Perspective: Tech mergers: Is it safe?

Tom Taulli says IBM's $2.1 billion offer to buy Rational Software may have broken a psychological barrier to deal-making in the technology business.

3 min read
Valuation is certainly a funny business. In the late 1990s, investment bankers stretched their spreadsheets to the breaking point trying to justify valuations. In some cases, the thinking was mind-boggling. For example, in December 2000, Ciena bought Cyras Systems for a stunning $2.6 billion even though there was no revenue. Essentially, Ciena looked at future revenue (and they are still looking!).

Of course, valuations have become much more reasonable in the past few years. In fact, there is a good argument that the pendulum has swung too far to the other extreme. Does it make sense to have a company sell below its cash value, even though there is an underlying fundamental business that makes sense?

Then again, the stock market is not necessarily a forum for common sense. It's mostly about what the economist John Maynard Keynes said: "animal spirits."

To reverse the negativity, there needs to be a market leader that declares it is safe to enter the market again. It appears that this came in early December, when IBM shocked the tech world by announcing a $2.1 billion offer to buy Rational Software. (This was the largest deal for Big Blue since its acquisition of Lotus for $3.5 billion in 1995.)

Since then, there has been a flurry of tech deals, especially in the software niche. Interestingly enough, Yahoo decided to buy Inktomi during Christmas week for a hefty premium. Besides indicating it is safe to do deals, IBM did something else very important: It established a valuation benchmark.

When contemplating transactions before that, dealmakers had the major problem of trying to put a value on the company. Looking at comparable valuations meant looking at inflated dot-com valuations. In other words, there was no way a buyer could justify a deal. Also, a prospective seller still kept on thinking that values would somehow reinflate.

Besides indicating it is safe to do deals, IBM did something else very important: It established a valuation benchmark.

With the IBM deal, we now have a good metric. Rational is expected to generate revenue of about $625 million for the past year. Thus, IBM paid roughly 3.3 times revenue or, as I call it, the "3x Factor."

The 3x Factor is the missing link in the instigation of mergers and acquisition (M&A) activity. How? Let's take an example: ABC private equity fund has lots of cash, as have most of its peers. The fund wants to make deals but has a difficult time justifying them. True, valuations look compelling, but what is the exit strategy? The IPO market is one idea. But who believes it will come back any time soon?

Then again, why not buy a company and then sell it upstream to a major player like IBM? When IBM announced its deal for Rational, it said that a driving force was a wish to build its new "on-demand" strategy, which takes a new look at software. It means investing in R&D, as well as in M&A. Whatever the strategy is called, there are other players who will be rushing to do the same--such as Microsoft, Oracle and even Sun Microsystems.

Now that there is an exit strategy, a dealmaker needs to find prospective transactions that fit the plan. Take Vignette as an example. The company is a leader in content management software. Yet there is little interest in the company's stock, which has a market capitalization of about $370 million.

The 3x Factor is the missing link to instigate M&A activity.

Looking under the hood, you'll notice that the company has $360 million in cash. A dealmaker can make a tender offer for the company at $470 million and use $300 million, say, to pay back investors and any debt. So the company cost only $170 million. Next, the dealmaker can take steps to streamline operations (which, in fact, is already happening with the company).

Vignette generates about $170 million in annual sales. Assuming the 3X Factor works, the company has an enterprise value of $510 million, which is a nice gain on a $170 million investment.

This kind of looks like the market is inefficient? It certainly does. Academics may have studies that show there are "no $50 bills lying on the ground," but savvy dealmakers know otherwise. And don't be surprised to see them push the 3X Factor in a big way.