On the Inside, Looking Out

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

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.

Because 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).

In their renewed quest for the next big thing, many executive teams have realized that they may not have all the answers in-house. “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.

Some large companies have begun eyeing young businesses to meet their innovation needs after continually getting beaten to the punch on new products by their smaller rivals. For instance, two-thirds of the 25 drugs approved by the Food and Drug Administration in 2009 were developed by emerging companies, notes Christopher Wadsen, managing director of the strategy and innovation practice at PricewaterhouseCoopers. “Big Pharma spends all this money on R&D and isn’t as successful as small start-up companies in coming up with novel innovations,” he says.

An Eye on the Little Guy

While megadeals were few and far between in 2010, the number of transactions skyrocketed, with many deals so small that their details were not publicly disclosed. In sum, 427 venture-backed firms were acquired last year, the highest number since Thomson Reuters and NVCA began tracking such data more than 25 years ago.

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.

The number of venture-backed companies acquired last year rebounded sharply from 2009.

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.

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