Explaining M&A through the lens of Income Statement v Balance Sheet.

Two very different recent acquisitions. ServiceNow and Moveworks. Deel and the global payroll business of Safeguard.

I’ve seen a bunch of M&A deals over the years. I covered several while at Gartner, lived through the post merger acquisition experience at SAP SuccessFactors, was on the board of Immedis when it was acquired by UKG, I have advised several founders and CEOs through the acquisition process, and I even know investment bankers that I consider to be friends.

I am by no means an M&A valuation expert, so my explanation here is going to be rudimentary, but hopefully useful to non-financial types. Having the HR tech person (me) dabble in finance is a bit like having the finance person discuss personality assessment methods but let’s give it a go.

A wickedly clever and erudite equity analyst once described acquisitions to me as being either an income statement or a balance sheet play. I nodded, and then wondered what on earth he meant. I asked him to explain. Luckily he was patient. I hope I do his explanation justice here.

Remember:

A balance sheet is the record of a company’s assets and liabilities at specific point in time.

An income statement summarizes a company's revenues, costs, and expenses over a specific period.

A balance sheet acquisition is primarily adding an asset.

For instance, a large software company acquires a start-up that fills a gap in their product portfolio. The acquirer hopes that they can scale sales of the new product through their larger salesforce, or/and that the technology will improve their competitiveness. They may also be eager to hold on to the team that built the (asset) product. At the time of acquisition the start-up is likely have a higher revenue multiple than the acquirer. Financial people call this sort of acquisition dilutive of earnings. It reduces the earnings per share of the combined entity in the short term, but the expectation over time the new asset will generate significantly more revenue (perhaps at lower cost) that it did prior to acquisition, thus justifying the acquisition.

An income statement acquisition is primarily about adding revenue.

For instance, a highly valued scale up with a high revenue multiple acquires an incumbent vendor with steady revenues and a large number of customers. Because the incumbent is growing more slowly that the scale-up, its revenue multiple is likely to be significantly lower, even if it were profitable.

The acquirer believes it can move those customers off the old product onto their new product. The theory is that it will be easier, quicker and cheaper to convert those customers en masse than it would have been to compete and win them one by one.

This sort of deal is usually accretive because acquirer is essentially buying revenue at a cheaper price than the market values its own revenue. This typically has a positive effect on the acquiring company's financial ratios and can increase shareholder value.

The divide isn’t binary, but in almost all acquisitions there is a dominant element.

ServiceNow acquiring Moveworks is an example of a balance sheet acquisition.

The moveworks’ revenue is not really material for ServiceNow, but the product will significantly strengthen their AI Agent capabilities, a hot space these days.

Given the size of the ServiceNow customer base, its sales machine, and its track-record of similar tuck in acquisitions, ServiceNow will be confident that it can sell significantly more of the software than Moveworks could have done stand-alone, and that there will be engineering synergies with the other elements of the solution.

ServiceNow’s relatively high revenue multiple and cash pile gives it lots of acquisition firepower. ServiceNow acquiring solutions like Moveworks is an astute use of a relatively small chunk of that cash. The stock market reacted favourably to the announcement. ServiceNow has done many smaller acquisitions, and while this one is their biggest to date, ServiceNow has a slick PMI playbook and rock solid execution. I expect ServiceNow to do more acquisitions of this scale as it seeks to broaden its product footprint. There is space in the sales kitbag for more.

Derek Du Preez from Diginomica has a useful analysis here.

(I’ve not looked at the details of Moveworks offering).

Deel acquiring the payroll business of Safeguard is an example of an income statement acquisition.

(I’ve not spoken to Deel, and I’m just going off what I’ve read).

Deel has an extremely strong revenue multiple, given its rapid growth, and robust fundraising. It has been building a modern HR tech stack while making 11 (I think) acquistions.

Safeguard has a long standing payroll business, with many customers in a segment that Deel would dearly like to have a stronger position. While safeguard obviously has working payroll technologies, Deel aren’t buying this for the product, I don’t think a whole lot of product IP is in the deal. They are buying customers with the hope that they can move them expediently onto the Deel stack over time. This is the third significant payroll acquisition that Deel has made, Paygroup asia and Payspace.

We can assume given Deel’s recent secondary round it has a valuation of at least 12 Billion US$, and it stated recently that it had 800m US$ in revenue, so this means a revenue multiple at least 15. I don’t have sight of the Safeguard numbers, but I expect it will reflect those of a payroll services business, in the mid/low single digits (ADP’s is around 5 I think). So on the accounting side of things, this deal is highly accretive. Deel is essentially buying revenue at a cheaper price than the market values its own revenue. This typically has a positive effect on the acquiring company's financial ratios and can increase shareholder value.

Many financial analysts pundits predict that Deel will IPO soonish, so adding revenue now, through acquisition is a smart move. Not all revenue has the same quality or gross margin, so Deel will need to show how it is genuinely converting old school BPO into modern SaaS.

I’m of course oversimplifying this a bit. There are balance sheet elements in the deal that Deel will value. Safeguard has decades of supporting and selling to some of the most demanding payroll customers in the world, there will be some technology gems in amongst the safeguard’s ageing stack, and there are upsell synergies too, positioning Deel’s other capabilities to Safeguard users. It also elevates Deel’s relationship with Workday, as Safeguard is a significant Workday partner.

I’ve no deep insight into Deel’s tech-stack, and how they are managing the integrations, migrations and decommissioning. I’ve lived through this at SAP SuccessFactors, so I have some sense of the challenge. I’m watching this one with interest. The Deel playbook reminds me a lot of pre-ipo SuccessFactors.

Do have a look/listen at Pete and Julie’s take, they go into a lot more details than I do,

I’m not going to get in the challenges of post merger integration today. I’ve written before about the impact of acquisitions on customers of both the acquired and acquiring company. You may find it useful. I’d advise anyone interested in PMI to read this book. Tim Galpin knows more about M&A than anyone I know, and he has done a great job of taking that knowledge and making it accessible.

(Disclosure: ServiceNow Ventures is an LP in Acadian Ventures Fund II, and a co-investor in 2 portfolio companies).

As usual we need to finish with a tune or two. This was massive in my youth. I’m not quite sure what to make of the video, let’s simply say it was of its time. The tune is a banger. The photo of the mixing desk is a reminder that I ought get podcasting again at some point.

For those looking for something a little more highbrow. Mozart’s Sonata for two pianos. Barenboim and Argerich.