It’s no secret — there has never been as much merger and acquisition activity in the human capital management technology segment as there is right now, today, at this minute. Even so, small strategic acquisitions continue to be overlooked. Same as it ever was.
There is an unspoken rule that strategic buyers and private equity firms don’t look at companies under $10 million in annual revenue. Big-pocket category buyers tend to invest in larger acquisitions to increase market share, expand their solution footprint, infuse their company with talent, or make a big brand splash (among other reasons). Meanwhile, private equity firms tend to pass on smaller companies based on the perception that they are more risky. Search funds are an interesting exception to the rule — they tend to focus on smaller acquisitions, but rarely offer the seller a deal that keeps pace with the market’s higher valuations (especially during times like these).
So that’s the conventional wisdom on why smaller companies don’t get a look. But I have a different perspective. There are thousands of small software companies in the HCM technology segment. Thousands. Some are bootstrapped science experiments while others are modestly funded, profit-driven companies. The sheer volume of small HCM tech companies combined with other factors such as their geographic location and lack of brand exposure in the broad market means they are hard to find and research.
That’s the big picture — digging through the thousands of small HCM software companies out there to find a strategic fit is simply hard work. One has to take the time to listen to their story, separate the wheat from the chaff, and visualize the opportunity. Most strategic buyers and PE firms don’t have that kind of time, those kinds of resources, or the industry expertise. So much chaff, so little wheat.
Unfortunately for buyers and sellers (and the market), some of these small software companies offer the absolute best return on investment for strategic acquisitions. Here are a few opportunities offered by high-quality, smaller investments:
- Expand your feature set to create differentiation in your market segment (e.g., a mentoring solution adds differentiated value to your engagement solutions)
- Upgrade your brand with great technology while you pay off your technology debt in other areas (e.g., offer a great user experience for employee scheduling while you modernize your time-and-attendance solution)
- Infuse your company with fresh technology leadership (e.g., add a proven technology visionary to a struggling group in your company)
- Get more bang for your buck in terms of brand buzz (e.g., any acquisition with undisclosed terms is going to grab some headlines and create new opportunities for sales conversations)
The cream of the small-company crop is innovative and available. You just don’t know where they live and they can’t get past your gatekeepers. But it’s worth knocking on doors to find them. In addition to the opportunities above, here are some other advantages of smaller acquisitions:
- Clean cap tables mitigate risk of complex deals and uncooperative investors.
- Deal velocity is much faster with less due diligence required
- Technology is often not created in the same old tech bubbles, so you get something that’s actually different
- Overall risk is mitigated based on smaller size of the acquisition.
- You get tech built by makers rather than investors
So why do these smaller companies want to sell, anyway? I’m glad you asked. For the money. They want to sell for the money.
Most of the best HCM software companies below $10 million that I’ve seen were built to sell. The founders had an idea, built the software to prove their idea, sold a few million dollars’ worth to validate their idea, and are now, unfortunately, stuck with a good company that wants to grow. At this point, they have a few choices. They can hire a few people at a time and continue to grow a profitable software company. They can go out and raise some money with the goal to grow fast and sell. Or they can try to find a buyer now and maximize their return on investment.
The thing is, many of the folks with the best small software companies never intended to get into the business of running sales teams and marketing teams and finance teams and all that jazz. They just wanted to build a product that worked. The smart ones are wary of taking on a lot of funding since they already have a proven product and want to avoid the risks of managing a company with a more complex cap table only to be rewarded with diluted ownership while hoping for a long-shot blockbuster exit. But even though they are making a smart decision, they tend to underestimate what it takes to get on the radar of a strategic buyer.
So what is the upshot here?
If you are looking for a strategic acquisition to achieve any of the goals above, consider taking a dive in the deep end of the pool. Small tech acquisitions offer a lot of potential benefits (some of these deals are destiny-changing) with a much lower relative risk profile. But don’t expect to evaluate these companies based on standard financial metrics. That’s not this game, baby.
The Starr Conspiracy has been under the hood with more HCM software companies than any organization in the world. So we have the broadest and deepest view of the industry, bar none. If you’re looking for a gem in the ocean of small software companies, drop me a line. Between myself and the other 60 or so full-time team members at The Starr Conspiracy, chances are we know exactly who to put you in touch with. And we would be happy to share some specific stories with you about how small acquisitions have made a big difference.
This post originally appeared on LinkedIn, if you’re in to that sort of thing.
