Types of Corporate Development and Capital Allocation

This article outlines 10 corporate development capital allocation methods that I’ve witnessed while working in M&A banking and for tech companies. Additionally, I’ve listed 15 motivations for corporate (strategic buyer, not financial buyer) M&A activity. Authors such as Thorndike (The Outsiders) have demonstrated how capital allocation can be a major contributor to corporate growth, profitability, and stock price / valuation performance. Corporate development can also be an effective means for companies to stave off being disrupted. The article excludes discussion of R&D, marketing, pure organic growth, share repurchase, divestiture, dividend, and treasuries spending.

Organic Growth:

1. Corporate Capital:

· The company provides financing solutions for clients to purchase or lease its equipment.

· For example, Cisco Capital provides Finance Leases (effectively a loan agreement), Operating Leases (effectively a rental agreement), Sale and Leaseback, and other hardware and services financing.

2. Consumption Model:

· This helps customers to scale.

· The customer pays according to the resources used, thereby reducing the customer’s upfront Capex.

· This requires the company to take a capital risk on behalf of their customer by covering the Capex and assuming the risk that the assets will be utilized.

· Think of utilities e.g. water or electricity where you pay according to how much of the utility you use.

· This can take the form of I-aaS, P-aaS shared across customers, or sometimes even underwritten projects for single customers only.

3. Pilot Project Funding:

· A company sets aside capital that is used to pay for pilot and proof of concept projects where customers may not have access to significant capital or there is too much risk of an untested project for a private equity investor to invest.

· The company pays for the pilot project itself or provides very favorable financing terms (rather than requiring the customer to pay for it), whether or not it will be profitable or even break-even, with the intention of validating a concept that will lead to significant future projects and revenue.

· For example, a company like Cisco may have developed a new smart city connectivity technology or use-case but there may not be any customers willing to take the risk of building the monetizable project pilot. Therefore, a company like Cisco may fund the pilot itself to show customers that it can be viable on a larger scale.

4. Joint Ventures:

· Companies work together to launch a new project (through a special purpose vehicle) or company (external entity) and each contribute different aspects to the new venture with the understanding that it will drive new business for each party.

· For example, Cisco worked with Telenor Group to launch Working Group 2 (WG2), with Cisco providing the hardware and architecture upon which the WG2 solution was built and both parties combining resources to help with go to market and sales efforts. Each company may choose to fund the new entity depending on the ownership stake they desire, or even use a private equity partner to fund the new entity.

5. (Partnership) Warrants:

· Company X requests warrants in Company Y (usually in addition to some form of upfront investment) as a condition of a partnership that will boost Company Y’s business. Warrants will give Company X the right but not the obligation to buy shares in Company Y at a certain price, quantity, and future time. Thereby, Company X reduces the downside risk of a potential investment in Company Y. For example, imagine a big company like Walmart wants to launch its online store in a new geographical market like Mexico. Walmart might choose a local delivery partner and request warrants in that partner; Walmart will only exercise these warrants (and invest in the delivery partner) if that market launch and partner demonstrates success. Another example could be if a company like UPS makes a venture capital investment using a hybrid equity and warrant structure in a startup developing electric delivery trucks, while also placing a large order for trucks once they are production ready.

Inorganic Growth:

6. Corporate Venture Capital Backing:

· Motivations for this include tracking the venture funds’ investments to stay abreast of industry trends.

· For example, Cisco might directly invest in Venture Capital funds.

7. Corporate Venture Capital Investing:

· Motivations for this include tracking industry trends, identifying companies for full acquisition, identifying competitors, and developing an ecosystem of players developing technologies that will help the company’s sales.

· For example, Cisco has its own Venture Capital unit that invests in early stage companies developing products adjacent to Cisco products.

8. Corporate Private Equity Partner:

· A company invests in a private equity fund and the two entities partner through a strategic collaboration agreement to drive sales through growth equity, joint venture, project / infrastructure, or revenue share agreements.

· For example, Cisco set up its Global Infrastructure Funds team to support its investment in and agreement with Digital Alpha Advisors. The private equity fund receives preferred access to Cisco’s pipeline of commercial opportunities requiring equity financing (growth equity and joint venture), where Cisco will not invest directly due to regulatory, competitive/customer, or financial reporting reasons.

9. Public Market Investments when Capital Cannot Be Repaid to Shareholders:

· Companies such as insurance companies and banks may have to keep a sort of “float”. A float is money that they hold but don’t own, but which they invest in the interim until they pay out.

10. Mergers and Acquisitions (*Mostly Acquisitions):

I. Adjacent Technology / Product / Company

· Leverage existing sales network or complementary customer base, thereby accelerating market access for the target’s products.

· For example, Facebook acquired Instagram (a company with a similar user base and use-case) and leveraged its digital advertising expertise to improve the company’s revenue generation effectiveness.

· Another example is a big pharmaceutical company leveraging its existing salesforce after acquiring a small pharmaceutical company that is having difficulty reaching the entire potential market for an innovative product.

· In mature industries excessive Corporate Development / acquisitions could be a sign of underperforming Corporate Strategy and R&D teams not identifying industry trends, threats, and areas for growth.

II. Strengthen Product Offering

· For example, Cisco’s acquisition of MindMeld to strengthen Cisco’s Spark Teleconferencing solution

· Other examples include, Amazon’s acquisition of Do.com for Amazon’s Chime offering and Apple’s acquisition of Siri to enhance iPhones.

III. Substitute Technology / Product (company)

· Acquire disrupting force.

· For example, Blockbuster could have acquired Netflix in 2000; on-demand video, traditional cable tv and other media were disrupted by Netflix.

IV. Company / Technology that Provides an Internal Solution

· For example, Amazon’s acquisition of Biba Systems was then used to provide the teleconferencing and messaging system that Amazon uses internally as well as sells under the brand name of “Chime”.

V. Vertical Integration

· When a company acquires another company within the same market vertical to assume control of other steps, either production or distribution, in the creation (supply chain) of its product or service.

· Can be forward or backward integration.

· Some advantages can be reducing costs and improving efficiencies, but disadvantages can included reducing economies of scale that a specialized vendor may have.

· For example, Tesla acquired a supplier of automated equipment called Perbix.

VI. Acquire Talent / Acqui-hire

· For example, Amazon’s acqui-hire of Biba Systems and conversion of it into Amazon’s Chime.

VII. Diversify Revenue

· This is more likely to succeed when the acquired company is left to operate independently of the acquirer (see this article on spinoffs for why) otherwise there is risk that the acquirer’s bureaucracy will stifle the acquired company’s growth.

· For example, Advance Publications acquires 1010Data (in this example Advance Publications functions like a family office).

VIII. Improved Price Realization

· Acquire adjacent product (company) in industry with high barriers to entry in order to increase price.

· This is common in highly regulated industries such as pharmaceutical and airplane manufacturing.

· For example, Transdigm acquires airplane parts manufacturers and increases the prices because it knows that each airplane part requires extensive regulatory approval.

· Another example is Valeant, Turing, Retrophin, Rodelis, and Marathon pharmaceuticals increasing the price of lifesaving drugs.

IX. Expand Geographic Footprint

· Speed of expansion can be especially important when there is a “land grab” for an immature market.

· For example, Compass the real estate startup acquiring real estate agents in new geographies rather than building out new offices in those locations to increase the speed of expansion. Compass is effectively a real-estate agent roll-up strategy with a common tech platform.

· May be important to think about an asset versus a stock purchase in this case.

X. Increase Reach of Salesforce

XI. Economies of Scale

· Large companies may already be operating at scale and combining them may not lower unit costs

XII. Improve Performance of Target Company

· A favored strategy of private equity firms, more so than strategic acquirers

· Costs, margins, cash flow, revenue

XIII. Consolidate Market

· The fewer players in a market, the more pricing and purchasing power the players have.

· The success of a market consolidation strategy to achieve pricing power is generally relatively ineffectual unless the number of players is reduced to around 4.

· ‘Consolidate to remove excess capacity from industry’. If revenue growth and revenue driven returns on investment are difficult to achieve, then investors may seek returns through operational improvements and cost reductions (synergies) that increase profitability (reducing back-office tasks or economies of scale etc.) and leading to margin improvement.

XIV. Buy Cheap

· Buy at a price below intrinsic value, although the opportunity for this is relatively rare

· In cyclical industries, assets are often undervalued at the bottom of a cycle

XV. Private Equity Backed or Non-Private Equity Backed Platform / Roll-up Strategy

· Multiple Arbitrage i.e. smaller bolt-on acquisitions acquired for lower multiples than the exit multiple of the platform company (especially if the multiples are a function of scale).

· Growth Narrative i.e. when organic growth is hard to achieve, inorganic growth (revenue growth through acquisitions) can still provide a growth narrative that is valuable at exit.

· Improved Performance leads to better multiples on better margins.

Please let me know in the comments if I’ve left out any key types of corporate development activity or made any mistakes.

Thank you for reading and I hope this summary has been helpful to you,

-Alex