EDA companies are not the only companies involved in M&A. In 2000 American companies were involved in 8,505 deals with a total value of $1.75 trillion. The market for M&As plunged in 2001 and 2002, making a comeback to $200 billion for the fourth quarter 2003.
Rationale for M&A - General reasons
a) Improve competitive positioning
The action instantly reduces the number of competitors. This may improve the firm's pricing power over its products and services, its ability to compete for higher-quality opportunities, its ability to recruit talented personnel, its ability to develop new products and technology, and its ability to reach a greater number of customers.
b) Revenue Enhancements/Expansion
The combined company can offer a broader array of products and services, exploit broader marketing channels and leverage greater market presence. The company can cross-sell products from one to the other's customer base. Expansion can be in terms of new markets, geography, or product set.
c) Cost Savings/Economies of Scale
Cost savings can be achieved through sheer scale efficiency, elimination of redundant functions (particularly in consolidation of back-office operations and facilities), or through more efficient utilization of development and market resources.
d) Acquire Key Technology or Expertise
In high tech arena, smaller and more agile firms have frequently been able to identify and target new market opportunities with leading if not bleeding edge technology that larger firms have been unable to match. M&A is the result of a make versus buy decision.
e) Risk and Market Diversification
Market diversification can be achieved by broadening the geographic or product marketplace in which the company operates, diversifying the customer base and the demographics of the market and lessening the impact of a downturn in any particular market segment or geographic market. Simply increasing the size of a company can make it less reliant on any single customer, marketing channel or product line.
f) Strategic Opportunity
The acquisition may be undertaken to preclude being shut out of a particular market, or, alternatively, as a defensive mechanism to preclude others from entering the market.
This is where the whole is said to be greater than the sum of the parts or where 2+2 equals 5. Synergy is a much abused word, a catchall phrase.
The primary motivations for EDA vendors is to acquire technology and/or broaden their product offering as demonstrated by excerpts from representative press releases announcing past acquisitions.
“The Celestry acquisition is part of Cadence's ongoing strategy to acquire companies whose technologies complement its own product development and strengthen its ability to provide customers with the most complete, end-to-end design solutions available.”
“The proposed acquisition will significantly broaden Mentor's position in both the PCB systems and wire harness design markets through the integration of Innoveda's complementary solutions”
"Numerical's direct adjacency to our traditional business will not only allow us to grow in the rapidly emerging DFM market; it also strengthens our existing physical products and increases the value of our recently announced Galaxy Design Platform (Synopsys)”
Randy Tinsley, relatively new (8 months) Synopsys VP of Business of Development but with ~18 years M&A experience, see future acquisitions as a way to fill gaps in the product portfolio, to quickly address needs, to move to new markets and to augment the firm's own R&D. The large ($1B) acquisition of Avant! which occurred before Randy's tenure in June 2002 was a case of broadening the offering (back end tools) and increasing revenue ($400M/year).
Dennis Weldon, Treasure and Director of Corporate Business Development at Mentor Graphics, says his firm prefers to develop their own products internally and uses acquisitions to augment that strategy. They seek to strengthen their leadership position. Occasionally Mentor will acquire a company to get a toehold into a new space but only if they can become #1 in that space. He believes that most market segments within EDA will not profitably support two major vendors.
While price is always an issue, it frequently is not “the issue”. Randy Tinsley, Synopsys, says that the crucial element in negotiating and then successfully integrating another company is a shared mindset among the principals. Do the two companies have similar business philosophies and visions regarding how they will operate in the evolving space? Do both companies share the same expectations about where the marketplace is headed and how best to take advantage of opportunities that are being presented? Do the principals of the target firm embrace the reasoning of the acquiring firm? If it is difficult to achieve vision alignment, then there is a big problem.
Ray Bingham says the asset being acquired is people, brainpower. It is necessary to portray a future for the target company that satisfies, even accelerates their vision and dreams. After all they did or could have worked for a large company with less risk, less pressure and more salary.
Dennis Weldon says a critical factor is that key personnel must want to join Mentor. The reason behind the majority of failed acquisitions is that some or all of the key personnel leave post transaction. Mentor seeks firms with good technology that are channel limited where Mentor can provide value through its world wide sales and marketing presence.
In a company, culture simply defines how things get done. A corporate culture is identified by the values and practices shared across all groups within the organization. It is imperative to quickly determine how likely the cultures of the two firms will mesh.
The target firm has several constituencies that may have different agendas. Venture capitalists and shareholders would tend to treat any proposal from a purely financial perspective. Founders would have a pride of authorship, it's “their baby”. Current management would be concerned about their roles and responsibilities in the new organization. It is necessary to come to closure before egos on either side become an issue.
There may be concerns that between an initial understanding and final closure some negative financial or operational event may impact one of the firms. To cover such an eventuality there is often a “material adverse condition” clause which sets forth the basis by which the agreement can be unilaterally terminated. Other protection mechanisms include breakup fees, price adjustment if stock values change materially, escrow of a portion of the purchase until certain issues are resolved, earn-out arrangements if acquired company exceeds revenue or earning targets and insurance policies for certain contingencies. Where there's a will, there's a way.
Due Diligence - Trust, but Verify
Due diligence is a rigorous investigation and evaluation of the business to be acquired. It may be carried out by personnel of the acquiring firm, although it is not uncommon to contract diligence experts particularly for the financial, tax and legal analyses. The goal of due diligence can be expressed in a phrase “No surprises”. Due diligence covers market reviews, risk assessments, and the evaluation of management competencies, as well as to identify areas to concentrate on for synergies or operational impact. If the deal is going to be a stock swap then due diligence will be mutual.
Ray Bingham says the technical evaluation begins with the underlying science. Cadence often uses university professors and industry luminaries in this effort. Then Cadence uses its own expert to determine if the technology is suitable for integration into the company's larger solution.
Randy Tinsley says everything flows from the talent pool. What is their track history? How are they seen by their customers?
Dennis Weldon want to know that the technical advantage will hold up, that the product is extensible not spaghetti code. If the technology is in a new area, they may hire a consultant for due diligence.
Non-technical items cover all aspects of the business. A partial checklist of items to be reviewed include corporate documents and organization, financial data, SEC filings, internal management controls, materials related to indebtedness, contracts (liabilities, rights to assign or terminate), human resources policies and benefit plans, intellectual property (form, scope..), plant-property-equipment, and IT environment.
Valuations - How much is a company worth?
In the case of a public company, the starting point is its market capitalization, i.e. the current share price times the number of outstanding shares. There are several well recognized techniques for setting a valuation as outlined below.
Asset focused valuation methods
Book Value - assets net of depreciation and amortization less liabilities
Adjusted book value - use only tangible assets or change book value to market value
Replacement value or Liquidation value
Discounted Cash Flow (DCF) - the value is the sum of the net present values projected for future years (normally 3 to 5 years) plus the value of “continuing operations” after the projected period. The residual value might be the potential sale price for the business at the end of the forecast period or an assumed steady cash flow in perpetuity. An appropriate discount rate is the “risk-free” rate of return (as with government securities) plus some premium for investing in the risk of a business venture.
Market focused valuation methods
Multiple from comparable businesses based upon P/E, revenues, profit,
The First Chicago method evaluates risk reward scenarios by developing 3 distinct financial plans, assigning a probability to each, calculating a composite outcome and then generating a valuation based upon a required rate of return.
Each of these approaches has problems. Valuations based on tangible assets establish at best a floor value. Valuations based upon multiples require comparable businesses. There may not be a comparable business or there may be many with significantly different values. Any method based upon multiyear revenue or profit projections is subjective. Valuations are generally used to convince oneself or the other firm of the reasonableness or unreasonableness of any offer. If one pays too high a price, there is nothing left to invest. All acquirers want the acquisition to be accretive in a relatively short period of time.
Under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (HSR Act), parties to a merger or are required to report their intentions in advance and provide relevant information to both the FTC and DoJ. The parties must then await approval from the agencies or expiration of a 30-day waiting period before closing the transaction. This period may be extended by a request for additional material. As of December 2000, only those transactions valued at $50 million or more (the size-of-transaction test) must be notified. There is also a size-of-the parties test unless the deal exceeds $200M. These rules facilitate government review generally for concerns related to antitrust and public interest (e.g. proposed foreign ownership of critical technologies). There were 173 challenges in years 1999-2003
Generally, any purchase or sale of securities must be registered with the SEC at the federal level, or the applicable state securities agency unless an exemption from registration applies. A federal exemption is allowed when the terms of the exchange have been approved in a "fairness hearing" conducted by any state governmental agency. Only six states including California have adopted the enabling legislation to permit fairness hearings. This may result in reduced costs by the avoidance of registration fees and the time and expense required in order to comply with the Federal securities law requirements.
The bulk sales law found in the Uniform Commercial Code adopted by most states provides a mechanism under which Sellers of assets out of inventory must give advance notice to trade creditors. If the notice is not properly given, then the sale is ineffective against the Seller's creditors, and the assets may be levied against by the creditors.
If the transaction is a cash purchase, then neither company has a taxable event. However, the shareholders of the acquired company have a taxable gain on the sale of their securities.
If the transaction qualifies as a "reorganization" under Section 368 of the Internal Revenue Code ("IRC"), in which the Buyer's stock is exchanged for the stock or assets of the Seller, then generally no tax will be assessed on any of the parties. Gain will be recognized, of course, at the time that the stock that is received is resold following the transaction. Further, gain is generally recognized on cash and other non-stock consideration received - called "boot". A tax-free reorganization is deemed to have occurred only where there is continuity of equity interest and continuity of business interest.
Under certain restrictions previous net operating loses (NOL) of the acquired company can be carried forward to apply against future profits of the acquiring company for tax purposes.
Accounting for the Acquisition
In almost all cases the purchase price exceeds the value of tangible assets less liabilities. Tangible assets include cash, marketable securities, receivables, inventories, plant and equipment. Liabilities include accounts and notes payable, long term debt, accruals, projected benefit obligation in excess of plan assets. The excess is referred to as “goodwill”.
The Financial Accounting Standards Board (FASB) sets the rules of the road for how to record and report financial transactions. The relevant standards promulgated in June 2001 are No. 141, Business Combinations and No. 142, Goodwill and Other Intangible Assets. These standards mandated the purchase accounting treatment for M&As. Accordingly, goodwill is now subject to periodic impairment reviews. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value.
Intangible assets, whose benefits results from contractual or legal rights and that can be separately sold, transferred or licensed, are recorded separately from goodwill. Examples included patents, licensing agreements, and customer contracts. Intangibles with finite lifetimes are amortized over the expected useful life with possible adjustments if impairment is detected.
R&D projects underway within the acquired firm that have no alternative use and are not currently technologically feasible require immediate expensing. Technological feasibility is established upon completion of a detail program design or, in its absence, completion of a working model. The In-Process R&D (IPRD) charge is determined by estimating costs to develop the acquired in-process technology into commercially viable products, estimating the resulting net cash flows from such projects and discounting the net cash flows back to their present value. The discount rate reflects the uncertainty surrounding successful development of the acquired in-process technology.
After the Deal is Closed
M&As give the shareholders of the acquired firm a premium for their equity. The acquiring firm has the challenge of delivering value based upon superior management and synergy. Unfortunately, most mergers and acquisitions do not produce value for the shareholders of the acquiring firms. Key reasons why deals fail include incompatible cultures, inappropriate leadership, hidden liabilities, loss of key personnel, strategic misalignment and poor employee communication.
Randy Tinsley says that there is a temptation after the toasts have been made and the champagne has been drunk for those involved in the negotiations and due diligence to return to their “real jobs” and to lose focus. This is a critical time for the combined company. There can not be too much communication. People being people will want to know how all this will impact them individually.
In describing Cadence's approach Ray Bingham said it is critical when acquiring new, nascent and embryonic technology not to disrupt but to keep the team and leadership intact; to empower them to develop in a startup-like environment. Cadence provides earn-out structures to all with upside bonuses based upon technical deliverables and financial achievements. Scorecards are established, published and tracked. Give the people a sense of mission accomplished. Integration takes place at the group level not the individual level. The leaders are brought into the fabric of the development organization. He gave the example of Ping Chou former CEO of Silicon Perspectives who was made General Manager of Digital IC Solutions.
Dennis Weldon says that Mentor fully integrates the personnel of the acquired firm. You can't create more value than a stand alone operation unless you change. This must be made abundantly clear at the outset to the firm being acquired.
Impact on EDA Firms
It is difficult to objectively evaluate the effectiveness of EDA acquisitions because external factors have had a significant impact on stock prices and revenues in the industry. The shift toward subscription licensing also clouds the issue. Further firms do not report their results in a manner that identifies organic growth versus that due to acquisitions. By law the firms would have to write down goodwill, if the value was impaired and no significant write downs have been recorded.
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--Contributing Editors can be reached by clicking here.