It is no secret that valuations for high quality technology companies are at historic levels. This, combined with a strengthening economy, and an abundance of cash on the balance sheets of most strategic and financial investors, is helping to accelerate investment and acquisition activity. In light of this, how can middle market technology executives position their companies to be attractive to a strategic buyer or financial investor? Moreover, how can executives ensure a healthy relationship between buyer and seller, creating a solid foundation for post-acquisition success?
In this article, Alex Castelli, a CohnReznick partner and the Firm’s Technology Industry Practice Leader, and Rick Grinnell, Co-Founder and Managing Director of Fairhaven Capital Partners, share their thoughts, insights and observations about the level of transaction activity in the technology industry, in addition to key issues executives should consider in positioning a company as an attractive acquisition target and subsequently managing a successful integration.
M&A activity will continue to accelerate into 2015, as corporate buyers make strategic acquisitions to fuel future growth. CohnReznick’s 2014 Middle Market Private Equity Outlook predicted strong transaction and deal-flow in 2014, a forecast that has accurately reflected activity through the last half of the year. Many major technology companies, venture capitalists, and private equity firms have cash available and they are under pressure from shareholders and investors to utilize these assets in order to meet their investment objectives.
The latest research confirms that the current market conditions are fueling high valuations and high levels of M&A activity. Leading private equity data provider PitchBook reports that in 2014, there was an increase of almost 200% (based on multiples of their EBITDA) in the valuations of technology companies undergoing a M&A transaction. This figure is up from an average of 8.4x in 2013 to 17.1x to date this year. Interim figures from PitchBook also reflect that total capital invested is up 45% in 2014.
Technology markets go through regular cycles of innovation, and currently a number of core markets are experiencing such activity – including social media, mobile, big data analytics, cloud computing, storage, and security. “These areas continue to attract strategic investors who recognize that many times, it makes more financial and competitive sense to acquire intellectual capital and property rights in these areas than it does to build them organically,” said Castelli. He added, “Interested investors include not just traditional enterprise software companies seeking to innovate by acquisition, but also include organizations that were not previously considered technology-dependent; these companies are being driven by consumers’ growing digitization demands to purchase technology companies.”
Beyond consumer drivers, economic reasons for the current high rate of M&As include the fact that the Dow, S&P and NASDAQ are performing at or near historic highs. In addition, high-valuation public IPOs encourage valuation inflation in the private M&A market. Grinnell said, “A multiple expansion of company valuations in the public market inevitably leads to similar increases in the private investment market. Across many technology markets there’s been a rampant inflation of pre-money valuations over the last few years.”
While achieving a high valuation is desired, technology company leaders seeking investment may decide that focusing on building a strong business, rather than trying to position themselves directly for a merger or acquisition, is a reasonable strategy. Investors are interested in companies that can provide long-term, incremental revenue growth, so CEOs should set their sights on creating a successful, sustainable business. “There are measures companies can take to position themselves for sustainable success,” explained Castelli. “Foremost is to instill a focus on long-lasting growth and profitability rather than short-term liquidity. Such a strategy will inevitably make a company more attractive to investors.”
There are a number of factors that propel continued growth. The most significant boil down to two core elements: ensuring the company has the right products and services, and the right management team.
Technology: Innovate to the Top
Being in the right sector of the market – either a new technology market that is poised for fast growth, or an existing market where there is an opportunity to build-out or carve out a new segment and grow the company expeditiously – influences a company’s attractiveness to investors. However, being recognized as the most valuable acquisition target does not always come down to offering the best technology or being the best-positioned company in the market. “You’ve got to think of it through the lens of the acquirer,” said Grinnell. “It’s having the optimal product that best addresses the particular market they are interested in.”
A Powerful Management Team: The Crown Jewel
Attracting and retaining superior senior executives is critical to building a scalable business. Why? Because an experienced and well-functioning management team can address competition, respond to changes in the market and identify opportunities that drive business expansion. Companies that receive high M&A valuations are generally those that are well-managed, have products in demand, and are generating solid profits.
Castelli advises that CEOs build a management team strong enough to deliver a business model that is focused on lasting success. Maintaining the core strength of the business model can present many challenges to the senior team as the company continues to grow steadfastly. These challenges include ensuring that the business can take on high numbers of new customers or increases in revenues without suffering a decline in product or service quality, and ensuring that the company’s internal business systems are flexible enough to handle a rapidly growing customer base. The business model should provide for scalable customer and revenue growth while maintaining its integrity and providing for a solid foundation.
There are no shortcuts: to create continuing profitable growth, the whole management team must be focused on jointly creating a competitive advantage that steers the company to long-term growth. Some managers may attempt to achieve short-term competitive advantage by lowering prices or running more offers. However, such tactics generally do not improve competitive edge long-term. Competitive advantage requires maintaining a culture of continuous innovation so the business remains relevant to the market and maintains an advantage ahead of the competition not solely built on price.
Strong Internal Controls
A robust system of internal control is another important element that potential investors and acquirers will consider, focusing on the four key risk areas: operational, strategic, financial and business/entity. Investors will evaluate the integrity of the business’ data and financial information, the accuracy of its financial reporting, the security of its information systems, and level of compliance with relevant regulatory and legal requirements. Castelli summarized, “By focusing on creating a strong foundation built on rigorous internal control and processes, mid-market technology companies can ensure their assets are utilized efficiently and create an environment where the focus can be channeled to customer acquisition and revenue growth.”
How is acquisition readiness assessed?
To position a business for investment and enable it to remain relevant in the storm of constant competition, decision-makers should be prepared to articulate specific areas of the business well in advance of a discussion with an investor. Essentially, an investor would expect a solid management team to be able to readily answer questions as they relate to:
Where they fit into the market
Who their competitors are
What market needs they are addressing
Their current market share
Their potential market size
Who their key customers are, and how they are changing.
This market knowledge may also assist business leaders in recognizing when to look at making an acquisition themselves, as well as preparing to be acquired. For some mid-market technology firms, organic growth is ideal, but an acquisition may offer a way to accelerate business growth. In light of this, CEOs should be close enough to their competition, large and small, to consider building relationships with them if needed to pursue synergistic business opportunities. “The most synergistic acquisitions do not come from business brokers,” said Castelli. “The most synergistic acquisitions arise from the business owner or management team knowing the market and personally identifying targets and talent they are interested in acquiring.”
Closing a Quality Deal
Many CEOs view M&A transactions as a bridge to growing their businesses. Grinnell points to several factors that play a role in closing a quality deal and ensuring a positive working relationship and a successful integration:
Tell the truth. Be forthcoming with critical information about key assets of the business. Adhering to honesty as the best policy will earn the trust of prospective investors and effectively support building a long-term relationship.
Be open to improving the management team. Doing so will suggest to an investor that the company leader is eager to act collaboratively in the ongoing development of the company, post-acquisition.
Be realistic in forecasting sales, revenues and expenses. During due diligence, potential investors will examine the strength of the company’s prospect list. On occasion, said Grinnell, Fairhaven has interviewed potential customers that were described as about to place orders, and found them to be simply “kicking the tires in an evaluation.” Take measures to share all of the information that will eventually be proven in the due diligence process. Setting realistic sales projections will enhance trust in the CEO’s credibility and judgment.
Establish a cohesive management team. A management team that works towards the same goal will increase the likelihood of a successful integration, and thus, increase the company’s growth and value.
Ensuring the M&A is Successful After the Event
The human factor is vital in creating and sustaining a successful relationship, as post-acquisition success will largely depend upon effective communication and setting mutually agreed expectations, goals and strategies prior to the acquisition. This means compatibility between management teams is a key element in the ability to generate financial success. Business leaders should focus not only on the separate and distinct strengths of each company composing the merger – but also on their shared vision for the new organization and their collective drive and desire to deliver that vision.
What Does CohnReznick Think?
Investors are most interested in companies that can provide long-term, sustainable revenue growth. Mid-market technology companies that are well-positioned for a strategic acquisition transaction – and those that are most attractive to an investor or buyer – possess an overarching, dedicated goal of building a strong business. As that goal drives the direction of the business, it concurrently positions the company well for a merger or acquisition. In particular, investing in a superior management team, the development of relevant technology, programs that lead to increases in sustainable revenue, and establishing strong internal controls and processes will establish a business model that is both desirable to an investor and focused on lasting success.
Contact
For more information, please contact Alex Castelli, a CohnReznick partner and the Firm’s Technology Industry Practice Leader, at [email protected] or 703-744-6708 or Rick Grinnell, Managing Director of Fairhaven Capital Partners, at [email protected] or 617-452-0800.
