In 2001 Apple introduced iTunes based on the IP of a company it had acquired in 2000. By 2003, after the introduction of the iPod and of the iTunes Store, iTunes had become the de facto disruptive innovator of digital music. More recently Apple itself started being disrupted by Pandora and Spotify. These streaming music companies have been growing and taking market share away from iTunes because of their business model and technological innovations. For example, the data they collect about subscriber music libraries and listening habits can provide unique customer insights that can lead to better monetization of the service, as well as improved personalization of the service’s user experience. Apple’s internal efforts to develop a streaming music offering have been unsuccessful. In May, Apple paid $3b to acquire Beats, reportedly for its streaming music service. Apple’s 2000 acquisition shows that disruptive innovation can be acquired in addition to being created, and even companies with strong innovation DNA, such as Apple, Google, Facebook, and 3M, frequently acquire innovation for a variety of reasons, as we will see later on. Innovation can be acquired at an early stage, as Apple did in 1999, or at a later stage, as Google did more recently with the acquisition of Nest. In this blog I try to make three points:
- Innovation can be acquired, as much as it can be created within a corporation.
- Lack of growth in large corporations, combined with the accelerating innovation pace, are causing corporations to increase their innovation-driven acquisitions, particularly of earlier stage companies.
- Corporations must first identify the goal driving each innovation-driven acquisition and utilize five important dimensions with their associated actions during the acquisition and subsequent integration process.
Over the past several years and particularly during the last five years, corporations optimized their products, processes, and human capital. After extracting every conceivable type of efficiency through these optimizations, corporations find themselves with strong balance sheets, the result of the profits derived from their operations, but with little or no growth. They are starting to realize that they need to increase their growth rate in order to continue providing value to their shareholders. To do so they introduce disruptive products, services, and business models, as well as adopt digital-enterprise technologies. This has been the primary reason corporations have been increasingly interested in disruptive innovation. However, as we have previously discussed, the ability of corporations to create disruptions organically is not keeping pace with the overall pace of innovation that continues to accelerate. Because of cash available in their balance sheets, and also low-interest lines of credit, corporations view M&A as a primary tool to achieve the desired growth, including the acquisition of innovation. As a result, the overall acquisition activity is increasing. There was $1.8T of worldwide M&A during 1H14, including $1.1T during 2Q14, up 73% over 1H13. The acquisition volume represented the highest first half than any first half since 2007. The 73% bump is the largest such increase since 1998. Based on the results of the most recent PwC M&A survey (Figure 1), we see that transformational acquisitions (definitions of the various acquisition types are provided in page 9 of the referenced PwC document), most of which involve the acquisition of innovation, now represent the largest and fastest-growing category.
Figure 1: Acquisition type of the largest acquisitions in the past 3 years
In their drive to obtain innovation, corporations are starting to acquire earlier stage, venture-backed companies and are paying high prices in the process. They focus on companies working on fundamental technology building blocks (cloud computing, big data analytics, mobile computing, genomics, nanomaterials, 3D printing), new disruptive products that are based on these building blocks (SaaS applications, mobile applications, wearable devices, genomic sequencing and personalized medicine, drug delivery, smart energy grid), and new economies (sharing economy, experience economy, API economy). The NVCA reported that during 2Q14 alone 97 venture-backed companies were acquired. Of the 33 that reported transaction values, the average deal size was $98.6M. Figure 2 provides a few examples of such acquisitions.
Figure 2: Examples acquisitions of innovative technologies by large corporations
Before embarking on an innovation-driven acquisition, and in order to increase the acquisition’s success, corporations must determine the goal of each such acquisition. In my experience as the investor of innovative startups that have been acquired, as well as the CEO of a startup that was also acquired for its innovative product, these acquisitions typically have one or more of the following three goals:
- Get people, technologies or products faster and at a lower cost than they can be built internally, or after being unsuccessful at trying to build them. Companies like Google and Twitter (MoPub, Blue Fin, Snappy) routinely use this type of acquisition because it has determined that it can acquire faster than it can build products in certain areas and it is always looking for strong engineering and product talent. AOL acquired Adap.tv to address the online video advertising market. IBM acquired SoftLayer because it failed to create a competitive cloud computing platform. Additional examples include Apple’s acquisition of Beats, Paypal’s acquisition of Braintree, and Facebook’s acquisition of Instagram and WhatsApp that allowed it to enter decisively the mobile applications market.
- Pick an early category winner and help them develop their business to the “billion dollar” level. Examples of this type include Google’s acquisition of YouTube and Nest, VMWare’s acquisition of Nicira, Amazon’s acquisition of Kiva, EMC’s acquisition of Greenplum, eBay’s acquisition of Paypal, and Cisco acquisition of Webex to name a few. The truth is, however, that there are not many successful examples of corporations succeeding in this goal.
- Accelerate the acquirer’s entry in an important market. Examples of this type include Google’s acquisition of Android that allowed the company to enter the mobile operating system market and effectively compete with Apple, Yahoo’s acquisition of Tumblr and eBay’s acquisition of Zong. Large pharmaceutical companies routinely acquire smaller competitors that have new drugs, e.g., J&J’s acquisition of Aragon, and Roche’s acquisition of Seragon.
Corporations always evaluate a prospective acquisition along a set of dimensions, for example, personnel alignment between acquirer and acquired. However, the actions associated with each of these dimensions are very different in innovation-driven acquisitions, particularly of startups. For example, in market consolidation acquisitions, the acquirer typically reduces staff in order to cut costs and achieve efficiencies in the resulting company. In innovation-driven acquisitions, the acquirer’s goal should be to retain the acquired company’s staff and enable them to continue innovating in their new environment. As a result of such differences, the acquisition of early stage innovative private companies proves particularly hard. As reported by PwC, as well as by Blank here and by Chesbrough here, many of these acquisitions fail to generate the expected outcomes for the acquirers. Based on my experience in helping acquired startup portfolio companies become successes for their corporate acquirers, I believe that corporations should consider utilizing the following five dimensions and associated actions in innovation-driven startup acquisitions:
- Strategy: Align the innovation-driven acquisitions with a corporate innovation strategy that also includes venture investments, startup incubation and partnerships, always taking into account the needs of the corporation’s business units. This requires frequent communication between the organizations tasked with acquiring innovation (primarily corporate venturing and corporate development) and the business units, in order to understand their strategic priorities and gaps. It also requires the establishment of a common language to use in in order to make the communication effective. Understand the dynamics of the acquired company’s market because startup market leaders often don’t have staying power.
- Integration: Corporations are used to forcing every acquisition, regardless of its type, e.g., market consolidation/absorption, tuck in, into the same integration model. For the startup acquisition to succeed, the acquirer must adopt agile management practices. It may be necessary for the acquired company to operate independently for a period of time. For example, even though they were both early stage companies when they were acquired, Google allowed YouTube to operate independently whereas it folded Waze into its Maps unit immediately upon acquisition.
- Retention: Understand the differences in the cultures of acquired startup and the acquirer. Ensure that the acquisition is not based on convincing the startup’s principals to change in ways they are not prepared, or are not willing, to do. Allow acquired startup’s employees to continue innovating after the acquisition. In this way, the acquired talent will be retained more easily and the acquirer will continue benefiting from new innovations. Retention is not only about providing financial incentives to a startup’s employees. Finally, track the performance of the startup’s employees and determine who are the keepers. The keepers will deliver value to the acquired company even if the acquisition itself doesn’t ultimately achieve its goals.
- Measurement: Establish the appropriate timelines for assessing the performance of the acquired startup against the goals and a set of KPIs that drove the acquisition. For example, platform acquisitions, like Nicira, may require 5-7 year horizon before the acquisition goals can be achieved. Don’t try to optimize the acquisition too soon because such early optimizations tend to increase the probability of failure. No startup, regardless of how dynamic and high performance it is, grows as fast as imagined when operating in a large corporate environment.
- Risk: Understand the stage of the company the acquiring corporation has the ability of making successful, i.e., the risk the acquirer is willing to assume. For example companies like Google, Apple and Facebook are able to routinely assume early stage risk, e.g., Waze, Siri, and Instagram respectively, including pre-revenue companies, e.g., Oculus VR. On the other hand, companies like Salesforce and IBM prefer to acquire more proven business models. Startups get lost in a large corporation that is not ready to accept early stage risk within 1-2 budget cycles.
Acquisitions provide an effective, yet challenging, way to obtain innovation. Corporations have accelerated their pace of transformational acquisitions particularly of earlier stage startups operating in innovation clusters such as Silicon Valley, New York, and Israel. We expect this pace to continue for the foreseeable future. Not every innovation-driven acquisition will succeed. In fact, if every one succeeds, then maybe it is a sign that the acquiring corporation is not taking enough risks. However, for these acquisitions to ultimately succeed and provide real value to the acquirer, corporations must first identify the goal driving each innovation-driven acquisition and utilize five important dimensions with their associated actions during the acquisition and subsequent integration process.