Behind the Boardroom Doors 
with Acquisition Decisions

Director's Monthly
Newsletter of the National Association of Corporate Directors
Vol. 26, No 5
May 2002

By Diane C. Harris
Chair, Audit Committee
Flowserve Corporation
Dallas, Texas

Questions directors should be asking about M&A.

         As fiduciaries of a corporation, directors must safeguard the value of the corporation’s assets, approving plans that seem likely to increase that value and disapproving plans that seem likely to decrease it.  As such, directors must review and approve the company’s strategy for achieving growth in those assets, and, as necessary, even help develop such a strategy.

Inherent Risks

         In order to oversee a company’s strategy for growth, directors must understand the risks inherent in some kinds of corporate growth.  Furthermore, they need to know how to achieve control of those risks.  Finally, they need to know what questions can uncover those risks.
         Corporate growth strategies are either external, transaction-based initiatives or they are internal programs such as research and development, marketing, and leverage of current strengths to new applications.  Transaction-based strategies include mergers, acquisitions, joint ventures, partnerships, strategic alliances, and licensing – collectively “M&A initiatives.”
         M&A initiatives are generally recognized as more risky than other corporate activities.  For example, research often shows that a majority of all acquisitions fail in some way – whether according to an external measure such as comparison to peers, or an internal measure such as performance in comparison to goals.  Moreover, high-profile cases like Enron, using the external transaction vehicle of partnerships, raise questions of board governance and control.
         In view of such negative evidence, it is disturbing that more boards of directors do not 1) ensure that proper controls are in place and 2) ask more rigorous and probing questions before voting “aye” to M&A.

Appropriate
Controls for M&A

         There are two main sources of controls for M&A.  One is a best-practices-based M&A policy that is consistently applied.  The other is a fully relevant presentation by management to the board of directors when seeking transaction approval.

The M&A Policy
         The foundation for M&A control is having a mergers and acquisitions policy* in place before specific deal activity begins.  In an updated survey of the Fortune 1000, **62 percent of respondent companies say they have no written M&A policy.  Those same companies may have policies for travel, hiring, accounting, capital expenses, and severance, but the area of greatest investment and risk – buying other businesses – has no established policy.  The purpose for M&A policy is to minimize risk, ensure consistency across operating units, institutionalize best practices, and effectively streamline the deal process.
         Errors are much more likely to occur when each transaction is done on an “ad hoc” basis without a guiding policy.  For example, a board should not need to ask each time:  “Does management have any personal involvement in this transaction?” or “Is this valuation methodology the same as we have seen in previous transactions?”  Policy should be clear about such matters, with management required to report all exceptions to policy when the transaction is presented for approval.
         An effective M&A policy should affirm not only conformity with generally accepted accounting principles (GAAP) and with Securities and Exchange Commission (SEC) and antitrust laws, but should also commit to the principle that the entire transaction will be “fairly presented” to the board and ultimately to the investing public.  M&A policy will also clarify, for example, who is empowered to incur intermediary fees, who is a “qualified negotiator” for the company, what method of valuation is to be used, and what sources of financing will be considered, subject to what constraints.  Best practices are also included, such as conditions for confidentiality agreements, required signoff by the due diligence team, situations in which independent valuation will be required (such as in a sale to management), and detail required for a post-deal integration plan.
         A corporate director, while not needing to be intimately familiar with all the details of an M&A policy, should have the assurance that one is in place and that presentations to the board for approval will be consistent with that policy unless specifically noted otherwise.  For the subject areas to be considered in a sample policy, see p.5.

* Diane C. Harris, "M&A Policy:  A Board Responsibility," Director's Monthly, July 1998.
** "A Survey of Best Practices in Dealmaking Among the Fortune 1000," Hypotenuse Enterprises, Inc., 2001.

Presentation for Board Approval

   The M&A policy should specify the required information for review of a transaction by the board of directors.

Ø      The vision and corporate mission statement.  These statements should have been clearly articulated and agreed upon with the board of directors well in advance of a specific transaction presentation.  Such a vision should identify which areas management will pursue for M&A-based growth strategies, and which for internal growth tactics.  Thus, when an M&A proposal is made, the board of directors will not be hearing a mission or strategy for the first time, and need not search out the strategy imbedded in the proposal.  They can turn their attention instead to how well a particular M&A proposal achieves the already approved strategy.

Ø      Regular communications.  Directors should be leery of any transaction needing approval at the very next session, or, worse, by telephonic meeting.  The board should be informed of potential transactions at an early stage, and kept up-to-date on specific transaction progress so that when an approval is needed, the board does not hear about it for the first time just before a vote.  Regular, open communication enhances the trust that should exist between the board and management.

Ø      Relevant information in advance.  Directors should have sufficient time in advance of the board meeting to review the submission so that board meeting time is spent in relevant discussion, not in rehashing what has already been read.  At a minimum, directors should receive information covering the linkage to approved strategy, valuation, competitive situation/market data, management continuity, commitment forecasts, deal structure (e.g., asset vs. stock purchase, taxable vs. non-taxable, etc.), due diligence results, financing plan and impact, and the post-deal integration plan.

Relevant Discussion

          With appropriate controls in place, directors will be well-positioned to contribute to meaningful face-to-face discussion during the approval process.  (Although telephonic meetings can advance discussions, they should only be used when real, substantive discussion with other directors has already taken place face-to-face.)  Board meetings should not be a rehash of the pre-submitted materials.  They should provide a means for directors to elucidate what is written between the lines, and to create discussion leading to better board decisions.  Directors can test the thinking of the deal team, not just the data.  A sampling of such questions follows:

Is this proposed transaction consistent with the company’s vision/mission statement?  Variations:  How does this deal achieve our strategic objectives? or Why are we doing this deal?

         Too often, deals have a life of their own, arising opportunistically and acquiring momentum through the sheer effort of the team executing the transaction.  Some transactions end up not being what was originally envisioned.  A fundamental question is the “why” of the transaction, and might include the following follow-up inquiries:

Ø      What alternative strategies (to achieve the subject mission/vision) were considered and rejected?  If the management team did not consider any real alternatives about which they can speak knowledgeably, a director might conclude that depth of strategic thought is lacking.

Ø      If this transaction is not approved, what will happen?  How will the management team then deal with the issues this transaction is supposed to address?  This question drives deeper into the strategic fit.  The fewer alternatives management has, the more compromised it will be in negotiating the best terms for the corporation.

Ø      If a competitor were to step in and pre-empt this transaction, what alternative would the management team then pursue?  This question not only probes alternatives, but also usually leads to meaningful discussion on how the competitors may respond.  In one case, the customers wanted to buy from at least two different companies, for supply security reasons.  Thus, upon merger of two companies in the industry into just one company, the customers needed to begin buying from a third competitor, creating lost sales (negative synergies) for the acquirer.

Who is the deal champion – and is he or she responsible for making sure the value is realized?

         The chief champion of the transaction should also be the person most responsible for executing the post-deal integration plan and for achieving the forecast upon which the valuation is constructed.  This person should be someone who will benefit from the transaction’s future.  The “deal champion” should be visible, presenting the proposal to the board and asking for approval.  In more successful transactions, the deal champion is an operating person with power to command resources to deliver the results.  For the largest transactions, the CEO is the champion.  (Note also: Each deal should have one chief champion since diluted responsibility is no responsibility.)  Some related questions might include:

Ø      What is the previous deal track record of the champion, and does he/she deliver on promises?  A champion who has already successfully delivered on prior transaction commitments is more likely to deliver again.

Ø      Is the deal champion likely to stay in the current position for at least two years while the deal plan is executed?  It takes about two annual cycles of the financial plan to determine success.  A successor does not have the same personal commitment as the champion who asked the board for approval.

Ø      What kind of incentive system is in place to drive the champion and his or her team toward success and how important is this particular transaction to the champion’s overall compensation?  A small acquisition by a large operating unit or a small percentage of overall compensation tied to deal success is unlikely to create enough motivation to spur achievement of the plan.  Another demotivating factor may be a failure to connect post-deal success and compensation.  Of course, if compensation is tied only to an increase in revenues, rather than real growth in company value, such a connection may be counterproductive.

 How much is this transaction really worth?  And how do we know that?

         Although paying a few percent more or less is not usually the difference between success and failure, the board is obligated to ensure the price is fair to their own shareholders.  Questions about transaction value and price focus on whether or not the analysis is rigorous and driven by discounted cash flow concepts rather than negotiating exigencies.  Associated questions include:

Ø      Who did the valuation and how does the valuation methodology differ from the company’s standard valuation methodology?  What are the underlying assumptions?  The assumptions used in a valuation should be clearly specified.  A board of directors should be rightfully skeptical if valuation is prepared by anyone who is compensated on the basis of transaction price.  Similarly, if a discounted cash flow horizon of, say, seven years is suddenly used when five years has been policy, the board should be alerted and ask for explanation.

Ø      What part of the valuation depends on capturing synergies?  The best practice regarding synergy is to first value the target company on a stand-alone basis, then to identify and value each synergy separately, with appropriate probabilities.  For example, synergies driven by market growth are less likely to be achieved than cost-reduction synergies.  Each synergy has a different probability of being achieved.

Ø      What is the time table for achieving the synergies?  Directors should be wary of synergies promised for a relatively distant future.  The more distant that future is, the less controllable it will be.  A careful approach only recognizes value for what can be implemented within the first year.  After the first anniversary of a transaction, it is difficult to implement synergistic changes.  Of course, all future synergy flowing from the first year implementation is recognized in the year in which it occurs.

What, exactly, is the proposed deal structure?

         Directors should not be intimidated by complex deal structures.  Complexity may indicate that there are serious transaction problems that are being handled by excessive structuring.  Sometimes, a director will assume he or she is the only director who “doesn’t get it” and, relying on others’ expertise, may avoid asking further questions on a complex deal structure.  Instead, management’s inability to explain the structure and its rationale clearly may be evidence that they do not fully understand the deal either, or worse yet, that they want to hide their interests in the transaction.

Ø      What alternative deal structures were considered and why were they rejected?  This question sheds light on the dealmaker’s thinking and tests against the goals to be achieved; e.g., would it have been possible to license the technology in lieu of buying a company?

Ø      What contingencies have been built into the deal structure?  In structuring a transaction, dealmakers may minimize risk/cost and/or maximize returns by altering the timing or source of payments, or by ensuring the receipt of the payments against certain contingencies.  Buyers can minimize risk in a transaction by making part of the purchase price contingent upon realizing certain value-creating events or avoiding specific value-destroying events.  Directors should ask about (and understand) escrows, earnouts, “holdbacks,” milestone payments, indemnifications, and the like, all of which may be used to minimize risk and maximize the net value that will ultimately be achieved from a transaction.

Ø      What were the key negotiating issues and how were they resolved?  Understanding the major points of contention between the parties enables a director to better comprehend the compromises that were made.  This question probes the balance of power in the negotiations. 

What are the key due diligence issues and how is each being resolved?

         Very few transactions occur without the discovery of some significant issues during due diligence, such as a patent being less defensible than previously hoped, or unresolved litigation that is difficult to quantify, or unpaid taxes.  Solutions might include valuation adjustment, re-structuring, indemnification, or even special insurance.  Directors should ask what key issues were found and how they were handled to test the depth of management knowledge and involvement.  Related questions include:

Ø      What did you find in due diligence that surprised you the most about the target company’s management, products, customers, technology, markets, finances, etc.?  Surprises, by their very nature, are not implicit in the assumptions used in the preliminary valuation and will usually require adjustment.  Discussion can shed light on how the acquiring team dealt with such surprises.

Ø      Are there any liabilities to be assumed by the buyer not specified on the balance sheet?  Management should identify any liabilities being assumed that are not on the balance sheet.  A good M&A policy will specify this, and, to reinforce the policy, directors should ask the question specifically.

Ø      What involvement have outside bankers and consultants had in the due diligence process and how much reliance is being placed on their opinions?  Once the deal is completed, consultants can walk away.  Bankers usually are conflicted by being incentivized on transaction completion.  Due diligence services from the same auditor who will later give an opinion on the financial statements of the combined company may also create a conflict.  Is the deal champion fully sanctioning the third-party opinions and are those opinions reliable? 

How is the value of this transaction going to be realized?  What is the post-deal integration plan?

          Best practice is having the full post-deal integration plan in place before a final board approval is given (or at least before closing takes place.)  In the 2001 survey of the Fortune 1000, 47 percent of respondents require such a plan.  The board should ensure that the M&A policy requires an integration plan, and that for each transaction the integration plan is implemented.  Related questions include:

Ø      Is every synergy in the valuation also incorporated in the integration plan?  It is not unusual to find millions of dollars of synergies projected in the valuation, without any corresponding implementation of those synergies in the integration plan.  Those synergies should be dropped from the valuation and from the calculation of expected internal rate of return.

Ø      What does the deal champion consider the probability of achieving the integration plan?  If the probability is less than 100 percent, the valuation should also have been adjusted to reflect the lower probability.  If it is much less than 100 percent, the company may be overpaying, or the deal champion not fully committed, or there may simply be too many tasks and too few people to execute.

Ø      What parts of the integration plan are most vulnerable and what is the backup contingency plan for those items?  The backup plan should contain a time schedule – when a particular course would be abandoned and the contingency plan put in place.  The deal champion should be responsible, regardless of whether the original plan or the backup is implemented.

Post-Deal Audit

         A policy alone is not fail-safe; it still depends on rigorous review by the board of directors.  And the only way that the board’s questioning ultimately has meaning is through an audit of the results.  The post-deal integration plan should have commitments that can be tested at six-month, one-year, and two-year anniversaries.  At a minimum, the audit should include tracking whether the commitment forecast upon which the valuation was based was achieved, whether the key synergies were delivered, and whether the key milestones such as closing a plant, reducing employment, introducing a new product, or refinancing a loan were met fully, and on time.  The reward for the deal champion should then parallel the success of having achieved the value and strategic intent for which the board approved the transaction.
         Accountability, through the post-deal audit process, is the foundation upon which rests management’s credibility in proposing future transactions.  Boards do not need to accept that half to three quarters of all deals fail.  Best practices are known, and need not be reinvented.  Finally, the board might also ask itself:  “Are we reviewing proposed transactions in a manner that enhances the opportunity for success?”
         M&A initiatives should not be viewed separately from the remainder of good corporate governance, or be exempt from controlling policy.  Reading the materials supplied by management, listening attentively to the investment banking presentations and posing questions in one’s own “hot button” areas of interest may fall short of finding the deal issues that make the real difference between success or failure.
         With the right controls in place and by asking the most relevant questions, even directors who lack significant M&A experience can contribute to successful M&A initiatives.

KEY ELEMENTS FOR AN M&A POLICY

When asked, many directors say “Yes, we have a mergers and acquisitions policy.”  However, our most recent survey shows that fewer than half of the Fortune 1000 respondents have a written policy in place.  The answer, then, to the question “Do you really have an M&A policy?” depends on answering more specific questions:

Ø      Is the policy in writing, fully disseminated to all those participating in the deal-making process, and consistently followed?

Ø      Is the policy linked to the strategic plan?  Does it require approval for deviation from agreed-upon strategy?

Ø      Does the policy cover all deal types:  mergers, acquisitions, joint ventures, strategic alliances, equity participations, R&D partnerships, technology exchanges, licensings, and other long-term, irrevocable agreements?

Ø      Is the sell-side as well as buy-side covered in the policy (e.g., conditions on which an employee may discuss sale of company assets or businesses?)  Does the policy specify how inquiries regarding the sale of company assets are to be communicated to management and the board?

Ø      Are there dollar amounts and approval authorities identified for each deal type?

Ø      Is the timing of approvals specified, clarifying how far management may take a transaction before reporting it to the board?  Before seeking transaction approval?

Ø      Is there a management process in place (as gatekeeper or facilitator to board review) that is consistent with the M&A policy?

Ø      Is there sufficient deal-making skill required in order to ensure poor transactions are not pursued and that good transactions are not pursued and that good transactions are not lost through red-tape or inexperience?

Ø      Does the policy specify how valuations will be performed?  What time horizon will be used?  Cost of capital?  Corporate hurdle rate for approval?  When third-party opinion letters will be required?  What is acceptable dilution?

Ø      Is there a clear policy governing whether or not management may participate in or benefit from transactions by the company?

Ø      Are there guidelines regarding use of company shares?  How financing structures will be reviewed?  Unique deal structures?  Off-balance-sheet entities?  Takeover defense engagements?

Ø      Is it clear who may engage investment banking services and other outside deal resources, and what fee levels are acceptable?  Does the policy seek to protect the company against inadvertently incurring unwarranted finder’s fees?

Ø      Does the policy govern who is empowered to negotiate for the company, and how an employee or officer becomes empowered to negotiate?

Ø      Are there signoff procedures for valuation, due diligence, contractualization, and financing documents by participants in the process?  Are there standard checklists for each functional area’s due diligence responsibilities?

Ø      Are there standard formats for confidentiality agreements and is it clear who is empowered to sign those agreements?  Letters of intent?  Deal-related fee agreements?  The final contract?

Ø      Does the board require that there be an internal champion who personally commits to the forecast upon which approval is based?

Ø      Is a completed post-deal integration plan required before a transaction can be executed?  Is this plan presented to the board of directors?

Ø      Is there a post-deal audit provision (usually at six months and the first and second anniversaries) that is also tied to the champion’s compensation?

Ø      Is there an effort to isolate the key lessons learned to further improve the company’s deal-making process?

Ø      Are best practices in deal-making benchmarked regularly, and those learnings incorporated into the M&A policy so it stays leading edge?

What can the board of directors do to optimize returns from deal-making and to minimize risk?  They can ensure that there is an effective M&A policy in place, ask quality questions in the review process, and instill accountability for deal success or failure.