Strategies for Overcoming Common Obstacles in Manufacturing M&A Deals
November 18, 2024 | by Randy Rua
Selling a manufacturing business comes with unique challenges that can complicate the transaction process and post-acquisition integration. Many challenges are not anticipated by buyers and sellers and often don’t reveal themselves until deep in the merger and acquisition(M&A) process. Below are some of the most common obstacles in manufacturing M&A faced by buyers and sellers.
Unforeseen Financial Investments
One of the most common surprises for buyers is the money required to stabilize and modernize the acquired business. For instance, a manufacturing company may operate with outdated equipment or lack a robust accounting system. While the seller might have grown accustomed to these limitations, buyers, especially those backed by private equity, might see these gaps as significant risks.
The need for a cloud-based accounting system or an Enterprise Resource Planning (ERP) system may be non-negotiable for the buyer, but sellers often resist acknowledging the necessity or cost of these upgrades, leading to friction during negotiations.
Key Personnel and Customer Relationships
Retaining key personnel and transitioning critical customer relationships can present obstacles. Buyers often discover that certain employees are indispensable or that the owner has cultivated strong, personal relationships with key customers. The risk of losing these employees or customers post-acquisition can significantly impact the perceived value of the business. Sellers often underestimate how these relationships are tied to their personal involvement, leading to disputes over valuation and deal terms.
Seller’s Reluctance to Stay Onboard
Buyers may insist that the seller remains with the business for a transitional period—often through a three to five-year employment contract— if the buyer doesn’t have a strong management team to take over. This can clash with the seller’s motivations for selling, especially if they were hoping to retire or move on to other ventures. This misalignment can become a sticking point, as the buyer may view the seller’s continued involvement as crucial for maintaining stability, while the seller sees it as an unwanted obligation.
Working Capital Disputes
Working capital is another frequent source of conflict. Sellers often expect to be compensated for their inventory and receivables, viewing them as part of the business’s value.
For instance, a seller may focus on the company’s value based on a multiple of EBITDA, expecting the inventory value to be added to the agreed-upon purchase price. So, a company with $1 million in EBITDA might be valued at $4 million, but the seller will expect the $3.5 million working capital tied up in inventory and receivables to result in a purchase price of $7.5 million.
On the other hand, buyers typically believe that the purchase price should include everything necessary to run the business, including the existing inventory and receivables. This disconnect can lead to heated negotiations, especially when working capital levels are high.
Financing Complications
Financing M&A transactions in the manufacturing sector presents several challenges for both buyers and sellers. Buyers often rely on bank financing, but various factors can make securing it difficult. Banks may raise concerns about the condition of equipment, the stability of cash flows, or the adequacy of financial reporting.
Extended payment terms—sometimes stretching to 90 or 120 days—further complicate financing efforts, as they can strain cash flows, and banks are wary of these elongated terms and may be reluctant to lend against these receivables.
The fluctuating value of used equipment, often used as collateral, adds another layer of uncertainty as lower-than-anticipated valuations leave buyers with less collateral to secure loans. Rising interest rates also increase financing costs, leading to higher debt-to-EBITDA ratios, making it harder for buyers to meet sellers’ valuation expectations.
However, it’s not all doom and gloom on the financing front. In response to these challenges, creative funding solutions have emerged, and buyers can increasingly turn to a combination of traditional bank loans and private equity partnerships to close deals. Government programs like SBA and SBIC-backed loans also provide essential support, offering reduced payment terms and enabling banks to take on more risk.
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Environmental and Compliance Issues
Environmental due diligence is standard practice – especially when the buyer is purchasing both the business and the property— including Phase I and II environmental assessments. These assessments involve third-party agencies that inspect the manufacturing facilities for any signs of contamination, such as improper waste disposal or oil spills on the factory floor. If issues are identified, they can lead to additional environmental research, increased costs, and potential delays in the transaction, which may cause the buyer to reconsider or even walk away from the deal.
The liability associated with environmental compliance is also a key concern for buyers, as they could inherit significant risks if past environmental issues are not properly addressed. This often leads to intense negotiations between the buyer and seller, particularly over language in the agreement that protects the buyer from future liabilities. The safest approach is to conduct an environmental analysis to ensure that all potential risks are identified and managed before the deal is finalized.
Cultural Differences
In manufacturing M&A deals, company culture can be a significant obstacle, but it’s often overlooked before the transaction. Culture issues rarely derail deals during negotiations but can cause serious friction afterward. For instance, a buyer who values constant innovation might find it difficult to integrate with a company that has a more traditional approach. This disconnect can lead to operational inefficiencies and lower morale, making it harder to achieve the hoped-for synergies of the acquisition.
Cultural assessments are recommended before closing, and buyers should ask questions and pay close attention to identifying shared values to build on.
Data Access for Due Diligence
Buyers often express frustration with the difficulty of gathering accurate and comprehensive data in manufacturing M&A transactions. Sellers may be hesitant to share data or only share partial information, which may lead to misunderstandings and misinterpretations.
The best way to prevent misunderstanding is to build a solid data room with well-organized and vetted information. This fosters confidence in the buyer and allows the seller’s team to identify and address potential issues before they become deal-breakers.
Communication Breakdowns
Effective communication between buyers and sellers is crucial for a smooth M&A process, yet it is often where deals encounter obstacles. Emotions run high, and misunderstandings or overreactions to deal terms can lead to a breakdown in negotiations. For example, if a buyer suggests redesigning a product post-acquisition, the seller may interpret this as a critique of their work, potentially derailing the deal.
Having a neutral third party facilitate communication can help keep discussions focused on facts and market realities rather than allowing emotions to disrupt the process.
Pre-Sale Preparation
A common reason for failed M&A transactions is inadequate preparation on the part of the seller before going to market. A thorough pre-sale due diligence review involves collecting data and anticipating and addressing questions and concerns that potential buyers will have. Sellers who skimp on this process will likely face multiple failed attempts before successfully closing a deal.
These failed attempts not only incur legal and accounting costs but can also distract from the business’s day-to-day operations, potentially lowering its value. Conducting a thorough pre-sale due diligence process can help mitigate these risks and ensure a smoother transaction.
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These challenges underscore the importance of having experienced advisors involved in the M&A process. In the end, manufacturing M&A deals are often a delicate balance between the buyer’s need for stability and growth and the seller’s desire to exit on favorable terms.
Advisors can help buyers and sellers navigate these complexities, align their expectations, and ensure that the deal structure addresses potential risks. Whether aligning on valuation, addressing operational gaps, or ensuring compliance with environmental regulations, the expertise of seasoned professionals can be the key to a successful transaction.
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