Hope for the Best, Plan for the Worst

The great Chinese general Sun Tzu could have been speaking of mergers and acquisitions (“M&A”) when he made his famous statement about winning a battle and losing the war. Statistics show that a majority of U.S. M&A deals ultimately fail; in short, for many deals it turns out that one plus one adds up to something less than two. For example, in a 2007 study of 3,200 transactions between 1992 and 2006, the Boston Consulting Group concluded that around 60% of deals reduced shareholder value. (See Kees Cools et al., The Brave New World of M&A: How to Create Value from Mergers and Acquisitions, BOSTON CONSULTING GROUP, June 2007, available at www.giddy.org/appliedfinance/ufkl/Brave_New_World_MA_Aug_2007.pdf). Why is it that M&A often leads to a loss in shareholder value despite exhaustive due diligence (and ever-growing document reviews) and careful negotiation of the acquisition and ancillary documents? Part of the explanation for the failure of M&A transactions to yield expected benefits is poor or non-existent post-acquisition integration planning.

As an initial matter, many companies may not recognize that integration planning begins during the due diligence phase. Specifically, companies should use their pre-acquisition due diligence to begin shaping their views about how to incorporate the new business ' warts and all ' into the acquirer. Conversely, when integration planning is neglected, even the most promising ventures may fail. For instance, in July 2005, NewsCorp acquired MySpace for $580 million, hoping to capitalize on the social media network's 100 million monthly users. However, NewsCorp apparently failed to ensure MySpace had the resources to retain its competitive position, and eventually sold the company to Specific Media for a mere $35 million. Among cited reasons for MySpace's diminution in value after NewCorp's takeover were poor management, unreasonable pressure to hit revenue targets, lack of resources, and poor public relations ' all problems that could have potentially been avoided with better integration planning. (See Brian Stelter, News Corporation Sells My-
Space for $35 Million, June 29, 2011, N.Y. Times). Similarly, in a deal characterized as “one of the worst technology transactions of the decade,” eBay acquired Skype in 2005 for $3.1 billion, hoping to offer customers the ability to discuss their transactions in real time. When it became clear that Skype lacked synergy with eBay's main e-commerce and online payment businesses, eBay wrote down $900 million of Skype's value and sold the company for $2.75 billion. (See Brad Stone, Ebay is Said to Have Deal to Sell Skype, Sept. 1, 2009, N.Y. Times).

The loss in value from the failed Skype and MySpace acquisitions highlights the need for comprehensive integration planning in the due diligence phase. Companies can better handle the unexpected challenges during the integration phase by ensuring the right management and process tools are in place.

M&A Integration Issues: Process and Management

As noted, post-acquisition planning begins during pre-acquisition due diligence. A few key areas where attention should be focused are discussed below.

Process Issues

Standard due diligence acquisition guidelines cover a wide breadth of issues in legal, accounting and technical areas, including: 1) investigating the target company's assets, future earnings capability, and liabilities; 2) estimating potential cost savings and synergies; and 3) examining contracts, equities, and warranties. However, even exhausting this checklist of traditional due diligence matters will not guarantee a successful merger because it often overlooks the feasibility and costs of actually integrating the potential target, and fails to set aside adequate resources to handle them.

For instance, there may be immense differences in both companies' systems and organizational structures. Incompatible software systems can throw a monkey wrench into essential administrative and day-to-day operations of the combined entity, such as new hire orientation, training, and compensation calculations for the acquired employees. For example, the buyer may use sophisticated software such as PeopleSoft for its human resources and financial management systems, whereas the acquired company may use a more rudimentary system. The acquired company may not have the financial means to upgrade its entire system to PeopleSoft, and this cost may ultimately have to be absorbed by the parent company. And, even if the acquired company has the financial means, the data may not be created and maintained in a manner useful to a smooth transition to the buying company's systems.

A stark example lies in the April 2008 purchase by FairPoint Communications Inc. of Verizon Communications' land line and Internet operations in three New England states. Barely 18 months later, after a poorly planned technology transfer, FairPoint filed for bankruptcy with $2.7 billion in debt. (See Verizon Deal Sends FairPoint Spiraling Into Ch. 11, Oct. 26, 2009, Crain's New York Business.Com.). In its Chapter 11 filing, FairPoint attributed its bankruptcy to its inability to “overcom[e] the difficulty of transitioning certain back-office functions from Verizon's integrated systems to newly created systems of FairPoint.” (See In re FairPoint Communications, Inc., at 12, Case No. 09-16335 (BRL) (Bankr. S.D.N.Y. Oct. 27, 2009). FairPoint was forced to devote significant resources ' an extra $28 million, and management time and attention ' to resolving these “back-office” issues, which included problems with internal information technology, customer care, order management, help desk support, network monitoring, and billing and collection and supply chain systems.

The simple answer to these issues is that systems are a key part of pre-acquisition due diligence. A buyer should understand what systems the target company employs; how it enters, stores, sorts and maintains data; and whether and how it would (or should) integrate the target's data into its system. Understanding and monetizing these issues from the outset will permit a balanced picture of the true costs of the integration, not to mention the risks of any system transition.

Management Issues

It is axiomatic that “people” problems are one of the main reasons mergers ultimately fail during the integration phase. (See, e.g., Laura Carlson, How to Make or Break a Merger Deal, Part 1: A Top 10 List for Merger Failures, Trends: Your Business & The Law, Mar. 2000, at 1 (noting that when Faegre & Benson's business transaction team sent clients a memorandum offering 10 reasons why mergers fail, eight of the reasons involved management and people problems). The Sprint-Nextel merger in August 2005 is a prime example of how management issues can compromise a promising merger. During the due diligence phase, Sprint's management gave little attention to integrating Nextel's laid back culture into its more aggressive, entrepreneurial style, resulting in conflicts in almost every aspect of Sprint-Nextel's business. The contrast was symbolized in a Nextel manager meeting commemorating the merger's approval, where Nextel's CEO wore a casual sweater vest and khakis, while Sprint's CEO wore a suit and presented a PowerPoint presentation. According to reports, neither side understood or trusted the other. Nextel's CEO left the company soon after the merger, along with an “exodus” of Nextel executives. (See David Twiddy, Sprint Struggling Since Merger, Jan. 10, 2007, Washington Post, available at www.washingtonpost.com/wp-dyn/content/article/2007/01/10/AR2007011000123.html). Revenue per customer declined, while Sprint's stock price plunged more than 30% in October 2007 compared with 2004. (See Andry Haryanto, IOE 522 Integrative Report: Sprint Nextel Merger Analyzed Using Organizational Metaphors, April 12, 2008, available at www.scribd.com/doc/2621922/Sprint-Nextel-Merger-Analyzed). After Sprint's CEO eventually resigned and Sprint laid off 8% of its 60,000-strong workforce, the combined company was worth only 15% of the original value of the merger.

Similarly, Berkshire Hathaway's acquisition of General Reinsurance Corporation in 1998 was marked by adverse management choices, political infighting, and inconsistent leadership, which caused the company to lose money for four years following the acquisition. (See Timothy Galpin & J. Lee Whittington, Merger Repair: A Conceptual Framework for Restoring Employer/Employee Relationships, 2010, INSTITUTE OF BEHAVIORAL AND APPLIED MANAGEMENT, available at www.ibam.com/pubs/jbam/articles/vol12/4%20Galpin%209-2010.pdf).

Avoiding the “people issues” is a critical goal in post-acquisition integration. First, the buyer should develop a fulsome understanding of the acquired company's culture as part of its due diligence. Specific considerations should include: does the target analyze risk in the same way as the buyer or is it more aggressive or conservative; does decision-making occur similarly or much differently at the buyer (e.g., are people more or less empowered, are there different levels of signature authority, etc.); and how does the target handle compliance and ethics, two areas for which incompatibility can lead to hosts of legal and other issues. As part of the understanding, the buyer needs to determine which leadership individuals at the target embody or could easily embody the culture desired by the buyer. Those people need to be part of the transition plan, which should be as developed as possible prior to closing. It is usually well-known who will lead the new organization (old management or new), but often omitted are nitty-gritty details such as sign-off authority and the like.

Over the years, a key issue that M&A veterans discuss is how the buyer assures itself that the newly acquired entity is acting in a manner that the buyer finds appropriate. To that end, having trusted employees at the new company should be
de rigueur. The question that should be answered as early as possible is whether the buyer feels it must have some of its own people in key areas such as Finance or Legal, or whether it can rely on the new management. This should be considered and resolved as early as possible ' finding out that your new division has violated the International Traffic in Arms Regulations or Foreign Corrupt Practices Act because its does not utilize the same sort of internal review and compliance processes represents a failure of due diligence and planning.

Tools to Streamline the M&A Integration Phase: Committing Resources

The integration problems illustrated in the prior examples abound in M&As, but if more companies realize that integration planning can and should begin during the due diligence phase, they can be avoided in the first place ' or at least the losses can be minimized. Well before closing, a buyer should first decide upon an integration model and create a plan based on that model. A buyer may integrate the target's workforce using a “holding company” model, which involves minimal integration, or it can follow the “complete integration” model, where the buyer digests the target's entire employment operations. No matter where in the spectrum an M&A transaction lies, the buyer needs to establish a viable integration plan that will commit resources to: 1) account for differences in both company's key processes, and 2) minimize management issues.

Process Tools

Typically, the buyer conducts traditional due diligence before closing and gathers data to plan for the post-acquisition phase in the following areas:

• reorganization/restructurings: layoffs, increases or decreases in legal department staff/budgets, spin-offs, and divestitures of business segments;
• legal issues: contracts, assets, current and pending litigation, liabilities, and intellectual property ( e.g., non-disclosure agreements);
• financial issues: accounts payable, compensation, commissions and bonus plans, and benefits plans and programs.

Identifying red flags in these areas is essential, but a pre-acquisition analysis should also determine if the two companies have adequate resources to handle problems in any of these categories. Incompatible company resources can exacerbate the integration phase, negatively affecting post-merger synergies and valuations. Ensuring company resources are available to mitigate harm can minimize such losses.

For example, a company may find it needs to reduce staff levels, or make expenditure changes such as plant shutdowns, which can be very costly and complicated. Understanding key elements of the other company, such as its structure, employment disclosures and contracts, and financial and accounting models, can ensure smoother compliance with severance provisions during restructurings. Likewise, a company can account for potentially incompatible financial and human resource systems by setting aside a reserved amount of funds in the merger's purchase price for system upgrades. Implementing a standard human resources and accounting system early in the acquisition phase will enable the companies to quickly integrate employees into the same benefits and organizational structure, saving unnecessary costs and headaches.

Management Tools

Additionally, carefully selecting a restructuring team should be completed early in the due diligence process. Strong workforce leadership and continuity is essential to employee morale for the merged entity. Top-level management, such as executives and CEOs, who understand the values, beliefs, and habits of the merged organization, are vital to enhancing communication between the merging entities. Essential roles should be defined and selected carefully, such as an integration director who can resolve deal conflicts. Companies should also identify and retain employees other than senior management who are critical to the target's corporate memory and the success of the restructuring and integration of the combined entities, since people are a key source of information. The merger team should take steps early on to retain these key people, by proactive communications and providing incentives such as stay bonuses.

Conclusion

In sum, post-acquisition integration planning should be incorporated into and considered part of pre-integration due diligence. In so doing, companies will be able to more easily identify and resolve M&A issues which, in turn, should lead to smoother integration and potentially better performance.

Michael Finn is the vice president and general counsel of General Dynamics Advanced Information Systems (“GDAIS”). He recently participated as a faculty member at Consero's Corporate Counsel Forum in Palm Springs, CA, and spoke on Beyond Due Diligence: The Role of Corporate Law Departments in Maximizing the Strategic Value of M&A Transactions. The author acknowledges the assistance of Kristy Huh, University of Iowa J.D. Candidate 2012 and GDAIS law department intern in the research and drafting of this article.

The great Chinese general Sun Tzu could have been speaking of mergers and acquisitions (“M&A”) when he made his famous statement about winning a battle and losing the war. Statistics show that a majority of U.S. M&A deals ultimately fail; in short, for many deals it turns out that one plus one adds up to something less than two. For example, in a 2007 study of 3,200 transactions between 1992 and 2006, the Boston Consulting Group concluded that around 60% of deals reduced shareholder value. (See Kees Cools et al., The Brave New World of M&A: How to Create Value from Mergers and Acquisitions, BOSTON CONSULTING GROUP, June 2007, available at www.giddy.org/appliedfinance/ufkl/Brave_New_World_MA_Aug_2007.pdf). Why is it that M&A often leads to a loss in shareholder value despite exhaustive due diligence (and ever-growing document reviews) and careful negotiation of the acquisition and ancillary documents? Part of the explanation for the failure of M&A transactions to yield expected benefits is poor or non-existent post-acquisition integration planning.

As an initial matter, many companies may not recognize that integration planning begins during the due diligence phase. Specifically, companies should use their pre-acquisition due diligence to begin shaping their views about how to incorporate the new business ' warts and all ' into the acquirer. Conversely, when integration planning is neglected, even the most promising ventures may fail. For instance, in July 2005, NewsCorp acquired MySpace for $580 million, hoping to capitalize on the social media network's 100 million monthly users. However, NewsCorp apparently failed to ensure MySpace had the resources to retain its competitive position, and eventually sold the company to Specific Media for a mere $35 million. Among cited reasons for MySpace's diminution in value after NewCorp's takeover were poor management, unreasonable pressure to hit revenue targets, lack of resources, and poor public relations ' all problems that could have potentially been avoided with better integration planning. (See Brian Stelter, News Corporation Sells My-
Space for $35 Million, June 29, 2011, N.Y. Times). Similarly, in a deal characterized as “one of the worst technology transactions of the decade,” eBay acquired Skype in 2005 for $3.1 billion, hoping to offer customers the ability to discuss their transactions in real time. When it became clear that Skype lacked synergy with eBay's main e-commerce and online payment businesses, eBay wrote down $900 million of Skype's value and sold the company for $2.75 billion. (See Brad Stone, Ebay is Said to Have Deal to Sell Skype, Sept. 1, 2009, N.Y. Times).

The loss in value from the failed Skype and MySpace acquisitions highlights the need for comprehensive integration planning in the due diligence phase. Companies can better handle the unexpected challenges during the integration phase by ensuring the right management and process tools are in place.

M&A Integration Issues: Process and Management

As noted, post-acquisition planning begins during pre-acquisition due diligence. A few key areas where attention should be focused are discussed below.

Process Issues

Standard due diligence acquisition guidelines cover a wide breadth of issues in legal, accounting and technical areas, including: 1) investigating the target company's assets, future earnings capability, and liabilities; 2) estimating potential cost savings and synergies; and 3) examining contracts, equities, and warranties. However, even exhausting this checklist of traditional due diligence matters will not guarantee a successful merger because it often overlooks the feasibility and costs of actually integrating the potential target, and fails to set aside adequate resources to handle them.

For instance, there may be immense differences in both companies' systems and organizational structures. Incompatible software systems can throw a monkey wrench into essential administrative and day-to-day operations of the combined entity, such as new hire orientation, training, and compensation calculations for the acquired employees. For example, the buyer may use sophisticated software such as PeopleSoft for its human resources and financial management systems, whereas the acquired company may use a more rudimentary system. The acquired company may not have the financial means to upgrade its entire system to PeopleSoft, and this cost may ultimately have to be absorbed by the parent company. And, even if the acquired company has the financial means, the data may not be created and maintained in a manner useful to a smooth transition to the buying company's systems.

A stark example lies in the April 2008 purchase by FairPoint Communications Inc. of Verizon Communications' land line and Internet operations in three New England states. Barely 18 months later, after a poorly planned technology transfer, FairPoint filed for bankruptcy with $2.7 billion in debt. (See Verizon Deal Sends FairPoint Spiraling Into Ch. 11, Oct. 26, 2009, Crain's New York Business.Com.). In its Chapter 11 filing, FairPoint attributed its bankruptcy to its inability to “overcom[e] the difficulty of transitioning certain back-office functions from Verizon's integrated systems to newly created systems of FairPoint.” (See In re FairPoint Communications, Inc., at 12, Case No. 09-16335 (BRL) (Bankr. S.D.N.Y. Oct. 27, 2009). FairPoint was forced to devote significant resources ' an extra $28 million, and management time and attention ' to resolving these “back-office” issues, which included problems with internal information technology, customer care, order management, help desk support, network monitoring, and billing and collection and supply chain systems.

The simple answer to these issues is that systems are a key part of pre-acquisition due diligence. A buyer should understand what systems the target company employs; how it enters, stores, sorts and maintains data; and whether and how it would (or should) integrate the target's data into its system. Understanding and monetizing these issues from the outset will permit a balanced picture of the true costs of the integration, not to mention the risks of any system transition.

Management Issues

It is axiomatic that “people” problems are one of the main reasons mergers ultimately fail during the integration phase. (See, e.g., Laura Carlson, How to Make or Break a Merger Deal, Part 1: A Top 10 List for Merger Failures, Trends: Your Business & The Law, Mar. 2000, at 1 (noting that when Faegre & Benson's business transaction team sent clients a memorandum offering 10 reasons why mergers fail, eight of the reasons involved management and people problems). The Sprint-Nextel merger in August 2005 is a prime example of how management issues can compromise a promising merger. During the due diligence phase, Sprint's management gave little attention to integrating Nextel's laid back culture into its more aggressive, entrepreneurial style, resulting in conflicts in almost every aspect of Sprint-Nextel's business. The contrast was symbolized in a Nextel manager meeting commemorating the merger's approval, where Nextel's CEO wore a casual sweater vest and khakis, while Sprint's CEO wore a suit and presented a PowerPoint presentation. According to reports, neither side understood or trusted the other. Nextel's CEO left the company soon after the merger, along with an “exodus” of Nextel executives. (See David Twiddy, Sprint Struggling Since Merger, Jan. 10, 2007, Washington Post, available at www.washingtonpost.com/wp-dyn/content/article/2007/01/10/AR2007011000123.html). Revenue per customer declined, while Sprint's stock price plunged more than 30% in October 2007 compared with 2004. (See Andry Haryanto, IOE 522 Integrative Report: Sprint Nextel Merger Analyzed Using Organizational Metaphors, April 12, 2008, available at www.scribd.com/doc/2621922/Sprint-Nextel-Merger-Analyzed). After Sprint's CEO eventually resigned and Sprint laid off 8% of its 60,000-strong workforce, the combined company was worth only 15% of the original value of the merger.

Similarly, Berkshire Hathaway's acquisition of General Reinsurance Corporation in 1998 was marked by adverse management choices, political infighting, and inconsistent leadership, which caused the company to lose money for four years following the acquisition. (See Timothy Galpin & J. Lee Whittington, Merger Repair: A Conceptual Framework for Restoring Employer/Employee Relationships, 2010, INSTITUTE OF BEHAVIORAL AND APPLIED MANAGEMENT, available at www.ibam.com/pubs/jbam/articles/vol12/4%20Galpin%209-2010.pdf).

Avoiding the “people issues” is a critical goal in post-acquisition integration. First, the buyer should develop a fulsome understanding of the acquired company's culture as part of its due diligence. Specific considerations should include: does the target analyze risk in the same way as the buyer or is it more aggressive or conservative; does decision-making occur similarly or much differently at the buyer (e.g., are people more or less empowered, are there different levels of signature authority, etc.); and how does the target handle compliance and ethics, two areas for which incompatibility can lead to hosts of legal and other issues. As part of the understanding, the buyer needs to determine which leadership individuals at the target embody or could easily embody the culture desired by the buyer. Those people need to be part of the transition plan, which should be as developed as possible prior to closing. It is usually well-known who will lead the new organization (old management or new), but often omitted are nitty-gritty details such as sign-off authority and the like.

Over the years, a key issue that M&A veterans discuss is how the buyer assures itself that the newly acquired entity is acting in a manner that the buyer finds appropriate. To that end, having trusted employees at the new company should be
de rigueur. The question that should be answered as early as possible is whether the buyer feels it must have some of its own people in key areas such as Finance or Legal, or whether it can rely on the new management. This should be considered and resolved as early as possible ' finding out that your new division has violated the International Traffic in Arms Regulations or Foreign Corrupt Practices Act because its does not utilize the same sort of internal review and compliance processes represents a failure of due diligence and planning.

Tools to Streamline the M&A Integration Phase: Committing Resources

The integration problems illustrated in the prior examples abound in M&As, but if more companies realize that integration planning can and should begin during the due diligence phase, they can be avoided in the first place ' or at least the losses can be minimized. Well before closing, a buyer should first decide upon an integration model and create a plan based on that model. A buyer may integrate the target's workforce using a “holding company” model, which involves minimal integration, or it can follow the “complete integration” model, where the buyer digests the target's entire employment operations. No matter where in the spectrum an M&A transaction lies, the buyer needs to establish a viable integration plan that will commit resources to: 1) account for differences in both company's key processes, and 2) minimize management issues.

Process Tools

Typically, the buyer conducts traditional due diligence before closing and gathers data to plan for the post-acquisition phase in the following areas:

• reorganization/restructurings: layoffs, increases or decreases in legal department staff/budgets, spin-offs, and divestitures of business segments;
• legal issues: contracts, assets, current and pending litigation, liabilities, and intellectual property ( e.g., non-disclosure agreements);
• financial issues: accounts payable, compensation, commissions and bonus plans, and benefits plans and programs.

Identifying red flags in these areas is essential, but a pre-acquisition analysis should also determine if the two companies have adequate resources to handle problems in any of these categories. Incompatible company resources can exacerbate the integration phase, negatively affecting post-merger synergies and valuations. Ensuring company resources are available to mitigate harm can minimize such losses.

For example, a company may find it needs to reduce staff levels, or make expenditure changes such as plant shutdowns, which can be very costly and complicated. Understanding key elements of the other company, such as its structure, employment disclosures and contracts, and financial and accounting models, can ensure smoother compliance with severance provisions during restructurings. Likewise, a company can account for potentially incompatible financial and human resource systems by setting aside a reserved amount of funds in the merger's purchase price for system upgrades. Implementing a standard human resources and accounting system early in the acquisition phase will enable the companies to quickly integrate employees into the same benefits and organizational structure, saving unnecessary costs and headaches.

Management Tools

Additionally, carefully selecting a restructuring team should be completed early in the due diligence process. Strong workforce leadership and continuity is essential to employee morale for the merged entity. Top-level management, such as executives and CEOs, who understand the values, beliefs, and habits of the merged organization, are vital to enhancing communication between the merging entities. Essential roles should be defined and selected carefully, such as an integration director who can resolve deal conflicts. Companies should also identify and retain employees other than senior management who are critical to the target's corporate memory and the success of the restructuring and integration of the combined entities, since people are a key source of information. The merger team should take steps early on to retain these key people, by proactive communications and providing incentives such as stay bonuses.

Conclusion

In sum, post-acquisition integration planning should be incorporated into and considered part of pre-integration due diligence. In so doing, companies will be able to more easily identify and resolve M&A issues which, in turn, should lead to smoother integration and potentially better performance.

Michael Finn is the vice president and general counsel of General Dynamics Advanced Information Systems (“GDAIS”). He recently participated as a faculty member at Consero's Corporate Counsel Forum in Palm Springs, CA, and spoke on Beyond Due Diligence: The Role of Corporate Law Departments in Maximizing the Strategic Value of M&A Transactions. The author acknowledges the assistance of Kristy Huh, University of Iowa J.D. Candidate 2012 and GDAIS law department intern in the research and drafting of this article.