by Todd Whitson, Greg Art, and Chip Chapados
After participating in dozens of mergers and acquisitions, both as company managers and consultants for capital investors, we have found that people interested in capital investing or considering an acquisition or a merger often fail to consider the risks and opportunities associated with the functional performance of a business. Instead, investors generally use one or a combination of three sets of criteria when making a decision to invest in a company: financial performance, perceived opportunity in the market, and personal interest.
Financial opportunity is most often used by professional capital investors, by companies considering a merger or an acquisition, or by stock investors. These investors are usually seeking ways to minimize risk and looking for incremental gains. Capital investor groups or individuals wanting to exploit a market opportunity typically seek an innovation to introduce to the market or an opportunity to penetrate an underserved market. These investors are willing to take moderate and even high risk for substantial gain. People who invest out of personal interest often base their choices on their relationships with the people in whom they are investing, on an interest in the products or services being offered, or on intuition. These people accept a high level of risk or do not understand the risk involved with their investment. Many are naive about the actual gains or costs associated with their investment.
In reality, most investors base their decision on some combination of the three. For instance, Warren Buffett’s investment strategy looks at a combination of a company’s financial performance and the character of the company’s leadership. Due diligence for Buffet has at its core the review of approximately a dozen items roughly grouped into three areas: financial performance, valuation, and the honesty, truthfulness, and rationality of the leadership. Carl Icahn uses financial performance and market opportunity when choosing companies, usually looking for companies that are, in his opinion, lackluster in their return on equity to shareholders and that are failing to optimize their market position.
As necessary as an understanding of a business’ financial and future prospects is, that understanding is insufficient when committing significant amounts of capital. This isn’t to say that most investors do not do a functional assessment, but most investigations are either narrowly selective, too shallow, or both. Moreover, investors can be naive as to what their observations actually mean.
Our expertise is in assessing organizations’ business development, sales, marketing, and operational performance. In each of these areas we assess adequacy and effectiveness of the component pieces (e.g., people, procedures, processes, equipment, resources, etc.), and the actual performance of the area as it relates to the company’s profitability and future success. The strengths and weaknesses of each are assessed as they relate to the goals and objectives of the investors.
In our approach, an assessment of a company’s business development includes a review of the organization’s business strategy and how well the company is aligned with that strategy. We examine the organization’s availability and use of business development resources. In particular, we examine the company’s abilities and performance in executing projects to meet that strategy and the company’s abilities and performance in new product or service development. We assess a company’s new product development capabilities by examining how well it meets best practices for new product strategy, idea management, portfolio management, and project management. We benchmark the organization’s effectiveness in developing new products by comparing it’s practices to industry standards to identify any missing critical success factors.
A sales and marketing assessment examines the company’s resources and their use in marketing and sales. We examine the company’s performance in its market, its market segments, its sales performance, and its ability to meet future opportunities, challenges, or issues. In particular, we examine the alignment and coordination of marketing’s role as the market strategy agent, and sale’s role as the execution agent. We also look at the relationship marketing and sales has with executive management, operations (especially sales and operations planning), and business development, including new product development.
An operational assessment examines the company’s resources and abilities to provide customers with products and/or services profitably. The assessment includes a review of the company’s operational and production planning and information management, engineering management, materials management, production methods and production flow, labor management, equipment management, quality management, customer relationships and customer satisfaction.
The following is an example of the difference that taking a look under the hood can make. A company that had a dominant market share in a well-defined market niche was a prospective acquisition for an investment group with controlling interest in several other companies. They believed this company would complement their existing holdings by providing access to a market they wanted to enter, giving them additional manufacturing capacity for their current line of products, and giving them additional management and technical talent they could exploit for their other businesses. They examined the company’s current market performance, along with an analysis of the company’s financial performance, and based upon that assessment, they acquired the company. However, they failed to “look under the hood” to examine the company’s functional business performance and potential. First, they failed to adequately grasp how narrow the company sales and marketing expertise actually was. They assumed that the experienced sales force had knowledge, competencies and expertise transferrable to the larger market they wanted to enter. That was not the case. The company that was acquired dominated a highly specialized niche in the market with sales and marketing methods so unique that transferring them to the larger market was difficult. After the acquisition, the acquired company made little or no contribution to helping its sister companies gain a position in the targeted market. The company’s operational talent was also seriously misjudged. In their investigation, they saw a stable, experienced workforce in production with strong floor supervision. What they missed was that there were several critical positions staffed by experienced, talented, long-tenured people who were either close to retirement or had opportunities with other companies. Four individuals in these positions chose to leave the company, creating significant performance gaps. The acquired company had done little in terms of back-up or succession planning. These performance gaps caused a number of operational problems that created a ten percent increase in production costs, quality assurance problems, and degraded on-time delivery performance. Not long after acquiring the company they promoted and transferred three senior managers to the sister companies. Each of these managers excelled in their new roles with the sister companies, but their absence created problems for the company they left as no one remained inside the company who possessed the necessary skills and experience to replace them. The uniqueness of the company’s products and market meant that the expertise needed for these vacant positions was quite specific, so whoever filled them, whether by a promotion from within or by an outside hire, would have a long and painful learning curve. As a result, important projects were significantly delayed and additional costs accrued. Decision-making suffered and the company risked losing several clients.
In another example investors in a company that created a new switch technology did so because they saw the technology as a potential game changer in the market. They felt confident in their investment because the company had a solid base of customers for its existing products, along with the operational wherewithal to meet its existing demand as well as future growth. They were impressed with the new product design and the passion of the company owners who had conceived the product based upon their experience in the market. However, the investors failed to recognize that there was no one in the company who could manage the product development process. This deficit resulted in mistakes in material selection, hiccups in design adaptations as the product evolved, manufacturing issues, and inadequate marketing expertise, all of which added significant cost and time to the product’s development. A substantial amount of additional funding was needed to bring the product to market. To secure the new funding, additional equity in the business needed to be sold, which significantly diluted the equity of the owners and first-round investors. When the product did eventually enter the market two years after the intended date of introduction, there were now two similar competing products that had already been identified as high quality solutions and they had captured significant market share. As a result, the company’s new switch fell significantly short of sales and profitability expectations. The costs and strains of the effort damaged the company’s overall sales and profits. It took several difficult years for the company to regain what it had lost, and even longer for investors to begin to recoup their investments.
In both cases, had a functional performance assessment been done weaknesses would have been identified and different decisions, plans, and initiatives would have been taken by the investors.
In another instance, a contract manufacturer of vision devices experienced a devastating loss when its owner, plant manager, and senior engineer were killed in a plane crash. Immediately after the funeral the owner’s widow put the company up for sale. Several potential buyers looked at the company, but after reviewing the financials and the state of the market, they failed to make an offer. Sales and profits were both down and the company had significant debt. When the plane crashed, the company was just recovering from a significant downturn in the market. The company’s leadership had been traveling to a new customer to try to secure a contract, a major component in the company’s recovery strategy.
A month after the crash, another person bought the company. He understood the company’s weak financial performance, but bought the company anyway. He did so based upon the company’s functional performance and the prospects evolving from the market’s recovery. He found that the sales force had reached out and maintained relationships with key customers, assuring them of the company’s commitment to meet their needs. They also reached out to potential new customers, including the company the lost management team was going to meet. They convinced that customer to delay making a decision for sixty days so that a new proposal could be developed with input from their new owner. Acting as a sales manager, the company’s deceased owner had worked collaboratively with his sales force, creating a shared knowledge of market and customers as well as shared expertise coupled with standard Sales methods. The deceased plant manager had also developed a strong operations team. She and those who reported to her worked interdependently. They worked collaboratively toward a shared vision using shared standards and methods. After the plane crash, operational performance actually improved because the remaining team members knew that the plant and manufacturing would have to “step up” to meet the challenges that were sure to come with the disruption. In engineering, however, there was a different reality. The Engineering team was a small group, and with the exception of the senior engineering manager killed in the crash, the engineering team had little formal training, having been promoted from within. While they were perfectly competent handling the company’s day-to-day engineering tasks, none were qualified to manage the department or to even lead major projects.
The new owner quickly promoted from within a sales manager and a plant manager. He recruited outside the company and hired a new senior engineer with the necessary experience and expertise to lead the engineering team. In the next two years, the company increased sales by sixty percent and increased its margins from thirty six percent to fifty one percent.
Functional assessments help provide critical information about a company’s existing performance and a realistic assessment of its ability to perform in the future. Our experience is primarily in sales andmarketing, business development, and operations, and we believe these are critical functional areas that should be carefully studied by prospective investors. Depending upon the type of business and market circumstances, there are other areas that might be included in a functional assessment, such as health and safety, human resources, legal, regulatory affairs, etc. that might be critical to the business’ current and future success. The challenge is to know which areas are critical when considering an investment.
Unfortunately, when investors study prospects, functional assessments are not commonly used. David Emott’s Practitioner’s Complete Guide to M&A’s, An All Inclusive Reference, considered by many to be the gold standard in merger and acquisition practice, includes 98 topics to be addressed or at least considered. Only two of them focus on the business methods of the company (“Unlock Hidden Value”, “The Lean Enterprise”, and “The Real Deal: Lean”). Indeed, in most texts on investing, little is offered on the functional performance of business. A review of the criteria used by the major accounting and investment firms for analyzing prospects show that they pay little attention to a company’s functional performance. Indeed, in almost every case the people sent to do due diligence use checklists that focus on financial performance and potential market opportunities the company might exploit. In a quick review of fifteen teams sent by three major firms to study a prospective acquisition or equity investment, none of the seventy-eight people on those teams had any sales, marketing, operational or functional business development experience; most never taken a class in any of these areas during their professional training.
Disciplined businesses fare much better over the long term than those who aren’t, no surprise here. But discipline, in and of itself, does not guarantee success. Effective discipline has to use the right measures that focus the organization on the right process and outcomes for success. These measures are often different from what one can find in a financial statement, a marketing assessment, a product analysis, or a price-to-earnings ratio. Future investors or companies looking for acquisitions would do well to include in their prospect review an expanded functional assessment that will show the actual strengths and weaknesses of a company’s ability to perform in the real world in real time.
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