Protect yourself against vendor change of control - you'll need it

 

When a technology user discovers one of their ‘strategic’ technology vendors has been sold, divested and/or experienced a material change of leadership, it’s rarely a cause of celebration. It’s often an anxiety-producing event that foretells a series of reduced customer experiences. In short, it’s a bummer.

These material change of control events introduce change for the existing customers. Whatever the customer thought of their pre-existing relationship with the vendor, it’s now different and fluid. For example, customers might learn that the new owners/management will:

• dramatically change the direction of the company’s R&D efforts
• materially slash budgets for key functions like R&D, marketing, etc.
• strip key assets from the company and sell off parts of the firm to other firms
• significantly raise prices of new products
• raise maintenance fees for on-premises products
• aggressively audit prior customers to seek major revenue inflows (i.e., shale fracking the wallets of the existing customers)
• rollup the firm with another firm(s) in their portfolio
• run off all of the original development team and/or founders
• cut off key channel partners and try to capture all service revenues for themselves
• force march the existing customers onto a different product line
• drop support for (some of) the current products

It’s exceedingly rare that a tech company experiences a major change in ownership or leadership without significant change.

I always fight hard to include material change of control provisions into software and other tech contracts because acquisitions, buyouts, IPOs, asset sales, mergers, rollups and/or management changes might benefit shareholders under the current investing mantra of Applied Reaganomics (my term for shareholder value delivery at all costs) while triggering adverse impacts for customers.

Businesses often think of technology vendors in two buckets: strategic and tactical. Strategic technologies are key to their operations and help them differentiate their firm in the marketplace. Tactical applications are often common technologies that can be sourced from many similar vendors whose offerings are also similar in broad functional terms (e.g. email software). Ownership or leadership changes of tactical vendors generally don’t raise many concerns. But, the same changes in a strategic vendor triggers anxiety.

When companies get acquired, the new owners want to maximize the return on their new investment. To do so, they might adopt a growth strategy and invest in the future of the company or they slash budgets, raise prices, cut headcount and try to drive sales upward.  I often see a lot of the latter especially for older software companies but it's not unknown for vendors to chase both strategies in an effort to see which pans out better for shareholder value.

When tech companies slash headcount and budgets it might help short-term financial results but it often triggers devastating problems long-term as the R&D pipeline gets materially delayed and/or rendered obsolete. Tech companies that lose their ability to deliver market leading products just when the market for those solutions becomes viable go out of business.  What non-tech buyers of software companies never seem to understand is that technology is akin to the fashion business. There is almost no market for old products, products that get released late, etc. – all of that obsolete or out-of-date stuff is “sooooo last Tuesday”.

There’s another cost associated with the slashing of R&D budgets and that comes from the loss of many of the tech company’s best and brightest innovators. The geniuses that created the early market successes of the firm enjoy working for hard-charging, innovative firms. They probably won’t like working for financially-oriented, non-technical people who care more about the dollars than the creation of cool, new things. The best and brightest often leave.  Customers should be concerned if a brain-drain occurs at one of their strategic suppliers.

The implicit contract

There are often two agreements in effect when a company acquires new software. There’s the financial contract that the two parties sign and there’s an oral agreement that lays out the implicit “partnership” between the two companies. That partnership agreement identifies things like:

• expectations for future product enhancements
• expectations for future industry functionality additions
• timing of new innovation releases and availability
• commitment to receive top priority for product support
• willingness of customer to sit on key advisory panels/groups and of the vendor to listen to these groups

Unfortunately, all of that oral understanding stuff and the goodwill attached to it falls to the wayside once new owners or management come into the picture. Good contract lawyers (and I) will tell you that oral promises are rarely enforceable – if it’s important to your firm, get it in writing.

You should also remember that your firm is only a ‘strategic partner’ of many vendors UNTIL the contract is signed. After signing, your firm is just a customer. You lose all your power and leverage over a vendor immediately upon contract signing.

And, that what makes material change of control issues so frustrating.  Scores of software customers have no voice in the future of the acquired/different firm.  It’s really frightening for those who believe they had a strategic relationship with the vendor one day and a non-existent one the next.

Event frequency

Sadly, many software contracts between vendors and customers outlast many marriages. While that says a lot about marriages, it should cause more companies to look at the contractual relationship more carefully.

But what’s even more interesting and compelling is how frequently material change of control events occur.

So far in 2017, we’ve seen HR vendor Fairsail and accounting vendor Intacct scooped up by Sage. Netsuite was acquired by Oracle in late 2016.  Check out this list of acquisitions on the thenextweb.com’s Index tracker. Or this list curated by TechCrunch.

Large numbers of smaller firms are frequently acquired by large technology firms on a routine basis. Many of these deals are characterized as “tuck-in” deals as the new technology and people will be added to the larger firm’s portfolio and staff complement.  Accenture has made numerous deals this year to bolster their growing digital practice.  Tuck-in deals are generally net positive for customers of the acquirer but could be disconcerting for the customers of the acquired firm. In some deals, I’ve seen the acquirer take the people, shut down the old products and put the acquired team on new R&D efforts.

During any software selection project, the customer’s selection team needs to discuss both the likelihood and the consequences of a potential material change of control for the finalist vendors.  I like to take the top executives of my clients to the home offices of the vendors to meet their counterparts. Besides being a great way to judge the culture of the tech company and the competency of its management, these meetings allow for a frank opportunity to discuss when/if the tech company will go public, seek new financing/owners, rid itself of its private equity owners, etc.

In a recent selection I completed, we did exactly that. The client avoided one finalist as it looked too likely that this firm would get acquired. It was, in fact, acquired a year later by a major ERP vendor.  In another deal where I helped the client negotiate potential ERP contracts with two finalists, one vendor’s ownership by a private equity firm became a real stumbling block. No matter how hard the CEO of this vendor argued that the company wouldn’t be sold, it was clear that in year 5 of the private equity firm’s ownership that a liquidity event was forthcoming. It was flipped about 18 months later.

Smart firms look for the ‘tells’ that foreshadow future material change of control actions and plan for appropriate defenses to these. Just to be clear, this is about avoidance of risk, a key metric in any selection process.

Management/Leadership changes

When a tech firm gets a new CEO, industry analysts can expect to get a call from the PR firm in a few days/weeks after the new person is installed. We’ll be told in gushing, fawning excitement how great things are going to be now that the new executive is in place.

We’ll likely get a tissue-thin briefing on the new direction for the company. It will be long on buzzwords and really short on details. We’ll also hear about how everyone is staying on while new executives also come on-board. Almost immediately after this call, we’ll learn that virtually all of the old team is leaving or has already, quietly left. If not then you can bet that drain will have occurred within either a lockup period or at latest 12 months after the acquisition. Don't believe me? Check how long people stay on average at your favorite Silicon Valley based vendor.

Granted sometimes a founder CEO wants to leave after growing the company to some amazing level or due to some personal reason. That’s generally not the kind of change you should worry about. The change to worry about is when activist shareholders, the acquiring firm, private equity owners, etc. install their own group of management to run the technology firm. They’ll want to take the company, its products and its people into a new direction.

Colleague and industry watcher Jarret Pazahanick and I were trading tweets the other day. He pointed out the changes at HR vendor SuccessFactors in this tweet.  ERP vendor SAP acquired Success Factors in early 2012. If only ½ of these leaders introduced changes to the product direction, pricing, etc., the impact on customers could be intense.

Is material change of control or leadership change ever good?

Sometimes change is needed.  There have been some spectacular instances of CEO bad behavior in the trade press of late.  When more adult supervision is needed, executives need to be replaced.

However, many executives are driven out by an active board. They might replace a founder to put in someone who will complete a ‘transaction’. A transaction is often the sale of the company or some other liquidity event like an IPO. Transactional CEOs are often short-timers. They’ll dress up the balance sheet and other financial statements to make the company look more attractive to a buyer. What that often means is that budgets will be slashed especially in areas like Marketing and R&D. The appearance of a transactional CEO should be a huge red flag to existing customers: Your tech vendor relationship is going to change.

Sometimes the board will oust executives when the company is no longer garnering the valuation they want it to have. For example, if the last financing round triggered a $1 billion valuation for the firm but recent financial results no longer warrant that, then a vulnerable executive could get replaced.

Just remember, the company you fell in love with was commanded by a team with a known strategic direction for its technology. The new leaders will likely have a different product direction, leadership team and culture for the firm. Will that be compatible with your firm’s needs/desires?

Going Forward

Planning is everything.

I consistently advise clients to think about material change of control language for their technology acquisitions. It’s hard to get these requirements into contracts because vendors think this language and any potential penalties or refunds that it triggers makes the company less appealing from an acquisition perspective.  Oh, boo-hoo. Since when should you care about how well positioned for a takeover your strategic technology vendor is?

No.  Your firm needs to get proactive in constructing the appropriate pre-nup clauses for any relationship it creates.   None of these relationships lasts forever and even in the long-lived ones, one party or the other might want to ‘go another direction’. It’s going happen –plan for it.

In some deals, you should ask for the ability to terminate the deal for a variety of reasons e.g., for cause, for convenience, etc. The reasons and monies associated with each should be clearly spelled out. For some deals like big ERP implementations, you’ll want some kind of protection in your expensive ‘investment’ should the vendor get acquired/sold especially while the implementation is in process or recently finished.

You always need an alternative. I don’t believe that there is one and only one vendor out there for a specific business need. You need to have a Plan B and the will to exercise that option.

What you’ll have less success with is making the acquirer pay your firm some kind of fee or penalty. As a general rule, you can’t contractually bind a party that was not part of the original deal to a specific set of actions. You can bind the original firm you contracted with though.

Don’t get seduced by a vendor’s talk of how much they want to partner with you. While you, too, might want that, unless you’re a Walmart, you’ll only be a customer. Set your expectations accordingly.

But, through it all, take Elmer Fudd’s advice: be very, very careful.