Confessions of a Corporate Dealmaker

Valuation Round III - How the Buyers Do It

Since it's Friday afternoon and I'm sick of hearing myself write, I thought I would give an inside look at how two of the largest and most active technology acquirers view valuation.

First up is Brian Roberts former VP and head of Microsoft's Global corporate development organization.  Brian is now with San Francisco-based Evercore Partners and is a good guy to boot.

CCD: Brian, MSFT completed over 50 acquisitions while you ran corporate development, how did you approach valuing targets?

BR: We used a combination of techniques and then applied judgment to form a valuation opinion of a company or asset.

CCD: Which techniques did you use?

BR: One of the most powerful techniques used was to develop a free cash-flow differential between the buy and build cases.  We then could value the discounted cash flow benefit of the acquisition vs. standalone cases.

CCD: There certainly must have been cases where the cost of building would have been difficult to calculate or just too restrictive? 

BR: Even in situations where we did not plan to build, creating the analytical framework often improved our understanding of the technical, marketing and sales requirements and could even impact the stand-alone valuation of the target.

Second is a recent quote from the EVP of Corporate Development at a $7 billion Silicon Valley tech company which is also an active acquirer:

For acquisitions valued at $300 million or less, ... we determine what the valuation would be if the business went public and then apply a 20% discount.  Our own [trading] multiples become the ceiling on what we're looking to pay out there.

Why They Leave

Here's a bonus track for today.

Over the last few years, and especially since I started this blog, I have talked to a number of people who used to work in corporate development.  I always ask them why they left.  I think I have finally reached a statistically-sound sample size, and can tell you that the overwhelming majority of people who leave corporate development do so because they completed no deals during their tenure with the company.  It's not that they didn't complete enough deals, it's that they couldn't complete any deals.  Further, all of these people tell me there was plenty of deal flow, and they often signed LOI's and negotiated merger docs.  It's that their company's didn't have the cajones (thank you Guy) to close the deal.

Before you sign that LOI check your potential acquirer's track record, but more important look into the management team's record.  Does the acquirer have a new CEO or CFO (or even CIO) that has never done an acquisition?  What about their board - do the new members have acquisition backgrounds?

M&A is risky.  It takes a certain kind of management team to do deals.  Don't get pregnant and left at the alter.

Due Diligence & Integration

Last week I discussed how the deal screening process works, and with this post I'll finish up this series that looks inside the new corporate development function, by providing an overview of the due diligence and integration teams and committees.  In a future series I'll write about the tactical things you can do to make your company more attractive from a screening, diligence and integration standpoint.

Due diligence hasn't changed much over the years, but two trends I see more of these days are larger, multi-disciplined teams; and the use of due diligence committees.  It used to be that an attorney, banker, accountant and a couple of people from the company would sit in a law firm's conference room and wade through boxes of documents for a few weeks.  Now, there tends to be a lot more operational people involved, and since many of the data rooms are virtual, it's much easier to directly include several ops functions.  Use of a diligence committee also seems to be gaining popularity.  This committee is made up of C-level execs and business function leaders from the due diligence team.  The committee meets regularly to review the status and findings of diligence, and to ask "hard" questions.  Often this committee has built-in stops, or pre-determined times where the members must discuss or vote on whether or not to move ahead with the transaction.

Integration hasn't changed much either, but it's planned for much sooner than in the past.  Integration used to start right after the deal was signed, as it was commonly referred to as post-merger integration or PMI.  Everyone now talks about how critical pre-merger integration planning (PMIP I suppose?) is.  Thus the integration team and committee are put into action at the same time due diligence commences.

Here's what you need to understand as an entrepreneur.  First, both teams (diligence and integration) are often staffed by the same people - that's not new, as for years diligence teams morphed into integration after the close - what's new is that they now do diligence and plan integration at the same time.  Believe me this really changes the flavor of due diligence, in addition to making it take longer.  Second, this is extra credit for the operational members of the teams.  They all have primary job responsibilities to get done as well, and they were all probably told, not asked, to be on the team.  So do yourself a favor, and treat them with the utmost respect and courtesy.  Remember their names, offer to get Starbucks not the stuff in the kitchen, walk them to the restrooms instead of providing directions, laugh at their jokes and listen attentively to the same stories they told you yesterday.  Due to the committee system, these people now have power!

Corporate Mating Season?

Stacey Higginbotham, in today's TechConfidential post, and this InfoWorld article (which is based on an IDC report - I don't have the link, but how's that for three degrees?) bring up some good points about IT standardization and merger integration.  Two take-aways for entrepreneurs, especially at tech companies:

1. While it is important to know what your potential acquirers' run under the hood, don't get too carried away.  They probably all develop on different platforms, and the minute you switch they probably will to.  That said, if you find everyone in your segment is standardizing, then you probably should to.
2. Here's the bigger problem (particularly for software companies) - you're too smart, and for some reason (cost, pride, competition, too much time on your hands?) you'd rather build business process applications than buy them off the shelf.  The only secret sauce at your company should be in the product(s) you sell.  I've seen home-made accounting, billing, CRM, work-flow, SFA and HR systems to only name a few.  They may work great for you, but for me they're an integration problem [read: your valuation is going down].

By the way, don't make the mistake of building the value of a non-core, home-grown application into your valuation case.   I will agree with you as to its monetary value, then announce we're doing an asset deal, carving out the IP around the app, lowing the valuation by the agreed value of the app and letting you and your VCs keep it.  I have yet to have any takers, so we've all agreed that the app is really worth nothing and the valuation goes down anyway.

Deal Screen Part III

Many companies, along with their boards, have begun creating acquisition parameters or a set of boundaries for their acquisition strategy.  While I don't think understanding these parameters is as important as gaining clarity on would-be acquirers' strategies, it may impact how you position your company for a sale.  Plus, it may make you reconsider which companies are viable acquirers.

Examining a buyer's past acquisitions should give you a good idea of where they would like to play.  To give you examples of the types of limits you can run into, I've spent some time this week talking to three corporate development colleagues from the software industry.  Their companies are all public but vary in size and market segment.  Here is a sample of what they had to say about acquisition parameters:

Company #1: "We're a company that's about products not technology, so we look for acquisitions that are proven in their markets.  Most of our acquisitions have been in business for at least of seven years.  We believe that's the amount of time it takes for a product to be mature enough to live without its management team.  Size isn't an issue to us - we're not afraid to do large deals, and our smallest deal was around $25 million - I can't imagine going any smaller.  Every deal goes in front of the board no matter the size.  They may not vote on it, but they want to know what's going on.  We use both stock and cash depending upon circumstances, FAS 141/142 has made using stock a lot easier.  Valuation is our biggest issue, we will never pay a higher multiple than where we trade.  We are very patient - we walk away from about two-thirds of the deals we're interested in because of valuation.  We've never done a cross-border deal, but targets with a strong presence outside the U.S. are more appealing to us."

Company #2: "We limit our acquisition size to 10% of our market cap per deal.  Our board is pretty stringent on that.  They've shot down a couple deals that would have gone beyond.  We don't have any valuation parameters per se.  We work with the target's management team to develop of plan and base the number off that.  We can be pretty aggressive if we feel the team is energized by the plan.  Too often we see management teams completely burned out by the time they show up.  We walk from those deals - we want people who are still hungry.  We prefer to buy local [Silicon Valley].  We want everyone in the same building - that's important to us."

Company #3: "Mid-sized acquisitions ($250 - $350 million in value) are our sweet-spot - we're committed to doing one a year.  We're moving away from the small stuff.  In the past we've bought too much technology and not enough market share.  We need immediate impact, the Street wants numbers not promises.  We've never used our stock for a deal, and I don't see that changing.  Our #1 rule is that you must beat us at least once in the market place to get bought.  I spend an enormous amount of time with our sales managers finding out who customers are considering using and why.  We look at public comps for valuation, but for the most part we stick with the multiples we've paid in the past - we know they're right."

The Deal Screen Part II

Your exit goal as a venture-back company is to be bought not sold.  Holding the top spot on several acquirers' target lists is the best way to achieve that, and it makes getting through the deal screening process much easier.  Understanding the acquisition strategies and parameters of your potential acquirers will help you to begin positioning and preparing your company to make it to the top of the list.

Gaining this intelligence is not that hard, but I find very few small companies take the time or have the discipline to do it.  Here's how it's done.

Take our merry band of managers from yesterday's post, they had no idea what eBay's acquisition strategy is, but they should have.  Take the low-hanging fruit first - enter "eBay's acquisition strategy" in Factiva or Lexis-Nexis for the last two years and you will see 62 written articles.  Now google eBay and "acquisition strategy" and you will get 26 results.  Check the earnings call transcripts, especially after a big acquisition.  Research analysts will usually ask several questions about how the acquisition fits into the strategy.  Next, find the press release about the company's Analyst Day, as it usually lists who attended from the research community.  Then call an I-banker from those firms and get each of the research reports from Analysts Day, they usually have a paragraph on acquisitions.  Also, ask the banker if he or she knows the strategy.  Often times they have met with the company and know exactly what the strategy is.  Keep digging and pretty soon, I guarantee, you will have a very clear picture of your potential acquirer's strategy, as well as, a wealth of knowledge on their operations, strengths and weaknesses.

Take that cobbled together strategy and ask yourself honestly does your company fit within it?  What changes does your company need to make to be more attractive to the acquirer?  What are they trying to accomplish with acquisitions?  Does your company solve their stated problems and help them reach their stated goals?

The Deal Screen

This week's focus is on the how the corporate acquisition process has changed within the last three years.  The primary changes have been brought about by the tech bust, FAS 141 & 142, SOX and some of the recent corporate scandals.

Within the corporate acquisition process, there are three main committees and teams - screening, due diligence and the integration.  I'll look at the screening committee today.

Deal screening used to be a one-person affair - usually the CEO would take a call from another CEO or intermediary (banker, board member, VC) and decide whether or not to proceed.  So your relationship, or that of your intermediary, with the CEO of a potential acquirer was extremely important.  This certainly led to conflicts of interests and some deals that should have never been done.  Today, many acquirers use a deal screening committee and formal process to adhere to their acquisition strategy and parameters.  This committee usually meets once or twice a month and consist of the C-level execs, BU heads and the corporate development team.  They look at any deals that have come in unsolicited and discuss proactive attempts to contact pre-defined targets.  No deal process can start until the committee "green-lights" it.

As an entrepreneur why does any of this matter to you?  Well, let me give you a good example.  I met with a start-up in November that had a decent product, good niche and was getting some traction in their market.  They had raised a couple of rounds of funding, had hockey-stick projections and talked about an exit within three years via sale or IPO (don't even get me started on the IPO stuff).  For better or worse, it seems that the only viable buyer would be eBay, to which I agreed.  The problem is that when I asked them to name all the companies that eBay has acquired, or the multiples paid, or the smallest deal size, or the business model of each acquisition or the structure of each deal they hadn't a clue.  But, one of their VCs knows Meg Whitman!  And LinkedIn tells me that I'm actually only three degrees separated from Kevin Bacon - big deal!  If the extent of your preparation for a sale is that your VC knows someone, you're in trouble.

So we rolled up our sleeves and did some work.  First I brought their projections down to something slightly more realistic and figured the amount of funding it would take to get there.  Then I got some data on eBay's past transactions.  Bad news - when I applied the revenue multiples from eBay's three smallest deals (in terms of revenue not consideration) to the future time when our company thought it would hit those revenues, not only didn't they beat their liquidation preference, but it meant running the company a lot longer than they had originally thought.  Reality sucks!

Good Question, Bad Answer

A CEO emailed regarding yesterday's post wondering what I meant by, Before moving forward with an outside opportunity, the corporate development team must show that it has compared the deal to other possible transactions or options.  This is a great question, and one I would rather not answer.  However, given that the whole reason for this blog is to share an insider's view as to how corporate acquisitions are done, here goes.

This is an old trick that has been rejuvenated because the strategy and specifically the deal sourcing processes have gotten so strict.  So, let's say you've decided to proactively sell your company, hired a banker who made a pretty book and sent the book to me - the corporate development person at some big, public technology company.  You of course have had me sign some sort of confidentiality agreement.  The good news is that your company fits within my company's acquisition strategy, parameters and is even on our target list.  Here's the bad news - your company is actually number three on my target list, with your two biggest competitors ranked higher based upon our internal intelligence and assessment.  Now, because my company's deal screening committee has adopted this process of comparing deals sourced from the outside to other transactions and alternatives, I am required to contact your two top competitors to see if there is a better deal to be had.  After all, they rank higher than you do.

Wait you say, you signed a CA or NDA or something like that.  Yes I did, and I am very careful not to violate it by even mentioning your company.  Also, since I have established a previous dialog with the CEOs of your competitors regarding an acquisition, partnership or alliance and told them I would be regularly checking in with them, contact regarding a potential sale is not outside my normal business practice.  The fact of the matter is that selling companies and their bankers are almost always completely naive that this even happens.  The other truth is that nearly half the time your competing CEOs have a copy of your book sitting in front of them when I call - which you probably didn't want - and suggest that I then give you a call!

I'll address confidentiality agreements and the things you can do to avoid this scenario in a later series along with a series on the selling process.  I hope this helps, and please let me know if there are any other topics you would like me to address.

Who the Players Are

Because the corporate acquisition process has changed, you as an entrepreneur need to understand who the new players are and how the process works now in order to better navigate.  Today's post will look at the new and most influential players within the corporate acquirer.

So if you read yesterday's post, you know the investment bankers and research analysts no longer influence (read: force-feed) acquisitions that a company might make, the global equity research settlement of 2002 took care of that, and CEOs no longer champion deals, the Sarbanes-Oxley Act of 2003 took care of that, so who is getting all of these deals getting done?

The new deal champions, if you can even call them that anymore, are the head of corporate development and the head of the business unit in which the target is going to be integrated.  Because these two people will have significant staff investments in due diligence and integration, they are now the most influential in getting the deal done.  Yes I know the CTO and the HR manager are very important in getting the deal done but not as important as these two people.

The goals of the BU head are centered on revenue and margin growth - acquisitions provide a way to quickly give existing customers the new features they want, win new accounts and cross-sell.  Successfully garnering an acquisition also gives the the BU head a lot of positive visibility within the organization.  These people are risk takers who are looking to move up.  I know this because I've worked with many of them.

The goals of the corporate development officer are much different.  They usually want to keep their job, do a handful of good if not great deals every year and get a bonus, maybe even a raise, at the end of the year.  Acquisition mistakes, write-offs and meltdowns jeopardize all of these, so this person tends to be risk adverse, yet very diligent and careful with a great attention to detail and process.  I know because this is what I do.

Your goal should be to make your company very attractive to the BU head and me from several perspectives: strategic, due diligence, valuation and integration.  The higher you rank in these areas, the more of an asset you are (BTW - yes I do rank all deals in these areas).  Figure out how your company can achieve a high ranking, how you can best position your company, how it can become easy to integrate and how you can make my job easier.  Look, I don't pay the highest multiple for the target that is the most strategic or has the nicest projections or prettiest book.  I simply pay the highest multiple for the highest grade - it's a risk reward relationship for me.  The higher the grade, the lower the risk, the bigger the potential reward for both of us!

Tomorrow's post will look at how the process has changed within corporate buyers and the current acquisition climate.

This is Not Your Father's M&A Transaction

Corporate dealmaking in the old days (pre-2002) was a lot different, I know I was there - CEOs called all the shots, championing deals along with their investment bankers and sell-side research analysts.  Acquisition strategies didn't exist - things were changing too fast, valuation was an ever-changing art, due diligence a formality and integration irrelevant - acquired companies were better off left alone.  Synergies were most often revenue related - companies didn't buy other companies to enhance their products (that would be an admission of inferiority), they bought complementary products and services in areas they often knew little or nothing about.  Corporate boards seldom asked any questions, and there was no accountability after the close regarding the claims and promises made along the way.  In short, deals were opportunistic not strategic.

We've come a long way in a very short time - written acquisition strategies are prevalent among most public tech companies today, and these strategies rely on the input, knowledge and ideas of numerous senior managers throughout the corporation.  The strategy process often identifies and ranks targets in addition to establishing valuation parameters.  Potential deals coming from outside the company are vetted against the strategy and target lists prior to consideration.  Before moving forward with an outside opportunity, the corporate development team must show that it has compared the deal to other possible transactions or options.  When the acquisition process starts, integration planning also begins, with lengthy discussions on how to achieve cost synergies.  Due diligence is much more tactical, with walk-away points built into the process.  Boards are more involved, even on smaller deals, with some setting up M&A committees.  Boards are informed earlier and on a much more frequent basis about acquisitions in progress.  Board members ask difficult questions and review diligence findings and integration plans prior to closing.  CEOs are no longer the champions of deals, but instead gatekeepers, making sure that everyone has performed their roles adequately.  Even Wall St. analysts are pushing for more specific post-deal milestones and post-merger segregated reporting and transparency.

Are you, your board or your investment bankers prepared for this new process?