Remember lessons of dot-com era in tech M&As

From both a volume and a value perspective, 2014 was a strong year for technology mergers and acquisitions. Similarly, 2015 is off to a healthy start. The impact of the recent buying spree on transaction timelines, valuations and purchasing companies’ stock prices has many experts and executives wondering, “Are we repeating mistakes made in the dot-com era?”

On the buyer’s side, 2014 saw a variety of increases. Strategic buyers, including both public and private companies, closed 13 percent more deals in 2014 than in 2013. Private investment buyers, typically private equity groups, closed 22 percent more deals.

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On the seller’s side, technology companies in all sub-industries have been acquired as a result of this recent increased activity. Software companies remain the M&A target leader in the number of deals and their value. However, transactions involving Internet companies, including e-commerce, mobile and social networks, and the Internet of Things are rapidly accelerating. Even the hardware industry, which saw a slight decrease in deal value, is seeing an increase in transaction volume. There were also more deals involving IT service companies, and the value of these deals has increased dramatically.

Origins of the M&A tech boom

Several factors are responsible for the increase in industry M&A activity. Mobile devices, online payment processing, cloud-based storage, exponentially increasing consumer data and serious digital security concerns are the result of more technology-based products and services provided by more technology companies than ever.

Technology buyers have been stockpiling cash. The great recessions caused many companies to focus more on profitability than growth and grow the cash on their balance sheets. The result? They are prepared to spend when the right strategic acquisition opportunity comes along.

The shortage of talent, particularly among software engineers and developers, has caused some companies to pursue a strategy of talent-focused acquisitions. These “acqui-hires” often are a factor in cross-border acquisitions – foreign companies seeking U.S. talent or American companies seeking talent in emerging markets.

As the traditional technology, media and telecom industries undergo transformational changes, new cross-channel businesses are rapidly emerging. These new businesses often seek acquisitions as a method to diversify or grow in size and scope.

With the speed of change in the industry, competition is fierce. Many strategic buyers are looking to stifle or absorb competitors with rival technology, as can be seen by the consolidation in travel website companies, as a good example of this M&A trend.

Strategic issues for M&A success

Beyond knowing what is causing the growth in technology transaction activity, what can buyers and sellers do to ensure their transactions are as strategic and strong as possible?

Customer retention. It is critical, especially in this industry, for buyers and sellers to know how easy or difficult it will be for a new owner to maintain the target’s customer base. Some dealmakers suggest a retention strategy goal as high as 95 percent. One challenge to this, however, is whether any government (domestic or foreign) or military organizations are a target’s customers. These kinds of contracts often require additional permits, review and/or approval, and may present a problem to a new owner with such permission. Similarly, a significant percentage of international customers also can present challenges to customer retention.

Recurring revenue streams: Closely related to the customer-retention issue is projectable revenue streams. Technology companies that offer subscription-based or rapid repurchasing revenue streams are significantly more attractive than those that offer one-off purchases or open-ended license fees. Similarly, whether a technology product or service is offered via the cloud can have significant impacts on revenue and, therefore, acquisition value.

Ease of business integration: Some companies are using acquisitions to strategically transform their business models. Examples of this include technology hardware manufacturers moving into the software space or a licensing software company acquiring a cloud-based software provider. While this strategy can work, there are often significant cultural integration issues. In addition, as device technology use increases, basic compatibility is a foundational element to a successful cross-business acquisition.

Accounting and finance: Although the new revenue-recognition standard does not apply until 2017 and may be delayed further for another year, many public technology companies (in software and semiconductors, for example) will be significantly impacted. Compensation and bonus plans, taxes on revenue, and controls and processes are just some of the areas that will be affected and will impact future valuation multiples and purchase price. The capitalization of costs is another important area for technology companies pursuing M&A strategies. Changes to EBITDA (earnings before interest, taxes, depreciation and amortization) as a result of software development cost capitalization can have dramatic impacts on both valuation multiples and business value.

State and local taxes: The rate of technology change has created a major challenge for state and local governments in maintaining tax regulations that make sense. The compliance of the seller in such a complex and antiquated environment is difficult but extremely important. Buyers are weary of acquiring companies that are unaware of possible risks and how state and local tax rules apply to them. Companies that have proactive strategies in state and local taxes are likely to have a better chance of successfully completing a transaction, lower escrow percentages of purchase price, and shorter escrow periods.

While the increased volume and value of technology M&A transactions is expected to continue through 2015 and beyond, all deals will not prove profitable. Focusing on the above issues will ensure the deals your technology company is involved in are as strategic and successful as possible.

Consulting partner and certified public accountant Joanne Baginski leads the transaction services group at EKS&H LLLP and can be reached at 303-740-9400 or jbaginski@eksh.com. Audit partner and CPA Brent Peterson leads the high-tech client industry group and can be reached at 303-740-9400 or bpeterson@eksh.com.