Monday, August 25, 2014

Leap of Faith M&A: Mind the Gap

There is an Interesting Post on the difficulty in valuing tech M&A targets highlighting the Facebook-Whatsapp acquisition. We previously discussed the Transaction offering some tentative observations. I agree trying to value or price early stage targets with no earnings is difficult. I, however, strongly disagree with the assertion that such deals cannot be analyzed and we should rely on the judgment of successful entrepreneurs like Facebook’s Zuckerberg because tech is different and not subject to the laws of economics. I am always suspicious relying upon “great men” because of the difficulty distinguishing between luck and skill. Besides, the jury is still out on how this acquisition performs. Furthermore, the “they can afford it anyway” argument made in the FT post is dangerous-I think Hewlett Packard blew itself up using such an affordability argument in its disastrous acquisition program.

The tech “is different” canard was used during the 1990s boom, and did not have a happy ending-remember EToys and Early start-ups without sales, let alone earnings, lack intrinsic value and are difficult to evaluate. Their price depends on what buyers are willing to pay. The absence of a valuation anchor means tech is subject to substantial mispricing risk. Option pricing methods can help analyze such situations.

Option pricing methodology is tricky and subject to misuse - akin to trying to value lottery tickets. The keys to option value include

1)     Skill: does the acquirer have the skill to develop? Many tech investors (Venture Capitalists) acquire not to develop, but to hold a portfolio of deeply out-of-the money options and hope for the best on one of the investments.
2)     Exclusivity: does the option offer exclusive rights to the acquirer e.g. R&D, patents, etc.? If not it has no value.
3)     Sustainability: how long do the benefits last - what is the “T” or product life cycle?
The keys in tech M&A, just like in regular M&A, are the ability to identify winners in advance and acquire them at a reasonable price. 

The complications in tech M&A are

1)     The story (sizzle) dominates while the numbers (performance) lags.
2)     New metrics cloud the analysis. Remember “it is the cash stupid”!
3)     Paradigm shifts occur - AKA  _hit happens.
4)     Information is lacking.

Acquirers must guard against the growth trap of assuming rich future follow-on investment opportunities that can justify anything. The problem is the future opportunities fail to deliver sufficient returns. This is especially true in the tech area with its short product life cycles.
Beware the “this time is different” justification for tech M&A. All investments, tech included, have to produce sufficient cash at some time to offset the current investment. Tech is difficult, but not impossible to evaluate given the information uncertainties and short product life cycles. Nonetheless, that does not justify taking a leap of faith. Keep in mind the difference between flying and falling - at first not much, but then a lot. The same is true for leap of faith M&A.


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