The exhalation started sometime in Spring and is about to accelerate--it's a perfect time for companies with cash reserves to pick up strategic targets. A friend on the West Coast has advised a few recent acquisitions, and his update got me thinking about it.
Note: These views are from an industry observer--I might have some of this wrong, but this is my take. The M&A experts will likely want to pipe in with adjustments and other perspectives.
So what makes an acquisition strategic?
Typically, a company is acquired by a complementary company for its team, its products, the revenue from those products, and its profitability (EBITDA).
Profitability is an obvious reason; take a company’s price/earnings ratio, add profit to it, and the stock price will likely increase. A company with $5 million in profit annually buys a company with $500k of profit and similar cost profile, and its market capitalization (and stock price, of course) should increase by 10% on the merits of increased profit alone.
But that’s a linear acquisition.
A strategic acquisition is one where the combination of the assets and activities of the target company increase the value of the acquiring company on a non-linear, upward basis. That is, the buyer gets more than they paid for, with an eye toward long-term growth enabled and accelerated by the acquired company.
In the software industry, a strategic acquisition contains these elements:
- The target brings specific technology that enhances core product offerings
- The target brings products and platform that have modest, demonstrated support from third-party developers, which in turn act as an external sales force because of the dependency on target’s platform
- The target’s platform enables external value creation for the target’s product lines
- The target’s platform enables external value creation for the acquirer’s product lines
- The target’s products generate immediate revenue and profitability when introduced to acquirer’s existing customers, channels, and distribution partners
- The target’s products and platform give reasons for existing customers to stay with acquirer, saving potential lost revenue.
The financial difference between a typical, linear acquisition and a strategic one is typically one of significant multiples. In the example above, the acquiring company increases in value on a 1:1 basis, with profit as the driver.
But for strategic acquisitions, the multiples range from 5 times revenue to up to 100 times revenue—there’s really no cap on strategic value, just the eye of the beholder. If Microsoft (as an example) views their strategic need as
- something to add tens of thousands of external salespeople (developers, companies, evangelists, etc)
- something to increase the revenue per customer
- something to counter competitive moves by Salesforce, Intuit, Sage, etc
- something to rapidly address a specific need of its customer base
…then they are willing to pay something greater than a linear factor, because they believe that the acquisition can catalyze exponential growth and strengthen their hold on their existing market.
This was the case recently with Intuit's acquisition of Mint.com for $170 million. For Intuit, though, it signaled a sea change at the company when it replaced the Quicken team with the Mint team.
It doesn't always work out though. Ebay bought Skype, then sold it. They didn't make strategic use of Skype, and it hurt both them and Skype. So they've sold Skype. Sun bought Cobalt Networks, and then dropped 97% in value (that hurt) because of the bursting bubble--not just the dotcom bubble, but the Y2k IT replacement bubble.
Stay away from the linear acquisition. Yes, it's important to generate revenue and profitability--absolutely. That should be a factor for what's possible. But consider the list of strategic angles above.
And never go it alone--hire an M&A firm with experience in your sector, and don't cap their % (5% to 7% is typical if they are doing the shopping). It's rare that a management team is good enough and experienced enough to do better than a decent M&A team can do--plus it's a ton of work.
I hope that helps someone out there. And M&A folks--start correcting...