Case Study: Mitigating M&A Risks in a Tech Acquisition (and why M&A is a team sport)

Much is said about the importance of due diligence in an M&A process.

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But often it’s the HOW that can make or break an M&A deal.

• How the diligence team identifies the risks
• How the acquirer works with internal and external resources or advisors to mitigate risks
• How the corporate development team partners with legal counsel to structure the deal
• How the acquirer sets up the right post-close integration plan and deal-tracking processes to maximize the impact of the acquisition

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?Below is a case study where we recently advised a company as they executed an M&A transaction. Due diligence uncovered a few red flags but the combined deal team successfully structured a deal to mitigate them.

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And time after time, I'm reminded how an M&A process is a team sport. If one area doesn't perform, the deal is likely to fall apart - no matter how good the strategy is or how attractive the business rationale for the acquisition is.

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?(Anonymizing the names of our client as "Client" or "Acquirer", target as "Tech Solutions" or "Target")

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Background:

Our client, a global technology company, was looking to enter a rapidly growing sector in an adjacent space.

The company's CEO and the leadership team, identified Tech Solutions, a mid-size product and services company, as a potential acquisition target.

Despite the collective excitement surrounding Tech Solution's cutting-edge technology and impressive revenue growth, we recognized the need for a careful approach to avoid pitfalls in the acquisition process.

Here are three key findings during the due diligence process, and how we mitigated them (this is not an exhaustive list, merely a few areas worth highlighting).

1. Intellectual Property (IP) Evaluation:

Our client leveraged their internal Legal / IP team to assess Tech Solutions' technology and software for any potential IP infringements. This step ensured that the acquisition would not lead to legal challenges.

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DD finding:

It was discovered that there was an ongoing lawsuit against the target involving patent infringement allegations. The lawsuit was brought against by a competitor, alleging that the company's flagship product infringed upon several patents held by the competitor.

Business Risk:

Proceeding as is would expose our client to legal liability, reputational damage and business interruption - not to mention loss of revenue if the product had to be discontinued.

Mitigation:

1. Expert legal advice: We advised our client to hire experienced IP attorneys (external counsel) to assess the lawsuits' merits and potential financial exposure.
2. Settlement: In the meantime, Tech Solutions was already exploring amicable settlement options.
3. Technology workaround: Our client evaluated workarounds to avoid infringing on competitors' patents.
4. Insurance coverage: Explored supplemental IP infringement insurance for additional financial protection
5. IP infringement indemnification: As part of the deal structuring, the agreement included an air-tight IP infringement indemnification clause and a sizeable hold-back (escrow) to protect our client post-close.
6. IP protection: Our client invested in additional IP protection measures, such as patent filings and agreements with key developers, to safeguard Tech Solutions' technology and prevent future legal disputes.

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?2. Commercial Diligence:

Customer Analysis: Partnering closely with the client's commercial and business leadership, we coordinated in-depth interviews with Target's existing customers to gauge their satisfaction levels and assess the potential for customer retention.

Our client also engaged the help of an external firm to advance this. Tech Solutions' customer data was not clean, so it took some effort to organize the information such that we could glean these trends.

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DD findings:

1. High churn rate: The target had a higher (than we hoped) customer churn rate. Customers were discontinuing their subscriptions and moving to competitors.
2. Dissatisfaction with customer support: Customers expressed dissatisfaction with the target's customer support services. Longer response times and unresolved issues were common complaints.

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Mitigation:

1. Customer experience improvement: Our client believed they could solve the customer experience problem by investing in better customer support processes and training the support team to address issues promptly and efficiently.
2. Product development: Our client also believed they could introduce new features that would attract new customers and improve customer retention.
3. Customer retention incentives: Our client's leadership developed strawman customer retention incentives (to put in place post-close), such as discounts for long-term subscriptions and exclusive offers for loyal customers, to encourage existing customers to stay with the target's product post-acquisition.

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This was a deal risk that our client largely accepted but had a high degree of confidence in their (our client's) ability to rectify post-close.?

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3. Valuation Gap

The target had growth projections (prepared by their advisor) that were (unsurprisingly) aggressive - contingent on successfully launching a new product line and expanding into a new market.

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However, the valuation model that we built for our client was more conservative and took into account potential market challenges and uncertainties. We built in a downside case to assess what would happen if Tech Solutions' strategies did not work out as expected.

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As a result, both sides had divergent views on the target's future earning potential, leading to a substantial gap in the purchase price.

Mitigation:

1. To bridge the valuation gap and provide incentives for Tech Solutions to achieve its growth targets, we proposed an earnout arrangement as part of the deal structure.
2. The earnout offered a portion of the purchase price to be paid in the future, contingent upon the achievement of predefined performance metrics by the target after the acquisition.

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Terms of the Earnout:

Performance metrics: We agreed on a $ revenue target metric that would determine the earnout payment.

Earnout period: The earnout period was set for two years after the acquisition. This timeframe allowed enough time for the target to implement its growth strategies and demonstrate the achievement of the agreed-upon metrics.

Payment structure: The earnout payment was structured to be paid in installments over the earnout period, providing Tech Solutions' leadership with ongoing financial incentives to meet the performance targets.

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We believed that this earn-out structure aligned interests and shared risk fairly with the target's management team - along with allowing both parties to reach an agreement even when there was a valuation gap.

Note:?Earn-outs are almost always hard to monitor and deliver against (while ensuring that Target's management feels like they're part of the same team), but our client's leadership team was confident that they could manage this post-close.

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These were the top three areas that surfaced, but there were other diligence issues found and other mitigations we help put in place to bridge other deal risks ... eventually our client was able to get to a successful sign and close.

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The process re-emphasized for me the power of collaborative teamwork and effective leadership in navigating complex acquisitions.

Are there any other situations that you've been part of, that illustrate how M&A is a team sport?

#mergersandacquisitions