Tech & Software M&A Dynamics

Jacob Orosz Portrait
by Jacob Orosz (President of Morgan & Westfield)

Executive Summary

A prerequisite to understanding how to value your company and how to increase the value of your business is understanding how buyers think. This article will take you into the mind of a potential buyer of a technology or software company and provide you with an overview for why they make acquisitions and what is important to them when they are considering making an acquisition.

Having knowledge regarding the underlying drivers of M&A activity in the technology marketplace is also helpful to accurately predict long-term trends within your industry and broader macroeconomic trends that may affect the value of your business. This knowledge can be used to manipulate the drivers of value for your company — in other words, knowing what impacts the value of your company helps you maximize the value of your software, tech, or online business.

It’s important to understand industry dynamics since that’s what drives acquisitions. There are two important things to take into consideration:

  • Demand for Software: The demand for software in general will continue to increase, which will increase the overall volume of acquisitions. This will continue to make software companies attractive as acquisition candidates.
  • The Cycle of Innovation: It is important to understand the cycle of innovation. In the early stages of innovation, solutions are highly fragmented as bits and pieces of a total solution and are developed independently. Then, as the solutions mature, they become consolidated through acquisitions of fragmented solutions. In the initial stages of innovation in an industry, there are lots of little competitors or companies developing their software independently. Eventually, bigger companies come along and see opportunities to acquire these smaller companies and their technology that they can combine into a higher-level solution.

There is a disconnect for a lot of entrepreneurs since they don’t know what opportunities exist in their industry and what acquirers are seeking (i.e. value drivers), and they don’t understand how acquisitions fit into the overall ecology of their industry. The value drivers for your business should first be considered from the buyer’s perspective.

Value drivers can be compared to a buyer’s grocery list. If you know what is on the buyer’s grocery list (e.g. eggs, cheese, milk, bacon), then you can simplify the work needed to supply the buyer with those items. It’s what they want from a company.

Below is a high-level overview of the factors affecting middle-market technology companies. This will help you determine where in the marketplace your business fits as a potential acquisition, who the likely buyer may be, and their reasons for considering an acquisition. It’s important to understand the reasons for acquisitions and the consolidation of industries, and why companies choose to make acquisitions as opposed to investing in internal R&D, or why PE firms invest so heavily in tech companies. Developing an understanding of the underlying industry factors will help you understand the drivers that affect the value of your business.

This article will examine these ideas and information:

  • How demand and growth of software affects the value of your software company.
  • How innovation drives acquisitions and consolidation.
  • The most popular acquisitions by industry segment.
  • How the adoption time by industry players affects acquisitions.
  • Buyers and their objectives for purchasing a company — if you know their objectives, you can meet their objectives.
  • The effect of key metrics for tech companies and how these drive acquisitions.

By the time you finish this article, you’ll be in a buyer’s state of mind.

Demand for B2B Software

Demand for B2B software has been, and will continue to be, high throughout the next decade. According to NPD’s Small Business Quarterly Technology Monitor, 66 percent of small businesses plan to invest in software, which is up 7 percent from 2018 overall, and up 8 percent from the fourth quarter in 2018. Software represents the number one investment that small businesses plan to make in the coming years.

Growth in B2B Software

B2B software grew at a 10 percent compound annual growth rate (CAGR) during the previous three years, compared to just three percent for non-software categories. And the trend is expected to continue. As the effects of innovation continue to ripple through businesses, small companies must keep pace with competitors and their primary means of doing so is through the purchase of cloud-based software.

Drivers of Tech Innovation and Acquisitions

As the three primary drivers of tech innovation continue — connectivity, cloud services, and data — consolidation in the industry will continue as well. Tech deals have represented almost 40% of private equity transactions as of 2019 and the trend is likely to continue as long as these investments have the potential to generate outsized returns. Larger corporations now rely less on internal Research & Development (R&D) and are gaining access to IP, data, and talent externally through acquisitions.

Industry Dynamics Drive Acquisitions

The industry dynamics of increased demand for software due to innovation through connectivity, cloud services, and data paves the way for a high volume of acquisitions in software and other tech categories as new innovative solutions continue to be created and as industry solutions subsequently consolidate both within industries and across industries. For B2B solutions, consolidations may occur on either a horizontal or a vertical basis. The majority of acquisitions in recent years have been in vertical categories where software integrates functions within an industry, such as software that automates accounting, payroll, and scheduling functions within the automotive industry. This is as opposed to horizontal acquisition categories which include software that can be used across industries, such as a CRM that can be used in financial, industrial, and automotive industries.

The most popular B2B software categories based on buyer mandates in 2020 were:

  • Healthcare (HealthTech)
  • Financial (FinTech)
  • Marketing (MarTech)
  • Education (EdTech)
  • Infrastructure
  • Business Intelligence (BI) & Analytics
  • Business Process Outsourcing (BPO) Technology
  • Enterprise Resource Planning (ERP)
  • Industrial
  • B2B Online Marketplaces

The Effects of Adoption Times

Three of the top four markets — healthcare, financial, and education — have been slow to adopt technology in the past and are playing catch up. The degree to which they are able to catch up is hampered by the bureaucratic nature of their industries and their slow adoption times, which are further limited by lengthy approval processes. The lack of early adopters in these industries changes the acquisition dynamics and parallels can’t always be drawn between these and other faster-moving industries. The pace at which disruptive technologies are adopted varies amongst industries and this adoption rate impacts industry dynamics, and therefore the growth and acquisitions strategies of companies operating within each industry.

Buyers for B2B Software Companies & Their Objectives

For companies offering B2B solutions, realistically speaking, this means you are most likely to sell your software company to a buyer within your industry through a vertical acquisition. In these instances, one of the buyer’s objectives will be to acquire companies with the strategic purpose of integrating multiple functions within the industry. Such a buyer is likely to be an existing competitor or a PE-backed platform company. In most cases, the buyer will operate software in your industry with a larger user base than yours and will plug your software into their existing suite of services, thus improving their overall metrics across several fronts, such as improved retention, increased LTV, etc.

The Resulting Consolidation of Technologies

Ultimately, software consolidation is best for small businesses as this lessens the volume of software a small business must learn, manage, organize, and operate.

Consolidation is also a win for the acquirer, as the more services the software integrates, the higher their retention rates are and the more dependent the customer (i.e. the business) becomes on the software. The larger and more dominant the software becomes in the industry, the more entrenched the company becomes, until soon the software becomes the go-to solution within the industry, as has happened with Mitchell Software in the automotive industry. Small businesses become dependent on the software, especially if an ecosystem is created that benefits from network effects (e.g. Salesforce, Slack, Skype, Linked In, Yelp, Houzz, Zillow), however, this is more common in B2C industries.

Key Metrics for Technology Companies

Customer dependency on software improves the following metrics for the acquirer:

  • Customer dependency increases switching costs for the customer since it’s difficult for customers to switch software if they are highly dependent on it.
    • This increases customer retention, thus reducing customer churn. Higher customer retention allows the acquirer to build a stronger sales team by offering higher commission rates to its salespeople, therefore attracting stronger salespeople.
    • High switching costs also increase the customer LTV (lifetime value), which lowers customer acquisition cost (CAC) as a percentage of LTV, which allows the acquirer to invest more dollars in acquiring each customer.

Knowledge of these metrics is helpful because these are the underlying primary drivers for the acquirer. Knowing why a company is seeking to acquire you is helpful in increasing the value of your company. It’s also critical when attempting to maximize the value of your company in negotiations — not only must you build strategic value, but you must also communicate the strategic value of your company to any potential acquirers. Knowing how acquirers think and communicate facilitates your ability to wrap your language in the most persuasive packaging possible so the potential value of synergies can be translated into dollars and sense.

Once you have identified your value drivers, you can then use our proprietary ‘Return on Value Drivers’ (RVD™) model to prioritize which value drivers to focus on first — based on the potential impact on the value of your business, its associated risk, and the required time and investment involved in implementing the strategy.

Related Resource: M&A Talk Podcast — Jeff Wald, Founder of WorkMarket, on a $100 Million+ Exit — In this episode of M&A Talk, I interviewed Jeff Wald, who successfully founded and exited several technology companies. His most recent exit was a $100 Million+ exit to ADP.

Sources: The NPD Group, Small Business Monitor, “SMB Spending Intentions Paint a Rosy Picture for the US Tech B2B Indirect Market in 2019”, by Michael Diamond, 9 April 2019