Strategic Alignment Between M&A and Corporate Strategy

Corporate strategy vs M&A strategy

Yeah, this is one of those things where it's important to get the nomenclature right. So let's start with the corporate strategy. Corporate strategy is the top-level strategy which sets the direction for the company as to where it wants to be in the long term. 

For example, your corporate strategy could be price or cost-centric, or it could be product differentiation-centric. I'll give you a couple of examples. For price-centric, a perfect example is Walmart. Everyday low prices. That's what they advertise. 

In addition, they have become a tech leader by providing omnichannel access where a person, whether they go into the store or online or mobile, they get the same experience, same price. That's how they differentiate themselves. 

For product differentiation, there's no better example than Apple. Think back to the days of the iPod, then iPad, iPhone. The amazing thing about what comes out of that company is it's so easy to use. That's where they differentiate themselves.

And I'll go back to a company I worked with before Avaya. Their tagline is 'innovation without disruption.' This means all their customers who traditionally were on-premise need to be moved to the cloud. How do you do that in a seamless way that does not disrupt them? For that, you have to build capabilities, whether it is people, partners, or products. So those are the examples of what I call corporate strategy. 

Now let's look at M&A strategy. M&A strategy is simply finding the gaps that the company has in its capabilities. This could be on the product side, it could be on the commercial side. Examples of that define what your M&A strategy is.

One case could be you are trying to build your scale. This happened with a lot of airlines. Continental merged with United. The second is you might be trying to expand into another geography. Uber acquired Kareem in the Middle East. There are others where it's a roll-up strategy, which works well in a fragmented space.

You keep buying very similar products. You build scale, squeeze out the cost, or you could be doing it to enhance your product roadmap. So you buy technology, or it could be an acqui-hire case where you just want talent. Now those address specific gaps. 

The thing of most importance in M&A strategy is they should always support the top-level strategy. Like if you go into a 10K of a company like Google, they tell you that acquisitions, investments, JVs, and divestitures are all elements that support our top-level strategy. So corporate strategies are the top.

Anyone and everyone in the company should directly or indirectly support it. And M&A execution and strategy is one element that supports it. You cannot have the word 'M&A strategy' separate from 'M&A execution.' That's why I said it is nothing but finding what the gaps in your capabilities are. Finding the gaps is essentially telling what the rationale for the deal is. 

So think about this in very simplistic layman's terms: the rationale for the deal more than anything more complicated than that. It is the mechanical piece that addresses or supports the top-level corporate strategy.

Getting the strategy right

Yeah, first of all, if the strategy starts with the M&A team, that is not true corporate strategy. It has to start from the CEO, CFO, and business units. That is where it starts. You should be an active participant in that, but it cannot be something that starts in M&A and then you try to bring other people aboard.

So that's absolutely right. I'll give you my example. I used to report to our chief strategy officer. The chief strategy officer had the M&A and corporate development function reporting to him. His scope and purview was a lot bigger, and he was truly responsible for the strategy, which he looked to me and my team to handle that one component.

But he also looked at other aspects, like partnership, which is a huge component. How do you address that? And also, considering all the capital that comes in, what are the best places to invest? The prioritization of that is tied to strategy so that you make sure you're putting the limited dollars in the right places to advance the cause of the company.

So, yes, it needs to start at the very top, and then you as an M&A practitioner have to make sure that what you're doing is not disjointed from that in any way. In fact, you should be an active participant in the framing of that, but that cannot be your sole responsibility.

Best ways to pitch deals

Always start with the fact that this is our corporate strategy. So, for example, a lot of companies these days are transitioning to become more digital and more streaming. That is part of the corporate strategy. Now, if you acquire a company that helps lead in that direction, then you tie it back to that.

This is how it supports this component of the corporate strategy. There might be multiple ways to achieve this, like build, buy, or partner. There are multiple avenues to support the corporate strategy. Assuming the other options are not viable, then you say that M&A, bringing the assets or technology in-house, is the best way to do it. But it all has to always tie back.

So, when you talk about deal rationale, it eventually has to connect. Why are you spending very limited and precious corporate dollars on something? Absolutely, it has to connect. No M&A deal can ever be done in isolation without tying it to the broader company.

Pillars of corporate strategy

First of all, you need to be more surgical. This means you need to specify where, with a specific element of that corporate strategy, this particular M&A transaction is addressing.

So I'll go with the three examples you mentioned. One was you want to be the number one player, another was parallel customer support, and the third was reaching a billion dollars of ARR. The way I see it, the first two are ways of getting to the third. 

You can get to a billion dollars of ARR by just buying revenue, which I don't consider as the core part of the strategy. That might be an overall corporate goal, but that is not strategy.

For example, even though the companies I worked with were lopsided in the revenue they got from the U.S. versus international, a big part of that was diversifying so that the risk is low and the growth opportunities in the international markets are availed. 

That's your strategy. So, when you go out and look for a transaction, you look for certain assets and companies in international markets that are in the purview of what you do. You don't want to just randomly buy something that is not in your core area of ex pertise. That's a simplistic example of how you can support the strategy to expand internationally.

That was partly a trick question because I wanted to get to the point where some companies are all revenue-based, anticipating acquiring revenue to meet their target goals.

Actually, in a lot of PE-backed portfolio companies, when they're trying to build scale, they have this roll-up strategy. But there is a lot of thought process even in that roll-up. They're not just randomly adding revenue. They're saying that the other company we are buying absolutely adds revenue and ARR, but it should advance the core area in which we are already working. 

If you have proactively decided to expand the scope of what you do, that is fine too. Otherwise, if you just want to increase revenue, you could go and buy a bunch of McDonald's franchises and bring them under your company. You will have higher revenue, but that's not your area of expertise. 

Capital allocation 

I'll bring the concept of M&A into it. A lot of it is operational finance, but for any company to grow, they need capital injection, whether it is for R&D, sales, or anything in between. 

Let's take an example. There's one company with four business units. At the beginning of the year, they have their operational plan set, meaning each business unit gets their own revenue target and is told how much they can spend to achieve that target revenue. 

In a sense, it is a simplistic P&L where your contribution EBITDA is how you are measured. For the time being, let's ignore the corporate allocations that get added to each of these business units.

So, let's assume there is an R&D budget that a particular business leader has been given. Everyone complains they don't get enough, even at the most well-funded companies. 

Some folks might actually look at M&A as a way to buffer up their R&D capabilities by supporting a tech acquisition that doesn't come with any revenue. So they can build their R&D muscles, whether it be an acqui-hire or something else. 

That acquisition is being supported with a very narrow view, not the way precious M&A dollars should be spent. M&As are episodic events and difficult to predict a year in advance. That's one way. 

In tech companies, software development is the biggest expense. Companies have the ability to capitalize some of that software expense and move it onto the balance sheet. By doing that, they reduce their operating expense as it relates to R&D, which means it improves their EBITDA. 

Did you really improve your profitability at the business unit level? No, you just took advantage of how some of the accounting works. The best antidote for all of these things is to have a view of cash-based metrics. 

If you looked at that business unit purely from a cash flow perspective, you would include the CapEx expense and look at the whole expense, regardless of how much of it is OpEx and CapEx.

That's one way to ensure there is the right amount of accountability and avoid gimmicks that make you artificially look better than you are. Similarly, if you did an M&A transaction and it cost the company money, you could ask for some money back from the business unit because you spent some money. Even if you don't want to do that, then increase the top line targets. 

You got something; you need to show the benefits of this expense in year two, three, four. It's just that discipline and the clear message to the teams that your true profitability is how you're going to be measured, not just on a one-year basis but on a multi-year basis.

So, there must be no clear-cut budget for M&A. Companies must rationalize it as opportunities come up. Because if there are four business units, it doesn't mean that each one gets to do one transaction every year. That's a very myopic way of looking at it. 

First of all, you're constraining yourself, and then you're forcing those business units to think that they need to do one transaction in their space because they have some budget for it.

And that's not the best way to do it. It goes back to the concept of a portfolio, like in financial terms. If you have four small portfolios and you're trying to optimize them individually, they might not be optimized when looked at collectively. 

What one portfolio might be doing could be the same mistake another is making. The best way to manage capital allocation is to look at them collectively, and that's how the M&A dollars should be looked at. It's possible that of the four business units we're talking about, one doesn't get to do a transaction for two years, and that's fine. 

M&A is not something that is done artificially. It has to be tied back to the corporate strategy and not the business unit strategy. 

Measuring business unit’s success

There are different metrics to measure performance, especially when evaluating a company, projecting its financials, and considering methods like DCF and multiples.

IRR (Internal rate of return) is a good way to do it. From a pure finance perspective, IRR is the discount rate at which the future value becomes zero. An IRR clearly has to be significantly higher than the cost of capital for the company. Otherwise, it doesn't make sense and will be dilutive.

The good thing about IRR is that it's a tighter view than DCF. DCF (Discounted cash flow) has much of its value tied to long-term internal value, and it's challenging to predict how things will be 10 years out. IRR is actually a pretty good metric.

When we look at any of these metrics, none are looked at in isolation. That's why we have a 'football field' where you have different measures, and you come up with the most scientific triangulation. IRR could be a part of that.

The easiest way to hold a company or a business unit, with a P&L, accountable is to focus on the things they have direct control over. So, revenue and all the direct costs are completely within their control. You can give them a bit of wiggle room on the allocations, but they cannot blame anyone else for these factors.

That's why IRR is important. For example, the cost of capital is at the corporate level. If there are two business units, one with a stable line of business and the other with high fluctuation, the high fluctuation business should account for the higher IRR. 

If you're a public company raising funds, using your parent company's stability to squeeze a lower interest rate is essentially cross-subsidizing that particular business unit. It should be charged internally based on its fluctuations, as opposed to another more stable business unit.

The point of all this is that there are direct ways to measure the performance of business units without immediately jumping to IRR, discount rates, and other considerations. In most cases where a transaction fails, the first issue is not meeting revenue targets. 

You hardly ever see a scenario where the company meets revenue targets but incurs slightly higher expenses. In M&A circles, that would not be considered a failed transaction because it's generally easier to reduce costs than to increase revenue. Increasing revenue requires a customer to write a check to you, but reducing costs is within your control.

That's why I tie back to what's in your control. Those are the metrics you use to measure the performance of a business unit or something broader than that.

Holding business units accountable

The whole point is, if you're measuring business units on things they control directly, such as contribution EBITDA, they might reduce expenses by being more aggressive in quantifying how much of their R&D expense is CapEx. However, companies can't go without any restraints. There are accounting and controllership gates that prevent them from going too far. They can't move everything.

When an auditor comes, there's always a bit of wiggle room. I used to work with auditors during my controllership work and would put forth my case for certain values, which they eventually have to sign off on before it gets released.

It's important to make sure it's clear that things they control, even when split between OpEx and CapEx, are things they are held responsible for.

It makes sense to hold them accountable and prevent any acts that make them look better than they are. That's why you've got to go back to cash as your North Star for most things because it clears all the clutter. 

In the public sector, companies that pay dividends are considered highly. No matter what you do in your SEC filings, when you pay a dividend, the cash has to leave the company. You could do whatever you want accounting-wise, but that's a truth you have to face.

That's why those companies get a lot of respect. For instance, Facebook recently decided to start issuing dividends, which is very unheard of for tech companies. This move highlights to the broader industry that they can be viewed more confidently, as opposed to being a tech company that is not as solid in delivering to shareholders.

Why take a public company private

I'll start in general terms first and then come to the specifics. When you think about why companies go private, I can boil it down to two reasons. 

One is the public markets not valuing you correctly. They don't see your intrinsic value. This could be because you have unstable earnings every quarter, making it difficult to predict your performance, which makes public investors nervous. Or, you might have missed one or two earnings cycles, or you play in a sector under pressure, affecting your stock.

The second, and more important reason, is being under the quarterly spotlight as a public company. If you're trying to do something transformative that requires not just one quarter but many years, going private is a good way to make your investments without the pressure of quarterly earnings and analyst questions. 

Then you can go public again after achieving your goals. Now, regarding the media and advertising sector, it's been undergoing transformation at a surprising rate. Traditional TV is giving way to linear OTT and digital platforms. 

For example, Disney, Fox, and Warner recently announced the launch of a super app for sports content. This is monumental because sports programming is a major factor keeping traditional TV erosion at bay. For instance, to watch NFL football on Thursday, you now need a Prime subscription.

The shift to digital impacts measurement companies, whose job is to track who watches what and when. It's easier with traditional TV but much more complex with digital. These measurements are the currency for ad buyers and sellers. For digital, it’s more difficult to measure, especially when you have to combine digital and traditional metrics.

Building a system to bring these measurements together, test it, and get it adopted by customers is a huge effort. It's not easily appreciated in public markets, and I believe that's one of the bigger reasons for companies in this sector going private.

Any time a company's sponsors take it private, there are standard costs that are cut to improve profitability. However, just improving profitability by itself is not a sufficient condition to take a company private. 

There has to be a promise of significantly improving the top line and growing it. In some cases, businesses are too spread out, so bringing back the focus is important. Therefore, any time a company gets taken private, there has to be a component that talks about top line growth.

When you think about a private company starting to grow and go public, there used to be a metric requiring six consecutive quarters of top line growth. No matter how high your profitability is, if your top line is flat, you are not a great candidate to go public. 

That's why there are companies that can go public with no profits. They might be burning through cash, but there is a promise of top line growth, and that's very key

Steps to take a public company to private

Yeah, so, I know a bit about that one because there was a sponsor involved that was also involved in a company I was at. In fact, it could be said that Michael Dell pushed for going private for the same reasons, which is to not be in front of the analyst every quarter and to build something great before going out again. 

When you go public, there's a lot of fanfare, but going private doesn't mean the inverse of that. In fact, it can be positive. When a company is taken private, someone is seeing more value in that company than its current trading value.

There's optimism in how you can squeeze and enhance that value by going private. There's a lot more discipline, and sponsors bring their skills, network, and benefits to help the company grow in the private sphere. 

It shouldn't be seen as a reversal of going public. When a company goes public, there's hope for growth. Eventually, if it stagnates or starts declining, that's where sponsors find value. You have to compare not with the point where the company went public, but where it was just before it gets taken private. 

Usually, there's a premium paid on the trading price to take a company private. If a company is trading at a 60 percent discount to last year and you give a 15-20 percent premium, it's still a discount to last year. There is negotiation, and sometimes deals don't go through if the companies can't support the valuation.

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It's interesting how these things are negotiated. There's no flat formula; it's about big-picture thinking and perceived value with shareholders. If there's a company with a core growth driver, even trading at a 60 percent discount, they might be happy to take that price if they believe it could fall further.

If people think the price could go further down and someone offers a premium, they will likely jump on it. No one is forced to agree to that price; the company knows where it is heading.

There is no hard formula, but every company evaluates based on their specific situation and life cycle. Take extreme cases like Bear Stearns. I remember when it used to trade around 100, and then it was bought by JP Morgan for a very low price. That's an extreme example from the last massive crisis.

Similar things happened recently with First Republic and Silicon Valley Bank. There's no cookie-cutter approach. It depends on what the management and shareholders think about the value and the offer made by the sponsors.

Real life examples

Yeah, first of all, every deal, regardless of size, has its own idiosyncrasies. Each deal is unique, whether it's half a million dollars or 25 billion dollars. I'll mention two deals. The first one is an M&A deal, and the second one is also an M&A deal but interesting for its financing aspect. 

In the first one, when I was at Avaya, the company was going through a Chapter 11 restructuring. 

During this process, if the company sells part or most of its assets, it's dictated by a Section 363 sale. We had networking assets that were not core to the company and drew interest from a buyer. This buyer becomes a stalking horse, setting the floor for the valuation and establishing the basic terms of the purchase agreement. 

In bankruptcy, unlike traditional M&A, there's another actor involved – the bankruptcy judge, who oversees the auction to ensure the company gets the best price for the asset.

This process was interesting to learn about, both technically and from a human nature perspective. Managing and quarterbacking a fluid situation like this, especially motivating those involved in the transaction, was a challenge. 

For sophisticated buyers they love situations like buying an asset out of a bankruptcy. These assets are free and clear from any liabilities that you would generally accept in other transactions. Also you don't have to pay high valuation. 

But the downside of this is that you cannot return it and there are limited reps in warranty and escrows which is why it's almost always on a cash basis. 

The transaction was successful, and many of those who moved with the transaction are still at the buyer, a good metric of its success.

Now, the second deal was at Telecommunication Systems, a mid-market public company with no debt and some cash. We wanted to make a transformational acquisition of a company called Networks in Motion, NIM. To finance this, we used the company's equity, went to commercial banks, and raised more funds from the street using a convertible debt instrument. 

Convertible debt has a lower interest rate, but it can dilute equity if the company's stock does well. We managed this by buying a “call spread”, which involves two call options to potentially eliminate dilution within a certain price band.

The convert we bought was for 90 million, oversubscribed, so we exercised a green shoe option, totaling around 103 million. This deal was complex and required understanding accounting for converts and call spreads, valuing them, and ensuring accuracy quarter to quarter. It was a great learning experience, integral to my role in corporate development.

These transactions were unique and provided a lot of learning opportunities, not because they were the biggest deals I've done, but because of their complexity and the creative solutions required.

Deal structure to preserve cash

Yeah, so in my experience, I've used a lot of earnouts in corporate development. Earnouts are essentially contingent consideration – if you meet the metrics, you get paid, otherwise, you don't. I've also used delayed consideration, where payment is not made at the close of the deal, but over a period of time. This is not tied to any metrics and helps preserve cash on closing. 

Another method I've used is escrow to backstop the basic reps and warranties. I push for the escrow to remain with the company, paying less in consideration. If there's nothing to charge against at the end of the escrow period, I pay it from the company's balance sheet. This allows me to use that cash for two years instead of having it parked with a third party.

In terms of escrow, it was created to bridge the gap between buyers' and sellers' expectations. It's effective as long as it's not too large compared to the underlying consideration. For example, in one deal, we held back a significant portion as an earnout until a key retailer signed the next year's contract. This approach saved us from a potentially embarrassing situation.

You learn certain things after doing a bunch of deals. M&A has become very structured in its process, but the variability comes with the different actors involved – the buyers, sellers, and other assets.

Regarding 100 percent financing or getting the seller to take the whole deal, if a seller is ready to do that, it's often a sign of desperation. If it's not contingent and they're financing you for a period of time, it's important to understand why the seller is agreeing to it. It could be due to a lack of other buyers or a belief in the combined capabilities of the two companies. 

However, if someone is willing to sell a company entirely on deferred or contingent consideration, there must be a solid and diligently reasoned explanation for why they are agreeing to that.

Dealing with reluctant seller

To convince the seller to sell, in this particular case, we're not talking about contingent consideration or anything. That comes next. We're focusing on just this one aspect. If you're doing that, whatever valuation you get will be high because you've already shown your desperation. 

The key is to convince the other side that they can realize higher value in the combination. You have to share the promise of the combination, which is the way to go about it.

Outside of that, the only way to convince any reluctant seller to sell is to offer a lot of money. Everyone will sell at some price point. The question is at what point it stops making sense. 

So, the way you provide value to the seller instead of just cash up front is a promise for a greater future tomorrow. In which case, you have to share a lot of your plans. You have to convince the other side that what you're doing has merit, and they see potential in it, wanting to be part of that journey. 

When it comes to deal structure, you don’t have to complicate things for the sake of doing it. If you have all these four options and decide to avail them for a certain transaction, the overhead associated with managing that post-transaction will be a lot. 

Cash is the easiest part as it gets settled at the closing, but everything else requires consideration for how you account for it in your books.

For example, with an earnout, you show it as a liability on the balance sheet because, at some point, you have to pay out that cash. Every quarter, you have to mark that. If your earnout is for 10 million, and it could be paid anywhere from 0 to 10, you mark it as a liability of ten on your balance sheet. 

If the business you acquired starts performing worse, you can write it down from 10 to 8 in the next marking period, and that difference runs as a profit through your P&L. But you have to keep track of those earnouts quarterly, which is extra work.

Equity is generally the most expensive way of financing in the spectrum between cash and everything else. It should be used wisely so that the other party feels they have a stake in the game.

For instance, we made a minority investment in a company, which was later sold to another company. We ended up holding equity in the acquiring company with whom we had no direct dealings, just because of the transaction.

There is work associated with these types of transactions. Before you choose different options like toys, you need to have a good reason for picking each one.

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