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.

Another plus: finance chiefs who do pull out their pens are getting decent deals, despite the increasing interest in acquisitions. 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. That’s partly due to ongoing uncertainty about the economy, and partly a legacy of the recession. Those who relied heavily on leverage to do deals in the past are particularly cautious. “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

That caution is warranted. 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.

A lack of historical data can throw finance departments off their due-diligence game. “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. Witness Google’s very public failed $6 billion bid to buy Groupon, the much-hyped shopping/social-networking site that offers consumers a daily chance to obtain deep discounts on local products and services. It’s a simple model, and lucrative: Groupon keeps half the revenue and passes the other half to participating merchants.

Even as it fended off Google, Groupon has been on a buying binge of its own, looking to buy copycat companies outside the United States so that it can simultaneously stifle competition and expand its geographic reach. In 2010, it bought six such businesses, including Citydeal, a site that was founded in Germany in late 2009.

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.”

For that reason, the human element of small-company transactions is a crucial consideration. “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.

The acquired business’s principals and employees — and their willingness to continue working at the same pace and at the same level of performance — could be a deal’s greatest risk, more so than financial issues. 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. They will likely want their business — even when it becomes a small part of a larger company — to continue to grow. “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. By developing a relationship — either by becoming a customer, an investor, an adviser, or a joint-venture partner — acquirers can learn about intriguing smaller companies and discover any potential problems.

Partnering is a long-standing practice at Intuit, the software company that makes QuickBooks. In its constant search for possible alliances, Intuit invites some 40 entrepreneurial companies to its headquarters about once a year. “The goal is not to sign up 50% right away,” says R. Neil Williams, Intuit’s finance chief. “The goal is to develop relationships longer term and to let [the smaller company] know who to contact if [that company has] a good idea.”

These relationships should benefit both parties, executives say. This means that would-be acquirers should be frank with entrepreneurial partners should a potential acquisition lose its appeal or simply not make sense. “If people want to talk to us about washing machines, that’s not part of our strategic plan,” says Williams. “They appreciate when we tell them up front that it’s not something we’re interested in and they can move on and not waste time talking to us.”

Williams acknowledges that even at a nimble software company such as Intuit, “innovation and creativity can be a scarce resource.” The company continues to encourage its employees and engineers to come up with great ideas, and invests in the internal resources needed to turn ideas into products, but Williams says that many of the most promising ideas will come from the outside.

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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