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Counter-intelligence in corporate mergers
JAMES B. BOULDEN
COUNTER-INTELLIGENCE IN CORPORATE MERGERS
o encounter questionable ethics in the
T field of corporate mergers is not a rare occurrence. This article will examine some of the ethical violations found in recent mergers and suggest certain preventive measures for the protection of both buyer and seller. The illustrations are drawn from the personal experiences of the author and his associates, specialists in corporate mergers. Although identification of the specific companies involved in these practices has been omitted, it is hoped that the publicity given to the more common ethical violations The author is a principal, 1. Boulden & Co., a consulting firm specializing in acquMtions and mergers. He is also an associate professor of management, University of Santa Clara.
WINTER, 1965
will encourage more thorough investigation and analysis by participants in future corporate acquisitions. Let us look at some of the more common malpractiees.
CAVEAT EMPTOR ACCOUNTING MANIPULATION
A pharmaceutical firm recently built a remarkable growth record, until an annum rate of eight figures was reached. Fortunately, a government agency stopped the pyramid immediately prior to a public stock issue. It then became apparent that the sales had, in reality, consisted merely of stocking distributors throughout the country. Today the firm is in bankruptcy, and the ware-
47
JAMES B. BOULDEN
48
houses are full of a wonder drug that was not really sold. Unfortunately, not all stories end with the seller suffering from his own deception. Many a buyer has been surprised to find after acquisition that past sales were on a conditional or contingent basis and were later returned in volume; that the backlog evaporated because the sales were not firm orders; and that because the seller had submitted low bids to build sales volume, the buyer was faced with performance on "loss" contracts. Because the trend in sales and profits is considered extremely important in determining the price for an acquisition, sellers occasionally arrange to write off inventories in the previous period to bolster profits in subsequent periods. Similarly, various incentives are offered to customers to place stocking orders early so that the sales volume may be increased, thus stealing sales from subsequent periods. Use of obsolete or misstated inventories is also a common problem. Even accounting audits afford little protection, particularly where highly technical products are involved. Only an analyst experienced in the same product and process is competent to determine whether the inventory is saleable and fairly valued. Certainly the outside auditor cannot answer these questions with any degree of certainty. The experienced corporate buyer will smile at the term "equipment at appraised value" (see balance sheet of detailed example). Sellers can get a very favorable evaluation on fixed assets by proper selection of the appraisal firm and by listing them under the nebulous term "insurance appraisal." One metal fabricator annually experienced heavy losses but managed to show an increase in net worth by simply reappraising assets upwards. DECEPTION TI-mOUGE OlVIISSlON
Subtle violations of business ethics occur through the failure of sellers to reveal perti-
nent facts, thereby implying conditions contrary to the actual state of affairs. The state of competition, for example, is difficult to determine by analysis of historical information. Any of the following possibilities can change the picture: A major competitor is entering the market area in the near future. The primary product is about to become obsolete. Technology has changed radically and the plant is no longer competitive. The market is saturated. Key personnel are leaving the tlrm to establish a competitive operation. Heavy losses in industries that are technically advanced have been involved with new products that have been represented as "developed, tested, and on the market." Yet the buyer determines after the merger that extensive additional development costs are required. Surprisingly, this particular fraud is sometimes perpetrated by highly respectable technical personnel whose professional integrity is thought above reproach. Some deceptions become apparent only through the passage of time. Expensive analysis and evaluation are necessary to reveal critical internal problems. For this reason, many buyers have set minimum size standards below which they will not consider acquisitions, because the potential benefits do not justify the cost of detailed investigation necessary to ensure a healthy state of affairs. UNSTATED LIABILITIES
Last year a private investor became interested in the purchase of an industrial firm in northern California. The prospective buyer retained a prominent national management consulting firm to evaluate the situation and submit recommendations. After six months of research, the consultants turned in a clean bill of health and recommended purchase. The transaction never materialized because at the last moment the seller became greedy and raised the price slightly. The buyer was offended and with-
BUSINESS HORIZONS
C O U N T E R - I N T E L L I G E N C E IN CORPORATE MERGERS
A Detailed Example of Malpractice in a Corporate Merger Desperation is one of many causes that drive sellers to engage in serious breaches of business ethics. The company president in the following example was seeking a bailout from desperate financial circumstances. I n advertising his desire for a merger, he wrote: "We are a publicly held company desirous of merger. Much of the work we are doing is in the high-vacuum field, and in cryogenics and thermodynamics, and is definitely at the top of the state-of-the-art with excellent promise of a decided breakthrough in technology. Our statement will show sales in excess of $2 million for the past ten months, with profits of about $200,000. This profit is not subject to federal income taxes by reason of a tax carry-over. W e look for a growth of at least 50 per cent for the next few years." An appropriate translation would be: "This organization is a machine shop selling to the defense industry. The company has been losing money for a long time and has run through the funds provided by a small public stock issue." Analysis of the following published financial statements of the seller reveals a negative net worth and heavy losses. The disappointed buyer in this case is suing the former owner for misrepresentation.
Balance Sheet
Liabilities and Stockholders' Equity Current liabilities Accounts payable ......................... $ 400,000 Contracts and notes payable ........ 400,000 Accrued taxes and expenses ........ 80,000 Total current liabilities ............ 880,000 Long-term liabilities Contracts and notes payable ........
360,000
Stockholders' equity Capital stock ~ ............................... 790,000 Retained earnings ........................ (280,000) Appreciation of fixed assets .......... 340,000 Total stockholders' equity ........ 850,000 Total liabilities and stockholders' equity ........................................... $2,090,000 r
1The accounts receivable include accounts hypothecated. [They are short of cash and have used up normal credit lines.] 2The value of the fixed assets represents appraised values. [Assets have been marked up to hide losses.] 3Research and development costs have been capitalized and are considered by management as subject to capitalization in b e development of proprietary products that management believes will be marketable during the next five years. [Losses amounting to $240,00'0 buried here.] 4Includes promotional stock.
Assets Current assets Cash ............................................... $ Accounts receivable1 .................... Loans receivable .......................... Inventory ...................................... Prepaid expenses .......................... Total current assets ................. Fixed assets z Machinery and equipment .......... Tooling and dies .......................... Office furniture and mobile equipment ................................ Leasehold improvements ............ Total fixed assets ......................
Profit and Loss Statement (Six Months) 130,000 400,000 40,000 250,000 50,000 870,000
460,000 260,000 40,000 50,000 810,000
Other assets Organization costs & expense of stock issue ................................ 40,000 Research and development costs 8 ........................................ 240,000 Goodwill from consolidation ........ 130,000 Total other assets ...................... 410,000 Total assets ...................................... $2,090,000
~VINTER, 1965
Sales .................................................. $1,400,000 Less cost of goods sold .................... 1,040,000 Gross profit ............................. 360,000 Less operating expenses Telephone & telegraph ................ Sales expense ................................ Professional services ................... Officers' salaries ............................ Oflqce expense ............................. Interest expense ............................ Insurance ...................................... Delivery expense ........................ Depreciation ................................ Bad debts ..................................... Auto expenses ............................. Total operating expenses .............. Net profit on operations ............... Add other income Gain on sale of assets ....................
25,000 60,000 25,000 10,000 80,000 40,000 20,000 15,000 5,000 15,000 15,000 310,000 50,000 90,000
Net profit ....................................... $ 140,000
49
JAMES B. BOULDEN
50
drew from the situation. Within two months thereafter, the company was sued by the U.S. government for malperformance on a large contract executed several years previously. Moreover, the chief executive of the company left the firm to start his own operation in immediate competition with the seller. Understandably, the buyer is still shaking from this experience. His prospective acquisition is virtually shut down and teetering OH the verge of bankruptcy. One is tempted to ask why the above liabilities could not have been determined by more intensive investigation and analysis of factual information. Such an investigation should consider the liabilities of product guarantees and warranties outstanding as well as pending lawsuits by competitors, customers, and other related parties. Unfortunately, many considerations do not come to light until years after the acquisition is accomplished; the only protection may be reliance on the guarantees of the seller.
PERILS OF THE CORPORATE SALE
The sale of a private corporation is often a once-in-a-lifetime decision; as a result, the owner-manager is not prepared for the unique ethical problems incurred in such a transaction. Tragically, the work of a lifetime may be lost by a failure to recognize potential dangers and to take appropriate protective measures. BLACKMAIL
The sensitive period of merger negotiations is an opportune time for certain employees to advance their own welfare. A large electronics firm was involved in merger negotiations several years ago. Immediately prior to the closing, the senior scientists presented the owners with a demand for new employment contracts at increased compensation. Further, the owners were required to sell part of their equity to the technical person-
nel at discount prices. The alternative was the resignation of the technical group and the almost certain termination of merger negotiations. A similar situation arises when key personnel elect to bypass the present owners and to negotiate directly with the prospective buyer. Trusted personnel occasionally attempt to barter confidential information or otherwise curry favor by revealing real or suspected weaknesses in the selling corporation. THE RAID
On occasion, situations arise where buyers have purchased companies for a small down-payment plus long-term corporate notes. The assets of the corporation are then siphoned off to other private or corporate interests, and the original owner is left with foreclosure on a debt-ridden corporate shell. This procedure is particularly prevalent in industries characterized by heavy investment in fixed assets that can be mortgaged to raise money. Although public sympathy is understandably against the corporate buyer who acquires a company for liquidation, a strong case can be made that such action is occasionally required. In a current situation, the corporate stock is trading at 60 per cent solid book value. Operations are at a standstill and have been for years. The directors own a very small percentage of the outstanding stock, yet are drawing attractive compensation for their services. Further, the assets of the firm are being used to the advantage of certain directors and officers. A proxy fight and subsequent liquidation would probably be to the advantage of the public stockholders. It is doubtful that many firms have been raided that did not deserve their lot. Existing management cannot be dethroned if the stockholders are satisfied with profit performance. Fortunately, the various securities regulations afford considerable protec-
BUSINESS HORIZONS
COUNTER-INTELLIGENCE IN CORPORATE 3,IERGERS
tion from subterfuge or misrepresentation in these corporate contests.
CURIOSITY SEEKERS
Confidential information must be revealed to prospective buyers if a merger is to be consummated; however, this information may later be used against the seller if a merger does not transpire. The seller is then in a dilemma because a merger inquiry is a convenient device that allows competitors to obtain critical operating information. In fact, many of the larger companies have diversification programs with one or more full-time staff members assigned to investigate prospective acquisitions. Occasionally these corporate shoppers approach potential buyers with little intention of entering into serious merger negotiations. The diseussions are occasionally little more than an interesting academic exercise, which the staff man can report to his management to demonstrate his activity on the job. Unfortunately, this shopping practice makes heavy demands on the time of the seller and may preclude him from entering into negotiations with more qualified buyers. The inquiry problem is compounded by the fact that prospective buyers do not always treat merger information with discretion. Corporate acquisition departments of larger firms occasionally act as conduits through which proprietary information is disseminated to other firms. This action is a serious breach of confidence. The simple rumor that a firm is for sale is damaghag to employee morale and detrimental to customer relations.
bank were positive. He proposed to open a 120-day escrow with a deposit of $10,000; the balance of the $1 million purchase price was to be paid at the close of escrow. Time passed and no additional funds materialized. The buyer could not be located. Further analysis showed that the securities he listed as assets were of little value. It appeared that he had no intention of consummating the transaction, but had in reality purchased an option on the company and was proceeding to sell this option to interested buyers. Related interests with a small public company purchased the firm at an inflated price, and the individual pocketed a handsome gain. Financially unqualified buyers are legendary in the field of mergers. They have numerous ways of building up net worth; a statement of fixed assets at inflated appraised values is a proven technique. Artificial market values for narrowly-traded stocks can be easily arranged. Sellers are generally sophisticated enough to be skeptical of the stock they are accepting in exchange for their ownership interests. The fact that a firm is listed on the New York Stock Exchange is not a guarantee of a strong market for the stock. Further, the seller will wish to consult his legal counsel concerning restrictions on future sale of these securities.
G U I D E S TO A SUCCESSFUL MERGER
Experience indicates certain guides that are useful in successful merger practice.
FoR THE BUYER UNQUALIFIED BUYERS
"I do not buy companies with promises and chicken wire." The speaker was a potential buyer from Chicago talking to the owners of a medium-sized metal-working facility on the West Coast. The man was highly recommended, and reference checks with the
WINTER, 1965
Retain a consultant knowledgeable in the industry if the buyer does not have a background in this specific field. Require the seller to guarantee accounts receivable and inventories. A portion of the purchase price may be kept in escrow account for this purpose.
5i
JAMES B. BOULDEN
52
Utilize qualified independent auditors and appraisers. Conduct confidential conferences with key personnel of the seller to ensure their support. In smaller situations, purchase assets to avoid unstated and contingent liabilities. Tie the purchase price to performance, thus requiring the seller to back up his claims and projections. Conduct a complete technical evaluation of new products to ensure their producibility. Do not make any promises that cannot be lived with after the merger, particularly with respect to employment. Do not base the acquisition on short-term performance of the seller. Agreements regarding the compensation of any intermediaries in the transaction should be clearly stated in writing.
FoR THE SELLER
Recognize that authority realignment is unavoidable after the merger. Gain acceptance of key personnel in advance of final merger negotiations. Recognize that, in some instances, termination and liquidation of the business may be a more attractive alternative for stockholders than sale or merger. Screen interested buyers for evidence of financial and moral responsibility. Reveal only summary statistics at the outset of negotiations and require a letter of intent before proceeding with negotiations. Reduce all representation agreements to writing when an intermediary is involved.
Confirm the market for a security before making an exchange of stock. Conduct several parallel negotiations if time is important in the sale or merger. Consult closely with an attorney and accountants on all aspects of the merger. Solicit professional counsel. Do not make any commitments or implications to the buyer that cannot be supported after the merger.
A goodly part of American business is transacted on the assumption that all parties involved are of high integrity. It is not practical to verify the quality, dependability, and performance of all claims. However, the corporate merger represents a special instance requiring extensive investigation. The conditions surrounding the merger are hardly conducive to high ethics: it is usually a one-time transaction, a very different situation from the sale of equipment where the seller can reasonably expect the buyer to return again; the stakes are high; the seller may be desperate; and contingent liabilities are difficult to identify. Likewise, the corporate buyer is frequently a professional with a number of acquisitions under his belt. The seller, in contrast, is often inexperienced in these matters. Surprisingly, even bankers, lawyers, and management consultants often become unwitting accomplices to unethical buyers and sellers. These professionals assume that their client will follow his normal ethical pattern, but this assumption is dangerous for those who rely on the professional's certification and recommendations. The best answer to the problem of malpractice in corporate mergers continues to be thorough investigation and analysis of factual information. This process is timeconsuming, expensive, and often frustrating - b u t there is no substitute. It is true that some large mergers have been accomplished over cocktails and consummated with a handshake. It is also true, however, that a number of corporations are still licking their wounds from just such casual practices.
BUSINESS HORIZONS
COUNTER-INTELLIGENCE IN CORPORATE MERGERS
o encounter questionable ethics in the
T field of corporate mergers is not a rare occurrence. This article will examine some of the ethical violations found in recent mergers and suggest certain preventive measures for the protection of both buyer and seller. The illustrations are drawn from the personal experiences of the author and his associates, specialists in corporate mergers. Although identification of the specific companies involved in these practices has been omitted, it is hoped that the publicity given to the more common ethical violations The author is a principal, 1. Boulden & Co., a consulting firm specializing in acquMtions and mergers. He is also an associate professor of management, University of Santa Clara.
WINTER, 1965
will encourage more thorough investigation and analysis by participants in future corporate acquisitions. Let us look at some of the more common malpractiees.
CAVEAT EMPTOR ACCOUNTING MANIPULATION
A pharmaceutical firm recently built a remarkable growth record, until an annum rate of eight figures was reached. Fortunately, a government agency stopped the pyramid immediately prior to a public stock issue. It then became apparent that the sales had, in reality, consisted merely of stocking distributors throughout the country. Today the firm is in bankruptcy, and the ware-
47
JAMES B. BOULDEN
48
houses are full of a wonder drug that was not really sold. Unfortunately, not all stories end with the seller suffering from his own deception. Many a buyer has been surprised to find after acquisition that past sales were on a conditional or contingent basis and were later returned in volume; that the backlog evaporated because the sales were not firm orders; and that because the seller had submitted low bids to build sales volume, the buyer was faced with performance on "loss" contracts. Because the trend in sales and profits is considered extremely important in determining the price for an acquisition, sellers occasionally arrange to write off inventories in the previous period to bolster profits in subsequent periods. Similarly, various incentives are offered to customers to place stocking orders early so that the sales volume may be increased, thus stealing sales from subsequent periods. Use of obsolete or misstated inventories is also a common problem. Even accounting audits afford little protection, particularly where highly technical products are involved. Only an analyst experienced in the same product and process is competent to determine whether the inventory is saleable and fairly valued. Certainly the outside auditor cannot answer these questions with any degree of certainty. The experienced corporate buyer will smile at the term "equipment at appraised value" (see balance sheet of detailed example). Sellers can get a very favorable evaluation on fixed assets by proper selection of the appraisal firm and by listing them under the nebulous term "insurance appraisal." One metal fabricator annually experienced heavy losses but managed to show an increase in net worth by simply reappraising assets upwards. DECEPTION TI-mOUGE OlVIISSlON
Subtle violations of business ethics occur through the failure of sellers to reveal perti-
nent facts, thereby implying conditions contrary to the actual state of affairs. The state of competition, for example, is difficult to determine by analysis of historical information. Any of the following possibilities can change the picture: A major competitor is entering the market area in the near future. The primary product is about to become obsolete. Technology has changed radically and the plant is no longer competitive. The market is saturated. Key personnel are leaving the tlrm to establish a competitive operation. Heavy losses in industries that are technically advanced have been involved with new products that have been represented as "developed, tested, and on the market." Yet the buyer determines after the merger that extensive additional development costs are required. Surprisingly, this particular fraud is sometimes perpetrated by highly respectable technical personnel whose professional integrity is thought above reproach. Some deceptions become apparent only through the passage of time. Expensive analysis and evaluation are necessary to reveal critical internal problems. For this reason, many buyers have set minimum size standards below which they will not consider acquisitions, because the potential benefits do not justify the cost of detailed investigation necessary to ensure a healthy state of affairs. UNSTATED LIABILITIES
Last year a private investor became interested in the purchase of an industrial firm in northern California. The prospective buyer retained a prominent national management consulting firm to evaluate the situation and submit recommendations. After six months of research, the consultants turned in a clean bill of health and recommended purchase. The transaction never materialized because at the last moment the seller became greedy and raised the price slightly. The buyer was offended and with-
BUSINESS HORIZONS
C O U N T E R - I N T E L L I G E N C E IN CORPORATE MERGERS
A Detailed Example of Malpractice in a Corporate Merger Desperation is one of many causes that drive sellers to engage in serious breaches of business ethics. The company president in the following example was seeking a bailout from desperate financial circumstances. I n advertising his desire for a merger, he wrote: "We are a publicly held company desirous of merger. Much of the work we are doing is in the high-vacuum field, and in cryogenics and thermodynamics, and is definitely at the top of the state-of-the-art with excellent promise of a decided breakthrough in technology. Our statement will show sales in excess of $2 million for the past ten months, with profits of about $200,000. This profit is not subject to federal income taxes by reason of a tax carry-over. W e look for a growth of at least 50 per cent for the next few years." An appropriate translation would be: "This organization is a machine shop selling to the defense industry. The company has been losing money for a long time and has run through the funds provided by a small public stock issue." Analysis of the following published financial statements of the seller reveals a negative net worth and heavy losses. The disappointed buyer in this case is suing the former owner for misrepresentation.
Balance Sheet
Liabilities and Stockholders' Equity Current liabilities Accounts payable ......................... $ 400,000 Contracts and notes payable ........ 400,000 Accrued taxes and expenses ........ 80,000 Total current liabilities ............ 880,000 Long-term liabilities Contracts and notes payable ........
360,000
Stockholders' equity Capital stock ~ ............................... 790,000 Retained earnings ........................ (280,000) Appreciation of fixed assets .......... 340,000 Total stockholders' equity ........ 850,000 Total liabilities and stockholders' equity ........................................... $2,090,000 r
1The accounts receivable include accounts hypothecated. [They are short of cash and have used up normal credit lines.] 2The value of the fixed assets represents appraised values. [Assets have been marked up to hide losses.] 3Research and development costs have been capitalized and are considered by management as subject to capitalization in b e development of proprietary products that management believes will be marketable during the next five years. [Losses amounting to $240,00'0 buried here.] 4Includes promotional stock.
Assets Current assets Cash ............................................... $ Accounts receivable1 .................... Loans receivable .......................... Inventory ...................................... Prepaid expenses .......................... Total current assets ................. Fixed assets z Machinery and equipment .......... Tooling and dies .......................... Office furniture and mobile equipment ................................ Leasehold improvements ............ Total fixed assets ......................
Profit and Loss Statement (Six Months) 130,000 400,000 40,000 250,000 50,000 870,000
460,000 260,000 40,000 50,000 810,000
Other assets Organization costs & expense of stock issue ................................ 40,000 Research and development costs 8 ........................................ 240,000 Goodwill from consolidation ........ 130,000 Total other assets ...................... 410,000 Total assets ...................................... $2,090,000
~VINTER, 1965
Sales .................................................. $1,400,000 Less cost of goods sold .................... 1,040,000 Gross profit ............................. 360,000 Less operating expenses Telephone & telegraph ................ Sales expense ................................ Professional services ................... Officers' salaries ............................ Oflqce expense ............................. Interest expense ............................ Insurance ...................................... Delivery expense ........................ Depreciation ................................ Bad debts ..................................... Auto expenses ............................. Total operating expenses .............. Net profit on operations ............... Add other income Gain on sale of assets ....................
25,000 60,000 25,000 10,000 80,000 40,000 20,000 15,000 5,000 15,000 15,000 310,000 50,000 90,000
Net profit ....................................... $ 140,000
49
JAMES B. BOULDEN
50
drew from the situation. Within two months thereafter, the company was sued by the U.S. government for malperformance on a large contract executed several years previously. Moreover, the chief executive of the company left the firm to start his own operation in immediate competition with the seller. Understandably, the buyer is still shaking from this experience. His prospective acquisition is virtually shut down and teetering OH the verge of bankruptcy. One is tempted to ask why the above liabilities could not have been determined by more intensive investigation and analysis of factual information. Such an investigation should consider the liabilities of product guarantees and warranties outstanding as well as pending lawsuits by competitors, customers, and other related parties. Unfortunately, many considerations do not come to light until years after the acquisition is accomplished; the only protection may be reliance on the guarantees of the seller.
PERILS OF THE CORPORATE SALE
The sale of a private corporation is often a once-in-a-lifetime decision; as a result, the owner-manager is not prepared for the unique ethical problems incurred in such a transaction. Tragically, the work of a lifetime may be lost by a failure to recognize potential dangers and to take appropriate protective measures. BLACKMAIL
The sensitive period of merger negotiations is an opportune time for certain employees to advance their own welfare. A large electronics firm was involved in merger negotiations several years ago. Immediately prior to the closing, the senior scientists presented the owners with a demand for new employment contracts at increased compensation. Further, the owners were required to sell part of their equity to the technical person-
nel at discount prices. The alternative was the resignation of the technical group and the almost certain termination of merger negotiations. A similar situation arises when key personnel elect to bypass the present owners and to negotiate directly with the prospective buyer. Trusted personnel occasionally attempt to barter confidential information or otherwise curry favor by revealing real or suspected weaknesses in the selling corporation. THE RAID
On occasion, situations arise where buyers have purchased companies for a small down-payment plus long-term corporate notes. The assets of the corporation are then siphoned off to other private or corporate interests, and the original owner is left with foreclosure on a debt-ridden corporate shell. This procedure is particularly prevalent in industries characterized by heavy investment in fixed assets that can be mortgaged to raise money. Although public sympathy is understandably against the corporate buyer who acquires a company for liquidation, a strong case can be made that such action is occasionally required. In a current situation, the corporate stock is trading at 60 per cent solid book value. Operations are at a standstill and have been for years. The directors own a very small percentage of the outstanding stock, yet are drawing attractive compensation for their services. Further, the assets of the firm are being used to the advantage of certain directors and officers. A proxy fight and subsequent liquidation would probably be to the advantage of the public stockholders. It is doubtful that many firms have been raided that did not deserve their lot. Existing management cannot be dethroned if the stockholders are satisfied with profit performance. Fortunately, the various securities regulations afford considerable protec-
BUSINESS HORIZONS
COUNTER-INTELLIGENCE IN CORPORATE 3,IERGERS
tion from subterfuge or misrepresentation in these corporate contests.
CURIOSITY SEEKERS
Confidential information must be revealed to prospective buyers if a merger is to be consummated; however, this information may later be used against the seller if a merger does not transpire. The seller is then in a dilemma because a merger inquiry is a convenient device that allows competitors to obtain critical operating information. In fact, many of the larger companies have diversification programs with one or more full-time staff members assigned to investigate prospective acquisitions. Occasionally these corporate shoppers approach potential buyers with little intention of entering into serious merger negotiations. The diseussions are occasionally little more than an interesting academic exercise, which the staff man can report to his management to demonstrate his activity on the job. Unfortunately, this shopping practice makes heavy demands on the time of the seller and may preclude him from entering into negotiations with more qualified buyers. The inquiry problem is compounded by the fact that prospective buyers do not always treat merger information with discretion. Corporate acquisition departments of larger firms occasionally act as conduits through which proprietary information is disseminated to other firms. This action is a serious breach of confidence. The simple rumor that a firm is for sale is damaghag to employee morale and detrimental to customer relations.
bank were positive. He proposed to open a 120-day escrow with a deposit of $10,000; the balance of the $1 million purchase price was to be paid at the close of escrow. Time passed and no additional funds materialized. The buyer could not be located. Further analysis showed that the securities he listed as assets were of little value. It appeared that he had no intention of consummating the transaction, but had in reality purchased an option on the company and was proceeding to sell this option to interested buyers. Related interests with a small public company purchased the firm at an inflated price, and the individual pocketed a handsome gain. Financially unqualified buyers are legendary in the field of mergers. They have numerous ways of building up net worth; a statement of fixed assets at inflated appraised values is a proven technique. Artificial market values for narrowly-traded stocks can be easily arranged. Sellers are generally sophisticated enough to be skeptical of the stock they are accepting in exchange for their ownership interests. The fact that a firm is listed on the New York Stock Exchange is not a guarantee of a strong market for the stock. Further, the seller will wish to consult his legal counsel concerning restrictions on future sale of these securities.
G U I D E S TO A SUCCESSFUL MERGER
Experience indicates certain guides that are useful in successful merger practice.
FoR THE BUYER UNQUALIFIED BUYERS
"I do not buy companies with promises and chicken wire." The speaker was a potential buyer from Chicago talking to the owners of a medium-sized metal-working facility on the West Coast. The man was highly recommended, and reference checks with the
WINTER, 1965
Retain a consultant knowledgeable in the industry if the buyer does not have a background in this specific field. Require the seller to guarantee accounts receivable and inventories. A portion of the purchase price may be kept in escrow account for this purpose.
5i
JAMES B. BOULDEN
52
Utilize qualified independent auditors and appraisers. Conduct confidential conferences with key personnel of the seller to ensure their support. In smaller situations, purchase assets to avoid unstated and contingent liabilities. Tie the purchase price to performance, thus requiring the seller to back up his claims and projections. Conduct a complete technical evaluation of new products to ensure their producibility. Do not make any promises that cannot be lived with after the merger, particularly with respect to employment. Do not base the acquisition on short-term performance of the seller. Agreements regarding the compensation of any intermediaries in the transaction should be clearly stated in writing.
FoR THE SELLER
Recognize that authority realignment is unavoidable after the merger. Gain acceptance of key personnel in advance of final merger negotiations. Recognize that, in some instances, termination and liquidation of the business may be a more attractive alternative for stockholders than sale or merger. Screen interested buyers for evidence of financial and moral responsibility. Reveal only summary statistics at the outset of negotiations and require a letter of intent before proceeding with negotiations. Reduce all representation agreements to writing when an intermediary is involved.
Confirm the market for a security before making an exchange of stock. Conduct several parallel negotiations if time is important in the sale or merger. Consult closely with an attorney and accountants on all aspects of the merger. Solicit professional counsel. Do not make any commitments or implications to the buyer that cannot be supported after the merger.
A goodly part of American business is transacted on the assumption that all parties involved are of high integrity. It is not practical to verify the quality, dependability, and performance of all claims. However, the corporate merger represents a special instance requiring extensive investigation. The conditions surrounding the merger are hardly conducive to high ethics: it is usually a one-time transaction, a very different situation from the sale of equipment where the seller can reasonably expect the buyer to return again; the stakes are high; the seller may be desperate; and contingent liabilities are difficult to identify. Likewise, the corporate buyer is frequently a professional with a number of acquisitions under his belt. The seller, in contrast, is often inexperienced in these matters. Surprisingly, even bankers, lawyers, and management consultants often become unwitting accomplices to unethical buyers and sellers. These professionals assume that their client will follow his normal ethical pattern, but this assumption is dangerous for those who rely on the professional's certification and recommendations. The best answer to the problem of malpractice in corporate mergers continues to be thorough investigation and analysis of factual information. This process is timeconsuming, expensive, and often frustrating - b u t there is no substitute. It is true that some large mergers have been accomplished over cocktails and consummated with a handshake. It is also true, however, that a number of corporations are still licking their wounds from just such casual practices.
BUSINESS HORIZONS