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. 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, for its streaming music service this time in order to defend its turf and not be disrupted. Apple’s 2000 acquisition shows that disruptive innovation can be acquired in addition to being created. 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. To access disruptive innovation corporations may acquire early stage startups as Apple did in 1999, or later stage private companies, as Google did more recently with the acquisition of Nest. In this post 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, corporations focused on optimizing their products, processes, and human capital in an effort to extract every conceivable type of efficiency. This approach provided them with short-term gains that resulted in strong balance sheets. More recently, corporate growth has started to flatten. Corporations realize that they need to increase their growth rates in order to keep their shareholders happy. But in order to do so they will need to introduce new products and services under new often utilizing digital-enterprise technologies. This has been the primary reason corporations have been increasingly interested in disruptive innovation. However, for a variety of reasons we have previously discussed, the ability of corporations to organically create disruptions is not keeping pace with the overall pace of technology and business model innovation that continues to accelerate. Because of the 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 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, corporations consider three types of innovation-driven (or transformational, as PwC calls them) acquisitions:
- Type 1: Acquisitions that provide innovations around existing products and business models. These may be acquisitions of any stage company. For example, Disney acquired Pixar, which was already a large company itself, to augment its animation business. Similarly, IBM acquired Netezza because its data analytic appliance fit with IBM’s big data line of business. Early stage companies may also be acquired because the acquirer determines that in this way it can access 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. In addition to the two examples mentioned above, even 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.
- Type 2: Acquisitions that provide innovations which enable a corporation to enter new markets that are adjacent to the ones it is already pursuing. For example, AOL acquired Adap.tv to enter the online video advertising market which complemented its display online advertising business. IBM acquired Demandtec in order to enter the cloud-based big data application market that is adjacent to the big data infrastructure market it was already pursuing. 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. Additional examples 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.
- Type 3: Acquisitions of companies that provide disruptive products, technologies and business models and help them develop their business to the “billion dollar” level. Examples of this type include Google’s acquisition of YouTube and Nest, Monsanto’s acquisition of the Climate Corporation, 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.
In their drive to obtain disruptive innovations, corporations are starting to acquire earlier stage, venture-backed companies and are paying high prices in the process. Based on recent data, corporations appear to 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 business models (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
Consistent with my corporate innovation model, in this post I focus on the third type of innovation-driven acquisitions though many of the points I make apply to the other two types as well. Before embarking on an innovation-driven acquisition, and in order to increase the acquisition’s success, corporations must determine the goal, and therefore type, of each such acquisition.
Corporations always evaluate a prospective acquisition along a set of dimensions, such as personnel alignment between acquirer and acquired. A set of actions the acquirer can take is typically associated with each dimension. For example, in market consolidation acquisitions, the acquirer typically reduces staff in order to cut costs and achieve efficiencies in the resulting company. While the dimensions remain the same, in innovation-driven acquisitions the associated actions are different. For example, 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 in actions 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: Determine when it is important to acquire rather than initially invest in or partner with a startup and acquire the company at a later time. For example, as it typically does, IBM first partnered with Cloudant before acquiring the company. Conversely determine when it is more important to acquire even if initially thinking of investing or partnering with a startup. For example, after Samsung established the Internet of Things as a strategic priority, it initially considered investing in SmartThings, a startup that had developed a cloud-based consumer platform for the smart home. However, in the course of conducting its pre-investment due diligence, Samsung decided to acquire SmartThings and make it the centerpiece of its connected home initiative. For all these reasons it is important to align innovation-driven acquisitions with a corporate innovation-enabling strategy. Such a strategy should also include venture investments, startup incubation and partnerships. The acquisition strategy should be taking into account the strategic priorities and gaps of the corporation’s business units. This requires the constant collaboration between the innovation-enabling organizations (corporate development, business development, venture investing, incubation and R&D) and the frequent communication between these organizations and the corporate business units. Finally, it is also important to understand that acquiring startups is different than acquiring large companies. This means that the corporation will need to set up a corporate development organization whose members understand what it means to acquire startups and work with their founders and management teams.
- Integration: Many corporations use the same integration model for every company they acquire, regardless of the type of acquisition they make, e.g., market consolidation/absorption, tuck in. Under such a model the acquired company is absorbed by the acquirer. 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.
- Talent retention: Retaining the acquired company’s talent in an innovation-driven acquisition is of paramount importance. The acquiring company must 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 the 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 company against the goals and a set of KPIs that drove the acquisition. For example, acquisitions of early stage companies, like Nicira, may require a 7+ year time horizon before the acquisition goals can be achieved and the target ROI is realized. On the other hand, the first type of innovation-driven acquisitions may have a short-time ROI horizon (1-3 years), whereas acquisitions of the second type typically achieve their target ROI within 4-7 years. 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 being acquired, the risk this stage reflects and the risk the acquiring company 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, even for innovation-driven acquisitions, 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 and the acquisitions become failures.
Acquisitions provide an effective, yet challenging, way to access innovation. Corporations have accelerated their pace of innovation-driven acquisitions particularly of earlier stage startups operating in clusters such as Silicon Valley, New York, and Israel. We expect this pace to continue, and even increase, 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.