The technology merger and acquisition market has been quite active in recent years for medium and large companies, but the real story of how prices are determined is often a mystery. This article seeks to shed a little light on the topic for technology company owners and shareholders.
We've all seen the headlines about big technology acquisitions, such as Google (Nasdaq: GOOG) acquiring Motorola Mobility for $12.5 billion in 2011. Oftentimes with public transactions, the valuation metrics are clearly announced, frequently as a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA) and/or revenue. But what about a private technology company with $5 million to $100 million in revenue? It is not a startup any longer, but it is not yet a big company. What kind of valuation should shareholders expect in an acquisition?
There are many excellent reasons technology companies seek a formal valuation, including employee stock ownership plans, goodwill impairment tests, or fairness opinions. But they are typically not required when selling a midsized company. A company's actual value is likely to be different for each potential bidder. Each will calculate what the company is worth in a different way. However, owners can still obtain a reasonable idea of the company's worth by looking at comparable transactions to estimate a range of possible prices.
Large technology companies are often acquired as a "business" expected to drive buyers' earnings directly. They are typically valued based upon more financial metrics like these.
Earnings:
This includes EBITDA, revenue, and their respective growth rates.
Protection of earnings from a variety of threats:
The company could be in a growing market where barriers to entry are high. It could be positioned to respond to competitive pressures, as evidenced by a steady increase (or at least holding) of gross margins.
A patent portfolio that protects key IP:
The company could be protected from reliance on one or two key employees or customers. It could have high-quality engineers and managers who would stay on after the acquisition. A buyer's due diligence will often focus on ensuring that the earnings stream is protected from such threats.
But midsized tech companies are often valued differently. Oftentimes they are in growth mode, having invested heavily in R&D and customer acquisition, resulting in lower EBITDA. Usually, the buyer acquires the company for the IP, the customers, the engineers, and, to a lesser extent, the revenue. There are a number of ways that a bidder estimates what they think such a company is worth. For example, the buyer of an IP-centric company will validate that the technology really works, so it can be leveraged by the buyer to drive profits and win customers.
Buyers will often look for evidence of value in these categories.
Revenue:
Yes, buyers will still use revenue as a benchmark for valuing the company. Revenue will always be important to most buyers, but probably not as important as validating that the product actually works, and that someone is actually paying money for it.
Key customer wins:
Large strategic customers are more demanding and harder to win, and they can help iron out software bugs. Having design wins at the likes of Cisco and Microsoft would certainly look good, and winning deals only with other startups would be a red flag for a buyer.
Penetration and expertise in key market segments:
This may give the buyer an easier path to expand, for example, beyond mobile electronics and into the defense sector.
Key partnerships:
Relationships with relevant chipset, OS, application, and hardware vendors are also a value driver. If an embedded software firm has relationships with key chip/IP vendors such as ARM, TI, Intel, and Qualcomm, this not only shows credibility, but it also increases the pool of possible buyers.
Demos:
Anyone who has ever performed a technical sales demonstration of a software product knows it rarely goes perfectly. However, technology buyers often put high importance on seeing for themselves that the product really works while visualizing what else they can do with it.
A patent portfolio:
This offers evidence that the seller's IP is real and can be legally protected. In addition, frequently the buyer can use those patents as a negotiating chip with competitors, which can drive significant financial returns. In many acquisitions, patents are the biggest value driver.
Cost for a buyer to create the technology on its own:
What would it cost to hire a team of engineers and recreate what the seller has to offer? The buyer's lost opportunity costs must be considered in addition to the development costs. For example, what business or programs might have been lost if 100 engineers' time were sacrificed for two years for the program?
What is it worth to acquire key customers?
What else could the buyer sell to those customers? What are those relationships and contracts worth?
What would it cost to buy a similar off-the-shelf solution from another company?
Many buyers look to off-the-shelf solutions first. They start looking at acquisitions if they desire to own and control the solution or if there is no other solution available.
What is it worth to block competitors?
What would the impact on a competitor be if this tech vendor were acquired and its solutions were now unavailable?
Ultimately, there is no cookie-cutter formula for determining real value in the market. The best way for owners to get the most value is to receive multiple competing bids, ideally at the same time. Each potential buyer has its own holes it is trying to fill, its own views about competitors, and its own predictions about the market's direction. A good technology M&A adviser who understands the target market can facilitate this process and achieve the highest value and best terms in the sale of the business.
I do expect to see this trend continue more or less indefinitely. Many chip companies like Texas Instruments and Intel, and IP firms like ARM and MIPS have very well-cultivated ecosystems of third party software partners. It doesn't mean that semiconductors will or should acquire all these partners. But often times they go into a big OEM lacking some sort of software and it's not enough to refer the customer to a 3rd party. Maybe this big OEM customer has a very important high-volume design planned, and they want "one throat to choke" with the chip vendor and software solution. Often they want one entity to own both silicon and software. This will often drive chip companies to acquire software partners to bring the capability in house and better support big OEM customers.
Brent, Thank you for the additional perspective. In your opinion, with regard to the semiconductor sector, do you see in future many more strategic acquisitions as companies in the market expand offerings? I ask because for chipmakers, it is becoming obvious that supplying only hardware (silicon) is not enough. OEMs now want more and would prefer chip vendors that have embedded software applications in their hardware offerings.
If this is the case, I guess we should expect more of the small to mid-size acquisitions that you've discussed in your postings.
Thanks for the comments. You are right that while the focus of my post was about mid-sized companies, looking at the big deals is always interesting. One way I look at acquisitions is sort of binary - a financial aquisition or a strategic acquisition. (The reality is that most deals are a mixture of both.)
You mentioned Freescale and NXP acquisitions, both of which were acquired by private equity and later taken public. Deals like these, where a larger company is acquired by private equity, are typically financial acquisitions. Meaning, they take over the company, restructure it, hopefully make it more profitable and attractive, and then sell it either to a strategic buyer or sell it by taking it public. Sometimes they win, sometimes they lose, but that is all part of the business model of private equity.
Of course not all financial acquisitions are done by private equity. All that it means is that one company acquires another company where the key interest is the profitability of the target, as measured by EBITDA typically. (Earnings before Interest, Taxes, Depreciation, and Amortization).
A strategic acquistion is where the buyer can take the seller's offering and leverage it in a lot more places. A good example of this is my blog from last week, about chip companies acquiring software companies. For example, maybe a processor company acquires a company with a graphics software development engine. The buyer can leverage the tool kit across dozens of product lines, earn more design wins, and ultimatley sell more chips and make more revenue. So the acquisition is strategic in nature rather than financial.
But again, most acquisitions, especially mid-larger ones, are a mixture of both strategic and financial interest.
Brent, Many of the additional factors (beyond the typical sales and profit metrics) you discussed as being critical factors that weigh in when a company's value is being determined seem to come down to goodwill, that vapor-like essence of what makes a company different from the competition.
I certainly agree with you that the potentials of the company, its likely market size and position, current market standing and ability to penetrate deeper, the value a potential purchaser places on its essential employees and the buzz it creates in the market place deserve a premium. Assigning a value to these factors is often very difficult and sometimes the wrong value is placed on these - up or down.
I recall AOL's reverse-acquisition of Time Warner years ago (it was a burst for the buyer -- in this case Time Warner's shareholders) and the foray of some leverage buyout specialists into the semiconductor market in the last decade. These include the purchase of Freescale and NXP Semiconductor. The buyers lost their shirts and it's not clear how they've made out years later.
But these are bigger companies and your blog was about mid-size entities. Often, the valuation comes down to the gut feeling of the lead acquirer. If it feels like the fit is right, in terms of the product, and the corporate culture is equally correct, then the premium goes up. If these don't fit, a potential buyer should walk away notwithstanding the value and price of the target company.
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Peter Drucker famously said "Trying to predict the future is like trying to drive down a country road at night with no lights while looking out the back window." Yet in the razor's-edge world of electronics—with a lean supply chain and just-in-time demands—the need to know the future is vital.
You've heard the saying "the No. 1 supply chain risk is your people." That hasn't always been the case. But today's complex global supply chain requires a new type of multitalented employee. It's one who understands, finance, marketing, economics, is savvy with technology, graceful with relationships and can think analytically.
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