M&A In A High-Tech World: Redefining Due Diligence
To build or to buy, that is a question keeping the C-suite up at night when determining growth strategy.
As global M&A activity reached more than $1 trillion during the first quarter of 2019, it’s clear that “buy” continues to be high on the agenda for senior leaders.
However, another M&A dilemma is causing business leaders sleepless nights: making sure they’ve found the right company to buy, as well as whether they’ve put the right price tag on their targets’ assets.
With the shift toward technology in the past few decades, asset valuation can be more complicated. In 2019, approximately $19 trillion in market value – nearly 85 percent of the value of the S&P 500 – is represented by “intangible” assets such as intellectual property (IP) in the form of brands, patents and technology – all of which is driving the majority of M&A activity.
Lewis Lee, chief executive officer, Intellectual Property solutions at Aon, states, “Intellectual property is increasingly becoming a key reason – and in some cases, the main reason – for companies to acquire others that help hit growth targets.”
And with six out of the 10 top spots on the S&P 500 going to technology companies, tech will continue to affect business strategy, including by maximizing M&A deals.
Today’s increasingly digital economy is shifting transaction diligence. Intangible asset-value and cyber risk will increasingly become a greater priority for deal terms to compete effectively and deliver returns.
Global M&A activity reached $3.35 trillion in 2018, its highest level since 2015’s record-setting levels. And 2019’s first-quarter numbers indicate that this pace will continue.
It’s little surprise that fintech, digital health (mHealth), e-commerce, robotics and software are among the key areas expected to experience considerable M&A activity in the year ahead. Given that these industries all have valuable IP assets, they are lucrative M&A candidates. And because highly valued IP tends to be accompanied by technology, it inherently heightens cyber risk.
The challenges to M&A success are numerous – as the landscape evolves, successful deals will rely on greater diligence around IP and cyber risk.
Understanding The Value Of Intellectual Property
Across industries, intangible assets are becoming primary sources of value. “Over the past decade, intangible assets have begun to overtake tangible assets in terms of value,” says Lee. Copyrights, patents, formulas and source codes have overtaken property or equipment as some of the most valuable items on a balance sheet.
Yet despite the increased importance of intellectual property as a source of value, many companies are unsure of the associated value, or even how much of the IP they own. Understanding this value and the lack of transparency around it is crucial for both buyers and sellers to maximize the value of the deal.
Buyers need a detailed assessment of an acquisition target’s IP to value the target appropriately. For sellers, on the other side of the deal, valuing IP accurately can lead to a higher sale price, also known as exit valuation.
Whether it’s by confirming that a target company actually owns the claimed IP or source code or by understanding the competitive risk landscape for a target’s IP, acquirers also should carefully assess how the target’s IP fits with their own long-term strategy. For example, are there patents that aren’t worth maintaining long-term, or can possible income streams be realized in licensing nonessential patents to third parties?
Despite the increased value of IP, however, “Many companies have been slow to adopt approaches to managing and valuing their intellectual property portfolios in a manner that creates enterprise value,” states Lee. This fundamental understanding of worth is critical in protecting IP and, in the case of M&A, maximizing sale value for the seller and creating lasting growth opportunities for the buyer.
Cyber Risk Is Pervasive And Is Magnified During M&A Deals
Just as our connected world has made nearly every company a tech company, nearly every M&A transaction is a tech deal. And with that technology comes a level of cyber risk that can threaten deal success.
Ian McCaw, head, Cyber M&A for EMEA at Aon, notes the disconnect between a growing risk and proper diligence: “We’re facing a global cyber threat. Cyber attacks and breaches continue to impact businesses, however, in the case of strategic activity such as M&A – there is a considerable gap,” McCaw adds. “In my experience, a minimal percentage of deals actually include any specialist cyber due diligence.”
And a first step toward managing the emerging risk is simply understanding it. McCaw highlights a few key areaswhere cyber exposure can impact the overall deal outcome:
•Post-sale financial liability. Breaches of target companies’ systems that compromise customer data or IP can bring long-term financial consequences, including costly lawsuits, regulatory fines and brand damage.
•Costly infrastructure needs. A target company’s underinvestment in cyber security can result in the need for significant commitments of capital and personnel to bring security to an acceptable level.
“M&A cyber diligence is critical to identifying potential threats to the deal. Evaluating a target’s security posture and controls early in the deal cycle can help prevent costly remediation,” states William Shortt, head, M&A Cyber Strategy at Aon.
Buyers should use a broad, comprehensive approach of due diligence to cyber risks in M&A deals. Both buyers and sellers should identify those cyber security issues that need to be addressed by the seller as part of the deal’s terms, setting parameters and deadlines for their resolution.
In addition, McCaw and Shortt recommend that buyers quantify financial exposure associated with cyber risks in the target’s business operating model through quantitative analysis and data analytics. Without this process, the buyer can ensure neither that the deal financial model accurately reflects the target’s value nor that warranties and indemnities and other deal terms are constructed adequately.
Embracing New Due Diligence Maximizes The Chance For M&A Success
As business leaders seek ways to maximize their company’s performance, mergers and acquisitions will continue to reliably deliver profitable growth. Whether acquiring source code or an industry-changing patent, IP heightens value and brings new opportunity. As tech can be a source of even more value, lurking cyber threats can equally heighten the risk.
“M&A will continue to drive growth,” says Brian Cochrane, executive chairman, M&A and Transaction Solutions at Aon. And as activity continues and targets become even larger, “buyers with best-in-class processes will find ways to power incremental growth and de-risk transactions as these deals close.”