The Five Types of M&A Outcomes in Enterprise Technology

Transformational M&A is a double-edged sword. What are the underlying reasons for why some deals work while others fail? What should boards look for while approving big bets?

Large companies’ cash balances are at their highest levels ever with relatively low debt. With a frothy market willing to value growth more than repurchases or dividends, boards and CEOs have grown bold in their capital allocation strategies— particularly the use of M&A to drive value creation.

But the truth is M&A can also destroy value faster than any other corporate activity. Every acquiring CEO selling a deal to their board makes the claim for why 1+1 will be 3 or more. Rarely does this come to pass. As Mike Tyson once said, “Everybody has a plan until they get punched in the mouth.”

All transformational M&A pursuits—leaving aside smaller technology tuck-ins— have their origins in one of three motivations:

a) Consolidate market share in current markets, b) Expand total addressable market, or c) Harness a broader platform shift to offer a next generation product in current or new markets that transforms the customer’s economics and/or experience.

While the true impact of a M&A transaction can only be assessed in the fullness of time, there are 5 types of scenarios we have seen unfold over the years as the high hopes of a deal come into contact with messy reality.

Here are the five scenarios, and the common causes and dynamics underlying each.

1. Disaster: 1+1 <=1

The deal is an unmistakable catastrophe. It is value-destructive to the buyer.

Common causes involve over-paying for the target relative to intrinsic value, no customer or revenue synergies coming to pass, and target’s revenues dissipating post M&A. The buyer eventually writes off most of the purchase price (or) sells assets at a deep discount.

Examples include HP+Autonomy, Microsoft +Acquantive, Microsoft + Nokia, Verizon acquisitions of AOL and Yahoo, Subex+Syndesis, etc. The reasons vary by case and span the spectrum from poor due diligence and over-leveraging to strategic misfits and sudden macro-shifts.

Irrespective of the underlying motivation for a deal, if the target and its assets are not valued right, the strategy is muddled, or the execution is bungled, failure is far more likely than not.

Side-note: Bigcos with strong balance sheets can absorb M&A failures without even flinching. Microsoft wrote off almost $14B of the Nokia and Acquantive purchases with little impact on its long-term value.

2. Consolidation Without Growth: 1+1 <=2

This is the deal that sought to consolidate market share but realized little synergies with the portfolio of the acquirer. The acquired company’s product revenues stayed stagnant or grew anemically and eventually declined.

Buying legacy competitors in the same market with overlapping products fits this category. Examples include SSA Global and Infor acquisitions in ERP and Manufacturing, and Oracle acquisitions of Peoplesoft, Siebel, JD Edwards. Some private equity (Thomas Bravo, KKR, Vista Equity Partners, etc. ) buys of maturing on-premise and SaaS firms also exhibit similar characteristics, seeking to optimize for profitability and cash flows vs. investing in growth.

The common reasons for stagnation —though the causes are rarely identified as such— are: a) the lack of a unifying platform or PaaS that could persuade customers to use more of the acquiring vendor’s products, and b) the target’s technology stack being perceived as older generation, leaving new customers to look elsewhere.

When every acquired product of the acquiring company stands as another silo with its own proprietary stack, there are no incentives for legacy customers to deepen and broaden the relationship beyond the current product. The attrition is slow but inevitable. Combine it with slashed R&D budgets post M&A, and low net new customer wins, and you get stasis.

Some consolidation deals —especially in tech sold to older industries where refresh frequency is low— have indeed delivered decent IRR and growth in valuations. But in general, consolidation pursuits of legacy products seldom create outsize results over the long term. Too often, they result in write-offs of the excess purchase price, divestitures, and downsizing of customer and investor expectations.

3. TAM Expansion With Middling Growth: 1+1 >=2 but <3

The goal of the acquirer was to seek new pastures for growth and expand its total addressable market (TAM).

These deals enjoy significant revenue and customer synergies, leading to cross-pollination and growth in both Buyer’s AND Target’s revenues.

But the outcome is not strategic: As in the acquisition is not a force multiplier and does not boost or protect the acquirer’s revenues, profits, or valuation in a profound way.

There are still disconnects in strategy, diligence, valuation, or the execution impeding higher levels of growth in top-line and valuation. These may include acquisition of a slower-growing legacy vs. next generation target to spend less money on the M&A, lack of a platform or PaaS strategy to unify the solutions, challenges in cross-selling to install base, or over-all issues of cultural fitness.

Nevertheless, these deals are successful at a financial level, with a positive impact on the Buyer’s valuation. Examples include SAP acquisition of Business Objects, SAP acquisition of Callidus Cloud, or the Paypal acquisition of Xoom.

4. TAM Expansion with Strategic Value: 1+1 >=3 but <=5

The deal not just met but exceeded expectations. Buyer’s valuation gets a significant boost as it increases its TAM, top-line growth, and competitive positioning.

The target may represent a new product line, a new buying center, specific geographic focus, (or) new platform shifts. Buyer’s core business is uplifted because of the new assets in play. The acquisition provides a new angle and dimension to the buyer’s business unlocking (or protecting in some cases) tremendous value. The whole is substantively greater than the sum of the parts.

Microsoft + Github, Microsoft + Linkedin, Salesforce + Mulesoft, and Atlassian + Trello are great examples here. In each situation, the strategic value to the acquirer was significant as a) it propelled them into new markets, b) enhanced the core, c) prevented competition from acquiring these assets, while d) able to substantively grow the acquired business through the buyer’s distribution channel.

5. Game-Changer With Platform Shifts: 1+1 >5

These are unique opportunities where the buyer is able to acquire a target that is exploiting a new platform shift to create a next generation product. The target could be a disruptor in an existing market of the acquirer (or) a new market where the acquirer does not have a presence.

The difference from Type 4 is that these acquisitions —when they come off—are game changers. They may help the acquirer survive and even thrive amidst a dramatic shift in underlying technology and market behavior. They diversify revenue, expand to customer segments that need new business models, or neutralize a future threat to the core. It is equivalent to buying options on uncertain futures with asymmetric returns.

The size of impact has little correlation to the size of the deal or multiples paid. Small deals timed right at early stages of markets in transition can deliver huge returns just as likely as big deals can go awry.

Famous examples in consumer internet are:

Youtube —bought by Google for $1.6B in 2005, now valued stand alone at $200B

Whatsapp —bought by Facebook for $19B in 2014, now has more than 1.5B users sending 60B mobile messages a day. Think of the deal as Facebook spending <5% of its valuation at that time to protect its other 95%.

Instagram —bought by Facebook for $1B in 2012, now worth >$100B with 1B+ users.

In enterprise tech, some recent deals made with high hopes of a transformational impact include:

Visa’s acquisition of Plaid: Visa paying 50x revenue multiple ($5.3B) to buy a fin-tech company that would expand its market beyond credit cards to consumer electronic payments and software-based financial services.

Intuit’s acquisition of Credit Karma : A book-keeping and tax software giant paying $7B to expand into consumer finance to diversify revenue and strengthen direct customer relationships.

Morgan Stanley’s acquisition of E-Trade: A $13B acquisition to expand into no-commission retail brokerage and diversify revenue. As an analyst said, “For Morgan Stanley’s 15,000-plus financial advisers, it might feel like inviting cannibals in for dinner.”

In Summary,

M&A deals that turn out to be transformational (1+1>3, and 1+1>5) exhibit some of the following elements:

• They are premised on embracing an underlying platform shift that dramatically changes the experience or economics of the customer.

• They expand TAM to address adjacent customer needs or new customer segments that diversify revenue vs. consolidation of market share.

• The acquirer has a platform or a PaaS that helps unify its offerings (organic and acquired) over a period of time. This is critical to ensure that the customer gets more value from deploying multiple products that run on a common substrate. In its absence, up-sell/cross-sell is ineffective, data is silo’d, and the vision of the “whole bigger than the parts” never comes to fruition.

• The underlying industry is competitive, and clients are facing pressure from their customers to transform how they do business —leading to higher refresh frequency and more investment in technology on the whole.

Paying premium multiples for platform shifts —or products that present a new way of doing things— is the smarter strategy in dynamic high-velocity markets. While valuations may sound silly at the outset and do contain risk, these deals can deliver massive returns over the longer term— especially if the acquirer has the distribution channel and reach to amplify to scale. Solving only for market share or immediate revenue /EPS is even riskier as it may not be sustainable for long.

With that as the background, I will deep-dive into Salesforce M&A strategy and playbook in the next post.