the largest transaction an individual or company will do in their lifetime. It’s also something that people don’t do day in and day out. You need to surround yourself with the right team. You can avoid these common pitfalls.

Most deals don’t go south. Most do miss their ROI targets, but if you educate yourself, surround yourself with the right team and you build the right plan, I strongly believe you have increased your odds of having a successful transaction. I hope you enjoyed this content. If you enjoy our content, please remember to subscribe and review our show. I look forward to seeing you again on the next episode. Until then, please remember that scaling, acquiring or selling a business takes time, preparation and the proper knowledge.

Important Links:

• SunAcquisitions.com

About Domenic Rinaldi

As owner and managing partner of Sun Acquisitions, Domenic helps clients buy and sell businesses across a variety of industries. Since 2005 he’s been personally involved in over 300 transactions for businesses with enterprise values of $2 million to $50 million.

Recognizing many business owners didn’t understand the full requirements of successful exit, acquisition and scaling processes, he founded K2Adviser. The mission – educate business owners and buyers so they can maximize transaction benefits and minimize transaction risks.

Domenic’s an industry-recognized expert who frequently shares his hard-earned knowledge from the stage, in print and over the airwaves – including as host of the popular M&A Unplugged podcast.

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