Tech market is booming - in federal, defense sectors

By Paul Serotkin

Despite the economic downturn, the federal and defense sectors of the technology market has experienced a thriving merger and acquisition pace.
ompanies that sell technology services to the Department of Defense and to civilian agencies such as the Environmental Protection Agency have generally experienced growth, some of it robust, with many engaged in M&A activity within the past few years.

The market is particularly attractive for the thousands of small and mid-sized federal contractors who wish to exit their business via a sale to a larger, better-positioned buyer.

Minuteman Ventures LLC, an investment bank that focuses on the federal IT sector, tracked 51 M&A transactions in this sector since October 1, 2002. Eight in 10 involved smaller, private firms, with annual revenue under $50 million. Over 40 percent of the selling companies were firms having under $20 million in revenue.

While M&A pricing metrics vary depending on size and specialty, the environment for continued M&A activity in this sector should continue.

A moribund IPO market for years, the federal IT sector re-emerged as Wall Street darlings in 2001 and 2002. Long-private firms such as Anteon Corp., SRA International Inc. and ManTech International Corp. went public. In total, Wall Street raised $2 billion in equity and debt capital for the sector, giving rise to significant resources within this growth-minded group.

The pressure for growth on this newly public class comes as the government tries to 'bundle' smaller contracts into larger ones, rewarding ever-larger firms armed with ample bandwidth to handle complex IT problems.

In anticipation of 20 percent growth, the investors value these public firms at significant multiples of earnings. Internal growth must be augmented by external sources, such as acquired companies, to maintain that growth pace and valuation metrics.

Other forces drive the M&A market for the acquisition of sub-$50 million firms. As the federal employee workforce is shrinking due to retirement, world events - such as terrorism - are forcing the U.S. to spend more on technology that protects the country and allow the government to operate in a more efficient, secure manner.

Smaller, nimble IT firms have become great resources to federal agency customers. They build secure products, manage IT facilities and agency help desks, model business and defense simulations, create systems used in emergency response scenarios and develop 'smart' munitions for combat.

Larger firms, and those bent on becoming large, appreciate the value brought by these smaller firms.

M&A valuations for these 'acquirees' typically start at 4 to 5 times operating earnings for relatively undifferentiated firms under $20 million in revenue and can reach an eight-to-nine times multiple depending on special circumstances. Those firms providing software and technology for homeland security solutions, intelligence, security, chem/bio remediation and interoperating combat systems 'missions,' for example, warrant pricing at the top of the range. As the revenue size increases, so, typically, does the valuation multiple.

Many of these smaller firms bring very valuable assets to buyers, to the point where very large companies are willing to acquire them. Examples of this are BAE Systems' purchase of the $15 million Corbett Technologies and Lockheed Martin Corp.'s acquisition of 250-employee Orincon Corp. within the past year.

In addition to specialized mission skills, smaller firms can offer:

  • Employees that have the needed secret clearances to perform federal work.
  • Prime contract positions that can command project control.
  • Hard-won contract 'vehicles' that limit competition in approaching new government business.
  • Contract backlog that approaches two, three and even four times their current annual revenue.

Most important, perhaps, is their relationship with certain agency customers, introducing the buyer to a new world of contract opportunities.

The federal M&A market continues unabated. Smaller company founders, having built a successful entity, may well want to explore liquidity options in this environment.

Paul Serotkin is president of Minuteman Ventures LLC, an investment bank focused on privately held federal IT firms. He can be reached at