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Financial value, strategic value, market value, product and service assessments, and key management evaluations are common elements in the analysis of mergers and acquisitions. The value of the customer, however, usually the fundamental driver of business success, is either ignored or given only cursory attention by acquirers and their banking advisers because a detailed assessment of customers often is regarded as a "soft" process and seemingly not quantifiable. The defection of customers is only estimated and considered a foregone conclusion. But this omission, or rough estimate, raises some very important questions. How can the financial impact of combining two organizations be defined if the extant customer base is not considered as a fundamental element in that assessment? How can a realistic financial evaluation of a company be determined if the customers' opinions of that company, its products, services, and support are not objectively considered? The fact is that the metrics of customer value should be a major input in defining financial value.

A recent industry-wide banking survey disclosed that more that half of the customers of banks that merged had an unfavorable opinion of the consolidations. Moreover, approximately 20% of these individuals switched to another bank after that merger; most did so within six months.

Since 1980 there have been more than 8,000 bank mergers, yet high customer turnover triggered by those events continues unabated. How could this happen? How could mergers and acquisitions be proposed and evaluated with so little apparent understanding of the customers' reactions?

Financial value, strategic value, market value, product and service assessments, and key management evaluations are common elements in the analysis of mergers and acquisitions. The value of the customer, however, usually the fundamental driver of business success, is either ignored or given only cursory attention by acquirers and their banking advisers because a detailed assessment of customers often is regarded as a "soft" process and seemingly not quantifiable. The defection of customers is only estimated and considered a foregone conclusion. The merger, whether in banking or many other industries in which scores of deals have been undermined by customer erosion, may progress using only an assumed defection and its associated revenue loss as a financial measure in the projections of the combined company.

But this omission, or rough estimate, raises some very important questions. How can the financial impact of combining two organizations be defined if the extant customer base is not considered as a fundamental element in that assessment? How can a realistic financial evaluation of a company be determined if the customers' opinions of that company, its products, services, and support are not objectively considered? The fact is that the metrics of customer value should be a major input in defining financial value.

What Is Customer Value?

Customer value is the quantitative and qualitative analysis of a company, its management, its representatives, and its products or services as defined by its customers. This can be expressed in absolute financial terms in quantitative value measurements and in relative market strength (in comparison with competitors). Customer value cannot be derived by an internal assessment or even externally by an abstract analysis. Rather it requires information that must be obtained directly from the customer and subjected to structured evaluation. In other words, when all else fails, ask the customer.

There are four parts to customer value:

* The relationship between customer satisfaction and revenue;

* Evaluation of the components of customer satisfaction;

* Identification of the key drivers of customer satisfaction; and

* The characterization of customer culture.

These elements can be combined to provide both quantitative and qualitative analyses based on an absolute and relative scale and then associated with revenue potential to characterize the value of the customer base.

There are absolute scales that can be used to quantify customer opinions. Extensive databases allow a relative ranking of customer opinions to be defined with respect to other companies. Techniques are available to objectively define customer priorities. There are methods of quantitatively defining the financial impact of changes in the customer perceptions pertaining to price, quality, delivery, support, service, etc. Given these capabilities, customer value can be objectively defined and utilized in characterizing the value of a potential acquisition.

Obtaining Customer Data

You cannot obtain objective customer data simply by asking several customers a few probing questions or by conducting a handful of focus groups, the so-called "audit" approach. The information required for substantive decisions needs to be accumulated through surveys conducted in a carefully structured statistical mode. In this context, "statistical" means the ability to quantitatively define the range of accuracy of the results.

Who is surveyed is as important as the questions that are asked. Any organization that understands its customers can easily divide the base into three classes - large revenue producers, strategic customers, and the broad remainder. Strategic customers are those with the potential to become key in the future. Normally 10% to 20% of the customer base constitutes the major source of revenue and operational success. This does not imply that the remaining 80% to 90% are uninteresting and cannot contribute key data. But it suggests that the survey emphasis should be on the most critical customers.

The fundamentals of obtaining customer opinions must begin with the survey and how it is created, implemented, and analyzed. Some of the elements of a successful process are deceptively complex. For example, the identical survey will generate different answers, often significantly different, when conducted on the Internet, by telephone, by personal interview, or by mail. Changing the order or the number of questions will alter the results. Using a different scale e.g., excellent, good, fair, poor, etc. versus a 1, 2, 3, 4 ranking - will change the answers. Consistency is critical if the results of a survey are to be used as a base for analysis, particularly if a relative comparison against a historical database is to be considered.

Comparing a survey with other surveys without the disciplined use of standards would be like comparing financial measurements using two different methods of derivation. It just doesn't work. Understanding customers must begin with a standardized methodology of surveying them to obtain a true and unbiased opinion.

The Relationship Between Customer Satisfaction and Revenue

The first and most direct element of customer value is the impact of the satisfaction of the customers on revenue.

Here is how it worked in an actual customer evaluation project we did for a client. Initially, we statistically derived the relationship by tracking quarterly revenue and customer satisfaction measurements of 800 international and domestic company accounts over a four-year period.

The conclusions of this statistical analysis were in some ways surprising. It demonstrated that a somewhat satisfied customer would generate 38% of the revenue of a totally satisfied customer. A somewhat dissatisfied customer generates 7% of revenue but a totally dissatisfied customer costs 180% of the revenue of a totally satisfied customer. Interestingly enough, in Japan the weightings for the satisfaction metrics are virtually identical to those in the U.S. except for the totally dissatisfied customers. Here, the cultural reaction to dissatisfaction is stronger, as it costs 310% times the revenue derived from a totally satisfied customer. This occurs through lost customers and associated negative PR. The impact of dissatisfied customers is rarely understood and taken into account. This aggravated class of customers offers poor leverage for the cost structure in the postmerger environment, and occasionally may be the root cause of a merger that did not live up to expectations.

By weighting each category in the satisfaction scale by the percentage of customers choosing the various satisfaction levels and totaling the result, a Revenue Index can be derived. This index defines the percentage of the potential revenue that is being contributed from the customer base. For example, if the Revenue Index is 67%, this means that approximately another 33% of revenue could be obtained through an increase in customer satisfaction. This also means that a 1% increase in the Revenue Index will result in a 1 % increase in revenue, as illustrated in Table 1.

After the Revenue Index is calculated, the next question is whether the measure is good, bad, or indifferent. That answer can be obtained through a comparative summary, which is graphically displayed in Figure 1. This statistical result is based on more than 50,000 individual customer surveys conducted for more than 100 different clients. In the example described above, with a Revenue Index of 67% and with reference to Figure 1, the result shows that the company is in the 65th percentile of companies - not bad but with room for improvement that can add value.

Evaluating the Components of Customer Satisfaction

Many different elements are associated with a service or product, e.g., quality, features, price, etc., that a customer unconsciously integrates to form a level of overall satisfaction. The knowledge of these details is important if the current customer base is to be thoroughly understood. For example, how satisfied customers are with the firm's sales personnel, the features of the product, or product pricing, to cite a few elements.

As with the Revenue Index, both an absolute number and a relative ranking with respect to the database of surveys can define the results of each survey question. Figure 2 illustrates the percentile ranking for the question, "How satisfied are you with response to your questions about the product?" For example, if 45% were Totally Satisfied, this would place the response to that question in the 55th percentile.

Loyalty Is an Action, Not an Intention

A very interesting and tempting query to the customer is if he or she intends to repurchase your service or product in the future. Tempting, yes. Valuable information, no! A recent repurchase represents loyalty and provides a very good statistical base for evaluation. Since true loyalty can only be measured after the fact, the potential of a repurchase by itself is speculation. Loyalty is important. It can be measured by inference, but that is risky. A more realistic approach is to determine actual past behavior and use that as a precursor of the future. Loyalty is a key fundamental measure in customer value.

What Questions Should Customers Be Asked?

Using a survey to gather opinions for calculating customer value requires a minimalist approach. The shorter the survey the better. The process begins by identifying the correct questions to ask. Fortunately, this is not complex. If the intent is to develop a marketing campaign, evaluate a product, test advertising, or gain information on very specific areas, the formulation of questions can be a major challenge. But standard categories can be used to characterize customer value. As the goal of a survey in this context is informational and not action-oriented, the questions tend to be framed at a higher level.

The Identification of the Key Drivers of Customer Satisfaction

There is typically a common portion of the decision process that is used in making choices. This is why advertising works; it appeals to universal needs and wants. The common evaluation process is certainly not the only element involved in arriving at a decision but it is a significant influence. In fact, our research has shown that approximately 60% of the reasons for selecting a product or service in the United States tend to be consistent among purchasers. The remaining 40%Io is not definable and is probably based on prejudices, familiarity, habit, and other personal elements that are unique to the individual.

If the vast majority of customers are totally satisfied with the elements of a product or service, these elements, ironically, are not likely to positively or negatively influence a purchase decision; they become accepted elements. However, if there is a range of satisfaction opinions with respect to specific elements, that potentially raises the importance of these elements in the decision process. The goal is to identify and quantify those "key de-influencers."

Asking customers to rate the importance of elements that determine their satisfaction with a product or service, while seemingly straightforward, is doomed to failure. Many studies have validated that the human decision process is primarily emotional and that we tend to rationalize after the fact by offering "logical" reasons to others and to ourselves. For example, a customer may be unwilling to reveal, or to even be conscious of the fact, that the relationship they have with a sales person, as opposed to quality, is the fundamental reason that he or she purchases a service or product. The reality is that the critical customer priorities, which are the key driving elements of customer satisfaction, must be indirectly identified. As an example, consider the Overall Satisfaction with a product or service. At the top level, there are four major aspects, or inputs, that influence an individual's opinion (see Figure 3). They are price, quality, delivery, and features.

The variations of satisfaction with those inputs will have consequences on the Overall Satisfaction level. The relationship between those inputs and the satisfaction level can be derived through techniques currently used in data mining. We specifically use Neural Network Analysis because it is appropriate for the nonlinear decision process that is typical of a purchase selection.

The results of this analysis identify the percentage of the Overall Satisfaction that is directly influenced by changes from individual inputs. For example, if price is a 15% influence, that means a 100% change in satisfaction with price would create a 15% change in overall satisfaction. As a rule of thumb, if a specific input influences the Overall Satisfaction by less than 10%, it may be considered to have a very minimal affect and may be ignored. A viable impact usually arises from a 20% to 40% influence. Above 50% is relatively unusual and demonstrative of extreme priority for that input.

Customer Expectations Are Critical to M&A Success

Every company has a customer culture that is formed over time by the integration of the aggregate experiences between the customers and the providing organization. The strengths of a company and the needs of the customers evolve and are refined by a self-defining process to create a specific customer culture. The company builds capabilities to match its customers, which in turn attracts and keeps customers that are drawn to those capabilities.

If a target company has a different customer culture than the acquirer and there is an integration of virtually any two internal groups from the different organizations, there potentially could be a significant loss of customers as a result. It is vital that the merging partners be cognizant of the customer cultures of both organizations. Being different is not necessarily a reason not to merge but it should influence whether the target should maintain autonomy or how the partners should develop a carefully managed integration plan.

In recent history, for example, Xerox Corp. instituted major reassignments of its sales force without recognizing the critical role of the personal relationships that existed between the customers and the sales people. The result was a loss of business and customers, which was particularly serious for Xerox as its market deteriorated.

Three major categories of customer expectations constitute customer culture:

* Actual product or service offerings;

* Customer service provided to the customers of those products or services; and

* Personal relationships that exist between individuals in the company and their customers (see Figure 4).

One of these fundamental components of customer culture usually dominates in most companies.

The characterization of the customer culture may be obtained by including survey topics that address the higher-level questions that deal with satisfaction of the three major components. This is illustrated in Figure 5.

When two companies merge, there eventually needs to be a match between each organization's customer culture in order to avoid problems that can lead to defections. This requires an identification of the impact of the three fundamental elements on customers' satisfaction in both companies. It can be derived by using a process very similar to that used to determine the key drivers of customer satisfaction. Consider the hypothetical acquisition case illustrated in Figure 6, where an obvious mismatch is apparent.

The customer culture of ABC Corp. is clearly customer service-driven while that of XYZ Corp. is dominated by personal relationships. Both show an impact of about 55%, which is unusually high and therefore clearly defines the potential for the loss of current customers. This merger certainly is not optimal if the intent of the merger is to form one organization with relatively homogeneous approaches to the market. A very careful and phased plan for integration is required.

Returning to the banking example, a typical mistake occurs when a large bank with primarily city experience acquires a smaller bank serving a suburban area. The important impact of the personal relationships at nonmetropolitan banks is often overlooked. The larger acquiring organization has positioned its core competencies as offering a broad range of financial products with competitive and occasionally slightly better loan rates or service costs. The strategic goal of those acquisitions is usually growth, efficiency, and control. In executing the acquisition and striving for efficiency, the acquirer often reduces staff, installs new faces at branch offices, and implements different policies. These actions can cause small-town customer defection from the new, seemingly impersonal approach of the acquiring organization.

Information From a Customer Value Analysis

In general, the customer value analysis provides the quantitative and qualitative information that allows an assessment of the value of the existing customer base to the business. It also provides an external assessment of many of the functions of the company that directly and indirectly interface with those customers.

Specifically, the following would be available from the analysis:

The Revenue Index, providing the percentage of available revenue from the existing accounts. Distribution of customer satisfaction levels for all the significant elements comprising the company's products, services, customer service, and company relationships. Both the Revenue Index and the measure of the various components of customer satisfaction would be available in both absolute terms and percentile ratings vis-a-vis other companies.

* Identification and quantification of the strengths and weaknesses of a company as viewed from the customer's perspective.

* Prioritization and quantification of the key drivers of customer satisfaction and their relationship to revenue growth.

* Quantification of the customer culture characterizing the degree to which the fundamental elements of product, service, and personal relationships influence customer purchase habits.

* Measurement of customer loyalty, as defined by past actions.

* Customer recommendations for improvement of the product or service offerings.

* Sales force analysis, characterizing the group's strengths and weaknesses as well as absolute measurements and relative rankings.

* Effectiveness of the company's management, as defined from the customer's point of view. The information can be used to create a reasonable future forecast of sales.

Customer Value in M&A Due Diligence

The critical role of the customer in defining the value of a company, his or her expectations from the company as a service or product supplier, and the synergistic culture that exists between the customers and the company is critical for the success of most mergers.

It can also impact these areas:

Negotiation - Combining companies is basically an auction process, most critically on the sell side. The seller wishes to obtain the highest value while the buyer looks for the bargain. Characterizing the customer value can offer opportunities for leveraging those negotiations. This is particularly true for the seller if the customer value is quite high.

Assessment - Typically, a product, service, and technology analysis, a market analysis, and a management analysis are part of the due diligence process in determining a valuation. The inclusion of customer value adds a critical element to support the evaluation. In most cases, this element will supplement the traditional process and it will take some time to become familiar with and gain comfort from its impact. In most acquisitions of established companies, the customer base represents the business value of an organization.

Value-Added Service - The ability to offer additional value-added capability could be a competitive advantage to m&a banking advisers and can be useful for obtaining repeat business or recommendations. Customer value can be important in determining valuation and can provide the management of the merging organizations with the equivalent of a management consulting service. This information has the potential to offer a significant value and to be an influence in postmerger tactical and strategic actions. In this sense, the service provided by the investment bank does not end when the deal is concluded.