It seems the best words in our business vocabulary get ruined through overuse and mismanagement much the same way a pristine tropical paradise turns into to a ghetto of ugly strip shopping centers and boxy condos over time. One such word is “synergy.” A really great word, frankly, that conveys the simple but powerful idea that the combination of two or more entities can be greater than the sum of their parts. It is in fact the Raison d’être of acquisitions. However, not only has the word synergy been misused and misaligned, the miscalculation of synergy is probably the single reason the majority of acquisitions never meet expectations.
But how do we realize synergy in a corporate environment? Typically, it is one of the following ways:
- Market Synergy: Company B can sell more of Company A’s products and services through its channels, and vice versa. This can be a result of geographic coverage, industry span, or customer penetration;
- Product Synergy: The products and services (or technologies) of the two companies are complementary and complete each other making either more valuable or easier to sell;
- Management or organizational Synergies: Management, organizational structure, and culture can cut both ways. Ideally, the combination of talent and structure will create additional value; very often it is the source of post-acquisition friction and negative synergy;
- Economies of Scale Synergies: the simple idea that activities and functions – particularly general and administrative – can be shared and redundancies eliminated.
As you can see by the definitions, synergy only occurs after a merger acquisition transaction is complete. Therefore, it does not exist prior to the deal. Therefore, one can argue that the business being acquired does not yet include these intrinsic properties of synergy and the seller should not be compensative for value that will only be created when the buyer integrates the company into their organization.
But, then we have the troubling issue of free will and at least perhaps for a few more years, a free market. The value of a company is set ultimately set through negotiation between buyer and seller and beauty is of course, in the eye of the beholder. So, for a buyer, when is it appropriate to consider synergy as justification for paying a premium over what net book value plus discounted cash flow would justify?
The conservative buyer will take the position, “why pay a premium at all?” There are two basic reasons to consider a premium; 1) to convince a seller to sell; 2) to convince a seller to sell to you and not someone else.
You can only justify a premium if the the value to you as purchaser is greater than the company as it exists today. The seller certainly has no right to capitalize on the extra value that will accrue to you, but they do have the right to hold out for a premium if they think they can get it.
Because no two companies are the same, and private companies’ stock is not traded publically, the basic value of a company comes down to the following fundamentals:
- Future Earnings Value: book value (or net assets) plus the net present value of future earnings. his is the only accurate way to value a business as it exists independently. The key to an accurate valuation; however, are the underlying assumptions which support the future earnings proforma.
- Market value: Just like in real estate, this is what comparable companies are being sold for. That’s why you often hear investment brokers talk about multiples of EBITDA, but multiples are only a proxy for discounted cash flow. The problem with purchasing a private company is there is no real market and comparable acquisitions ultimately come down to what a competitor is willing to pay for the same company. If the seller has another suitor, it is likely you will have to pay a premium if you want to “out-bid” the other suitor.
- Seller’s value: at the end of the day, you can only buy a private company if a private seller is willing to sell it for your offer price. Emotions and irrationality come into play here; particularly for a smaller firms where owners often have an inflated view of the value of their company. The bottom line is you sometimes may have to pay a premium to overcome this irrational valuation if the acquisition is valuable enough to your company.
So, should you pay for synergy? Theoretically, no, since it does not exist until after the deal has been consummated. However, if you feel you have to pay a premium over what book value plus discounted future earnings can justify in order to overcome market value pressure or seller reluctance, synergy is the only way that premium can be paid for over time. In this regard, it is important to be very analytical in determining what real synergy (not vague hopeful synergy) can be realized and then be willing – reluctantly and cautiously – to spend some small portion of it in order to realize its greater overall benefit. However, if you spend too much of the yet unrealized potential value at transaction, you may in effect remove the entire profit motive that made the acquisition attractive in the first place.
Putting too much value on synergy is why most acquisitions fail to meet expectations. While considering synergy to justify a reasonable premium is a very rational and economically sound approach, it is a slippery slope and the one area where buyers often substitute hope for strategy; ego for analysis; and emotion for planning. Synergy doesn’t exist until you create it; spend its future potential stingily.