Businesspeople frequently talk of mergers & acquisitions (M&A), but the emphasis is usually on acquisitions, with relatively little thought given to mergers. Yet in today’s financial markets, it may make even more sense to consider mergers.

Why is this the case? Consider the following (very common) scenario: due to anemic economic conditions, two companies in the same industry may both be hurting. Both of them may be experiencing much lower than usual profitability and cash flow, perhaps even a loss. Both of them may be experiencing a liquidity crunch. Both of them may be reluctant to exit at what would most likely be very low valuations. Furthermore, lack of liquidity would make it difficult or impossible for one company to acquire the other.

In this type of scenario, a merger may be the perfect solution: with a cash-free transaction (e.g. a merger), two marginal or unprofitable companies may combine to form a profitable company, with greater market share, economies of scale, and rationalized costs. This is the definition of synergies: 1+1 = 3. Because investors prefer to invest in larger entities, a merged entity may also be a more saleable entity in the longer term. Hence corporate value is enhanced, in preparation for the day when financial markets (and valuations) improve.

Sounds too easy? While the upside in such a scenario is more often available than business owners realize, there are also numerous potential pitfalls. Allow me to enumerate some of these pitfalls, both with respect to doing a merger transaction, as well as pitfalls with respect to making the merged entity work.

A merger is often a much more complicated transaction than an acquisition:

• Each party must perform a due diligence and valuation of the other (as opposed to the case of acquisitions, where only the acquirer values and performs a due diligence on the target company). It is often very tricky for the parties to come up with the relative valuation that each party will obtain in the new merged entity.

• How will the owners of the merging companies share the governance of the new entity? Will they be equal partners? Will one or both have veto rights? Will there be rights of first refusal, put or call options?

• A party may need to give up control of his or her company, without receiving cash in the transaction. This often gives at least one party to the merger cold feet.

• How will the loans of both merging corporations be handled? Will banks become joint lenders to the merged entity? Or will there be a refinancing? Banks of both merging entities will likely need to approve any merger, or be paid off on or before the merger closing. Banks may be afraid of the risks associated with the merger, for example, whether management will be capable of realizing the merger synergies.

   

Pitfalls in making the merged entity include:

• Joint management of any company, among people who have typically been used to being sole CEOs, can be very trying.

• The realization of synergies may prove elusive. For example, on paper it might appear simple to rationalize expenses, in practice there may be resistance from within the organization.

• The two organizations may have different corporate cultures, which may create difficulties in implementing any merger. A merger seldom if ever works unless the corporate cultures are fused into one.

It requires enormous expertise to successfully execute a merger. The potential upside of a merger may be huge; but the potential pitfalls and risks are also great. In times of recession a merger is nevertheless one of the best ways that “financial engineering” may create corporate value.

Running a small business is arguably more difficult than running a large one. I have done both, and that has certainly been my experience. When running a large company, you have resources: specialized staff, better systems, in general, more resources to solve problems as they arise. When running a small company, it is often difficult to afford high-powered staff. A small company might be lacking certain functions altogether, such as controller, HR director or in-house counsel. If a small company loses a key staff member, it usually leaves a gaping hole; where a larger company loses a key staff member, one can more often promote someone from within. In a small company, the CEO often has to be a jack-of-all-trades, chief cook and bottle-washer, filling several operational functions at once.

But this article is not so much about managing small companies, rather about doing transactions with small companies, whether raising equity or selling the company or, as will be discussed below, merging two small companies. It is also much more difficult to do transactions with smaller companies than with larger companies, for the following reasons:

• The greater difficulty of managing small companies, as explained above, makes them higher risk, and hence less desirable, to investors.

• Ironically, it is often easier to find buyers for larger companies than for smaller companies. Strategic investors and private equity firms prefer targets that “move the needle,” that have a certain critical mass.

• It takes just as much time and effort, sometimes more, to buy or sell a company valued at €2 million company than €20 million.

• As an owner of a small company (say €1-2 million revenues), it is often difficult to afford an experienced law firm for a transaction, let alone a good financial advisor, who might be used to earning a success fee of several hundred thousand euro.

• For buyers, investing in a small company, that often has a very “thin” management team, can be a high-risk proposition. If one or more members of such a thin management team leave, or turn out not to meet expectations, the entire investment may be at risk.

• Small companies often lack audited statements, or any kind of management accounting.

• In any transaction involving a smaller company, it is often challenging to obtain timely and quality information, due to lack of systems, specialized staff (such as a controller), etc. This can cause enormous strain on the management team of a small company, as well as in the negotiations between the parties.

Furthermore, the valuation of larger companies is often more advantageous than for smaller companies, often commanding substantially higher multiples of revenues, cash flow, EBITDA (earnings before interest, tax, depreciation and amortization), etc.

So what can a small business owner do in order to improve valuation and chances of doing a transaction? Become a larger company:

• First, growing the company organically to a larger size, so long as that growth can be done profitably and without endangering the financial health of the company, might be one approach.

• Acquiring other companies might be another way of growing – obviously, the acquisitions should be value accretive rather than diminishing value.

• Merger is another option to increase size. This is an option which is perhaps not applied as often as it might be. It is entirely possible to merge two smaller loss-making companies and create one profitable larger company. This requires careful financial engineering, and a good mix of management skills and human resources.

• Qualitatively improving the small company, to have it run more like a large company (e.g. with a high-quality management team, better systems, better corporate governance) can help at least partially to dig the company out of the trap.

In a nutshell, doing a first transaction with a small company can be even more challenging than managing a small company. Finding expert legal and financial assistance that is capable of working within the budgetary constraints, is also an important ingredient to success.