When A Merger Isn’t The Best Idea

mergerThis year is the 50th anniversary of one of the most catastrophic mergers in history — the merger of two very large railroad companies, the New York Central and the Pennsylvania Railroads. Already powerful, the two combined were the sixth largest corporation in the US. (Though ever-fluctuating, by comparison in today’s economy, Apple, ExxonMobile, and Walmart reside somewhere at that level on the corporate size lists.)

Two years later, in 1970, the newly merged company, Penn Central, filed for bankruptcy. It was the then largest bankruptcy in America’s history.

In retrospect, there were quite a few reasons why the merger was ill-fated. Market forces—the steady march of emphasis on automobiles, trucking, and airplanes for transportation—had already placed the two railroad companies in a weakened position. Rising costs and increasing regulation were also a stressor.

And that old yet persisting reason for failed mergers—the inability to align competing cultures—likely played a significant role in the two long-time rivals’ failure.

Wouldn’t it be nice to be able to tell when not to pursue a merger? To stave off in advance the consequences of a very bad decision by simply not making that decision at all?

That was the gist of a conversation I had with an acquaintance one recent sunny weekday as we drank coffee outdoors and talked business. We were discussing a company we both knew in the services industry that was interested in merging with a larger company.

Both of us agreed that if the merger occurred, it would bring disaster.

“But how do we know this?” my friend asked. “What are the rules for a corporate leader about when not to acquire or merge, even if the financial model looks good?”

Much of my work involves guiding corporate entities through the complex legal and financial processes of M&A – both domestic and international. (Cross-border transactions supply even greater possibilities for mistakes and failures). Certainly, anyone involved in M&A understands that intensely competitive markets, industry evolution, and economic downturns can destroy a merger that probably would have been successful otherwise. But even if the market, the industry, and the economy are absolutely perfect for the merger, if two companies merge with any one of the following three principles against them, I can usually predict failure.

“Despite the complexity of M&A, these principles to guide companies away from acquisition or merger—or guide them towards it—are simple.”

Despite the complexity of M&A, these principles to guide companies away from acquisition or merger—or guide them towards it—are simple.

1) If the cultures of the two companies are substantively different, even if both cultures are strong, functional, and healthy, the risks of collapse are quite high.

The inability to integrate distinctive cultures is probably the primary reason offered for failed mergers (which, depending on how you define failure, can float between 50% and 85%).

If one company is dynamic and innovative and the employees within it are receptive to change, and the other is staid and traditional and the employees within it are resistant to change, it will be extraordinarily difficult to meld the two cultures.

Culture, though hard to define, includes the reasons that employees come to work, the motivation behind what they do, and the ideals they uphold. People choose where they work based on who they are, and certain cultures attract certain types of people.

Choosing the dominant culture to emphasize in a merger—picking “one culture as the host culture“—is a good strategy, but the reality is that the expected merger synergies will be hindered even when giving a clear lead to the dominating culture. When one radically different culture among healthy cultures “wins out” over the other, those left out are less able to contribute in the new company.

I’ve found, too, that in their zest to pursue a merger, C-suite leaders often are in denial about just how incompatible their company cultures are. Most outsiders can simply observe two different cultures in action for a week, sense the significant differences, and even describe them effectively. Employees also, when asked to submit a list of ten adjectives describing their own corporate culture, can easily reveal the vast differences between companies.

Ask your employees to produce such a list. Ask the other company to do the same. Then compare the lists. If they list reveals significant differences in core cultural principles, don’t do it. It’s that simple.

2) If a company is flush with cash but has not yet developed a well-defined acquisition strategy and robust corporate development capabilities do not acquire another company. The “we have a lot of cash and are under pressure to grow, so why not” approach is fraught with danger.

Companies that are unprepared for M&A often don’t know how to develop criteria to “qualify” targets, evaluate synergies, create financial models and hurdles that must be met at each stage of the M&A process, negotiate deal terms, identify transition needs, and integrate the acquisition target. Even with the best processes in place, M&A requires a tremendous amount of time and effort by a company’s top leadership. In the end, an unprepared company that pursues M&A risks not only wasting excess cash but also valuable leadership resources. 

Beyond the risk of inexperience, though, is the principle that mergers and acquisitions should be conducted for a strategic purpose. Acquisitions are meant to “do something” significant, beyond simply a company getting bigger.

In the current market, cash-rich corporations are competing with other cash-rich corporations and with private equity firms that have record-high amounts of capital to deploy. The C-suite may be under significant pressure to find deals and close deals – in many cases, their bonuses are tied to meeting M&A objectives. But going through the stress and excessive risk of an acquisition for no significant reason is simply too much of a gamble. The shareholders are often better off if the company invests its cash in its current businesses to fuel organic growth – for example, funding capital improvements or expansion, expanding R&D efforts, or rewarding extraordinary talent within the company. Shareholders even may be better off if the company returns excess cash to them as dividends, to be deployed by them in other worthy investments.

3) If a company’s leadership is struggling with a serious internal issue—one that the company’s leadership has put off dealing with—and they now think that a merger with a larger, healthy company that will “fix” the problem is the answer, they’re wrong.

They merely export their dissension and inability to lead effectively into another corporate culture. And both teams will be miserable.

One common internal conflict, for instance, is low-performing managers or partners in companies that do not have hierarchical structures to deal with them. In some cases, because the low performing individuals are embedded within the leadership structure, or because corporate culture weighs against taking negative actions against long standing employees, it’s challenging for the internal team to address the situation. Other common internal issues are the need to institute huge layoffs, or to sell off a low-performing but revered sector considered integral to the corporate history and tradition. These uncomfortable actions are so significant that some companies are paralyzed in dealing with them.

If, rather than confronting the problem and dealing with the matter internally, the company pursues a merger in the hopes that the merger partner will “deal with it,” whatever “it” is, both companies likely will suffer. After all, if “it” was hard for one company, it will be hard for the next — and in the midst of having to deal with leadership, cultural, and business integration, dealing with “it” can destroy a merger.

There are plenty of excellent reasons to pursue M&A, and for companies that have fleshed out their M&A strategy and prepared themselves for the process, M&A can be a highly successful element of a company’s growth strategy. But for other companies, even when the markets, industry, and economy are stable and strong, even when all of the due diligence investigation of the target business has been accomplished, and even when the numbers look good, there are still some situations in which a company should hold back.

Edward Teller, the great Hungarian-American physicist, said “life improves slowly and goes wrong fast, and only catastrophe is clearly visible.”

It’s true that failures are most clearly seen in retrospect; most of us would not have foreseen some of the most significant M&A failures that are now a part of the history books.

It’s difficult to see successes quite so clearly, as successes often come more slowly and methodically. Even now, there are successful mergers that, decades from now, will have stood the test of time and which everyone will recognize as successes. It’s that kind of success that corporate leaders need to pursue in their choices on mergers and acquisitions.

Melinda Davis Lux
Melinda Davis Lux, a partner with Womble Bond Dickinson, is a mergers and acquisitions attorney with broad experience in providing guidance on sophisticated merger and acquisition, joint venture, and corporate financing transactions for companies in a variety of industries.