This article, a few decades in the making, is about the end of the process vs. the beginning. So, if you’re interested in an “insider” view of the sell-side and buy-side of M&A, there’s quite a bit here if you want to learn how to take advantage of the opportunities and avoid many of the challenges.
Let’s start by acknowledging that there are tens of thousands of articles you can read that are from the investment bank (ibank), tax / audit and M&A practices of the global consulting firms and boutique / bespoke firms. The insights I’m writing about are from the inside. These are honest, transparent, a bit unpolished, non-marketing worthy perspectives that you might find in an open Q&A on Clubhouse or a Twitter Spaces conversation.
For context, I’ve served as the lead on the buy-side consulting on the $295M purchase of Olson (owned by KRG Capital Partners — https://www.krgcapital.com) by ICF International, www.icf.com. I’ve also served on the sell-side of companies in the $40M and below range, which is where I specialize. I’ve built and sold a company — yes, ICF acquired the company I co-founded after we led buy-side efforts on their behalf. My background, if you choose to research me, is in running strategic firms focused on digital transformation, leading global practices and operating consulting services companies. I actually do the work. I don’t just pontificate. My career didn’t begin at McKinsey or BCG, and I’m not from the traditional Wharton or Harvard programs where a high percentage eventually end up at Goldman, Credit Suisse or UBS. I’m a roll-up the sleeves, get it done strategic lead.
Here are the key sections.
- What’s your plan?
- Recognize and understand what you’ve built
- Know when to exit
- Understand the value
- Select your advisors wisely
- Maximize your outcomes
- Plan for post-sale
What’s your plan?
The first question any founder needs to ask is what’s the plan? Is it to build something that’s “new” that doesn’t have a competitive set to benchmark against? Is it to enter an existing market with a “differentiated” offering? Is it to build a business that’s driven by pre-existing customer / consumer demand or to fulfill on a lack of capacity within a market? As a founder, are you building a business that’s an annuity — providing monthly, quarterly and annual profits that are effectively short-term capital gains? Do you want to build a business that out-performs industry peers or investor thresholds as part of a larger “valuation” play? Are you in it for the long-haul, or are you looking to exit quickly to a strategic buyer? Are you going it alone or are you taking on early and mid-stage capital to fund the business in exchange for capital? Are you building an early concept business requiring VC funding, or are you maturing and in need of working capital or a PE buyout? Each of these questions has a subset. There’s no single answer because these questions actually exist within a matrix filled with dependencies. But… let’s start with the question — What’s your plan?
From the original conceptual framework, is the business being built for the long haul or being designed to be “attractive” to a buyer? In ’21, when the cost of money is incredibly low, by historical standards, the number of companies looking to make strategic acquisitions is, in many ways, unparalleled. So, did you build it to sell it or run it? What’s the desired outcome?
Recognize and understand what you’ve built — Why does ____ exist?
There are, for all intent and purpose, 3 types of business owners. First, those who really don’t understand the value of what they’ve built. The second have a bit of an understanding of the value and market valuation, but they may not understand how to mature the business to a maximum valuation. The third believe they know everything necessary to maximize a sale (Purchase Agreement). The truth is, typically, most are a bit misguided because they’re lost within their own business, operating without an understanding of the market, the financial parameters, product and service maturity and the operational sophistication to achieve the ultimate valuation. Businesses first have to understand why they exist. Is it to achieve maximum profitability for shareholders / owners / employees? Is it to develop a proprietary solution? Is it a hybrid professional services + SaaS offering? Is it exclusively a SaaS company? etc.
Let’s start with the fact that as in life “know your worth” business isn’t any different. Unfortunately, most businesses either under or over-value their worth to a strategic buyer. For those that under-value, it’s typically because they don’t recognize the forward value of the combined entity post acquisition. For companies that are sold based exclusively on their EBITDA are effectively looking to the past as the future. Acquiring firms (buy-side) use this as a framework, in many instances, to devalue acquisitions. Companies that don’t understand the value of their contracts (MSAs, SOWs, PO’s) combined with their unique IP, the talent they’ve assembled and their client roster (i.e. logos) discount their valuation. For those that over-value their business, it’s a bit like seeing yourself in a mirror without anyone else to compare yourself to as far as attraction. We’ve all met these founders / leaders. Those who believe they’ve built the next “best” solution. For angel or VC, these companies are the ones that we all have stories about including why they walked away or why they regretted investing.
Understanding the value of what a company has built is an exercise in clarity. External firms (ibanks) will provide valuation services, but many, if not most, follow antiquated, decades-old models developed by Goldman, Credit Suisse, Lehman, etc. These models struggle to value new companies delivering or solving for highly sophisticated market challenges and opportunities. Valuing a company that develops AI solutions for cyberpolicy valuation for a Series A is fundamentally different than valuing a retail business. In the end, in order to understand what’s been built, founders / owners need to understand not only their company and its IP, but the market in which it exists and the size of the opportunity. In addition, it’s critical to obtain an external valuation using models that reflect the intersection of the industry, the IP and the maturity of the company. With this combined knowledge, it’s possible to understand the “worth” of the company.
Know when to exit
Maturity is a strange thing. We all remember what it was like to be an adolescent. Those teen years when we were “gangly” weren’t the best, but on the other side, we grew up, not only physically, but mentally and emotionally. Most early to mid-stage companies look a lot like adolescents. They’re mature in some areas, highly immature in others and outright outlandish in some. A PE firm we work with used the term “cartoonish” as it related to financial performance of a company we were assisting with a pre go-to-market sell-side initiative. The company had incredible IP, terrific talent, high margins (too high), terrific, large / enterprise clients, limited competition, analyst endorsements and C-suite buyers. Unfortunately, the company lacked investment, systems, processes and was understaffed and ultimately underfunded for scaling, yet throwing off enormous profits (cartoonish). In a situation like this, the company wasn’t ready to exit. They felt they were, but everything about the operations and the scalability of the company said NO. Through discussions it was clear that a number of strategic decisions coupled with a stepped process could easily drive a __x multiple over the current valuation, while only requiring a ___Y/Y increase in revenue, while increasing investment and reducing margin — yes, reducing margin.
Understanding when to exit means:
- Recognizing the market dynamics (e.g. growth tipping points, competitive landscape, shifting market demand, etc.)
- Growth beyond capabilities — Founders syndrome is, in many cases, the most significant impediment to a company’s future (e.g. knowing when a company has matured to a point where leadership / ownership limits the growth potential through vision, operations or financial management). Know when the company has reached the maximum capabilities and capacities of leadership to scale further scale the business.
- Leverage data / insights to recognize market inflections and peak velocity for the business. Trend lines correlate to market value and valuation.
Understand the value
As a founder / owner / investor, you have to understand the value of the business through the lens of the owned IP, market size, market demand, financial metrics, financial performance vs. market performance, operational maturity, competitive landscape, client composition, revenue density, market trends, potential buy-side synergies, etc. When you look at most ibanks, their due diligence teams are built to address the financial metrics through the lens of a historical perspective, but there’s very little understanding of the intangible value of the business other than through the traditional intangibles accounting attribution by the Financial Accounting Standards Board (FASB) guidelines. Your job as an owner is to understand the value of what you’re building as it directly correlates to personal investments, early stage financing, retained earnings models and and ultimately to the desired outcome(s). If there’s one thing that I see often, it’s a significant disconnect between founder / investor comprehension of value and the asset (company value) itself, and this applies to under and over valuation. In addition, it’s important to note that many companies are “lifestyle” businesses. There’s nothing wrong with this, but there’s a “You can’t have your cake and eat it too” scenario in which using the company as a personal “piggy bank” means you’re not re-investing and therefore reducing future value. Just the process of rationalizing the books within companies to industry norms can be an incredibly complex process, and most founders find that “normalizing” their salary and perks means they want an enormous multiple to offset the salary and perks reductions if they’re to remain with the company in an earn-out capacity.
In order to understand the value, beyond the items previously noted, a significant portion of the valuation is based on the post-acquisition synergies, which means the strategic buyer has to align to the ability of both firms to maximize the benefit — 1+1 = 3 or 4. Another core aspect of understanding the value of the company is to determine the mean. Any earn-out is typically “at risk” based on the contribution of the sell-side to the buy-side and the subsequent political, economic and operational issues encountered. Maximizing the earn-out can be challenging, which is why developing metrics that are not financial performance “heavy” are critical to the weighted expectation of total valuation.
Select Your Advisors Wisely
Most ibanks follow the Lehman Formula. This formula is dated, created in the early 1970’s by Lehman Brothers, but so are many of the ibank models, methods and processes. To be honest, prior to this formula, the cost of capital raises and underwriting of deals varied wildly with many scenarios exceeding 15%. Here’s the model, for reference:
- 5% of the first $1 million
- 4% of the second $1 million
- 3% of the third $1 million
- 2% of the fourth $1 million
- and so on, with a 1% charge on everything above $4 million
Depending on the agreed upon target price, anything above that threshold can be charged at whatever fee the ibank can extract from the founders / investors. On a recent sell-side that my company isn’t involved in, we were made aware that the % above the target threshold was being charged at 7%. To be honest, that’s usury, in our opinion, but the company agreed to the fee.
In the world of SaaS, ML, AI, Cloud, Social, Content, AdTech, MarTech, media agencies, digital agencies, etc. where the types of companies blend and blur, understanding the market, the value of the post-acquisition synergies, is critical. Without naming specific ibanks, many of these firms have Partners that are incredibly wealthy, decades from actual category experience, if ever involved and are exclusively finance and deal makers. Most of these firms, very well known and easily recognizable, will not even engage in a discussion unless their base fee of $1.2M will be met through the transaction. With this in mind, here are few items to note:
- The larger the deal the higher the probability that the ibank will negotiate the retainer against the success fee. If they close a deal above ___ threshold, they will discount their retainer fees against the final success fee.
- Due dilgence is a *@&#! process. Most firms below $15M in net revenue, which is where much of the market value and transactions are occurring, aren’t mature in their Legal, Financial, HR, Operations and Client Management functions. This is where specialty firms that work on smaller transactions are critical. For all intent and purpose, these founders / investors need significant “hand holding” in order to maximize the value of the company through the due diligence process and to represent the best possible scenario of growth post acquisition through synergies.
- Ask the difficult questions. Do the ibanks you are interviewing have any understanding of the business, category, competitive landscape and market trends beyond the basic ___ financial multiple expectation by using the past 3 year trend on gross revenue, net revenue and EBITDA. If not, you should pass.
- ibanks live off of “access.” They’ve done deals with larger institutions and investors, they know the PE and VC world exceptionally well and there is a “panache” to hiring a firm such as Goldman, Canaccord Genuity or Palazzo. If it’s about the post-buyout investment opportunities, the upside of access to new investments with the newly found funding sources from an exit may be more valuable than the millions in addition fee paid over more specialized and qualified sell-side firms.
Maximize Your Outcomes
The entire process from the decision that the company is in a place to maximize the value of a strategic exit to the structure of the go-to-market, (Broad Auction, Limited Auction or Targeted Solicitation), to the selection of a partner that is focused on preparing the company for the right time, to proper packaging and the right valuation are all critical to maximizing the outcomes. There is an “arrogance” to investment bankers. Smaller company founders can easily be intimidated and brushed aside by the larger ibanks, recognizing their Partners have deal portfolio performance requirements that they must achieve. In these instances, the time, level of effort, financial terms and final value of the transaction dictate their interest. There are few other inputs to their decision regarding interest and participation.
As someone that’s worked on both the buy-side on a $295M digital agency transaction to the sell-side on smaller valuations, I have a fundamental belief that the value created by founders / investors should remain with those that took the risk to build the business, which is why we recommend a much smaller transaction fee and rate structure for the consulting services. Question the value to the return and ultimately use a selection process that validates the understanding of the business as a stand alone entity and post acquisition synergies gained by the buy-side in order to maximize the value.
Planning for Post-Sale
It’s important to understand that most valuations contain a base Share Purchase Agreement (SPA). In addition to the SPA, there are, in many instances, Earn-Out Agreements that are either tied to future employment by the founders or performance criteria, independent of future employment. In certain instances, the entirety of the purchase valuation is tied to the SPA with no future earn-out. Future earn-outs are typically designed to maximize the post-acquisition value for the strategic buyer, while including clauses that ensure opportunities to reduce payouts wherever possible. The role your advisory firm should play is to negotiate the maximum value achieving opportunity regardless of the structure of the strategic sale.
It’s important to remember that the colleagues the company has assembled in building a company are part of the post-acquisition business and should be valued throughout the strategic exit process. They will, for all intent, represent the most significant aspect of achievement of the post earn-out value achieved. Our counsel is to ensure the proper structure, roles, compensation and support programs are agreed upon in writing in order to ensure retention and satisfaction with their future employment and your future relationship.
You can reach me on Twitter — @digitalquotient or on LinkedIn — https://www.linkedin.com/in/bobmorris/