Balancing IT Options for Effectiveness, TCO and CapEx/OpEx in an Acquisition

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Balancing IT Options for Effectiveness, TCO
and CapEx/OpEx in an Acquisition:
A Case Study
Michael Harris
President & CEO

©2014 David Consulting Group
Background
• In 2013, the David Consulting Group supported a client through the acquisition
of part of another business.
• Our client’s intent was to acquire this substantial but minority part of a non-
performing larger business and to turn it around as a smaller, profitable
business in its own right.
• Early in the due diligence, we identified that the seller’s existing IT
infrastructure and historic software choices were placing a significant load on
costs. The hypothesis was that a carefully thought out new approach to IT,
taking advantage of new ways of implementing and paying for IT, could make
the difference between a successful business case and continued loss-making
as “business as usual.”
• My role was to lead the IT team planning the transition and to investigate IT
options, while carefully balancing the effectiveness of the systems with total
cost of ownership and the business case implications for CAPEX and OPEX.
This presentation is a case study of the project (with identities obscured to
protect the innocent).
1

The “Before” IT Picture
2

The “Before” Geographic Picture
3

The Negotiation
• Seller
– Product of recent merger of two
major players (A & B)
– Revenue for A falling over
several years
– IT infrastructure for A built up to
support several times its current
revenue
– Losses driving sell-off of majority
of A to a different buyer in early
2014
– Losses in remainder of A’s
business forcing sale of some or
all to Buyer with close down for
remainder by end of 2013
• Buyer
– Existing relationship as sub-
contracted partner for part of
Seller’s business
– Investments but no operations in
U.S. Market
– Wish to take on as many clients
as “makes sense”
• Buyer only able to include
one major client in deal
• Willing to “pass on” other
clients
– Seek major Transitional Services
Agreement (TSA) from Buyer
• Only limited TSA on offer for
the one major client
4

The Timeline
Due Diligence
Operations
1st LOI signed
Seller cannot
comply with
1st LOI
2nd LOI
5

The Buyer’s Challenges
• Limited TSA for the one major client
– Payments are at the heart of the business, but the Buyer, understandably, did not
want to handle cash belonging to the Seller or its clients so …
• Buyer needed to set up new hardware and software systems to keep the
business running on Day 1
– Seller reserves right to shut down TSA if/when major deal with other buyer closes in
1Q14 so …
• Buyer needs to be ready to implement full IT system by March 31, 2014
• “Pass On” Clients (over and above the one major client)
– Buyer needs to be able to offer full service to “pass on” clients from Day 1
• Credibility
– Need to demonstrate creditworthiness to all sorts of service providers
– Need to pass industry Process and IT audits
– Need to attract new customers
6

The Buyer’s “Limited TSA” Options
• Short-term (Day 1) versus Long-term (ha! ha!)
• Build a payments-handling infrastructure
– Need a data center
• Implications for availability and costs of office lease
• Implications for time to build out
• Use SaaS for payments infrastructure
– Another dependency (out of control?)
– What can you expect?
• Automated mail processing
• New website (to accept payments)
7

The Buyers “Pass On” Client Options
• Short-term is only game in town
• Options:
– Build own solution
– “Off-the shelf” services
– Buy an existing business
8

Why Renting Software and Hardware
is More Practical than Buying
• Aligning IT Costs
– 2008 recession exposed the inability of many IT departments to reduce
their costs quickly, in line with reductions in staffing
– Renting software and hardware makes it easier to identify individuals and
departments IT costs for some form of ABC
• CapEx versus OpEx
– Rented software and hardware costs can be expenses in the year they are
incurred, whereas purchased software costs must be depreciated over 5
years
• Compliance
– Rented hardware in vendor locations may come with various regulatory
(e.g. security) and best practice (e.g. disaster recovery) compliance
requirements built-in as part of the vendors service proposition
9

CapEx Versus OpEx – Simple View
• Buy a piece of IT hardware or software and, in most cases, you
cannot write off the cost in 1 year. Rather, the cost must be
depreciated over (typically) 5 years.
• Typically, the cost of services to provide hardware or software
can be expensed as they occur.
• Pros of OpEx:
– Less cash required upfront – important for a new business
initiative
– Costs incurred only as services are used (more or less) –
for new initiative, this allows flexibility for everything
between unexpectedly rapid growth and failure
– Drive the software off the lot and the resale value is
typically zero. No “Used Software” salesmen out there!
• Cons of OpEx:
– TCO may be higher. For example, if purchase price
equates to 5 years of rental price for 50 users, then rental
price is more;,if buyer has more than 50 users of the
software for more than 5 years (of course, this is a
double-edged sword)
– IT cannot be “hands-on” with the technology (this is also a
double-edged sword)
10

Examples of Current IT Perspective
• Mary Jo Foley, Redmond magazine, December 2013:
– “When Microsoft said it would let customers rent Office by subscribing to
Office 365 Home Premium for $100 a year, instead of buying it once,
many predicted customers would reject the dramatic shift. The carrots
Microsoft added to sweeten the deal did the trick … and it has already
managed to sell 2 million subscriptions to its Home Premium service.”
• Variations on “But we have always done it this way …”, “It has worked for us
in the past …”
– Yes, but the services options available today were not available then.
– Maybe that’s still the right way to go for home-grown, proprietary, USP
software, which is not available in SaaS format, but even the
infrastructure for that may be better as a service.
• Security risk – a valid concern, not to be minimized, but compare your
corporation’s ability and cost to defend itself versus the service provider’s
ability and cost to defend itself.
11

How It Went Down (in chronological order)
with apologies to the participants for oversimplifying their views
• Mike: Let’s assume that we buy as much IT as we can as services –
cloud software and, if necessary, cloud hardware (e.g. Sungard).
• Current CIO: We need a new network with a small data center in the
U.S. and an expanded data center in India – here are the costs for the
sort of robust network that I can guarantee service from.
• Owners: Our customers are and will be US-based. We need to be
able to show them attractive corporate offices and a robust data center
– find somewhere impressive.
• (New) CEO: I need this all up and running in 2013 with a business
model that makes money sometime soon (before I get fired by the
owners).
• Finance: We cant make the numbers work with this level of CapEx
• Owners: Cut the CapEx to this number $xxx.
• Current CIO: OK – here is the absolute minimum CapEx – it doesn’t
work – I recommend we go to rented hardware and services.
• Finance: Ok, I can make the business model work now
• CEO and Owners: We told you to go OpEx in the first place
• Mike: Anything you say, boss,
Maybe we
could buy an
existing
business?
12

How It Went Down (some complicating factors)
(and a chance to restore some relations with the team and why the CapEx didn’t work)
• THE CapEx did not work because the cost of building a highly failure-tolerant IT
infrastructure could not be supported by the likely revenue in the first 3 years (the goal
for profitability was 3 years). In short, IT over-engineered the in-house solution initially.
• While confident about the ultimate success of the business, the owners could not tolerate
putting this much capital at risk up-front based on the projected revenues – the
combination of high risk of success and low ROC was unacceptable.
• Although the local real estate market was soft, office (and data center) leases were set
for a minimum of 5 years and, in any case, with the available options the build-out costs
were such that they would need to be depreciated over 5 years.
• There was a more than fair chance that it would not be possible to find and buy a small
working business in the U.S. in the timeframe.
• The Seller’s reluctance and capability to support the IT under the TSA only became
apparent over time.
• There was only one guaranteed customer In the deal and they had the highest
compliance requirements – it became clear that they were willing to bend those in the
short term but not break them.
13

Theoretical Cost Projections
CapEx Focus OpEx Focus
0
1
2
3
4
5
6
7
2014 2015 2016 2017 2018
Remaining Available
Capital
CapEx
Depreciation
OpEx
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
2014 2015 2016 2017 2018
Remaining Available
Capital
CapEx
Depreciation
OpEx
2014 2015 2016 2017 2018
OpEx 1.87 1.87 1.87 1.87 1.87
Depreciation 0.10 0.10 0.10 0.10 0.10
CapEx 0.50 0.00 0.00 0.00 0.00
Remaining
Available Capital 3.53 1.57 0.00 0.00 0.00
2014 2015 2016 2017 2018
OpEx 1 1 1 1 1
Depreciation 0.4 0.4 0.4 0.4 0.4
CapEx 2 0 0 0 0
Remaining
Available Capital 2.6 1.2 0 0 0
Assumed Fixed Investment justified by ROI 6.00
CapEx required 2.00
CapEx as OpEx (3 years + 30%) 0.87
More initial capital to invest in sales!!!
14

Cost Projections
710
642 608
433 433 445 445 445
-50
50
150
250
350
450
550
650
750
-
0.50
1.00
1.50
2.00
2.50
3.00
USD/FTE
mUSD
Estimated IT Cost Trend
Software Hardware Teleco & BW
Manpower TSA Cost FTE
Before
After
15

Final Thoughts
• Redmond magazine readership survey, “What’s on your 2014 IT
Agenda” (January 2014, 376 responses) – 6% said “Move from a
CapEx to an OpEx model for procuring IT apps and infrastructure.”
• Think about CapEx investment in IT hardware and software licenses as
investment in real estate – low liquidity (if any) and may not be best
use of capital available.
• There are options for how far down the path of OpEX you go:
– SaaS – Software as a Service
– PaaS – Platform as a Service
– IaaS – Infrastructure as a Service
16

Questions?
Michael Harris
President & CEO
m.harris@davidconsultinggroup.com
610.644.2856
17

Balancing IT Options for Effectiveness, TCO and CapEx/OpEx in an Acquisition

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