April 2002: Volume 44, Number 4
Mergers & Acquisitions in the Water Industry, Part 2 -- Factors to Evaluate and How to Put a Deal Together
by Steve Maxwell
Summary: In February alone, there were four significant acquisitions in the water treatment industry -- GE acquired BetzDearborn, Vivendi Environnement sold USFilter Filtration & Separations Group to Pall Corp., Crane Environmental picked up Kavey Water and Danaher bought Viridor Instrumentation from Pennon Group. Here are more details on how such agreements are consummated and some basic rules.
Once a company has identified a potential acquisition, it should begin to gather information to evaluate the marketing, financial, operational and overall strategic situation of the target. This process is often referred to as the “due diligence” period, during which the buyer will try to identify the following sorts of attributes:
* A proprietary market edge, or a differentiable service,
* Compelling economics and a verifiable financial situation,
* The size and growth components of the target company’s markets,
* A sustainable client base or “book of business,”
* Objective and independent proof of the company’s technical or service claims, and
* A sense of comfort with the management team.
Although idealized, these attributes are worthy to strive for in the due diligence process. Too many deals go sour because of hasty and incomplete due diligence, or a generally poor understanding on the part of one or both parties of what they will encounter. In turn, this inevitably leads to disappointment and distractions on both sides of the deal, often costly and ineffective legal wrangling between the parties, and poorer economic performance on the part of everyone involved. Any acquisition is a bit of a gamble, but a clear vision and plan with a thorough up-front analysis can help avoid a lot of problems later.
Once the prospective buyer has carried out a satisfactory due diligence evaluation on the acquisition target, the parties must agree on a valuation for their proposed deal. Beauty is in the “high” of the beholder -- and it goes without saying that the buyer and seller often have different perspectives about value. That said, though, there are a number of standard and accepted methods or rules-of-thumb for calculating the value of a commercial enterprise. As in the selling of a home, corporate valuations are typically determined by a comparison to similar recent transactions.
Method of payment
If a valuation range can be at least loosely agreed upon, then the real work of negotiating the terms and conditions of a deal begins. Transactions typically involve payments from the buyer to the seller in some combination of cash, debt and/or stock. Transactions in the water business often include components of all three types, in a range of combinations and variations that can become exceedingly complex; however, skill and creativity in the use of these three key components may allow both parties to achieve the specific benefits necessary to make them feel they’re getting a fair deal.
As the old saying goes, “Cash is king.” All sellers like to be paid in cash. Once a cash payment is in hand, the deal is done. The seller has none of the future concerns or worries that may come along with accepting a note from the buyer or taking a potentially risky stock position in the buyer’s company. In turn, some cash is better than no cash; partial payment in cash signifies the buyer’s seriousness and total commitment to the transaction. Buyers, on the other hand, will obviously prefer to pay less in cash rather than more, and to pay it in the future rather than today. While the buyer may offer a certain amount of cash up-front to show good faith and to meet the “drop dead” demands of the seller, he or she may want to structure a deal that defers cash payments into the future.
A common means of providing some cash to the seller and sharing the risk of the transaction between both parties is the so-called “earn-out” arrangement. Here, future payments are tied to some measure of performance or profitability in the acquired company going forward. This is often a mutually acceptable structure -- the seller is willing to take the risk that the combined operation will be profitable and that he or she will actually receive the payments, and the buyer is comfortable that his payments will only be made if the ongoing operation is successful. This works when the seller is going to stay involved in the business; it usually doesn’t work if the seller is exiting altogether.
Whenever the buyer is trying to preserve cash, payment with borrowed money is more common than payment with cold cash. Companies with strong credit may borrow the money, in effect putting the risk of the deal on their bank’s shoulders. Buyers with weaker balance sheets may not be able to borrow for such purposes, and hence may request that the seller himself take back some sort of “note” -- whereby the seller effectively “loans” the buyer part of the purchase price. While this is clearly a less palatable arrangement, many sellers will take a note from the buyer if it provides them with what they want -- and they’re convinced of the fundamental stability of the buyer and believe the combined organization will be a stronger one in the future.
In such cases, both parties realize that the ultimate repayment of the debt is dependent upon the ongoing viability and performance of the buyer. In other words, if the company fails the seller probably won’t get paid; however, many sellers may see a debt obligation from a relatively strong company as their best alternative for recognizing the value of their own investment or, in some cases, for exiting a business they want to get out of for strategic reasons.
A stake in the buyer
Buyers in strong and vibrant industries like the water treatment business typically use their stock to make acquisitions -- i.e., the selling company shareholders take stock in the acquiring firm. When equity values are high, a little stock in the acquiring firm is worth more to the seller and doesn’t dilute the buyer. If the seller takes stock from the buyer, he or she obviously will want confidence that the value of this stock is likely to go up. More important, they’ll prefer a stock that offers some liquidity -- i.e., a stock that can legally and actually be sold. When the buyer is a large public company, the “sell-ability” of the stock is not an issue; however, many buyers are small public companies or private companies, and hence the attractiveness of a stock-oriented deal is more speculative. Taking stock in a relatively small and private company involves many of the same risks and questions that were mentioned in the debt section above: 1) Will the company succeed and generate value appreciation in its stock? and 2) how will the firm measure the value of its stock?
The use of securities, such as stock, also confronts the buyer with difficult choices. While it protects valuable cash and avoids the assumption of new debt, it dilutes the ownership of the company and may change the balance of power amongst shareholders. If the stock value is high, the buyer needs to issue less to the seller in order to reach a certain transaction value. If the stock value is low, the buyer will have to offer more shares of stock to reach the same value and hence will create more dilution of the existing shareholders. Common ground between buyer and seller can sometimes be accomplished by creating special type of securities -- classes of “preferred” stock that carry special privileges or debt instruments that can be converted into equity under certain circumstances.
This brief overview barely touches on the dizzying array of structures and complex combinations of financing approaches which may allow the buyer and seller to make a desirable deal go forward. There are an infinite number of ways to structure and finance a transaction -- creative and determined parties can usually hit upon a scheme that is acceptable to both sides.
About the author
Steve Maxwell is managing director of TechKNOWLEDGEy Strategic Group, a Boulder, Colo.-based management consulting firm specializing in mergers and acquisitions, and strategic planning services to the water and environmental services business. Maxwell is also the editor and publisher of The Environmental Benchmarker and Strategist, an industry newsletter covering competitive and financial developments in the broader environmental services and water industry. He consults frequently to water companies on strategic planning and merger and acquisition issues, and can be reached at (303) 442-4800, email: firstname.lastname@example.org or web: www.tech-strategy.com/
EXTRA: M&As Online
There are a number of merger and acquisition courses for which information is available on the Internet, but few actual “nuts and bolts” websites on the complex financial arrangements and related considerations involved without having to buy something or listen to a consultant’s sales pitch.
Thus, for additional information, we at WC&P suggest you first go to About.com’s Entrepreneur section under “Mergers and Acquisitions” at: http://entrepreneurs.about.com/cs/mergeracquisition/
A ton of background and educational material can be found at this site that’s written in simple, easy-to-understand language. It also provides links elsewhere on the web to related data and terminology that will save you huge amounts of time if you were surfing for this on your own.