On the Inside, Looking Out

As CFOs gear up for growth, they are seeking targets that can help their companies innovate.

CFO Magazine

Sarah Johnson - CFO Magazine

March 1, 2011
After a long hiatus, companies are once again focusing on growth. But in an environment in which organic growth will be challenging and big deals may look too risky, many are taking an alternative path, exploring the acquisition of young businesses that can supply them with new talent, new technologies, and new products or services. Above all, today's dealmakers are looking to buy innovation.

Image via CrunchBaseBecause so many companies responded to the recession at least in part by downsizing research-and-development budgets and addressing short-term needs like liquidity, they are now "basically buying their R&D by buying companies they think have real potential to grow over the long term," says Mark Heesen, president of the National Venture Capital Association (NVCA).

…"For us to expect that we'll think up all the great ideas and develop them internally is a stretch," says Bruce Knooihuizen, CFO at computer-services firm Rackspace, which has acquired four start-ups in the past four years.
The idea of purchasing a market-ready new product or service has a particularly strong appeal, because it allows a company "to accelerate an R&D or product-diversification process that otherwise would take years on an organic basis," says Mat Wood, a partner in BDO USA's transaction advisory practice….
An Eye on the Little Guy
…There are several factors in buyers' favor in the market for early-stage businesses. One is that many development-stage companies have had time to gestate while waiting for M&A activity to pick up and are now ready for prime time. "From an acquirer's perspective, you've got well-trained people, developed technology, defensible patent positions, and companies becoming increasingly profitable or near-profitable," says Trevor Chaplick, a partner at law firm Proskauer Rose.

Small companies with hot technologies are also more open to being purchased rather than holding out for an initial public offering, given the challenging market for IPOs and the high bar for success as a new public company.
… It's still a buyer's market, although the distressed-firm markdown bin is not as full as it was 18 to 24 months ago.
Despite those advantages, CFOs are nonetheless moving more methodically, even on smaller transactions. …"We don't see folks rushing to the market with a checkbook to do an irrational transaction," says Steve Joiner, managing partner for the southeast M&A group at Deloitte.
Smaller, but Not Easier
…Despite their bite-sized nature, smaller deals come with challenges of their own. Less-sophisticated companies may have little-to-no revenue, unclear business agendas, and disorganized finances. They may have failed to protect their intellectual property. And they may have made concessions on agreements that will lead vendors or customers to expect new terms following a change in control.
… "The two things these companies get acquired for are things that CFOs tend to not be focused on," says Matthew Bartus, a partner at law firm Dorsey & Whitney who represents emerging growth companies. "These acquisitions are not about revenue or earnings; they're about the people and technologies." As a result, the long-term worth of venture-backed companies can be hard to determine.
Such deals can also easily fall apart. …
Jason Child, Groupon's CFO, says the company considers many things when deciding whether it should buy sites in certain regions or build new ones from scratch. "It depends on a combination of factors," he says. "How long would it take [to do the acquisition]? How closely aligned are they with our approach and our style?"
Child says one of the main issues that arises when a big company targets a smaller one is the delicate business of approaching and winning over entrepreneurs who are used to working independently. "Entrepreneurs are excited about building stuff," he says. "They are not excited about larger companies' reputation for having more processes, more constraints, and more bottlenecks."
… "When you're buying a company that's run by an entrepreneur, that person may be used to calling the shots and won't want to collaborate," says Jim Cohen, executive vice president of mergers and acquisitions at Consolidated Graphics, a commercial-printing company that frequently buys family-owned businesses.
… Inexperienced buyers often underestimate the difficulties of integrating smaller teams into their infrastructure, notes Bartus. "You can manage liabilities with escrow, but you can't address a situation where you acquire a team that won't work in the [new] organization," he says.
To keep a newly acquired staff interested, buyers might consider adding retention bonuses to earnout targets. M&A experts also suggest that buyers ensure a degree of autonomy for valued legacy employees, and recognize that those employees may expect more from the deal than a payout, however large. … "The business objectives and the personal objectives of the ownership and key managers are often intertwined," says Will Frame, managing director of Deloitte Corporate Finance.
Grab a Partner
To get a handle on the true worth of a start-up and minimize the risk of a mismatch, many corporate buyers rely on the practice of establishing partnerships with potential targets. …
Will 2011 see early-stage deal-making continue at the same pace? With caution continuing to dominate CFOs' outlook, a sudden return to giant deals seems unlikely. Yet according to the latest Duke University/CFO Magazine Global Business Outlook Survey, fully a third of the CFOs who responded plan to spend cash on acquisitions in 2011 — twice as many as plan to use cash for research and development.
So, while a strengthening economy and growing confidence may usher in some larger transactions, for now, small deals — especially if they lead to innovation and growth — are indeed beautiful.
Sarah Johnson is senior editor for strategy at CFO.

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