How to tell if your small company needs to expand through acquisitions

The market for mergers and acquisitions, particularly in software, is red-hot: Big private-equity firms, flush with cash, did 170 software deals worth $27.22 billion in the first half of 2016 alone. Beleaguered Yahoo was scooped up by Verizon for $4.8 billion; Microsoft announced a blockbuster $26 billion purchase of professional-networking site LinkedIn. That deal prompted waves of speculation about just how Microsoft will leverage LinkedIn’s treasure trove of resume data to bolster its own products.

But the software M&A frenzy also highlights how smaller tech companies can turbocharge their growth by pursuing highly strategic, add-on acquisitions.

As a software investor focused on mid-sized technology companies, I meet many business owners in this segment who (unlike the executives at Microsoft!) don’t recognize the signals that their company needs to grow in a new way — chiefly, by acquiring other companies that can fill holes in their product line or offer complementary products and services. Spotting these signs is more than just smart leadership; it can help companies uncover growth opportunities — and lead to bigger possibilities long-term.

What’s more, as valuations for some private technology companies trend downward these days, it’s an especially good time to consider this type of growth strategy.

It’s the customer growth rate, stupid

One telltale sign that you may need to consider M&A is a change (namely, a negative one) in your rate of month-to-month customer growth. This signal is tricky, though. As long as you keep gaining new customers, a dip in the growth rate probably isn’t a big deal, right? Isn’t that typical of companies as they grow in size?

Sometimes. But a dip in your rate of customer growth can also signal a need to expand beyond your current market, and should at least prompt a re-evaluation of the products you’re offering. You should be asking: What else do your customers need? What are they buying elsewhere today? This could, in turn, lead to new ways to boost new customer growth.

A rule of thumb in my business is that customers spend 1-2 percent of their revenue on software. If that amount for Customer X equals $100,000, and they’re spending $10,000 with you, there’s another $90,000 you’re missing out on. Figure out how to capture that spend. It’ll be a gain on both sides, as customers often find a one-stop shop makes their process easier. The old saying “one throat to choke” holds true.

Brightree* is an instructive case here. Initially a business-management software company for home medical equipment providers, Brightree acquired C&S Billing Center in 2009 to expand its product offering. With C&S Billing, Brightree customers could get relief for their billing headaches and pay Brightree for the add-on service involving skilled staff. The acquisition significantly boosted Brightree’s overall revenue.

Not all new offerings are bolt-ons, however. Sometimes broadening your product line makes your company attractive to adjacent buyers, increasing your overall market. For example, let’s look at another Brightree acquisition — CareAnyware, in 2013. Similar to Brightree, CareAnyware was a cloud software provider but sold to two different post-acute markets: home health and hospice. By expanding into new segments of the healthcare continuum, Brightree greatly increased its potential size of the pie. ResMed (NYSE: RMD) acquired Brightree for $800 million in April 2016.

Another key metric to track as you’re thinking about potential M&A is whether your product’s average sales price is staying the same, or declining. Perhaps it could generate more revenue if you combined it with another service to solve a bigger problem for customers. Start this evaluation by talking to the sales reps. What questions do they hear on repeat? What keeps customers up at night?

WebPT*, which helps physical therapists run their businesses effectively, asked these questions a couple of years ago. Their customers told them that they knew Obamacare would eventually tie medical reimbursements to successful patient outcomes.

WebPT looked for a way to help customers stay ahead of that requirement long-term — knowing that, in the short term, patient outcome data would also help therapists do their jobs better. Enter WebOutcomes, a firm WebPT bought in November 2014. What initially seemed like a one-off feature — outcomes data — is fast evolving into a core offering for the company.

Churn, baby, churn

Finally, all companies should be closely tracking customer churn as a potential M&A signal. Better yet, you should be on alert for the very early signs that customers are simply unhappy, and may churn away in the future.

Maybe you haven’t heard from them in a while, either on the customer-support lines or through email. Perhaps they downgraded their service plan, or — in the software business — their usage stats shift, indicating they’re not as engaged in your product, meaning not using it as often as they once did, or using as many features. Any of these could be an early sign of a customer who’s thinking of pulling the plug.

But customer churn can also signal bigger opportunities if you’re open to smart acquisitions. Use this opportunity to find out if customers are thinking of going elsewhere, and why. Your sales reps might already have this intel, or you can ask customers point-blank.

Once you know the competitors eating your lunch, size up their offerings. You can respond in one of several ways: You can buy them outright; you can invest in more technology to beat them; or, if you’re a larger player competing with some shiny new toy, you might opt to change your pricing or service bundle. A startup that isn’t well-funded might not outlast a competitor who can afford a canny pricing pivot.

Even huge technology players often grow via add-on acquisitions — particularly as the entire industry shifts to newer cloud-based software. In fact, your next phase of growth may involve partnering with a big gun.

Oracle has acknowledged the importance of the cloud-software trend, making several strategic acquisitions of companies like HR software company Taleo; marketing software companies Responsys and Eloqua; Big Machines, which provided back-end sales processing software in the cloud; and, more recently, Opower and Textura.

Similarly, Salesforce expanded from a CRM-only business into areas like cloud services and marketing through targeted acquisitions. The company gained even more wallet share by acquiring companies such as ExactTarget*, an email marketing platform, and Assistly, which it renamed Desk.com and leveraged to provide strong customer-service support. Salesforce announced in June it would acquire Demandware, a marketing platform for retailers.

Think of your company like a shark: If it’s not moving forward, it could die. Don’t be afraid to look around your market, and remain open to partnering with competitors and complementary companies. If you stay aware and give your business the occasional boost, you will not only survive, you will thrive.