“Emerging Technology” and Why It’s Different

A separate market

In contrast to traditional M&A markets – which are dominated by sectoral consolidation, roll-ups and bolt-on activity – emerging technology 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 in every sector in which new solutions have the potential to be applied (often with a disruptive impact) increasingly see this as an M&A focus.

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

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 affect your competitive position? For companies looking to raise funds or existing owners looking to exit, understanding how potential investors are likely to view the situation is the secret to unlocking maximum value.

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

What is “emerging technology”?

“Emerging technology” is a broad concept that covers areas as diverse as AI, robotics, biotechnology, blockchain and quantum computing. While these technologies have important differences, they also share two critical commonalities:

The technology is developing rapidly. As a result, it does not have a long established operating or commercial track record. Indeed, by the time the deal has closed, in some cases the technology may have moved on significantly from the start of the deal process; and Applications of the technology and the markets in which it will generate revenue are in 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 technology companies may not have a proven commercial model or even a solid product roadmap; they may not even have any income. 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 rate hike, or one competitive new platform can be enough to materially alter growth trajectories – as we’ve seen with the impact of transformative AI solutions on the valuation of a range of technology businesses.

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

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

The variety of ways to look at valuation from the buy side only highlights the significant potential for mismatch with the seller’s expectations, and the challenge of bridging likely gaps between seller’s aspirations and buyer’s wariness.

Contingent counter-performance mechanisms, such as earnings or milestone-based payments, provide an option to close any perceived value gap, while 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 technology, the future shape (and even independence) of the business is much more likely to be uncertain – greatly increasing the complexity.

Accuracy and transaction terms

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

Designing a due diligence process that is adequate as well as focused and efficient is an important element of a successful M&A investment strategy; especially when participating in a process (where speed is likely to be of the essence) and/or working with M&A risk underwriters.

This places a premium on clearly focusing on the key risk and value items in the deal from the start. For any business, the most fundamental questions are probably:

Will it have access to the assets, people and data it needs to operate and grow as planned? Are its financial results a fair reflection of its past and potential performance or are there factors, such as defective contracts or potential liabilities, that may call this into question? Can anything stop him from continuing his business as planned in the future?

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

The characteristics of emerging technology cast a very different light on the due diligence process than that involving more established targets:

First, 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 that are critical to the business. Second, the track record of the business in proactive risk management and compliance and the prospects for changing future regulatory risks (and opportunities) are unlikely to be important.

An early-stage evaluation—separating the wood from the trees in the design of both the due diligence process and the contractual terms (such as warranties, representations and disclaimers) attached to it—is critical. In practical terms, this means analyzing a few key questions:

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

As with valuation, different emerging technology investors are likely to have very different perspectives on diligence. Financial sponsors who want to develop the business on a stand-alone basis can benefit from a particularly narrow point of view.

Other investors 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 about the limitations – both technological and rights-based – on interoperability and integration. Their commercial assessment – ​​whether investment is the optimal solution or licensing similar technology offers a viable alternative way forward – is also likely to take a different view than that of pure equity investors.

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

Speed

Emerging technology deals are typically fast. There are a number of reasons for this:

the transaction is often driven by the demands of emerging technology for investment speed of development means the profile of the assets, and the competitive environment (including the potential emergence of transformative alternatives) may change during the course of an extensive process for the reasons described above, the role of due diligence in driving valuation decisions is typically limited meaning valuations based on commercial judgment

This is an environment that is “par for the course” for emerging technology funds. In contrast, large enterprises often have well-entrenched systems and controls with multi-layered sign-off processes designed to analyze and control risk. This very often conflicts with the essence of the emerging technology business – taking a risk on the future.

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

Likewise, those seeking investment should carefully consider the balance between speed and value maximization. In an auction process, a specialized financial investor will almost always move faster than an experienced corporation. With this in mind, creating the strongest overall competitive environment requires thoughtful preparation to ensure that the concerns of more “complex”, but potentially more profitable, investors are addressed at an early stage.