26 May 2008
Plan B: Five reasons companies merge and acquire
Posted by Alistair Croll under: Competition; Creating great products; Exit strategy .
Every startup dreams of making it big. And some do; but it’s vastly more likely that you’ll get acquired by a bigger fish.
This is one of the reasons VCs look so hard for exit strategies involving other people in your market. It’s a more likely outcome, and it means that if when things go wrong, you have a Plan B. It’s important to understand why companies want to merge and acquire within their space.
When acquisitions happen, particularly by public suitors, the business must be accretive to revenues in the first year, and must not impact margins. This is because the public company’s investor’s will scrutinize revenues and margins, and will expect to see an uptick. So the obvious motivations for acquisition are for getting new stuff to sell to existing customers, or for getting new customers.
When a market consolidates — meaning firms of roughly equal size acquire one another, or the bigger players roll up the smaller ones, different criteria dominate. This tends to happen in “nuclear winters” like the funding shortage many think is upon us.
Strategic Marketing 101 talks about four kinds of products: Stars, Dogs, Cash Cows, and Question Marks. The classification comes from two dimensions: Whether the product line is profitable (showing things like decent revenues and good margins) and whether it’s growing (showing an increased number of users and buyers, with hopefully an accelerating rate of adoption.)
Everyone wants a star, and that’s what startups are after. Most startups are question marks: No customers, no revenues, and high hopes. If they can get both growth (customers) and profitability (revenues), things are good. But if they manage profits without accelerating growth, it’s a clear sign that mergers are in the cards.
Here are five other motivations behind M&A in consolidating markets.
- Cost-side economies of scale. By spending less money on development and amortizing fixed costs across more customers, they can milk the cash cow for more. Oracle’s roll-up of the ERP/CRM world, including Peoplesoft and Siebel, is a great example fo this.
- Technology, particularly IP litigation. If one firm has a legal advantage, they may be able to “cash out” and let the other guys do the work. This is different from “patent trolling”, where there was no desire by the patent owner to bring the idea to market. Rather, it’s a pre-emptive response to what would otherwise be a lengthy and disruptive process for both parties.
- Controlled pricing. If the company can own most of the market, it can often set pricing monopolistically because it is the de facto standard. As a result, it can dictate prices and boost its margins.
- Expanding the total addressable market (TAM) of the company. When like competitors in the US and Europe merge, it’s a clear sign of this. Both firms want to address a global market and can’t afford the effort of a pitched battle on the others’ turf. It’s also a way to artificially show growth, to some extent, which might help move from a cash cow to a star.
- Follow-on sales. It’s far easier to sell something to an existing customer than it is to go find new ones. So if one firm has customers, it can sell the second firm’s product to them.
This is a pretty fundamental list. But it does offer some advice to startups who want to ensure their Plan B is in place. So what should a startup CEO incorporate into their strategy to ensure a plan B?
- Be boring about what doesn’t make you special. This makes you easy to assimilate, and it wasn’t your strategic advantage anyway. For example, don’t use weird chipsets. Follow standard management interfaces. Use open APIs. Many of the networking companies Cisco has bought over the years used a command-line interface that Cisco’s support personnel could understand.
- File IP. You don’t want to be forced to buy someone because they could make trouble. Plus the act of filing will make you aware of what others are up to. The Content Delivery Network is rife with examples of this, with constant infighting between players. This means you still have some threats, and your acquirer something to show for their work.
- Charge the market in the way it likes to pay. Learn how the market likes to pay for things, then go along with it. If you’re trying to get your customers to pay per-CPU and everyone else pays per-seat, you’re going to have a hard time. In SaaS, this is often per-seat, per month. In on-demand computing it’s per compute-hour. For enterprise servers, it’s per computer core. It will make it much easier for your new spouse to assess your value.
- Pick a niche that others will need later. In some cases, this could be a foreign language version, a government sector, or an unusual region where you can be the market leader. Several companies we talked to have become real contenders because they “snuck up” on the bigger firms by getting big in Asia. You’ll be on the right side of a build-or-buy decision later.
- Plan to play nice with others. If you have a potential suitor in mind, create default configurations that work alongside them. Follow their pricing model. Find ways to augment them. Eventually, buyers will start putting your product on their invoice. Going back to Cisco again, NetQOS has done a great job of managing alongside Cisco’s Netflow protocol, even before it was a standard, and it’s contributed greatly to their success.
Done right, Plan B can be a great outcome.