Marketing Expert's Corner
This article written in 2004
The Urge to Merge
"A surprising number of small and midsize software companies survived the downturn. Not all of them should have." -- McKinsey Consulting, Feb 2004
Looking back at Bay Area Techwire over the last two months, something over a third of the news items were about mergers and acquisitions, mostly involving pre-public companies. Due to business conditions and the availability of capital, 'tis the season for mergers and acquisitions. The number of pre-public US companies merged or acquired has risen dramatically of late, to over $2 B in Q4CY03. (Update: the rest of the industry reported on this trend months after this report.) In fact, since 2000 there have been 10 times as many M&A events as there have been IPOs.
One of the drivers for this is a tremendous overhang of VC-funded software companies. As I wrote, there are still probably more than 2000 VC-funded software companies that are not likely to ever go public. So, two paths forward start looking good:
Fuse two private companies together to increase their chances of success; this often means an unamusing write-down of the investment.
Get a larger public company to acquire the smaller private one for its technology; this can sometimes (but by no means always) mean spectacular valuations for the early-stage firm.
Having participated in two very positive acquisitions prior to starting this consultancy, I must confess my bias: I know that a merger or an acquisition can fundamentally improve the situation for both companies involved.
The Good Reasons to Merge
It sounds trite, but all the good reasons to merge are related to one principal: the two companies will be able to pursue their strategy more effectively together than they could apart.
Due to limited resources, early stage IT companies are almost always incomplete: sales or marketing or consulting or the product itself isn't really functional yet. Many early stage companies are really fragments of what they need to be. So merging or being acquired is a logical way for an early stage company to more fully pursue its strategy. The M&A event itself (and the financing round that often goes with it) helps to reduce customers' concerns about company viability, and can dramatically improve the operational capabilities of the two companies.
There's another issue with small companies, public or private. According to the McKinsey study (click image), virtually all IT companies below $50 M are losing money much faster than at any time before. Even with all the layoffs of the last two years, market conditions and lengthened sales cycles make burn rates of small IT companies much higher than is economically sustainable. Said simply, bigger is better right now -- largely because in the customer's mind bigger is safer.
Finally, a merger is probably the fastest way for a company to dramatically reposition itself. Repositioning is important if your chosen market space has been tapped out. But repositioning is rarely effective without changing something fundamental about your company or product because repositioning is about changing your reputation. Prospects have no reason to believe your new positioning unless you have new references, a new product, a new channel, or some newfound financial stability. A merger, properly conceived and executed, can get you all that much faster than would ever be possible with organic change.
Choose Your Partner
The critical issue for a merger or acquisition is the right partner.
There are two basic paradigms for good partners:
A merger of approximate equals: the two companies are colleagues, with complementary skills, technologies, and customer bases. In this model, creating the healthiest company possible involves highly complementary matches in technology base (e.g., language, chipset, or architecture), management style, business model, and overall value proposition. To avoid internal competition and waste, it is important to avoid overlap as much as possible in sales coverage and individual feature sets. If a merger is a marriage, it is a marriage of complementary skills and agendas, not a fortification of identical skills, technologies, and strengths. For this reason, it usually doesn't work for a small company to merge with a close competitor.
An acquisition of a small company by a public company, especially a platform player: the acquirer has money, a channel, and commercial credibility. The acquirer needs the technology and fresh approach of the small company, and will use its own sales channels to dramatically improve the market coverage of the acquired product. In this model, the acquired company will be the basis for a product line or at best a business unit, so the best outcomes occur when the acquired engineering organization is cohesive, tightly managed, and relatively autonomous of other groups in the acquired company.
Once the executive teams have gotten their minds around the principal of a merger or acquisition, the usual sticking point is price (acquisition) or capital structure (merger). The investors and executive team have to strike a deal that has enough potential profit for them on a personal basis. This usually involves weeks of emotionally draining negotiation, and is justifiably the focus of the executives' attention.
But an equally important set of decisions must be made about the thesis or ongoing purpose of the transaction. What will be the business agenda of the new entity? What will be its mission, vision, and strategy? Why will it be more compelling to customers? How will the merger create more traction in the market and more useful innovation from engineering? The development of this thesis always happens (usually embedded in a PowerPoint deck for investors), but it often contains a high degree of supposition or even outright fantasy.
It pays to be honest with yourself here. It is much easier to convince investors about the wisdom of the combination than it is your own employees. From AOL-Time Warner to nearly any of the dot-com combinations, the "dream thesis" (read: "you must be dreaming") is the root of why most M&As are unsuccessful.
The Morning After
The first order of business is to keep revenues flowing, and it is common to have revenue dips lasting 2-3 quarters after a merger is announced. Expect competitors and natural skepticism about the merger to hurt your sales for a while. Smart competitors will put out a "slam sheet" the day your merger is announced giving customers 15 reasons to jump ship, delay purchases, or call you for reassuring executive meetings. Count on this happening, budget time for it! Best practices for mergers (read: Microsoft and Cisco) include a major marketing campaign about the merger right away. Do not cut your marketing budget until the pipeline and closure rates recover.
Operationally integrating two companies, whether fusing complementary peers or adding a small company's products into a larger partner's portfolio, always involves reallocation and reorganization of resources. That's part of why you do the M&A in the first place: increased leverage. Almost inevitably, there is at least 10% redundancy and it's not unhealthy to have 30% or more of staff affected. This isn't to say everyone gets laid off, but the jobs and priorities have to change dramatically for many of these people:
Executives: you won't be needing two VPs of Marketing or two CFOs. In a merger, it's best if the post-merger management team is about the same proportion of execs from each company as the relative size of the companies beforehand. A merger of equals should have approximately equal membership from each of the original teams. In contrast, for acquisitions by a much larger company, it's usually critical for the acquired's head of engineering (either the VP or the CTO) to remain, but nearly every other executive role can be subsumed under existing departments in the acquirer. Depending on egos, flexibility, and company culture, the acquired's CEO, head of sales, and VP marketing may flame out in a few months even if you do try to keep them. Some acquirers recognize this and instantly convert executives into consultants for the first few months of company integration.
Sales and Channels: keep as much of the talent as you can, but you must create one sales/channel structure. Some companies try to have "parallel sales forces" -- one for general products and the other specializing in the new product line -- but this is really hard and I've only seen it really work once. To keep commercial traction, effectively integrating the sales channel is the most time-critical issue for the merged or acquired company. It is almost impossible to keep the two sales teams exactly as they were for more than a quarter, so expect to reorganize territories, compensation packages, and reporting structures. A high proportion of the Sales team that just won't adapt -- they're much less flexible than you might think -- and executive mortality rates can be very high due to ego and career path issues. Make the transition as smooth as possible for customers, and do not show them your internal "dirty laundry." Even though the faces in the sales force will change, you'll almost certainly need to support two sets of licenses, pricing models, and contracts for many quarters to come -- so don't lose the expertise from Sales Operations. Integrating sales teams is probably the hardest of any department, and causes revenue vulnerability for at least two quarters.
Engineering: integrate processes as fast as you can, but understand that
architecture will be ugly for at least 18 months. Engineering processes such as planning/scheduling, resource allocation, pre-production build, test, certification, and documentation should be unified as quickly as possible. These process are essential, but they do not add to design genius or product differentiation -- so go for simple efficiency here. In contrast, product design and architecture are often driven by a few true leaders in engineering -- and these gurus must be given room to excel. Mergers can lead to some very ugly architectural choices, and it is OK for weird compromises to last for years as long as the customer doesn't suffer. This is an area where perfectionism doesn't pay: look at the ongoing lack of integration between Word and PowerPoint, both of which were acquired more than 10 years ago by Microsoft. The technology of web services and a Service Oriented Architecture (SOA) can help by allowing loose coupling of technology bases, even to the point of keeping "parallel universes" indefinitely. Unfortunately, many mergers result in half the technology being gone within a year...and many engineers with it.
Infrastructure: unify intranets, email systems, and phone systems right away. Get unified contact information out to everyone. Create transition plan for "800 numbers" and publicly-viewable email aliases (e.g, email@example.com). Get VPN access and mobile device carriers straightened out.
Marketing: the first order of business is to create an iron-clad analyst and press story about the strategic rationales for the merger. Why is it good for investors? For customers? For the industry direction? You'll spend minimum two weeks planting your story in the right places. In parallel with this, you must launch a significant marketing campaign to promote the merged product line to your customers, reps, and channels -- without this, sales of at least one of your products will dive (thanks in part to competitors' FUD). Within 30 days, integrate all your marketing functions: of all the people in your company, marketing people are usually the most flexible and easiest to integrate. The key tasks for the first 100 days: creating a compelling integrated message; writing and distributing announcement letters to reassure customers and prospects; merging the domain names, and email aliases; deciding and enforcing all the details of naming and logos for the products and the company; delivering sales training for both sales forces, so that each knows how to sell and position the other's products; unifying the price lists and channel offers; reworking all the presentations and collateral documents; and issuing the first of a series of "post merger victory" press releases that show the positive impact of the merger. Over time, the marketing team needs to unify all the web site content, the eCommerce systems, the SFA, CRM, and reference databases, and merge the marketing campaigns. In the short run, unifying and monitoring the marketing budget may be tough, and the marketing budget may well have to increase. After six months, however, the marketing budget can be reduced by removing overlap, eliminating redundant functions, and consolidating agencies/service bureaus.
It usually does not work to merge with a close competitor. There will be far too much overlap, so almost no "win-win" decisions are possible. The competitiveness that existed before the merger -- played out in the marketplace -- will continue in an unhealthy way inside the merged company.
Mergers Work Only with Careful Integration
It's an easy mistake for executives to make: focusing on the merger transaction, and not deeply envisioning and planning the post-merger operations. Great mergers happen when you develop a compelling new company thesis, and drive it through the new organization for 2 to 3 quarters. Most acquirers use the Borg integration strategy: all the functions of the acquired firm are assimilated along strictly functional lines into the acquirer's existing organization. While this is simple and logical, it often destroys the beauty of the business you just bought. Seriously consider keeping engineering, marketing, and sales support as a business unit with its own P&L in your organization, so you don't kill the goose for the golden eggs.
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