Winter 2012
Five Integration
Best Practices
that will Make or
Break a Software
M&A Transaction
Industry Whitepaper
by Waterstone
Management Group
Mark Hauser, Partner
Nick Latz, Senior Associate
Carolanne Fried, Analyst
Despite macroeconomic challenges and uncertainty in the broader economy, investment demand for software companies has been strong in 2012. In fact, the volume of private equity sponsored software deals has increased steadily since 2008, and deal volumes are on track to finish the year at the highest level seen since the market peak in 2007.
Source: Pitchbook (through 3Q 2012)
The robust private equity investment environment has been complimented by strong demand from strategic buyers who are looking to acquisitions as a means to improve existing product sets and capabilities (as seen in a number of recent SaaS acquisitions) or expand into adjacent markets or capability areas.
As software company executives work through the opportunities and challenges that M&A deals present, they should recognize that the software industry has structural characteristics that significantly impact deal integration. When executing large-scale mergers and acquisitions within the software industry, a general understanding of traditional post-merger integration (“PMI”) best practices is not enough. In order to execute a successful integration, software executives must consider five critical integration imperatives. A strong understanding of these imperatives can easily make the difference between a value creating software merger and a failed transaction.
1. Tailor the integration approach to the strategic rationale
Strategic M&A transactions in the software industry typically fall into one of three categories:
1. Consolidate: A merger or acquisition within the same product space or vertical market 2. Improve: An acquisition intended to improve an existing product set or capability 3. Expand : A merger or acquisition driven by adjacent market expansion
While M&A deals take place across all three of these areas, the majority of transactions will fall into the Improve and Expand categories. As illustrated in Figure 1, each of these
transaction types has different characteristics, objectives, and strategic rationales. As a result, software executives must tailor their integration approach to the type of transaction they are integrating.
Figure 1 – Software M&A Transaction Types
2. Plan for Value Creation to be driven by Revenue Growth and Strategic Operating Leverage
One important characteristic of the software industry is that it is human capital intensive. Software companies do not have an abundance of physical assets such as inventory or manufacturing plants. Rather, a software company’s most critical assets are its human capital and intellectual property. The human capital intensive nature of the industry makes it difficult to implement large-scale cost reductions after M&A transactions. In both Improve and Expand transactions, the deal thesis is driven by revenue growth and/or defending an incumbent market position. In these transactions, the acquired company is usually left to operate as a standalone business unit and is not fully integrated into the operations of the acquirer (at least not in the short to medium term). Thus, the expense synergy opportunities in Improve and Expand transaction will be limited (Figure 2).
CombinedCo P&L Expense Synergy
Opportunities ProForma P&L
Revenue Software 20 20 Maintenance 40 40 Professional Services 25 25 Other 15 15 Total Revenue 100 100 Cost of Revenue Software 0 0 % of SW Rev 0% Maintenance 4 4 % of Maint. Rev 10% Professional Services 18 7% 16 % of PS Rev 70% Other 11 11 % of Other Rev 75% Total COR 33 32 OpEx G&A 13 18% 11 % of TR 13% S&M 22 8% 20 % of TR 22% R&D 14 12% 12 % of TR 14% Total OpEx 49 43 EBITDA 18 25 % of TR 18% 25%
EBITDA Margin Improvement 7%
Figure 2 – Expense Synergy Opportunities by Functional Area and Transaction Type
1) Assumes that the merged companies are of similar size and scale (i.e. smaller company represents 25% or more of CombinedCo total revenue)
Figure 3 – Representative Consolidate Transaction
In Consolidate transactions, there will be opportunities to realize strategic operating leverage. Figure 3 provides an illustrative example of the magnitude and functional areas in which expense synergies can be realized in a representative Consolidate transaction. As the example shows, the most significant expense reduction opportunities will come from General & Administrative (i.e. Finance, Accounting, IT, etc.). Moderate expense synergies can be realized within Professional Services, Research &
Development, and Sales and Marketing (See Figure 2).
While the 7% EBITDA margin improvement (shown in figure 3) should increase the
enterprise value of the combined entity, these expense synergies alone are not driving the deal thesis. Even in Consolidate transactions, a significant portion of value creation will be
driven by revenue growth opportunities or defending an incumbent market position.
Note: CombinedCo P&L revenue mix and expense line items were determined by analyzing financial performance across a set of 435 public Software companies; expense synergy opportunities are based on Waterstone client experience.
3. Sell the vision
Regardless of the transaction type, it is critical that the executive leadership team sell the vision of the combined entity to customers, employees, and other stakeholders. When a software company is acquired, its customers are often concerned about decreased support, maintenance, and / or enhancements for the applications they are using. Other customers will refrain from purchasing new products or services until they have a strong
understanding of the product direction for the combined organization. Software companies can minimize the risks of customer defections and delayed sales by quickly communicating a vision for the combined entity and a roadmap direction that protects customers’ existing investments while also adding new features and capabilities. Since software companies are reliant on human capital and intellectual property, it is especially important to reassure employees after a transaction in order to prevent unnecessary attrition and to maintain employee engagement and productivity.
4. Prioritize the development of the product roadmap
After the transaction has closed, the executive team of the combined entity should prioritize the development of the combined product roadmap. While ownership of the product roadmap typically lies with product management, the creation of the roadmap should not be left up to one person or group. Rather, the development of the roadmap must be a cross-functional effort that incorporates the perspectives of Product
Development, Sales, Professional Services, and Marketing.
The combined product roadmap is critical to the transaction integration because it serves as a guide from which other major integration decisions can be made. A well thought out product roadmap that is aligned with the company’s strategy and operating blueprint will significantly speed up the integration process and will allow the executive team to:
Determine the optimal allocation of capital and resources,
Identify redundancies and cost savings opportunities, and
Communicate confidently with customers and employees about the post-transaction product direction
5. Take a close look at the development footprint
Given the large number of Improve and Expand transaction in the software industry, many company’s product development footprints have expanded into multiple geographies and
have become increasingly difficult to manage and monitor. Many of these companies are now struggling to work through the hidden costs associated with offshoring. These hidden costs - which include attrition, wage inflation, loss of intellectual property, increased training, and increased product testing - can significantly reduce and might even eliminate the labor arbitrage opportunities associated with offshoring.
Another factor that is causing software companies to re-examine their geographic footprint is the increased adoption of agile development methodologies. Agile development is most effective when team members are co-located and able to communicate with each other without interruption or delay. Software executives should use M&A integration as an opportunity to optimize the combined entities’ development footprint, ensuring that it is assembled in a way that will drive productivity and increase the yield on product
development expenditures.
Conclusion
Moving forward into 2013, we expect that financial and strategic buyers will continue to drive a flurry of M&A activity within the software industry. To ensure success, software executives should follow these five imperatives in order to proactively manage an integration plan that enables revenue growth and strategic operating leverage.