For the past two years. companies have hunkered down and hoarded equity capital and cash on their balance sheets, bringing mergers and acquisitions to a virtual halt. With dealmaking reviving, bidders would be wise to stop, catch their collective breath and ask, "Am I buying what I think I'm buying?" That's the message from Mary Adams, co-author, with Michael Oleksak, of a new book, Intangible Capital. In it, they argue that many mergers and acquisitions come unglued because the customary methods of valuing a target company's intangible assets fail to tell the full story. While no finance executive would disagree that putting a number on an intangible asset like goodwill is more art than science, in a transaction where shareholders are scrutinizing every dollar spent, a better way is surely needed.
If intangible assets were only a small fraction of a company's value, they might not make much of a difference in whether a deal succeeds. But according to an Ernst & Young survey of 709 M&A transactions in 2007, intangibles essentially are the company. The survey indicates that a mere 30% of the average purchase price of a company could be allocated to tangible assets, while 23% could be allocated to identifiable intangible assets like customer lists, contracts and intellectual property. That leaves a whopping 47% in goodwill--the extra value ascribed to a company by virtue of its brand and reputation.
Adams believes a better grasp of targets' intangible assets will reduce the carnage. "I don't want to give the impression that intangibles do not get valued in today's business world; they get valued all the time, through discounted cash flow, fair value and other valuation approaches," she says. "The problem is that these approaches don't give the full picture of the target company."
Stephan Thollot, a partner in the transaction advisory services division of Ernst & Young in New York, which produced the report on intangible capital, has a similar view of valuation methodologies. "The techniques usually rely on forward-looking information, which makes their forecasting subject to uncertainty," he says.
Arrow closed four acquisitions in the last year. As part of the financial due diligence for these deals, the company's M&A team, of which Reilly is the senior member, invested time evaluating the targets' bench strength. "I don't necessarily mean just the senior officers, but the people who truly make a difference at an organization," Reilly says. "It could be someone in sales or in customer service. If they leave after the deal closes, you haven't bought what you thought you bought."
He adds that it's not uncommon for Arrow to identify key salespeople and make it a condition of the closing that they stay on for two or three years. A similar process applies to other employees. "If the target has the same customer we have, and their customer service rep has a better relationship with this customer than our person does, we don't insist that our guy take the reins," Reilly adds. "We select the better person to serve the customer."