The Scales Tip: ‘Buy vs. Build’

How Software R&D Trends Have Influenced M&A Behavior [Contributed by Jeffrey Vogel, originally published on Tech MVP | Bulger Partners]Contrary to the expected assumption, advances in software development technologies and processes the past decade have led to more buying and less building in the industry’s buy vs. build calculus. In this article we discuss how rather than making building more attractive, advancing software development technologies and methods are decreasing the importance of organic development for mature software companies and increasing the importance of growth through acquisition.Technological advancement has given software developers increasingly sophisticated and user-friendly tools. Parallel to the better-known Moore’s Law, Yannis’s Law states that programming productivity doubles every six years. Improved efficiency has progressed through the sophistication of organizational concepts regarding collaborative processes, and the commoditization of significant layers of the software stack (virtual machines, application servers, databases, middleware, high level programming languages, etc.) Indeed, programming performance is up by a factor of 500 in 50 years, making new software production substantially less of an obstacle than ever before. As a result, more significant challenges in the increasingly sophisticated software marketplace form when attempting to differentiate a brand from the growing competition, acquire customers, and build a community. Since M&A has proven the most effective tool in quickly achieving market share, we can expect an increasing number of software companies to seek acquisition of companies and products to meet their growth objectives. Software Development: The Devil You KnowDespite the advent of successful software strategies such as the SaaS model and Agile Software Development, internet speed has further tipped the scales towards buy. Though at first glance the increased ease and decreased costs of software development could lead to the conclusion that build should be favored over buy; this trend has, in fact, had the opposite effect. Significant development projects take 12-24 months to evolve from conception to first customer (first revenue) while new product development holds the additional risks of shifting product requirements during development.As it turns out, as risky as M&A might be considered, significant new product software development can be even riskier. Even if well-executed, it is likely that by the time it is completed a new product development project will have missed the window of a rapidly moving or evolving target market. Through robust diligence M&A can become the devil that you know, while large development projects are the devil that you don’t.Google, for example, has executed a number of acquisitions aimed at expediting market access. In late 2009 Google acquired AdMob for $750 Million. Incorporated just one year before the first generation iPhone, AdMob had already gained 50% market share on the iPhone OS at the time of the merger. The acquisition allowed Google to achieve a whopping 24% market share for the entire mobile advertising industry, virtually overnight. New inventory instantly materialized as a network of ads displayed on more than 15,000 mobile websites and applications for iPhone and Android (another one of Google’s acquisitions).As a result of its efforts to acquire market share, Google put itself in a very good position to capitalize on 41% compounded annual returns for the mobile advertising industry over the subsequent 5 years; with conservative expense estimates at $5 Billion for 2015 in the US alone. However, without an acquisition program expediting market access, even Google itself could never have garnered the incredible market share it has in time for the next five years of rapid mobile platform usage expansion. Diminishing Returns of Software ProductivitySoftware development managers have long known about the Mythical Man Month dilemma (first described by Fred Brooks in his 1975 book of the same name.) The Mythical Man Month dispels the notion that labor and time are interchangeable when it comes to staffing software projects. As Brooks says, “adding manpower to a late software project makes it later.” Due to the Mythical Man Month phenomenon, companies with even the deepest pockets (i.e. Microsoft, Oracle, Google, Facebook, etc.) have no way to accelerate the build of a product past a certain point. Thus, regardless of budget and available resources, buy becomes the only method of obtaining a new product or capability quickly.A few decisions driven by the mythical man month phenomenon include major acquisitions by leading software and systems companies, investing to stay ahead. Rather than delay market access during years of development, and spending hundreds of millions to possibly develop a sustainable product, Microsoft chose to secure most of its ERP strategy through two strategic acquisitions; Great Plains SW and Navision.Google, too, acquired major regions of its product offerings including YouTube, AdMob (mobile advertising), DoubleClick (Ad Network and Ad Server interface) as well as major pieces of Google Apps and Google Voice (Grand Central.) Though either of these power players could have built, it’s evident both Microsoft and Google recognized that the gains from immediate time-to-market superseded the time-delay required to build and establish a new product revenue base. Clearing the Integration HurdleHistorically, something that often hindered the buy analysis were those costs associated with integration. To fully recognize many of the synergies often modeled in an M&A transaction, software products have to be integrated. The costs and time associated with the integration would often counteract any of the synergies, benefits, and even shareholder accretion associated with a transaction. Thus, the bar was high.However, in recent years, emerging technologies including SaaS/Cloud, Web Services (SOAP, REST, etc.), and loosely coupled APIs and bindings in general have enabled integration costs and timelines to be reduced dramatically. Furthermore, some hard showstoppers such as incompatible stacks are no longer integration concerns as the aforementioned new technologies enable products built on different stacks (java and .Net for example) to more easily integrate in a way that is transparent to the end user.There is no better showcase of this than Apple’s April 2010 purchase of Siri. Because of SaaS and web services, Apple was able to complete that purchase in the spring of 2010 and by the summer ship a new version of the IPhone 4 complete with Siri integrated (and tested) in several languages around the world.While Apple acquires sparingly and judiciously, Google acquires a company a week. Though most of Google’s acquisitions are technology tuck-ins, some are meant to grow into billion dollar businesses, sometimes quickly. This is sometimes known as the buy and build strategy, where the core is bought, but the acquirer takes execution responsibility for growing the acquired business to something of significant scale.We can point to five Google acquisitions that have or are likely to become billion dollar businesses, and whose growth to that level was far from certain at the time Google acquired them. They include Admob, YouTube, Android, Waze, and most recently Nest. Private Companies are Acquirers and Wallets Run DeepAnother long-held tenet that is going by the wayside is that M&A is reserved mostly for larger public companies. Venture-backed and other smaller companies historically relied on organic development for growth. However, due to the trends we have described here, smaller and smaller companies are looking to M&A to fuel growth.As evidence of this we look at the number of acquisitions made by private companies over time. In 2003, in 58% of tech acquisitions the acquirer was private. However, by 2013, that percentage had increased to 74%. This is evidence of both the trend towards inorganic growth as well as the trend towards larger growth equity investments in private companies.As a final weight tilting the Buy vs. Build scale, companies have record amounts of cash sitting idle on the balance sheet. Leading tech companies have increased their cash positions almost threefold since 2003. In 2003, the top 100 cash rich tech companies had a combined $253 billion, but by 2013 the top 100 had cash of $628 billion. This war chest will need an avenue for deployment. As the Federal Reserve continues to maintain interest rates near 0%, there is incentive for companies to look towards alternative means of return on their cash stockpiles.With original technological development becoming less of a barrier to entry, investing in the production of new software technologies creates little sustainable competitive advantages. Instead, we can expect the majority of vendors to maximize the potential return of their cash reserves through augmenting market share. Since the most immediate and reliable means for doing so is through M&A, an increasing number of firms will look towards buying and doing so somewhat robustly.In summary, today’s technology and economic environment favors buying new software capabilities rather than building them. The primary driver is the pace and ease with which the technological frontier has been moving forward on an international scale. Recent progressions in software development stacks are making new software easier and cheaper to produce as well as integrate. As a result, relevant factors affecting the financial success of software companies are starting to do less with unique technological innovation, and more with scale, adoption, establishing a community of customers, and acquiring mind share.Since time-to-market is a primary factor in acquiring market share for any given product, technology corporations are emphasizing M&A strategies aimed at immediate market access. This shift in priorities, combined with corporate cash stockpiles hovering at record high levels, leads us to conclude that the velocity of M&A activity for software and software-centric businesses is going to increase at a significant rate.

Posted on October 16, 2014 in Insights, Technology Industry