Tercera’s Battle Tested Lessons on M&A (Part 1 in a Series)
Technology sector M&A is expected to rebound in 2024. If so, billions will be spent. But if history is an indicator, many deals will underperform. Tercera believes it doesn’t have to be this way. If firms approach M&A carefully, they can dramatically improve their chances of success.
The team at Tercera has several decades of experience navigating the complex journey of M&A. We’ve been buyers and sellers in a wide variety of scenarios, both as investors and operators. We’ve seen success and we’ve seen failure — and learned from it!
In this post, the first of a three-part series, we share key insights we’ve learned along the way. This particular blog focuses on the early stages of M&A – knowing whether M&A is right for you, finding and assessing targets, and crafting a fair offer.
First, Why Not to Acquire
Technology services firms seek to acquire other firms for a variety of reasons, sometimes prudent and sometimes ill-advised. Given the trail of bones in M&A, it can help to start with a reason NOT to pursue M&A. We are generally wary of acquisitions purely for the purpose of financial engineering. That might sound antithetical to a growth equity firm. However, if you look at M&A merely as a means to achieve a targeted valuation, it can degrade rather than create value.
We are generally wary of acquisitions purely for the purpose of financial engineering.
On a superficial level, M&A can seem transactional. In reality, a merger is more like a marriage. To succeed the leadership teams and (eventually) the employees at both companies need to see that the union will flourish and benefit them. This is particularly true for services firms, where you’re buying people and knowledge, not a physical asset. If the talent departs, the acquisition fails.
If the sole purpose of an acquisition is for multiple arbitrage, that becomes apparent in services companies rather quickly. Of course scale, revenue growth and profitability are important when it comes to moving up the plateaus of growth, but incompatible businesses or cultures can result in the business equivalent of organ rejection.
QUESTIONS TO ASK BEFORE YOU MOVE FORWARD
Having a strong and thoughtful reason for pursuing M&A is critical. Ideally, an acquisition should advance one or more strategic goals, such as helping your company expand into new geographies, expand its service offerings or acquire a scarce skillset. M&A can be a great method to accomplish all of these and more. However, before finding and engaging potential targets, leaders should ask themselves these questions:
- Can we address this goal organically, by building the capability internally? If so, would this be the preferred option? Or is there a strong case for paying a premium to acquire a firm that already has the capability? For instance, if you aim to develop global delivery capabilities, you may be better off building it organically if you have the right leadership and ties in that market.
- Do we know ourselves well enough to bolt on another organization? You need to have a strong sense of your own values, mission, culture, and market fit before you can determine whether an outside firm would be a good match.
- Do we have the resources to make the acquisition work? You need resources – cash, time and people – to make an acquisition work. M&A, in many cases, can be capital intensive. However, often overlooked is the time and attention it takes for leaders to find and vet the right firm, to conduct due diligence, and most importantly, to integrate the company after the transaction. If you don’t do the latter well, you’ll lose the value of the acquisition (more on this in the third blog in this series).
- Does the leadership team (and board) concur that M&A is a wise move? You must have agreement, if not consensus, that the timing is right and that the firm has the necessary resources to make it work. Without strong buy-in, you are going to push a boulder uphill and potentially justify decisions the whole way up.
WALK THEN RUN, AND AVOID GIANT PIVOTS
Once you know you are ready, our advice is to start small, with modest ambitions. Like pretty much anything in life, firms improve at M&A with experience. It’s a muscle you have to develop. In the beginning, it takes longer, it’s harder, and you’re bound to make mistakes. Acquiring or merging with a company of equal or larger size can be particularly perilous. If you attempt this with little acquisition experience, you could be putting both companies (and a lot of capital) at risk.
Experience has also shown that it’s better for firms to seek complementary skills rather than go for giant pivots. Success is rare when a firm has a strong reputation in one niche and tries to diversify into something totally different. It’s not impossible, but rare.
Experience has also shown that it’s better for firms to seek complementary skills rather than go for giant pivots.
On the other hand, adjacencies — such as verticals, technologies, or service offerings that mesh with your core business — make good prospects. For example, if you support large customers in the financial services sector, attractive targets might include firms with IP or adjacent capabilities in the same sector that can deepen and expand relationships.
DATE BEFORE YOU MARRY
You can also boost the likelihood of success by using an arrangement that essentially lets you date before you marry. For instance, a “partner-to-acquire” relationship allows you to develop a working relationship with the target firm before embarking on an acquisition. This can be valuable in helping you assess cultural fit and vet capabilities ahead of an acquisition, in addition to making integration post-acquisition go more smoothly.
There are ways to structure these relationships to make an acquisition more likely ahead of building up value in the relationship. These include joint venture agreements (JVAs) and build-operate-transfer (BOT) structures. A BOT — where a partner builds and operates a team dedicated to your company and your clients, with the option to transfer (acquire) it at a certain time — can be a very effective way to build offshore or nearshore capacity.
THE SEARCH: FINDING SUITABLE PARTNERS
There are a variety of methods for finding the right target company. The search may be more straightforward if you’re looking for scale in your core business, because the target is likely to be a competitor. If you are aligned with a specific software partner, the alliances, professional services, or corporate development leader at that vendor may be able to provide information on other partners that seek to be acquired or to merge.
The search is more opaque if your target operates in another ecosystem or provides an entirely different service. Investment banks and business brokers that specialize in small technology-services deals can help here, researching and reaching out to targets on your behalf and setting up introductory calls. These firms typically charge a monthly retainer in the five-figure range, plus a success fee. Depending on financial advisor, the acquirer may (or may not) want to seek their counsel during diligence.
EVALUATING PROSPECTS
It’s important to develop an objective framework to evaluate targets before you fall in love with anyone on the team. The figure below shows a generic matrix Tercera has used in the past, which we adapt to specific goals.
The matrix ranks prospects on eight (or more) considerations and allows each to be weighted by importance. A firm seeking to diversify its geographic reach without expanding its service capacity could increase the weighting of the first line in the matrix and decrease the second. An experienced capital partner such as Tercera can provide strategic guidance to identify the appropriate considerations and weightings, in addition to helping source and assess targets.
VALUING THE TARGET AND SELLING THE DREAM
As Warren Buffet has famously said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
How do you determine a fair price? Precedent transactions generally establish the jumping-off point. A banker or one of your investors can help you find similar companies that have traded recently to understand their multiples. It’s not unlike buying a house — you want to see what other homes in the neighborhood have sold for. However, no houses (or companies) are exactly alike. One might have a bad foundation that could require years and significant investment to fix, while another could be a pristine new build.
As Warren Buffet has famously said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Your price will depend on what you are buying, but the benchmarks will give you a starting point. (See our blog outlining factors that enhance or diminish value in a services business.)
When it’s time to create and sell an offer, structure it so the elements you are interested in remain robust after the transaction. In particular, the deal should incentivize the team to remain with the firm and keep building. There are various levers that can be used to promote this. For instance, offering stock in addition to cash can ensure that the founders remain invested in the success of their team. Alternatively, earnouts — where the acquiree earns equity or cash based on post-transaction performance — can de-risk the investment and encourage founder motivation post-sale.
Simple deals generally work better — in part because they’re easier to understand and sell to all stakeholders.
Deals tend to get complex. In our view, simple deals generally work better — in part because they’re easier to understand and sell to all stakeholders. Because services firms depend heavily on their employees to maintain and grow revenue, you need to convince a lot of stakeholders that the union will improve their lives. An experienced advisor can help the acquirer craft an attractive deal and sell it effectively.
It’s also helpful to remember (and position) the fact that the initial offer establishes ballpark expectations. A price may be adjusted to account for factors that you discover during diligence. For example, if you offered a premium valuation and in diligence discover a significant employee or customer satisfaction problem, or a weak pipeline that doesn’t justify their projections, you may need to have a conversation. The more work you do upfront, the more precise you can be on price.
Assuming you’ve found the right partner, crafted a fair and reasonable offer, and sold the team on the dream, it’s time to dive into diligence. We tackle this process in our next blog in this series, explaining how to use it to assess and cement your future partner.
