One topic that might not be obviously relevant to start-ups is corporate development through Mergers and Acquisitions (M&A). But can it happen rather quickly in the early life of a company? I would say yes. I recall from reading a Bill Gates biography that when pushed against a deadline with the IBM operating system contract, he acquired another operating system developed by another company. Microsoft at that time was only a couple years old.
M&A should fit within the overall strategy of a company while increasing shareholder value. Rather than focusing on the financial considerations in mergers and acquisitions, which are fairly well known to anyone with a background in finance and accounting, I rather discuss the strategic reasons for making such M&A.
When I was employed by a relatively young telecom company, I found out after a few months later that the carrier relied on software to generate its phone calls, using a system named “call-back.” It would buy minutes and resell them, which, in reality, was an arbitrage position. But most established and profitable telecom companies relied on infrastructure – switches, conduits, copper lines, etc. Their pricing could be managed through the underlying infrastructure.
Meanwhile, the arbitrage position was only tenable for a short period of time while an imbalance in international calling prices existed. Furthermore, competition among 300 similar call back companies kept shrinking the margins. The company had to migrate to a facility based system or be pushed out of existence. The solution: acquire infrastructure -a switching operation. Hence an acquisition can be motivated by a strategy for the company to migrate to a different vertical level –through infrastructure purchase- and continue to compete against other companies. In essence, the acquisition increased the enterprise value of the company. And of the hundreds of many similar companies, it was one of the handful that survived.
Another M&A activity can be motivated by the diversification of product lines. One sees this in the software development world when Facebook acquired Instagram, and Zynga with various game developers. Sometimes, in a very quick moving market place, the in-house business development team feels that growth is critical but yet finds that it is cheaper to acquire than develop a competing product in-house. One can refer to the Coase Theory of Firm, a Nobel Prize winning theory of determining the value of external resources versus the internal ones, and to increase the value of the firm, it pays to acquire it. This style of M&A is driven by speedy growth and product diversification.
Some M&A activity is financially driven. One publicly traded company acquired everything from alarm systems to ships. Financial teams look at discounted companies with consistent cash flow and give a green light to acquire the company, adding the new asset to its portfolio. Your rarely see this in high tech industries but you see this strategy employed by large conglomerates to add shareholder value when the core business demonstrates slow growth.
Generally, M&A is driven to increase shareholder value, not decrease it. It should be guided by the strategic considerations for the company. Another factor, not all M&A activity works. I have heard horror stories of companies making acquisitions in the software space, finding out that sales were overstated. The lawyers will begin their lawsuits, but still the acquirer is stuck with an undervalued asset that now decreases shareholder value. The fault lies in the acquirer not doing its due diligence. And many of these acquisitions are driven to increase sales when it cannot do so organically. And the product lines are so similar that the synergy is not there; sales drop through cannibalization.
A major problem with software acquisitions lies on its “soft” inventory. One can touch and feel a factory, manufactured products. Software valuation relies on distribution networks, maintenance agreements. Recently, HP made an acquisition of a British software company, which, after an accounting of potential sales and distributions, the accountants had to reduce the valuation considerably.
The best acquisitions I believe are those that you can integrate its team into the company, can establish successfully the due diligence in the assets/liabilities, refine the technology while dramatically increasing the shareholder value tremendously, and increase revenues. Cisco has done so consistently — as well as Apple. I have also seen the same in smokestack industries, where old line products are remodeled into new ones. For example, modifying water hoses into fiber optic conduits.
Note that a company has two expansion options- grow organically or through M&A. If the organic option is not available, the next best thing is to execute M&A. Wall Street is always hungry for these deals since many can be financed through the underlying value of the target. However, the wrong M&A strategy can backfire. I have seen bad choices decrease the value of the company. Sometimes I believe that those incorrect choices come from desperation and not evaluating the target properly or fully integrating the new asset into the firm.