When we began the mergers-and-acquisitions journey at Cisco (s CSCO) in 1993, we had no idea what we were getting into. It was clear that there was a new category of products called “switches” that was threatening our leadership position in routing at the time. Our engineering team felt that they could build a better switching product based on Cisco’s existing technology foundation. But the venture community had funded a number of switching companies that were months if not years ahead of Cisco in the race to market. Instead of developing our own technology, we decided to buy Crescendo Communications, which turned out to be a huge success. The descendants of that Crescendo product line provide Cisco with in excess of $10 billion in revenue and rich profits today.
The truth is, we got a bit lucky. Historical data shows that the majority of acquisitions fail. The Crescendo acquisition didn’t, and we were encouraged, so we set ourselves on a path that eventually lead to 75 acquisitions over the next seven years. At its peak, these acquisitions collectively represented 50 percent of Cisco’s revenue. Along the way, we made a lot of mistakes and learned a lot of important lessons, but we were also fortunate to be held as one of the role models of tech M&A.
Today’s mega-companies — Facebook, Google, Groupon, Zynga, LinkedIn, Twitter, etc. — all face the same opportunity around M&A. And, in fact, the lessons that we painstakingly learned in the late ‘90s could well be applied in the current environment. The methodologies for acquisition-as-growth, as employed by Cisco, could be a template for a wide range of media and retail businesses that aspire to generate their next growth phase.
The first and perhaps most important principle of a scalable and repeatable M&A is that an acquisition is not an event but a process. Companies are like human beings. When trained in a given discipline, they perform incredibly well. You look at Roger Federer on a tennis court and you know he never makes a shot for the first time in his career. Everything he does has been practiced and honed before; it’s part of a larger process. Compare that to a hack like me who is likely to attempt 50 percent of his shots for the first time this weekend, and you can quickly predict the outcome of my game (along with a possible pulled hamstring). Corporations are the same way. If you ask them to do tasks they have not done before, the probability of a successful outcome is fleetingly small.
To avoid that pitfall in M&A, companies have to make a long-term commitment to many acquisitions. That way, the entire organization can learn and adapt to the strains of the process and eventually make it a core competence. Why not just hire experienced acquisition professionals? Prior experience undeniably helps, but since a company – and its DNA – are highly organic, an outsider will have difficulty engaging with the various parts of the organization. It is critical to develop a company-wide process over a series of transactions rather than relying on hired help.
Assuming that the company is committed to the multi-M&A process, there are six extremely important principles that underlie a successful acquisition strategy. I’ll address the first two here and the last four in my post tomorrow.
1. Keep principal objectives consistent
All too often, companies acquire for a hodge-podge of reasons: gaining market share, economies of scale, entering new markets, accumulating critical assets, fortifying weak product lines, ingesting talent, etc. Each one of these motives implies a different acquisition criteria, deal structure and integration process.
At Cisco, we were pretty clear that we wanted to enter new markets. We had a global and powerful distribution machinery (both direct and indirect). And we fundamentally believed that we could better leverage that distribution channel with a product portfolio than was broader than what our development organization could produce within the necessary timeframes. As a result, we bought lots of young companies with promising technologies or products. Since the acquired product portfolio was adjacent to the existing Cisco product lines, the sales teams were quickly able to expand to push the new additions to customers.
Furthermore, since Cisco had an advantage of a 10x or more distribution scale over the acquired company, the revenue from acquired sources would quickly increase post-integration.
2. Understand probability
No matter how good of an acquisition process you assemble, the odds are stacked against you that any given deal will succeed. Fundamentally, companies are not created to be bought or integrated. And, people — who are the core assets of most technology companies — often “review” their loyalty to an acquirer since it’s not the company they had originally chosen to join. At the same time, acquisitions can be enormously transformative when they work out correctly.
This draws an interesting analogy to the venture capital business. In most VC portfolios, a significant portion of investments simply don’t work out. In fact, historical data from one of our significant limited partners shows that 58 percent of invested capital returns less than 1x capital. Another 33 percent of investments yield modest returns (about 20 percent of the total return value). The magic comes from 9 percent of the fund’s invested capital, which produce outsized returns — 5x to 50x (or more) the original investment. These outliers make the VC asset class work.
Acquisitions, on the other hand, are generally viewed as deals that cannot fail. As such, acquirers tend to be risk-averse about the companies they buy and what they pay for them. Rather than looking at acquisitions as a portfolio, acquirers look at them as individual events. So long as that perspective is applied, the technology acquisition game doesn’t work well. It’s only when you assume a certain failure rate to be the norm and believe in the occasional massive success that the probability and expected value equation begin to work in your favor.
My good friend Andy Rachleff, who was a founder of Benchmark Capital and is now the CEO of Wealthfront and teaches at the Stanford Graduate School of Business, has collected a set of data that reveals the similarities between the hit-driven returns of the VC business and the serial acquisition strategies of eBay and Cisco in the ‘90s and 2000s.
Simply put, 10-15 percent of the capital deployed via acquisition yields 70-90 percent of the value creation. As this chart clearly shows, a significant number of acquisitions don’t directly contribute to the value creation. But the ones that do have huge impact.
In my next post, I’ll look at four other key principles of a successful acquisition strategy.
Between 1993 and 2000, Cisco became a role model of tech M&A, making 75 acquisitions over those seven years. At its peak, those acquisitions collectively represented 50 percent of Cisco’s revenue. We learned a lot along the way. In my previous post, I explained two of my six key principles of a successful acquisition strategy: keeping objectives consistent and understanding probability. In today’s post, I’ll describe the remaining four.
3. Option value
Another way to look at this issue of probability is that big acquirers are actually purchasing options in the future success of the acquired entity. These options tend to be worthless, but about 20 percent of the time, they produce a huge outcome.
This brings me to the point of valuation. As Chief Strategic Officer of Cisco, I was often criticized for overpaying for companies. But, if an acquirer is hunting for those 2-out-of-10 outsized returns, then the precise valuation of the two magical companies doesn’t really matter too much. Our rule of thumb was that plus or minus 30 percent was not terribly significant. This is anathema to most corporate development executives who are motivated to get “the best deal.” But, if you apply the probabilistic logic I described, you shouldn’t look for “best deal,” you should make sure you buy the “best fit.” The valuation is a secondary consideration.
The key message here is to worry less about what you pay and worry more about what the market is saying about the products and the company’s fit with your organization.
4. Aligning Incentives
Having seen many technology acquisitions over the years, I am constantly amazed how often companies structure deals without considering the key concept of aligned incentives. The most common pitfall in deal structure is earn-outs. At Cisco, we structured all kinds of earn-outs. The key thing we learned: avoid them at all costs.
The problem with earn-outs is that they create a schism right at the starting point of the two companies’ relationship. Earn-outs are typically structured with a set of metrics that create a sliding scale for the price paid for the acquired company. Post-sale, however, there is no longer an objective value metric (like stock price) for the acquired company, other key performance indicators are used to determine the achievement of milestones. These are metrics like revenue, earnings, market share, key customer wins, etc. The problem with all of these metrics is that they can all be gamed by both the acquirer and the seller. As a result, the incentives for the buyer and seller are not the same in the long term. This creates big problems in the long term.
Whenever possible, simple acquisitions using stock rather than cash are much more effective. Of course, they help retain the acquired employees. But most importantly, this aligns the incentives of both parties: Everyone involved wants the acquirer’s stock price to increase in value.
5. Buying market leaders
Corporate Development professionals are dealmakers. In the heart of every dealmaker is the desire to cut a “good deal.” But the key question is this: What is a “good deal”? All too often we think of this as buying an asset for a given value. The challenge Corp Dev professionals often face is choice. There are several companies that they can acquire: the market leader, the number two player, and then a series of tier-two competitors in the market. At first blush, we assume that given the acquirer’s distribution, if the technologies contained in the potential acquisitions are about the same, the cheaper one — maybe the number two player or the tier-two competitors — seems like the “good deal.”
All too often, however, buying the lesser players is not the right answer. Given Internet valuations, the market leader often trades at a significant premium – sometimes 5-10x the value of the number two player. So, it seems awfully expensive.
The right way to frame the question is not “how much are you paying for an equivalent asset,” but rather “how much better can the market leader perform when combined with the assets of the larger company.”
Think back to Google’s acquisition of YouTube. There were many YouTube wannabes in the market. Google could have acquired any one of them for 1/10 YouTube’s value. Instead, it paid $1.75 billion for the market leader, a seemingly enormous amount of value for a young company. But few today would suggest that it was not a good deal. Through that bold move, Google closed out that market. YouTube with Google behind it was the winner — no one could catch them.
6. Synergies, synergies, synergies
Buying market leaders, however, does not mean randomly shelling out big bucks and buying anything in sight. When paying top dollar, acquirers must ensure that there are synergies in the combination. Just exchanging stock owned by founders, employees and VCs for the acquirers stock creates no incremental value. In fact, it often detracts value because the acquired employees lose the motivation that they had as an independent company. There needs to be a “1+1=3” factor in the acquisition process.
So, what are these synergies? There are many ways in which value can be created via mergers and acquisitions. But, principally, two approaches stand out. The most important one is distribution synergies. Smaller companies typically don’t have the distribution muscle of a larger player. However, they often do have the best product. By placing the best product into a large distribution channel, massive synergies can be created.
Another path to synergies is operational synergies. Larger companies typically have scale economies that smaller companies can’t dream of achieving. These leverage points can exist in procurement of services (bandwidth, server, storage) or production scale. Acquisitions can create value by taking advantage of these scale economies.
One form of synergy that is often cited, but not captured, is cost reduction – especially through cost cutting and staffing. While cost reduction-based value can be extracted, in a fast growing environment, expense cuts are often much less relevant than the growth-accelerating synergies like revenue and operational scale. When acquisitions are justified by cost-cutting in the acquired company, that should always raise a skeptical eyebrow.
M&A can be an enormously powerful strategy, but it must be used in the right way. There are a great number of nuances that need to be understood in order to execute the strategy. Equally, there are a great many pitfalls that can destroy huge value. Companies that shy away from acquisitions because of the fear of failure could be missing massive opportunity. But, for those more daring ones, following the principles outlined above could really help in realizing the potential.
Mike Volpi is a partner in the London office of Index Ventures. He joined Cisco as Senior Vice President and General Manager of the Routing and Service Provider Technology Group and also served as the company’s Chief Strategy Officer. He would like to extend a special thank-you to Andy Rachleff who helped develop and articulate a number of these principles at a breakfast we had a few years ago.