10 Dec Why Internet and Software M&A Multiples are Always High
The seemingly and unnaturally high multiples found throughout tech M&A over the last couple of decades can seem a bit unnatural, but with a bit of technical delving it will become apparent that they have been, and continue to be logically grounded in financial wisdom and strategic insight (well…for the most part). Granted, some M&A deals become much too frothy and overpaying is not uncommon. However, almost every deal is at least somewhat rationally based in the following areas (or, at least the management somehow convinced shareholders it was a good deal).
Anytime a large, publicly-traded beast intends on merging with a smaller company, there is something calculated into the equation known as a business synergy. Synergies can be recognized and calculated in a number of ways. A synergy is anything where the combined entity is able to recognize significantly more top-line revenue or bottom-line savings than each individual company could do on its own. In essence, it’s 1 + 1 = 4.
Synergies could include any of the following:
- Marketing & Sales Synergies
- Revenue Synergies
- Management Synergies
- Cost Synergies
- Tax & Accounting Synergies
- Knowledge Synergies
In many cases companies, unless their conservative by nature, are more likely to overvalue synergies. M&A is charged in a great deal of testosterone and macho. If done right, synergies play a huge role in the amount for which software companies are bought and sold.
Build vs. Buy
Large acquisitions often involve an acquisition of technology, talent or tacit know-how. When the acquirer is unable to build, hire or acquire the knowledge organically in a quick-enough fashion, they buy it. And remember, speed always comes at a premium.
Even if the acquiring entity is sure they can grow such a division or technology internally, the threat of external entrants may force them to acquire more rapidly. There are essential three costs, each of which are significant in the build vs. buy scenario: money cost, human cost and time cost. They’re all intertwined and neither is more important than the other. The difficult part is placing specific numerical values on unknown forward-looking assumptions. The build/buy calculation represents a significant reasons software merger multiples remain higher than traditional businesses.
In growth sectors, the deals are almost always about timing. When a deal becomes strategic it either means a competitor has already entered into a particular space or will enter soon. If you compare the decision to pay a premium to a sporting event it can be very illustrative: consider a preemptive acquisition as a great offense and a strategic late acquisition as a good defense. In either scenario, the target’s value significantly increases, not because of any increase in fundamental cash flows, but mostly because of the need to win. A quote from Sun Tzu’s Art of War is helpful:
“Victorious warriors win first and then go to war, while defeated warriors go to war first and then seek to win”
In strategic moves, much of the success of potential targets is not necessarily held in the synergies or the technology itself. No, success in software M&A is almost all in the timing.
Take the aQuantive acquisition by Microsoft, for instance. It was a late-to-the-game strategic acquisition. In 2007, Microsoft purchased aQuantive for $6.3 billion in cash in a deal that never really materialized. In fact, the resulting collateral damage was so intense, many attribute Microsoft’s only quarterly loss directly to the aQuantive deal. The 85% premium spent for aQuantive was expected to bring home hoards of synergies–which never materialized. While some solely blame managerial execution foibles, timing played a huge role in the aQuantive blunder. It was akin to overpaying $100K for a home in late 2006 or 2007, right before the bottom dropped out. In short, it was terrible timing.
In hindsight, all deals in software investment banking do not result in synergistic harmonization. However, the potential to scale and recognize synergies can be done much more rapidly with an existing sales force on the ground than with some tech start-up that simply has some great technology a good base-line track-record.