Why Mega Software M&A Often Fail (Pt.1)

Summary

• Software M&A is driven by the need for rapid adaptation but often results in shareholder value decline due to integration challenges and overpaid premiums.
• Acquirers face difficulties with target profiles, including high premiums for mature companies and risky bets on high-growth, unprofitable startups.
• Successful software M&A requires cultural and operational synergies, careful valuation, and a strong track record in integration to avoid costly missteps.

Software M&A has emerged as a distinct and expanding category, driven by the sector’s growing digital footprint and maturation. Historically, serious investors approached the software industry with caution, viewing it as somewhat intangible compared to traditional physical businesses, where most assets are clearly represented on the balance sheet. In contrast, software companies rely heavily on intangible assets, making it challenging to assign precise balance-sheet values to intellectual property (IP).

In recent years, however, investors have increasingly recognized software as a valuable and legitimate business sector — albeit one with unique accounting and valuation considerations. Indeed, software companies bring distinctive characteristics and complexities, presenting additional challenges for M&A stakeholders.

Observing the market closely, we often see acquirers in major software M&A deals face immediate big share price declines. While traditional corporate finance theories suggest acquirers might experience some loss in shareholder value, the historical track record of software M&A introduces an additional layer of investor concern.

Large software companies are often in a bind, because due to the fast, dynamic landscape of technology, it is not possible to build new applications from the ground-up to serve an emerging demand. Hence, they are compelled to acquire the needed software in order to remain relevant, and even survive as a business. However, software integration is incredibly hard, and most of the challenges are not foreseeable until the integration happens. Ultimately, these opposing forces are what makes the M&A scene in software so intriguing, because it must keep going, but more often than not shareholder value is decremented rather than incremented.

In this article, we’ll explore the key factors influencing software M&A and examine why many of these deals struggle to succeed.

Pre M&A

Target Profile: Available Companies at Reasonable Prices

One of the biggest challenges in large-scale software M&A is that the available target companies are often not the highest-quality; they come with inherent limitations:

Top software companies are rarely for sale

The leading software and tech companies, often led by their founders, are typically unwilling to sell, at any price. Founders frequently view these companies as extensions of their own lives and have little incentive to exit. For example, when Mark Zuckerberg declined Microsoft's bid for Facebook for $15bn in 2007, when the social media network was only generating about $150m in revenue. When a founder does express interest in selling, it’s crucial for acquirers to assess whether the founder’s intentions are genuine and not simply a strategic move to offload the company. A keen interest by the founder to stay with the merged entity to help it continue innovating, pursue the long-term vision, and ultimately grow sales, is a key factor for evaluating the success of the M&A. Complexities arise, however, when the acquiring firm holds a starkly different vision to the acquired founder.

Premiums for positive cash flow but little growth is risky

Often an acquirer seeks a target with an established customer base, consistent revenue, and positive margins and cash flow. Such software companies have already passed their peak growth phase, are mature, and hence are valued in the multi-billion dollar range. Much of the high-growth, value-creation phase is behind them, meaning they’re now in a period of lower returns. This makes it challenging for acquirers to justify paying a premium that can be recouped. The problem, however, is that oftentimes the premium is paid anyway due to various stakeholder pressures and a poor understanding of the integration challenges, thus putting the M&A on an immediate back foot in regards to the ROI.

Premiums for high growth but unproven profitability is also risky

Young software targets are usually generating high growth but deeply negative margins and cash flow as a result of spending heavily on S&M to capture their market before the competition. However, unless the target can develop a moat and suppress the competition, S&M expenses will remain very high, raising questions about the path to profitability.