Can M&A extend the life cycle of companies facing digital disruption?

Introduction

  • The life cycle of a company starts with a founder identifying a need for a product in a growing market.The founders look for capital to build their products/services aligned to the market.For this, they look at funding from VC funds.Depending on their product market fitment approach, VC sponsors fund capital to build a product.Once the product is launched, the founders test their product success based on the adoption and usage by customers.Once more customers leave their incumbent products and switch to the new products, the company starts to grow.Then it reaches a matured phase where it can continue to grow for a long period depending on its competitive differentiation that it had created.Once the product offering is no longer relevant or the target market growth starts to decline, then company growth starts to decline and slowly get extinct.
  • The life cycle of companies differ within industries.For example, life cycle of a tech company is far more compressed compared to a non tech company.In a tech company, entry barrier is extremely low as few upfront investments are required to start a company as against a non tech company where more capital expenditure is necessary to set up the infrastructures for product manufacturing.The tech companies also exhibit a strong growth compared to a non tech company.This is the reason why there are more tech companies who have attained the unicorn status than non tech companies.As fast as the growth is, it becomes challenging for tech companies to sustain growth which explains the low maturity phase compared to a non tech company.The tech companies also face threat of a disruption from a new entrant far more than non tech companies due to the low entry barrier.Once disrupted, the tech companies immediately face extinction and is no longer a force to reckon with. As tech companies do not have any assets to liquidate, their operations ceases to exist.For example, Yahoo, Nokia and BlackBerry are some firms which had a meteoric rise but had a rapid decline due to a disruption caused by a new entrant.

How do successful companies grow?

Growth is more important than Margins

  • High growth will increase market share.This increase in market share is necessary as capturing market share quickly acts as an entry barrier to its competitors. In this digital age, this is called "Winner take it all" approach.For this to happen, companies need to be ready to burn cash at the expense of growth and this can be possible if companies have access to funding from financial sponsors.It is also important that markets and economy are favorable for investments.In a recession or in a downturn, it is difficult to get funding.

High Growth increases Shareholder value

Expansion to New Customers and Geographies

Building IP and Patents

Having a clear incentive structure

When do Companies start facing decline?

How to stem this decline and when M&A can be used?

  • Companies that already operate in a fast growing high addressable market can be extend their product offerings or come up with a new product for the same market.Example Amazon or Facebook can continue to bring new business models when their traditional models are declining. For instance, Facebook advertising revenues are declining and they are moving to payments business model for the same addressable market.
  • Companies whose addressable market is slowly becoming saturated and when their product offerings are no longer differentiated and relevant, can move to adjacent markets and redefine their business model.For example, Microsoft that was a pioneer in Desktop Operating systems moved to Server operating systems and then to Enterprise applications like Sharepoint when these respective markets became saturated. Now Microsoft has moved to Cloud Infrastructure services and provide productivity applications like Office365 in cloud for enterprises.
  • For the companies to move to adjacent markets, M&A can be a great tool to achieve their objectives.This explains why so many enterprise apps companies like Salesforce are doing acquisitions to gain market share in Cloud.If the companies are able to manage their integrations successfully, then this will increase their growth phase for longer periods.
  • Companies in products business can also move to platforms business by building an ecosystem around it where third parties can build their applications on the platform.This gives rise to Network effects where more participation further increases the value of platforms.Companies like Facebook and Google have built a strong platform model which allows other companies to build applications in their platforms to run their businesses.

Conclusion

  • Companies that are continuing to be profitable, always operate in high growth markets.Incumbent companies can move to high growth adjacent markets by doing M&A which is the quick route for them to build a presence.Companies also needs to be careful on their choices to enter a new market.Their decisions can backfire if their choices turn out to be wrong.
  • The decision and the time to transition to new business is also critical.Companies that abandon their existing business to move to new businesses stand the risk of losing their market share and if companies delay this decision, then they no longer continue to be relevant.

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Ramkumar Raja Chidambaram

Experienced M&A, Corporate Development Professional with extensive VC/PE experience