TRY BEFORE YOU BUY
Companies are using alliances to take the risk out of acquisitions.
By Don Durfee

When Andreas Mueller-Schubert decided to move his company into the home entertainment business, he knew he would have to buy another company to do it. His company, Siemens Communications’ Fixed Network Solutions, provides broadband internet service providers in the US with the array of add-ons (such as internet telephone service) they use to attract new subscribers. By 2003, customers were asking about a new technology: television service piped over the internet, known as IPTV.

Mueller-Schubert, president of the Siemens division, began searching for promising acquisition targets. He soon found one: Myrio, a US-based start-up with software that enables the various features of IPTV, such as video on demand. “This kind of middleware is the brain of the solution,” says Mueller-Schubert. “If you want to be a leader in this market, it’s a strategic asset you have to own.”

But buying a start-up in a high-tech business is risky. Technology changes fast, and companies often discover too late that they’ve placed the wrong bet. The target’s products may not work well with the buyer’s products. And, of course, fitting sometimes eccentric entrepreneurs into a large bureaucracy may prove futile.

Siemens’s answer was to hedge. Instead of buying the company outright, it signed Myrio up as an OEM partner in late 2003. Shortly thereafter, Mueller-Schubert persuaded Siemens Venture Capital, the corporate-venture arm of parent Siemens AG, to take a 15% stake in Myrio, enough to secure a seat on the board. Two years later, after getting to know the business firsthand and building relationships with the company’s managers and engineers, Siemens bought the rest of Myrio.

The result was a fast integration that retained the key people. “When you buy a technology company, you’re buying the recipes they’ve created, but you also want to keep the cooks,” says Mueller-Schubert. “And we hardly lost anyone.”

Siemens is by no means the only company to use alliances as a step toward an acquisition. Motorola does it occasionally. US-based drug maker Amgen did it in January when it bought Abgenix, a biotechnology firm with which it had had a licensing and development deal since 2002. Microsoft did something similar last year when, after three-and-a-half years of close collaboration with Groove Networks on development and marketing, it bought the US company. That deal also yielded Microsoft a distinguished new chief technology officer – Ray Ozzie, the founder and CEO of Groove Networks and the inventor of Lotus Notes.

When done right, preceding an acquisition with an alliance can improve the chances that the deal will succeed. A 2004 study found that a prior alliance increases the postacquisition return on assets for the acquirer. And companies that rely on this technique report success. Motorola measures the performance of its acquisitions annually, reviewing their performance over five years or more. According to Don McLellan, corporate vice president and director of M&A at Motorola, the difference between deals preceded by a collaboration and others (such as those pitched by bankers) is striking. “It’s absolutely the case that those [with previous alliances] tended to be the ones where we had more success,” says McLellan. Or, as Alexander Roos, vice president and director at the Boston Consulting Group office in Berlin, Germany, puts it: “This approach gives you half the risk and double the odds.”

A look under the hood

That’s a tantalizing prospect, given the patchy track record most companies have with mergers and acquisitions. And it’s probably no coincidence that the technique is most common in technology and pharmaceuticals, where the risks of buying the wrong company or fumbling the integration are probably higher than anywhere else.

Tech companies like the approach because they can use alliances as options to buy. Such options are particularly valuable in a rapidly changing business like home entertainment, where it’s rarely clear which of the scores of new ideas in the market will turn out to be the winner. With alliances, a company can place its bets more widely than with M&A, and acquire only those targets that look like sure things.

Cisco Systems, Intel, and Motorola recognized the value of the try-before-you-buy approach during the internet boom, when they started in-house venture-capital arms. Scouting out acquisition targets isn’t the only reason companies maintain those VC operations (they also give early access to new technology and earn a return), but it’s a good one. For example, while Motorola historically acquires only about 5% of the companies in its VC portfolio, “it’s a valuable tool to help us sift through and figure out which deals make sense and are practical,” says McLellan.

Indeed, an alliance makes better due diligence possible, particularly when the company owns enough to win a board seat (typically 8 to 10% for a private firm). “When you have a board seat, you understand the financials from one end to the other,” says Dick Cook, a senior advisor with Focus, a boutique investment advisory firm. “You understand if the board is under pressure to sell or if they’re having a hard time paying their bills.”

When working together involves some sort of joint customer interaction, companies can also benefit from their customers’ reactions to the alliance. In 2002, Motorola acquired a small stake in Mesh Networks, a company that creates technology to allow fire and police departments to create ad-hoc communications networks. As the companies worked together on research and sales initiatives, Motorola was able to gauge customers’ interest, which turned out to be strong. It bought the rest of Mesh Networks in 2004.

It’s hard to overstate the value of such customer validation, says McLellan. “Our acquisitions are fundamentally about whether the customers we serve will find it valuable,” he says. “And with an alliance, they get to see you working together over time. In some ways, they are the best sounding board for whether this is a good deal.”

Cure for optimism

Collaboration can also be a cure for blind optimism, says Bill Lawlor, head of the M&A practice group for law firm Dechert in Philadelphia. “Alliances expose warts as companies get to know each other better,” he says. “With one-off deals, you often see executives get caught up in deal heat. Alliances wash a lot of that away.”

An alliance can also smooth postmerger integration and soothe culture clash, since it gives companies time to think through how to mix sales forces, say, or complicated technologies. Crucially, it can reassure the target company’s employees. Postmerger uncertainty often prompts an exodus of the acquired company’s engineers and managers – the very people in whom much of the company’s value resides. “They think their pet projects are going to go away, or they don’t really trust the new management team,” says Corey Phelps, a professor at the University of Washington Business School who is beginning a three-year study to understand the impact of alliances on M&A success. “Prior relationships can mitigate a lot of that uncertainty.”

That was the case with Motorola’s Mesh Networks deal. Over the course of the relationship, Motorola employees worked closely with their counterparts at Mesh. By the time the acquisition was signed, Motorola already knew where within its organization Mesh’s managers would fit. There was continuity in the team at Motorola that managed the alliance, too. “It wasn’t an accident that the investment manager who handled the investment for us for the first couple of years is now responsible for the integration team we put together,” says Warren Holtsberg, who founded and runs Motorola Ventures.

Mike Benjamin, CEO of US-based Open Ratings, a division of business information provider D&B, confirms that an alliance goes a long way in easing concerns in a smaller company. Benjamin was CEO of Cybergear, a six-person start-up that created interactive fitness equipment, when the company licensed its technology to Tectrix Fitness Equipment, now a unit of Cybex International. “Their motive was to keep us at arms’ length to see if we could deliver,” says Benjamin. “Our goal was to get to know them. Were these people we could work with or not?” They were. Cybergear’s full team stayed on, at least until Benjamin left to join another company in 1998.

The limits of cooperation

Clearly, the mere presence of an alliance isn’t enough to prevent problems. An earlier joint venture didn’t seem to help the Hewlett-Packard and Compaq merger, for example. Indeed, alliances don’t appear to make much difference for large mergers. The reason: while a partnership with a small company might easily expose the other partner to 50% of its staff and all of its major products, that’s not the case when two large companies make an alliance. “With two very large companies, even a large-scale alliance is going to give you only a very narrow window into the other enterprise,” notes Phelps.

There is at least one case where that narrow window provides enough of a peek: when companies use joint ventures as a step toward buying another firm’s business unit. Carrier Corp, a US-based unit of United Technologies, did this in 2004 when it used a joint venture with the German firm Linde as a means of eventually buying Linde’s refrigeration business. Just as it would have in an alliance with a small company, the buyer got an inside look at the assets without having to pay for the whole thing outright. With such an arrangement, “you can make sure the mother company isn’t selling you any hidden bombs,” comments Boston Consulting Group’s Roos.

Another problem with alliances is that a company may end up paying more for the target. “When a company like Cisco forms an alliance, there’s a huge endorsement effect on the smaller company,” explains Phelps. “The company can go around saying, ‘Look, we were just invested in by Cisco.’ At the end of the day, you end up paying more.”

There are ways to address this problem. Stephen Jancys, an investment banker with New York-based Trenwith Securities, recommends that companies include provisions in the original alliance contract to guard their interests. These might include a standstill agreement or a right of first refusal, which is effectively a call option on the company’s equity. “These guys might have something interesting you’d like to sell to your customer base, but it’s still three to five years away,” says Jancys, who has used the alliance-to-acquisition model with acquirers such as Hewlett-Packard. “You’d hate for your competitors to get it before you.” Of course, if you are too restrictive, your potential target may lose interest (see “Seller Beware”).

For his part, Motorola’s McLellan argues that a higher purchase price may be worth it if it helps avert a flop. “If we can make the acquisition less risky by validating it in the marketplace, then we’re far better off paying the market value later,” he says. “When you buy it earlier, there is a lot of uncertainty priced in, since you are almost guessing at the value.”

Alliances can be a waste of time for a company that knows what it wants and wants it fast. Ingersoll Rand, the diversified industrial company, is midway through a string of what CFO Timothy McLevish calls “bolt-on acquisitions”. It has closed more than 60 deals since 2000 and plans to spend another US$400m on deals this year. Technology doesn’t change fast in most of the businesses where Ingersoll Rand operates, with the exception of security systems, so hedging bets isn’t often necessary. The company knows exactly what it wants in terms of products and synergies, and it wants to move quickly.

“For most of the acquisitions we do, we know the business and can assess the risk pretty well,” says McLevish. “We don’t need to buy a management team to bring us their expertise. I find that when you have a minority interest in the target beforehand, that can be an impediment.” That’s because the buyer doesn’t have a free hand to make the changes it knows will be necessary, he says.

Closing the gap

Despite such drawbacks, the alliance-to-acquisition model can be applied successfully outside of the technology sector. For example, Deutsche Bank acquired National Discount Brokers Group in 2000 after holding 16% of the company’s equity; soft-drink supplier Cott acquired Premium Beverage Packers in 2002 after a licensing deal; and in October 2005, Grupo Santander bought 20% of Sovereign Bancorp with the option to buy the remaining shares over the next couple of years.

And even Ingersoll Rand has employed the technique, albeit reluctantly. In early 2005 it bought CISA, a European security business, after buying equity stakes over three years. The alliance was a way to help the buyer and seller agree on a price. “I’ve never approached an acquisition where there wasn’t a gap between what we thought the value was and what the seller said it was,” comments McLevish. “The equity stakes can be a means of closing the gap by saying, ‘If you, the owner, stick around for a couple of years and prove that your forecasts are legitimate, then we’re prepared to pay your price.’”

Back at Siemens, Mueller-Schubert is thinking about trying the alliance-to-acquisition model again. “When I compare our acquisition of Myrio to other deals that were done in the company at around the same time, we were able to drive this deal faster,” he says. “Usually, in acquisitions, you don’t have the time to get to know each other and really understand what is going on in the company you are buying. But we had interaction with this company right down to the R&D level.”

Don Durfee is research editor of CFO in the us.