December 12, 2000, 10:52 AM — The times they are a-changing. No longer do top technical executives oversee
just the corporate technical needs: They are also involved in bottom-line, revenue-
generating decisions. As their influence is felt in boardrooms across the country, CTOs
and other IT executives must back up business decisions with financial savvy
Technical executives are joining the business development team and becoming
involved in the early stages of merger and acquisition activity. As a result, they need
a basic understanding of the financials behind the deal, says Tim McAdam, general
partner of the Menlo Park, Calif.-based venture capital firm, Trinity Ventures.
1. Uncover a target's fiscal health
The financial due-diligence team reviews the target acquisition's financial
statements, including the income statement, cash flow statement, and balance sheet --
collectively "the financials" -- and often the business plan/operating budget, McAdam
says.
Other information holds clues to the target's fiscal health. Look at the metrics
around margins, McAdam says. "Metrics refer to the comparable companies that are
competitors within the same sector. If the average gross margin [of a comparable
company] is 50 percent, then the company being considered for acquisition should have
similar margins."
2. Interpret R&D spending
When McAdam considers backing a company, he wants to know the percentage of
revenues spent on R&D (research and development). "I look for 25 to 40 percent of
revenues to be spent on R&D in early-stage companies. If you are spending and
reinvesting in technology, you are creating a barrier to entry for your competitors,
[thereby] maintaining your competitive advantage," he says.
3. Understand gross margin
Review gross margins and expenditures reported in financial statements. "High gross
margins cover a lot of sins, such as spending too much on sales and
marketing/advertising or spending money on R&D that doesn't lead to much," McAdam
says.
The venture capitalist wants to see an increase in gross margins over time. "This
really relates to the average sales price of the product or service and the quality of
what you are selling vs. what it costs you to produce. The higher the gross margin, the
more valuable the product or service is to the end-user," he says.
4. Understand attrition's impact
McAdam suggests that business development team members carefully consider how the
employee retention rate affects the target acquisition's bottom line. "This goes to the
stability of the company. Are the employees motivated and entrenched within the
company?" McAdam asks. If talent is leaving -- and McAdam considers anything more than
a 5 percent attrition rate to be high -- then he wonders "how good are the underlying
technology and financials?"
