"Emerging tech" and why it is different ISCWT CDWEB

A distinct market

In contrast to traditional M&A markets – dominated by sectoral consolidation, roll-ups and bolt-on activity – emerging tech investment is highly diversified. Specialist technology funds and “big tech” do play a central role, but they are far from alone. The value of emerging technology lies in its (potential) application; companies and funds across every sector in which new solutions have the potential to be applied (frequently with a disruptive impact) increasingly see it as an M&A focus.

The result is that there is often a wide range of potential investors in an emerging tech opportunity and those investors frequently have quite different perspectives on, experience of, and approaches to emerging tech M&A. This can make the process less consistent, more complex and more unpredictable for both buyers and seller.

For any potential investor, it is essential to see the bigger picture – what approach are other potential buyers likely to take and how might this impact your competitive position? For companies seeking to raise funds or existing owners looking to exit, an understanding of how potential investors are likely to look at the situation is the secret to unlocking the maximum value.

In this series, we seek to demystify some of those perspectives to provide a roadmap for everyone approaching the legal aspects of Tech M&A.

What is “emerging tech”?

“Emerging tech” is a broad concept covering areas as diverse as AI, robotics, biotechnology, blockchain and quantum computing. Although these technologies have important differences, they also have two critical common characteristics:

• The technology is rapidly developing. As a result, it does not have a long established operational or commercial track record. Indeed, by the time the transaction has closed the technology may, in some cases, have moved on significantly from the start of the deal process; and
• Applications of the technology and the markets in which it will generate income are at an early stage of development. In some cases, the technology may not yet have any significant market at all. In others, the success of the technology may depend on it successfully disrupting existing business models.

Practical implications for M&A

These characteristics have fundamental implications for the M&A process.

Valuation and pricing

Emerging tech businesses may not have a proven commercial model or even a settled product roadmap; they may not even have any revenue. The target’s most valuable assets may be intangible and difficult to price, such as proprietary algorithms, data sets, user networks and developer talent. And often the market is as uncertain as the technology itself: one change in regulation, one tariff increase, or one competing new platform, could be enough to materially alter growth trajectories – as we have seen with the impact of transformative AI solutions on the valuation of a range of tech businesses.

In many cases, revenue, cash flow and comparable transactions may not be a helpful guide to a value proposition which lies far more in future potential.

The range of potential investors in emerging tech can be a further complication, with potentially three fundamentally different ways to look at valuation: (1) a financial sponsor is likely to be focused on the business’s future revenue streams; (2) the value to some potential corporate investors may lie in integrating the technology into their underlying business and the potential competitive advantage that will bring them; and (3) others may be looking at the potential threat the technology poses.

The variety of ways of looking at valuation from the buy-side only accentuates the significant potential for mismatch with the seller’s expectations, and the challenge of bridging likely gaps between seller’s aspirations and buyer’s caution.

Contingent consideration mechanisms, such as earnouts or milestone-based payments, provide an option to close any perceived value gap whilst providing protection to the buyer if the business does not perform as expected. These mechanisms are very often complex, even for a business whose parameters are clear and which is expected to remain independent. With emerging tech, the future shape (and even independence) of the business is much more likely to be uncertain – significantly increasing that complexity.

Diligence and deal terms

The function of due diligence in any investment process is to test the buyer’s expectations of the business whilst identifying business risks and supporting mitigation of those risks.

Designing a diligence process which is adequate and also focused and efficient is an important element of a successful M&A investment strategy; particularly when participating in a process (where speed is likely to be of the essence) and/or working with M&A risk insurers.

This places a premium on focusing clearly from the outset on the key risk and value items in the deal. For any business the most fundamental questions are likely to be:

• Will it have access to the assets, people and data it needs to operate and grow as planned?
• Are its financial results present a fair reflection of its past and potential performance or are there factors, such flawed contracts or potential liabilities, which could bring that into question?
• Could anything stop it carrying on its business as planned in the future?

Legal, financial and technical due diligence aim to test these questions from various perspectives.

The characteristics of emerging tech cast a very different light over the diligence process from that involving more established targets:

• Firstly, because the value drivers within the business are likely to be focused on a relatively small scope: key intellectual property and data, key individuals and only a small number of contracts which are critical to the business.
• Secondly, the track-record of the business in proactive risk management and compliance and the prospects for changing future regulatory risks (and opportunities), is likely to be disproportionately important.

An early-stage assessment - to distinguish the wood from the trees in designing both the diligence process and the contractual terms (such as warranties, representations and indemnities) attached to them – is critical. In practical terms this means analysing some core questions:

• Will the technology work for the use cases promised?
• Is there something better on the horizon that will supersede this technology?
• How much will it cost to build, operate and sell?
• Will new regulations emerge?
• Will public perception and consumer attitudes favour this technology?

As with valuation, different emerging tech investors are likely to have quite different perspectives on diligence. Financial sponsors looking to develop the business on a self-standing basis may benefit from a particularly narrow point of view.

Other investors, who are looking to integrate the technology into their own businesses or, perhaps, combine it with other prospective acquisitions, will ask a much wider range of questions concerning the constraints – both technological and rights based – on interoperability and integration. Their commercial assessment – whether investment is the optimal solution or licensing of similar technologies offers a viable alternative way forward – is also likely to take a different view to that of pure equity investors.

For those seeking the investment, this diversity of perspectives offers its own challenges – not simply to tell the business and financial story in a way which speaks most powerfully to multiple audiences, but also to organise the diligence process in a way that anticipates and addresses the most likely questions and challenges from each of those audiences.

Speed

Emerging tech transactions are typically fast paced. There are a number of reasons for this:

• the transaction is frequently driven by the demands of emerging tech for investment
• speed of development means the profile of the assets, and the competitive environment (including the potential emergence of transformative alternatives) can change during the course of an extended process
• for the reasons described above, the role of diligence in driving valuation decisions is typically limited meaning valuations based on commercial judgement predominate

This is an environment which is “ordinary course” for emerging tech funds. By contrast, large corporates often have well-entrenched systems and controls with multi-layered sign-off processes designed to analyse and control risk. These very often conflict with the essence of the emerging tech transaction – taking a risk on the future.

For these corporate buyers, one driver of success or failure in the emerging tech market is frequently their ability to “think differently” – often using external advisors to challenge an “established way of thinking” and to avoid almost inevitable alternative fate of “missing out” on an opportunity as a result of bureaucratic processes or hesitation at the critical moment.

Those seeking investment equally need to consider carefully the balance between speed and value maximisation. In an auction process, a specialised financial investor will almost always move more quickly than an experienced corporate. With this in mind, creating the strongest overall competitive environment requires mindful preparation to ensure that the concerns of more “complex”, but potentially more lucrative, investors are addressed at an early stage.