The technology boom

Merger and acquisition (M&A) activity in the technology sector is booming. Both the volume of deals and the transaction values are at some of the
highest levels ever. According to The 451
Group, a company that tracks technology
deal-making, buyers announced 1,900
transactions worth $347 billion in the first
half of 2007. While this is a slight decline
from last year’s deal flow, spending was
almost 50 percent higher than in the first
half of 2006.

Smart Business asked Lawrence B.
Mandala, chairman of the Corporate
Transactions and Securities Practice
Group of Munck Butrus Carter, P.C., a
Dallas-based law firm, about the tech buyout frenzy, tech company valuation, and
the increased use of earnouts and other
contingent payment arrangements.

Why is tech M&A so hot?

First, there has been a lot of spending this
year by the private equity (PE) firms. Not
that many deals, but very high-dollar transactions, like the pending buyouts of First
Data Corp., Alliance Data Systems and
CDW Corp. Those transactions by themselves account for over $43 billion of the
tech M&A deal value this year. Second,
market conditions have been very good for
the tech buyer for the last year or two. Low
interest rates, higher profits, readily available financing and increased stock prices
(at least until this July) all fueled the buying spree. A number of large cap companies and PE firms have big cash balances
they’ve wanted to put to work.

Investors look at the technology sector
for several reasons. First, tech companies
are more mature, with more stable earnings histories, than at the height of the dotcom boom. This makes them more attractive to the buyout firms. Second, tech companies have become used to growing at
double-digit levels. Companies are using
acquisitions to fill the gap between growth
they can deliver internally and their growth
targets. They use acquisitions to add new
lines of business, as well. Finally, many tech industries are fragmented, so there is
a drive to consolidate some market segments, like business software. Big companies have the resources to get the deals
done, and small companies are wondering
if now is the right time to sell and become
part of a larger enterprise, rather than go it
alone.

Is it difficult to value a technology company?

Valuing a tech company can be very different than valuing other types of businesses. For example, if the company is new to
market, it might not have a traditional valuation metric like profits. Even if it has
earnings, the last year or two may not bear
any resemblance to expected future
results. If the company has a unique product coming to market, there may not be
competitors to measure the company’s
progress against. If it’s a private company,
or a public company with a volatile stock
price, there won’t be a reliable market
value for the company. In each of these
cases, the parties may have a more difficult
time agreeing on a valuation. It’s also harder to value intangible assets like intellectual property (IP) than tangible property like inventory, real estate and equipment. While
IP rights may be important to every company, the tech company’s IP is frequently
among its most important and valuable
assets. Valuation differences between the
buyer and seller ultimately lead to more
use of contingent payment structures like
earnouts or royalty payments.

When should a seller include an earnout or
royalty payment in a transaction?

Earnouts bridge a valuation gap. If the
seller believes his business has growth
potential and the buyer is unwilling to pay
now for unknown future performance, the
parties might include an earnout in their
deal structure. In an earnout, the buyer
doesn’t pay the entire purchase price at
closing. He pays a certain amount now and
more later depending on the financial performance of the acquired business.
Earnout milestones could include targets
for revenue, gross or net earnings, or EBITDA. An earnout may allow a seller to realize a higher sales price if the business performs as the seller believes it will. It can
also be a vehicle to defer taxes. An earnout
reduces the buyer’s initial expense of
acquiring the business and minimizes the
risk of overpaying based on uncertain projections of future performance. An earnout
also motivates the seller’s management to
stay with the business and contribute to its
future success.

Royalty payments can achieve many of
the same goals. If the seller believes the
buyer is not paying enough for a particular
invention, for example, he might propose
the buyer pay a royalty on future sales.

LAWRENCE B. MANDALA is chairman of the Corporate
Transactions and Securities Practice Group of Munck Butrus
Carter, P.C., a Dallas-based law firm. He has over 20 years of
experience representing publicly and privately owned businesses
in business transactions, including mergers and acquisitions and
public and private securities offerings. Reach him at (972) 628-3600 or [email protected].