Acquiring innovation Strategic deal-making to create value through M&A

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1 Acquiring innovation Strategic deal-making to create value through M&A March 2014 At a glance 39 percent of US CEOs are planning on an acquisition in 2014 according to PwC s Global CEO Survey. A PwC survey of tech companies found that 76 percent of acquisitions focused on buying innovation met or exceeded expectations. With the right inorganic growth strategy, buyers in all industry sectors can apply critical success factors to their innovationfocused pursuits.

2 Deal-makers talk deal-making As part of an ongoing series, PwC conducted a roundtable with a number of Silicon Valley corporate development executives to explore the subject of innovation-focused acquisitions. We drew the specific topics of the conversation from the results of a survey of technology organizations conducted in the months prior to the roundtable. The corporate development leads from several technology-focused Silicon Valley companies participated in the roundtable. In this article, we draw on some of the key themes aired during the roundtable discussion and offer some perspectives on leading practice that PwC has observed in the market. The discussion reinforced our view that innovation is becoming an increasingly important motive for M&A. As one roundtable participant put it, Acquiring innovation will continue to be a necessity for technology companies. Faced with a competitive environment that demands ever-greater speed to market, they have increasingly looked to M&A to complement internal research and development (R&D). Deals, however, are not assured of success, and innovation-focused M&A presents sizable and unique challenges that must be understood and addressed to realize the full value of a deal. If not managed appropriately, acquisitions can hurt, not help innovation efforts. The participants in PwC s M&A roundtable focused on some of the key challenges they face when undertaking innovation-focused acquisitions. Several key questions dominated the discussion, including: How do we educate and engage key deal stakeholders? How do we identify the right acquisition targets? How do we value and assess targets? How do we execute post deal and measure performance? The article accompanying this sidebar captures some of the most thoughtful responses to these questions, as well as PwC s own perspective, shaped by our extensive experience in the field of technology M&A. 2 Acquiring innovation: Strategic deal-making to create value through M&A

3 Strategic deal-making M&A is clearly a potent source of growth if guided by sound strategic direction. Tech companies, for example, are under relentless pressure to innovate. They look to M&A to complement and enhance innovation via internal research and development (R&D). Exhibit 1: Innovation as a driver of acquisition activity over 36-month period % of Deals Innovation Channels and market access Consolidation/cost reduction/market share Geographic expansion Vertical integration/supply chain 2% Defensive 3% 6% 12% 21% 57% Done right, M&A can help these companies increase speed to market, outflank competitors, and relieve pressure from threatening disruptive market forces. (See Exhibit 1, Innovation as a driver of acquisition activity over 36-month period. ) As one participant in a 2013 PwC roundtable on tech-company M&A put it, We will not be able to achieve our strategic intent in a timely manner by organic means alone. (See the sidebar, Deal-makers Talk Deal-Making. ) Because of its reliance on M&A to fill its innovation pipeline, the technology industry can provide a model to other industry sectors for using M&A to invigorate, diversify, and accelerate their search for breakthrough innovations. By studying how leading companies develop inorganic strategies around growth themes, search and screen for target acquisitions, perform commercial due diligence, and integrate their acquisitions, senior leaders across all industries can use examples from tech sector M&A to better meet their own organizations need for innovation. 0% 10% 20% 30% 40% 50% 60% PwC 3

4 Deal performance According to the 2014 PwC Global CEO Survey, 39 percent of US CEOs plan to initiate a domestic acquisition this year. To do so successfully, many CEOs are focused on improving their organization s ability to pursue M&A, joint ventures or strategic alliances. Thirty-five percent of US CEOs are considering M&A improvement initiatives. Another 22 percent have change programs underway. The challenges of successful M&A execution are no easier when making innovation-focused acquisitions. Creating value often entails monetizing the intangible assets of the target company, which may operate at a considerable distance from the acquirer s core markets. Academic research confirms that, if not managed effectively, acquisitions can degrade the innovation output of both target and acquirer. 1 Over the course of our work in the technology M&A sphere, PwC has observed that small, tuck-in deals have a higher probability of success than largerscale transactions. Management is better able to manage and control the post-merger integration process with smaller deals than with larger 1 Journal of Marketing, January 2005 ones, which are more complex and resource-intensive. (See Exhibit 2, PwC performance observations by deal category. ) A large portion of these tuck-in deals involve technology or talent acquisition. A PwC survey of tech-company corporate development and IT executives reveals that more than half of innovation-focused acquisitions many of them tuck-ins have at least met expectations. (See Exhibit 3, Innovation-Focused Acquisition Results Over the Past 36 Months. ) But that performance has not come easily. Exhibit 2: PwC performance observations by deal category Exhibit 3: Innovation-focused acquisition results over 36-month period % of Deals Innovative Traditional Small ( tuck ins ) 3 Large ( transformational ) Note: Numbers represent observations of deal performance with 1 indicating likelihood of high performance and 4 indicating likelihood of low performance Far underperformed expectations Underperformed expectations Met expectations Exceeded expectations Far exceeded expectations 5% 11% 13% 36% 35% 0% 5% 10% 15% 20% 25% 30% 35% 40% 4 Acquiring innovation: Strategic deal-making to create value through M&A

5 Exhibit 4: Deal continuum Strategy Deal execution Value capture #1 Strategy assessment #2 Options evaluation #3 Deal evaluation #4 Negotiation and close #5 Integration #6 Transformation Growth strategy Market analysis Investment hypothesis Alignment with corporate development initiatives Assessment of potential acquisition targets Commercial due diligence Financial/ accounting, strategy, and tax considerations Deal structuring (accounting and tax) Core diligence (IT, financial, tax, HR, insurance, operations) Regulatory and compliance, accounting/ financial reporting, SPA Financial packs and operational issues in the TSA and SPA Preparation for capital raising Post-closing purchase price adjustments Employee agreements 100 day plans Target operating model Synergy planning Functional integration support and Integration Management Office (IMO) planning, setup and governance structure Target operating model Customer, channel and product strategies Operating improvements and cost reduction Financial reporting requirements Portfolio analysis Business performance analytics (operations, IT, and financial) Target operating model diagnostic The deal team In discussions with tech executives, we learned that success depends on a dedicated deal team that owns the strategic development, acquisition and integration process and that is accountable for executing it on time and to plan. The optimal deal team brings a diverse range of skills, functions, and expertise to bear on a complex undertaking. (See Exhibit 4, Deal continuum: PwC s perspective on key evaluations necessary in each phase of the deal strategy, execution, integration.) There are seats at the table for the following roles: Corporate development executive to develop and communicate the deal s strategic rationale; orchestrate the interactions between buyer and seller; interface with the seller s investment bank; and set the deal structure. Deal sponsor, typically an executive from the business unit that originally identified and analyzed the target, who helps make the business case for the deal. Deal approver, often the CFO who scrutinizes the deal s economic impact on the company; this individual may also help arrange financing and will lead a robust review of strategic alternatives to an acquisition. M&A integration team, responsible for rapidly aligning the target s people, operations, systems, and processes with the acquirer s corporate structure. Deal engineer, typically the chief technology officer or other senior technology executive tasked with integrating the acquisition onto the acquirer s technology platform and resolving software and hardware incompatibilities. External advisors, including third-party advisors, investment bankers and legal advisors, to support deal execution and documentation. This team then draws on the skills of specialists who can assist with all aspects of commercial, operational, and technical due diligence and integration. PwC 5

6 M&A is only a tactic to execute strategy. It is not the strategy itself. While the above roles are adequate for smaller, quicker tuck-in deals that pose lower amounts of risk and complexity, larger transformative deals where officers are betting the farm require more up front planning and scrutiny to succeed. Well before any targets are identified, companies need an inorganic strategy that properly analyzes the macro and microeconomic markets, factoring trends and disruptive market forces. M&A is only a tactic to execute strategy. It is not the strategy itself. Companies need to have a clear, well-defined strategy for their specific business vertical. And that strategy should be distinct from but complementary to the organic growth strategy. The inorganic strategy should identify areas of potential new growth to evaluate for market entry, product portfolio expansion, etc. Target identification Successful acquisitions begin with the right target, and executives explore numerous channels in their search for companies with superior innovation potential. Most tech sector executives place the most weight on internal channels, primarily corporate development teams and R&D and engineering teams. They are willing to explore unconventional channels, such as venture capital funds, to identify targets and increase deal flow. They also use existing alliances and relationships with other organizations to perform informal due diligence on potential targets. (See Exhibit 5, Survey results identifying and screening potential innovation-focused acquisitions. ) As one roundtable participant said, You may want to do a licensing deal to get warmed up and see if they are the target we think they are and get to know management better. Exhibit 5: Survey results Identifying and screening potential innovation-focused acquisitions Commonly used Target identification does more than just uncover possible acquisition candidates. The very process of exploring multiple channels and touch points acts as a powerful market-sensing tool that enables potential acquirers to collect valuable intelligence on competitor, market, and product trends. We speak with a number of players, one roundtable participant said, and it is a hugely valuable process whether or not we consummate something with them. Proactive pipeline development within corporate development team R&D/engineering team Sometimes used Rarely used Venture capitalists/private equity funds Investment bankers Customers Board members/executive team Consultants/3rd party experts Sales team 6 Acquiring innovation: Strategic deal-making to create value through M&A

7 Valuation Valuation is a particularly thorny problem for innovation-focused tech acquisitions. It is nearly impossible to apply traditional valuation techniques to companies in their early stages of development, when operating histories are brief and there s little or no historical or predictable future cash flow. Acquirers therefore must resort to other measurements to build the case for a particular investment. (See Exhibit 6, Valuation techniques ranked by relevance and effectiveness. ) Their executives typically consult internal R&D and Very often, the acquirer has the necessary capability, but the lead time to build the product or service is prohibitive, and an acquisition can significantly improve speed to market. product teams to determine the cost in terms of both time and money of building a product or service internally. Very often, the acquirer has the necessary capability, but the lead time to build the product or service is prohibitive, and an acquisition can significantly improve speed to market. I am confident that in most instances our engineering team could build the solution, one roundtable participant said, but it is the time component that is critical and makes M&A attractive. Exhibit 6: Valuation techniques ranked by relevance and effectiveness for evaluating innovation focused acquisitions Less important More important NPV analysis Selling party expectations Market comparables (public companies) Market comparables (similar transactions) Cost to build analysis EBITDA and earnings multiples Most recent financing round valuation Revenue multiples Option value analysis PwC 7

8 Post-deal execution Integration of any sort of acquisition places significant demands on the acquirer s capabilities and resources. But innovation-focused acquisitions are a unique challenge. With innovative acquisitions, the real challenge comes post-completion, one participant in our roundtable said. It takes a significant level of commitment, patience, and ongoing investment to make these deals work. Indeed, such deals require commitment and focus from stakeholders that extend well past the first 100 days following closing. Measuring the outcome of an innovation-focused acquisition requires the development of a scorecard that captures and quantifies the deal s value-creation rationale and enables executives to monitor the target s post-acquisition performance. Because many targets have little or no revenue history and may take several years to earn out, the scorecard s metrics must include both financial yardsticks and a broader set of strategic milestones, such as product-development targets, talent retention, degree of collaboration, and the level of technological uptake. You can steer the deal off course if you place too much emphasis on revenue, one roundtable participant said. You may artificially drive the business to produce short-term revenue that is inconsistent with the long-term strategic intent of the transaction. Because innovation-focused acquisitions tend to have longer time horizons and highly uncertain outcomes, successful acquirers build a great deal of flexibility and agility into their post-deal plans. Some go so far as to develop a range of post-deal scenarios to prepare for deal outcomes that diverge from the original plan. Other companies focus on critical areas to improve the odds of post-deal success. Our survey of innovation-focused acquirers reveals several of those areas. (See Exhibit 7, Survey results: Most effective strategies for capturing deal value in innovationfocused acquisitions. ) For a more extensive focus on M&A integration as it impacts the research and development (R&D) function, see the PwC white paper, R&D Integration: Unlocking product development opportunities in M&A. Exhibit 7: Survey results Most effective strategies for capturing deal value in innovation-focused acquisitions Clear roadmap Strategic integration Ownership by sponsorship Clarity of objectives and articulation of roadmap Defined yet flexible product plan Defined go-to-market strategy from the beginning Team retention, integration, and alignment with BU Alignment of long-term strategic vision between acquired team and acquisition sponsor High degree of involvement by acquisition product team 8 Acquiring innovation: Strategic deal-making to create value through M&A

9 Conclusion The ability to identify and execute deals efficiently and effectively is a critical competency well worth studying by executives in other industries that depend on innovation for advantage. M&A is an important weapon in the arsenal of tech sector companies whose success depends on producing a steady stream of innovations whether those innovations occur in products, processes, or business models. As a result, the ability to identify and execute deals efficiently and effectively is a critical competency well worth studying by executives in other industries that depend on innovation for advantage, such as healthcare, financial services, and retailing. The value of innovation-focused technology acquisitions is often predicated on the ability to monetize intangible assets. Moreover, innovation-focused transactions often entail a long return horizon and a high risk profile. These deal characteristics create a number of challenges that M&A leaders must manage. The responsibility for addressing these challenges extends beyond the corporate development team, requiring continuing engagement by R&D, the product development team, the strategy function, and senior management long after the deal has closed. The M&A process need not end in a transaction to be successful. It s also valuable as a tool for gathering competitive and market intelligence that can be exploited strategically. Capturing and sharing the intelligence collected along the deal continuum can be of significant value to organizations seeking to innovate and grow, and represents an opportunity that many organizations have not yet explored in full. PwC 9

10 To have a deeper conversation about how this subject may affect your business, please contact: Roger Wery Principal, Strategy (415) roger.wery@us.pwc.com Patrick Gordon Principal, Strategy (646) patrick.g.gordon@us.pwc.com Chris Lederer Principal, Deals Strategy (646) chris.lederer@us.pwc.com Martyn Curragh Partner, US Deals Leader (646) martyn.curragh@us.pwc.com Rob Fisher Partner, US Technology Industry & Silicon Valley Practice Leader, Deals (408) rob.fisher@us.pwc.com Copyright 2014 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the US member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. PH