The Psychology of Divesting an Entity
by M. Eric Furlow
I have heard the same statement tossed around for many years, “at least 50% of mergers and acquisitions have been shareholder value destroying events for the buying entity”. This is a fact not many finance professionals would argue with. Why not look at this statement from the other side of the transaction, from the seller’s standpoint. If slightly over 50% of transactions were shareholder destroying events for the buying entity, were slightly over 50% of transactions shareholder value maximizing events for the selling entity? … in my opinion, absolutely not. The real percentage is much higher, maybe 90%. I have covered in previous articles the numerous reasons why many mergers and acquisitions are shareholder value destroying events for the buying entity. Most of the points are well-known and covered elsewhere. They include, among other reasons, simply overpaying and the poor execution of post-closing integration strategies.
Looking at transactions from the seller’s standpoint, how many divestitures occur at less than market value with less than reasonable terms? Or in other words, how many transactions occurred where “money was left on the table”? Maybe a more important question: How many proposed, well-valued transactions do sellers pass on, and at what future cost?
Addressing the first question, how many divestitures occur at less than market value with less than reasonable terms? In the scenario where a seller is being represented by a professional, the answer is not many at all. Hence, in my opinion, 90% of divestiture transactions are shareholder value maximizing events for the seller. When a company is being represented by a professional, that person is in tune with market values, typical deal structures, and is financially motivated to get the highest price. So if the seller takes a deal, it is either a well valued deal and/or it addresses the needs of the seller with regards to liquidity, tax implications, and so on.
Addressing the second question, how many proposed, well valued transactions do sellers pass on and at what future cost? In this scenario, whether the seller is being represented or not, the answer is a lot. Many sellers pass on the best deal only later to settle for an inferior deal. Why? It has a lot more to do with psychology than people think. A person can get a degree in finance then go off to work, or get a degree in the IT space and do the same. Inevitably everyone faces the same “next dimension” in business, the psychology of business participants. There has been a vast amount of research done on the psychology of business managers and how they make decisions regarding purchasing, hiring and firing, financial and operational leverage, forecasting, and so on. But what I haven’t seen is a body of work addressing the psychology of sellers or selling decision makers. Here are a few of the behavioral patterns I have seen over and over during the 12 years I have been doing mergers, acquisitions, and divestitures.
One of the most common behavioral traits is what I call a deer in headlights. When a seller decides to potentially divest the company and goes through the process, it is typically a new experience, so once the seller becomes confused, over-whelmed or unsure, the reaction is to “pull the plug” and not do the deal.
Another trait is seller’s pride. Creating and building a business to the point which other entities would want to acquire it is truly an impressive feat of a combination of skills. Pride is a common and very understandable feeling among sellers because of what they have created, and many would like to add a premium to the value of the entity to address their perceived superiority. This is an area, as a consultant, I have to approach carefully. The market decides what something is worth in the reality of a proposed arm’s length transaction.
Another trait is the misconception that friends or non-industry advisors know when to sell a company, who to sell it to, and for how much. Why is it that some sellers are intelligent and disciplined enough to build a business, only hiring the best employees and managers who know the industry, yet when it comes time to sell the entity, they seek the advice of others who have no idea about the inner workings of the business much less the industry? Regarding valuation, whatever the industry valuation measure, whether it is a revenue, EBITDA, Net Income multiplier, or a dollar per subscriber measure, these metrics change all the time. From my observation, most telecom and Internet subscriber type industry valuations trend downward over time and rarely go back up. The past is the past. Old industry valuations are irrelevant other than being used for forecasting future values. Many sellers have old valuations in their minds and inevitably this kills good deals. Finally, some sellers have a lack of realization of the illiquidity of businesses in general. One would think in today’s commercial and residential real estate market that more people would understand this. In addition, selling a business in the top quartile of an industry’s valuation cycle is actually hard to do. Most sellers sell their businesses either too early or too late.
What is the cost to the seller of passing on a reasonable deal? First, the most probable buyers have looked at the company, and then walked away for the reasons mentioned above, never to return. Inevitably the seller will never get the best buyer's offer price out of his mind. Another cost of passing on a good deal is the seller will be a bit disenchanted by the process, which previously in his mind, was time consuming and never generated any positive results.
I represent about the same number of buyers as I do sellers. What I always recommend is to be more cautious when acquiring other entities and more aggressive when divesting.