You know the Pareto Principle—in most cases, 80% of the effects come from 20% of the causes. This allows us to focus on the important stuff, the stuff that results in 80% of our objectives. But when it comes to mergers and acquisitions, Pareto would roll over in his grave thinking about our inability to apply his principle.
Think about the due diligence done in most acquisitions. Groups of attorneys pore over documents proving the value and ownership of hard assets. Accountants wear out their green eyeshades worrying about how those assets and the related liabilities are recorded in the financial statements. Both groups do a great job of executing their assignments. But let’s be clear—their assignments are to give comfort over about 20% of the value of the total business.
Don’t believe it? Across many industries, the average Price-to-Book ratio is about 5. What that means is that for every $5 of value, $1 is made up of the recorded value and the other $4 is made up of intangible assets. Companies focus their due diligence efforts on the $1 and virtually ignore the $4!
What makes up the $4? A lot of things, but nearly all of them are either the value of the customer base or things directly impacted by customers. A company with a loyal customer base is much more valuable than one whose customers are not loyal. In fact, in a study of IT companies that we performed, the price/book ratio of loyalty leaders was 5.7 times versus 2.7 times for loyalty laggards.
Before your company buys another after scouring records to prove the value of the hard assets, make sure that the assets that really drive the value—the customers—get a good solid investigation as well.