Synergy Valuation in Industrial Software Acquisitions1264943/FULLTEXT01.pdf · 2018. 11. 21. · Synergy Valuation in Industrial Software Acquisitions Christoffer Marin Erik Tretow

IN THE FIELD OF TECHNOLOGYDEGREE PROJECT INDUSTRIAL ENGINEERING AND MANAGEMENTAND THE MAIN FIELD OF STUDYINDUSTRIAL MANAGEMENT,SECOND CYCLE, 30 CREDITS

, STOCKHOLM SWEDEN 2018

Synergy Valuation in Industrial Software Acquisitions

CHRISTOFFER MARIN

ERIK TRETOW

KTH ROYAL INSTITUTE OF TECHNOLOGY

SCHOOL OF INDUSTRIAL ENGINEERING AND MANAGEMENT

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by

Christoffer Marin Erik Tretow

Master of Science Thesis TRITA-ITM-EX 2018:151

KTH Industrial Engineering and Management

Industrial Management

SE-100 44 STOCKHOLM


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Synergivärdering vid bolagsförvärv inom industriell mjukvara

Christoffer Marin Erik Tretow

Examensarbete TRITA-ITM-EX 2018:151

KTH Industriell teknik och management

Industriell ekonomi och organisation

SE-100 44 STOCKHOLM


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Master of Science Thesis TRITA-ITM-EX 2018:151


Christoffer Marin

Erik Tretow

Approved

2018-05-30

Examiner

Terrence Brown

Supervisor

Tomas Sörensson

Commissioner

Contact person

Abstract

Engaging in M&A is a common corporate strategy and deals are often motivatedby synergies, the concept that the value of the combined entities is greater thanthe sum of their standalone values. However, it is often difficult to capture syn-ergistic value in reality and increasing the probability of a successful acquisitionrequires a thorough assessment of potential synergistic effects pre-acquisition.

In this thesis, we have analyzed the strategic rationale, synergies, and valua-tion methods used in acquisitions of industrial software companies. Throughmultiple case studies comprising empirical material from interviews, valuationmodels and other transaction-related documents, we have studied five bolt-onacquisitions, three of which were completed by subsidiaries of Marrow and theremaining two by an industrial software company under private equity owner-ship.

Main conclusions from the study are:

• The foremost strategic rationale and source of synergy is revenue enhance-ments through acquiring technology and leveraging established sales chan-nels to cross-sell and accelerate market access for the target’s products

• A prevalent cost synergy is consolidation and/or renegotiation of contractswith third party software providers whose products are used in industrialsoftware development

• Financial synergies are not explicitly estimated nor valued

• Valuation is conducted using both the DCF and multiple method witha varying degree of sophistication in the underlying estimations, rangingfrom a granular bottom-up approach for each line item to a top-downapproach based on experience and intuition

Lastly, the results indicate that synergies may to a greater extent be a function ofthe strategic rationale rather than a function of industry. However, acquisitionsof industrial software companies seem to be underpinned by the same strategicrationale, namely revenue enhancements through leveraging sales channels andcross-selling. Thus, the corresponding synergies may be comparatively morecommon in this industry.

Keywords: Synergy Valuation, Industrial Software M&A, Industrial SoftwareSynergies.

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Examensarbete TRITA-ITM-EX 2018:151

Synergivärdering vid bolagsförvärv inom industriell mjukvara

Christoffer Marin

Erik Tretow

Godkänt

2018-05-30

Examinator

Terrence Brown

Handledare

Tomas Sörensson

Uppdragsgivare

Kontaktperson

Sammanfattning

Att genomfora forvarv ar en vanligt forekommande foretagsstrategi och affarermotiveras ofta av synergier, konceptet att vardet pa det sammanslagna foretagetar storre an vardet pa summan av de enskilda foretagen. Dock ar det oftasvart att realisera vardet av synergierna i praktiken och det kravs darfor engrundlig utvardering av potentiella synergieffekter innan forvarvet for att okasannolikheten for ett lyckat forvarv.

I denna uppsats analyserar vi de strategiska motiven, synergier samt varderingsmetodersom anvands vid forvarv av foretag inom industriell mjukvara. Genom flertalcasestudier bestaende av empiriskt material fran intervjuer, varderingsmodelleroch transaktionsrelaterade dokument har vi studerat fem tillaggsforvarv, treav vilka genomfordes av dotterbolag till Marrow och de resterande tva av ettforetag inom industriell mjukvara under agarskap av private equity.

De huvudsakliga slutsatserna fran studien ar:

• Den framsta strategiska rationalen och kalla till synergi ar intaktsforbattringargenom forvarv av teknologi och utnyttjande av etablerade saljkanalerfor att korsforsalja samt accelerera marknadstillgangen for det forvaradeforetagets produkter

• En framstaende kostnadssynergi ar konsolidering och/eller omforhandlingav kontrakt med tredjepartsleverantorer vars produkter anvands for attutveckla industriell mjukvara

• Finansiella synergier ar varken explicit estimerade eller varderade

• Vardering utfors med bade DCF och multipelmetod dar graden av sofistik-ering i de underliggande estimaten varierar, fran att granulart estimeravarje post till overslagsestimat baserade pa erfarenhet och intuition

Slutligen, resultaten indikerar att synergier kan i storre utstrackning vara enfunktion av den strategiska rationalen snarare an en funktion av industri. Emeller-tid ter det sig att forvarv av foretag inom industriell mjukvara motiveras avsamma strategiska rational, namligen intaktsforbattringar genom utnyttjandeav saljkanaler och korsforaljning. Darmed kan de korresponderande synergiernavara komparativt mer frekvent forekommande i denna industri.

Nyckelord: Synergivardering, M&A inom industriell mjukvara, Synergier inomindustriell mjukvara

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Foreword

This thesis is our final academic project and marks an end to a five-year eraof engineering studies at the Royal Institute of Technology. We would like tothank the Marrow team for their hospitality and generosity, in particular ourcompany supervisors O.J. and O.P. for making this project possible. Further, wewould like to express our gratitude to our academic supervisor Tomas Sorensson,Associate Professor at the Industrial Engineering and Management Departmentof KTH, for his enthusiasm for the project and valuable feedback during thewriting process. Last but not least, we would like to thank our friends andfamilies for their support during our academic journey.

Christoffer Marin and Erik Tretow

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Abbreviations

CAPEX Capital Expenditures

CAPM Capital Asset Pricing Model

COGS Cost of Goods Sold

D&A Depreciation and Amortization

DCF Discounted Cash Flow

EBIT Earnings Before Interest and Taxes

EBITA Earnings Before Interest, Taxes and Amortization

EBITDA Earnings Before Interest, Taxes, Depreciation and Amortization

ESG Environmental, Social and Governance

EV Enterprise Value

FCF Free Cash Flow

M&A Mergers and Acquisitions

OPEX Operating Expenditures

P/E Price-to-Earnings Ratio

P&G Procter and Gamble

R&D Research and Development

RQ Research Question

ROIC Return on Invested Capital

UI User Interface

WACC Weighted Average Cost of Capital

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List of Figures

2.1 Research process overview . . . . . . . . . . . . . . . . . . . . . . 62.2 Marrow’s corporate structure . . . . . . . . . . . . . . . . . . . . 82.3 Ownership structure of Heracles during private equity ownership 92.4 Results and analysis structure . . . . . . . . . . . . . . . . . . . . 12

3.1 Ways that an acquired business changes the product-market op-portunities of a bidder business . . . . . . . . . . . . . . . . . . . 16

3.2 M&A executives’ survey responses . . . . . . . . . . . . . . . . . 213.3 Sample framework for estimating cost savings . . . . . . . . . . . 32

4.1 Illustrative schematic of Marrow’s estimation of revenue synergiesin the acquisition of Apollo . . . . . . . . . . . . . . . . . . . . . 40

4.2 Stand-alone revenue for Apollo and revenue synergies throughHelius’ channel . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

4.3 Enterprise value impact in Apollo valuation from revenue syner-gies using EV/Revenue multiple valuation . . . . . . . . . . . . . 42

4.4 Identified synergies in Marrow’s acquisition of Poseidon . . . . . 474.5 Synergy impact on enterprise value from DCF valuation for Po-

seidon acquisition . . . . . . . . . . . . . . . . . . . . . . . . . . . 484.6 Synergy split in the Poseidon acquisition . . . . . . . . . . . . . . 484.7 Multiple valuation of Poseidon . . . . . . . . . . . . . . . . . . . 504.8 Synergy impact on enterprise value from DCF valuation for Athena

acquisition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 544.9 Multiple valuation of Athena . . . . . . . . . . . . . . . . . . . . 554.10 Illustrative example of multiple arbitrage . . . . . . . . . . . . . 60

1 DCF Valuation of Poseidon . . . . . . . . . . . . . . . . . . . . . 832 DCF Valuation of Athena . . . . . . . . . . . . . . . . . . . . . . 84

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List of Tables

3.1 Overview of synergy types . . . . . . . . . . . . . . . . . . . . . . 21

5.1 Summary of strategy and strategic fit for the studied acquisitions 63

1 Summary of M&A strategy concepts and sources from the liter-ature and theory review. . . . . . . . . . . . . . . . . . . . . . . . 85

2 Summary of synergy concepts and sources from the literature andtheory review. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

3 Summary of valuation concepts and sources from the literatureand theory review. . . . . . . . . . . . . . . . . . . . . . . . . . . 87

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Contents

1 Introduction 11.1 Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1.1.1 Case Company - Marrow . . . . . . . . . . . . . . . . . . 21.2 Identified Problem . . . . . . . . . . . . . . . . . . . . . . . . . . 21.3 Purpose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31.4 Research Question . . . . . . . . . . . . . . . . . . . . . . . . . . 31.5 Positioning of Research . . . . . . . . . . . . . . . . . . . . . . . 31.6 Delimitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41.7 Disposition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

2 Method 52.1 Research Process . . . . . . . . . . . . . . . . . . . . . . . . . . . 52.2 Literature and Theory Review . . . . . . . . . . . . . . . . . . . 62.3 Empirical Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

2.3.1 Multiple Case Studies . . . . . . . . . . . . . . . . . . . . 72.3.2 Case Study Structure . . . . . . . . . . . . . . . . . . . . 82.3.3 Interviews . . . . . . . . . . . . . . . . . . . . . . . . . . . 92.3.4 Documents . . . . . . . . . . . . . . . . . . . . . . . . . . 10

2.4 Empirical Data Analysis . . . . . . . . . . . . . . . . . . . . . . . 112.5 Research Quality . . . . . . . . . . . . . . . . . . . . . . . . . . . 132.6 Ethics of Method . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

3 Literature and Theory Review 153.1 Mergers & Acquisitions . . . . . . . . . . . . . . . . . . . . . . . 15

3.1.1 Strategic fit . . . . . . . . . . . . . . . . . . . . . . . . . . 153.1.2 Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . 163.1.3 Drivers for M&A . . . . . . . . . . . . . . . . . . . . . . . 20

3.2 Synergies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213.2.1 Operating Synergies . . . . . . . . . . . . . . . . . . . . . 223.2.2 Financial Synergies . . . . . . . . . . . . . . . . . . . . . . 243.2.3 Issues Related to Synergies . . . . . . . . . . . . . . . . . 25

3.3 General Valuation Methods . . . . . . . . . . . . . . . . . . . . . 263.3.1 Discounted Cash Flow Model . . . . . . . . . . . . . . . . 263.3.2 Multiples . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

3.4 Synergy Valuation Methods . . . . . . . . . . . . . . . . . . . . . 313.4.1 Estimating Cost Synergies . . . . . . . . . . . . . . . . . . 313.4.2 Estimating Revenue Synergies . . . . . . . . . . . . . . . . 333.4.3 Synergy Phasing . . . . . . . . . . . . . . . . . . . . . . . 34

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3.4.4 Choosing the Right Discount Rate . . . . . . . . . . . . . 343.5 Closing Remarks on Literature and Theory Review . . . . . . . . 35

4 Results 374.1 Acquisition of Apollo . . . . . . . . . . . . . . . . . . . . . . . . . 37

4.1.1 Acquirer . . . . . . . . . . . . . . . . . . . . . . . . . . . . 384.1.2 Target . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 384.1.3 Strategic Rationale . . . . . . . . . . . . . . . . . . . . . . 384.1.4 Synergies . . . . . . . . . . . . . . . . . . . . . . . . . . . 394.1.5 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

4.2 Acquisition of Poseidon . . . . . . . . . . . . . . . . . . . . . . . 434.2.1 Acquirer . . . . . . . . . . . . . . . . . . . . . . . . . . . . 434.2.2 Target . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 444.2.3 Strategic Rationale . . . . . . . . . . . . . . . . . . . . . . 444.2.4 Synergies . . . . . . . . . . . . . . . . . . . . . . . . . . . 454.2.5 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . 46

4.3 Acquisition of Athena . . . . . . . . . . . . . . . . . . . . . . . . 514.3.1 Acquirer . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514.3.2 Target . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514.3.3 Strategic Rationale . . . . . . . . . . . . . . . . . . . . . . 514.3.4 Synergies . . . . . . . . . . . . . . . . . . . . . . . . . . . 514.3.5 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

4.4 Acquisition of Cronus and Perses . . . . . . . . . . . . . . . . . . 564.4.1 Acquirer . . . . . . . . . . . . . . . . . . . . . . . . . . . . 564.4.2 Target . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 564.4.3 Strategic Rationale . . . . . . . . . . . . . . . . . . . . . . 574.4.4 Synergies . . . . . . . . . . . . . . . . . . . . . . . . . . . 574.4.5 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

5 Analysis and Discussion 615.1 Strategic Rationale . . . . . . . . . . . . . . . . . . . . . . . . . . 615.2 Synergies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 635.3 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66

6 Conclusion 696.1 Answer to the Research Question . . . . . . . . . . . . . . . . . . 696.2 Sustainability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 716.3 Research Contribution . . . . . . . . . . . . . . . . . . . . . . . . 716.4 Limitations and Further Research . . . . . . . . . . . . . . . . . . 72

Appendices 79A Interview Script . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80B List of Interviewees . . . . . . . . . . . . . . . . . . . . . . . . . . 82C Valuation of Poseidon . . . . . . . . . . . . . . . . . . . . . . . . 83D Valuation of Athena . . . . . . . . . . . . . . . . . . . . . . . . . 84E Literature and Theory Review Summary - M&A Strategies . . . 85F Literature and Theory Review Summary - Synergies . . . . . . . 86G Literature and Theory Review Summary - Valuation . . . . . . . 87

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Chapter 1

Introduction

This chapter provides an introduction to the research topic. We further intro-duce the purpose and research question of the thesis, followed by delimitationsand a disposition of the paper.

1.1 Background

When a strategic buyer acquires another company, one of the most commonmotivations for the deal revolves around synergies. The concept of acquisition-related synergies is that the value of the combined companies post-acquisitionis greater than the sum of the standalone value for the individual companiespre-acquisition. In his book ”Corporate Strategy” Ansoff (1965) described thisphenomena as the ”2 + 2 = 5”-effect. Although creating value by realizing syn-ergies through acquisitions is a seemingly attractive strategy, it is often difficultfor the acquirer to capture the value in reality.

”In some mergers there are truly major synergies - though oftentimes the acquirer pays too much to obtain them - but at other timesthe cost and revenue benefits that are projected prove illusory.”

— Buffet (1997)

The acquiring company often pays a premium related to synergies, which on av-erage ranges from 10 to 35 percent (McKinsey, 2004). The ability for a strategicbuyer to pay a premium entails a favourable position in bid processes vis-a-visfinancial sponsors due to the latter lacking the ability to realize synergies inprincipal investments (Bargeron et al., 2007). However, studies such as Mal-mendier and Tate (2008) have shown a significantly negative share price effectfor publicly traded companies on the date that they announce an acquisition,which may serve as testimony to the market’s skepticism towards acquirers’ abil-ities to realize value matching that of the bid premium. As such, realizing M&Avalue is a challenge where the strategic buyer must have a clear understandingof which synergies can be extracted and how to accurately measure those.

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1.1.1 Case Company - Marrow

Marrow is a global technology company providing hardware and software solu-tions for a wide range of industrial manufacturing applications. Over the years,Marrow has expanded its product and service offering, as well as its presence innew markets and industries, by acquiring several companies.

Marrow is undergoing a transition from offering both industrial hardware andsoftware to a specialized focus on industrial software. Additionally, Marrow’sseeks to shift their current industrial software offering based on selling perpetuallicenses with corresponding support and maintenance to a subscription-basedmodel, thus increasing their share of recurring revenue. Marrow has expressedthat further M&A activity in the industrial software segment will be a corner-stone in its strategy to transition into an industrial software-focused company.With an M&A landscape characterized by low interest rates and intense bidcompetition inflating valuations, combined with an overall industry consolida-tion rendering fewer acquisition opportunities, Marrow has to keep a clear focuson identifying synergies and extracting value from these in a market with lim-ited and increasingly expensive investment opportunities.

1.2 Identified Problem

For a strategic buyer, valuing synergies can prove highly difficult. Synergiesare often described on a high level, such as economies of scale. This poseschallenges in translating a synergy into specific actions upon which to executepost-acquisition, as well as unclear connection between an abstract synergy andits actual value (Ficery et al., 2007). In order to increase the probability of asuccessful acquisition, Loukianova et al. (2017) advises acquirers to thoroughlyassess the potential synergistic effects prior to the acquisition.

Hence, there is a need for a granular breakdown of specific synergies, as wellas corresponding underlying drivers. It is first when these factors have beenclearly outlined that the synergy value can be extrapolated. Further value maybe extracted by pursuing industry-specific synergies; in the software case, expe-rienced software investors tend to outperform generalist investors that executeindustry-agnostic synergy strategies (BCG, 2017). In addition, identifying thesynergies prior to the acquisition has the added benefit of providing a structuredroadmap for realizing synergy value post-acquisition.

While investment professionals around the world frequently encounter the chal-lenges of identifying, valuing and realizing synergies, there is limited empiricalresearch publicly available that deliver concrete evidence on how synergy valueis best captured. In this thesis we will take the opportunity to tap from thebody of knowledge within the corporate sphere by studying Marrow, a globalindustrial company with a long and successful track record of capturing synergyvalue through strategic acquisitions. In addition, examining Marrow’s historical

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acquisitions through an academic lens has the potential added benefit of provid-ing Marrow with new perspectives on their process for identifying and valuingsynergies. The difficulties in identifying and valuing synergies outlined aboveserve as the foundation of the research question for this thesis.

1.3 Purpose

Given the difficulties related to synergies discussed in the literature and thelimited empirical research on the subject, we see our study as an opportunityto contribute with empirical evidence to the research field. The purpose ofthis thesis is to investigate potential synergies and how these are valued inindustrial software acquisitions. As such, the thesis has the extended purposeof investigating synergies in an industry-specific setting.

1.4 Research Question

In order to fulfill the purpose of this thesis, the research question (RQ) has beendefined:

RQ: What are the potential synergies when acquiring industrial soft-

ware companies and how should those synergies be valued?

1.5 Positioning of Research

This thesis’ contribution will be empirical in nature where the findings will berooted in empirical material gathered from interviews, internal documents andvaluation models regarding previous acquisitions completed in the industrialsoftware space.

There is a gap in current empirical research on granular approaches for identify-ing synergies and their respective drivers. In addition, there is limited empiricalevidence providing a clear link between synergies and the valuation of thosesynergies. Moreover, theoretical research on synergies is often focused on a par-ticular type of synergy and non-industry specific synergies (Qudaiby and Khan,2013; Bena and Li, 2014). In contrast, in this thesis we will explore poten-tial synergies and their corresponding valuation but in the specific context ofacquisitions of industrial software companies.

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1.6 Delimitations

The empirical material forming a basis for this thesis will be industrial softwareacquisitions conducted by subsidiaries of Marrow, completed both under currentMarrow ownership as well as under other prior owners. As such, this thesiswill not base its analysis on acquisitions in other industries, nor will it coverindustrial software acquisitions completed by companies unrelated to Marrow.

1.7 Disposition

1. Introduction - The introduction chapter outlines the background to theresearch topic and presents the research question which the thesis aims to an-swer.

2. Method - The method chapter describes the process of data collection anddata analysis for the research. The main data sources for this thesis are inter-views as well as Marrow’s internal documents and valuation models.

3. Literature and Theory Review - In the literature and theory reviewchapter we present relevant literature and theories for the thesis, which is de-vised in mergers and acquisitions, synergies, general valuation methods andsynergy valuation methods.

4. Results - In the results chapter we present our findings from the empiricalmaterial, devised in separate subsections for each acquisition.

5. Analysis and Discussion - In the analysis and discussion chapter theacquisitions covered in the empirical material are analyzed and discussed in re-lation to one another as well as to previous theory and research on the topic.

6. Conclusion - In the conclusion chapter we present an answer to the researchquestion by drawing conclusions from our analysis and discussion. Additionally,we consider sustainability factors relating to Marrow, as well as highlight ourthesis’ contribution to the research field. Last, we outline the thesis’ limitationsfrom which we propose topics for further research.

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Chapter 2

Method

This chapter presents the research process along with the different componentson which it is based: literature and theory review, multiple case studies andempirical data analysis. We further discuss how our approach affects researchquality and address the ethics of our method.

2.1 Research Process

Our research process is designed with an inductive approach to answering theresearch question, in that we draw conclusions based on patterns observed fromempirical data. An overview of the research process is illustrated in figure 2.1.

First, since the thesis requires knowledge on subjects relating to M&A strate-gies, synergies and valuation, it is necessary to quickly develop a knowledgebasis to serve as a point of departure. This knowledge basis will be formed froma literature and theory review utilizing a range of sources comprising previousresearch and theory on the aforementioned subjects.

Next, we will conduct multiple case studies covering a number of industrial soft-ware acquisitions. The empirical material will be both qualitative and quanti-tative in nature. The qualitative component comprises interviews with Marrowemployees involved in the transactions and internal documents such as mate-rial presented to the Board of Directors for evaluating whether to pursue theacquisitions. The quantitative component comprises valuation models used inthe transactions, which incorporate synergy valuation.

Last, we will analyze and discuss the cases across the dimensions of M&A strat-egy, synergies, and valuation in order to discover similarities and differencesbetween the cases. Further, the findings will be discussed in relation to previ-ous research and theory. The analysis and discussion will be synthesized into

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conclusions serving as our answer to the research question.

Literature and Theory Review

Multiple Case Studies

Employee Interviews Internal Documents Valuation Models

M&A Strategy Synergies Valuation

Empirical Data Analysis

Conclusions

Figure 2.1: Research process overview.

2.2 Literature and Theory Review

The literature and theory review will be conducted in order to provide a deeperunderstanding of the concepts and theories related to the research area. In do-ing so, the literature and theory review aims to form a setting of incumbenttheory and previous research on which to:

• Position our own study (Randolph, 2009)

• Design the multiple case studies (Cooper, 1984)

• Analyze and discuss the empirical material (Cooper, 1984; Creswell andCreswell, 2017)

Based on the above mentioned purposes, the literature and theory review willfirst cover the strategies and rationales for M&A. We will then provide a break-down of different kinds of synergies, followed by an overview of principles andmethods used for valuing companies. Last, we will review practices for synergyvaluation as presented in the literature.

The methodology of gathering literature and theory will be searching for specifickeywords in various databases such as SSRN, JSTOR, KTH Primo and GoogleScholar, as well as studying university textbooks and industry papers on top-ics related to the research area. Search terms to be included in the literatureand theory review will be for example: Mergers & Acquisitions, M&A Strategy,M&A in Industrial Software, Industrial Software Synergies, Synergy Valuation.

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In order to ensure quality and relevance, material included in the literatureand theory review will be subject to a set of selection criteria with guidancefrom Cooper (1984) and Greener (2008). Cited research articles must be peer-reviewed and published in recognized journals in relevant fields. Similarly, citedtextbook sources must come from publishers widely recognized in universityeducation. Industry papers may only be included if they come from relevantcompanies and professionals with recognized expertise in the field.

2.3 Empirical Data

2.3.1 Multiple Case Studies

We have chosen multiple case studies as the main research methodology for thisthesis. This choice was in part based on an opportunistic approach as noted byOtley and Berry (1994), wherein access to Marrow’s otherwise confidential datawill be given.

Otley and Berry (1994) further suggest that the case-based method is particu-larly suitable when existing research and theories on the area are insufficient,which holds true for our research area as specific research has not been conductedon the topic of valuing synergies in industrial software acquisitions. However,they also emphasize that the case-based method needs to take departure from atheoretical position, which again is suitable for our thesis as extensive researchand theories have been formed on related topics such as corporate strategy andvaluation.

Moreover, Yin (2012) suggest that the case-based method is favourable whenstudying a phenomenon within its real-world context by collecting data in anatural setting as opposed to collecting ”derived” data from for example ques-tionnaire responses in a survey.

Our multiple case studies will be based on empirical material gathered aroundacquisitions of industrial software companies. Each case study will investigate ifand how synergies were identified and valued previous to the acquisition. Hence,the outcome of the multiple case studies is a comparative analysis of synergiesand their corresponding valuation between the cases and vis-a-vis previous re-search.

The empirical data gathered in the multiple case studies will be both qualitativein the form of interviews with employees engaged in the acquisitions and inter-nal documents, as well as quantitative in the form of operating and financialassumptions in the valuation models.

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2.3.2 Case Study Structure

The multiple cases studies in this thesis comprise five industrial software ac-quisitions, three of which were completed by subsidiaries of Marrow, and theremaining two completed by a current Marrow subsidiary while under its priorprivate equity ownership. As illustrated in figure 2.2, Marrow’s corporate struc-ture includes several wholly-owned subsidiaries, including Helius and Heracles,who to some extent operate independently of Marrow’s other subsidiaries. Inturn, Marrow has performed bolt-on acquisitions through its subsidiaries, in-cluding Heracles’ acquisitions of Poseidon and Athena, and Helius’ acquisitionof Apollo. Marrow was highly involved in these bolt-on acquisitions and led thetransaction processes. Our first three case studies will cover these acquisitions,namely 1) Heracles’ acquisition of Poseidon, 2) Heracles’ acquisition of Athena,and 3) Helius’ acquisition of Apollo.

Marrow

Apollo

Heracles Helius

AthenaPoseidon

Other

subsidiaries2. Subsidiaries

3. Bolt-on

acquisitions

1. Parent

company

Figure 2.2: Marrow’s corporate structure, including several wholly-owned sub-sidiaries through which it has conducted bolt-on acquisitions.

Prior to being acquired by Marrow’s, Heracles was owned by a private equityfirm. Heracles served as a principal investment vehicle through which the pri-vate equity firm conducted bolt-on acquisitions, see figure 2.3 for an illustrationof the ownership structure. In addition to the first three case studies coveringbolt-on acquisitions led by Marrow, our last case study will comprise Heracles’acquisitions of Cronus and Perses during its private equity ownership. Knowingbeforehand that the two target companies were similar in terms of size, strategyand technology, combined with the limited access to data that follows from theprivate equity firm having lead the transactions no longer being involved withHeracles, we choose to bundle the two acquisitions in a single case study. Assuch, our fourth and last case study will serve as a backdrop from which we candiscuss Marrow’s approach to industrial software M&A, rather than an elabo-rate study on private equity-specific strategies.

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Private Equity Firm

Heracles

Cronus Perses

2. Principal

investment

3. Bolt-on

acquisitions

1. Parent

company

Figure 2.3: Ownership structure of Heracles during private equity ownership.Heracles served as a principal investment vehicle through which the private eq-uity firm conducted bolt-on acquisitions of Cronus and Perses.

2.3.3 Interviews

As our research revolves around obtaining a detailed description of events intheir natural setting (as opposed to for example structured experiments), theinterview research design is a key factor to fulfilling that purpose (Weiss, 1994).Further, Kvale (1996) points out that events in their natural setting are oftennot directly observable and thus talking to people is one of the most effectivemethods for attaining and exploring such constructs. In our case this holds trueas acquisitions occur relatively infrequently and multiple acquisitions are seldompursued simultaneously. Therefore, it would be difficult to construct multiplecase studies on acquisitions by observing those events in their natural setting.

Although the interview method is deemed suitable, there are several types ofinterview structures to consider, and it is important to consciously choose thestructure that fit best with the intended output of the empirical data. Blomkvistand Hallin (2015) state three types of interview structures, namely 1) Struc-tured, 2) Unstructured and 3) Semi-structured.

The structured interview’s key feature is that it is mainly focused on a set ofpredetermined direct questions that require immediate and mostly ’yes’ or ’no’type answers (Alshenqeeti, 2014). Berg (2007) states that both the interviewerand interviewee have very limited freedom in the structured interview, and sincewe in this study seek to attain detailed descriptions the structured interview isnot deemed a suitable method.

The unstructured interview on the other hand provides greater freedom and flex-ibility to both the interviewer and interviewee (Gubrium and Holstein, 2001).This structure can be described as a loosely guided conversation revolvingaround an overarching subject matter. Despite the inherent freedom and abil-ity to explore in this structure, we deem it more suitable to conduct interviews

9

more strictly guided by areas relevant to the thesis.

The semi-structured interview, albeit not as flexible as the unstructured inter-view, provides the interviewer with the opportunity to probe and expand onthe interviewee’s responses (Alshenqeeti, 2014). Berg (2007) recommends usinga list of questions in the semi-structured interview to help cover relevant areasand keep the interview within the boundaries set by the purpose of the study.

Out of the interview structures outlined, we have chosen the semi-structuredinterview method using an interview script consisting of pre-determined ques-tions. This approach allows us to expand on interesting responses while at thesame time enabling a meaningful comparison between the case studies as the in-terviewees will answer the same questions. Keeping the interviews time-efficientthrough focusing on areas relevant for the study is highly important since theinterviewees may have limited time available.

Further, we have deliberately chosen to interview people that either led, or werehighly involved, in the acquisitions as we deem them to have unique insightsinto the overall transaction process including acquisition strategy, valuation andsynergies. The emphasis on choosing key individuals with expertise in the fieldis suitable as we aim to gain in-depth views into a specific type of situation(Denscombe, 2010). Although this selection process ensure interviewees withrelevant knowledge and experience, and consequently ability to give informedresponses, it also entails a limited pool of potential interview candidates.

In order to ensure that interviews are of high quality, we will take several mea-sures proposed by Blomkvist and Hallin (2015). We will only include open-endedquestions in our question list so that the interviewees’ responses are not lead ina certain direction. In addition, we will inform the interviewees of the interviewtopic and purpose of the study ahead of time so that they have time to famil-iarize as well as allowing the allotted time to focus on the question list. Duringthe interviews we will document the results by taking notes digitally in order tobe able to easily go back and see what has been said and potentially follow upon specific responses.

2.3.4 Documents

While the interview method is a powerful tool of obtaining insights into the in-terviewees’ perceptions, Ho (2006) argues that it can go hand in hand with othermethods. Adding to this, Alshenqeeti (2014) proposes using for example obser-vations to supplement interviews, thus allowing the researchers to investigateparticipants’ external behaviour and internal beliefs. They further argue thatusing more than one method for data collection would assist in obtaining richerdata and validate the research findings. As such, in accordance with Ho (2006)and Alshenqeeti (2014) we have chosen to supplement the interviews with datacollection via internal documents and valuation models in order to validate the

10

interviewees’ responses with their actual actions.

Although beneficial to supplement the empirical data with documents, theyshould not be accepted at face value without ensuring their validity, as arguedby Denscombe (2010). They further mention four criteria for document validity,namely 1) Authenticity, 2) Representativeness, 3) Meaning and 4) Credibility.We deem that the documents we will gather coupled with the source we aregathering from will help satisfy these criteria, although we will continuouslyevaluate each document gathered to ensure validity.

First, the documents will be gathered directly from Marrow without the riskof obtaining fakes or forgeries, thereby ensuring their authenticity. Second,both transaction-related documents detailing for example acquisition strategyand target description, and valuation models are deemed to be representativedocuments used in acquisition processes. Third, the meaning and informationconveyed in the documents need to be clear and if any ambiguity arises wewill request clarification from the documents’ authors. Last, the credibility ofdocuments depend on factors such as what purpose they were written for andwho produced the documents. Since the transaction-related documents andvaluation models constituted critical material for the decision process regardingacquisitions they are regarded as credible.

2.4 Empirical Data Analysis

In order to answer the research question, we will in the empirical data analysisevaluate the acquisitions covered in the case studies in 1) comparison to oneanother, and 2) in relation to incumbent research and theory on M&A strategy,synergy and valuation. As noted by Collis and Hussey (2009), qualitative re-search is often characterized by an intertwined data gathering and data analysis.Hence, the first levels of analysis will be performed when for example conduct-ing and transcribing the case study interviews.

As noted by Eisenhardt and Graebner (2007), there can be a challenge in pre-senting the rich qualitative data associated with a case study. One way to tacklethis is to present it as a rather complete story while intertwining it with the-ory and analysis that ties the empirical material to the research question. Thisapproach may however prove difficult when dealing with multiple case studies,where we encounter a trade-off problem between a rich narrative and a resultsstructure which can be easily analyzed and discussed, see the ”1. Case by case”model in figure 2.4. Another approach would be to present the results in orderof the underlying topics of the research and use the evidence from the differentcases to drive the argumentation, as illustrated by the ”2. Topic by topic” modelin 2.4. While useful for building a well-structured analysis and discussion, wehere face the reverse problem of omitting a holistic view of the individual cases.

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Ord

er o

f pre

sent

atio

n

Case 1

Case 2

Case 3

1. Case by case

Topic 1

Case 1 Case 2 Case 3

Topic 2


Topic 3


2. Topic by topic

Case 1

Topic 1 Topic 2 Topic 3

Case 2


Case 3


3. Case by case, topics aligned

Figure 2.4: Results and analysis structure. In the first and leftmost model, eachcase study is presented as a complete story independent from the rest. In thesecond model, evidence from case studies are used to support theory developmentfollowing a predetermined set of themes. The third and rightmost model consti-tutes a hybrid of the two, where the case studies are presented in their entiretywhile being internally bounded by a predetermined set of themes relating to theresearch question.

With guidance from Eisenhardt and Graebner (2007), we choose to organizeour results chapter in accordance with the ”3. Case by case, topics aligned”model in figure 2.4, presenting the cases one after another, but with identicalsubsections corresponding to the overarching frame of the research question. Indoing so, we present the results in a way which make the multiple case studiesdistinguishable while still enabling a clear comparative analysis in the subse-quent analysis and discussion chapter.

With its benefits highlighted above, we will apply the ”2. Topic by topic”structure (figure 2.4) when analyzing and discussing the results, with topicscomprised of 1) Strategic Rationale, 2) Synergies, and 3) Valuation. In order toproduce a rich answer to the research question, we will follow these themes toanalyze and discuss how deal rationale and target characteristics, among otherthings, affect:

• Choice of acquisition strategy

• Which synergies were identified

• How synergies were valued

• The synergies’ contribution to the valuation

The aforementioned sub-questions will be examined both comparatively betweencases as well as in relation to the previous research covered in the literature andtheory review chapter.

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2.5 Research Quality

Although the case-based method is deemed suitable for this thesis it is importantto note the drawbacks of the method in order to actively manage the scientificquality of the research. Yin (1994) states three factors impacting the researchquality of the case-based method, namely: 1) Construct validity, 2) Externalvalidity and 3) Reliability.

Construct validity refers to establishing appropriate measures for the conceptbeing studied and Yin (1994) suggest using multiple sources of evidence in thedata collection process in order to mitigate the risks of a sub par constructvalidity. As we will gather material from interviews, internal documents andvaluation models a solid construct validity is deemed to be achievable. More-over, in accordance with Yin (1994) we will let key interviewees review the draftof the case study report in order to secure a higher construct validity.

External validity regards the issue of determining whether the findings of astudy can be generalized beyond the immediate case study. Yin (1994) statesthat one of the main concerns of the case-based method is that the sample sizeof cases is too small to generalize across a larger universe. However, we willmitigate the otherwise low degree of generalization by conducting multiple casestudies. Furthermore, Yin (1994) also notes that findings from case studies canbe generalized, albeit on an analytic basis rather than on a statistical basis.

The last factor proposed by Yin (1994), reliability, refers to the ability to repeatthe operations of the study and arrive at the same results. As suggested byYin (1994) we will aim to achieve strong reliability by thoroughly detailing ourresearch process by for example including the interview script used. However,we have to take some measures essential for the research process which mayhave a negative impact on the reliability. The main action we have to take isensuring the anonymity of the interviewees in order to secure unbiased answersand hence it will not be possible to replicate the study with the exact sameinterviewees.

2.6 Ethics of Method

There are several aspects to our thesis which expose us to ethical challenges.These aspects include that fact that our study involves two different stakeholderorganizations (Marrow and our academic institution), as well as the fact thatwe will be dealing with sensitive company specific information. Furthermore,our research approach of conducting semi-structured interviews raises additionalethical issues and risks. The dimensions of ethical issues include, but are notlimited to, the confidentiality and trust of involved people and corporate andacademic entities, as well as potential biases introduced from our method ofselecting, collecting and interpreting empirical data. As a general guideline wewill follow the Swedish Research Council’s codex for social science research as

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presented by Blomkvist and Hallin (2015), which includes four pillars of require-ments which scientific research in social science must fulfill:

• The information requirement - the people and entities studied mustbe informed of the purpose of the study.

• The consent requirement - the people or entities studied must giveconsent to being studied.

• The confidentiality requirement - the collected or created materialmust be treated with confidentiality, and if necessary be presented in away that makes the source of information unidentifiable.

• The good use requirement - the collected material must only be usedfor the purpose(s) stated beforehand.

In accordance with the four principles above, several specific measures will betaken in order to remedy the ethical issues in our study. We will alter all nominalfinancial figures presented in our results as to protect anonymity while retain-ing the logical coherence of calculations. Furthermore, names and terms relatedto specific business and technology areas while be generalized to a level whereanonymity is protected while retaining mutual intelligibility to a degree wheremeaningful discussion can still be had.

With regards to the interviews, the same four principles make up central ele-ments for an ethical study. As discussed by Ryen (2016), following principleslike these does not only improve the ethical quality of the research, but alsopromotes interviewees trust and their willingness to aid with additional insightsand contacts for the study. The information and consent requirements will befulfilled by establishing the purpose of study and the consent of every inter-viewee beforehand. In order to achieve confidentiality, the interviewees will beoffered to have their names anonymized (Collis and Hussey, 2009). In orderto ensure good use, all interviewees will be invited to take part of the researchresults before published and given the opportunity to review that they have notbeen misunderstood or misquoted.

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Chapter 3

Literature and Theory

Review

This chapter provides a theoretical foundation on which the empirical materialwill be analyzed. First, we cover the strategies and rationales for M&A. We thenprovide a breakdown of different kinds of synergies, followed by an overview ofprinciples and methods used for valuing companies. Last, we cover methods andinsights for synergy valuation as presented in the literature.

3.1 Mergers & Acquisitions

According to Baker and English (2011) the terms merger and acquisition are of-ten used synonymously although there are slight differences. Baker and English(2011) further state that if two companies of similar size decide to consolidateto a single entity, it is called a merger. Moreover, mergers do not occur often inpractice whereas acquisitions, namely when a larger company acquires a smallerone, is more frequently occurring.

3.1.1 Strategic fit

Shelton (1988) provides a framework for classifying the strategic fit of acquisi-tions, based on the concepts of related-complementary and related-supplementaryby Salter and Weinhold (1979). The framework is illustrated in figure 3.1. Ac-cording to Shelton (1988) a purely related-complementary fit is a vertical inte-gration, which Baker and English (2011) describe as the integration of two firmsengaged in different stages in the value chain, for example a manufacturing firmacquiring a distributor. A pure related-supplementary fit on the other hand isclassified as a horizontal integration according to Shelton (1988), which Bakerand English (2011) describe as an integration of two firms engaged in the samebusiness, for example two competitors.

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The unrelated fit in the framework could be described as a conglomerate merger,which Baker and English (2011) defines as the combination of firms engaged inunrelated businesses, for example a manufacturer and an insurance company.Although Shelton (1988) does not define the identical fit, one could argue thatit encompasses risks of cannibalization, described by Copulsky (1976) as theextent to which one product’s customers are at the expense of other productsoffered by the same firm.

Related-Complementary

New products

Similar customers

Unrelated

New products

New customers

Identical

Similar products

Similar customers

Related-Supplementary

Similar products

New customers

Serving New Customers

Strategic Fits Between a Target and a Bidder Business

Addi

ng N

ew P

rodu

cts

Figure 3.1: Ways that an acquired business changes the product-market oppor-tunities of a bidder business (Shelton, 1988).

3.1.2 Strategies

In their book ”Valuation: Measuring and Managing the Value of Companies”Koller et al. (2010) state that there is a limitation in empirical analysis to iden-tify specific acquisition strategies that create value due to the wide variety oftypes and sizes of acquisitions, as well as the lack of an objective way to classifyacquisitions by strategy. Furthermore, Koller et al. (2010) argue that a com-pany’s stated acquisition strategy may not be its real strategy since companiestypically communicate various strategic benefits from acquisitions when theyessentially only revolve around cost cutting. However, previous literature haveoutlined several acquisition strategies.

Improve Performance of Target Company

One of the most common acquisition strategies, especially among private eq-uity funds (Acharya et al., 2013; Lichtenberg and Siegel, 1990; Smith, 1990), isto pursue value creation by improving the performance of the target company.This strategy typically revolves around improving the target’s margins and cash

16

flows through radical cost reductions. In some instances, the acquirer may alsotake initiatives to increase revenue growth (Koller et al., 2010).

One should note that improving the performance of a company with low marginsand low return on invested capital (ROIC) is easier than for a company withhigh margins and high ROIC. For example, if one acquires a company with a 6percent operating profit margin and subsequently manage to reduce costs by 3percentage points from 94 percent to 91 percent of revenues the operating profitmargin would increase to 9 percent, which could entail a 50 percent increase inthe value of the company.

On the other hand, if the acquired company’s operating profit margin would be30 percent the same value increase of 50 percent would require a margin increaseto 45 percent. In this case, costs would need to be reduced from 70 percent to55 percent of revenues, which equates to a 21 percent reduction in the cost base.

Consolidate to Remove Excess Capacity from Industry

As mentioned by Gaughan (2013), during times when the demand for an indus-try’s products is high, there may be room in the market for several competitorsto supply the product. However, they also state that when an industry declines,there may be too many competitors in the market and a need for reduction ofexcess capacity. In that case, instead of letting the competitive process termi-nate less competitive companies, corporate managers in the industry can try tomerge in order to reduce the overall capacity.

Koller et al. (2010) provide an example of the rationale behind removing ex-cess capacity in the chemicals industry. Chemicals companies are continuouslylooking for ways to increase production in their plants at the same time asnew competitors continue to enter the industry. High production from exist-ing capacity coupled with new capacity from new entrants often result in moresupply than demand. Although supply exceeds demand it is not in any singlecompany’s interest to shut down a plant. It is often the case that companiesfind it easier to shut down plants in a larger combined entity resulting from anacquisition than shutting down their least productive plants and ending up witha smaller company in the absence from an acquisition.

Moreover, Koller et al. (2010) state that shutting down plants to reduce excesscapacity is a highly tangible action, however reducing excess capacity can alsotake less tangible forms. As an example, the consolidation in the pharmaceuticalindustry has led to significant reductions in sales force capacity since mergedcompanies’ product portfolios have changed and they have rethought how tointeract with doctors. In addition, pharmaceutical companies have significantlyreduced their research and development capacity as they have discovered moreproductive means to conduct research and streamlined their portfolios of devel-opment projects.

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Accelerate Market Access for Target’s (or Acquirer’s) Products

According to Koller et al. (2010), relatively small companies with innovativeproducts often have difficulties in accessing the entire addressable market fortheir products as they lack the large sales forces required to sell and promotetheir products. As such, larger companies sometimes acquire these smaller com-panies and utilize their own large-scale sales forces in order to accelerate the salesgrowth of the smaller companies’ products.

IBM (2014) exemplifies a company that pursued this strategy when it acquired43 companies for an average of USD 350 million each between 2010 and 2013.IBM (2014) identified that the acquired companies possessed scalable intellec-tual property, which IBM capitalized on by leveraging its global sales force tosell these companies’ products.

In some instances, the acquired target can also facilitate an acceleration inthe acquirer’s revenue growth. For example, when Procter & Gamble (P&G)acquired Gillette, the combined entity benefited from individual companies’ dif-ferent market exposure where P&G had stronger sales in some emerging marketswhile Gillette had stronger sales in others. Through the combined entity theywere able to introduce their products into new markets much more quickly (WallStreet Journal, 2005).

Acquire Skills or Technologies Faster or at Lower Cost Than TheyCan Be Built

According to Ford and Probert (2010) acquisitions of external technologies areoften motivated by the need to develop technological capabilities, where man-agement attempts to fill gaps in its own R&D knowledge or capabilities throughacquisitions. Ford and Probert (2010) further state that the aim of these ac-quisitions vary from filling holes in a product line to creating and establishinga new product.

Furthermore, Ford and Probert (2010) argue that the need for these types ofacquisitions arises due to specialist technical expertise and capabilities oftenbeing difficult to obtain and companies may not have the ability to internallydevelop these knowledge-based resources. In addition, these acquisitions pro-vide companies with the ability to acquire technological assets on the market inorder to overcome internal technological constraints.

Moreover, Ford and Probert (2010) state that when companies need to innovatemore rapidly, they can acquire technology as it can reduce the time to themarket. In addition, Ranft and Lord (2000) points out that developing newcapabilities and technologies internally may take too long and/or be too costly,

18

and acquiring technology can create these in less time. Sen and Rubenstein(1989) argue that reducing development time allows companies to move fasterand be more responsive to market demands.

Acquire Winners Early and Help Them Develop Their Business

According to Koller et al. (2010) picking winners early involves acquiring com-panies early in the life cycle of a new industry or product category before othercompanies recognize that the industry or product category will grow to repre-sent a sizeable market.

Pursuing this acquisition strategy requires a disciplined approach by manage-ment in three dimensions:

1. Willingness to make early investments, long before competitors and themarket recognize the industry’s or company’s potential

2. Willingness to make multiple bets and expect some to fail

3. Possess the patience and skills required to nurture the acquired company

Roll-Up Strategy

Gaughan (2011) describes the roll-up strategy as consolidating an industrywhere larger companies acquires smaller competitors in a series of acquisitions.The acquired companies are subsequently combined into a larger entity which isthen able to achieve economies of scale. They further point out that this strat-egy is most suitable for markets which are highly fragmented and where thecompetitive landscape is characterized by small competitors unable to achieveeconomies of scale. Adding to this, Koller et al. (2010) state that the roll-upstrategy can be successful when the acquired businesses as a group can achievesubstantial cost savings or higher revenues than the individual businesses.

Consolidate to Improve Competitive Behaviour

According to Koller et al. (2010) there are many executives in highly compet-itive industries hoping that industry consolidation will result in competitorsfocusing less on price competition, leading to an improved ROIC for the indus-try. However, evidence show that competitor pricing behaviour does not changeunless an industry consolidates to three or four competitors and can keep newentrants out, since smaller companies or new entrants often have an incentive togain market share through price competition. Therefore, in an industry with forexample 10 competitors, a significant amount of deals need to be made beforethe basis of competition changes.

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Acquire Undervalued Targets

The final acquisition strategy is outlined by Depamphilis (2009) and revolvesaround acquiring a company cheaply, in other words at a price below the targetcompany’s intrinsic value. However, opportunities to acquire companies cheaplyare both rare and relatively small.

Although the market value of a company revert to its intrinsic value over longertime periods, there can be brief instances when the two fall our of alignment.Sometimes markets overreact to negative news, for example the failure of asingle product in a company’s otherwise strong product portfolio.

3.1.3 Drivers for M&A

In a recent survey by KPMG (2016), 550 U.S. M&A executives provided theirforward-looking view of the M&A landscape. The survey provides insight intothe current strategic rationale of M&A deals among executives. The resultsfrom the executives when asked ”What are the primary reasons for the acqui-sitions your company or fund intends to initiate in 2016?” are shown in figure3.2. (note: respondents were asked to select up to three alternatives).

From figure 3.2 one can note that the top three drivers for M&A according toU.S. M&A executives, namely 1) Expand customer base, 2) Enter into new linesof business and 3) Expand geographic reach, are focused on growth. As Kolleret al. (2010) argue that a company’s communicated acquisition strategy maydiffer from its real strategy one should take precaution in accepting the responsesin the survey at face value. However, since the individuals and correspondingcompanies are not disclosed in the survey, one may argue that the anonymizedresponses to a greater degree reflect the actual views of the M&A executives.

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7%

13%

16%

20%

25%

34%

36%

37%

37%

Defend against competition

Responding to activist investors

Acquiring additional elements of the supplychain

Financial buyer looking for profitableoperations and/or gain on exit

Opportunistic - target becomes available

Enhance intellectual property or acquire newtechnologies

Expand geographic reach

Enter into new lines of business

Expand customer base

Figure 3.2: M&A executives’ survey responses (KPMG, 2016).

3.2 Synergies

Different types of synergies can be categorized into two broad groups: operatingsynergies and financial synergies. We have categorized and summarized syner-gies related to the two groups in table 3.1. The following subsections outlineeach type of synergy in further detail, as well as issues related to synergies.

Category Synergy

Operating SynergiesEconomies of ScaleIncreased Pricing PowerHigher Growth in New or Existing Markets

Financial SynergiesOpportunities for Excess CashIncreased Debt CapacityTax Benefits

Table 3.1: Overview of synergy types.

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3.2.1 Operating Synergies

Operating synergies relate to the operations of the combined companies andinclude economies of scale, increased pricing power and higher growth potential.

Economies of Scale

Damodaran (2011) states that a combination of two companies can provideopportunities for increased cost efficiency and thus profitability. Generally, syn-ergies regarding economies of scale are often realized through horizontal acqui-sitions, that is a combination of two companies within the same business.

De Graaf and Pienaar (2013) further divide synergies from economies of scaleinto scale economies in production and scale economies in non-production areas.They state that achieving scale economies in production is particularly relevantto manufacturing firms that are capital-intensive. Additionally, De la Mano(2002) mentions that scale economies in production are closely related to theunderlying production technology, where more efficient production technologyis generally available to a greater extent at higher output levels.

Besides scale economies in production, De Graaf and Pienaar (2013) also em-phasize the scale economies in non-production areas such as management, mar-keting, distribution, and R&D. Whereas scale economies in production are fo-cused on reducing the average production cost per unit, scale economies in non-production areas are focused on reducing the average total cost per unit. Fur-thermore, De la Mano (2002) provides examples of how M&A could generatescale economies in non-production areas, including creation of a single, consoli-dated brand in order to reduce advertising expenditures, combining sales forcesor distribution networks and improving utilization of an unsaturated distribu-tion channel.

Increased Pricing Power

According to De la Mano (2002) a company’s power in the market is its ability tomaintain prices above competitive levels for a significant period of time. Kolleret al. (2010) argue that acquisitions can entail pricing power synergies due toa reduction in competition as well as a larger market share for the combinedentity. An increase in pricing power will result in margin expansion all else equal.

Moreover, Koller et al. (2010) state that an increase in pricing power is mostlikely to occur in a consolidated industry with few competitors. However,they also point out that acquisitions in a consolidated industry may entail anoligopoly environment, which anti-trust laws are set to stop and thus acqui-sitions of that nature may be difficult to conduct. Although anti-trust lawsput constraints on the ability to conduct a merger or acquisition motivated bymarket power, Chatterjee (1986) states that in cases where this does happen, it

22

could represent significant synergy benefits.

De Graaf and Pienaar (2013) highlight two examples of mergers, one vertical andone horizontal, motivated by an increase in market power. The vertical mergerexample relate to a supplier of a key input for a certain industry’s productionmerging with a company engaged in activities closer to the end-customer in thevalue chain, and subsequently discriminating against competitors in its pricingof the input.

The horizontal merger examples highlighted by De Graaf and Pienaar (2013) re-volve around certain circumstances motivating market power through a merger,including a falling demand in the market (leading to excess capacity with therisk of price reductions), and a local market facing the risk of a highly possibleentry by foreign competitors (with the risk of a price reduction).

Higher Growth in New or Existing Markets

As stated by Gaughan (2011) corporate managers are under constant pressureto achieve growth, especially when the company and the industry has a his-torical track-record of achieved growth. However, growth can stagger when forexample the demand of an industry’s products or services slow down and inthose cases managers often look to M&A as a way to achieve further growth.Gaughan (2011) mention that managers often hope that acquisitions will entailrevenue accretion greater than the separate entities revenues combined throughsynergistic effects.

According to Gaughan (2011) revenue-enhancing operating synergies may bemore difficult to realize than cost reduction synergies. They further state thatthere are many potential sources of revenue synergies and that these vary greatlyfrom deal to deal. Gaughan (2011) highlights a few revenue synergy sources,such as the market opportunity of cross-selling each merger party’s products.The broader product line post-acquisition could enable each company to sellmore products and services to their customer base.

Additionally Koller et al. (2010) outline another revenue synergy source, namelythe opportunity to leverage the each company’s sales and distribution network.For example, if the acquiring company utilizes its strong sales and distributionnetwork to push the target company’s products which have great potential butlimited ability to take them to market before competitors can react and seizethe period of opportunity. Gaughan (2011) also points to the importance ofutilizing the country-specific know-how of a target when engaging in a cross-border deal as a way to tapping into a new market.

Moreover, Gaughan (2011) states that revenue synergies can also arise from acompany with a strong brand name lending its reputation to the product lines

23

of the acquired or acquiring company.

Although revenue synergies exist, Gaughan (2011) emphasize that they are dif-ficult to quantify and build into valuation models and are thus discussed ratherthan explicitly quantified. They further state that cost synergies are often high-lighted in M&A deals, as it is easier to say for example that specific facilitiesare overlapping and can be reduced.

3.2.2 Financial Synergies

Operational matters aside, an acquisition or a merger can provide financial syn-ergies, which include opportunities for excess cash, tax benefits, and a higherdebt capacity.

Opportunities for Excess Cash

Chandra (2014) states that financial synergies can stem from a more profitableutilization of cash slack. In practice, this means that a company with excess cashon its balance sheet coupled with a limited number of projects to invest in canrealize financial synergies by acquiring a company with limited cash reserves,but with a larger number of high-return projects to invest in. Thereby, thecompany with excess cash can employ its capital in projects generating higherreturns on invested capital than it could have by investing in its own projects.

Debt Capacity

According to Gaughan (2011) the combination of two companies may reducethe risk of the combined entity if the companies’ cash flows are not perfectlycorrelated. Thus if the merger or acquisition reduces the volatility of the cashflows, hence making them more stable and predictable, then suppliers of debtcapital may consider the combined entity less risky.

Gaughan (2011) argues that this effect will lead to a reduced cost of capital forthe combined entity and in addition Damodaran (2011) states that the combinedentity can also increase debt leverage since the debt capacity would be higherthan for the individual entities. Increased debt leverage will in turn provide taxbenefits. Similarily, JP Morgan (2009) suggest that the relative value of debtcapacity synergies may increase in times of financial crises, where firms outsideor in the lower ranges of investment grade credit ratings become restricted byhiking credit yield spreads. In these situations, a financially strong acquirer maybe able to reap major synergies from a decreased cost of capital by improvingthe credit profile of a financially weaker target.

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Tax Benefits

According to Damodaran (2011) an acquisition can entail synergistic effects inthe form of a reduction in tax burden. For example, if a profitable companyacquires a loss-making company the former may utilize the net operating lossesof the latter the reduce tax expenses. In addition, the acquiring company maywrite-up the target company’s assets and thus increase its depreciation expensespost-acquisition entailing a reduction in tax expenses.

Eccles et al. (1999) state that one of the most common synergies from taxplanning relate to transferring brands and other intellectual property to a low-tax subsidiary. In addition, they list a number of other tax planning synergies,such as placing shared-services and central purchasing to a low-tax subsidiary,reorganizing within a country to pool taxes and transferring debt into high-taxsubsidiaries. However, although the authors argue that there are real benefitsfrom tax planning synergies they argue that firms should not make deal decisionssolely based on tax synergies.

3.2.3 Issues Related to Synergies

Biased Evaluation Process

Damodaran (2011) states that in most M&A deals the assessment of whetherthe target company is an attractive investment at the offered price is conductedby the investment bankers for the acquiring firm. As such the M&A process isprone to conflicts of interest and bias since the investment bankers’ fees rely onthe deal being executed and not on whether the deal makes sense. Damodaran(2011) further states that this bias coupled with the fact that managers at mostacquiring firms have decided to follow through with the acquisition at any pricelead to many bad deals being conducted with acquirers overpaying for synergyand control.

Managerial Hubris

In his paper titled ’The Hubris Hypothesis of Corporate Takeovers’ Roll (1986)argues that hubris on the part of managers in the acquiring firm can explainwhy they pay too much for their targets. Roll (1986) further discusses that thehubris factor lead to managers in the acquiring firm consistently underestimatethe time it will take to realize synergies as well as overestimate the amountof synergies that exist in an M&A deal. Scrutinized examples of managerialhubris includes the USD 2 billion bid premium in Viacom’s 1994 acquisition ofParamount (Hietala et al., 2003) as well as the heavily criticized acquisition ofN.V. Nuon Energy by Swedish state-owned energy company Vattenfall in 2009,where the acquirer seven years later had written down 60% of the original trans-action value of SEK 89 billion (Nilsson, 2016).

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3.3 General Valuation Methods

3.3.1 Discounted Cash Flow Model

The discounted cash flow (DCF) model is used to value a company by discount-ing its free cash flows available to all its investors, including equity investors,debt investors, and other non-equity investors. Discounting the free cash flowsis conducted by utilizing a discount factor, the weighted average cost of capi-tal (WACC), which is the blended cost of capital from all investors. The DCFmodel arrives at a company’s enterprise value (EV), and in order to determinethe company’s equity value one has to subtract cash flow claims from debt andnon-equity investors from the EV (Koller et al., 2010). In their book ’ValuationMeasuring and Managing the Value of Companies’ Koller et al. (2010) suggestthat the process of valuing a company’s equity using the DCF model comprisesof four parts, namely:

1. ”Value the company’s operations by discounting free cash flow at theweighted average cost of capital.

2. Identify and value nonoperating assets, such as excess marketable securi-ties, nonconsolidated subsidiaries, and other equity investments. Summingthe value of operations and nonoperating assets gives enterprise value.

3. Identify and value all debt and other nonequity claims against the en-terprise value. Debt and other nonequity claims include (among others)fixed-rate and floating-rate debt, unfunded pension liabilities, employeeoptions, and preferred stock.

4. Subtract the value of nonequity financial claims from enterprise value todetermine the value of common equity. To estimate price per share, divideequity value by the number of current shares outstanding.”

Valuing a company’s operations requires projecting its revenue growth, returnon invested capital (ROIC) and free cash flow (FCF). Free cash flow is driven byrevenue growth and ROIC and constitute the basis for an enterprise valuationusing the DCF model. However, projecting FCF beyond a medium horizon of5 to 10 years is difficult and thus valuing free cash flows beyond this horizonrequires the use of a continuing-value model (Koller et al., 2010).

Therefore, valuing operations comprises two parts:

Operations

Value of=

during Explicit Forecast PeriodPresent Value of FCF

+after Explicit Forecast Period

Present Value of FCF(3.1)

26

where FCF is defined as follows according to Bernstrom (2014):

FCF = EBIT−

EBITTaxes on

+AmortizationsDepreciations &

−

expendituresCapital

−

net working capitalInvestments in

(3.2)

The present value of FCF during the explicit forecast period is calculated as:

n∑

t=1

FCFt

(1 +WACC)t(3.3)

where n is the number of years in the explicit forecast period.

Valuing the free cash flow after the explicit forecast period requires, as men-tioned above, a continuing-value model. Rosenbaum and Pearl (2009) proposethe use of the perpetuity growth method for estimating the terminal value, de-fined as:

Terminal V alue =FCFn ∗ (1 + g)

WACC − g(3.4)

Where g represents the perpetuity growth rate, which is the company’s expectedlong-term industry growth rate typically in line with nominal GDP growth.

The formula for valuing a company’s operations is therefore:

OperationsValue of

=n∑

t=1

FCFt

(1 +WACC)t+

FCFn ∗ (1 + g)

WACC − g(3.5)

Weighted Average Cost of Capital

A key component in valuing companies is determining the cost of capital, ascompanies are financed using equity, debt and other sources and the cost ofthese sources must be estimated in order to determine an appropriate discountrate (Ross et al., 2013). A common methodology to determine a company’sdiscount rate is to calculate its weighted average cost of capital (WACC), whichincorporates the company’s capital structure as well as the cost of respectivecapital according to the formula below:

WACC =E

D + E∗Rs +

D

D + E∗Rb ∗ (1− tc) (3.6)

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where E

D+Econstitutes the share of equity financing, D

D+Econstitutes the share

of debt financing, and Rs and Rb represents the cost of equity and pre-tax debtrespectively. As interest expense is tax deductible for corporations, one needsto account for the tax shield when determining the post-tax cost of debt, whichis captured in the (1− tc) factor in the WACC formula where tc represents thecorporate tax rate (Ross et al., 2013). The cost of equity is measured by theexpected return of an equity investment in a company. However, a fundamentalquestion to answer in corporate finance and corporate valuation is how the risklevel of an investment relates to its expected return (Perold, 2004). A com-mon approach to determine the cost of equity is to use the capital asset pricingmodel (CAPM) proposed by Sharpe (1964). According to Ross et al. (2013) theexpected return of an equity investment is derived with the following formulausing CAPM:

Rs = RF + β ∗ (RM −RF ) (3.7)

where RF is the risk-free interest rate, RM is the expected return of the market,RM−RF is the difference between the risk-free interest rate and expected returnof the market, also known as market risk premium. The β value of the formulais a factor measuring the underlying security’s responsiveness to movements inthe market (Ross et al., 2013).

3.3.2 Multiples

Valuing companies with the DCF model provides a granular view of the assump-tions driving the value in the forecasts. However, if the underlying assumptionsare inaccurate the value may be over- or underestimated. By employing thevaluation technique of multiples, one can assess the plausibility of the DCFassumptions by comparing the value to peer companies’ value through stan-dardized metrics (Koller et al., 2010). In order to construct a useful multipleanalysis, Koller et al. (2010) propose that the following three requirements aresatisfied:

1. ”Use the right multiple. For most analyses, enterprise value to EBITA isthe best multiple for comparing valuations across companies. Althoughthe price-to-earnings (P/E) ratio is widely used, it is distorted by capitalstructure and non-operating gains and losses.

2. Calculate the multiple in a consistent manner. Base the numerator (value)and denominator (earnings) on the same underlying assets. For instance,if you exclude excess cash from value, exclude interest income from theearnings.

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3. Use the right peer group. A set of industry peers is a good place to start.Refine the sample to peers that have similar outlooks for long-term growthand return on invested capital (ROIC).”

EV/EBITA

Koller et al. (2010) argue that the EBITA multiple provides the most accuratedepiction of a company’s value. The EBITA multiple is preferred to the EBITmultiple since amortization is a non-cash expense in accounting related to previ-ous acquisitions, and thus is not correlated to future cash flows and will distortthe enterprise value. Furthermore, Koller et al. (2010) rank the EBITA multiplehigher than the EBITDA multiple despite the fact that depreciation is, simi-lar to amortization, a non-cash expense in accounting, which reflect sunk costsof historical capital expenditure. The reason for this is that depreciation ex-pense in many industries indicate future capital expenditure required to replaceexisting assets.

EV/EBITDA

In some instances however the EBITDA multiple is preferred over the EBITAmultiple according to Koller et al. (2010). An example of such an instanceis when a current depreciation is not an accurate indicator for future capitalexpenditures, for example if a company overpaid for equipment due to poornegotiations.

EV/Sales

According to Koller et al. (2010) the EV/Sales multiple contains an importantrestriction compared to the EBITA and EBITDA multiples, namely similaroperating margins for the company’s existing business. Koller et al. (2010) statethat this restriction does not hold for most industries and that the EV/Salesmultiple should be limited to companies with volatile earnings or other situationswhen earnings fail to represent long-term operating potential.

Publicly Traded vs. Precedent Transactions

Bernstrom (2014) states that the data source for the peer group generally com-prises either publicly traded companies or precedent transactions. They alsodiscuss various factors to consider when choosing the data source for multiplevaluation.

For publicly traded companies Bernstrom (2014) points out that the data iseasily retrievable from various public sources and that the data is always up todate as share prices are continuously updated. They further state that shareprices reflect an informed minority investor’s point of view which is unaffectedby effects such as synergies which would only be realizable by a few specific

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buyers.

For precedent transactions on the other hand Bernstrom (2014) highlights sev-eral challenges making this approach more complicated. Firstly, is it often diffi-cult to retrieve data as the transactions mainly concern private companies whichdo not generally need to disclose information regarding transactions. Secondly,the transactions may include unknown agreements between the buyer and theseller such as earn-outs or compensation other than cash, for example paymentin full or in part with shares or another kind of financial instrument. Lastly, thetransaction price may include synergies only realizable for that specific buyerand hence the price may be regarded as the ”investment value” for the specificbuyer.

Peer Group Selection

As proposed by Koller et al. (2010) choosing the right peer group is a criticalrequirement for multiple analysis and whilst they define some factors to considersuch as similar outlooks for long-term growth and ROIC, Bernstrom (2014)outlines the following additional factors to consider.

He argues that one should seek to find peers operating in the same geographicalarea as the valuation subject in order to capture the same economic value driversand risks. They further argue that if the number of suitable peers is limited inthe immediate geographical proximity one should look for peers in a geographicalarea with similar economic conditions with regards to factors such as risk profile,maturity, interest rates, inflation and economic growth.

Furthermore, they argue that one should look for peers with similar businessmodels and value drivers with regards to factors such as:

• Market dynamics: Similar business cycle in terms of structure andstrength to reflect an appropriate risk exposure. Moreover, the peersshould act on a market with similar barriers to entry and competitivelandscape in terms of for example consolidation

• Product mix: Similar products such that the peer does not have abroader product portfolio containing products in other business areas

• Suppliers: Dependency on the same type of raw material such that thescarcity of the resource or commodity does not differ. Additionally, byusing the same type of raw material the peer will procure from the samesupplier base which minimizes any difference in bargaining power andsubsequently price due to for example a monopolistic supplier

• Customers: Similar type of customers, both in numerical terms andbehaviour as these factors will influence the producer’s bargaining powerand subsequently the price that these can charge

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3.4 Synergy Valuation Methods

While a large body of models and frameworks exists for the topics of synergiesand valuation separately, there is less in-depth material on synergy valuationspecifically. In a critical review of incumbent theory, De Graaf and Pienaar(2013) highlight three universal (i.e. not specific to a specific type or originof synergy) synergy valuation approaches: (1) the McKinsey & Co. ”outside-in approach” (Koller et al., 2010), (2) the ”three key variables driving synergyvalue” (Evans and Bishop, 2002), and (3) the discounted cash flow based processby Damodaran (2005). These relate to different levels and aspects of synergyvaluation and are thus arguably best employed in combination rather than asseparate standalone models.

In short, Koller et al. (2010) provide a framework for breaking down cost savingsand revenue improvements into more easily quantifiable items. In a more highlevel fashion, Evans and Bishop (2002) describe three drivers for synergy value:(1) the size of the synergy benefit, (2) the timing of the synergy benefit, and (3)the likelihood that it will be achieved. Last, Damodaran (2005) ties the synergyestimates in the profit and loss statements to the DCF valuation in order toreach an enterprise value (and thus, a potential maximum bid premium) of thesynergies. The following subsections will outline and discuss different aspects ofsynergy valuation in further detail, with support from above mentioned authors.

3.4.1 Estimating Cost Synergies

A common practice when estimating cost savings is to simply consider the dif-ference in financial performance between the bidder and the target. However,Koller et al. (2010) argue that this approach is too simplistic in the sense thatfor example a bidder with high operating margins will not necessarily be able totranslate those into better performance for the target. As such, their ”outside-inapproach” seeks to structure and calculate cost savings by disaggregating theoperations into smaller parts, as exemplified in an industry-agnostic frameworkin figure 3.3.

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Figure 3.3: Sample framework for estimating cost savings (Koller et al., 2010).

While helpful on a conceptual level, applying a generic framework to estimatecost savings may prove difficult in reality. When dealing with a live case, Kolleret al. (2010) propose to structure the analysis in four steps:

1. ”Develop an industry specific business system.

2. Develop a baseline for costs as if the two companies remained independent.Make sure the baseline costs are consistent with intrinsic valuations.

3. Estimate the savings for each cost category based on the expertise of expe-rienced line managers.

4. Compare resulting aggregate improvements with margin and capital effi-ciency benchmarks for the industry, to judge whether the estimates arerealistic given industry economics.”

In the first step, the business system must fulfill three criteria. First, it mustbe able to map each cost item of the target company to one (and only one)segment, as to ensure examination of the entire cost structure and to avoiddouble-counting cost savings. Second, the business system must be able tocapture cost savings in the bidder’s organization. Finally, a complete businesssystem must be able to capture cost savings in sufficient detail. If a large portionof the total cost savings have been mapped a one single segment in the business

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system, this should be further disaggregated to smaller parts until sufficient de-tail is achieved.

The next step is to forecast baseline costs for all segments in the business systemfor both the bidder and the target company. These baseline estimates shouldcorrespond to the scenario where both firms continue to operate as stand-aloneentities. To reach accurate cost savings estimates, each financial saving shouldbe tied explicitly to operational activities in the business structure. When esti-mating the feasibility of cost savings, assistance from experienced line managersin the acquirer’s organization can provide insights on the impact on quality andcapacity which may follow from headcount and resource reductions.

Once the cost savings estimates are complete, the results for the combinedcompanies should be aggregated and benchmarked against industry figures foroperating margins and capital efficiency. Koller et al. (2010) propose to createa fully integrated income statement and balance sheet and to ensure that ROICand growth projections are reasonable when compared to the industry at large.The ROIC for the pro forma company recquires particular attention and mustland at a sensible continuing value for the pro forma company and in line withthe overall competitive structure of the industry. If the competitive advantagesof the pro forma company are unlikely to be sustainable, the cost synergies mayalso need to be scaled down over the long term.

3.4.2 Estimating Revenue Synergies

In general, making accurate revenue projections appear to be more difficultthan making accurate cost projections. Koller et al. (2010) argue that the com-mon pitfall of simply estimating pro-forma revenue by combining the revenue ofthe standalone companies and then adding potential cross-selling often leads tooverly optimistic projections. McKinsey (2004) study on a sample of 167 trans-actions in the 2000’s may be illustrative to this proposition, showing that whilea large majority of acquirers realized most of (or more than) their projectedcost savings, almost half of the acquirers realized less than 70% of projectedrevenue improvements. There are several reasons to be cautious with revenueprojections in a bid process. In general, mergers can have a disrupting effect oncustomer relationships, leading to potential revenue losses. Competitors mayuse ongoing mergers as an opportunity to snatch talented salespeople. Further,customers with a dual sourcing policy may move part of their business to a com-petitor in order to maintain a minimum of two suppliers, or leverage a turbulentongoing merger to negotiate lower prices (Koller et al., 2010).

When projecting revenue improvements, estimates of pricing power and marketshare must be consistent with the underlying market growth and the compet-itive positions of the merging entities. Any revenue growth beyond base-caseestimates must explicitly be attributable to either one or multiple of the fol-lowing: an increase in a product’s peak sales level, a product reaching its peak

33

sales faster, extending a product’s life (staying at high or peak sales for longer),or adding new products or features which the two standalone companies couldnot have developed independently. Alternatively, the opportunity to raise pricesdue to weaker market competition after the deal is a very direct way to improverevenues, although there are typically regulations and authorities preventingcompanies from fully utilizing this lever (Koller et al., 2010).

In terms of the Evans and Bishop (2002) model, these revenue synergy esti-mates, together with the cost estimates in the prior subsection, address the firstkey synergy driver: the size of the benefits. Depending on how meticulously thecost and revenue improvements are modeled with regards to different scenarios,these assumptions do in part also cover the third synergy driver: the probabilityof the benefits. Other more thorough ways of valuing an investment with regardsto uncertainty of outcomes include real-options valuation models, pioneered ina corporate finance setting by Dixit and Pindyck (1994) and further discussedby van Putten and MacMillan (2004). Arguing that DCF analysis alone tend toundervalue the potential of high-risk projects, while real-options analysis oftenignores the residual value of assets from abandoned projects, van Putten andMacMillan (2004) propose an integrated approach to capture a base value esti-mate via DCF analysis and the value of potential gains via real-options analysis.

3.4.3 Synergy Phasing

As Damodaran (2011) states, synergies are likely to be realized over time ratherthan instantaneously. Thus it is important to determine when the synergies willstart to affect cash flows since the value from synergies is the present value of thecash flows generated from them. Therefore, the longer it takes for synergies tobe translated into cash flows, the less their value. Applying a realistic phasingcorresponds to the second key synergy driver as presented by Evans and Bishop(2002): the timing of the benefits.

3.4.4 Choosing the Right Discount Rate

According to Damodaran (2011) acquiring firms often use an incorrect discountrate when valuing incremental cash flows relating to synergies. As such, usingan incorrect discount rate when valuing synergy cash flows in a DCF modelfor example, will lead to synergies being misvalued. Damodaran (2011) arguesthat the governing principle in the estimation of discount rates, namely thatthey should reflect nondiversifiable risk in the cash flows, continues to hold trueregarding cash flows from synergies. As the cash flows stemming from synergiesaccrue to the combined entity rather than to the acquiring or target companyseparately, the discount rate should be based on the combined entity’s cost ofequity and/or capital. In many acquisitions the cash flows generated from syn-ergies are discounted at either the acquiring company’s or the target company’scost of equity/capital.

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3.5 Closing Remarks on Literature and Theory

Review

The foundation for our literature and theory review is based on theories andframeworks provided by a range of authors. In addition, our literature andtheory review highlights the lack of previous research based on empirical find-ings with regards to the topics of M&A strategies, synergies and valuation, seeAppendix E, F and G for summaries of sources by type for the aforementionedtopics. Furthermore, the existing body of literature and theory regarding thesetopics has an industry agnostic perspective and does not cover the industrialsoftware industry specifically.

As such, we seek to bridge the gap between theory and practice on these topicsby providing results based on empirical findings within the industrial softwareindustry, which will subsequently be analyzed through the lens of incumbenttheories and frameworks. This thesis will thus supplement the existing bodyof literature and theory with empirical insights, and outline similarities anddiscrepancies between academia and real-world practices.

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36

Chapter 4

Results

This chapter presents the structure as well as the results from the multiplecase studies. The cases studied comprises the acquisitions of Apollo, Posei-don, Athena, Cronus and Perses. For each case, we provide a description ofthe acquirer and target company, the strategic rationale of the acquisition, theidentified synergies as well as the synergy valuation.

Foreword

The valuation material presented in this chapter as well as in the appendiceshave been altered in order to maintain financial confidentiality. The alterationshave been conducted by re-basing the revenues. Furthermore, the line items inthe income statements are driven by ratios of revenues and these ratios havebeen kept the same in the altered models. As such, the presented valuationmaterial represent the relative impact of synergies, albeit with altered nominalfigures.

4.1 Acquisition of Apollo

The following results builds upon an interview with Employee A, valuationmaterial and internal documents. Employee A works in strategy development aspart of the global business development team, usually focused on the automotiveindustry. Furthermore, Employee A has been with Marrow for more than adecade and works with product lines and product management together withthe CEOs of Marrow’s subsidiaries in order to extract synergies across Marrowas a group. Before joining Marrow, Employee A worked for a large and globalsoftware company. Employee A was the project leader for the acquisition Apollo.

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4.1.1 Acquirer

Marrow’s strategic direction is to complement the technologies they have todaywith how the market is evolving. There is a distinct shift in the market fromonly selling hardware towards also providing software, both for value generationand differentiation. Furthermore, the current hardware systems are becomingtoo similar because they have reached maturity in the technology life cycle andsoftware is a tool to differentiate ones offering from competitors. Marrow en-gages in acquisitions when it sees a strong gap in its product portfolio or whenan opportunity arises.

Prior to the acquisition of Apollo, Marrow had acquired Helius, a software com-pany focused on serving the automotive and power train industries. EmployeeA stated that Helius was a great company, albeit operated in a niche, whereasMarrow aims to target all discrete manufacturing industries. Employee A fur-ther stated that although it is nice to have a strong position in a niche, Heliusneeded to expand its business to both new industries as well as sub domains ofthe industries it was present in. For example, Helius was supposed to be a toptier player within automotives but it did not serve all domains of this industryand had room for further penetration.

4.1.2 Target

The acquisition target, Apollo, was a small software company based in Germany.Its software was sold through a subscription-based model, meaning customerspaid an annual fee to use the software, and the company had a customer baseconsisting of loyal and long-term relationship customers.

Furthermore, Apollo was cautiously managed and mainly focused on its homemarket of Germany, which diminished the exposure of its software and sub-sequently its growth rate. However, Apollo did sell its software to customersoutside of Germany but only when there was a strong pull from these customersas Apollo did not actively seek these types of sales.

4.1.3 Strategic Rationale

Employee A stated that usually when Marrow look at acquiring software com-panies, the identified targets’ business models are based on selling perpetuallicenses, meaning that customers pay once for the license and can use it in-definitely as opposed to the subscription-based model. Employee A mentionedthat the industry is shifting towards a subscription-based model since perpetuallicenses entail lumpy revenues and are difficult to compare when there are bothperpetual and subscription licenses in the market. Apollo had a subscription-based model in place and Marrow saw potential for increasing the number ofsubscribers.

38

Furthermore, Employee A stated that Apollo was well liked by its customers, asevident by the strong pull from customers outside Germany, and that it also hada strong position within the automotive industry. Marrow saw an internationalexpansion opportunity where they could successfully migrate Apollo’s productsand Helius’ operational capabilities to markets outside Germany. Moreover,Marrow also saw potential for Apollo’s home market of Germany, where it hada very small sales team and could not sufficiently target its core market.

Marrow’s tactic was to initially increase sales in Germany through Helius’ saleschannels, which were very strong in Germany where they had contacts andcustomer lists. After targeting Germany, Marrow intended to apply the sametactic to markets outside Germany. Marrow also sought to cross-sell productsby bundling Apollo’s software with hardware systems Marrow had in its port-folio. Lastly, Marrow knew that the technology Apollo had would cost themmillions to develop, which was something they had in mind during negotiations,whereas the sellers’ were only focused on any additional revenue Marrow wouldgain during the price negotiations.

4.1.4 Synergies

Marrow identified several synergies with the acquisition of Apollo, where themain focus was on revenue synergies stemming from pushing Apollo’s productsthrough Helius’ established global sales channels, as well as cross-selling throughbundling of hardware and software.

The revenue synergies were estimated through a bottom-up approach as illus-trated in figure 4.1. Firstly, Marrow categorized the target customers of Apollo’ssoftware by type. Secondly, the number of customers to be added per yearthrough Helius’ sales channels was estimated for each respective customer type.Thirdly, the number of new customers per type was multiplied by the annuallicense fee for the respective customer type in order to derive annual revenuesfrom that category. By summing the revenues from each customer type cate-gory, Marrow had estimated the total revenue synergies from pushing Apollo’sproducts through Helius’ sales channels. In addition, Marrow applied phasingfor revenue synergies, where Employee A stated that everything is slower to re-alize in the first year but that they modelled an accelerated synergy realizationin the second and third year.

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# new customers year X

Annual license fee per

customer type A

Revenues from

customer type A in year X

Total synergy revenues in

year X

Customer type A

# new customers year X

Annual license fee per

customer type B

Customer type B

Revenues from

customer type B in year X

Figure 4.1: Illustrative schematic of Marrow’s estimation of revenue synergiesin the acquisition of Apollo. Annual synergy revenue from each customer typeis derived by multiplying the number of new customers per year with the annuallicense fee for that customer type. The total annual synergy revenue is calculatedby summing the annual synergy revenue from each customer type.

Additionally, Marrow saw several cost synergies related to integrating techno-logical features from Helius’ products into Apollo’s products, thereby reducingthe need for Apollo to develop these feature by investing in R&D. As the targetwas small there was no room for cost synergies through headcount reductionsbut rather the opposite, a need for headcount increase in order to realize themodelled revenue synergies.

Marrow did not explicitly value the cost synergies stemming from the reducedneed for R&D investments and Employee A mentioned that any additional costsynergies, for example if Apollo used the same systems such as Office 365, wouldbe great but would not move the needle in the investment decision and werethus not explicitly valued.

Moreover, Marrow did not value any integration costs but Employee A empha-sized that Helius’ management team had to focus on post merger integration,which was expected of them. Employee A further emphasized the importanceof focusing on post merger integration activities by stating:

”Part of the lessons learned is that if you want synergies to happen,you need to make them happen.”

— Employee A

With regards to financial synergies, Marrow looked at for example the possibilityof splitting assets between legal entities but they did not value these synergiesexplicitly.

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4.1.5 Valuation

As for the valuation of Apollo, Marrow used both the DCF and multiple method.Figure 4.2 illustrates the growth of the revenue synergies as well as their relationto Apollo’s stand-alone revenue. There is a ramp-up of synergy realization inyear 2 and 3, where synergy revenue constitute 4% of stand-alone revenue inyear 1 but 35% and 68% in year 2 and 3, respectively.

EURk. Forecast Period

Year 1 2 3

Stand-alone revenue 1,000 1,122 1,280

% growth n.a. 12% 14%

Revenue through Helius' channel 37 394 872

% growth n.a. 963% 122%

% of stand-alone 4% 35% 68%

Total revenue 1,037 1,516 2,152

% growth n.a. 46% 42%

Figure 4.2: Stand-alone revenue for Apollo and revenue synergies throughHelius’ channels. Synergy revenue constitute 4% of stand-alone revenue in year1 and is accelerated in year 2 and 3 to represent 35% and 65% of stand-alonerevenue, respectively.

Note: The apparent calculation errors in the ”% growth” of ”Revenuethrough Helius’ channel” for years 2 and 3 are caused by a rounding error.

DCF

As for the WACC used for valuing the synergies, Marrow applied their standardWACC since the Apollo acquisition was not an acquisition of their tangibleassets but rather an acquisition of their intellectual property. Thus, the legalentity of Apollo was not of interest and additionally the acquisition was so smallin size that it would not move the needle on any adjustments to the WACC.

Multiples

Figure 4.3 illustrates the enterprise value impact from the revenue synergieswhen valuing Apollo using the EV/Revenue multiple method. One can notea significant difference in enterprise contribution from synergies between year1 and 3 with the multiple valuation method, ranging from 4% to 68%. Thisis due to the aforementioned effect of accelerating realization of synergies inyear 2 and 3 compared to year 1. Furthermore, the acquisition did not occurat the beginning of year 1, which also affects the potential synergies in thatyear as there was less time to realize them. Basing the multiple valuation onforward-looking multiples too far from the valuation date entails a higher degreeof uncertainty due to 1) Increased uncertainty in estimation of target’s financialsand 2) Increased uncertainty in estimation of peer group financials (driving the

41

multiples). Therefore, a reasonable proxy for the percentage of enterprise valuecontribution from synergies would be 35% in year 2.

2,000 2,07474

EV excl.synergies

RevenuethroughHelius'channel

EV incl.synergies

EV/Revenue Year 1

2,000

2,702702

EV excl.synergies


EV incl.synergies

2,000

3,3631,363

EV excl.synergies


EV incl.synergies

EV/Revenue Year 2 EV/Revenue Year 3

+4% +35% +68%

% EV

contribution

from synergies

EV/Revenue 2.0x 1.8x 1.6x

(EURk.)

Figure 4.3: Enterprise value impact in Apollo valuation from revenue synergiesusing EV/Revenue multiple valuation. The percentage EV contribution fromsynergies significantly increases in year 2 and 3 as a result of a ramp-up ofsynergy realization in those years.

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4.2 Acquisition of Poseidon

The following results builds upon an interview with Employee B as well as thevaluation model and other internal documents used in the acquisition processof Poseidon. Employee B has an academic background in mechanical engineer-ing, specifically aerospace systems engineering, and started their career withinindustrial building construction. They joined Marrow in a business developerrole after completing an MBA and has transitioned into working more on M&Aover the last few years. During this time, Employee B has been involved innine acquisitions, of which six they had led themselves and one co-managed.Employee B was part of a larger M&A team during the Poseidon acquisition.

4.2.1 Acquirer

Prior to the acquisition, Marrow had acquired a company, Heracles, which devel-ops and sells software used in industrial manufacturing across several industries.The workflow in an industrial manufacturing process is comprised of severalconnected sub-processes from design to finished product, each of which utilizea specific software. These software programs are connected and dependent oneach other for information. Heracles provided a range of software programs forthis type of workflow, although it did not provide software programs for theentire workflow.

Heracles’ business model revolves around selling a perpetual license and thenproviding optional software maintenance subscription for an annual fee. Em-ployee B stated that even though maintenance subscription is not a must amongcustomers, they typically prefer to have it as they value having a hotline to theirsoftware provider. Furthermore, Employee B noted that although selling soft-ware via a subscription-based model is relatively more attractive than sellinga perpetual license, it is not always easy to convince a customer that its thebest thing for them. The customers propensity to choose a subscription-basedmodel varies depending on the size of the customer as well as the region in whichit operates. Larger customers, which is the focus segment of Apollo, typicallyprefer a subscription-based model whereas smaller customers often want to buyand own the software, even though they might have more unpredictable cashflows which would warrant the utilization of a subscription. The ’buy-and-own’mentality can also be found in certain geographical regions. Employee B usedcertain parts of Germany as an example where some smaller machine shopsare conservative to the point of being reluctant to finance their business viabank loans, which also plays into their hesitancy in using the relatively modernconcept of software subscription services.

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4.2.2 Target

The acquisition target, Poseidon, was a company providing a software comple-mentary to Heracles’ in that it is utilized in a sub-process to which Heraclesdid not provide a software. Poseidon’s business model was slightly differentfrom Heracles’, where it sold a perpetual license and a mandatory maintenancesubscription for an annual fee. If a customer failed to pay the maintenancesubscription fee, Poseidon would shut down their use of the software.

The competitive landscape for Poseidon’s product only comprised a handful ofplayers, which limited the number of available acquisition targets for Marrow.Poseidon was one of the stronger players in this field and fulfilled the acquisitioncriteria of being the right size, having the right technology and offering, as wellas being available for sale at a reasonable price. In terms of size, Poseidonconstituted less than 10% of Heracles’ revenue and had a decent sized team withgood infrastructure, which would enable a scale-up for global demand while atthe same time maintaining Heracles as the clear parent company.


The main rationale of the acquisition was to fill a gap in Heracles’ software port-folio in order to expand the software offering across the workflow in industrialmanufacturing processes. Employee B stated that a source of creating customervalue in the industrial software space is to bundle software as much as possibleso that customers can reduce the number of vendors they procure from. Simi-larly, additional customer value could be gained from product bundling in thesense that the customers could reduce the number of software interfaces thatthey interact with in their daily operations. Adding to this, Employee B pro-vided an analogy for the customer value this strategy entails:

”In the early days of word-processing software, you could not triggerthe printer within the word-processing software and needed to usean additional software for that specific purpose. Over time, word-processing software started incorporating a printing feature, whichgreatly improved the value for the customers as well as reducing theirneed for several software programs. Our product bundling strategywith the Poseidon acquisition will create customer value in a similarway.”

— Employee B

Moreover, similar to the strategic rationale of the Apollo acquisition, Heracleswould also use its direct and indirect sales channels to push Poseidon’s products.One factor to consider when utilizing this strategy in the Poseidon acquisitionis that the business models between the acquirer and the target were slightlydifferent for the maintenance subscription service. Our initial thought was thatif Poseidon switched to an optional maintenance subscription service, the shareof recurring revenue would decrease as customers could opt out of maintenanceand still use the software, thereby affecting the revenue synergies and valua-

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tion. However, when asked about whether the valuation and synergy modellingscenario was based on Poseidon keeping the mandatory maintenance subscrip-tion service or switching to Heracles’ optional maintenance subscription service,Employee B stated that it did not matter financially. The logic behind thestatement was that customers have a strong preference for having maintenanceservice, as evident by Heracles’ large share of customers opting for maintenance,so that even if Poseidon switched to an optional model the customers would stillbuy it. Therefore, the revenue impact in the modelling would only be marginallyaffected by a switch to the optional model.

4.2.4 Synergies

The synergies associated with acquisition of Poseidon comprised both revenueand cost synergies. On the revenue side, Marrow saw an opportunity to sellPoseidon’s products through Marrow’s direct as well as indirect sales channels.The size estimation of the revenue synergies was conducted by firstly extractingthe average sales value for Poseidon’s software. Secondly, Marrow identified thenumber of customers in its current customer base that would be target cus-tomers for Poseidon’s software. Lastly, Marrow estimated how many of thesecustomers it could sell Poseidon’s software to and hence derived the revenuesynergies. Furthermore, Marrow conducted a sanity check regarding the feasi-bility of achieving the revenue synergies by calculating what percentage of itscustomer base that would need to be penetrated by Poseidon’s software in orderto generate the estimated synergies.

The cost synergies comprised of access to government grants, headcount reduc-tions and reductions in payments of third party royalty fees. The governmentgrant synergy relates to Poseidon’s strong ability to access government grantsfor R&D in its home market. Marrow had not previously pursued accessinggovernment R&D grants in this market and therefore saw an opportunity toleverage Poseidon’s expertise in this area to attain a larger share of governmentgrants.

For the headcount reductions, Marrow identified existing capabilities in Hera-cles able to assume the responsibilities of some of Poseidon’s employees acrossseveral functions, including sales, administration, and marketing. Furthermore,Heracles had employees within R&D working on early stage development of asoftware similar to Poseidon’s own and who would therefore not be needing towork on that project post-acquisition. As such, these employees could focustheir time on other projects that needed resources and thus Heracles would re-duce its need to hire additional R&D employees for the other projects.

The last source of cost synergies stemmed from reductions of third party roy-alty fees. This item relates to royalty fees paid for tools to develop some ofHeracles’ software. In this acquisition, Heracles could eliminate the royalty feespaid for tools to develop the software similar to Poseidon’s own. In addition,Employee B stated that synergies stemming from reductions in licensing and

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royalty payments similar to the one described is more common in the industrialsoftware acquisitions than in the industrial hardware acquisitions that Marrowhas conducted. Employee B also noted that cost synergies stemming from reduc-tion in Cost of Goods Sold (COGS) relating to activities such as procurement,manufacturing and logistics, can lead to large savings in industrial hardwareacquisitions, whereas they are more limited in industrial software acquisitions.

In contrast to the operational synergies, Marrow did not estimate any financialsynergies. Employee B stated that synergies related to debt capacity are usuallynot a factor in Marrow’s acquisitions since the targets are often small relativeto Marrow, which entail no impact on credit rating nor improved debt capacityfrom increased size. Moreover, the targets tend to have strong balance sheetswith a net cash position, resulting in limited potential to renegotiate betterterms for the targets’ loans.

In addition to the synergies, Marrow also identified restructuring costs asso-ciated with integrating the Poseidon acquisition. These costs are of a non-recurring nature and include items such as legal costs.

4.2.5 Valuation

DCF

Marrow’s DCF valuation incorporates an explicit valuation of synergies, see Ap-pendix C for a more in-depth view on the DCF valuation. Figure 4.4 illustratesthe identified synergies and their respective ratio to total revenues. In figure4.4 one can further note that the forecast period stretches five years, whereasthe synergies are only explicitly stated for the first four years. This is due toMarrow considering the acquisition as fully consolidated in year 5 and beyond.Employee B stated that sales channels become blended over time, which is whyit difficult to ascribe a certain portion of sales to synergies in the outer years.Therefore, the DCF valuation of the synergies described in this section may beconservative as they are not explicitly valued in year five nor in the terminalvalue, although synergies will most likely affect the cash flows in year five andbeyond. Moreover, as the terminal value constitutes approximately 70% of thetotal enterprise value as illustrated in Appendix C, one could argue that a largeshare of the total synergistic value in the DCF would stem from the terminalvalue if they had been explicitly valued for the terminal year.

Moreover, when calculating the free cash flows the changes in working capital,capital expenditures, and depreciation and amortization are all set to zero, thushaving no impact. Employee B stated that they assumed capital expendituresequaled depreciation and amortization, hence a net zero impact on free cashflows. Furthermore, Employee B explained that the zero change in workingcapital was a gross simplification, albeit based on the assumption that Poseidonwould need minimal investment in working capital despite a scale-up. This as-sumption is partly based on the asset-light business model of industrial software

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companies, where they carry minimal inventory as their products can be storeddigitally and packaged in USB sticks.


Year 1 2 3 4 5

Revenue through Marrow channel 41 77 111 137 n.a. n.a.

% growth n.a. 88% 45% 24% n.a. n.a.

% of stand-alone 4% 7% 9% 10% n.a. n.a.

Royalty savings - 31 31 31 n.a. n.a.

% of revenues - 3% 2% 2% n.a. n.a.

COGS overheads 28 46 46 46 n.a. n.a.

% of revenues 3% 4% 3% 3% n.a. n.a.

Total COGS synergies 28 77 77 77 n.a. n.a.


R&D Grants - 10 10 10 n.a. n.a.


Selling costs 18 27 27 27 n.a. n.a.


General & Administrative 6 6 6 6 n.a. n.a.


R&D - 20 20 20 n.a. n.a.


Total OPEX synergies 24 64 64 64 n.a. n.a.


Restructuring costs (78) (28) (10) - - -

% of revenues (7%) (2%) (1%) - - -

Terminal

Figure 4.4: Identified synergies in Marrow’s acquisition of Poseidon. Thesynergies are explicitly quantified for the first four years although the forecastperiod stretches five years. This is due to Marrow considering the acquisitionfully consolidated in year five and thus the value of synergies is not captured inyear five nor in the terminal year.

Note I: While the synergies displayed are relating to cost items, they arenot presented as negative (-) numbers since they are in fact cost savingsaffecting earnings and cash flow positively.

Note II: The apparent calculation errors in the ”Total OPEX synergies”for years 2, 3, and 4 are caused by a rounding error.

The identified synergies can be categorized as 1) Revenue synergy, 2) COGSsynergy, 3) OPEX synergy, and 4) Non-recurring cost, according to their impacton the income statement. In figure 4.5 the nominal impact on the enterprisevalue from synergies is illustrated. One can note that the enterprise value ofPoseidon increases by 16% when accounting for the synergy effects includingrestructuring costs.

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3,089

3,591

25364

115 2170 16

42 (80)

EV excl.Synergies

RevenuethroughMarrowchannel

Royaltysavings

COGSoverheads

R&DGrants

Sellingcosts

General &Admin

R&D Restructuring EV incl.Synergies

Revenue synergy COGS synergy OPEX synergy Non-recurring cost

(EURk.)

Figure 4.5: Synergy impact on enterprise value from DCF valuation for Posei-don acquisition.

The largest synergy contributor to enterprise value stemmed from revenue,which constituted 44%, whereas COGS-related synergies constituted 31% andOPEX-related synergies constituted 26%, as illustrated in figure 4.6.

44%

11%

20%

4%

12%

3%7%

Revenue through

Marrow channel

Royalty savings

COGS overheads

R&D Grants

Selling costs

R&D

General & Admin

Figure 4.6: Synergy split in the Poseidon acquisition. Revenue synergies consti-tute the largest share of enterprise value contribution at 44% followed by COGS-related synergies at 31% and OPEX-related synergies at 26%.

In Appendix C, the discount factor does not correspond to a full-year discountwith the WACC. A full-year discount has a problem of discounting future cashflows too much, since it assumes that the entire value of the cash flows for agiven year comes at the end of that year. To mitigate this issue, Marrow em-ployed a mid-year discount, assuming that the cash flows for a given year comein halfway through that year. In effect, the free cash flow for a given year t wascalculated as:

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FCFt

(1 +WACC)t−0.5(4.1)

Multiples

In addition to a DCF valuation, Marrow conducted a multiple valuation for theacquisition of Poseidon, using both publicly traded peers and precedent transac-tions. Moreover, Marrow looked at what multiple levels investors had investedin various equity funding rounds in for example start-ups. Employee B noted anego factor among sellers who often claim that their company should be valued atthe higher end of already high software multiples, even though their companydoes not warrant such a multiple. Furthermore, Employee B said that somesellers want to have an innovation price premium relating to their ability togenerate ideas in the future that will eventually materialize in strong products.

Figure 4.7 shows the multiple valuation of Poseidon. The synergy impact onenterprise value using the EV/Revenue multiple ranges from 4% to 10%, whereasthe synergy impact using the EV/EBIT multiple is significantly larger, rangingfrom 130% to 195%. The discrepancy between the multiples is attributableto the significant EBIT margin expansion as a result of cost synergies, whichare not captured in the EV/Revenue multiple. In addition, both the nominalenterprise value and the synergy impact from the EV/EBIT valuation is vastlygreater than in the DCF valuation. The implied EV/EBIT multiples from theDCF valuation in year 2 and 3 are 10.9x and 8.7x, respectively.

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Year 1 2 3 4

Stand-alone revenue 1,000 1,139 1,224 1,316

% growth 9% 14% 7% 8%

Revenue through Marrow channel 41 77 111 137

% growth - 88% 45% 24%

% of stand-alone 4% 7% 9% 10%

Total revenue 1,041 1,215 1,335 1,454

% growth 4% 22% 17% 19%

EBIT (stand-alone) (27) 111 159 214

% margin (3%) 10% 13% 16%

EBIT (incl. synergies) 65 329 411 492

% margin 6% 27% 31% 34%

EV/Revenue 3.1x 2.7x 2.5x 2.3x

EV (stand-alone) 3,089 3,089 3,089 3,089

EV (incl. synergies) 3,215 3,297 3,370 3,412

Synergy impact 4% 7% 9% 10%

EV/EBIT 30.0x 27.7x 19.4x 14.5x

EV (stand-alone) n.a. 3,089 3,089 3,089

EV (incl. synergies) 1,958 9,117 7,989 7,111

Synergy impact n.a. 195% 159% 130%

Figure 4.7: Multiple valuation of Poseidon. The synergy impact on enterprisevalue using the EV/Revenue multiple ranges from 7% to 10% between year2 and 4. Valuation using the EV/EBIT multiple yields a significantly highersynergy impact on enterprise value, ranging from 130% to 195% between thesame years. The discrepancy in synergy impact between the multiples canbe attributed the significant EBIT margin expansion occurring as a result ofCOGS and OPEX synergies, which is not captured in the EV/Revenue multiple.

Note: The apparent calculation error in the ”Total revenue” for year 2is caused by a rounding error.

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4.3 Acquisition of Athena

The following results build upon an interview with Employee B, valuation ma-terial and internal documents. For a background description of Employee B, seesection 4.2. Employee B was the project leader for the acquisition of Athena.

4.3.1 Acquirer

The acquiring company was Heracles, a subsidiary of Marrow. A Detailed de-scription of Heracles can be found in section 4.2.1.

4.3.2 Target

The acquisition target, Athena, was a small German company providing soft-ware solutions for systems integration in manufacturing facilities. It servedthe German and near German markets of Austria and Switzerland, also knownas the DACH region. Heracles’ German branch already had a long-standingworking relationship with Athena, in that they had collaborated on projectsand already shared several customers prior to the acquisition. As such, theMarrow/Heracles transaction team knew that Athena had a strong team ofprogrammers, a strong and commercially proven suite of products, as well as agood reputation on the market.


The strategic rationale behind the Athena acquisition was to take direct controlof their software, intellectual property, customer base and developers, and inte-grate their offering into Heracles’ team and sales channels. With Athena’s mar-ket focus currently limited to the DACH region, Marrow further saw a growthopportunity in rolling out Athena’s products on a global scale. In addition, Mar-row identified an opportunity to enrich Heracles’ offering with Athena’s softwareand thereby differentiating itself to its competitors, who did not offer softwaresimilar to Athena’s.

4.3.4 Synergies

Relative to Marrow’s many other previously acquired companies, Athena was awell run company with historical operating margins higher than Marrow’s own.From a cost perspective, this meant that there were few areas with potential forsignificant cost reductions. As such, the synergies associated with the Athena

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acquisition were primarily revenue synergies stemming from an increase in bothdirect and indirect sales. The plan for increasing direct sales was to leverageHeracles’ growing direct sales teams across the U.S. and a few key markets inwestern Europe. Target accounts primarily constituted large customers withhighly automated production machining cells.

When setting up a strategy for indirect sales, Marrow had to consider the tech-nological aspect of Athena’s product offering in that it was not a ”plug andplay” solution. Resellers of Athena’s products needed to be technologically so-phisticated in order to install the products. As such, the strategy for increasingindirect sales was analogous to that of direct sales: leverage Heracles’ existingnetwork of distributors and focus on technologically capable resellers with largerand more integrated customers. In addition to Europe and North America, theindirect sales strategy also included a key reseller in Brazil. In order to fullyenable their indirect sales growth strategy, Marrow also planned for Heracles tohost technical training events for resellers across all geographies.

While Marrow had an actionable strategy for realizing revenue synergies, thevalue of those synergies were estimated in a simple top-down fashion by Her-acles’ CEO. Compared to the baseline stand-alone case where revenues wereexpected to grow 3% per year during the initial four year period, followed by a2% perpetual growth rate, the synergistic case had an estimate of 10% annualrevenue growth for the first three years, followed by 5% for the fourth and fifthyear. In addition, a more careful synergistic growth scenario was modeled sce-nario in order to accommodate a case where only some of the revenue synergiesmaterialize, with revenue growth peaking at 5% in the second year and remain-ing at 4% for the remainder of the 8-year forecast period.

In conjunction with the direct and indirect sales strategies, Marrow had a listof technical priorities and enablers related to Athena’s R&D, such as switchingsome of the development tools and adopting Heracles’ agile work process. Whilethese priorities included technical standardizations and process improvementswhich were likely to improve cost efficiency, no cost synergies were explicitlyquantified. Instead, the primary objective of these activities was to enable com-patibility between Athena’s and Heracles’ software suites and to create a moreend user- and reseller-friendly product offering. As such, integrating the R&Ddid not only offer possible cost reductions, but played an integral part in real-izing the synergistic sales growth targets.

4.3.5 Valuation

The valuation process for the Athena acquisition differed from Marrow’s previ-ously described acquisitions. Athena’s seller specified a price which they thoughtwas reasonable for the company on a stand-alone basis. Marrow subsequentlyreverse engineered a DCF model based on that price to get a sense of the as-sumptions the seller had made regarding the business in order to derive the

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asking price. Thereafter, Marrow deemed that the price was in line with theexpected development of the business and supplemented the stand-alone valua-tion with synergy effects. Hence, both parties had reached consensus regardingthe purchase price and Marrow valued the synergies in order to identify thepotential upside it could realize with synergies.

DCF

The valuation was mainly conducted using the DCF method and as mentionedabove the stand-alone valuation was a product of reverse engineering a DCFmodel based on the asking price. Furthermore, as the strategic rationale forthis acquisition revolved around revenue improvements through sales channelleverage, Marrow needed to estimate the revenue synergies for the DCF model.This was conducted through a top-down approach wherein the CEO of Heraclesincreased the growth rate to a level that they deemed feasible to achieve byleveraging Heracles’ sales channels for Athena’s products.

In addition to the revenue synergies, Marrow identified that Athena’s OPEXcost base solely constituted fixed costs, meaning that increased growth fromsynergies would not entail a proportional increase in OPEX. As such, Marrowcould in its main growth scenario (as opposed to the medium growth scenariowhere revenue synergies only partly materialize) leverage the fixed OPEX costbase in order to drive margin improvements where the EBIT margin reaches46% in forecast year 6 in the synergy case, compared to 30% for the same yearin the stand-alone case. See Appendix D for a more in-depth view on the DCFmodel.

Combining the revenue synergies and OPEX leverage in the DCF model resultedin an 86% increase in enterprise value from the asking price, as can be seen infigure 4.8. Furthermore, the OPEX leverage constituted 58% of this increase,whereas the revenue synergies constituted 28%.

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2,864

5,331

1,666

801 2,467

EV excl. Synergies OPEX leverage Revenue throughHeracleschannel

Total Synergies EV incl. Synergies

+58%% EV

contribution+28% +86%

(EURk.)

Figure 4.8: Synergy impact on enterprise value from DCF valuation for Athenaacquisition. The total synergistic value increased enterprise value by 86%, ofwhich 58% stemmed from leverage on fixed OPEX cost base and 28% stemmedfrom revenue synergies.

Multiples

Although multiple valuation was not used in this acquisition, one can still ana-lyze the relative impact of synergies on enterprise value from a multiple valua-tion given the financial assumptions in the DCF model, as illustrated in figure4.9. The percentage impact on enterprise value from synergies when using theEV/Revenue multiple ranges from 7% in forecast year 1 to 28% in forecast year5. Using the EV/EBIT multiple yields a significantly higher enterprise valueimpact from synergies, ranging from 22% in forecast year 1 to 87% in forecastyear 5. The discrepancy between the EV/Revenue and EV/EBIT multiples isdue to the margin expansion not being accounted for the former.

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Year 1 2 3 4 5

Stand-alone revenue 1,000 1,029 1,060 1,092 1,114

% growth 3% 3% 3% 3% 2%

Revenue through Heracles channel 67 144 231 264 310

% growth n.a. 116% 60% 14% 17%

% of stand-alone 7% 14% 22% 24% 28%

Total revenue 1,067 1,174 1,291 1,356 1,423

% growth 10% 10% 10% 5% 5%

EBIT (stand-alone) 287 310 319 328 339

% margin 29% 30% 30% 30% 30%

EBIT (incl. synergies) 351 447 538 579 633

% margin 33% 38% 42% 43% 44%

EV/Revenue 2.9x 2.8x 2.7x 2.6x 2.6x

EV (stand-alone) 2,864 2,864 2,864 2,864 2,864

EV (incl. synergies) 3,056 3,266 3,488 3,556 3,661

Synergy impact 7% 14% 22% 24% 28%

EV/EBIT 10.0x 9.2x 9.0x 8.7x 8.5x

EV (stand-alone) 2,864 2,864 2,864 2,864 2,864

EV (incl. synergies) 3,498 4,132 4,835 5,050 5,354

Synergy impact 22% 44% 69% 76% 87%

Figure 4.9: Multiple valuation of Athena. Enterprise value increase from synergyimpact ranges from 7% in forecast year 1 to 28% in forecast year 5 when usingthe EV/Revenue multiple. Using the EV/EBIT multiple yields a significantlyhigher enterprise value impact from synergies, ranging from 22% in forecast year1 to 87% in forecast year 5. The discrepancy between the multiples is due to themargin expansion not being accounted for in the EV/Revenue multiple.

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4.4 Acquisition of Cronus and Perses

The following results build upon an an interview with Employee C, Group Fi-nance Director of Heracles. Employee C is responsible for finance, reportingand strategy, and works in close co-operation with the finance team at Marrow.Employee C has worked for Heracles for 15 years, both while being a listedcompany as well as under private equity and later on Marrow ownership.

4.4.1 Acquirer

The acquirer in these cases were Heracles, prior to being acquired by Marrow.During Heracles’ acquisition of Cronus and Perses it was owned by a privateequity firm and at the time Heracles had a strong position within a niche of itsindustrial software space. In this industrial software space, there were a lot ofsmall companies that were established in the 1980s and 1990s when microcom-puters started becoming common and people started developing early versionsof software. These companies operated within specific niches of the industrialsoftware space, were often family-owned and functioned as lifestyle companiesin the sense that the founders had made a nice business, were comfortable (onthe verge of complacent in terms of pushing sales and margin improvements)and were sometimes looking to retire.

At the time, Heracles was looking to expand its existing portfolio with otherniche software within the same industrial software space. Employee C statedthat one of the things they had found with software is that it is generallya quite sticky product. This refers to customers having a strong and long-lasting relationship with their software provider and thus have an unwillingnessto switch provider. As such, it was easier to sell new software as an add-on toexisting customers rather than targeting new customers and trying to get themto switch from their current provider.

4.4.2 Target

The targets in these acquisitions, Cronus and Perses, were very similar to eachother. They were both active within a specific industrial software niche ad-jacent to Heracles and had strong customer bases in different industries andgeographies. As described above, they had become lifestyle companies for thefounders, who did not push their respective organizations to further increasesales growth and improve margins since both companies had decent growth andmargins.

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As the market for industrial software was fairly fragmented at the time withmany smaller family-owned businesses, the private equity firm owning Heracleshad an overarching strategy to acquire and consolidate the competitive land-scape by employing a roll-up strategy.

The strategic rationale for both acquisitions was similar, and Employee C furtherstated that the strategic rationale for acquiring industrial software companiesis generally similar overall. The number one rationale for acquiring industrialsoftware companies is to acquire intellectual property, according to Employee C.The focus lies on identifying what intellectual property the target company has,and how well it fits in the acquiring company’s product portfolio. In the cases ofCronus and Perses, they both had software that was adjacent and complemen-tary to Heracles’ product portfolio. Relating to acquiring intellectual property,Employee C also mentioned that retaining the development team at the targetcompany is highly important in industrial software acquisitions. They statedthat finding skilled development employees with the right experience is bothdifficult and crucial for developing competitive products in a high technologyenvironment.

The second most common rationale is to gain access to the acquired company’scustomer base, according to Employee C. As mentioned above, industrial soft-ware is a relatively sticky product and as such it is easier to sell software as anadd-on through tapping into the acquired company’s established customer rela-tionships than it is to sell software to the same customers absent any previousrelationship.

Through the combination of acquiring the intellectual property and gaining ac-cess to Cronus and Perses customer bases, Heracles saw an opportunity to pushproducts through both its own sales channels as well as the target companies’sales channels. Additionally, as both Cronus and Perses were founder-led andhad become lifestyle companies that did not push improvements to the extentthat they could, Heracles also saw opportunities to improve the target compa-nies’ performance by employing operational improvements.

4.4.4 Synergies

The synergies associated with the acquisitions of Cronus and Perses comprisedboth revenue and cost synergies. On the revenue side, Heracles sought to bilater-ally leveraging sales channels and customer bases, and employing a cross-sellingstrategy. Employee C stated that they applied a fairly simplistic approachto estimating revenue synergies. Heracles did not perform any complex mod-elling regarding revenue synergies but rather looked at for example where theycould sell products through new geographic exposure resulting from the acquiredcompanies sales channels. The size estimation of the revenue synergies was con-ducted with a top-down approach by simply adding a slightly higher growth rate.

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The cost synergies were in part constituted by headcount reductions in over-head and administration. The cost synergies from headcount reductions wereestimated through a bottom-up approach where the number of identified em-ployees which could be let go in each function were multiplied by their respectivesalaries. All R&D employees were retained due to their aforementioned impor-tance to the company’s competitiveness, and the facilities in which they werelocated were also kept as the developers were deemed to be unwilling to relocate.

Apart from the headcount reductions, Heracles identified additional cost syn-ergies, although they were not explicitly estimated and valued. For example,Heracles saw opportunities to improve the product development process throughscale economies. Since many of the underlying software building blocks couldbe standardized across the companies, Heracles saw a potential in moving to-wards a common platform and a standardized user interface (UI) on which theirproducts could be developed, or as Employee C put it:

”Say you have six products, instead of looking to develop six UIs, weare developing one. The basic fundamental factors of the softwareare the same, creating a 3D shape for example. We are working ona core platform that all products can sit on.”

— Employee C

Additionally, Heracles uses third party software to develop its products andEmployee C stated that they had been involved in a number of software acqui-sitions where the target utilized the same third party software as Heracles forproduct development. This was also the case for the acquisitions of Cronus andPerses, which posed a cost synergy source in the form of consolidating the num-ber of third party software or negotiating better agreements with third partysoftware suppliers since they had a greater scale. Although improvements indevelopments processes and consolidation or better contracts with third partysoftware suppliers was deemed a source of cost synergies, their size or value wasnot estimated.

Regarding financial synergies, Employee C mentioned that they were consideredoverall in the acquisitions but that things like tax synergies are not a major ra-tionale from their point of view, but rather a nice to have. As such, no financialsynergies were explicitly valued in the Cronus nor the Perses acquisition.

4.4.5 Valuation

Since these acquisitions took place prior to Marrow’s ownership of Heracles,we did not have access to any financials. However, we did receive a generaldescription of the valuation processes.

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DCF

According to Employee C the DCF valuation models were fairly simplistic, par-ticularly with regards to synergies. The revenue synergies were incorporated inthe models with a top-down approach by adding a slightly higher growth rate.Some of the identified cost synergies were explicitly incorporated with a bottom-up approach in the models, such as headcount reductions, since these are fairlystraightforward to estimate. Other cost synergies such as scale economies inthe development process and consolidation and/or renegotiating contracts withthird party software suppliers were not explicitly incorporated in the models.

Multiples

Heracles used the multiple method for both Cronus and Perses. Employee Cstated that they mainly looked at the EV/EBIT multiple and that the peer mul-tiples were focused on precedent transactions rather than publicly traded peers.When asked whether Heracles took any action towards mitigating acquirer-specific distortions in precedent transaction multiples, such as incorporated syn-ergies, Employee C stated that they applied a haircut to the multiples but couldnot remember exactly how this haircut was applied. Employee C further statedthat ultimately the multiple determining the value was based on what the pri-vate equity owners were willing to pay. By acquiring companies at a lowermultiple than the acquiring company would be valued at, the private equityfirm could exploit multiple arbitrage, as illustrated in figure 4.10.

If a company is trading at an EV/EBIT multiple of 15.0x with an EBIT of 1,000its enterprise value would be 15,000. Furthermore, if that company decides toacquire a company trading at an EV/EBIT of 10.0x with an EBIT of 500, thetarget company would be valued at an enterprise value of 5,000. The combinedvalue post-acquisition would then be 20,000 if both entities were valued at theirstand-alone EV/EBIT multiple. However, the combined entity is more likely tobe valued at the larger acquiring company’s EV/EBIT multiple, which wouldentail a combined EBIT of 1,500 valued at 15.0x EV/EBIT resulting in anenterprise value of 22,500. Hence, by exploiting multiple arbitrage the valueof the combined entity has increased by 2,500 by simply acquiring at a lowermultiple than the acquiring firm trades at.

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15.0x

10.0x

Acquirer Target

EV/EBIT

1,000

500

1,500

Acquirer Target Combined

EBIT Enterprise Value

15,000

5,000

22,500

Acquirer Target Combined(Valued at

acquirer’s multiple)

Figure 4.10: Illustrative example of multiple arbitrage. If a company trading at15.0x EV/EBIT with an EBIT of 1,000 acquires a company valued at 10.0xEV/EBIT with an EBIT of 500 the value of the combined entity would be20,000 if both entities were valued at their stand-alone multiples. However,the combined entity is more likely to be valued at the larger acquiring company’sEV/EBIT multiple, hence the combined value would be 22,500 and thereby ex-ploiting multiple arbitrage have increased the value by 2,500.

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Chapter 5

Analysis and Discussion

This chapter provides an analysis and discussion of the results obtained fromthe multiple case studies. Further, the analysis and discussion is divided intothree categories, namely 1) Strategic Rationale, 2) Synergies and 3) Valuation.

5.1 Strategic Rationale

From the interviews and internal material we have taken part of, it is clear thatone strategy is prevailing in the studied acquisitions, namely acquiring technol-ogy and leveraging sales channel networks to cross-sell products, see table 5.1for a summary of strategies and strategic fit for each acquisition.

Furthermore, this strategy does not seem to be specific to Marrow since theprivate equity firm owning Heracles before Marrow also employed this strategy.However, one could argue that one of the reasons that Marrow acquired Hera-cles was the alignment of strategies. On the other hand, Employee C noted thatthe strategic rationale for acquiring industrial software companies is generallythe same, that is acquiring intellectual property and pushing sales by leveragingboth parties’ sales networks. At its core this strategic rationale revolves aroundpursuing growth, which is in line with the top three drivers for M&A accordingto U.S. M&A executives in the survey conducted by KPMG (2016). Althoughgrowth seems to be an industry-agnostic strategic rationale, we would arguethat the defined strategy and subsequent execution may be specific to indus-trial software acquisitions.

The strategy of acquiring skills and/or technologies mainly revolved around fill-ing holes in the product portfolio and obtaining specialist technical expertise,which are motivations also noted by Ford and Probert (2010). Moreover, theprivate equity firm had two strategic components, namely a roll-up strategyand improving the target company’s performance, which Marrow did not stateexplicitly as a strategic rationale in their acquisitions. However, Marrow mayhave implicitly incorporated these components as there is not a clear cut line

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between for example accelerating the market access for the target’s productsand improving the target’s performance. Nonetheless, the private equity firm’srationale of improving the target company’s performance is in accordance withAcharya et al. (2013), Lichtenberg and Siegel (1990) and Smith (1990) whostate that this a particularly common acquisition strategy among private equityfirms. Additionally, the market landscape had the characteristics described byGaughan (2011) to make it suitable for a roll-up strategy by the private equityfirm, namely a high fragmentation with many small competitors.

As for the strategic fit, we would argue that all acquisitions can be classifiedas related-supplementary fits based on the framework by Shelton (1988). Theproducts acquired were adjacent to the existing products in the acquiring com-pany’s product portfolio and the target companies’ customers were located innew geographies and/or operated in new industries relative to the acquiring com-pany. Further, we argue that there are a couple of reasons that Marrow and theprivate equity firm did not engage in acquisitions with a related-complementarystrategic fit. First, there may be limited potential in upstream integration asindustrial software companies are not particularly reliant on for example rawmaterials. Second, the acquiring companies already had established sales anddistribution networks, both direct and indirect, which may have limited the at-tractiveness of downstream integration by acquiring for example a distributor.Instead, it may have been more attractive to strengthen the businesses’ coreoperations by conducting acquisitions with a related-supplementary fit.

Seeing as the overall acquisition strategy tends to be the same, it is interestingto investigate why it is prevalent in industrial software acquisitions. One ofthe reasons may be that the marginal cost of production for software licensesis low because once you have developed the software you can simply transfer itto a USB stick to have an additional product to sell. As a contrasting example,an industrial manufacturing company employing the same strategy probablyhas a higher marginal cost of production since it would need to invest morein working capital, machinery, et cetera to manufacture additional products.However, an industrial manufacturing company would most likely also benefitfrom economies of scale in its production, a factor which is more limited for anindustrial software company.

An additional reason as to why this strategy is suitable for industrial softwareacquisitions is the bilateral access to the acquirer and target’s customer base.Access to each others customer base is most likely a relevant factor in acqui-sitions within other industries, however it may be especially important in theindustrial software space due to the stickiness of customers.

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Acquisition Strategy Strategic Fit

Apollo

Accelerate Market Accessfor Target’s Products

Related-Supplementary(horizontal integration)

Acquire Technologies Faster or atLower Cost Than They Can Be Built

Poseidon




Athena




CronusandPerses




Roll-Up Strategy

Improve TargetCompany’s Performance

Table 5.1: Summary of strategy and strategic fit for the studied acquisitions,wherein the most prevalent strategies were accelerating market access for target’sproducts and acquiring technologies faster or at a lower cost than they can bebuilt. Further, we classify all acquisitions as being of a related-supplementarystrategic fit.

5.2 Synergies

The synergies that both Marrow and the private equity firm focused on wereprimarily of an operational nature. Financial synergies were considered but notexplicitly estimated nor valued, and were classified as more of a nice to haverather than a prerequisite. In Marrow’s case, Employee A mentioned that theiracquisitions focused on intellectual property rather than tangible assets. Addi-tionally, Employee B stated that the acquisition of small businesses with strongbalance sheets limits the potential for financial synergies in terms of increaseddebt capacity and lower cost of capital.

Across all studied cases, the main source of operating synergy was revenueimprovements relating to higher growth in new or existing markets. These rev-enue synergies stemmed from both cross-selling each company’s products asmentioned by Gaughan (2011) and leveraging established sales and distributionnetworks to push the target’s products as mentioned by Koller et al. (2010).The latter could also be classified as economies of scale in non-production areas

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as stated by De Graaf and Pienaar (2013) and De la Mano (2002). However,economies of scale in production was limited across the cases studied, which isin line with the characteristics particularly relevant to achieve such synergiesoutlined by De la Mano (2002), namely capital-intensive companies operatingwithin manufacturing.

Further, given the similar strategic rationale among the acquisitions studied, itis natural that revenue synergies are the most important. Since the synergiesappear to be closely related to the rationale of the acquisition, studies of in-dustrial software acquisitions with other rationales may have given other resultsregarding synergies. For example, an industrial software acquisition with therationale of cost cutting may have had little to no emphasis on the revenue side.Although revenue synergies are not exclusive to industrial software acquisitions,they may be more prevalent than in other industries given that the strategicrationale seem to be similar and focused on revenue enhancements. As such,synergies overall may be closer linked to the acquisition strategy rather thanthe industry, whereby some acquisition strategies are more frequently occurringin specific industries.

The revenue enhancements in the studied acquisitions stemmed from increasesin sales volume rather than increases in sales price. Given the relatively frag-mented niches of the industrial software space in which Marrow’s acquisitiontargets operate, improving revenue through price increases appear less feasible,at least in the short term, as laid out by Koller et al. (2010), since individualentities have limited pricing power in a fragmented market. As such, the shortterm revenue synergies, enabled by cross-selling, are mainly attributable to thefirst two revenue synergy drivers outlined by Koller et al. (2010), namely 1)products increasing their peak sales level, and 2) products reaching their peaksales level faster.

While cross-selling acquired product portfolios may have been Marrow’s primarysource of revenue synergy in the short term, incorporating acquired technologiesin existing products in order to improve the value proposition and customers’willingness to pay (thus enabling price increases) may prove a greater sourceof revenue synergy in the long-term. The latter is however much more difficultto quantify with an acceptable degree of certainty, thus it may suffice to focusthe revenue synergy estimates on cross-selling opportunities and instead applya cost-based method (i.e. ”what would it cost to develop this ourselves?”) whenidentifying and valuing the long-term potential of acquired technologies. Onthe subject of pricing power, one could however imagine the industrial softwaremarket becoming increasingly consolidated in the future, hence increasing thepricing power of individual players. This could make price increases a moreviable source of synergy in acquisitions, however this is not certain when con-sidering the anti-trust laws in place to counteract market abusive behaviour insuch an oligopoly environment.

Although the revenue synergies stemmed from a similar source, namely increasedsales volume through bilaterally leveraging sales channels, they were estimated

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with a varied level of sophistication. In most cases Marrow employed a bottom-up approach which was anchored in their business model and the estimationswere therefore more precisely tied to reality and subject to feasibility checks.On the other hand, the private equity firm employed a top-down approach inestimating revenue synergies which consisted of adding a slightly higher top-linegrowth rate, a method that Employee C described as simplistic.

The discrepancy in level of sophistication when estimating revenue synergiesbetween Marrow as a strategic buyer and the private equity firm is interesting.One could think that private equity firms would be diligent in thoroughly iden-tifying and estimating potential value as they are pressured to generate abovemarket returns to investors. However, they may have an upper limit in the pricerange in order to exploit multiple arbitrage. As revenue synergies are inherentlydifficult to estimate, the private equity firm may be reluctant to acquire com-panies at a higher multiple by ascribing a certain value to revenue synergies.Therefore, the private equity firm’s simplistic estimation may be justified as ameans to obtain a sense of the magnitude of revenue synergies and their impacton value.

On the other hand, the private equity firm may benefit from a more sophisti-cated and precise estimation in order to have a more clear view on the feasiblevalue to be realizable post acquisition, even though they might not increase theirbid offer. It is also worth noting that the relatively unsophisticated estimationapproach only reflects a couple of acquisitions for a single private equity firmand does not reflect the entirety of private equity firms.

As for the cost side, a common source of synergy among the acquisitions studiedis headcount reductions as a result of economies of scale in non-production ar-eas. While headcount reductions can be regarded as an industry agnostic sourceof synergy, its structure may vary between industries. For example, EmployeeC noted that it was important to retain the acquired companies’ product de-velopment staff as skilled developers with the right experience is hard to find.While there in some cases, such as the acquisition of Poseidon, was an overlapin R&D activities between the acquirer and target companies, Marrow used thisas an opportunity to re-allocate R&D employees to other projects rather thanto reduce headcount. As such, headcount reductions within R&D may be lessfrequent in industrial software acquisitions than in less technology-intensive in-dustries as the high technology nature of the products requires a highly skilledworkforce. This characteristic may be especially prevalent in the narrower nichesof industrial software, where the right technical competence is even more scarce.

Moreover, consolidation and/or renegotiating contracts for third party softwareused in industrial software development seems to be an industry-specific costsynergy. However, this synergy could be categorized under the broader term ofimproving procurement operations, which is applicable in other industries. Forexample, a large industrial manufacturing company acquiring a smaller companycould most likely renegotiate supplier contracts for the target as a result of beingintegrated into a larger entity. On the other hand, the nature of procuring this

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specific type of software is most likely not widespread among other industries.

In addition, the potential to create a common platform on which to developindustrial software and standardize the user interface among software productsin the portfolio seems to be a source of cost synergies specific for the indus-trial software industry. This synergy source was mentioned by Employee C forthe acquisitions of Cronus and Perses, however it was not quantified. Beyondcost control in development and product support, harmonizing the underlyingtechnology and user interface between software suites may provide upselling op-portunities in that it lowers customers’ barriers to try add-on software to extendfunctionality.

Last, the cost synergies stemming from leveraging the target company’s skills ofobtaining R&D grants in the Poseidon acquisition may be specific to industrialsoftware companies. Depending on the countries in which a company operatesand their respective policies regarding R&D grants, there may be grants ear-marked for industrial software development. However, there may also be grantsearmarked for R&D efforts in other industries such as pharmaceutical develop-ment. In order to obtain a definite understanding of whether this synergy isspecific to industrial software companies, one would have to research policies forR&D grants across a wide range of countries, which is outside the scope of thisthesis.

5.3 Valuation

Valuation in the case studies comprised both the DCF and multiple methods,although the synergies were explicitly valued to a varying degree. The DCFand multiple valuation methods are means to mechanically derive value, wherethe actual drivers of synergy value lies within the estimation of source, size andtiming of the synergies.

In the Apollo acquisition, revenue synergies were estimated using a granularbottom-up approach in which the assumptions were based on a specific businessand sales model for industrial software. For this case, the revenue synergieswere the only explicitly valued type of synergy, even though some cost synergieswere identified relating to reduced development costs as a result of integratingtechnological features between products. Additionally, integration costs and theneed to hire additional employees were not valued.

The most granular approach to synergy estimation and valuation was in thePoseidon acquisition, which incorporated detailed breakdown of source, size es-timation and timing for both revenue and cost synergies, as as well as integrationcosts. On the revenue side, the size estimations were grounded in Marrow andPoseidon’s specific business and sales models, much like in the Apollo acquisi-tion. On the cost side, the synergy sources were broken down into specific line

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items relevant for this particular acquisition, for example Poseidon’s ability toaccess government R&D grants.

Although these cases have a relatively granular approach to valuing synergies, inboth the Apollo and Poseidon acquisitions there may have been synergistic valuethat was not valued. This value relates to the leverage each company would geton its fixed cost base as a result of revenue synergies, which generated significantmargin expansion and consequently value in the Athena valuation wherein totalOPEX were of a fixed nature. In the Poseidon case the COGS and OPEX costsas percentage of revenues do not distinguish between fixed and variable costs.

As an example, assume that for a given year a target’s revenues amount toEUR 500 million excluding synergies. Further, the COGS cost base totals EUR100 million excluding synergies, split 50% fixed and 50% variable COGS, whichwould entail a gross profit of EUR 400 million and corresponding gross marginof 80%. If the revenues including synergies represent a 20% increase to EUR600 million, variable COGS increases linearly with revenue growth and fixedCOGS is kept at the same level, then the total COGS would amount to EUR110 million including synergies, representing a gross profit of EUR 490 millionand corresponding gross margin of 82%. In this example, the leverage on thefixed cost base results in a 2 percentage point increase in gross margin whenaccounting for revenue synergies. Since Marrow does not distinguish betweenfixed and variable costs in the valuation, there may be hidden synergistic valuein the valuation models, although we do not know the magnitude of these values.

While varying between cases, Marrow’s approach to estimating synergies sharesseveral traits with some of the leading practices outlined in the literature. Theirgranular breakdown of activities and cost items is similar to the industry-specific(in this case, industrial software) business system proposed by the McKinsey”outside-in” approach (Koller et al., 2010). Marrow’s transaction team did alsoin part capture the key synergy value drivers outlined by Evans and Bishop(2002) with their detailed estimations of both the size and the timing of thesynergies. The last driver, likelihood, was however given less attention. Whilethey for example in the Athena acquisition modeled multiple revenue growthscenarios in order to accommodate a probabilistic aspect in the valuation, thescenarios were not assigned any quantified probabilities and could thus not beused to produce a probability distribution for the target company valuation.

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Chapter 6

Conclusion

This chapter provides conclusions drawn from the analysis and discussion, aswell as a discussion regarding sustainability matters. Additionally, we presentthis thesis’ research contribution and outline its limitations which can serve asa foundation for further research.

6.1 Answer to the Research Question

The purpose of this thesis has been to investigate the potential synergies and howthese are valued in industrial software acquisitions by answering the followingresearch question:

RQ: What are the potential synergies when acquiring industrial soft-

ware companies and how should those synergies be valued?

From our research we have found that revenue synergies seem to be the mostimportant type of synergy in industrial software acquisitions. More specifically,the revenue synergies are generated by accelerating the market access for thetarget’s products by leveraging the acquirer’s established direct and indirectsales channels to cross-sell. Furthermore, Marrow’s initiatives for synergisticrevenue growth appear to be more focused on increasing the volume of soldproducts rather than removing competition or disrupting pricing power in themarket.

We have also found several cost synergies associated with industrial softwareacquisitions. First, it is possible to consolidate the number of third party soft-ware development tools or to renegotiate better agreements with these providersdue to the increased size of the combined entity post-acquisition. Second, head-count reductions from employee redundancy can provide cost savings. However,retaining the acquired company’s R&D employees is critical as skilled software

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developers with the right experience is both essential for delivering competi-tive products in a high technology market and difficult to find. Third, one canachieve scale economies in the product development process by establishing astandardized platform and user interface on which the software can be devel-oped. Last, the target company may have expertise in accessing governmentR&D grants in some geographical markets, which the acquirer can leverage toattain a larger share of government grants in those markets.

In addition, our multiple case studies revealed that financial synergies were to alarge extent neglected and viewed by the acquirer as more of nice to have ratherthan need to have. The potential for financial synergies related to increaseddebt capacity and lower cost of capital was limited since the targets had strongbalance sheets and were small relative to Marrow. We argue that the negligenceof financial synergies may in part also be attributed to the asset-light nature ofindustrial software companies, rendering e.g. debt capacity a less potent syn-ergy value lever compared to companies operating in industries with greatercapital expenditures and working capital requirements.

Our multiple case studies indicate that the strategic rationale for industrial soft-ware acquisitions is similar, namely acquiring intellectual property to push thetarget’s products through the acquirer’s sales channels. Naturally, this strategyentails revenue synergies, which are not exclusive to the industrial software in-dustry. Hence, the revenue synergies may be a function of strategic rationalerather than industry. However, there are a couple of industry-specific factorsindicating that this strategy may be more prevalent in within industrial softwarecompared to other industries. First, the business model is highly scalable withlow marginal cost of production making it suitable for accelerated growth. Sec-ond, the customers are sticky meaning that they are reluctant to switch fromtheir current provider. Therefore, it is attractive to bilaterally tap into eachothers established customer base via acquisition in order to facilitate sales tonew customers.

As for the valuation, the methods used in the studied acquisitions are multiplesand DCF. The multiples used included publicly traded peers, precedent trans-actions and equity funding rounds in for example start-ups. When studying theDCF models we gained some interesting insights. First, the projected workingcapital requirements were low despite a scale-up of the target due to the asset-light business model of industrial software companies, where the inventory isstored digitally for example. Despite the scalability it does not appear that itwas standard practice to model leverage on the fixed cost base resulting fromrevenue synergies. Hence there may be significant synergistic value not capturedin the valuation models.

While both the DCF and multiple methods are means to mechanically derivevalue, it is the underlying estimations that drive value. On that note, there werevarying degrees of sophistication in synergy estimation between the acquisitions,ranging from a granular bottom-up approach for each line item to a top-downestimation based on experience and intuition.

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6.2 Sustainability

In this study, we have not considered any environmental, social and governance(ESG) factors related to Marrow or any of their acquisitions. As such, we willabstain from commenting on Marrow’s success (or lack thereof) in their sustain-ability efforts. It may however be noted that Marrow likely faces ESG-relatedchallenges similar to those of many other large corporations, in that they oper-ate on a global scale and in interface with large number of suppliers, customersand partners over a wide range of industries.

Beyond aforementioned properties, there are reasons to argue that Marrow mayface challenges related to supply chain control greater than that of the averageglobal corporation. Relating to the M&A topic, Marrow’s operations are char-acterized by both (1) a high pace of M&A activity (both principal and bolt-oninvestments), and (2) a relatively high degree of autonomy for its subsidiaries.Combining these two factors, Marrow may, relative to other fully integratedglobal corporations with standardized systems, processes and contracts, be ex-posed to heightened sustainability risks stemming from a lack oversight. Theserisks must be actively managed in order to enable Marrow’s management teamto guarantee investors and regulators that none of their subsidiaries or businesspartners across the globe breach any boundaries of what is environmentally andsocially responsible.

6.3 Research Contribution

This thesis investigates real world acquisitions in multiple case studies in orderto obtain an understanding of what the potential synergies are, and how thosesynergies should be valued, in industrial software acquisitions. The foundationof the case studies is derived from interviews, valuation models and internaldocuments. These types of contents are oftentimes kept confidential by compa-nies and thus we have gained valuable access to material otherwise difficult toobtain. Therefore, the main contribution will be empirical in nature and helpingto bridge the gap between theory and practice.

The empirical contribution from this thesis can serve two categories, 1) Othercompanies and 2) Academics and research. As pursuing inorganic growth oppor-tunities via M&A is a common strategy with the software industry experiencinghigh M&A activity, the results and conclusions presented in this thesis can serveas guidelines for other companies in their industrial software acquisitions. Ad-ditionally, the proprietary nature of this thesis can provide valuable insights foracademics and research with regards to real world examples of industry-specificstrategic rationales for M&A as well as corresponding synergies and valuationprocesses.

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6.4 Limitations and Further Research

The research encompasses some limitations. First, the majority of cases westudied were based on Marrow’s acquisitions and the remainder were based onHeracles’ acquisitions, a company that Marrow later acquired. Further, it islikely that a contributing factor to Marrow’s acquisition of Heracles was thestrategical alignment, and thus the studied cases may all be based on Marrow’sstrategy. As we found a relationship between strategic rationale and synergies,the results may be function of Marrow’s strategy rather than the industrialsoftware industry as a whole. Second, as we only studied acquisitions in theindustrial software industry the comparability of our obtained results to acqui-sitions in other industries is limited. Third, we did not conduct any assessmenton the ex ante valuation vis-a-vis the ex post outcome. Hence, we could notconfirm whether the synergies were correctly identified and valued, nor did weexplore any methods for measuring synergies post-acquisition.

Based on the limitations of our research we propose the following topics for fur-ther research. First, it would be interesting to explore other companies’ synergyidentification and valuation in industrial software acquisitions in order to ob-tain a larger sample size and increase the generalizability of the results. Second,the comparability of synergies and corresponding valuation between industrialsoftware acquisitions and acquisitions in other industries could be improved byreplicating this study for other industries. Additionally, as synergies and valu-ation approach is perhaps more closely linked to strategic rationale rather thanindustry, this relationship could be further set by looking at a larger set of ac-quisitions with different strategic rationales. This would provide a basis fromwhich to draw industry-specific conclusions with a higher degree validity. Third,a combined pre- and post-acquisition study exploring ex ante valuation and postante outcome could provide insights into the accuracy of synergy identificationand valuation, as well as methods for measuring synergy realization.

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78

Appendices

79

A Interview Script

Initial Questions

• Tell us about your role

• Tell us about your experience

• Tell us about your in the acquisition of Company X

Transaction

• Tell us about the background of the acquisition

• What was the rationale for acquiring Company X?

Revenue Synergies

• Did you identify any revenue synergies and if so, which?

– Which inputs did you use to estimate revenue synergies?

– How did you derive these inputs?

• Would you say there are any revenue synergies specific to industrial soft-ware companies?

Cost Synergies

• Did you identify any cost synergies and if so, which?

– Which inputs did you use to estimate cost synergies?


• Would you say there are any cost synergies specific to industrial softwarecompanies?

Integration Costs

• Did you identify any integration costs and if so, which?

– Which inputs did you use to estimate integration costs?


• Would you say there are any integration costs specific to industrial soft-ware companies?

80

Financial Synergies

• Did you identify any financial synergies and if so, which?

– Which inputs did you use to estimate financial synergies?


• Would you say there are any financial synergies specific to industrial soft-ware companies?

Valuation

• Which method did you use to value the identified synergies?

• Did you apply phasing of the synergy realization?

– How did you apply the phasing?

• Which WACC did you use to value the synergies?

81

B List of Interviewees

Date Interviewee Company Position

2018-03-15 Employee A Marrow Director, Strategy Development2018-03-21 Employee B Marrow Business Development Manager2018-04-05 Employee C Heracles (Marrow) Group Finance Director2018-04-18 Employee B Marrow Business Development Manager

82

C Valuation of Poseidon


Year 1 2 3 4 5

Revenues 1,000 1,139 1,224 1,316 1,526 1,549

% growth 9% 14% 7% 8% 16% 1%

Revenue through Marrow channel 41 77 111 137 n.a. n.a.

% growth n.a. 88% 45% 24% n.a. n.a.

Revenues incl. synergies 1,041 1,215 1,335 1,454 1,526 1,549

% growth 4% 22% 17% 19% 16% 1%

COGS excl. synergies (385) (399) (412) (425) (366) (372)

% of revenues (37%) (33%) (31%) (29%) (24%) (24%)

Royalty savings - 31 31 31 n.a. n.a.


COGS overheads 28 46 46 46 n.a. n.a.


COGS incl. synergies (357) (322) (335) (348) (366) (372)

% of revenues (34%) (27%) (25%) (24%) (24%) (24%)

Gross Profit 683 893 1,000 1,105 1,160 1,177

% margin 66% 73% 75% 76% 76% 76%

OPEX excl. synergies (642) (629) (654) (678) (638) (648)

% of revenues (62%) (52%) (49%) (47%) (42%) (42%)

R&D Grants - 10 10 10 n.a. n.a.


Selling costs 18 27 27 27 n.a. n.a.


General & Administrative 6 6 6 6 n.a. n.a.


R&D - 20 20 20 n.a. n.a.


OPEX incl. synergies (618) (564) (589) (613) (638) (648)

% of revenues (59%) (46%) (44%) (42%) (42%) (42%)

EBIT 65 329 411 492 522 530

% margin 6% 27% 31% 34% 34% 34%

Restructuring costs (78) (28) (10) - - -

% of revenues (7%) (2%) (1%) - - -

Provisions for Tax (6) (24) (60) (77) (188) (191)

% of EBIT less restructuring costs 45% (8%) (15%) (16%) (36%) (36%)

Less: Increase in Working Capital - - - - - -

Less: CAPEX Fixed Assets - - - - - -

Add-back: D&A - - - - - -

Free Cash Flow (18) 277 341 415 334 339

Discount Factor 0.95 0.87 0.79 0.72 0.65 0.59

Present Value of Free Cash Flows (17) 240 268 297 217 201

Enterprise Value

Sum of Present Values (Forecast Period) 1,005

Free Cash Flow (Terminal Year) 339

WACC 10%

Terminal Growth Rate 1.5%

Future Value of Residual for Terminal Year 3,975

Discount Factor 0.65

Present Value (Terminal Year) 2,586

Enterprise Value 3,591

Terminal

Figure 1: DCF Valuation of Poseidon

83

D Valuation of Athena


Year 1 2 3 4 5 6 Terminal

Stand-alone revenues 1,000 1,029 1,060 1,092 1,114 1,136 1,159

% growth 3% 3% 3% 3% 2% 2% 2%

Revenues through Heracles channel 67 144 231 264 310 359 366

% growth n.a. 116% 60% 14% 17% 16% 2%

Revenues incl. synergies 1,067 1,174 1,291 1,356 1,423 1,495 1,525

% growth 10% 10% 10% 5% 5% 5% 2%

COGS (53) (59) (65) (68) (71) (75) (76)

% of revenues (5%) (5%) (5%) (5%) (5%) (5%) (5%)

Gross profit 1,014 1,115 1,227 1,288 1,352 1,420 1,449

% margin 95% 95% 95% 95% 95% 95% 95%

OPEX (663) (668) (689) (709) (719) (734) (749)

% of revenues (62%) (57%) (53%) (52%) (51%) (49%) (49%)

EBITDA 367 463 554 595 649 702 716

% margin 34% 39% 43% 44% 46% 47% 47%

D&A (16) (16) (16) (16) (16) (16) (16)

% of revenues (2%) (1%) (1%) (1%) (1%) (1%) (1%)

EBIT 351 447 538 579 633 686 700

% margin 33% 38% 42% 43% 44% 46% 46%

% margin excl. OPEX leverage (stand-alone) 29% 30% 30% 30% 30% 30% 30%

Tax (105) (134) (162) (174) (190) (206) (210)

% of EBIT (30%) (30%) (30%) (30%) (30%) (30%) (30%)

Less: Increase in Working Capital 6 6 7 4 4 4 2

Less: CAPEX Fixed Assets (13) (16) (16) (16) (16) (16) (16)

Add-back: D&A 16 16 16 16 16 16 16

Free Cash Flow 254 319 384 409 447 485 492

Discount factor 0.95 0.87 0.79 0.72 0.65 0.59 0.54

Present value of Free Cash Flows 242 277 303 293 291 287 265

Enterprise Value

Sum of Present Values (Forecast Period) 1,693

Free Cash Flow (Terminal Year) 492

WACC 10%

Terminal Growth Rate 2%

Future Value of Residual for Terminal Year 6,145

Discount Factor 0.59

Present Value (Terminal Year) 3,638

Enterprise Value 5,331

Figure 2: DCF Valuation of Athena

84

ELiteratu

reand

TheoryReview

Summary-M

&A

Strategies

Them

eConcept

Theories&

Fram

eworks

Em

piricalStudies

LiteratureReview

Miscellaneous

M&A

Strategies

Strategic

Fit

Shelton(1988)

--

-

ImproveTarget’s

Perform

ance

Koller

etal.(2010)

Ach

aryaet

al.(2013)

Smith(1990)

LichtenbergandSiegel

(1990)

--

Consolidate

toRem

ove

Excess

Capacity

Gaughan(2013)

Koller

etal.(2010)

--

-

Accelerate

Market

AccessforProducts

Koller

etal.(2010)

--

IBM

(2014)

WallStreetJourn

al(2005)

Acq

uireSkills

orTechnologies

-Ranft

andLord

(2000)

Sen

andRuben

stein(1989)

Ford

andProbert(2010)

-

Acq

uireW

inners

Early

Koller

etal.(2010)

--

-

Roll-up

Strategy

Gaughan(2011)

Koller

etal.(2010)

--

-

Consolidate

toIm

prove

CompetitorBeh

aviour

Koller

etal.(2010)

--

-

Acq

uireUndervalued

Targets

Dep

amphilis

(2009)

--

-

DriversforM&A

--

-KPMG

(2016)

Tab

le1:

Summaryof

M&A

strategy

concepts

andsources

from

theliterature

andtheory

review.

85

FLiteratu

reand

TheoryReview

Summary-Synergies

Them

eConcept

Theories&

Fram

eworks

Em

piricalStudies

LiteratureReview

Miscellaneous

Operating

Synergies

Eco

nomiesofSca

leDamodaran(2011)

Dela

Mano(2002)

-DeGraafandPienaar(2013)

-

Increa

sedPricing

Power

Dela

Mano(2002)

Koller

etal.(2010)

Chatterjee(1986)

--

Higher

Growth

Gaughan(2011)

Koller

etal.(2010)

--

-

Financial

Synergies

Opportunitiesfor

Excess

Cash

Chandra

(2014)

--

-

Deb

tCapacity

Gaughan(2011)

Damodaran(2011)

--

JP

Morgan(2009)

TaxBen

efits

Damodaran(2011)

--

Eccleset

al.(1999)

Issu

esRelated

toSynergies

BiasedEvaluation

Process

Damodaran(2011)

--

-

ManagerialHubris

Roll(1986)

--

Hietala

etal.(2003)

Nilsson(2016)

Tab

le2:

Summaryof

synergy

concepts

andsources

from

theliterature

andtheory

review.

86

GLiteratu

reand

TheoryReview

Summary-Valuation

Them

eConcept

Theories&

Fram

eworks

Em

piricalStudies

LiteratureReview

Miscellaneous

Gen

eral

Valuation

Methods

DCF

Koller

etal.(2010)

Bernstrom

(2014)

Rosenbaum

andPea

rl(2009)

--

-

WACC

Ross

etal.(2013)

Sharp

e(1964)

Perold

(2004)

--

-

Multiples

Koller

etal.(2010)

Bernstrom

(2014)

--

-

Synergy

Valuation

Gen

eralSynergy

ValueDrivers

EvansandBishop(2002)


-

Bottom-upCost

&Rev

enueEstim

ates

Koller

etal.(2010)


-

DCF

inSynergy

Valuation

Damodaran(2005)


-

Rea

l-Options

Valuation

Dixit

andPindyck

(1994)

vanPutten

andMacM

illan(2004)


-

Tab

le3:

Summaryof

valuationconcepts

andsources

from

theliterature

andtheory

review.

87

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