Imagine this: You build a tech company with lots of happy customers and an enterprise value of 1.0 times revenue. So you challenge the sales team, the company doubles its top-line revenue and achieves an enterprise value of .75 times revenue. Or less.
This may sound ridiculous. But it happens all the time.
Take a look at Cisco over the last decade. On July 31, 2001, the company’s fiscal year-end sales were $22.3 billion, and its stock traded at $19.22 ($18.94 adjusted). With 61,467,392 shares outstanding, Cisco’s enterprise value was $85.2 billion. On July 31, 2011, Cisco’s year-end sales were $43.2 billion and its stock traded at $15.97 ($15.85 adjusted). With 66,850,160 shares outstanding, Cisco’s enterprise value had fallen to $60.2 billion.
So over the span of 10 years, Cisco’s sales rose nearly 94 percent while its enterprise value actually declined 29 percent.
Cisco is not alone among legacy technology companies. Do the same calculation for any number of them and you’ll get a similar result.
Sales don’t create value, what you do creates value
How can it be that a successful company with seemingly healthy revenue growth can decline in enterprise value? The answer is increasing sales alone rarely translates into value.
Because when it comes to value, what you do matters – the business you’re in, the markets you serve. And while sales growth is important, revenue mix and profitability also matter.
There is one more thing: the enterprise value of your company is based not just on past performance – a fact that Investors in the public market are continually reminded of. To owners of privately held mid-market tech companies, let me remind you: Past performance is no guarantee of your company’s value to a potential acquirer because value is also based on what that company can do with your collection of assets going forward.
That’s one reason why IBM’s sale of its PC division to China-based Lenovo was so successful. It freed capital for IBM to continue its shift from selling low-margin, commodity products to high-value services. Plus it gave IBM better access to the fast-growing Chinese market. At the same time, Lenovo gained the opportunity to expand beyond China and according to Gartner [http://www.gartner.com/it/page.jsp?id=1893523] is the second-largest PC maker in the world. [Note to editor: This report is more current than the one originally included – current for Q4 2011, reported in 1/12.]
In the packaged foods industry, that’s one reason why Procter & Gamble’s sale of its Jif peanut butter and Crisco brands to jelly maker J.M. Smucker & Co. made sense. Both companies were executing on strategic decisions – one to exit a struggling business and the other to expand into complementary businesses.
Now, back to mid-market tech companies. Ask their owners whether they are building their businesses so they can enjoy a certain lifestyle or to create tangible assets with value that can be sold. Chances are they will tell you the latter.
However, most of the owners I meet take daily actions that erode or even destroy value.
Often this hits them in the face like a two-by-four when they decide to sell the company. They look around and see younger companies with lower sales selling for multiples of revenue. Then they discover their companies are only worth a discount to revenue.
I know this firsthand after nearly 15 years of working with buyers and sellers of tech businesses as an M&A advisory to midmarket technology companies in IT outsourcing and managed services. Since 1997, my firm has completed more than 100 transactions in six countries. From that experience, I have created the top five things that destroy value in companies:
1. Opportunistic acquisitions
Let me start by saying this: Most acquisitions don’t work.
Most companies don’t know how to integrate acquisitions, because most companies don’t know what they are actually buying. Even more do not know how to leverage those acquisitions into future value – even when they are part of a strategic growth plan. Think about when HP bought Compaq.
It’s even harder when an acquisition occurs because a company is presented with an unexpected “opportunity,” and management decides it’s just “too good to pass up.” In these situations, most management teams are too intoxicated by the possibilities to see the pitfalls.
They would be well served to take a deep breath and think it through – especially hearing out all the naysayers – before they write a check.
In 2000, AOL bought Time Warner for $162 billion. News of the merger – the largest in corporate history – sent Time Warner’s stock up 39 percent. AOL stock was flat that day. But the deal fizzled out. Nine years later, the two companies split.
On this deal that was “too good to pass up,” both companies should have passed.
2. Growth for the sake of growth
Conventional wisdom is that businesses must grow or die. In reality, there are businesses in every industry and every locale that never grow beyond a certain size. They are usually run by owner/entrepreneurs who want to be their own boss.
But when it comes to creating enterprise value, the “grow or die” conventional wisdom is right. There is a catch, however. Growth simply for the sake of growth is not enough.
Many companies are lured into growing revenue by pouring resources into the markets of today, the now markets. While it may seem smart – and it always seems safe and familiar – it’s actually a high-risk game. Today’s markets, especially in technology, can rapidly give away to new markets. And businesses cannot ignore new markets because that’s where tomorrow’s growth is going to come from.
As hockey great Wayne Gretzky said, “A good hockey player skates to where the puck is. A great hockey player skates to where the puck is going to be.”
A classic example is Sun Microsystems. Once a high-flying Silicon Valley titan – a company known as the hardware supplier to the world’s most demanding Internet companies – the company was hit hard by the bursting of the dotcom bubble. By December 2001 the company’s stock price had dropped to less than $10 a share from its all-time high of around $100 a share. Along with the rest of the industry, Sun spent the next six years or so struggling to regain its stride and by November of 2007, its stock price had reached $20 a share.
At this point, Sun made a fatal mistake. Instead of refocusing the company on software – the future – and especially on making its powerful Solaris operating system available on industry standard, smaller, cheaper hardware – the company stubbornly maintained its allegiance to its own proprietary, high-end hardware.
Two years later, in April 2009 (deal closed January 2010), Oracle acquired Sun in a fire sale for $9.50 a share in a transaction valued at $7.4 billion, net cash and debt, $5.4 billion.
3. Weak balance sheet
Let me state the obvious. Owner/operators creating enterprise value who consider the balance sheet impact before every major business decision is made create stronger, more stable, more valuable businesses.
And those that don’t? They are usually the ones eroding value because they aren’t weighing financial metrics beyond revenue and profitability. They haven’t really thought through whether they have enough working capital or, even more fundamental, cash flow.
Simply put, the marketplace will recognize more value in the company that increases the value of its balance sheet or at least is aware of its implications. This signals sophistication.
That sophistication starts with a kind of clairvoyance. For example, the best time to get money is when you don’t need it. And there are two ways to get money – borrow or raise it from equity investors, typically institutions.
The advantage of borrowing money when you don’t need is that it helps utilize your lines of credit and assets to the fullest. Raising equity funding when you don’t need it makes sense if it’s “smart” money – money from investors who can help you grow.
4. Convoluted ownership structures
For a variety of reasons, some companies have convoluted ownership structures. In fact, show me a family-owned business and chances are I will show you a complicated ownership. Or show me a roll-up company built over time through opportunistic acquisitions where owners came together in shotgun weddings, and chances are I will show you a convoluted ownership.
Regardless of how companies arrive at them, convoluted ownership structures can lead to conflicting goals and squabbling. They can also create complicated voting rights that make it difficult to make decisions in any reasonable time or sometimes even at all.
Once our firm worked with a company whose ownership was divided 49.9-49.9-.02 between three individuals. This created a situation in which the two 49.9 percent owners were forced to constantly lobby the .02 percent owner for support. At one point in time, the company turned down acquisition offers of $50-70 million. Over time, the company’s asset-value diminished to the point of bankruptcy. If one owner had had 51 percent — that is, ownership control – the company would have been sold. Instead, the minority shareholder controlled the company, and they missed their window.
The moral of the story is this: there will almost always be a buyer for your company. It’s up to you to structure ownership so it can be sold.
5. Missing the window on a liquidity event
It’s well understood that acquisition windows of sale opportunities open and close based on economic conditions. It’s also true that they depend on the maturity cycles of industries and market segments.
But here is something many business owners don’t consider: the first acquisition in a market usually realizes the highest valuation.
As a hypothetical example, if Oracle buys your competitor to leverage a complementary product or service across its sales force as well as partner and customer relationships, then Oracle has made its play in that segment. That reduces the value of all the other companies in that segment.
In fact, our research shows that the first acquisition in a segment can reduce the value of the second by as much as half.
Case in point: One IT services company we sold just 36 months ago at 8 times trailing revenue to an overseas niche buyer now trades at 75 percent revenue. It pays to be first. And once that first mover advantage is gone, it’s gone forever.
As we like to say, “If you snooze, you lose.”
Marty Wolf is Founder and President of Martin Wolf, a leading middle market IT M&A specialist. Since 1997, he has guided buyers and sellers in the IT Services, Business Process Outsourcing, Supply Chain and Software industries through more than 100 transactions, including divestitures of Fortune 500 divisions. Marty also serves as a trusted advisor to CEOs of select IT firms on M&A strategies.