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Four Tests for Successful Acquisitions

lot of academic research shows that the odds of making an acquisition work are not high. Should companies just forget about M&A, and focus exclusively on innovation and organic growth? Maybe not, at least in some cases.

Careful thinking about what it means for an acquisition to succeed, coupled with an analysis of why deals fail, can lead to some practical advice for managers, thus helping them to develop a more refined view. More specifically, in order for acquisitions to pay off, they ought to pass four tests. I describe the tests below, showing how each offers a way to head off common sources of merger malfunction. The Industry Attractiveness Test

If the industry in which the acquired company participates has the potential to remain profitable, then the target passes the industry attractiveness test. One reason that mergers fail is that the inherent profit potential of the target company’s industry is low. That is, the average player in the industry does not earn very high returns and the factors that drive those investment returns are likely to keep them low in the future. Such was certainly the case, for example, with JDS Uniphase, which paid way too much for SDL because a huge drop in demand in the wake of the dot-com crash, was turning its optical components industry into a huge money loser. The “Better Off” Test

If the acquirer and the target boost their market share and growth potential in the industry as a result of their combined capabilities, then the deal passes the better off test. A second reason for merger failures is that when the acquirer and the target combine, they end up being weaker as a combined company than they would have been separately. As a result, the combined companies end up as hobbled competitors in that new market. Consider here a merger between two tech firms in Silicon Valley, both of whom had IBM as a leading customer. When the merger was announced, they both lost IBM’s business. “IBM wanted to know why they were not told of the change.”1 The Net Present Value (NPV) > 0 test2

If the future cash flows from the deal discounted to the present significantly exceed the price paid, then it passes the NPV > 0 test. One of the most common reasons mergers fail is that the acquirers overpay. The high tech mergers I cited above all failed this test miserably. In retrospect, that failure was obvious. And although many people at the time complained about the frothy market valuations of high technology companies, many of the acquirers did not take those warnings seriously because their own stock prices were similarly inflated and they convinced themselves that they were too smart to be trapped by the problem. The Integration Test

Finally, if the acquirer and target companies can agree on who will run the combined company and put in place the systems, processes, and culture needed for it to appear seamless to customers on the day the deal closes, then the deal passes the integration test. Most companies that do mergers go into the closing with a conqueror’s mentality. This means the acquirer’s management team will replace that of the target. Often this leads to the loss of much of the talent that made the target worth acquiring in the first place. At the core of these people problems is a gap between the cultures of the acquirer and the target.Then, there are other big integration problems—such as taking too long to get the processes and systems of both companies linked together so the deal will appear seamless to customers. One example that comes to mind is the merger between Sweden’s Electrolux and Italian appliance manufacturer, Zanussi. This deal in 1984 took years to integrate, and shareholders, customers, and employees suffered as a result.3 Most acquisitions fail. But they can help companies grow profitably if done well. The four tests of a successful acquisition can help managers seize the opportunities and avoid the many pitfalls....
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