Exit Value

Sep 2014

(Based on an Office Hours)

 

“Always set your goals higher than you could ever possibly reach. That way, when you barely fall short, you’re still better than everybody else.”

– Carson V. Heady, Birth of a Salesman

 

“Life’s battles don’t always go to the strongest or fastest; sooner or later those who win are those who think they can.”

– Richard Bach

 

When I started my first company, Inksimple, I received an acquisition offer a few months after launching it. It was about $120k in cash, another $100k in stock plus a $60k salary at the company and I’d have to work there for 4 years plus get free tickets to events. I was a first year computer science student and had just joined university at this point so it was a big deal for me. It was surprising because at the time there was very little revenue, basically 0. I wasn’t really sure why they were trying to buy us.

The offer actually came from an entertainment company that managed a bunch of artists and venues. It turned out they were spending a lot of money, millions per year, on print marketing for their artists and venues. By buying a printing company they would immediately save 2/3rds of that which could be spent on other things. The price, which took a while to negotiate was a lot for me but just a drop in the ocean for them. They’d save an order of magnitude more than that immediately.

It’s because they would get manufacturers pricing on the same print marketing they were previously getting at retail price. And so they went looking for a small printing company they could buy cheaply and found us. A web based printing and art firm. Plus I used to be an artist who bought lots of print marketing so understood the problems they were having. They could repurpose the company and reap the savings for their own use and could also make revenue from other print customers.

They weren’t trying to buy us for the revenue at all. But for all these other reasons that had nothing to do with us. In that sense we were just lucky. In the right place at the right time. That was the first acquisition offer we got. The second one came about a year later from another printing company. They explicitly wanted to buy it for the revenue, even though we were making a loss at the time. To buy it as a sister site and run another branch of their already existing printing business. They wanted to buy at a 5X multiple of our revenue, no stock and I’d have to work there for 2 years.

I was 18 at the time and ended up turning down both offers. Inksimple is still running as a lifestyle business. The reason is because I thought I was young and undisciplined. If I suddenly had a huge amount of money I would probably just do stupid things and waste it. Plus if it ran over 10 years, it would easily make a lot more than both acquisition offers and I didn’t want to work there for 4 years since I’d have to drop out of my degree. If I’d taken it, Medicine would never have happened. But learned a lot going through the buying process.

 

The stages of an acquisition are: initial interest, due diligence, valuation, negotiation, documents, closing.

It’s useful to have a lawyer and an accountant during each of these phases. It’s common for founders to ruin their chances of an acquisition by having small administration problems that could easily be fixed by a service professional.

The first thing that happens when a company tries to buy you is they contact you. That might sound obvious but it’s an important difference. Usually it’s the other way around. A company tries to approach a buyer. This is an interesting dynamic because it sets the stage for the negotiation. Whoever wants the other more usually ends up getting the worse terms. I don’t know why this is but think it has something to do with people trying to take advantage of the other.

After the first round has been fired and both parties agree to come to the table. A non disclosure agreement will be signed so they can reveal private information to each other without it being released publicly. One of the ways people feel burned during an acquisition is when the non-disclosure isn’t honoured.

It’s very difficult to actually enforce a non-disclosure agreement. It proves more as a whip that can be used but on few occasions is it actually done so. The reason is because they are really hard to prove. It’s like trying to prove who said what and that it definitively did damage the company. The upside of following through on it is minimal.

Something people should be worried about is when the acquiring company uses an acquisition as bait. They treat it as an opportunity to see the inner workings of another company and then cancels the acquisition after they’ve learned everything. This is negotiating in complete bad faith but it does happen. And it sucks.

A common practice is for big companies to use acquisition negotiations to look at the books and private financials of a competitor to see how well they’re doing or to give them ideas. This happens to particularly innovative companies where what they know is a huge competitive advantage. Like in the core sciences. Then they cancel if they aren’t doing as well as first thought or find a reason to change their mind at the last second. Companies who do this should just be avoided full stop.

During the acquisition process. It’s really important a company think long and hard about what they actually reveal. If they have some secret sauce or special hard to come up with ideas, partnerships or plans for the future. They should definitely not reveal those. A good rule of thumb is you should reveal about 2/3rds of what is important. But keep the most important 1/3rd close to the chest.

 

A good way of judging interest is to have the buying party sign a letter of intent before coming to the table. It’s just a document that says they are interested in buying. Like a test for how serious they are in buying you. It’s to stop companies from screwing around and wasting time. If they won’t sign, they weren’t really interested and were testing the waters.

At this point it’s made explicit that the company wants to be bought and the other is serious about buying. This is when due diligence starts. The bigger company will ask to take a look at all aspects of the company and all of the metrics to slice and dice the numbers.

They’ll want to see the capitalisation table, traffic statistics, user numbers, balance sheet, profit and loss statements. If they’re really good they’ll even call your customers to judge how happy they are with your products. These are going to become the ammunition which both sides use to justify a valuation and purchase price for the business.

Really great accountants or financial executives will keep all of this in a secured folder somewhere from the inception of the company. It’s easier to start earlier and keep it up to date than having to scramble to get it all together if someone interested comes along. It should contain everything there is to know about the company. That way when someone is interested in acquiring you, this folder can be sent. It’ll turn a very tedious process into a fast one.

Most people get taken by surprise with the amount of information an acquirer wants. They’ll want to know everything. Think of it like buying a car. You’ll want to know everything about the car before buying it. When you actually close an acquisition, it will mean signing a thankless number of documents. It will surprise anyone by the sheer tediousness of going through a purchase. Then one day it’s like a huge weight gets lifted off your shoulders.

They’ll then search for everything going wrong in the company. Effectively the buyer is searching for a reason to disqualify you. Things like contracts not in place that say all the employee ideas are actually owned by the company or that a large customer doesn’t have to pay you if there is a new owner.

Don’t hide anything bad. If you’ve used someone else’s code or are about to be sued for patent infringement. It should all come out in this process. It’s going to come out anyway and the best way of going about it is just to be earnest.

Be forthright and honest about what is going wrong. It saves everyone time and if the buyer will end it there, it’s better to get to this point sooner rather than later. If they really want to buy you, they’ll buy you anyway and if they don’t, it’s their loss. Right?

The due diligence process can take anywhere from a few weeks to months. For bigger companies, this process takes much longer. For small companies it’s faster because there is less to know. For really big companies, sometimes they have to get governmental approval just to go through with an acquisition and it can take years. Sometimes during this process an outside company can be hired to facilitate it.

An acquisition is actually a hard process. Because it’s taking two distinct and different entities with different values, culture and ideas – then fusing them into one. As you’d imagine this might be difficult and really hurt. There aren’t a lot of mental models for how this process works. The best one is in chemistry.

When two cells fuse in a petri dish, one cell overpowers the other and removes everything unnecessary. The makeup of the new cell ends up being primarily the more dominant of the two cells. If a company were a person, they don’t need two hearts for example. So what should stay and what should go is a process that takes place in the negotiation.

 

After the due diligence is the negotiation. Sometimes this can come before and is usually decided by geography. In the US they like to negotiate first. In Japan the due diligence process comes first. In Australia it depends on the person. This is the process by which both parties establish and argue over the value of the company in order to come to a price for what to pay for it and how it should operate afterwards.

There are different ways to do this and depending on what the company does, there are rules that certain industries follow. You can’t value a high growth technology software as a service business the same way you would value a legacy run family agriculture and farming business which is again different from how you’d value a high end cement making business. Much of this is as much science as it is art and ends up coming down to how convincing one side is in persuading the other of its value.

How do you measure how valuable a company is? The 5 dimensions of an acquisition are how much revenue it makes, how much profit it makes, how valuable the assets are such as patents and the team, how fast it is growing and how many users or customers they have. Every acquisition takes place because of a combination of these. The secret dimension is strategy.

How strategic it would be to buy a company. Strategy in the acquisition sense is just – how much could the smaller company help the bigger company with what they’re already doing or could do in the future. For example if a company figures out how to make something cheaply. It doesn’t matter if they have no customers and no revenue, some big company will buy them to make their products cheaper too.

A question becomes, why would they buy another company in the first place. Why not just do it themselves? Usually it’s cheaper just to buy another company. If it costs a big company 10 million dollars to do something and a startup is already doing it. Then it is cheaper to just buy the startup if it costs less than 10 million dollars to do so.

What big companies don’t like to admit is that when they buy another company, usually it is a sign of defeat. They were beaten by the small company. What every company that buys another company asks themselves is how quickly and easily could they do the same thing? If the answer is it would be difficult, expensive or take a long time, this will be the fire under the canopy for buying the smaller one.

When Ebay bought Paypal, they had tried for years to build their own payment technology Billpoint but failed. They were beaten by Paypal who had built a better payment system. Users just liked them better. So it was easier for Ebay to buy them than to whip their dead horse of a payment gateway. This is how a lot of technology companies get bought even though they may have unsustainable businesses or unenviable user, revenue or profit numbers.

The company isn’t valueing the business per se but it’s potential. The opposite of this and one of the hardest parts of the acquisition process is when a company owns something the other side doesn’t value. When Gilette was in acquisition talks, they believed their new Mach 3 razor, which had not hit the market yet, would be a game changer. And so they wanted a premium on the acquisition price. The buying party didn’t agree and thought it had very little value beyond the patents. The acquisition didn’t go ahead and what proceeded was the buyer ate their words as the Mach 3 became one of the best selling razors of all time.

Sometimes this will mean bringing in an outside consultant to establish a price external to what either wants. The buyer obviously wants to pay a lower price and the seller wants as much as they can get. What an external party does is create an impartial benchmark to compare to. It becomes a fixed point to negotiate around. It’s what a lot of finance types and management consultants do. But they should really be impartial.

If someone is brought in by the acquirer to set a benchmark, you can bet it won’t be unbiased. It just gives them more ammunition in the negotiation. When this occurs the seller gives away a lot of their negotiating power to this new fixed outside justification for the value of their business.

 

After the price of the business is set. It’s time to go through with the acquisition. This means preparing all of the documents that facilitate the transfer of the entity that is the company and everything the company owns. A lawyer should be hired who will handle this process. Founders should never try to execute an acquisition without their lawyer present. If they don’t have one, they should get one. Preferably one who knows about this.

Acquisitions can take a number of shapes. Sometimes a buying company will offer only stock. Other times it will offer only cash. A good combination is some form of stock and cash. And they’ll want the employees of the company they are buying to work for the new company for a set number of years. This is to prevent them from buying a timebomb or bag of hot air which releases shortly after purchase.

It is dangerous to accept only stock because if the acquiring company dies, you sold your company for basically nothing. The acquisition terms end up being worthless. This is what happened during the 2000 .com bubble. Newly formed companies would buy other long running companies in stock only deals, using paper to buy real revenues. Then their companies would tank, the share price would hit 0 and it would ruin the livelihoods of people who’d run their business for years.

It also happened to the Bakers, founder of Dragon Systems, makers of the popular DragonNaturallySpeaking, the best voice recognition software on the market. It was invented out of the research of Dr James Baker. They were acquired in an all stock deal valued in the hundreds of millions by a firm known as Lernout & Hauspie which committed financial fraud and went bankrupt. After going bankrupt the rights for the technology were bought by Scansoft for a song, which later rebranded as Nuance and DragonNaturallySpeaking proceeded to become their best selling product. The Bakers walked away with comparatively little and sued.

This is an extreme example but highlights the dangers of accepting an all stock deal whereas it is in the best interest of a company to offer one. It’s because an acquiring company isn’t going to want to spend their cash reserves buying companies. They would better spend it investing in growth of their own. The opportunity cost of buying a company with cash is all the places the cash could have been spent. None of this opportunity cost exists with a stock deal. It’s only dilution which need be worried about.

A rule of thumb is some combination of cash and stock is ideal. The cash cushions the founders from any downside and the stock allows them to participate in any upside of the buying company. The buying company benefits too because they can use their cash for investing in other things and can buy a company for less. The value of issuing stock versus paying cash is huge. When you issue stock to purchase something, the earn out can be over years which reduces the impact of it. But paying cash happens immediately.

 

It’s also ok to turn down an acquisition offer if you receive one. Just because an offer comes in, it doesn’t have to be accepted. Even after going through this process and completing due diligence. As the saying goes, you regret none of the mistakes you don’t make. The best companies probably have turned down many. Turning down buyout offers is almost a crest that you are in fact building a meaningful company.

What you should not have is desperation to be acquired. This is a huge handicap in a negotiation. Even if the company is going badly, put on a brave face and show what you’ve made. The ability to walk away from a deal is paradoxically often the leverage that will help close that same deal. It’ll also increase the price. The other side will have to or else you’ll just walk away.

It’s the stereotypical movie love scene. The more the guy wants the girl, the less likely she is to go for him. But when he pretends he’s not interested, she comes around. It’s a sad fact of life that the amount someone wants something is related to how able they are to not need it. And for how much or how little the other side needs them back.

The most important takeaway when a company is interested in buying you is to not stop working on the company. Acquisitions can take a long time. But worse they can distract you from running your company and nothing might come from it. You start to imagine what life might be like after the windfall of an acquisition and how hard running a company actually is. It starts to seem like heaven just to be rid of the stresses. Those thoughts, like the sirens for Odyseus can cause shipwrecks.

It sucks when a company pulls out of an acquisition but happens all the time. Running a company should not be the second prize if the acquisition doesn’t work out. The acquisition should be the second prize. It effectively means losing all control and freedom. The number of stories of people who worked hard building their dreams only to be bought out and have it shut down is depressing. It’s almost the majority.

It’s very important to figure out early what will happen to the company and employees after the company gets bought. Is the product just going to be shut down and the team fired? Is the bigger company going to scrap the old company and sell it for parts? Or will the company be left to operate independently, maybe even with more funding from the bigger corporation?

If you don’t voice exactly what you want before the acquisition takes place, then you definitely won’t get it after. The flipside is it’s common for every promise made during the acquisition to not be honoured years later once the company has been integrated into the new one. Plans change. The world changes. And what seems like a good idea at one point might turn out to be disastrous at another.

 

The speed of the acquisition is the best indicator of how interested the company is and how much you can get away with asking for. If they are trying to push a fast purchase, they are really interested. If it seems like an endless negotiation then they are probably reluctant to follow through and you shouldn’t get your hopes up.

A lot of big companies professionally have someone who looks for smaller companies to buy. These people have unceremonious titles like corporate development where there real task is like a vulture circling around a gladiator pit. They might contact a hundred companies with the goal of only buying one, if any.

Most of this is just being precautious. If a big company is going to get disrupted, it will likely come from a small startup. So they have these people try and pre-emptively find and buy them. The price they offer to buy them would seem comparatively small compared to the havoc wrecked to their business if left to survive. It’s the Innovators Dilemma in practice.

Yahoo famously tried to buy Google for 1 million dollars and Facebook for 1 billion dollars. Both turned down the acquisitions and proceeded to decimate Yahoos portal business. I’m sure in hindsight Yahoo realises had they adjusted their price or followed through on both acquisitions, they would have snapped up two of what would become their biggest competitors.

Big companies buy smaller companies for different reasons. Very often it’s for reasons that don’t have anything to do with whether or not it makes a good business sense. They buy companies as a proxy for hiring as known as an acqui-hire or for technology that they can develop, or to take out a competitor, or for strategic relationships or partners, not necessarily for the revenue and profits. It’s like playing chess. Sometimes your opponents can’t see why you’re making a move.

I think a lot of people grow up assuming that businesses have to make conventional business sense to get bought. That a company makes revenue, then it subtracts operating expenses and has profit left over. And the reason a company would get bought is because of these profits. You see this misunderstanding all the time. When people complain that a company doesn’t make much profit for example or is failing yet still gets bought for a high price.

Profit can be a misleading metric because many companies sacrifice it for growth. So their revenue grows while their profit diminishes. Zappos when it was bought by Amazon for nearly 1 billion dollars had no profit but was generating close to a billion dollars per year in revenue.

In theory the perfect business would be one that makes a huge amount of profit, has a large number of customers, grows rapidly, increases revenue and has a lot of valuable assets and a spectacular team. But in the real world, this doesn’t happen. It’s usually only a handful of the above. Rarely is it all of them.

When Color, a photo sharing app was bought by Apple for 40 million dollars, it was a failing business that made no money and had a declining userbase. The reason it was bought was for their patents and engineers. When Whatsapp, a phone messaging app was bought by Facebook for 19 billion dollars, it made comparatively little revenue, about 20 million per year, but had a huge and growing userbase. Same with Instagram which had no revenues but a huge and growing userbase.

The reason each was bought was for their userbase. Facebook hadn’t done super well on mobile device messaging, where WhatsApp thrived and Instagram was taking users away from Facebooks core image hosting service. Neither of these acquisitions had anything to do with how successful a business case either would make. But for external reasons. It didn’t matter how much revenue and profits either business had. They were bought for reasons other than their balance sheet.

Other times it stuns people when a company buys another one then shuts it down straight away. In cases like this it’s because they are taking out a competitor by buying it. So the main business will have less competition and make more sales. Other times it’s to buy the intellectual property or assets only and they didn’t care about the business.

In some places companies use acquiring companies as a way for hiring talented employees to work for them. So they buy the company, shut it down and get the new employees to work on their own products. They are explicitly buying the employees to work on their core business and is how companies can reach very hard to get employees.

When Facebook bought Friendfeed, they also got their founder Paul Buccheit to work for them. So even though Friendfeed had no revenues, they bought a a great product, a strong userbase and the creator of Gmail and Adsense, two incredible and widely used Google products. Most companies would kill to have him work for them. That’s not to say it was the only reason but it was probably something they thought of before going ahead with the purchase.

How you value these kinds of companies is very difficult. How do you value the quality of a person? Some people are better and worse than others. They have better ideas and create better products. If someone has a habit of creating great things and doing great work, the value of that employee is probably higher than the average. That is why companies pay such a high price when they acquire a company for the team.

This is primarily while the companies are private. These kinds of multiples can only be paid in private markets where there is no one who’ll get angry. And if people do it’s none of their business. If public companies were to do this, they’d get a huge amount of public backlash. It would be claimed they’d be intentionally overpaying for another company. And that would largely be true. Because the quality of people is intrinsically hard to determine.

A lot of acquisitions take place for reasons that if people knew about they’d scream foul play. Someone on a board of a big company makes an investment in a small company then convinces the big one to buy the small one reaping a huge return. Conflicts of interest are received badly from the public but are almost encouraged in private. They’re called networks.

Someone did a favour to someone once and so allows them into opportunities they wouldn’t normally have gotten. Doors are opened for family members. Board members offer jobs to their colleagues. Famous venture capitalists like John Doerr even openly claim if there’s no conflict there’s no interest. This isn’t a bad thing. Disagreeable actions with benevolent intent still create a lot of good.

 

Where the wealth is created in a company actually has very little to do with it. It’s in the perception of it. If everyone thinks a business will be great, regardless of whatever position it is in currently, then it will be valued higher. The number of people who doubt the potential of small companies who later become huge is tantamount to that.

A rule of thumb is when a company is small they can be valued higher in private markets. When a company becomes big they can be valued higher in public markets. A good rule for what is a big company is if they have more than 500 employees. In my mind, if there are less than 500 employees then they’re still small.

People forget in the tech world that even big tech companies are considered small on the world stage. Walmart employs over 2 million people and has revenues of nearly 480 billion dollars. Google, Microsoft, Facebook et al are a far cry from those kinds of figures.

You could make the leap and say any company that doesn’t end up on the stock exchange is missing out on unrealised value. They are missing out on the multiple they could get on their earnings when valuing the business. Much of the real wealth is created on the stock exchange. The reason they are valued higher on public markets is because of multiples. Multiples are almost universally smaller in private markets than public.

The average multiple on a public company trading on the stock market is 18 X revenue + assets + another multiple based on the growth rate. If it was a fast growing company that might go up to 25X revenue. For really fast growing companies that can get crazy and go up to over 100X. It takes into account all future earning over the lifetime of the company and once it’s public it is assumed the company will be around for a long time.

That means a company that makes 50 million dollars in revenue could be considered a billion dollar company if it went public. It also depends on how favourable the stock market is to the specific type of company. Companies, like clothes, go in and out of fashion. The stock market is a proxy at large for what people want. If people want what a company makes, its stock will go up. And when people love a type of company too much it affects their judgement of it.

This can be how bubbles get caused. In the late 2000s people loved banks, in the early 2000s people loved finance firms, in the late 1990s it was internet companies, in the 1920s it was houses, in the 1840s it was railways, in 1720s it was ships and in the early 1630s it was flowers.

They’re also influenced by the world at large. Two identical companies with exactly the same earnings could be valued completely differently taking into account perception, industry changes and macroeconomic indicators. If the USA goes to war with China, all of the publicly traded weapons making companies stock will soar while Chinese public companies will probably go down.

Conversely, in private markets as a rule of thumb, a highly profitable company will be valued at 5-20X their revenue depending on how fast they are growing. While a low margin or low profit company will be valued at 1-5X their revenue depending on how fast they are growing.

 

At the time of acquisition if a company has raised money from investors, a lot of the exit value will go to them. Sometimes more than the founders. Often it will even be the investors forcing the company to sell when the founders want to keep going or to keep going while the founders want to sell. The reason is because of the economics of the investor. They have to get a return.

It’s very important and few people think about it. The only two ways of getting a return are by selling the company or going public on the stock market. There isn’t really any middle ground. If a person just wants to run a company for the rest of their lives, they are probably better off not having investors who will force them to do things they don’t want.

There are some fascinating new structures emerging in regard to dividends and different capital structures. One way is to invest in a private company and have dividends from the get go so you can just hold onto the stock forever without going public. Another is to have internal share buyouts where a company uses its revenues to internally buy out its investors so they can get a return while the company stays independent. But these are still new, unpopular and largely unproven.

At the time of an exit. The more money raised by a company means less of the value will go to the founders. This can dilute the hard work put into building the company over years. This isn’t to say raising money is bad. In a lot of cases it is necessary to make a business succeed. But there is an important tradeoff being made between raising money and the percentage of the outcome of a company exit that will go to the founders.

One question I’ve always struggled with answering is: why do you need money? I could never find a convincing answer for that. What it means is I didn’t. Most of the time you don’t. Too many people try to raise money who don’t need it and it gets in the way of the companies who do.

I never understood this concept until I came across a company that did need to raise money. They were a 3D printing company started by a former NASA scientist. They would have no business if they couldn’t afford to buy the infrastructure to print their products.

How can you tell if a company needs to raise money. 2 questions. Could this company exist if it doesn’t raise money? If the answer is no then it probably needs to. Will this company die if it doesn’t raise money? If the answer is yes then it probably needs to.

The side benefit of having lots of money is growing faster but that’s not a reason to need it. It’s more a want. You want money to grow faster. You don’t need it to grow faster. Because for that imperative to be true it means the company would be unable to grow without money which would send it into the argument of the second question.

The best example of this is Box.com which is about to go public. When it does, the founder will own only a 6% stake in the business. Granted, that stake is worth a lot. Could Box have gotten to where they are without raising any money? Probably not. Which is the counter argument. Box would not have grown if it didn’t raise money. Its existence would not be possible.

Selfishness in the early stages of a company is a very good thing. It prevents a founder from selling shares in the business too early and as a result they are less likely to be taken advantage of. A company is your baby and it’s largely your hard work that brings it to fruition. The maxim is short term selfishness, long term generosity. Even to the point of giving it away. What is in the best interest of the founders usually is what is in the best interest of the company.

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