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Why large companies make acquisitions

Mergers and acquisitions have a notoriously high failure rate and as a result investors knocked a couple of percent off Cisco’s share price yesterday following the announcement of their $5bn acquisition of NDS Group. This morning the Financial Times’s Lex column ran a piece which gives a partial explanation of why big companies push ahead with acquisitions in spite of the stats and antipathy from their shareholders. This is the money quote:

Many acquisitions fail. But for most tech companies they are an unavoidable risk as competition and technical advances relentlessly drive down prices and margins on legacy products. Witness the recent margin pressure in Cisco’s core switching business.

There was a second Lex article this morning, this time about Chinese internet darling Tencent which gives the other part of the explanation, they can’t organically add new products and businesses with enough pace to offset the declines in their legacy businesses and deliver the growth their investors demand. This quote from Lex explains how Tencent’s management is offsetting declining subscription revenue growth by growing their revenue from games, including by acquisition (e.g. of US games developer Riot Games, a $400m deal last year):

Sales growth from subscription fees and virtual items on Tencent’s social networking platforms slowed to a fifth year on year in its fourth quarter, from 25 per cent during the same period in 2010. As a result, Tencent depends even more on its online games to support sales. ….. To roll out blockbuster games fast enough it has turned to acquisitions.

The good news for entrepreneurs and their investors is that as the pace of change continues to accelerate new markets spin up and get big in shorter and shorter periods of time making it harder and harder for large companies to respond organically. Moreover, the faster a market gets big the more valuable the market leading startup will be when it comes to exit. This logic is playing out up and down the scale from $20m exits to much larger ones.

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