Newport Board Group, a National Business Advisory Firm of CEOs Cautions Buyers on 5 Questions to Ask Before Acquiring a Technology-Based Middle Market Company

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Now is a great time to buy or merge with middle market companies whose products incorporate fast changing technology.

A buyer or merger partner must be prepared to ask some tough questions about whether its core technology will continue to deliver value

Middle market merger and acquisition (M&A) activity has been accelerating throughout 2013 across all industries as cash rich buyers seek to place their capital in productive assets. Despite the differences across industries, all M&A transactions have a good deal in common. The acquirer must perform rigorous due diligence to verify the history and quality of the target company’s earnings. Potential risks must be carefully considered.

But when due diligence involves a middle market company, whose value consists largely of its technology and intellectual property (IP), one issue is especially important. The acquirer or merger partner must question the future value and relevance of the acquired company’s technology.

Consider what is at stake in many acquisitions. To satisfy their investors and drive a rising valuation, firms that own a portfolio of niche technology manufacturing companies must deliver top and bottom line growth every quarter. To meet this goal, the parent company or private equity sponsor needs to see consistent organic growth and margin improvement from operational efficiencies.

Avoiding an M&A Train Wreck

Too often the evaluation of a company and its products rests on a forecast of future growth that projects past revenue trends forward. A buyer or merger partner must be prepared to ask some tough questions about whether its core technology will continue to deliver value. If its core technology is in transition or is likely to be soon, the impact on the company’s future product road map must be carefully considered.

5 Questions to Ask

To validate your investment hypothesis, a buyer should ask five key questions:
1. Do the CEO and management responsible for R&D and Marketing have a well-grounded conviction about where their technology and products are headed?
2. Does the technology deployed in the product have a future life--or is it about to be replaced or significantly modified?
3. Does the company have a history of predicting market, product and technology transitions accurately—and developing a road map to plan product transitions?
4. Has the company demonstrated the engineering, R&D and marketing capabilities to manage such product transitions?
5. Does the company have a record achieving revenue growth from new products?

A Real Life Example

A niche technology manufacturing company in the electronics industry was acquired by a larger firm. Due diligence did not uncover any issues regarding threats from new technology to its core, cash-producing products. Shortly after the company was bought, two issues arose, threatening the future of the business, neither of which was uncovered in due diligence.
Issue 1 – The core electronics/intellectual property supplied by outside vendor partners was becoming obsolete and not available for future product designs.
Issue 2 – Competitors were making advances in the area of the company’s core electronics technology, lowering barriers to entry and producing new entrants whose lower cost alternatives threatened the company’s leadership position. The experience of the R&D personnel of the acquired company was with the older technology. The company was thrown into turnaround mode. Its response was:
1. Cost cutting – because expected revenues and growth were delayed.
2. Launching an aggressive search for an outside development team to deliver a “crash” project to develop electronics compatible with the new technology.
3. Asking customers to wait and not place orders with competitors until the new products were ready.

M&A Failed to Deliver

With great difficulty, the company accomplished a near-term turnaround. Internal personnel were replaced with outsourced talent, a painful experience for all. Many customers waited to buy the new products and were pleased with them. The short term crisis was averted. But over the longer term the financial justification for making the acquisition failed to materialize. The company was eventually sold.

Learning the Right Lessons

All could have been avoided if the proper analysis and evaluation had been done before the deal was consummated. The lessons of experience were:

  • Especially where an acquisition strategy creates pressure to deliver quarterly results, proper due diligence is critical to evaluate the likely future financial gain from a given technology.
  • The analysis must address the availability of complementary and competitive IP elsewhere in the company’s ecosystem.
  • The buyer must have the right R&D talent and know how in-house to identify and license external IP to develop next generation products.
  • Firms should complement their internal engineering and product development talent with out-sourced experience. This is especially true of smaller companies that have limited development budgets.

Now is a great time to buy or merge with middle market companies whose products incorporate fast changing technology. But rigorous due diligence as to the future of the technology they are acquiring is required if the buyer is to have a chance to achieve the results they seek.

Michael Gioseffi is a partner in the Southern California practice of Newport Board Group. Mike can be reached at (626)253-4799.

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