Technology M&A, Cash Flow, And The Middle Market

Hot technology companies were once synonymous with pre-cash flow, intellectual property (“IP”), revenue multiples, venture capital, and strategic buyers. With the maturation of the technology sector broadly, one now needs to think of EBITDA growth, recurring revenue, cash-flow multiples, bank debt, and both strategic and private equity buyers.

Successful technology startups from years past that today generate positive cash flow can proudly say they are members of the middle market, and because of that they are facing an M&A market ready to reward them for both growth potential and current cash flow.

In 2005, there were 371 middle-market technology transactions involving North American companies, equaling 15% of all transactions between $25 million and $500 million in value. Mature technology companies are starting to recognize that the M&A window of opportunity is wide open. So far in 2006, we have already seen 220 middle market technology transactions representing $28.3 billion in transaction value, a 1.9% increase in deal volume and an 8% increase in transaction value from the same period a year ago. While there have been concerns about decreased M&A activity among “large cap” technology companies, M&A in the middle market remains robust.

Several factors are contributing to the renewed vigor in middle-market technology M&A. For one, cash flow is king. Successful technology startups that survived the bursting of the 1990’s tech bubble have evolved into profitable middle-market enterprises. As such, traditional middle-market valuation metrics such as cash-flow multiples are now relevant. The cash flow generated by these companies has inspired the current wave of consolidation of mid-market technology companies by larger strategic buyers. Cash flow generation has also made these companies candidates for leveraged buyouts, resulting in a significant increase of private equity investment in technology sectors previously dominated by venture capitalists.

Another factor playing a role is a growing appetite from strategic buyers who themselves need to find avenues toward growth, and are turning to the M&A market to do so. Strategic industry participants have reentered the market aggressively and are making acquisitions to gain critical mass within their core businesses. The larger companies have rebuilt their internal M&A teams and are actively courting the market for opportunities. The first difference from the last up-cycle is that these companies, while willing to pay a premium to gain control of a relevant target, are much more disciplined about not making acquisitions outside their core businesses. The second difference is that when they do want a targeted company, they are now much more likely to be competing not only with other strategics but also with well funded private equity groups, which leads to another factor contributing to the sector’s percolating M&A market.

In the financial community, technology investments have become mainstream and are no longer simply the domain of a handful of specialized funds. This is demonstrated both by the significant portion of private equity players active in technology deals and the expanding number of “crossover funds” that formerly were exclusively focused on earlier stage investments but now have broadened their mandates to include technology buyouts. With private equity investors both aggressively pursuing new technology investment opportunities and bringing their existing technology portfolio companies to market, technology and technology-driven companies have grown to represent well over 20% of all private equity portfolios.

The increased participation of private equity groups is a function of both demand for higher yielding investment opportunities and the supply of capital that’s available to invest. As of the year-end 2005, approximately $180 billion in un-invested private equity capital conservatively represented around $500 billion in buying power, and 2006 is on track to be a record year private equity fundraising. Furthermore, maturing investments are at an all time high representing a market that is even larger than it might appear since these maturing investments have experienced significant capital appreciation.

As middle market companies in those sectors have begun to generate significant cash flow, debt providers have become increasingly comfortable with tech sectors they had avoided only a few years ago. The continued availability of credit further fuels M&A activity and the competitiveness of financial buyers. Today, buyers of quality middle market technology companies with strong EBITDA growth are consistently able to raise total debt of between 5x and 6.0x LTM EBITDA.

Another factor, and no less significant, is the lackluster performance of the IPO market. With only 21 technology IPOs with offering amounts in excess of $25 million so far in 2006 and half of them trading below their original offering price, an IPO is currently not a likely liquidity event for most middle market companies. Domestically, the regulations, reporting requirements, and costs of the Sarbanes-Oxley Act make a listing less attractive and, while the AIM market in the U.K. is much discussed, it also has limited trading volumes and limited equity analyst coverage for listed “small cap” middle market companies.

Everything Old Is New Again

Even more traditional private equity investors are participating in this market by helping old technology companies retool their solutions for current market needs. For example, Broadcast Electronics, which Thompson Street sold to Audax Group for over $100 million earlier this year, has long been a leader in analog broadcast hardware and software, but its investment in digital HD broadcast solutions has made it the clear technology leader. At about the same time, 3i Group sold its German portfolio company, Knürr AG, to Emerson for $98 million because management had expanded beyond its traditional rack and power supply platform to deliver the market leading cooling solution for new blade server architecture. The application of newer technologies to “old tech” is clearly one of the investment theses of private equity investors looking to uncover hidden value.

Software & Services Accelerating

Fixed cost structures and strong revenue growth has resulted in strong cash flow for successful software and related services companies, which represent a significant amount of the current deal activity. The migration to outsourced ASP business models from shrink-wrapped or other stand-alone software platforms has simultaneously driven margins and provided enhanced functionality. DMG Information purchased Genscape for more than $130 million earlier this year because they believed they could leverage the proprietary energy information channel and analytical tools that the company had built. Insight Venture Partners and Lightyear Capital recently purchased Realm Business Solutions, Inc., which has the market leading real estate valuation tool, in part because they thought they could accelerate the migration to an ASP model and greater functionality. The venture capital thesis that many of these IP-based business models would eventually generate gobs of cash is now being proved out.

International Opportunity Growth

Global “flattening” is also driving mid-market M&A activity in the technology sector. International competitiveness and acquisition activity is no longer the domain of just the multinationals; successful middle-market companies recognize they need to be globally competitive as well. Private equity groups are looking to China, India, and elsewhere for outsourced manufacturing, services, and software. Globally, there were 499 middle-market technology transactions in 2005, 60 of which were cross-border transactions with North American acquirers. More than 60% of these transactions involved a North American company acquiring a European target. But, the deal flow is not all being derived from the U.S.; there has also been a substantial increase in cross-border deals by overseas acquirers such as the recent acquisition of AIM-listed INCAT Plc by the Indian company Tata Technologies, Inc. The middle market has evolved to the point where financial and strategic buyers are looking globally for technology companies that can provide solutions for a flattened world.


It is no longer an oxymoron to make a reference to a “middle market technology company.” These companies have become solid value creators and attractive investment opportunities with their cash flow and profitability becoming more predictable and their growth trends remaining strong.

It is expected that the positive trend in middle market technology transaction deal flow will continue until impacted by changes in the larger economic cycle. As long as the private equity community has a significant amount of available capital to put to work, they will look to invest their capital in the kind of positive cash flow, strong growth opportunities that these middle-market technology companies represent.

Jeffery M. Bistrong, Managing Director of Harris Williams & Co., heads up the firm’s technology group from Boston. Harris Williams & Co., a member of The PNC Financial Services Group, Inc. (NYSE:PNC),a mergers and acquisitions advisory firm focused exclusively on the middle market. Member NASD/SIPC.