M&A activity is starting to show signs of a real recovery in 2004 due to a number of factors and will likely be the primary means of funding new initiatives as well as providing an exit strategy.

James Montgomery

Three key factors will drive a surge in emerging growth M&A activity in 2004: (1) macro-level M&A trends; (2) continued weak initial public offering (IPO) market conditions through 2004; and (3) micro-level consolidation drivers within the technology sector.

Factor 1: At a macro level, M&A activity is expected to rebound in 2004 as the equity markets continue to rally and/or stabilize. With Nasdaq showing gains of approximately 40 percent in 2003, many technology and life sciences stocks have returned to share price levels unseen since 2001.

As the economy improves, potential acquirers are growing increasingly comfortable with making strategic acquisitions. With investor confidence rebounding and companies posting improved earnings and share prices, both strategic and financial acquirers are becoming more aggressive M&A players. In addition, the expected growth in information technology (IT) spending makes many technology companies more financially attractive as acquisition candidates.

Recent data demonstrates that the technology M&A market may have bottomed out in the first quarter of this year, when only 588 technology deals were announced at a median deal value of $12.3 million. By comparison, during 2001 and 2002, the number of deals per quarter fluctuated between 600 and 900, with a median transaction value between $13 million to $18 million. M&A activity has risen gradually and fourth-quarter 2003 looks promising, with the number of deals expected to reach 2002 levels and the median deal value expected to be over $25 million.

The recent rise in share prices across broad segments of technology may also have a salutary effect. Companies that have seen a run-up in share price will take advantage of aggressively pursuing strategic companies in first-quarter 2004. Accordingly, we expect a 50 percent increase in M&A activity during 2004. When stock prices appear stable to potential acquirers, they will begin purchasing companies to meet their internal growth objectives. By analogy, this would be akin to pharmaceutical companies acquiring drug pipelines or technology companies buying key products or intellectual property.

Factor 2: The IPO market is not expected to fully recover until 2005. In the early 1990s, the exit mechanism of private companies was evenly split between M&A and IPO events. During the first nine months of 2003, M&A transactions represented 98 percent of all private company exits. The number of technology IPOs priced has fallen from 406 in 1999 to 12 in 2003. Our firm believes the IPO market bottomed out and a gradual increase in the percentage of IPO exits is expected, ultimately moving toward our long-term estimate of a 3:1 split of M&A to IPO exits. However, in the near-term, we believe most private technology companies have a limited IPO opportunity, thus driving M&A as their most likely exit.

Factor 3: The "tech bubble" of the late 1990s drove rapid company formation, which ultimately had two major implications: (1) the economic downturn that began in late 2000 led to severe reductions in headcount and R&D spending at many technology firms; and (2) the technology market became extremely fragmented. As the technology market matured after the "tech bubble," corporate IT managers began to demand fewer vendors with a broader suite of offerings.

It's also likely that large technology players seeking to fill empty spaces in their existing suite of offerings will become very active in the near term. Acquisitive companies are looking for good technology/R&D and strong management/employee teams that can be acquired at opportunistic valuations. It is often quicker and more effective for technology firms to acquire companies with key technology/employees than rehire employees and/or develop expertise in-house. The current wave of consolidation has encompassed several subsectors of technology, including security software, enterprise resource planning, enterprise application integration, content management, online services, portal software and semiconductors.

Historical data show that, in a consolidating sector, it is important for companies to factor exit timing in making M&A decisions. Our recent study of portal software, security software and semiconductor markets concluded that in a consolidating market, the first companies to exit tend to receive the highest multiples, while those who exit later receive lower valuations. This game of musical chairs implies that an early exit is optimal -- even for the strongest company. It also implies that public markets are irrational when a take-over (e.g., Yahoo!'s acquisition of Overture earlier this year) drives up the value of the entire sector.

Our view is that an optimal exit timing strategy must properly combine an understanding of macro-factors (i.e., M&A and IPO markets) with micro-factors (i.e., predicted consolidation activity within a sector). Firms that are able to identify both macro- and micro-market movements successfully will gain the best exit.

Montgomery is founder and CEO of Montgomery & Co. LLC, a West Coast-based investment bank serving emerging growth companies. Montgomery & Co. currently employs 23 technology and life sciences investment banking professionals and has headquarters in Santa Monica, offices in San Francisco and Seattle, and recently opened an office in Del Mar. Visit www.monty.com for more information.