Designing Good Exits: It’s Not Just for Architects
None of us would feel comfortable in a building where no thought had been given to how to exit the structure. A rushed and panicked egress would be dangerous, and no building has its first brick laid without viable exit paths being designed into its architecture.
The same is true with start-up companies. But, more often than not, founders don’t give thought to architecting exit paths for their start-ups until it’s too late. Entrepreneurs are a sanguine lot, and nurse heady visions of exit via IPO for their companies. However, as recent numbers show, over 91% of all exits are through mergers and acquisitions (M&A), not IPO: according to the National Venture Capital Association’s 2017 Yearbook, the period 2012-2016 saw 4,084 M&A transactions against 387 IPOs.
With these probabilities in mind, start-up entrepreneurs are well-served by planning for their most likely exit path, the M&A, and doing so just as architects do: from the very beginning of their start-up project. Today — and every day that follows — is the right time to lay the groundwork for a good M&A exit. Being M&A-ready is not an afterthought that should be left to Day N of your company’s life.
Of course, the ideal path to an exit, including to an IPO, is via regular and substantive revenue growth, with the start-up’s steady approach to profitability. If your company falls into this happy category then you’ll have a long line of corporate suitors (and maybe even IPO underwriters) wending its way to your door. But whether your company is a wild success or whether your start-up life is characterized by hand-to-hand combat for customers and hand-to-mouth finances, you need to start today in planning and preparing for your statistically-likely exit. Here are five guideposts to help you on that path.
Build a Business Case for Your “Customer”
In an M&A, your “customer” is the acquirer. So just as you take pains to understand why your actual end-customers will pay you good money for your product, you should also take pains — on Day 1 of your company’s life — to understand your universe of potential acquirer “customers”, and why each would pay good money to one day acquire your company. Understand at a deep level the essence of the business of each potential acquirer and how you would add value (specifically, revenues) to it.
No acquirer — not public companies nor private ones — want negative effects on their bottom line from an acquisition. Everyone needs a plausible reason as to why an acquisition will be earnings-per-share (EPS) accretive, if not today then at some point in the not-too-distant future. As a consequence, the foremost thing you need is a believable business case that illustrates the customer and revenue impact you can bring to the acquirer. With the business case as your driver, partner early and partner closely with each potential acquirer. (Co-selling is the best form of partnership!) Keep in mind that end-customer sales cycles are always longer than you expect, and corporate partnerships (both at the organizational level and the ever-crucial personal level) take a long time to build.
It’s a truism that companies are bought, not sold. The best guidance for how to engineer your start-up to be bought is to always see it as an acquirer (and their investment banker) would: discover the holes and liabilities and fix them; discover the strengths and (revenue) opportunities and build on them.
Identify Multiple Acquirers
Imagine turning up at an art auction and finding that you’re the only bidder there. Who’ll then set the price for whatever masterpiece is on offer? You will, of course. It’s for this reason that start-ups need to build partnerships as early as possible with multiple potential acquirers. One is not enough, no matter how deep the relationship. Identify potential acquirers who are in complementary spaces so that your partnerships aren’t derailed by competitive concerns. Build a business case for each acquirer. Then partner aggressively with all of them. Remember, if there’s only one bidder for your M&A deal then you’re not going to be the one setting the acquisition price.
Exercise Corporate Hygiene — Always
Start-up life is characterized by an unending series of exigencies, each more critical than the last. It’s easy under these circumstances to lose sight of the dreary, quotidian bureaucracy also associated with running a company. Doing so, however, will likely be an M&A deal-killer. Acquirers want transparency into your business and a comprehensive understanding of all of the risks, liabilities and obligations your start-up might bring.
Satisfying the need for transparency requires that you exercise corporate hygiene in the running of your company from the very first day. This will allow you to build a bulletproof portfolio of diligence items that an acquirer will eventually demand. At a minimum you should be prepared to provide:
- Clear evidence of IP ownership: signed confidential and proprietary information agreements with employees and contractors, including with mundane entities such as off-shore QA companies. In the software sector, acquirers might also expect an assurance that you use no open source code in your technology base.
- Patents: and who’s listed on these patents?
- Organizational chart: employee name, job title, location, compensation. Any severance agreements or stock acceleration?
- Signed board minutes for all board meetings
- Unresolved litigation. Also, might there be litigation risk once the acquisition is announced?
- Stock issues
- D&O (directors and officers) insurance: always better to have this in hand. You may not be able to get a policy once a term sheet has been issued.
- Quarterly and annual financial statements
- Customer lists
- Cap table
- Copies of all agreements (must be transferrable to an acquirer): customers, partners, vendors, landlords
- Employee records: any tax issues?
- Employee benefit programs
- Presentations used in diligence meetings
Corporate hygiene — i.e., religiously keeping on top of all of the items above — needs to be institutionalized into your operating practices from the day your company’s founded. It’s well-nigh impossible to build in hygiene as an afterthought, let alone at the eleventh hour of an M&A diligence exercise. Bear in mind that while this will be your company’s first acquisition, it may easily be your acquirer’s hundredth. They’ll have a process! You need to be able to smoothly feed that process as your acquirer demands.
The topic of “disclosures” will also arise: specifically, what dark secrets lurk in your company that must be divulged? Lawsuits? Delinquent employment taxes for that former sales rep in Monterey? Unpaid invoices? The best advice on disclosures is to disclose everything. This is the only thing that’s going to release whatever transaction proceeds that will be held in escrow, and also prevent you from getting sued for fraud somewhere downstream.
Importantly, employ an outstanding attorney as company counsel from your very first day of business. In an M&A, you never want your attorney to merely be the second smartest legal mind in the room. It’s painful.
Get a Good Banker
Just as you want your attorney to be smarter and more experienced than your acquirer’s attorney, you also want your investment banker to be smarter and more experienced than your acquirer’s banker and internal M&A team. Recruiting — and I mean “recruiting”, not “selecting” — a top-notch banker is key. The best bankers can do without your business, which is why you’ll need to sell them on your deal, as much as (indeed, more than) they try to sell you on their services.
There’s a large class of bankers who can make the sun shine in the Mojave and the tide come in twice a day, and will cite these as proof of their capabilities. Needless to say, avoid these masters of the facile. The best bankers, whether they’re high-profile, bulge-bracket firms or world-class boutiques, add actual value in your transaction. They help build the synergy story for the acquirers, have credibility with potential acquirers, are able to bring multiple suitors to the altar, are familiar with what the “market” conditions are for deal terms (escrow periods, holdbacks, management carve-outs, …), and are able to maximize the results of the transaction.
Perform rigorous due diligence on all bankers under consideration: confirm that they’ve added value in multiple sell-side transactions in your space. References with past clients are best.
Time is Not on Your Side
It’s probably fair to say that never in recorded history has an acquisition price gone up after an M&A term sheet has been issued. If you’re lucky, the deal will close at the term sheet’s price. But perhaps more likely, your deal will close at a lower price than on the term sheet. Why? Because “issues” get exposed in the diligence process, issues that negatively affect the acquisition price.
Time, therefore, is your greatest enemy in an M&A process. The longer your diligence runs the greater the chance that some issue or development will reduce your acquisition price, if not upend your transaction altogether. These may be anything from macro-economic forces, to negative diligence results, to litigation, to management turn-over or missed quarterly earnings at the acquirer. Which is why every start-up needs to have its sell-side diligence — business case and corporate hygiene items — in hand well in advance of any deal. Delaying this “until we need it” only compromises speed and your ability to have the exit you so desire.
Start Yesterday. You’ll Thank Yourself Tomorrow.
For start-ups, unfortunately, it remains a buyer’s market. Power is firmly vested in the hands of larger acquiring companies. This dynamic is unlikely to change — ever. With that reality in mind, and given the sheer number of start-ups being founded every year, the vast majority of whom will find themselves clamoring to be acquired, entrepreneurs need to carefully craft their businesses to optimize their chances for a profitable exit via the path of acquisition.
Just as you wouldn’t wait till age 65 to start planning for your retirement income, nor should you wait till your “We have to exit!” moment to start planning for getting your start-up acquired. Nothing is gained by ignoring the realities of life. So start planning and preparing for an acquisition at the earliest possible moment, and keep these M&A dynamics in mind when making day-to-day operating decisions. Do things right, and the only time you’ll see the words “No Exit” will be on street signs you pass as you drive to consummate your M&A mega-transaction.