M&A from a CFO’s Perspective Session 2

The Role of CFO

There are five things you can do with your capital within a company: you can invest in your business, often referred to as OPEX, you can pay a dividend, you can buy back debt, you can buy back stock, or you can engage in M&A. The primary role of the CFO is to determine at any given moment the most effective use of the capital within the company.

There's an excellent book on this subject titled 'The Outsiders' by William Thorndike. This book offers a great deal of insight into these strategies. It's a must-read for every CEO on the planet; it should practically be mandated by regulation.

It's an exceptional book that discusses the strengths and weaknesses of CEOs. CEOs. They're typically good at establishing a vision. If you subscribe to Simon Sinek's philosophy, you might even argue that the CEO's title should be Chief Vision Officer. 

However, their weakest point often lies in capital allocation. It's crucial to align the money you allocate within a company with the people you have and the vision you aspire to achieve. M&A plays a significant role in this process. 

When you consider M&A in the context of those five options for capital allocation, you gain clarity on when to pursue M&A and when not to. That's primarily a CFO function. It might sound a bit dry—like spreadsheet mechanics—but the numbers change daily and it requires focused attention. We have a finite amount of money.

Determining what to do with that money at any given second is the CFO's responsibility. The CFO is the strategic advisor to the CEO, directing the most effective use of capital at any moment. That's the first aspect. 

The second involves the deal mechanics. They're essential, particularly when it comes to pricing the deal, liaising with bankers and lawyers, and due diligence.

You need a senior executive, such as a COO or CFO, to handle this. I strongly believe it's the CFO's job to ensure that the information we're basing our bid and price negotiations on is accurate. Negotiations are significantly easier when you start from a position of truth. 

For instance, a company may claim that they're about to launch a product that will be worth a tremendous amount of money. What's the analysis behind that claim? Is it true or not? Once you understand that, the negotiation becomes almost secondary. 

You have a price that aligns with your five frameworks of capital allocation. As long as you stick to your price and don't exceed it, you'll be fine. CEOs are inherently optimistic, which is part of what makes them successful. 

However, they also need a pragmatic perspective, acknowledging that while they can acquire anything, there's a price to pay for each transaction. That's the CFO's role; he or she determines the worth of these acquisitions.

It's a relatively straightforward task once you understand why you're pursuing an acquisition and what return it will provide. Ultimately, we aim for financial returns from the actions we take. As soon as financial returns are mentioned, that's the realm of the CFO.

Risk Management

Now, risk management is also critical. There are a couple of facets to it. Firstly, there's due diligence. Is the information we have accurate? I'm sure many of your podcast guests have acquired something only to discover a few months later that the situation wasn't quite as they'd perceived during due diligence.

There are always surprises. For instance, are you billing customers who have churned and recognizing that as revenue? Everyone encounters such challenges. That's where the importance of risk management comes in. It's like remodeling a house—you're always told to add 20% to your budget for unexpected costs. That's risk adjustment.

The second part of risk management involves understanding what you're integrating. Are we acquiring this company for its customers, its technology, or because we aim to drive a transformation? If you don't understand the rationale behind the acquisition, you can't properly identify the key risks.

So let's break this down: If you're acquiring customers, then customer retention becomes paramount. If you're acquiring products or moving into market adjacencies, the key questions become about your sales force's capacity to sell these products and the quality of the products themselves. If you're driving a transformation that may involve keeping the management team of the acquired company, employee retention becomes crucial.

Thus, you need a clear acquisition framework: the first level is why we're acquiring, and the second level deals with the core reason and price. Your risk assessment should relate back to why you're making the acquisition. These considerations then become top of the to-do list during integration planning.

Every business leader makes trade-offs every day. You will inevitably have to sacrifice something. Plan ahead for these sacrifices. By doing so, you can direct your maximum effort, resources, and brainpower towards the most critical aspects.

Integration aspect

The reason I advocate for placing integration under the CFO's authority is because the CFO creates a set of assumptions that make the pricing model work. Let's use an example for clarity.

Say company A is acquiring company B to gain access to company B's customers. The most crucial figure here is the retention rate of company B's customers. The CFO will have a model that suggests in order for this acquisition to work financially, we need to retain a certain percentage of customers. We need revenue synergies of X and cost synergies of Y.

Now, if the CFO creates this model, prices the acquisition based on it, and then hands it over to someone else who didn't build these assumptions, it can lead to problems. The person taking over might not fully understand or buy into the assumptions, even if they were involved in meetings or discussions.

So, in my view, the CFO needs to own this. They built the model, and decisions were made based on it. They are the ones who need to see it through and make it happen.

Alignment on assumptions

As CEO, you might suggest to the management team that we should acquire company XYZ. This isn't the case at a larger scale, like at Microsoft, where a business development person or a general manager of a division might make the call due to the size and scope of the company. But at a smaller scale, some leader will propose an acquisition based on business trends, goals, and strategies, with finance staff involved to varying degrees.

At some point, before even entering due diligence, you'll need to seek consensus from your management team, your division management team, or your overall management team. You have to go around the table, calling out each person by name, asking them to weigh in. It's essential to force a decision, thumbs up or thumbs down.

Of course, this isn't set in stone, but the idea is to avoid the indecisiveness often found in economics, where on one hand it's this, on the other hand it's that, leaving you without a clear answer. You need a straight answer, should we acquire or not? Because once a M&A transaction is completed, there's no return policy.

It's crucial to get buy-in from everyone involved. Then, during due diligence, you assign respective directors or leaders to their core areas. Each one will be responsible for integrating their respective areas – sales, customer support, R&D, etc.

However, the CFO serves as the executive sponsor, ensuring the integration happens, while not getting into the nitty-gritty of the process like which scrum team is getting linked to another. That's the domain of your engineering leadership. You need to ensure everyone's on board, and that understanding needs to go all the way back to before due diligence begins.

Managing people

When you reach an enormous scale, you might have the luxury to afford dedicated M&A teams handling all aspects of integration full time. However, for the majority of companies, about 98%, it's the regular staff juggling their usual responsibilities along with the integration. It's not a separate team; it's the same people.

Misunderstandings often arise from assumptions about responsibilities. People think, 'they're doing it,' but in reality, the responsibility falls on their own shoulders.

Consider this, Harvard Business School, among others, have written extensively about M&A. They identify two primary factors that determine the success of an M&A: the price you pay and your ability to integrate the new acquisition effectively.

Integration doesn't necessarily mean full assimilation; it could mean operating as a wholly owned subsidiary or any other degree of integration that was built into the original agreement.

The key is to execute that level of integration correctly, the operational aspect of the transaction. That's what will drive the entire process, from start to finish - the price you're paying and whether the operations work. The moment you mention operations, it becomes a human endeavor.

Best integration practices

You set the framework ahead of time. When we did acquisitions that were small, we didn't use any external parties for integration. However, when we executed our FUSA transaction, we engaged EY's integration team for 12 weeks. This was extremely beneficial, particularly as it was our first global transaction. Dealing with HR policies and back-office entity structures in 20 different countries required professional assistance. You need to have a plan for all of this well in advance.

Let's use a marriage analogy. I've been married for 23 years, and there's an excitement in dating, but the success of a marriage depends on day-to-day living together, not the dating phase. The same is true for transactions. A transaction has to work post-acquisition.

As a CFO, you're responsible for establishing this framework. Who's going to do what? How will it be done? Will we have a weekly meeting? A daily meeting? Stand-ups? How are we going to communicate progress?

If you expect your CEO to do this, you're mistaken. As a CEO, I'm being pulled in multiple directions. A transaction might occupy 10 of those paths, at best, taking up 25% of my focus. But I still have to run the core business, which is a full-time job in itself.

Working with the CEO

The first and most important thing is that you have to be the arbiter of truth. Transactions are made much easier if you know what's true. I've been involved in transactions where the CEO's initial reaction was a resounding 'no', and then progressively shifted to 'maybe' and finally to an enthusiastic 'yes'. During that same time period, my perspective as CFO went from considering it a potentially good transaction to decidedly against it due to findings from due diligence. You have to be the party that uncovers the truth.

In almost every successful transaction we've undertaken, there was a point where we walked away due to a significant issue. In most cases, we managed to negotiate our way around it, but there was always something that made us pause. As a CFO, that's your responsibility.

Remember, the CEO, board, advisors, and the investment bankers all want a deal done. Your business development team wants a deal done. Often, the employees receiving the products want a deal done too. You have to be that source of truth. It's the most important job.

The CEO ultimately makes the call, taking into account all of the information presented. As a CFO, our role extends beyond M&A activities to the broader financial picture of the corporation. We don't have responsibilities tied to a particular operating division; we don't build, sell, market, or support products or services. Our role involves managing the financial picture of the company.

Numbers serve as unbiased representations of the company's operations at any given moment. The CFO's role, in essence, spans the entirety of the company. We are tasked with interpreting the company's performance and presenting it as clear-cut numbers. Numbers don't lie. My previous boss on Wall Street used to say, 'Numbers don't lie; management teams do.' Hence, a CFO's general role is to be the arbiter of what is truly happening within the company.

Walking away from a deal

In the initial stages of a transaction, when a target provides a compelling presentation outlining their numbers, financial model, and new products, we also build a financial model and estimate the value. However, during due diligence, we discovered that one of the numbers, pivotal to the financial model, was not accurate. They had presented the number without taking into account certain negative aspects.

This discovery significantly altered our financial model. When we attempted to renegotiate the price based on the new findings, the other party refused. They claimed that one-time or non-recurring events were not included. We responded by referring back to their original presentation, highlighting the incorrect number, pointing out there was no asterisk or footnote.

True to this tale, the deal fell through. They left and by the time they landed back home, they were calling to find out how to resurrect the deal.

This serves as a prime example of why due diligence is crucial. We once discovered a tax issue during a transaction, which we then addressed by setting up a separate reserve. They were disputing some taxes and their advisors were confident they could resolve the issue for a certain amount. Our advisors, however, were less optimistic. We agreed that we would cover the issue up to a certain point, beyond which the remainder would be deducted from the holdback.

What's important is identifying risks. Once you have identified them, you can allocate resources, negotiate contract terms, and understand why you're doing the transaction. You need to comprehend the financial assumptions around the deal, and the due diligence data. There may be minor issues that don't influence the core premise of the transaction. While it would have been better to know these upfront, they don't warrant renegotiation. However, if a finding is key to the purpose of the deal or its pricing, it is imperative to address it.

Getting involved in the deal

Once you begin signing legal documents, there are various gates, each one setting off a new set of legal ramifications. This begins with signing the NDA, the LOI, the actual terms of the deal, and so on.

There are generally three ways to source deals. The first is when the CEO finds it, typically at a social event, and another CEO suggests a merger. Second, business development teams are always on the lookout for potential deals. Lastly, your investment bankers might present you with an idea.

The CFO should be involved soon after these initial encounters. The CFO might not be directly involved initially, delegating the initial research to a member of their FP&A team. As soon as we decide we want to pursue the deal, I usually instruct someone from my team to build a model and maintain a spreadsheet tracking our assumptions.

As the first presentations start coming in, the CEO and CFO need to maintain constant communication. The CFO should be present at all major presentations, but there will be instances when the CEO has independent conversations. In such cases, the CFO needs a readout of those conversations. It's not essential for the CFO to be in the room, but a brief update is necessary. For example, a quick text stating, 'Talked to John Smith. He says...' This allows the CFO to validate the CEO's information and correct any inaccuracies.

To a CFO, the expectation is clear: maintain accurate books, present to the board and investors, and perform your daily tasks. But between us, your real role is to be the arbiter of truth. You're knee-deep in numbers, constantly analyzing and understanding them. This was my reality as a CFO, and I was intimately familiar with the minutiae. As a CEO, I've somewhat lost that close relationship with numbers because of the context switching involved in the role.

As a CEO, one minute you're in a meeting with the product team, the next with sales, followed by support, then you're on the phone with our top channel partners, an upset customer, and then a potential client. You're constantly switching contexts.

As a CFO, you're deeply involved with the numbers: the model, the forecasts, the Salesforce dashboard. Your role is to distill that information for the CEO. We have a weekly meeting called 'Course and Speed' led by the CFO, where we discuss our direction and pace. It's the CFO's responsibility to run this meeting, arguably the most important one we have.

Tying the Strategy

As a CEO, you carry the strategy and vision for the product, customers, and markets. Let's take your business for example. I presume you primarily target business development personnel, investment banks, and law firms. You have a plan, perhaps focusing on larger firms first and then smaller ones. But the key role of your CFO is to determine if this strategy is working.

A CFO's role doesn't extend to organizational matters, such as hiring the right people and ensuring they're in the right seats. While they might contribute to the interview process, setting the company's vision is primarily your job as CEO. It's a common mistake for CEOs to equate an outcome with a vision. If your goal as a private company is to reach a 5 billion valuation, I would argue that this isn't a vision. Instead, envision having 10,000 customers paying you $10,000 a month and 100 customers paying you a million dollars a month. This vision leads to your desired valuation based on your assumptions. This customer-oriented vision also drives the actions each department takes.

To illustrate, let me share my own experience. Currently, I have 65 Scrum teams working on our Contact Center product. I see the Contact Center market as a 40 billion opportunity. To effectively seize this opportunity, I want to increase the number of Scrum teams to over 100. This is what keeps me up at night. The fused transaction we carried out was a strategic move to add 20 Scrum teams, which we paid for by properly structuring their business.

This is where a CFO steps in. When I need to figure out how to expand, the CFO provides critical insight. One approach is to grow revenues organically or through acquisition. The CFO plays a vital role in executing this strategy, steering it clear of unfounded claims. I've witnessed scenarios where grandiose plans fall flat because they don't align with the numbers. The numbers always need to match.

Remember, the CFO doesn't have a vested interest in any specific department. They're not out to protect a specific team or claim. Their focus is purely on the financial stability and growth of the company.

Integration Budgeting

Let's step back a bit and understand why you're doing the deal. There are three types of M&A transactions. First, there's a product or service acquisition, where you're integrating a new technology or extending your product range. Second, there's buying customers - a strategy often seen with Oracle and large telecoms like AT&T, Verizon, and Comcast. Finally, there's a transformational transaction which fundamentally changes the tone and tenor of the business.

When considering a product acquisition, the core decision is whether to make or buy. Why are you acquiring this instead of building it in-house? This decision is influenced by numerous factors. Do you have the in-house talent to build it? Is there a time-to-market factor? For instance, if you need to build a new product slightly outside your core competency, it may take a year to enter the market, which may not be viable if customers are demanding it now.

Using Cisco as an example, they choose to let others, like Sand Hill Road, invest in multiple product categories. Cisco then purchases the winners, which ultimately is more cost-effective despite paying a premium for market leaders.

As for customer acquisitions, you have the option of acquiring customers through marketing and sales efforts at a certain customer acquisition cost, or you can purchase customers in the open market.

So, regarding budgeting, M&A should be viewed as an extension of what you're already doing. There's no need for a separate M&A budget per se. If you planned to spend 10 in R&D to build a product but decide to acquire it instead, you no longer need to spend that 10 on your own R&D. Thus, product acquisitions are extensions of the R&D line on the income statement, while customer acquisitions extend the sales and marketing line.

So no, M&A is not budgeted separately. It comes down to which option is most effective. This is where the CFO plays a crucial role. They analyze the current customer acquisition cost and the cost to acquire risk-adjusted through M&A, helping the company to make informed decisions.

We are continuously searching for acquisitions, even when our stock price is low. The search for acquisitions operates like an engine, never ceasing.

When our stock price is low, we have to consider the options. Is it better to acquire another company or to buy back our stock? Each decision impacts revenue on a per-share basis. So, at any given moment, we're weighing up the possibility of acquiring another company against purchasing our own shares, which trades on the open market with low integration risk.

To me, this is as constant as our daily sales, marketing, and R&D operations. We also prospect for M&A opportunities daily. The likelihood of doing a deal, the so-called hurdle rate, depends on various factors. When we're trading at a high valuation, we're more likely to do a deal as our cost of capital is very low. So, it's more advantageous to acquire than to buy back stock.

This is an ongoing process and makes it impractical to have a fixed budget. Every day, our stock price, acquisition costs, and R&D needs are changing. Therefore, it just needs to be part of what the business does daily.

At any given time, we are investigating four to six potential transactions. The CFO's job entails assessing risk adjustment. It's not just about the cost of advisors and capital but also the potential costs of involving outside parties. Let me provide an example.

For every company we've acquired, I've brought in between two to six contractors to review all their procurement contracts. The moment the deal closes, these contractors start examining each contract to identify any supplier overlap or price discrepancies compared to our benchmarks.

Those are all elements the CFO should have accounted for as budget items. We have to consider if we require an integration partner, service providers, or contractors. All of these expenses factor into the deal price.

Let's use a startup as an example. You might calculate the deal price as a hundred dollars in revenue times a five times price sales ratio, which equals $500. But that's only for their equity. You need to add integration costs of, say, $20 million. Therefore, the total price I'm paying is $520 million. We need to evaluate how that compares to alternative uses of that money.

In this framework, the CFO plays a crucial role in adding up these costs for the company. They don't necessarily focus on the specifics of gaining 20 more salespeople or 50 more engineers. They're concerned with the bigger picture: increasing cash flow per share

Working with corporate development

Indeed, I collaborate extensively with my investment bankers and business development person. As a naturally collaborative individual, I believe everyone involved needs to understand our corporate strategy.

Our business development person, who is excellent at his job, has been frank enough to advise against pursuing certain deals. In one instance, after conducting due diligence, he urged against moving forward, stating that the deal was too complicated.

Collaboration is essential, as is creativity. I pride myself on our ability to approach mergers and acquisitions innovatively. It's not just about company A buying company B. We consider strategic partnerships, minority investments, joint ventures, and various other transactions.

Many transactions that initially started as an intent to acquire have transformed into partnerships. We often add a clause in the partnership agreement that if the partnership proves successful, we'll proceed with the acquisition at an agreed-upon valuation.

Advice for first time acquirers

I'll reiterate what I said earlier. The advice revolves around the price you pay and your ability to operationalize the acquisition. These are the two most crucial factors. The price you pay should also be evaluated relative to other potential capital allocation decisions. Too often, CEOs, and I myself am guilty of this, become enamored with the prospect of acquiring a company, imagining all the possibilities.

It's essential to treat it as a hard-nosed business decision. Looking at successful acquirers throughout history, such as Warren Buffett, Catherine Graham, Tom Murphy, or Brian Roberts of Comcast, they all have a structured approach. There's a framework. Decisions are never made on a whim, but follow the same structured framework used to decide on hiring sales reps or investing in product development.

This disciplined approach should be applied to M&A as well. The one piece of advice I'd add is to take some quiet time, perhaps with a stiff bourbon, and ask yourself: Why is this company selling?

This question is particularly relevant when dealing with technology startups. Why is this venture capital-backed startup selling to me? Often, during due diligence, you'll discover various issues, like the product not being enterprise-ready, not functioning as advertised, or having a weak pipeline. These factors may very well be the reason the company is selling.