 M&A as a Leapfrog Strategy
Legacy research and development is being replaced by mergers and acquisitions
by Mark W. Sheffert
June 2007
In the spring of 1804, a party of explorers crossed the Mississippi River a short distance upstream from St. Louis and began their now-famous trip up the Missouri River. The goal of their expedition was to find a Northwest Passage to the Pacific Ocean, a direct and practical waterway that would take them across the continent and all the way to the coast for the purposes of commerce. The expedition was led by Meriwether Lewis and William Clark. Everyone thought it would last about one year, resulting in an instant “superhighway” of communication and business.
As we know now, it wasn’t that easy. The explorers encountered incredible hardships, disappointments, and dangers. They reached the coast, but didn’t find the water route they sought. They had modern weapons and the blessing and financial backing of President Thomas Jefferson, but it wasn’t enough. They had to adapt, use their imaginations, change their expectations, and rely on collaboration and help from others along the way.
Although Lewis and Clark’s expedition never found the Northwest Passage that was envisioned, their exploration spurred the settlement and industrialization of our nation.
The scale of Lewis and Clark’s exploration wasn’t seen again until 1969, when Neil Armstrong became the first man to walk on the moon. That exploration was also difficult and was preceded by many disappointments and dangers. Americans finally made it to their goal, which then spurred on a rapid advancement of computers and technology around the country.
Which brings us to today’s exploration of the next unknown: the new world of globalization. Web-based technologies, outsourcing and insourcing, offshoring, informing, personal digital devices, and other innovations have expanded throughout the world and the net result is a global online world ripe for exploration.
As Thomas L. Friedman, author of The World Is Flat, explains, globalization is now shifting into warp speed. Years from now, after the dust has settled, historians will look back on the beginning of the 21st century as a benchmark time for the development of a new Internet frontier—for we ain’t seen nothin’ yet. Friedman says that the world is flat because the balance of power is moving from powerful countries and corporations into the hands of individuals armed simply with a computer and Internet access.
For business leaders today who are navigating through this confusing and tumultuous new world of globalization, that also means encountering incredible disappointments and dangers. The power of individuals to create new technologies and innovations that disrupt the status quo of an industry (or politics) has never looked like this before. The very foundations of established, time-tested industries are being shaken and turned upside down. I know this: The old ways of doing business simply don’t work anymore.
Forget Old-School R&D
While the new world of globalization has many implications for business leaders, the one area I’m going to concentrate on for this column is its impact on traditional research and development.
For the past 100 years or so, corporate research and development was sort of like going on a diet—everyone knew it took effort, time, and commitment, but if you stuck with it, you’d eventually get results. Companies built big research and development buildings and departments with dedicated staffs of scientists, engineers, and technicians who were given latitude to develop innovative technologies, pharmaceuticals, and products. Industry analysts measured the amount of investment into research and development as a benchmark for success. The assumption was that big investments resulted in big product revenues, which in turn resulted in big shareholder value.
Then the world started to change with the spread of the Internet and Web-based applications in the mid-1990s. The pace of business went into overdrive and the exploration of the new world of globalization began. Those explorers with vision and enthusiasm quickly adapted. They asked themselves: “How can I develop innovations that meet new market needs more quickly?” The answer? Acquire, collaborate, and partner with previously unlikely partners.
Case Study: Cisco
A good example of the “buy it” research and development strategy is Cisco Systems, Inc., a networking communications firm based in San Jose, California. Cisco has acquired 114 companies since 1993. On its Web site, the company describes its acquisitions as “innovative start-ups,” and describes its research and development strategy in this way: “Cisco innovates in many different ways: via technology development and the expansion of technologies after their
initial invention, and through
adjacent technology and market
extension. We also innovate through world-class integration and scaling of acquisitions by starting new business models, and in the way we partner with other companies.”
The proof is in their pudding. Cisco spent $4.07 billion on research and development in their fiscal year 2006; in March 2007, the company said it would acquire WebEx for about $3.2 billion, which is just one of many acquisitions to date in 2007. According to an article in the Autumn 2001 issue of The McKinsey Quarterly “Trading the Corporate Portfolio,” by 2001 nearly 40 percent of Cisco’s revenue was coming from start-ups it had acquired since 1993.
Active M&A Equates with Shareholder Value
Now the new measurement of success isn’t how big your research and development budget is; it’s measured by merger and acquisition activity. The same McKinsey article outlines research conducted on 200 of the largest companies in 1990 that were still trading independently in 2000 and analyzes their acquisitions and divestitures during those 10 years that were worth more than $100 million.
The writers found that companies with active merger and acquisition programs that aggressively allocated capital to acquire new businesses, and also divested of businesses when their cost advantages were not sustainable any longer, created 30 percent higher total return to shareholders than did the companies that transacted few deals.
New Entrepreneurial Dream
This trend is becoming so strong that the old entrepreneurial dream of building a company and making the big time with a blockbuster initial public offering has also gone by the wayside. Several factors, including the post-dot-com bubble burst and post-Enron regulations, have made the IPO route difficult and costly. The new goal is acquisition. Start-ups seem to exist solely to be bought by the likes of Yahoo, Google, or Microsoft.
For example, in 2002, Niklas Zennstrom and Janus Friis created Skype, a company that provides voice communication over the Internet. Three years later, they were bought by eBay for $2.6 billion.
Or consider Chad Hurley, Steve Chen, and Jawed Karim, who founded YouTube in February 2005 as a means of sharing free videos on the Internet. Only 20 months later, Google bought their company for $1.65 billion—Google’s largest acquisition ever at the time. Not a bad deal for three computer geeks, huh? And it enabled Google to leapfrog its competitors into a leading role in the Internet marketplace.
Change is Industry Agnostic
It’s easy to understand how these changes are occurring in the Internet industry. But if you look more closely at old traditional industries, you can see the winds of change there, too.
Even the pharmaceutical industry is swapping out traditional research and development with merger and acquisition activity. I found a PowerPoint presentation on the Internet given in March 2007 by Pfizer executives at an investment conference on health care. It outlined Pfizer’s research and development priorities, such as shifting funds from bricks and mortar to the company’s pipeline, to biotherapeutics, and to other growth opportunities, and expanding collaborations by looking for the best science outside the company.
Pfizer is not alone. According to Deloitte Consulting, it takes about 10 to 12 years to bring a new drug to market. If the new drug doesn’t eventually generate at least $500 million in sales, the pharmaceutical company won’t break even, according to Deloitte. The commercial stakes are so high, it makes it exceedingly difficult to take a lot of up-front scientific risk. So large pharmaceutical companies are acquiring small biotech start-ups that have already developed a promising new chemical compound. This works because the smaller companies are more skilled in niche markets. In addition, they infuse entrepreneurial insight and innovation into the larger organization.
The Bottom Line
In a nutshell, the new world of globalization is moving at warp-speed, so virtually no one has the time to wait to develop innovations organically. The days of multimillion-dollar research and design projects are being replaced with million-dollar and billion-dollar acquisitions of start-ups that offer leapfrogging technology and entrepreneurial spirit to established companies.
And this is just one way the business world is changing as we embark on an exploration of the new world of globalization. Are you ready? I hope you are, and that you have the enthusiasm of Meriwether Lewis, who wrote in his journal on April 7, 1805:
“We were now about to penetrate a country at least 2,000 miles in width, on which the foot of civilized man has never trodden; the good or evil it had in store for us was for experiment yet to determine . . . [yet], entertaining as I do the most confident hope of succeeding on a voyage which had formed a darling project of mine for the last 10 years, I could but esteem this moment of my departure as among the most happy of my life.”
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