The Uncertainty Principal

The ‘observer” and the observed, Andy Warhol Exhibit, High Museum of Art, Atlanta USA [Photo: R. Wottrich]

The Uncertainty Principal was first articulated in 1927 by the German physicist Werner Heisenberg. It states that the position and the velocity of an object cannot both be measured exactly, at the same time, even in theory. The very concepts of exact position and exact velocity together, in fact, have no meaning in nature. Only with exceedingly small masses of atoms and subatomic particles does the product of the uncertainties become significant. “Any attempt to measure precisely the velocity of a subatomic particle, such as an electron, will influence it in an unpredictable way, so that a simultaneous measurement of its position has no validity. This result has nothing to do with inadequacies in the measuring instruments, the technique, or the observer; it arises out of the close connection in nature between particles and waves in the realm of subatomic dimensions.”

But in the world that is our reality we have ‘observed’ what seems to be the Uncertainty Principal at work when buyers circle a company that may be in play as an acquisition. The very knowledge that buyers are ‘observing’ a corporation as a potential acquisition can cause the target’s ownership to change their behavior. The most common question I receive once an offer has been tendered for a company is, “What should we do now?” The correct answer is that ownership should run their business as they always have, but in practice this often isn’t the case. In one case a private seller injected personal cash into the business to meet cash-on-hand requirements, which in turn influenced the purchase price upwards based on the EBITDA multiple being paid.

Once it is clear that a transaction is possible sellers tend to become more conservative. A risk that they might have taken previously to grow the business, suddenly is perceived as a threat to the purchase price. Capital expenditures that would normally be made, are now seen to drain cash and potentially impact the control numbers that set the price. New employee hires that would usually be considered as additive to the business, now may be put off in favor of not expanding the payroll. An increase in the company’s bank credit line to fund routine growth may be delayed in anticipation of the closing of the acquisition.

Buyers compound this behavior by the very terms of their proposed offers. They insert financial control numbers that cause the seller to become risk adverse, lest they drop the price by opening new business opportunities. They insert debt-equity ratios that discourage adding debt to fund new business. They insist on employment contracts with key executives, which as anyone might imagine causes those executives to think long and hard about taking any business risk that might backfire on them. They insist on a closing audit that freezes the company at a point time, which is the dynamic opposite to how companies live and breath. It is only natural that the sellers seek to keep their company exactly as it was when the offer came in. In essence, the buyers freeze the seller into a defensive position that usually will have an adverse effect on the growth of the business.

I call this the Big Game Hunter Effect. The buyer views the acquisition target as a trophy – in stasis. To the contrary, the buyer should view the company for what it is – a living dynamic entity that is moving upward and onward. The buyer should propose terms that partner them with the sellers from the day the offer is accepted. The purchase agreement terms should allow leeway for normal and customary decisions that can be supported  as correct for the business. the purchase agreement should not penalize the sellers for taking risks and investing in new business that is consistent with the reason the buyers find the company to be attractive in the first place.

Richard Wottrich, DSI Global View LLC