Leap of Faith

This article originally appeared in The Bottom Line.

Some investors want to cannonball off the dock into the lake, while others are content to dip their toe in before deciding whether to go for a swim.

Buying a company outright gives a purchaser complete control, but there’s something to be said for acquiring a minority stake in an enterprise instead and creating a pre-acquisition partnership.

For starters, it gives you a window into the inner workings of the operation and lets you gather intelligence that you can use down the road when deciding to up your ownership or sell off your holdings.

And while it’s helpful to get a solid indication of how the hard numbers such as revenue and profit would increase in a full-scale merger, it’s just as important to feel confident that the two cultures would be a good fit.

And when you consider that studies consistently show the vast majority of corporate acquisitions fail, taking a test drive might not be a bad idea.

Such an arrangement can benefit majority owners, too. For example, an entrepreneur in search of a succession plan may find the best way to kick-start their retirement is through a gradual buyout by management.

“(Pre-acquisition partnerships) are essentially saying, ‘we’re going to date before we get married,’ ” says Stephen Shaw, Toronto-based senior vice-president and director at MNP Corporate Finance. “We’re going to put some conditions around the dating protocol and figure out if it makes sense, if there’s a common philosophy, if we share the same values and if synergies can be realized.”

Recent research from the University of Kansas found that preacquisition partnerships had a higher rate of success than deals between two companies that had no prior relationship. The report, entitled “Cohabitation before Marriage? An Examination of Pre-acquisition Alliance Partnerships and Merger Outcomes,” also found they contributed to superior long-term performance by the acquiring firm.

“Alliance relationships provide hands-on experience of resources sharing and business co-operation, mitigate information asymmetry regarding firm operations and certify the creation of synergy gains based on positive feedback of the alliance relationship,” the report says.

One instance where a pre-acquisition partnership worked well was the 2012 purchase by Ceridian Corp., a Minneapolis- based provider of human resources services such as payroll, tax filing, benefits and recruiting software, of Dayforce Corp., a management solutions firm in Toronto.

Ceridian started out cautiously, acquiring a 20 per cent stake in early 2011. When it rebranded Dayforce’s product, initial forecasts predicted about 100 clients in the first year. Nearly 500 came on board instead. After a 14-month courtship, a deal for the remaining 80 per cent of Dayforce was signed in April 2012.

“So, we’ve almost been operating as one organization already. It really feels like a continuation and more of a commitment to the relationship (than an acquisition),” Dayforce CEO David Ossip said at the time. (Ossip since has become president of a new Ceridian division called Ceridian Dayforce.)

Even though it might seem reasonable to need less due diligence when buying a minority stake in a company, it can be actually be far more complicated than buying the entire operation.

“You have to do twice as much work,” says Jim Ferguson, a mergers and acquisition and securities lawyer at Aikins, MacAulay & Thorvaldson in Winnipeg. “It’s the full kind of acquisition mode but it’s also the unwinding of it if it turns out it wasn’t what you anticipated. You probably won’t get a second kick at doing the due diligence,” he says.

Clint MacArthur, a Calgary-based partner at EY’s transaction advisory services group, essentially agrees, saying an acquirer would have to go through the same legal and financial due diligence regardless of what percentage of a company they were buying.

“You’re coming up with an enterprise value of the full company and you proportionately calculate what you want your working interest to be,” he says, noting the joint venture model is very commonplace in the energy sector. “It’s not uncommon to see premiums (paid) of 20 to 30 per cent on a full acquisition. When buying a non-controlling interest, an acquirer will typically not pay the same premiums, especially if they have limited control and don’t have the same level of board seats.”

But while there’s no shortage of due diligence required, a preacquisition partnership usually means less risk for the buyer and smaller potential losses if a long-term business relationship is doomed, he says.

However, that doesn’t mean you can skimp on setting out terms as early as possible. Structuring a deal when you’ve got a non-controlling interest is crucial when dealing with conflict, MacArthur says.
“If you wanted the company to go in a different direction or provide a different service in a different market and you don’t have control, you need mechanisms to deal with differences of opinion in the ownership structure. Typically, that’s negotiated up front in the deal. If you’re a controlling party, you’re typically not as worried about that,” he says.

Ferguson recommends building in certainty for both price and terms so both the target and acquirer know what the deal is now, and down the road. “You don’t want the target to say, ‘we’re more profitable now so the price you paid for the 10 per cent won’t be the same as you’ll pay for the remaining 90 per cent,’ ” he says.

If an acquirer deems a full-scale acquisition is untenable, they need to be able to fall back on predetermined conditions on whether they get their money back, if they have a non-compete
clause or if they’re able to solicit employees, he says.

“A lot of the divorce you have to pre-orchestrate to get (both sides) as close to where they were before the trial marriage started,” he says. Sometimes all of the numbers can make sense but a clash of two
corporate cultures can kill a deal during the negotiations or make a further purchasing of shares highly unlikely.

“The minority shareholder might say, ‘this is how I want things to change.’ But the majority owner could say, ‘no, I own 90 per cent of the business, it’s not going to change,” Ferguson says.

Other considerations when buying minority stakes include what to pay for the synergies, clients and market share brought to the table, MacArthur says.

“If you’re buying a minority interest, you can’t implement the same operations and go-to-market strategies so you won’t get the same value (as buying the whole company). You won’t put the same level of scrutiny into quantifying the synergies,” he says.

Of course, buying small stakes in a company can also be part of an investor’s growth strategy, enabling them to quietly build up sizeable holdings so as to stay under the radar of regulators. There is no cookie-cutter approach to pre-acquisition partnerships, either.

For example, Shaw says one of his clients is looking at succession and trying to figure out their future plans, but in the meantime they have an immediate need for capital to continue to grow the business.

Shaw’s team developed a plan for the client and introduced them to a strategic partner now in discussions to buy a minority interest in the operation. The partner will have the right to buy more shares in the company, but there’s no obligation.

“The majority shareholder may have the right to sell their shares to the minority shareholder or there may be a forced purchase of the balance of the shares,” he says.

Any time you’re bringing together two distinct organizations with their own separate cultures, the only way the two sides can set realistic goals is by collaborating, Shaw says. Both parties need to be at the table to discuss strategy, corporate values, how the company is positioned in the marketplace, where it wants to be in the next five to 10 years and how it’s going to get there.

“You clearly have people with different experiences and different backgrounds. The important part is to make sure those people all have a say in that process,” he says.

Having one side pushing for a full merger isn’t necessarily a red flag. It could be, for example, that the would-be acquirer merely believes strongly in the value proposition in front of them, Shaw says.

Even though there have been some high-profile success stories, Ferguson considers pre-acquisition agreements a “last resort.”

“If I had a choice of selling 100 per cent of a business, even at a slight discount, versus a 10 per cent trial run deal, I would go for the bird in the hand. So many things can go wrong,” he says. For example, taking on a 10 or 20 per cent shareholder eliminates what could be most valuable to a vendor — the opportunity to sell an entire company with no risk of having to deal with minority partners. “With a 10 per cent minority owner, I may not be able to sell to somebody else,” he says.

A corporate test drive can also be problematic, he notes, because many times the would-be buyer is a competitor in the same space. “They might say, ‘I’ve got 10 per cent, I’ve checked out the competition.
Maybe I’ve learned enough or maybe I leave. Now I know all I need to know about your company because I’ve seen it from the inside,’” he says.

Ferguson says if the minority ownership stake works out, that’s great because an investor has been able to check out the synergies before deciding whether to increase their ownership.

“The downside is, if it doesn’t work, it’s like unscrambling an egg after it’s been scrambled. How do you get out of the relationship? Will you get your money back? Maybe, but not at the same price.” It’s also unlikely that minority shareholders will get to implement many changes that they have in mind for the business and they probably won’t get much latitude from the majority owner, either, Ferguson says.

“If I’m the owner, I don’t know if you’re going to take over the business. I may have to boot you out. I’m not going to put you in as CEO and then find out you’re not very good and I’m not going to introduce you to all of my business relationships when I’m not sure if you’re going to be there in a year,” he says.