Buy and scale: How incumbents can use M&A to grow new businesses

Buy and scale: How incumbents can use M&A to grow new businesses

By Matt Dallisson, 20/01/2023

In line with that goal, business leaders report that their companies are currently building 50 percent more new businesses per year than they did two to five years ago.2New-business building in 2022: Driving growth in volatile times,” McKinsey, November 14, 2022. But as effective as building new businesses through internal innovation and organic growth can be, it’s often not sufficient for companies pursuing ambitious growth agendas.3Choosing to grow: The leader’s blueprint,” McKinsey, July 7, 2022. Instead, these companies could take a lesson from digital disruptors and embark on a series of well-considered acquisitions.

Large companies are no strangers to the benefits of M&A, but their focus tends to be on acquiring one or two businesses to leverage economies of scale and capture cost synergies. Digital disruptors, however, acquire many more companies to accelerate their growth, a strategy that has proven successful. Companies that make, on average, more than five deals per year grow at double the rate of companies that only selectively pursue M&A. They also spend 38 percent less on each acquisition deal,4n = 1,000 companies, median-deal-size analysis over a ten-year period. allowing them to pursue a more programmatic approach: building a portfolio of companies that help them scale rather than going all out for one or two big targets.

One of the compelling advantages of this programmatic “buy and scale” approach to M&A is that it can succeed even under seemingly adverse conditions. According to our research, the businesses that perform best are those that defy conventional wisdom and embark on bold M&A moves regardless of economic downturns.5Jens Giersberg, Jan Krause, Jeff Rudnicki, and Andy West, “The power of through-cycle M&A,” McKinsey, April 30, 2020. And as valuations have come down from their lofty heights, costs per acquisition are coming down, too. Start-ups with great talent and intellectual property (IP) are more open to acquisitions again.6How start-ups can manage uncertain times: Insights from leading venture capitalists,” McKinsey, December 13, 2022.

How incumbents can make buy and scale work for them

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In our experience, successful buy-and-scale efforts have five things in common.

1. A broad range of M&A goals based on a clear strategy

Digital disruptors undertake acquisitions for four reasons, each dictated by clear strategic objectives.

2. Governance structures to manage a portfolio of start-ups

Companies following a buy-and-scale approach typically establish a growth management office (GMO), an agile, growth-focused version of the IMO (integration management office) often used to manage acquisitions. In McKinsey’s latest survey on new-business building, most of the respondents who met or exceeded their revenue goals had in place formal governance structures, realistic expectations for required investments, and timelines to profitability.8New-business building in 2022,” November 14, 2022.

A typical GMO has three main tasks:

Once an acquisition is under way, the GMO sets up a lean M&A squad team to manage it, typically consisting of the senior business leader who drove the deal plus two or three working members. To get the effort off to the best start, functional and business experts from the incumbent spend time at the target to gain a deep understanding of its structure, assets, and needs.

3. Incentives tied to clear KPIs

Aligning incentives across the incumbent and start-up is critical in creating transparency on expectations for the path ahead. Road maps with clearly defined milestones and deliverables—such as revenue or customer targets or completion of a product-development stage—provide a mechanism for releasing additional funds and triggering bonus payments. Employee motivation and retention can be boosted through a range of measures tied to organizational goals, such as stock ownership plans. This approach requires the incumbent to develop a set of standards on bonuses, stock ownership plans, incentives, and performance management, which will be invaluable in getting alignment with the board and creating a consistent framework for integrating future acquired start-ups.

When one European cleantech company acquired several small businesses, for example, it offered their founders and executives vested equity in the newly merged entity to motivate them to continue to push for growth under the new ownership.

4. Retention of the start-up’s entrepreneurial drive and culture

When the primary purpose of M&A is to grow a start-up, the acquirer must curb any tendency to overcontrol the target, instead taking steps to uphold the acquisition’s entrepreneurial drive and decisiveness. Among mergers that take this approach, 72 percent avoid the typical first-year revenue dip.9Brian Dinneen, Christine Johnson, and Alex Liu, “Post-close excellence in large-deal M&A,” McKinsey, June 29, 2021. They do so by ensuring that the start-up’s leaders retain full decision-making authority in recruiting, product development, and other key areas, such as keeping office locations separate and dedicating each employee to either the incumbent or the start-up, with no overlapping responsibilities.

Since the value lies in accelerating the startup’s growth momentum rather than capturing cost synergies, they don’t attempt to integrate complex systems. McKinsey research shows that growth businesses that are separated from the incumbent’s core IT, marketing, data, and analytics functions and processes are significantly more likely to exceed growth expectations than those that are not.102021 global report: The state of new-business building,” McKinsey, December 6, 2021. At a portfolio scale, this approach also simplifies integrations and allows the start-ups to move quickly. However, the incumbent will need to establish standards, such as APIs, so that start-ups can integrate with each other as needed. These standards can vary depending on the needed depth of integrations, and the incumbent will need to review them often to ensure that they have systems in place to support scale and mutual benefit for the acquired businesses.

This separation of functions can take many different forms. For instance, when a global car manufacturer acquired a Silicon Valley start-up, it stipulated that operational requests from the parent company must be routed via its CEO so that tech talent could stay focused on the job at hand and not be flooded with unnecessary daily challenges.

Cultural fit is critical to the success of an integration, according to 95 percent of executives in a McKinsey survey.11Oliver Engert, Becky Kaetzler, Kameron Kordestani, and Andy MacLean, “Organizational culture in mergers: Addressing the unseen forces,” McKinsey, March 26, 2019. Similarly, 25 percent of survey respondents cited a lack of cultural alignment as the primary reason for integration failure. Poor cultural cohesion can have a detrimental effect on retention rates, as Niklas Östberg, CEO of Delivery Hero, points out: “Younger companies often employ a young workforce who are quick to jump to the next company if they don’t like the new direction.”12Achieving M&A success by letting start-up acquisitions be themselves,” McKinsey, February 7, 2020. Our experience suggests that if a company has retained more than half of the new talent three years after an acquisition, that counts as a big success. To keep employees on board, incumbents need to show sensitivity and respect for cultural differences.

New-business building in 2022: Driving growth in volatile times

5. Start-up access to incumbent’s assets

In successful buy-and-scale efforts, incumbents deploy their own assets—sales force, customer base, brand, capital, scale, knowledge, and so on—to accelerate an acquisition’s growth. They don’t wait until the deal is done to define the nature of the collaboration but use the acquisition contract to specify how the start-up will access the acquirer’s five core assets:

Sharing financial assets can be critical, too. Many incumbents provide working capital or funds for business building to help start-ups access low-cost capital and skip funding stages.

Developing buy and scale as a strategic muscle

Top companies look at M&A as an innovation engine.13Jeff Rudnicki, Kate Siegel, and Andy West, “How lots of small M&A deals add up to big value,” McKinsey Quarterly, July 12, 2019. With this approach, M&A becomes a powerful means of competitive differentiation as acquirers build organizational capabilities and establish best practices across all stages of the M&A process.14Chris Bradley, Rebecca Doherty, Nicholas Northcote, and Tido Röder, “The ten rules of growth,” McKinsey, August 12, 2022. Successful acquirers build their M&A muscle by constantly identifying, pursuing, and integrating high-potential targets and embedding this capability in their business strategy. Such an effort works best when a company takes the following two steps.

Set up a venture-building board to oversee all new business and growth initiatives

A venture-building board should be made up of members from in-house strategy, innovation, and M&A teams; a venture-capital investor with an objective view of the business; and external experts to fill any knowledge gaps.15Markus Berger-de León, Jerome Königsfeld, Leo Leypoldt, and Kai Vollhardt, “How to build a unicorn: Lessons from venture capitalists and start-ups,” McKinsey, October 19, 2022. This board typically meets monthly to review and approve budgets for new businesses launched by the incumbent (which are presented by representatives from the in-house incubator or accelerator) and to assess and approve M&A opportunities (presented by the GMO).

The GMO is in constant contact with the internal incubator or accelerator team that focuses on organic growth initiatives and what the company needs to accelerate them (talent, technology, IP, market access, or other assets), so that it can seek out acquisitions that provide these elements. One key requirement of the venture-building board is to ensure that M&A activities support the business’s overall strategic objectives and are complementary assets to the new businesses that the incumbent itself has launched.

Create deal-management tools

Successful companies create tools that the GMO can use to identify targets, assess their potential for accelerating growth initiatives, and help inform decisions on whether to acquire them. To identify targets, successful acquirers use tools that automatically scan databases such as patent registers, commercial registers, GitHub, and LinkedIn for possible deals in line with specific criteria. To assess a target’s potential fit, they score it against criteria such as how many developers it has (for acqui-hiring) or how many regions and customers it covers (for international expansion). And to help with decisions to invest, they use predictive models that evaluate factors such as team experience (professional and educational), funding (including the presence of anchor investors), digital footprint (through web traffic and semantic analyses of keywords), and financial data (drawn from company reports and press statements).

At one international consumer goods company, the venture-building board meets monthly to assess, prioritize, and make funding decisions for new growth opportunities, both M&A and organic.16How to launch a new business: Three approaches that work,” McKinsey, April 22, 2021. It evaluates potential targets and new-business-building ventures via an “opportunity funnel” that extends from idea sourcing to opportunity identification, prioritization, diligence, action, and portfolio management. Taking this approach, the company has built an engine that is able to successfully manage up to ten acquisitions per year to drive growth.

We see other companies taking a slightly different approach—for example, keeping a list of potential acquisition candidates that are prioritized by the GMO and reaching out to cultivate them for fit and a possible deal. Once a deal is approved, the GMO sets up a dedicated M&A squad to take responsibility for every stage of the acquisition, from due diligence to integration.

For approaches like these to work, senior leaders need to carve out blocks of time to cultivate targets and develop long-term relationships that may eventually lead to acquisition.

Strategic M&A is a catalyst for growth. That doesn’t mean making one big game-changing acquisition. Rather, it means pursuing frequent small acquisitions that fuel innovation across multiple areas and support in-house businessbuilding efforts in line with corporate growth objectives.

This content was originally published here.