M&A Knowledge for the IT Services Business Community.

Wedding Bouquet

Are You Really Considering an “Arranged Marriage” Merger?

By George Sierchio
Executive Vice President and Senior Partner

If you are the founder or top-tier executive in a technology company interested in getting a leg up on the competition, you might be thinking about joining forces with a company similar to yours in size, scope, geography or revenue. You might even have your eye on a company already, dazzled by the economic savings that can come from leveraging economies of scale, the promise of having a dedicated sales team or even the fact that you don’t need the funds required to underwrite a traditional merger or acquisition. All of those advantages are real and they can be seductive. But, before you take that leap, make sure you don’t end up in an “arranged marriage” that may not be your best, most lucrative match.

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Mergers are often likened to marriages and for good reason. Combining two companies that are the same or very similar in size into a single entity has serious, long-lasting consequences, positive and potentially negative, for both. Sometimes those newly combined companies function more like partners in an arranged marriage than two willing participants who wanted to get together. Cue the awkward silences and tense conversations about everything from finances to in-laws to children.

In our experience, transactions that involve exchanging stock to merge two (or more) companies demand as much attention to evaluation, valuation, due diligence and post-transaction integration than a traditional acquisition that has a true buyer and seller does – and it pains us to see that is often not the case.

Many IT Services companies under $5 million in revenue usually exist in a no man’s land of “too small to be of interest to larger players” that they want to be acquired by and “not operationally strong enough to financially purchase and successfully integrate their competitors” that would be a worthy acquisition for them. For those reasons, being a buyer or a seller doesn’t work for these organizations.

While arranged marriage might be attractive to two smaller companies, they need to understand that, in the end, alignment can be elusive and only one of them will be the surviving entity in most forms of mergers. Typically, there is no such thing as a 50/50 equity deal and often that is a mistake to try and achieve– even if the lesser-in-value entity is willing to pay to get it that way. On top of that, everyone in the ownership pool shouldn’t be paid the same, equal equity or not. Compensation should be based on the job to be performed by each individual.

The best laid plan is that there is truly one CEO leading the charge post-merger, and the person with the most equity doesn’t have to be the CEO. Consider the scenario in which one of the companies’ founders or executives head their company’s sales efforts. Spinning that person into being the leader of a sales team for the newly merged entity might make sense and greatly benefit the combined companies but naming that person a co-CEO certainly would not.

If you are headed down the small company merger path, there are few incredibly important things to do to avoid becoming entangled in the dreaded arranged marriage:

Start with the basics.

Each company will need a true valuation of what it’s worth and why – not the “back of the envelope” musings that can be customary in non-cash deals. The “my company is three times as big as yours so I’m 75% and you’re 25%” doesn’t work; is very likely not true; and doesn’t place an accurate value on the separate companies nor the combined companies that will be needed later. Often, founding executives believe their companies are worth more than they actually bring in the marketplace. Under- or over-valuing will likely cause future disagreements and disappointment when partners are ready to sell the company or go their separate way. Parties to a merger like this should use the same IT service company valuation expert to professionally and correctly determine the value of each company.

Find your “plus.”

Once the two companies settle on the value of each operation, you’ll need to do a pro forma together to determine the size and scope of the business opportunity for the new company. This important exercise includes delineating who will do what in the new organization, reviewing every position in each organization, deciding whom to keep and whom to let go, and understanding which company’s processes and procedures are the ones to follow when the two entities are combined. The companies need to be integrated just as you would if you were buying another business and not forever run as two separate companies with the same owner group. These exercises are critical if you are to leverage those economies of scale that were so attractive in the first place. You are looking to utilize the “M” in M&A. It’s a real transaction so it must have a positive effect in the areas of consolidation, synergy and growth opportunity — giving you the competitive advantage and ability to do things that were difficult to accomplish on your own before this marriage.

You might conclude that while you can afford to complete the deal, it will hamstring your operational success going forward. It’s far better to know that before you sign the paperwork than to discover it afterward. As the Cogent motto goes, one plus one must equal four (or better) for a deal to have a chance at realizing the planned positive effects.

Agree on the main details and intent.

Although not required and sometimes not used, we highly recommend writing and having all parties sign a Letter of Intent to organize the merger-marriage plan. Besides the obvious merging of the businesses into one entity and the owner roles, responsibilities, salaries, benefits, etc., there are many more moving parts that are better decided ahead of time –before legal paperwork and diligence starts. Who will be the owners in the end (maybe some employees are coming into play) and how is each owner holding on to his or her piece of the business (individually or via another company entity)? Who are the key employees, and do they need to have employment agreements? How are balance sheet items being handled (i.e., is the new company starting with working capital)? Should you decide upfront on a pre-set buy-sell agreement and/or “valuation” methods to go into an operating agreement? The time and ability for each party to do their due diligence under a “lockout period” is recommended to be established as well, for example.

Each side needs to conduct detailed due diligence about the other.

Reciprocal due diligence is a complex task and one that is not easy to do. You may need to bring in an objective third party to assist. In reviewing the details all the way down to the contract execution process, you are likely to find previously agreed to areas fading away. All this pre-closing, pre-integration detail work must be sorted out and agreed to before a deal can take place. Due diligence is the time when surprises, good and bad, need to be exposed and handled. Again, this is a real transaction requiring a detailed “plan of merger“ legal agreement, that was hopefully outlined in the Letter of Intent, and unlike buying the assets of a company, each set of owners is taking on the past, present, and future of their marriage partner.

Create an LLC for the new entity and a real operating agreement.

To help ensure maximum flexibility in the management of the new entity, it is highly recommended that the assets of the merged companies reside in an LLC with a true-to-form operating agreement. Whether merging with a lifelong friend or a 10-year business acquaintance, this document will help keep everyone honest as it sets the rules for collaborating, making decisions, extracting profits, and funding the business as well as covering the many ways that you and your business partners can part ways through the buy-sell portion of the agreement.

Stock-driven transactions should receive the same attention to detail that mergers or acquisitions involving money do. Success in both types of transactions depends on both sides agreeing on their current value, isolating the factors that can deliver financial upside post-transaction, understanding how value will be determined going forward, and operating the merged businesses to optimize success.

Whether they are arranged or not, marriages and mergers both have life-changing results. That’s why both kinds of these strategic mergers demand commitment and nurturing to be successful.

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