3 Rules to Capture Deal Value

A great piece of analytical insight from last year’s Harvard Business Review, which has had an impact in many areas, needs a more thoughtful reading by both buyers and sellers interested in capturing greater deal value in M&A transactions. The argument, by Michael Raynor and Mumtaz Ahmed of Deloitte, is that the long-term success of companies is determined by adherence to two rules: 1) create value for customers by differentiating instead of competing on price and 2) create value for your company by prioritizing growth ahead of cost reduction. A small number of “Exceptional Companies” emerged from the analysis, followed by a whole lot of “Average Joes.”

These simple rules recall familiar aphorisms such as the two-part strategy formula, “decide where to play and how to win,” as well as the admonition “you can’t cut your way to greatness.” The fact that the rules, however, were based on the performance of 25,000 public companies over 4+ decades makes the authors’ conclusions hard to ignore. Subsequent commentary has reinforced these conclusions, and the rules were released as a highly regarded book called The Three Rules, the third rule being the cutely referential[1], “there are no other rules.” (Hey, do we really need everything memorable to be in threes?)

An essential point to keep in mind is that the rules focused on identifying drivers of long-term success – a superior return on assets over several decades relative to competitors in a given industry. The problems with most mergers and acquisitions today stem largely from the proclivity of deal-makers on all sides to view their work as a short term transaction instead of a way to grow an exceptional company.

So, how do you capture greater value in mergers and acquisitions? Many people have identified two drivers of M&A success that somewhat parallel the Rules: establishing a reasonable valuation, or how much is paid for a business, and leading a thoughtful integration, including the range of decisions and actions post-merger about whether and how to bring the two companies together. Both dimensions of M&A success would be improved by application of The Three Rules.

Let’s start with valuation. Rule Number One says that exceptional companies, those consistently in the top 10 percent in ROA, focus on competitive differentiation, while the “Average Joes” usually compete on price. Business valuations tend to focus on near term historical and future performance through the lens of discounted cash flows. DCF understates the value of differentiation because it cannot look out far enough in time to capture the greater strategic value of the differentiated positioning. DCF analysis will consequently overvalue businesses that compete on price because price competition, according to the analysis, is not a reliable path to sustained high levels of performance.

Perhaps more significant are the insights the Rules offer around integration. Rule Number Two says that exceptional companies prioritize growth ahead of cost reduction. A revolution in merger integration success would grow by planting this seed of advice wherever an acquisition were contemplated. Why? Because the first thing acquiring companies usually focus on in planning for integration is how and where and how fast they can cut out costs. But investing near term in cost cutting reduces the financial and leadership resources available to grow the acquired business. This priority is often baked into financial models and forecasts developed during due diligence, and is hard to reverse later, after the deal has closed. Integration plans should focus on growth opportunities first, with the knowledge that cost reduction can always be brought to bear once the major growth opportunities have been addressed.

It’s pretty clear that buyers would benefit by more closely adhering to these two rules. They would more accurately value prospective targets, and they would tend to capture more of that value in focusing post merger integration decisions on growth. But how would sellers benefit from these insights?

Most sellers are well compensated for their work in growing a business or improving it to the point of a sale. But those who have built companies based on differentiated products or services should be wary of all-inclusive industry valuation benchmarks. In reflecting on valuation assessments, these sellers should consider what has happened over many years to the price competitors in the same industry, and insist on being paid for the extra value of their superior strategy.

Most entrepreneurs and leaders of public companies also have their legacies tied to what happens to their companies after the deal is done. There are ways to help ensure that strategic decisions about resources and costs are as consistent as possible with the historic strategy and vision for the company. It pays for these leaders to find a way to stay relevant and engaged during the integration period, usually by insisting on a key integration role for at least a year and ensuring that integration plans are developed that prioritize long term success over short term profitability.



[1] This reminds me of the two rules that Stew Leonard’s prints on each of its plastic grocery bags: 1. The customer is always right, and 2. If the customer is ever wrong, re-read rule 1.