The recent plunge in the dotcom sector seems to be doing for mergers and acquisitions what Ally McBeal did for the miniskirt. With planned IPOs being pulled in record numbers, and with share prices dragging like the muffler on a Yugo, acquiring technology companies is suddenly back in style.
The irony of this trend is not lost on Michael Heller, chair of the emerging business and venture capital group at Philadelphia law firm Cozen & O’Connor (www.cozen.com). “It’s only in the last few years that the tech market has gone from acquisition as an exit strategy to IPO as an exit,” Heller says. “Now, I think acquisitions will play a huge role in the tech industry again.”
The numbers tell the tale. In the first 10 months of 2000, companies initiated 2,019 technology-related M&A deals, worth $573 billion, according to Broadview International (www.broadview.com), a global information technology M&A adviser and private equity investor.
For the acquired, a buyout offers survival and much-needed capital. For the purchaser, there are two reasons to buy someone else’s science. “One is to acquire technology that can be incorporated into existing product,” notes Michael Ashby, vice president of corporate finance at San Jose, California-based Cisco Systems Inc. (www.cisco.com). “The second is to buy technology that gets you into new markets.”
Obviously, purchasing a company — and its technology — to gain a foothold in an unfamiliar market represents a serious gamble for the buyer. It also represents a serious professional challenge for the buyer’s CFO. Generally, CFOs oversee the M&A process because of their finance expertise and deal-structuring skills, not because of their knowledge of mass spectrometry.
Therein lies the rub. Assessing the merits of a high-tech takeover target often takes a CFO into unknown territory. For one thing, a finance manager must have some understanding of how a technology works, no small task in this age of micro-photonics. In those sectors in which a dominant technology has yet to emerge, the task gets even more complicated, forcing a CFO to examine competing, often bewildering, technologies.
What’s more, good science doesn’t come with a warranty. Even the most promising high-tech products have unforeseen glitches. Deployment goes slower than planned. Competitors claim copyright infringement. Batteries are sold separately. Worse, innovative solutions can get surpassed by more-innovative ones — call it the buggy-whip syndrome. And superior technologies may lose out to inferior ones.
Beyond technology concerns, CFOs must assess the human element in a high-tech takeover. Culture clashes, common in traditional acquisitions, take on new meaning in the technology sector. A botched integration can lead to an exodus of highly skilled, highly prized, and highly strung programmers, PhDs, and engineers. In the early days of an acquisition or merger, such a walkout can be a disaster. Loss of key employees can seriously hamstring an acquirer’s ability to generate a decent return on its money — let alone meet its hurdle rate for investments.
Less Than Zero
Few CFOs know more about the perils of high-tech acquisitions than Cisco’s Ashby. In fiscal year 1999, Cisco bought 24 — count ’em — 24 companies. The networking giant expects to acquire another 25 to 30 during the fiscal year begun August 1. Ashby himself is the former CFO at Cerent, a network equipment specialist acquired by Cisco for $6.9 billion. “An acquisition at Cisco is not an event,” he says. “It’s a business process.”
As such, all acquisitions at Cisco follow the same template. The minute a deal is announced, departmental SWAT teams begin to hammer out the integration issues. “Well-prior to the closing of the deal, every employee [at the target company] knows what his or her role, salary, and benefits will be,” notes Ashby. “Integration takes place on the day of the close or as soon after as possible.” Cisco’s top priority is to retain the intellectual assets of the acquired company — its workers. “Cisco approaches every acquisition intending to keep all the employees,” says Ashby.
He’s not kidding. When Cerent was acquired in August 1999, the company had 370 workers. Today, Cerent’s staff of 700 includes 359 from the original group. Conversely, acquisitions of more-traditional brick-and-mortar companies are often followed by downsizings and layoffs.
“Intellectual capital is spread as thin as real capital right now. Perhaps thinner,” notes Herbert H. “Woody” Davis, who has participated in almost 200 mergers and acquisitions as leader of the M&A practice at Denver law firm Rothgerber, Johnson & Lyons LLP (www.rothgerber.com). “Buying talent is almost as important as buying assets and revenues in today’s world.”
Cisco’s approach seems to work. Overall, first-year worker turnover at Cisco acquisitions averages 2.1 percent. In the world of high-tech talent, that’s equivalent to several degrees below zero.
Help Me, Mr. Wizard
Unlike Ashby, few CFOs have the benefit of bi-weekly acquisitions to hone their buying skills. Ask Randall Bolten, CFO at B2B specialist BroadVision Inc. (www.broadvision.com). In April, the Redwood City, California, company acquired publicly held Interleaf Inc. (www.interleaf.com), an e-content specialist. The $852 million deal was a first for BroadVision and its CFO. “I had some on-the-job training here,” Bolten concedes.
Still, Bolten is no stranger to technology gambles. He joined BroadVision before it had a cent of revenue, eventually helping guide the ecommerce software vendor to profitability within two years of its 1996 IPO. But black ink and a hot stock carry a downside. Bolten says he spends a lot of his time fending off pressure to buy companies. “In every investor one-on-one,” he says, “I’m asked what our acquisition plans are.”
Bolten eschews the idea of takeover as a financial engineering strategy, noting that even with the slide in dotcom issues, valuations — and prices — are sky-high. “We’re reluctant to buy something simply because it will make us look better to Wall Street,” he says.
BroadVision has acquired a few small service companies, but tends to partner to round out its product list. Building technology from scratch, Bolten explains, takes time — not generally an option in the light-speed world of ecommerce. Partnering, however, reduces time to market. And the buddy system has an added attraction: Partners often bring along an established customer list.
So why did BroadVision’s management decide to purchase Interleaf? According to Bolten, company executives concluded it would take two years to develop technology similar to Interleaf’s extensible markup language-based software. And Interleaf’s XML-based applications offered BroadVision an entree into new markets — namely, the wireless Web, as well as B2B applications, which often depend on exchanging standard documents.
Thus the acquisition satisfied an immediate need, and gave BroadVision a stepping stone into a burgeoning sector. “If the price is right, you’re better off buying,” Bolten says. “That gets you close to what you want with a fairly short time to market.”
Still, Bolten acknowledges that sussing out a potential high-tech takeover does add to a CFO’s pressures. BroadVision’s CFO admits he’d be a “fifth wheel” if brought in during the technology due diligence process. Nevertheless, boning up on a target’s technology enables him to strip away the technobabble and ask tough financial questions. “I’m less clouded by buzzwords as I hear the rationales for an acquisition,” he explains. “I don’t get caught up in owning the ‘coolest’ technology.”
Bolten’s no-nonsense approach comes in handy when dealing with investors. “The most important part of my job is helping investors understand what BroadVision is and what we do for a living,” he says. “My contribution with Interleaf was in writing some of the English-language materials about XML and why it is important to our future.”
Deuces Are Wild
So far, Interleaf has proven a good fit with BroadVision — surprises have been few and far between. M&A specialists say it’s almost always easier to acquire a publicly traded technology company since much of the due diligence has already been done.
Attorney Davis goes a step further, arguing that potential buyers of private companies should examine the target candidate the same way underwriters investigate IPO candidates. In fact, Davis believes prospective acquirers of nonpublic businesses should hire investment bankers as part of the due diligence team. “An underwriter will not only do due diligence,” Davis explains, “but will talk to significant customers to find out how stable those relationships are.”
The emphasis on customers is understandable. “We advise clients to do due diligence on the numbers behind the numbers,” says Davis. “More and more, we find revenues aren’t reliable on an ongoing basis.” One reason, he says, is that many dotcom customers are other dotcoms. That’s not necessarily ideal. “A lot of money floats around from one to the other, sustaining them,” he warns, “and you have to worry if that cycle is going to end.”
You also have to worry whether a takeover target’s assets are what they seem. Deducing if a company actually owns the intellectual property listed on its books can be maddening. Wrong answers can lead to wild assumptions and financial miscalculations. According to Cozen & O’Connor’s Heller, “The dollars and values are so significant, you would be foolhardy to rely solely on representations and warranties with respect to intellectual property these days.”
Eager not to get foxed, many companies acquiring software vendors hire consultants to determine whether the program is proprietary or if the developer used off-the-shelf software to create the application. It’s important to make sure no one involved in the development of a program can lay claim to the technology. A potential buyer should insist on proper development agreements from outside third parties and intellectual property assignment agreements with workers. Dotcom startups are particularly vulnerable to employee claims.
“Technology development at many companies happens at the very early stages of a company’s growth,” explains Heller. “Sometimes, it happens before they have their own accounting or law firm qualified to help them protect their intellectual property.”
Concerns over intellectual property should also make companies think twice about fishing for bargains in cyberspace. It’s common, Davis notes, for managers at competing dotcoms to leave infringement issues unchallenged because they assume one of the two companies won’t survive. “Once one gets acquired, it suddenly has resources behind it,” he points out. “The threat of a suit becomes more real.” Acquiring companies end up spending resources defending unexpected intellectual property challenges. “The suits might not have much merit,” Davis concedes. “But to the acquiring company, that’s almost irrelevant.”
Burn, Baby, Burn
Intellectual property isn’t just an issue in cyberspace. In any tech purchase, CFOs have to make sure they get what they pay for, says Jim Carrington, director of corporate development at Williams Communications (www.williamscommunications .com), a subsidiary of Tulsa, Oklahoma-based Williams Cos. “You’re not simply buying a black box. You’re buying the intellectual property that is reflected in that box.”
Williams, the largest transporter of natural gas in the US, is no stranger to acquiring technology to break into markets. In 1985, the company ventured into terra incognita by stringing fiber-optic cables through decommissioned interstate gas pipelines. The move created a reliable fiber network — ideal for third-party long-distance carriers. Williams sold most of the lines to LDDS Communications (the predecessor of MCI/WorldCom) in 1995 for $2.5 billion.
That move set the stage for a series of acquisitions. First, Williams purchased satellite uplink facilities from ICG Communications Inc. Then, in 1996, Williams acquired Global Access, a corporation that owned long-term leases on satellite transponders. The same year, Williams acquired CycleSat, a maker of satellite receivers. With the purchase of Viacom MCG in 1997, Williams gained a leading share of the electronic advertising distribution business.
Despite the buying, Williams’ management now prefers to partner to gain access to technology. “We use technology to deliver services to our customers,” Carrington explains, “so we don’t have as much need to own the technology.”
On the other hand, Ashby says there’s no end in sight to Cisco’s acquisitive ways. And given the ongoing flameout in the dotcom sector, there won’t be any shortage of fodder. In fact, for Ashby, the real question in assessing high-tech takeovers may not be how — but how many. “There are months when we do 3 or more acquisitions,” the Cisco finance head notes. “But I think 24 a year is close to the limit.”
Tim Reason is a staff writer at CFO and a contributing editor at eCFO.
When his management-led buyout of Wang Laboratories failed in 1992, Ken Olisa, former head of Wang’s European operations, turned his sights on the UK venture capital market. Olisa founded Interregnum (www.interregnum.com), a London-based IT investment house that also advises clients on high-tech mergers and acquisitions.
Seven years later, Interregnum is still in business and Olisa is still assessing technology companies. So how does Interregnum separate a Charles I from an Egbert of Wessex? Associate director Andy Bailey says Interregnum relies on four criteria when assessing tech companies — what the consultancy dubs the Four Pillars of Value.
First, Interregnum looks to see if a company’s products are market leaders. Then the firm assesses the company’s employees, looking for a well-balanced team. The third criterion is customers, particularly reference customers and strategic industry relationships. Finally, Interregnum examines a company’s brand. “Unless a high-tech startup has a strategy to develop these four aspects of its business operations,” says Bailey, “the company will flounder.”
As for metrics, Bailey says Interregnum looks at a company’s price-to-sales ratio, not price-to-earnings. “In early-stage companies, which many IT organizations are, earnings are inevitably skewed due to setup costs, significant R&D expenditures, and other general front-end loading of costs,” he explains. “That makes P/E ratios less reliable.”
While some tech analysts insist old-fashioned yardsticks don’t fairly value new-economy companies, Bailey says a price-to-sales ratio does give a potential buyer some sense of how well a company is selling itself in the marketplace. Actually, with the recent shakeup in the E-tailing sector, it seems traditional metrics may be a pretty decent indicator of the worth of dotcoms, after all. —Cliff Saran
A Game of Feathers
Phil Dean has spent plenty of time valuing technology assets. Dean is director of finance and administration (international) at Paris-based Netonomy Inc. (www.netonomy.com), a specialist in Net-based customer relationship management for telcos. Before joining Netonomy in May, Dean was finance and administration director at Sterling Commerce Europe. Dean also served as director of financial planning at AT&T Europe, where he helped oversee the breakup of Lucent and NCR on the continent.
Thus, you’d probably think Phil Dean would have a magic formula for figuring out what a tech firm is worth. And you’d be wrong. “There is no single correct way to value a high-tech business,” Dean says flatly. “Traditional valuations based on how much has been spent are useless.”
In fact, Dean believes the balance sheet of a high-tech company reveals very little. “In high tech, this historical cost valuation [the balance sheet] represents perhaps a few PCs and desks,” he says. Fixed assets like business premises are often irrelevant, as well. Why? “Most high-tech firms don’t own their own buildings,” he notes.
Even the classic approach to valuing a tech business — looking at discounted cashflow and affixing a price to the business model — can be tricky. Dean says it’s often impossible to agree on a cashflow model up front. And he says a suitor’s managers need to ask some tough questions before purchasing. How well will the product sell? How much will customers pay? How efficiently can the product or service be sold? He says an acquirer also needs to get a fix on the number of technically skilled employees at the target company — and how many can be retained.
Still, with the recent rollercoaster ride in dotcom share prices, Dean concedes affixing any price to a high-tech company is pretty much a dart throw. “The value of a technology business today is even more theoretical than it used to be,” he notes. “Any valuation is completely up in the air.” Your move. —Cliff Saran
Purchasing a high-tech company can be a complicated affair. Here are some basic questions to ask before green-lighting a deal: