When Life Gives You Lemons, avoid M&A

“When life gives you lemons, it’s not always possible to make lemonade…”

Have you recently received any unsolicited emails trying to entice you into the exciting world of M&A?

The story is usually the same: the company is a hidden gem with great future potential; the seller wishes to retire; they want to find a good home for what they have built – blah blah blah.

“Can I send the teaser/IM?” – You get the picture.

Even though it’s widely know that between 70-90% of M&A deals typically fail, they’re still all too easy to jump into headlong. Why? Because M&A is just so sexy and exciting, how can anyone resist!

To keep my curiosity in check I like to remind myself of the lemon problem; not the citrus type, but of the used car variety. A ‘lemon’ is an American slang term used to describe a car that has many problems and defects – what would typically be called a ‘jalopy’ in the UK.

What does lemons and M&A have in common?

In his 1970 research paper George Akerlof a Nobel Prize winning economist and professor at the University of California, Berkeley, put forward the theory of the lemons problem. His paper explores the issues that arise for buyers and sellers regarding the value of a used car due to the problem of asymmetric information.

In a nutshell, as the seller often has more information about a used cars quality than the buyer, this can inadvertently force the sellers of premium-quality cars out of the market. The reason?

Well, as buyers are unable to distinguish between poor-quality and premium-quality cars they are typically only willing to pay an average market price in case the car they buy turns out to be a ‘lemon’. This leads to premium-car sellers – who are not willing to sell below a premium price – to withdraw from the market, resulting in only lemons being left on offer.

The same problem can also arise with company transactions. Using an average multiple as a proxy for fair market value also encourage premium-quality companies to withdraw because their true value is perceived higher than the average. They choose to wait until the market improves. This leaves the market flooded with lemons who are happy to sell for the average as their fair value is most often lower.

Keep this in mind next time you are tempted by an unsolicited offer!

“Caveat Emptor” – Let the buyer beware!

However, if you are reading this too late and have already worked up a thirst to get the cheque book out at least watch out for these 5 red flags to avoid being left with a sour taste in your mouth:

1. The Hockey Stick > expected growth defies both industry logic and gravity.
2. The Blue Chip Bonanza > you see the big names but no big contracts.
3. The Margin Fast > the business is quickly shedding pounds in all of the wrong places.
4. The Buy Now, Pay Whenever > DSO has exploded and customers aren’t complaining.
5. The New Normal > everything has been “normalised” apart from income.

Look familiar?

As a word of advice, if acquisitive growth isn’t already embedded in your existing business plan it is probably wise to take a step back and put any proposal on ice for the time being. It’s far better to spend your time developing an M&A strategy and target list before setting off to ‘kick some tyres’.

Remember, when purchasing a company you are essentially making a bold statement that you can run the business better than anyone else. This may be true, but it could also be your ego talking. Impulsive M&A decisions tend to be driven by the latter!

You can find out more about how H&Hendricks can support your business with its growth aspirations by clicking here.