There’s no doubt that technology acquisitions have become a hot ticket in the defence, automotive and manufacturing sectors. As we come out of the COVID-19 crisis, businesses are increasing their focus on digitisation to increase competitiveness and accelerate the path to Industry 4.0 and the Internet of Things.
These deals are different: there’s more competition from new players and so they need to be approached differently too. It can’t just be a case of dusting off your old M&A process from the last transaction. In recent months, to name just a few we’ve seen Serco announce the acquisition of Whitney, Bradley & Brown to advance its D&A and AI capabilities, Snap-On buying Dealer-FX in the automotive sector to bolster its software as a service management systems capability and BAE Systems acquiring electronics company PPM as part of its strategy to develop breakthrough technologies.
There is significant competition for assets, accentuated by the catch-up factor after COVID-19. This is leading not only to high volumes but high values, with multiples considerably beyond sector norms. Another element driving this is competition from other funding routes – IPOs and SPACs (Special Purpose Acquisition Companies). In fact, there have been 258 SPACs this year alone, shattering the number in the whole of 2020, with technology featuring highly. Technology businesses are attracting investor capital through this route, away from mature industrial business based on forecast growth levels and promised higher returns.
So what are the critical success factors? First the origination phase is crucial. You need to be really clear about how a potential asset would fit with your organisation’s growth strategy. What value would it add to your portfolio? How will it help you meet evolving customer needs? What value will it bring to investors and stakeholders?
You need clarity about what you’re buying – so understanding the business model of the target and how their cash generation works is fundamental. This may not be easy if the target is not profitable or even generating revenue yet. You may need new diligence strategies too. Whereas with the purchase of a traditional manufacturing company you might go on a site visit, if it’s a software company your diligence will need to be more digitally-based.
Plan your integration at the same time as you structure the deal. It’s vital to get internal stakeholders fully on board. Ensure that key stakeholders know what role they can play in bringing the new business into the organisation and how they can help it to scale and deliver on an enterprise level.
The best deals, of course, are a partnership between the two parties. The cultural and people dynamics are therefore critical. The start-up business will be looking for trusted partners, not just owners. You need to plan out carefully how the incoming business can be integrated into the governance of the wider organisation without destroying its agility and the qualities that make it what it is. This makes it even more important to engage fully with the key individuals including founders, CTO, CEO and CFO. in the target company. It’s about getting the initial pact right between management and the new company over how they are going to be brought in and how the relationship will be developed, nurtured and sustained.
Undoubtedly, there is a risk of overpaying in a frothy market especially when competing with venture capital and PE houses who may be sufficiently diversified to be able to afford to ‘take a punt’. The target business may not yet be profitable or revenue-generating – so how do you put a sensible value on it? The fundamental principles remain the same – a combination of assessing future cash flow expectations and the risks associated with achieving these. We usually see the traditional income and market multiple approaches considered, but with a number of key differences.
On the income approach, it’s not unusual to see a traditional discounted cash flow methodology based on expected forecasts. However, the approach to estimating value beyond the explicit forecast period requires assumptions to be made about the longer term and these are usually based on exit multiple or IPO scenarios. The discount rates applied are also usually higher than what might be the norm to reflect the higher risk. Most importantly, we also see much more emphasis on really getting under the skin of the forecasts both in terms of commercial diligence and also scenario and sensitivity analysis it’s vital to understand what needs to be believed in order for the forecasts to materialise and what evidence or risk there is around these areas. Getting a handle on the path to profitability and cash burn / runway as part of this is vital.
Market multiple approaches are similar to those traditionally considered for more mature assets, although in the absence of established profitability, the focus tends to be on top-line metrics such as revenue or GMV. The lack of direct comparables can make benchmarking multiples a challenge, meaning investors may need to think more broadly around value and demand drivers and how these compare to other, tangential sectors.
There also needs to be an appreciation that it may be some time before returns are seen. We may be talking about 5-10 years – well outside the usual corporate timeframe. So articulating the equity story clearly to your stakeholders and investors is vital, especially for listed businesses.
This leads us to another consideration – How will you measure whether your deal is a success? especially in the early stages? In my view, you need KPIs that enable a balanced view. So, in addition to financial metrics, consider wider factors: the degree to which the integration is keeping to plan, the number of new product introductions, the extent to which technical milestones are being met, the employee retention rate (often really significant as much of the IP will sit with people), the ability to attract new talent in as the business scales.
There are many factors to consider, it can be challenging. But for those that hold their nerve and plan carefully, technology acquisitions could unlock significant business growth, but if you approach them using old M&A thinking you won’t be able to compete with those who have adapted to the new deal environment.