Many companies looking to enter the software economy, the ecosystem of companies that create or are enabled by software, do so through acquisitions, often by targeting startups. Evaluating the potential value of these smaller companies, however, is a specialized skill, says Jeff Vogel, head of the Software Strategy Group for EY-Parthenon. For companies, discovering and accounting for hidden talent and technology risks is a big factor in a successful merger or acquisition.
The acceleration of digital transformation and speed of customer demands is turning almost every business into a technology business. Creating, using, or selling technology is now a critical part of every enterprise. But how do companies add emerging technologies and innovations?
“They need to believe in the market, that there’s room to grow in that market or room to expand the market; believe in the company’s ability to execute; or believe that they’re coming with a transformation thesis that they’re going to fundamentally change what the company does and how it does it in order to recognize their return,” says Vogel.
Non-technical companies often look to acquisitions, particularly of startups that are touting emerging technology, to make business processes run more efficiently. They also see software investments offering opportunities for high growth and generally high gross margins. But it’s important to gauge the risk and the reward of acquiring software, Vogel says. In the same way that entering the software economy can yield high growth, the market moves fast, making it easy to lose value just as easily as it is gained.
While there are always risks in business, Vogel says that one indicator of a strong acquisition is talent retention and culture. A lack of synergy between company cultures and poorly managed or deployed talent can pose barriers to a smooth acquisition and integration.
“Because software is an intangible IP and it’s very much tied to the people who build it and maintain it, if you have talent drains due to culture, compensation, or other things after an acquisition, that’s usually the leading indicator that the thesis is going to go up in smoke,” says Vogel.
This episode of Business Lab is produced in association with EY-Parthenon. Learn more about EY-Parthenon’s disruptive technology solutions at ey.com/us/disruptivetech.
Laurel Ruma: From MIT Technology Review, I’m Laurel Ruma and this is Business Lab, the show that helps business leaders make sense of new technologies coming out of the lab and into the marketplace.
Our topic today is about acquiring emerging technologies. If it’s true that every company is becoming a technology company, then coming up with that technology can happen in many ways. Sometimes it’s homegrown, but other times acquiring technologies and startups is a frequent course of action, not just for the parent company but for funding innovation as well.
Two words for you: better building.
My guest is Jeff Vogel, head of the Software Strategy Group for EY-Parthenon.
This podcast is sponsored by EY-Parthenon.
Jeff Vogel: Glad to be here.
Laurel: So, you’ve been working in private equity for years and have more than three decades of experience as an entrepreneur and an executive in software and technology. Can you paint a picture of the current software economy?
Jeff: Sure. So, I might start by defining what we mean by software economy. This term that we define really refers to software companies. So that’s pretty clear to people. Companies that sell or license software. That could be on-premises old-school software; could be more modern, SaaS-based (software-as-a-service) software. But then there’s a whole new slew of companies that people might think of as tech-enabled services. Services businesses that aren’t selling their licensing software. That are selling you some business or consumer service, but powering it with software.
So people obviously know of companies in marketing technology and online search, in recruiting, in transportation, that enable their services with software, but they’re not selling software. So those companies. Particularly if those companies differentiate on the software, so they’re not just using third-party, off-the-shelf software to deliver their service. But they have hundreds of software engineers, dozens or more patents, tens of millions of lines of code when they’re developing proprietary software that powers their business service. And it’s actually how they differentiate even though they’re not licensing software.
So, this collection of companies that are either selling software or selling business services that are enabled by software, that are attempting to differentiate on that software, is what we call the software economy. And these software economy companies share in common those things I mentioned. Lots of software engineers, lots of code, often intellectual property (IP), patents, and trade secrets behind that code. And attempting to differentiate by the way that technology manifests itself to customers or enables a business service to be different, more efficient, faster, better, sometimes cheaper.
Laurel: That’s very helpful to get a view of the entire ecosystem there. So at EY-Parthenon, you help private equity companies with technology acquisitions. As an industry, how does private equity work versus say a basic acquisition of one company that acquires another?
Jeff: Yeah, sure. Good question there. So, when you think about a traditional acquisition, let’s say one tech company buying another, there could be three or four families of theses driving that acquisition. It could be vertical integration. Buy one of our suppliers and integrate it and take a middleman out. It could be cross-sell and TAM (total addressable market) expansion. We want to buy something that’s adjacent to where we are and we’ll achieve synergy because we can cross-sell it through our customers, through our channels, through our salespeople, and vice versa. It could be new market entry. We want to enter a market and it’s going to take us too long and cost us too much money to do that organically. So we want to acquire into it. Or it could be some form of transformation. We’re trying to transform our company over a period of years from one type of business to another.
And those are all types of acquisitions that are done. You can usually put them into those three or four buckets. And then it follows that there’s often some synergy because of those theses. It could be revenue synergy by cross-sell. As a revenue synergy, we’re going to get more revenue than the two companies combined because of the ability to cross-sell. It could be a cost synergy: could be that we have redundant products and we don’t need both of them. We can make all the customers just as happy by eliminating the redundant capabilities and presumably having more efficient product development, product marketing, go-to market organizations.
And even when you don’t see those obvious synergies, typically if you’re doing anything at scale, there’s always back-office synergy. I don’t need two HR organizations, I don’t need two finance organizations, I don’t need two marketing communications organizations. There’s usually some synergy there. So, tech-on-tech or company-on-company, you can often think through with that lens.
Now, private equity, of course, where it’s just a financial buyer, a private equity firm buying a company, none of those theses that require two companies exist, at least in the initial acquisition. So when the private equity company first buys a tech company, they’re going to have a thesis that’s based on belief in the product and the company and their ability to achieve a return on investment on that. And private equity firms are, to be upper quartile, they’re looking for a 20% net IRR [net internal rate of return] over some period of time in order to do that. So, there’s a significant hurdle rate. They’re paying top dollar for these companies, yet they have to achieve top return.
So, they need to believe in the market, that there’s room to grow in that market or room to expand the market; believe in the company’s ability to execute; or believe that they’re coming with a transformation thesis that they’re going to fundamentally change what the company does and how it does it in order to recognize their return. So, there’s a pretty high bar and some of those synergies that M&A has are not available, at least in the first acquisition. Now, it’s pretty common that after that first acquisition, a private equity firm might develop a thesis that’s about acquiring more companies. And those subsequent acquisitions, some people call that a platform build or tuck-ins, might have a thesis that’s more in line with what the tech-on-tech examples illustrate.
Laurel: So interestingly, once one technology company is bought, then a portfolio could be possibly assumed, et cetera, and it paves a way for more investment.
Jeff: So since you mentioned that, often that’s becoming more prevalent today because the private equity firms are paying up and they’re just, buy the company, believe in the market. And the company thesis sometimes isn’t enough to get their return. They need to add scale and dollar-average down. In other words, if I’m paying 20 times EBITDA [earnings before interest, taxes, depreciation, and amortization] and seven times revenue for the first deal, and I know that it’s going to be hard to make my return on that, I may need to go find some tuck-ins and some other deals where I can start recognizing some of the synergies that strategics have available to them and bring that multiple down. That first deal might be done at those multiples. Maybe subsequent deals are done at 60% of those multiples and your average multiple winds up being somewhere in between. And that’s pretty common these days, particularly as firms are paying up for the initial platform.
Laurel: So what are some of those differences between evaluating mature companies and startups? Because that’s got to be some kind of specialized skill.
Jeff: Yeah. It’s interesting. So sometimes—there’s a little joke in the industry that the earlier stage you are, the easier it is to raise money. And one reason is there’s less to diligence. So that’s why diligence in the venture capital world looks very different than diligence in the private equity world. There’s actually less to diligence. There’s a little more of term sheets, quote “on the back of a napkin.” A lot of venture capital is relationship based; it’s believing in the team. Because one thing they teach you at venture capital school is the business plan that you invest in won’t be the one that a company is ultimately successful in. So, you’re really betting on the team, you’re betting on the team’s ability to pivot and navigate and find the eventual path. Because that first one for early-stage companies is probably not where they’re going to wind up being successful.
So, there’s not a lot to diligence and there is market risk and there is product risk. Those are two big risks that you take in early-stage investing. You move over into later stage and mature companies, market is probably defined, the competitive set is probably defined, and there’s probably a product that’s doing something because these companies have substantive revenue. Now there might be a next generation of the product, the product might be under competitive threat.
The product might need to be transformed. It might have what we call technical debt. It might have a re-architecture or a re-platforming. It might be an on-premises product that has to move to the cloud and become a SaaS [software-as-a-service] product. All of those are things that could be roadmap objectives of a company that you would want to diligence because they’re essentially expenses that you’re signing up for—things that the company has to do to maintain or improve its market position and its financial profile over time that you’re betting on. And you want to diligence those really well. We call this technical debt “off-balance-sheet liabilities.” It’s like deferred maintenance on a house.
So these mature products have lots of it. They’re not on the balance sheet so I can’t read the financial statement and say, “You owe that bank a million dollars.” But under the covers, in between the lines, there’s a body of technology and that technology needs tender loving care and maintenance just like a home or a building might. And in diligence you want to try to understand that. You want to try to understand the market needs. You want to try to understand the competitive set, and the competitive landscape, and the roadmap that the company has for navigating that. And see if that aligns with your management teams and your ability to execute.
So we like to say all these companies have risks and a lot of diligence is about aligning the risks that are there with those that you as a private equity firm are well positioned to undertake. In other words, some firms are willing to live with some financial risk or some product risk or some market risk or some talent risk. But other risks they’re like, “no, no, no, no, we don’t take market risk, but you have some talent risk, which we can help with because we’re great at recruiting and retaining talent.” So a lot of it isn’t that there’s no risks in the deal, but it’s understanding them, attempting to quantify them. And then culturally and DNA-wise, what are the types of risks that your firm is well-suited to taking on and aligns with the culture and DNA of the firm, versus what risks you just can’t touch?
And for some folks that are newer to tech—if you’ve been a private equity firm investing in industrials and now you’re coming into tech, there’s a lot of product and market risks because markets change quickly and products have to change quickly. And those might be risks that some of the newer firms investing in tech don’t take, as compared to some firms that have been around and getting used to software economies for the last 10 or 15 years and are better suited to understanding the disruption and opportunity that comes along with software investing.
Laurel: You’ve mentioned a little bit of this, of why non-technical companies would want to acquire emerging technology companies, integration product portfolios, cross-selling, et cetera. But what is the potential value of these acquisitions in terms of that innovation, profit, and talent?
Jeff: We see a lot of these non-tech companies trying to become more software enabled and software driven and enter the software economy. And that could be for really good reasons. That software is good for their customers. It makes some business process easier, faster, cheaper, smoother, higher quality, more automated. But it could also be for financial ones. Software enjoys relatively low friction to grow and enter, opportunity for high growth. People see these crazy growth companies in the software economy all the time, and in other sectors of the economy it’s hard to grow at those rates. High gross margins in software. Cost of goods is a pretty small percentage of revenue and what you sell products for. We have a lot of rule of 40 or 50 or 60 companies. If you don’t know what that is, rule of 40 is when you add together the growth rate of a company with the EBITDA margin of the company. And 40 used to be great. If you’re growing at 20% and delivering 20% EBITDA margins, that’s pretty good.
But we’re actually seeing rule of 50 and 60 companies in software today. So combining those two [figures], those are typically trade-offs. I can grow faster if I invest more of my profits, if I’m a little less profitable, or I can grow slower and have more profit. But when I can do both in a reasonable percentage and I’m rule of 40, 50, or 60, that’s pretty strong. And we see a lot of those companies in software, high multiples. People love that because it means higher exits and lower cost of capital when they’re raising money. We don’t require a lot of working capital, we don’t have a lot of factories, we don’t have a lot of inventory. So managing the balance sheet is a lot easier.
So a lot of people are jealous of the metrics and low friction and the acid light nature of the software economy and want to try to make their companies start looking like that. And that’s why we see a lot of these companies either transforming themselves or starting to acquire software companies and attempt to garner some of the benefits of being in the software economy.
Now, the other side of the coin, of course, is there’s always a little bit of “be careful what you wish for” because you come on over to the software economy, and what’s different over here? Well, you can go from zero to 100 pretty quickly. You can establish yourself. You could not be a company one year and be a major player and dominate the market six years later in multi-billion-dollar markets. And we’ve all seen that, particularly in Silicon Valley. But the other side of it is you can go from 100 to zero pretty darn quickly, and you’re seeing some of those companies play out today also.
So there is another side of the coin, and you have to have the stomach for it and you have to have the risk profile for it and you have to have the DNA for it and you have to have the talent for it. So it is somewhat different from running non-software economy businesses. Those are the reasons why we see these non-tech companies starting to acquire tech companies and enter the software economy.
Laurel: Just so everyone is clear, EBITDA is earnings before interest, taxes, depreciation, and amortization, but we’re talking about indicators and what makes a technology company a strong acquisition without a crystal ball, without knowing what those successful companies may be, the zero to 100 and beyond. What’s a good example of how companies can actually start looking at some indicators?
Jeff: Well, if you’re six, 12 months into it, things that I look for… Now, let’s say you’ve got a non-tech company acquiring a tech company or even a large tech company acquiring a small tech company. When you enter the software economy, there are a lot of things that are different. One of them is talent, the way people think, the types of people that you hire, the culture of these software economy companies. And the great sign is how many of the key people are staying around, and more importantly, what their roles are in the company.
So when you see companies acquired and the executives from the acquired companies start getting promoted and taking on larger roles in the acquiring organization, that’s hugely a sign that the cultures are aligning. The things that the acquired company brings to the table are valued by the acquirer, the cultures are integrating. The benefits, even if they take longer because of integration of products and technology and channels and markets, might take a little longer. But if you see the talent integrating in that way, I’d say that’s a pretty good sign. Because software is an intangible IP and it’s very much tied to the people who build it and maintain it. If you have talent drains due to culture, compensation, or other things after an acquisition, that’s usually the leading indicator that the thesis is going to go up in smoke. So that’s the first thing I look for.
Now, in a private equity deal you don’t quite see that, because the company is pretty much the company. In some cases, the only thing that changes is the board of directors, especially if a company was well run and a private equity firm wants to keep it that way, there may not be a lot of change and things may just go on as normal. The only thing that changes is the shareholders. But when it’s an operating company being acquired, talent is a good place to look for leading indicators.
Laurel: With a growing number of companies attracted to the technology landscape as you described, it seems like a crowded market. So how can a company differentiate itself to stay competitive and be discerning when looking for investments?
Jeff: Yeah. So I think getting those theses right. Just being a holding company and buying something is probably not the best approach, although there are holding company models out there. Doubling down on the strategy and the M&A, some people might call it an M&A thesis or the integration thesis. So let’s take examples. Vertical integration: If you’re going to vertically integrate or acquire a supplier, that could have significant synergy, could have significant differentiation. And if you take the time to put that strategy out, find the right companies to acquire that fit the thesis, and make sure you fund the integration. Integration is not just a bunch of rows on spreadsheets, but it’s actually getting on the ground, in the weeds, figuring out the operating models, people, the business processes, the tools that are needed to successfully integrate to see your thesis through. Those can be differentiating and those can be game changers for companies both in the marketplace and on the P&L.
Laurel: And you mentioned this earlier, which is the unknown-risk, high-reward aspect of acquiring technology companies, but the new capabilities and talents is something that a new company can offer. So what are the most common obstacles that companies face then?
Jeff: I touched on this before, it’ll be a little redundant, but I would say the first is you’re coming into the software economy, it’s new to you. Companies can go from zero to 100 pretty quickly, but they can go from 100 to zero. The landscape is littered with companies that were high-flyers, leaders in their space, that are now gone and out of business. Were basically acquired in fire sales and somebody’s running out the maintenance long tail on some of these companies. So you’ve seen that in old-school desktop publishing, you’ve seen that in old-school CRM and ERP, you’ve seen that in various vertical applications serving vertical businesses. All those sectors have had once-dominant players that didn’t innovate, maybe lost their key talent, maybe had an upside-down balance sheet, were over-leveraged, and basically disappeared and went off the map as quick as they came on.
Again, you can go from not being a company to being the high-flyer leader in the space of five, six, seven years and just as quickly, possibly more quickly, go to zero. So it’s really important that folks acquiring these companies are investing in them, understand that risk, and realize that sometimes drastic things have to be done to keep these companies growing and high-flying, even after you think they’ve reached their apex.
And then the other is, cultures don’t integrate. Again, touched on this before, talent is a key thing. Software economy companies tend to have different cultures than businesses from other parts of the economy. And it’s pretty important that that’s recognized and there are strategies for dealing with it or else the talent won’t be as innovative, will have high attrition risk because—I’ll leave and start a competitor. We’ve seen that play out. Company gets acquired, people run out their non-compete or their retention bonus for a year, then they all go and start another company, and that other company does it even better.
One thing you’ll find in software is the first guys to do it are usually not the winners. In fact, often you may not know the first guys or gals. The second time around is usually better. Why? Because you learn from your mistakes. Or better yet, you learn from someone else’s mistakes. You have a model to work from. The first time you’re designing a mobile phone, you’re the first guys, you got to figure it all out. The second time, you’re learning from the guys who got it like 60% right, but 40% wrong.
The time before, in the web browser space, it wasn’t the first guys who won. In the mobile phone space, it wasn’t the first guys who won. In the desktop computing space, it wasn’t the first guys who won. It’s usually the second or third. So that’s a pretty common theme and often people who were on those first teams that learned, and they go start the second teams. And if you have that talent and you let it walk out the door, shame on you.
So trying to be the ones that put yourself out of business versus letting your former employees figure out how to do it is always a good idea. And I think the best companies do that. They form teams, they give them some autonomy, and they say, “Can you go build the next generation of our product rather than a competitor? Go build it.” And then that’s how companies reinvent themselves and mitigate the risk of the talent culture or the innovation culture walking out the door or springing up somewhere else.
Laurel: It certainly helps to have that history as perspective now, but looking forward into the future, how will private equity help shape the technology landscape in the next few years?
Jeff: So I mean, look, it’s a little bit of the Wild West. Private equity has never been so dominant in tech. I mean it’s hard to believe, but if you go back 12, 13, 14 years, maybe even 10, there was almost no private equity investing in tech. Private equity firms didn’t understand tech; they didn’t understand all the things I mentioned. Why the high gross margins? Why the high growth rates? I’m scared of companies going from 100 to zero; I know they can go from zero to 100. I don’t understand all this intangible IP that I can’t touch and feel. It’s not in the factory, it’s not an inventory. There was very little investing in tech and then there were some deals done 10, 15 years ago that were the first tech deals, big take-privates. And then more firms got into it, and then some specialized firms started doing only tech. And now tech private equity is a big part of our economy and the capital markets.
Some numbers that might be interesting to people. Last year in 2021, there were 129 tech IPOs for $70 billion, and actually a small fraction of that in 2022—so far, only 19 deals for $1.6 billion because of the market corrections. And if we look at buyouts, there were almost as many—in 2021 there were 139 buyouts, actually a little more, for $50 billion. But in 2022, this market actually was so white-hot at the beginning of the year that there were 99 deals for $60 billion. So there were 80 more tech take-privates than there were IPOs in 2022. That represents 43% of the deals, by value in 2019 and by number, were in the tech economy.
So tech is dominating the capital markets and private equity and tech are becoming a substantive portion of the capital markets. More so, the drastic change has been on the private side, and people realize there are companies now that have gone private, public, private, public, private, public, bounce back and forth, because there are things you can do as a private company that you can’t do as a public company. The quarterly financials make it hard to do things like a SaaS transformation, to go from big upfront contracts to recurring revenue. Makes it hard to do big investments in new products, makes it hard to spend a lot of money on R&D [research and development], or a lot of money on R versus the D, development and maintenance. A lot of these are things that people find are easier to do as a private company, outside of having to report every quarter and disclose everything you’re doing to the public. Thus, you are seeing this cycle that private equity is just a pretty meaningful part of the capital markets for tech companies overall. And we’re doing bigger and bigger deals.
We worked on a $17 billion deal.And I think we’re going to see a lot more deals in that size neighborhood over the years to come. While private equity has been slow the last six months or so with the correction, when the public markets, interest rates going up, what have you, there’s a lot of pent-up demand. There’s still a lot of money on the sidelines in private equity that’s going to be invested when private equity pops back, which will likely happen at some point here in the first half of 23. It’s probably going to come back with a vengeance, and I think we’ll see the effect of private equity on the capital markets for tech companies be as significant as ever later in 23.
Laurel: Completely fascinating. Jeff, thank you so much for being here on the Business Lab today.
Jeff: Appreciate it. Thank you.
Laurel: That was Jeff Vogel, head of the Software Strategy Group for EY-Parthenon, who I spoke with from Cambridge, Massachusetts, the home of MIT and MIT Technology Review, overlooking the Charles River.
That’s it for this episode of Business Lab. I’m your host, Laurel Ruma. I’m the global director of Insights, the custom publishing division of MIT Technology Review. We were founded in 1899 at the Massachusetts Institute of Technology, and you can also find us in print, on the web, and at events each year around the world. For more information about us and the show, please check out our website at technologyreview.com.
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Learn more about EY-Parthenon disruptive technology solutions at ey.com/us/disruptivetech.
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