Are you trying to make more informed decisions surrounding risk management and valuation adjustments? Studies suggest that 70% to 90% of acquisitions fail, with most failures attributed to integration problems. Whether your company is focused on identifying and purchasing target companies or facilitating sales on your clients’ behalf, it’s important to make data-driven decisions.
One way you can effectively manage risks and outcomes is through sensitivity analysis. In this article, we’ll cover four different real-world applications of sensitivity analysis in M&A scenarios, helping you improve your M&A closing rates.
Adjusting for Competitive Pressures
During the due diligence phase, you are looking to get the full picture of a company’s competitive pressures. After all, competitors will have a direct impact on the company’s bottom-line profitability. Sensitivity analysis helps you gauge the impact of a competitor taking over your market share. On the flip side, sensitivity analysis models can uncover the likelihood and financial benefit of your company gaining market share.
Let’s say your target company primarily sells software products in the organization space. As a part of your due diligence process, you are uncovering businesses with a similar product. You find that there are five relevant companies that pose a threat to the company. This raises concerns. You also find that there is a 40% likelihood that one of the companies will take over 10% of the business’s current customers.
Running a sensitivity analysis based on this information gives your team the ability to build best-case, base-case, and worst-case scenarios. Your team will feel more comfortable moving forward with the deal if the financial statement impact only decreases net profit by $10,000. This information also helps you craft better strategies to improve market share once the acquisition is finalized. Maybe you decide to roll out new products more frequently or start the trademarking and patent processes to protect your assets. Sensitivity analysis identifies the impact of competitive pressures to help you better prepare your company.
Evaluating the Impact of Regulatory Changes
Regulatory changes not only increase compliance risks but can also come with a stiff financial impact. Sensitivity analysis can be implemented to evaluate the likelihood and dollar amount of these changes. One recent example comes in the form of research and experimental expenditures. Prior to the legislation change, companies were able to take an upfront deduction for expenses. However, following the passage of new regulations, companies are required to amortize the expenses over the course of five years. Companies that failed to plan ahead for this change were met with a stiff tax bill, as 90% of expenditures were required to be added to taxable income in the first year.
Let’s look at another real-world example. Your company is considering purchasing an equity interest in a company. You have the option to purchase up to 70% of the target company’s stock. Under current regulations, companies with an interest between 20% and 50% are required to report using the equity method, while consolidation triggers with an interest over 50%. A sensitivity analysis could be run to determine the financial and tax impacts of purchasing an interest below 50% and above 50%. When it comes to regulatory changes, you need to comprehend the worst-case scenario to properly plan your resources and decide if it's worth pursuing a deal.
Realigning After Unexpected Integration Costs
Integration costs can widely vary by deal. From employee placement and IT consolidation to management restructuring and workflow integration, costs can pop up at any time during a merger or acquisition. Planning for unexpected costs gives your company the ability to keep adequate reserves and avoid the deal falling through. Maybe you decide if IT costs are 20% over budget, you will push off a capital expenditure to next year or that the rebranding process will be put on hold if employee morale starts to drop. Whatever the case, you infuse flexibility into the process when you plan for the worst.
Let’s say that your company is interested in purchasing a software company with ten employees. Five of these employees are considered key employees and play a crucial role in the development and deployment of the leading products and services. What happens if three of these key employees decide to leave after the merger? What would the financial cost be to fill these positions? Running a sensitivity analysis assigns a dollar amount to these challenges, making the unexpected more manageable.
Negotiating Terms to Fit Risk Tolerance
All mergers and acquisitions pose some level of risk. What if the company flops right after purchase? What if the company’s main product becomes obsolete or you uncover that 50% of the company’s receivables are old and uncollectible? Sensitivity analysis is commonly applied in the due diligence phase when your company still has the ability to negotiate deal terms, including the purchase price, financing options, closing date, liability limitations, and contingencies.
For example, let’s say that you are sifting through the accounts receivable ledgers of the company and find that historically, 50% of customers with balances over 90 days never pay. With the help of sensitivity analysis, you figure out that the impact of this over the course of a year is $500,000. Taking a $500,000 loss would also result in negative profitability, especially when considering other integration costs and required shareholder returns. As a result, you decide to counter your original offer and lower the purchase price by $500,000. In addition, you start building more rigid collection policies to reduce the risk of customer defaults.
Summary
Have you come across any of these four scenarios in your M&A processes? If so, have you used sensitivity analysis to draw data-driven conclusions and make more informed decisions related to the deal? Sensitivity analysis is an important resource when analyzing data, regardless of whether you have identified a potential target company, are in the due diligence phase, or have a freshly closed deal. The more transparency you have, the better.