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

Introduction

  1. Every living being in this world have a life cycle and are destined to aging process.This truth is applicable to corporate organizations too, who have their own life cycle and are destined to age and get extinct.Although corporate executives and investors would try to prevent this ageing and subsequent decline through different methods, it is a bitter truth that companies age and face extinction, unless they continue to redefine their existing business model subjected to the market conditions.
  2. 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.
  3. 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?

  1. In this volatile and ever changing business environment, it is very difficult to have a continuous high growth.Inspite of these volatility, some companies like Microsoft have stood the test of time and have continued to grow.The parameters for success change depending on what stage of life cycle the company is in.

Growth is more important than Margins

  • For companies in early stage after they have come up with a product market fit, Growth is the most important priority at the cost of 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

  • High growth or increase in topline for early stage companies increases shareholder returns.This is one of the reasons why Private equity firms and VC is ready to inject more cash when the startups show a high growth rate inspite of their negative earnings.Companies showing a high growth rate also have high probability to be listed in IPO.When the companies takes a decision for IPO, it would have scaled its size.Generally when the companies reaches $4B revenues, then the focus should be to grow with adequate margins.This explains why more companies change their growth strategy from topline focus to bottom line initiatives after they reach a minimum scale.

Expansion to New Customers and Geographies

  • Once the early stage companies are able to have a successful IPO, the companies generally employ these excess cash to extend their products to new customers or expand to new markets.

Building IP and Patents

  • Once the firms have expanded their adoption, they parallely also invest in R&D efforts in order to build differentiated solutions and create IP’s so that it would be difficult for competitors to emulate.This generally happens when the market becomes matured and companies look to increase their market share in increasing competition. An example would be when Smartphones market became matured, Apple and Samsung started registering more IP’s to increase more market share.The current IP law is not strong enough to protect the owner which explains why it becomes easy for competition to violate the weak laws.This also explains the cause for big IP suits fought between Apple and Samsung.

Having a clear incentive structure

  • Successful companies ensure that their employees remain committed to them by offering incentives aligned to their performance.The strong leadership team builds excellent processes and fosters collaborative culture to encourage innovation.

When do Companies start facing decline?

  1. Inspite of all the above processes followed, successful companies also face a period of decline.This happens when either the target markets becomes highly saturated with presence of too many players or the product offerings itself is no longer relevant.The biggest example would be the smartphones market which has reached a saturation level with influx of chinese firms affecting the growth of Apple and Samsung. In the saturated market, customers are the king as they have too many options available and they can switch their products easily.Hence companies generally reduce their prices in order to retain their market share.This reduction in pricing would have an impact on their margins, so companies would resort to cost initiatives to defend their margins.Cost advantage cannot be a differentiator to sustain leadership position for long time, hence companies inevitably start facing a slow and painful death.

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

  1. For Companies to remain profitable, it always needs to operate in high growth markets and provide products/services offerings aligned to the high growth markets.
  2. 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.
  3. 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.
  4. 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.
  5. 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

  1. Every company has its lifecycle which is marked by periods of growth, maturity and decline.This is because the markets where they operate in become saturated over a period of time which renders their product/service offerings irrelevant.
  2. 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.
  3. 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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