A Shaky Foundation

Mergers, acquisitions, and joint ventures (hereafter, referred to collectively as “acquisitions”) all involve financial modeling of the future.  Such models are the most popular method of determining the value of a target business – and hence, form the basis for the price that is paid in the transaction.  Financial models are typically developed by studying the past and predicting how the future will differ from recent history, often looking as many as ten years forward.

Are such models worthy of the faith we seem to place in them?  Or are they a placebo produced for others to consume, a tool used to justify doing what we (instinctively) want?

In large corporations, review and approval of the acquisition financial model often represents a gauntlet that must be run by the sponsoring executive in order to gain permission to pursue the transaction.  The temptation to manipulate the analysis can be extreme and consequences are often thought to be far off.  Manipulative behavior often leads to exaggerated expectations and a plan for the post-transaction entity that is unrealistic or even impossible to achieve.

Building it up from the details

Acquisition valuation often have both “bottoms up” and “tops down” aspects to them, and they often meet in a “messy middle”.

“Bottoms up” analysis begins with the entity’s historical performance, and works methodically through a large number of underlying assumptions (position in the economic cycle, market share and potential shifts, margin changes, inflation, possible cost savings, etc.) to develop a forecast of future performance.  The primary problem with this approach is the extremely large number of assumptions the analyst has to deal with.  Most honest acquisitions I’ve been involved in include moderately optimistic assumptions for each of these items – i.e. modest economic growth, moderate competitive reaction to the deal, a “reasonable” amount of cost savings, etc.

The problem comes when just a few (sometimes, only one) of these assumptions proves to be wrong.  The model often behaves like a house of cards which rest on a series of shaky critical assumptions.  Disturb just one of those at the base and everything comes crashing down.

This situation can be corrected by forcing assumptions to be more conservative, but it is easy to push this too far and produce a forecast that will preclude the deal from ever happening in the first place.  It can be quite stunning what a couple percentage points of growth or margin can do to the ultimate price you are willing to offer for the target.

An acquisition I once made included a detailed analysis of the future of the firm, one that I thought was appropriately conservative.  Unfortunately, only a few months after the deal closed, there was a severe economic contraction which no one anticipated.  Adding to the trouble caused by the economy was a highly aggressive competitive reaction to the announcement of the deal – something we also hadn’t anticipated (silly me, I thought the competitor would react rationally).  In just a few months, the results were in previously uncharted territory – unfortunately pointing in the wrong direction.

The deal never lived up to the original forecast.  My superiors never let me forget it.

Looking at the big picture

In most (but not all) deals, there is also a “tops down” analysis.  This study usually starts by trying to answer the question:  What will it take to entice the sellers to say “yes?”  While there is plenty of mathematics involved in this type of approach, it is of a completely method than the “bottoms up” valuation.  This analysis often focuses on rules of thumb like comparing “multiples” and examining the details of other, similar deals to determine what is a “fair” price.  There is also often analysis of the seller’s psyche, and how the story needs to be constructed to make the offer palatable.

While this “big picture” look doesn’t rely on a plethora of shaky assumptions, it does contain an implicit one – that the deals you’re using for comparison actually made sense.  We know from academic study that the majority of acquisitions disappoint, and that fact alone should call into question this assumption.

This is the cover of my latest novel, EMPOWERED, published on October 12, 2014.

This is the cover of my latest novel, EMPOWEREDpublished on October 12, 2014.

I’ve seen the most elaborate “tops down” analysis occur when there are Investment Bankers involved in the deal.  Of course, the I-bankers only get paid if a transaction happens (and then they are paid quite well), so they have an inherent motive to justify the highest price the buyer can rationalize.

One transaction I was involved in (essentially and auction) looked impossibly expensive to me using the “tops down” approach.  As deadlines approached for us to submit our bid, our Investment Bankers pushed hard for us to come up with a way to justify a (much) higher bid.  Eventually, it was my call to pull the plug on the transaction.

As it turned out, the I-bankers were right about the price it would take to buy the company – a competitor (one with a lot more synergies in the deal) ending up purchasing the target at a price even higher than we were contemplating.  I remain convinced to this day that if I had approved that bid we would have regretted it.

The messy middle

The place where “tops down” meets “bottoms up” is the zone of self-deception.

Under ideal circumstances, the “bottoms up” approach will produce a valuation that is higher than the “tops down” method.  In my experience, this is rarely the case.  Normally, if the “bottoms up” analysis had any modicum of conservatism in it, there is a gap – sometimes one that is quite large.

What usually happens next is manipulation of the “bottoms up” analysis – selective alteration of the assumptions to produce the desired zone of overlap between the two valuations.  When this happens, completion of the acquisition is extremely risky.  If this type of manipulation is present, the manager responsible for approving the deal should almost always take a pass.

I’ve witnessed such “numbers gaming” happen many times, and it almost always drastically increases the risk that the deal will be a disaster.  In one acquisition where such gaming was clearly present, I was brought in late to visit with the sellers and tour their site.  I quickly realized the underlying assumptions of sales growth in our “bottoms up” model were so rosy there was almost no chance they could be met.  I did my best to moderate that unrealistic assumption, and the target company was eventually purchased by someone else.

Years later, it was clear that the target company experienced nothing close to the growth rate our internal “experts” had been forecasting.


Acquisition analysis is a tricky and potentially dangerous process.  If you’re too aggressive in your assumptions you’ll end up with a deal based on unrealistic expectations, and chances are that subsequent underwhelming results will damage your career.  If you’re too conservative the deal will likely never happen.

If you sense manipulation of the analysis, the chances of a post-acquisition failure go through the roof. Under those circumstances you should almost certainly pull the plug on the deal, no matter how painful.  23.2

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These are is the covers of my Carson series novels.  PURSUING OTHER OPPORTUNITIES, released in April, 2014.  This story marks the return of LEVERAGE characters Mark Carson and Cathy Chin, now going by the name of Matt and Sandy Lively and on the run from the FBI.  The pair are working for a remote British Columbia lodge specializing in Corporate adventure/retreats for senior executives.  When the Redhouse Consulting retreat goes horribly wrong, Matt finds himself pursuing kidnappers through the wilderness, while Sandy simultaneously tries to fend off an inquisitive police detective and an aggressive lodge owner.

My novels are based on extensions of 27 years of personal experience as a senior manager in public corporations.