Platform Company vs. Add-on and Tuck-in AcquisitionsPlatform companies stand in contrast to add-on or tuck-in acquisitions where synergies to an existing portfolio company are believed to exist. Estimates vary across sources, but add-ons constitute roughly 40-50% of private equity (PE) buyout activity, making it critical for business owners who are thinking of taking a private equity investment to understand some of the strategic implications of both views. Add-on and tuck-in acquisitions are usually considerably smaller companies so as to not dilute the culture of the platform. Add-ons and tuck-ins are acquired for lower EBITDA multiples instead of high multiples.
In academia, platform companies are those that involve not only one company’s technology or service but also an ecosystem of complements to it that are usually produced by a variety of businesses. As a result, becoming a platform leader requires different business and technology strategies than those needed to launch a successful stand-alone product. There are two fundamental approaches to building platform leadership-coring and tipping. If you really want to make a lot of money, position yourself as a platform company that uses a coring or tipping strategy.
Coring and TippingCoring is using a set of techniques to create a platform by making a technology core to a particular technological system and market. When pursuing a coring strategy, would-be platform leaders think about issues, such as how to make it easy for third parties to provide add-ons to the technology and how to encourage third-party companies to create complementary innovations. Examples of successful coring include Google in Internet search and Qualcomm in wireless technology.
Tipping is the set of activities that helps a company tip a market toward its platform rather than another potential one. Examples of tipping include Linux’s growth in the market for Web server operating systems. Another tipping strategy is for a company to bundle features from an adjacent market into its existing platform. This is referred to as tipping across markets.
Platform Company AcquisitionIn common usage of the term, PEGs consider platform companies to be those that have sufficient economies of scale and talent acquisition, talent management, and succession planning capabilities upon which it can efficiently acquire add-on or tuck-in acquisitions. PEGs seek to acquire companies that they can grow or improve (or both) with a view toward eventual sale. In terms of growth, the financial sponsor will usually acquire a platform company in a particular industry and then seek to add additional companies to the platform through acquisition. These add-ons may be competitors of the original platform company or they may be businesses with some link to it, but they are added with the goal of increasing the overall revenues and earnings of the platform investment.
In some cases, PEGs will grow the platform company into a roll-up. When the platform company serves as a basis or foundation for this type of development, there are certain factors and techniques that need to be considered and implemented.
PEGs spend a great deal of time developing strategic buying plans and investment cases for a potential new platform; this is done in order to determine why they are buying a business and how they will generate an attractive return. This analysis is usually even more comprehensive for businesses that are new to a PEG. For add-on acquisitions, PEGs sometimes lean more on the expertise of its relevant portfolio company’s management to determine the fit, synergies, and strategic benefits of a transaction. That is why the talent acquisition, talent management, and succession planning are so important.
For new platforms, PEGs require that the company not only be self-sustaining, but also scalable. The ability to grow the company is the rationale behind the deal, and it defines how the PEG will create value through things like capital infusions, operating partners, and future add-on acquisitions. The PEG seeks avenues of growth to maximize the value of the investment. For new platforms, PEGs focus on issues including industry attractiveness, opportunities for growth, the self-sufficiency and scalability of the target, and whether the PEG can add value in the acquisitions process.
To be self-sufficient and scalable, the target must be able to prosper without any one individual. Customers must be "owned" by the company, not by one person and certainly not by the current owner. Critical processes must be mapped, and the organization must be in a highly efficient.
Appraising a Platform CompanyIf you are a business owner, ensure that you have created a company that can prosper without you: one that is self-sustaining and has the talent in place to take it to the next level. That is your path to greatest wealth.
Since 1975, the percentage of enterprise value that is derived from tangible assets has fallen from 80% to 20% among the Fortune 500. As we have moved from the industrial era into the knowledge era, an increasing proportion of enterprise value is due to 'intangible assets’, or what we call 'intellectual capital’, our middle name. Much of our work is centered around understanding the value creation process in the knowledge era.
But tangible asset values still matter. When a PEG begins seriously looking at a company, they talk to their commercial bank. Due to their forced adherence to Basel II and soon, Basel III, commercial banks must have tangible assets as collateral for relatively risky loans.
Basel created two metrics: Probability of Default (PD) and Loss Given Default (LD). The product of these two metrics is the expected value of the loan loss, for which the bank must reserve capital. If there are no tangible assets as collateral, the LD is 100% of the loan outstanding if there is a default. Thus, the risk of default would have to be de minimus for a bank to be able to afford to make the loan.
Thus, if tangible assets represent a small percentage of purchase price, it’s likely the PEG can’t get much in the way of bank financing, and must look to the much more expensive non-bank cash flow loan market, or use their very expensive, 25% required rate of return equity. But larger strategic investors are unhindered by this constraint. Due to their mass, their credit rating is based on long term cash flow projections, and virtually ignore tangible asset values. Take a look at two companies: Navistar and Google. Navistar has negative intellectual capital, and conversely, it’s all Google has. Navistar is an asset write-down waiting to happen. So, tangible assets are not a panacea, as many found out during 2009-2010. But it is easy for commercial bankers and the banking authorities to understand.
In our work, we use transaction multiples and market multiples, but discounted cash flow (DCF) is king. Our DCF is intensively focused on all the soft stuff: the culture of the company, and how it creates intellectual capital. We identify and classify each source of IC and analyze the highest and best use to individual acquirors. It’s possible that the real value of the company is vastly understated by EBITDA and that the real value is in the customer list, or in an innovative culture, or proprietary technologies that are not yet reflected in EBITDA. Looking at EBITDA or tangible assets as a proxy for enterprise value can be as misleading as looking at a parcel of land through the eyes of a farmer instead of as a real estate developer.