Between 1993 and 2000, Cisco became a role model of tech M&A, making 75 acquisitions over those seven years. At its peak, those acquisitions collectively represented 50 percent of Cisco’s revenue. We learned a lot along the way. In my previous post, I explained two of my six key principles of a successful acquisition strategy: keeping objectives consistent and understanding probability. In today’s post, I’ll describe the remaining four.
3. Option value
Another way to look at this issue of probability is that big acquirers are actually purchasing options in the future success of the acquired entity. These options tend to be worthless, but about 20 percent of the time, they produce a huge outcome.
This brings me to the point of valuation. As Chief Strategic Officer of Cisco, I was often criticized for overpaying for companies. But, if an acquirer is hunting for those 2-out-of-10 outsized returns, then the precise valuation of the two magical companies doesn’t really matter too much. Our rule of thumb was that plus or minus 30 percent was not terribly significant. This is anathema to most corporate development executives who are motivated to get “the best deal.” But, if you apply the probabilistic logic I described, you shouldn’t look for “best deal,” you should make sure you buy the “best fit.” The valuation is a secondary consideration.
The key message here is to worry less about what you pay and worry more about what the market is saying about the products and the company’s fit with your organization.
4. Aligning Incentives
Having seen many technology acquisitions over the years, I am constantly amazed how often companies structure deals without considering the key concept of aligned incentives. The most common pitfall in deal structure is earn-outs. At Cisco, we structured all kinds of earn-outs. The key thing we learned: avoid them at all costs.
The problem with earn-outs is that they create a schism right at the starting point of the two companies’ relationship. Earn-outs are typically structured with a set of metrics that create a sliding scale for the price paid for the acquired company. Post-sale, however, there is no longer an objective value metric (like stock price) for the acquired company, other key performance indicators are used to determine the achievement of milestones. These are metrics like revenue, earnings, market share, key customer wins, etc. The problem with all of these metrics is that they can all be gamed by both the acquirer and the seller. As a result, the incentives for the buyer and seller are not the same in the long term. This creates big problems in the long term.
Whenever possible, simple acquisitions using stock rather than cash are much more effective. Of course, they help retain the acquired employees. But most importantly, this aligns the incentives of both parties: Everyone involved wants the acquirer’s stock price to increase in value.
5. Buying market leaders
Corporate Development professionals are dealmakers. In the heart of every dealmaker is the desire to cut a “good deal.” But the key question is this: What is a “good deal”? All too often we think of this as buying an asset for a given value. The challenge Corp Dev professionals often face is choice. There are several companies that they can acquire: the market leader, the number two player, and then a series of tier-two competitors in the market. At first blush, we assume that given the acquirer’s distribution, if the technologies contained in the potential acquisitions are about the same, the cheaper one — maybe the number two player or the tier-two competitors — seems like the “good deal.”
All too often, however, buying the lesser players is not the right answer. Given Internet valuations, the market leader often trades at a significant premium – sometimes 5-10x the value of the number two player. So, it seems awfully expensive.
The right way to frame the question is not “how much are you paying for an equivalent asset,” but rather “how much better can the market leader perform when combined with the assets of the larger company.”
Think back to Google’s acquisition of YouTube. There were many YouTube wannabes in the market. Google could have acquired any one of them for 1/10 YouTube’s value. Instead, it paid $1.75 billion for the market leader, a seemingly enormous amount of value for a young company. But few today would suggest that it was not a good deal. Through that bold move, Google closed out that market. YouTube with Google behind it was the winner — no one could catch them.
6. Synergies, synergies, synergies
Buying market leaders, however, does not mean randomly shelling out big bucks and buying anything in sight. When paying top dollar, acquirers must ensure that there are synergies in the combination. Just exchanging stock owned by founders, employees and VCs for the acquirers stock creates no incremental value. In fact, it often detracts value because the acquired employees lose the motivation that they had as an independent company. There needs to be a “1+1=3” factor in the acquisition process.
So, what are these synergies? There are many ways in which value can be created via mergers and acquisitions. But, principally, two approaches stand out. The most important one is distribution synergies. Smaller companies typically don’t have the distribution muscle of a larger player. However, they often do have the best product. By placing the best product into a large distribution channel, massive synergies can be created.
Another path to synergies is operational synergies. Larger companies typically have scale economies that smaller companies can’t dream of achieving. These leverage points can exist in procurement of services (bandwidth, server, storage) or production scale. Acquisitions can create value by taking advantage of these scale economies.
One form of synergy that is often cited, but not captured, is cost reduction – especially through cost cutting and staffing. While cost reduction-based value can be extracted, in a fast growing environment, expense cuts are often much less relevant than the growth-accelerating synergies like revenue and operational scale. When acquisitions are justified by cost-cutting in the acquired company, that should always raise a skeptical eyebrow.
M&A can be an enormously powerful strategy, but it must be used in the right way. There are a great number of nuances that need to be understood in order to execute the strategy. Equally, there are a great many pitfalls that can destroy huge value. Companies that shy away from acquisitions because of the fear of failure could be missing massive opportunity. But, for those more daring ones, following the principles outlined above could really help in realizing the potential.
Mike Volpi is a partner in the London office of Index Ventures. He joined Cisco as Senior Vice President and General Manager of the Routing and Service Provider Technology Group and also served as the company’s Chief Strategy Officer. He would like to extend a special thank-you to Andy Rachleff who helped develop and articulate a number of these principles at a breakfast we had a few years ago.