Alliances Offer A Peek Inside Before The Deal Is Done

Sunday, September 17, 2006

Don Durfee, CFO - May 2006, Pgs. 48-54, http://

Abstracted from: Try Before You Buy

Risky business.
Buying a high-tech startup is a risky proposition. Technologies change rapidly, and today's new idea can be tomorrow's forgotten news. One way that smart CFOs avoid acquisition pitfalls is by creating an alliance with a potential target. Alliances improve the chances of a deal succeeding and also improve the return on assets for the acquiror, Don Durfee reports. The acquiror gets to know the target's management and products while assessing how the target would fit into its corporate structure. Communications giant Siemens did just this when it was considering a new technology called IPTV, television piped over the Internet. Siemens tracked down Myrio, a Washington-based startup working with IPTV, and took a 15% position in the company. This gave Siemens a seat on the board. After two years of collaboration, it acquired Myrio. Such a move enables Siemens­and other companies that employ alliances­to retain the target's key managers while acquiring the necessary technology. Motorola, which measures the performance of its acquisitions annually, has found that the deals which arise from alliances unequivocally are more successful for the company. As one M&A veteran observes, an alliance will give you "half the risk and double the odds."

What's behind the velvet curtain?
It comes as no surprise that alliances are most popular in the technology and pharmaceutical sectors, where the risks of buying the wrong company are highest. Tech companies such as Cisco Systems, Intel, and Motorola use alliances as options to buy. All of these companies have in-house venture programs, which regularly seek out potential alliances. They know that a seat on the board and a good look at the product or technology makes better due diligence possible. Alliance also gives them a window into the financials. Not least important is the fact that customers can be used as a sounding board for questions and research about the potential acquisition. One experienced M&A lawyer likes alliances for their ability to add reality and counteract an overly optimistic merger scenario. Alliances are also helpful for smoothing post-merger integration and minimizing clashes between corporate cultures, the author observes. The relationships created during an alliance can be reassuring to the target's employees and thus help to stem a post-merger exodus of talent.

Not a perfect panacea.
Several recent mergers in banking and manufacturing illustrate a successful use of the alliance-to-acquisition paradigm, including Deutsche Bank's 2000 acquisition of National Discount Brokers Group. Ingersoll Rand's alliance with CISA, a European security firm, helped the buyer and the seller agree upon a price for the eventual acquisition. Despite the many benefits, an alliance cannot help with every problem. The troubled merger of Hewlett Packard and Compaq Computer illustrates an alliance's failure to smooth the clash between two very different corporate cultures. When it comes to large companies, alliances do not seem to make a difference, good or bad. With a large company, only a small part of the entire operation is exposed in an alliance, not enough to give an accurate view. On the other hand, alliance can bring significant benefits to a startup, ranging from validating a product, to financing, to helping with product distribution. The author notes that for sectors where technology does not change rapidly, an alliance may simply be a waste of time, an unnecessary delay before an inevitable acquisition.

Caveat emptor.
For buyers and sellers alike, alliances can have significant drawbacks. The halo effect of having a large company ally with a much smaller one, suggests the author, can inflate the latter's value, so the acquiror ends up paying more. Contract clauses such as standstill agreements or other call options on the target's equity can mitigate this problem. One of the risks for the seller is that it does not realize as high a price as it would in an outright acquisition because of the acquiror's safeguards against overpaying (e.g., rights of first approval, standstill agreements). Another danger is that the smaller company might give away too much information or technology to the larger one. For example, a licensing deal may pay the smaller company only a fraction of the product's market value. The licensing partner might also miss its sales targets, thus compromising the products in the eyes of other potential buyers. In this case, the partner needs the protection of an option to cancel the deal or to demand compensation for the lost sales.

Abstracted from CFO,
published by CFO Publishing Corp.,
253 Summer Street, Boston, MA 02210.

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