For most technology companies achieving a highly profitable exit via an IPO or a strategic acquisition is an important goal. Unless you are lucky enough to work for a red hot technology company, achieving a good exit requires solid planning and hard work over a long period of time. Exit strategies are like sex in high school – everyone talks about it but only a few are doing it right. The objective of this post is to layout a basic approach your company can use to achieve a successful exit. There are three major components to an exit strategy: 1) Understanding Exit Options, 2) Identifying Likely Exit Scenarios for Your Firm, and 3) Developing and Working a Specific Exit Plan.
Understanding Exit Options
To begin with, there are a number of exit scenarios, each with varying degrees of return and probability as shown in the following chart:
Initial Public Offerings. IPOs are the holy grail of technology company exits. They provide the largest short and long term returns for investors and management teams. While the tech IPO market is rather lean right now, a few solid companies have made it out in the past six months like Open Table and Rosetta Stone. The requirements for an IPO remain pretty consistent. They include six or more quarters of consistent >15% organic revenue growth, profitability, and a strong or leading position in the company’s target markets. The harsh reality is that less than 0.01% of tech companies ever make it public via an IPO. In today’s market there are approximately 600 public technology companies on the NYSE, NASDAQ, & AMEX.
Strategic Acquisition. The next most profitable exit scenario is being bought by a strategic acquirer. Classic examples of this scenario include Google’s acquisition of YouTube, Cisco’s acquisition of Pure Digital, or Amazon’s recent acquisition of Zappos. In strategic acquisitions, the acquirer pays a huge premium for the acquired company – typically >5x trailing twelve months revenues. Strategic acquisitions are more the exception than the norm. They typically account for less than 5% of all tech M&A transactions. To put this in context take a look at the following chart that describes the number and value of U.S. software M&A transactions since 2006. The data is courtesy of the Software Equity Group which regularly publishes some of the best quantitative as well as qualitative data about software M&A transactions.
As the chart indicates there have been about 1,300 software M&A transactions in the past 12 months and maybe 50 of them could be considered to be strategic. Strategic acquisitions typically are driven by one of two criteria: 1) your company’s technology is truly game changing and significantly accelerates the acquirer’s business strategy or 2) the threat of a competitor acquiring your technology is too risky for the strategic acquirer to take. Just as with IPOs, it is extremely rare for any given technology company to exit via a strategic acquisition.
Reverse Mergers. In a reverse merger, a private company acquires a public company and the resulting merged company remains public. On the surface, this seems to be a viable strategy for technology companies that do not meet the requirements of a traditional IPO. Sometimes, a private company acquires a public shell company that is no longer active, but still is listed – such as Kahzam’s recent acquisition of Centarus Resources. The central theme of such deals is that the new company will have publicly traded stock that enables investors to cash out of some of their holdings. From a structural perspective these transactions are relatively easy, cheap, and fast to execute. The reality is, however, that there have been no technology companies of any significance that have executed and significantly profited from a reverse merger. If a private technology company did not have the performance to justify an IPO or a strategic acquisition, it is extremely unlikely that they will be able to attract significant market interest or high valuations via the reverse merger route. Instead they will simply have decreased their profitability by having to incur material expenses for SEC and stock exchange compliance. They will also probably suffer some competitive issues since as a public company they will need to disclose significant information about their business and performance that in the past were private and unavailable to the general public.
Minority Investments. A recent area of interest in technology marketplace has been minority investments by private equity firms in private technology companies. In this scenario, a private equity firm purchases a non-controlling portion of a firm’s stock. This enables founders, investors, and executives to monetize their equity while at the same time providing the company with new working capital to fund expansion and growth. In the past none months I have spoken with over a dozen middle market technology private equity firms who are searching for minority investments. These types of investors are looking for companies that have solid financials (strong recurring revenues, decent profitability, cash flow, and clean balance sheets) plus the opportunity to grow through the injection of new capital. Growth can come from organic sources (increased global sales and distribution) as well as from consolidative M&A transactions. While there has been a lot of activity around minority investments in the past year, few, if any material transactions have closed yet.
Leveraged Recaps. In a leveraged recapitalization, a company takes on new debt in order to pay investors, shareholders, executives, and option holders a one-time dividend. This was a common strategy during the height of the last credit bubble. I was fortunate enough to participate in one of these transactions at a PE-backed firm I was an executive at in 2005. The benefits of this approach are similar to a minority investment – investors basically get a return on their investment now instead of waiting for an IPO or strategic acquisition. Another benefit is that the company does not take on another set of owners who have ideas about how to drive their business. There are several disadvantages to this approach, however. First, your company has to service and retire the debt. Funds allocated to debt service cannot be used to invest in new products, expand distribution, or support mergers and acquisitions. Debt also comes with covenants that require your company to hit specific financial targets and can require lender consent for other types of corporate development activities in the future. Finally, the debt markets are basically frozen for almost all technology companies today. In 2006 and 2007 decent technology companies could raise covenant-lite debt in the amount of 4x to 6x trailing twelve months EBITDA. In today’s market if you are lucky to find some lenders the most you might be able to raise is between 1x and 2x ttm EBIDTA and you can expect to pay 12% to 15% interest.
Financial Sponsor Sale / Take Private. The second most prevalent exit scenario for tech companies today is the financial sale or take private transaction. Under this approach a company sells itself to a private equity firm or consortium who restructures the company for improved performance and eventually either takes the company public or sells to another investor / strategic acquirer down the road. Valuations for transactions like this are a fraction of what a company could achieve via and IPO or strategic acquisition. Most financial buyers will pay between 1x and 3x ttm revenues and/or 2x to 6x restructured EBITDA. The restructured EBITDA concept is important – financial sponsors look at how they can improve the profitability of a company relatively quickly. In the case of a public company most sales to financial sponsors involve taking the company private. Often, the elimination of public company costs (compliance, legal, board of directors, insurance, etc.) can deliver significant short term value.
There have been a fair number of financial sponsor / take private transactions over the past few months. Take a look at this post, Tech Private Equity is Like 2003 Again . . . And That’s a Good Thing, where we discuss the recent sales of MSC Software, SumTotal Systems, and Softbrands, Inc. A classic example of the success of this strategy comes from the much recently maligned Cerberus Capital Management (note: I was a corporate development executive at a Cerberus portfolio company from 2005 through 2007). As reported in BreakingViews.com Cerberus is poised to make a 24x return on its investment in Talecris Biotherapuetics. Cereberus bought the company from Bayer in 2005 for $590 million with only $83 million in equity. They refocused the company and realigned management incentives which drove a four-fold increase in profitability. They recapped the company in 2007 which resulted in a $630 million divided to Cerberus. Talecris recently filed for an IPO and if it prices out near the top of the range Cerberus could end up with another $1.4 billion. Additionally, a recent study by Ernst & Young demonstrated that European private equity backed firms generated significant growth in employment, profits, and exit valuations.
Cash Flow / Life Style. The last exit scenario is the hardest to accept but in reality is the most prevalent ‘exit’ for technology companies. Under this approach executive management and the board of directors finally come to the conclusion that their business will never achieve one of the other exits described above. Once that painful reality settles in, the company focuses on maximizing profitability and cash flow for the investors, management, and employees. Companies that reach this stage do not need huge R&D teams since investment in new products will not yield good results. They do not need large sales forces since the number and value of net new customers is very low – they simply need solid teams to manage and support their key existing customers. They do not need large marketing budgets or PR teams since these investments rarely generate enough new business to justify the investment. This is a hard decision to make, but at the end of the day all products and technology markets eventually phase out and are replaced by something new. This is not an indictment of management, just a recognition of the reality of the natural birth, growth, and decline of technology markets and companies. ‘Legacy’ markets and technologies can persist for decades and provide significant returns to appropriately sized and scale companies.
Identifying Likely Exit Scenarios for Your Firm
Once you understand the various exit scenario alternatives, you need to select what are the most likely scenarios for your particular firm and what sequence you wish to pursue the options in. This is a difficult process since it requires your team to be brutally honest about your company’s history and prospects. If your team is not willing to be honest then it is unlikely you can develop and execute a viable exit strategy.
Take a look at the following chart – it is not a hard and fast sequence of exit scenarios but it gives you a pretty good idea about how the options play out over time:
Exit scenarios tend to be time based. The longer your firm has been in existence, the fewer options you typically tend to have. If your company is a serious IPO or strategic acquisition candidate then you probably don’t need advice from someone like me – there are a ton of qualified people already knocking on your door to help you execute those strategies. To help eliminate any doubt, however, here are a few well accepted criteria you can use to assess the feasibility of exiting via an IPO or strategic acquisition in the next two years. If you cannot answer each of these questions with a resounding YES then you need to examine other potential scenarios. The criteria include:
- Does Your Company Have >$50 Million in Annual Revenues?
- Does Your Company Have >20% Sustained Year Over Year Organic Revenue Growth?
- Are >20% of Your Company’s Revenues from Outside the USA?
- >50 SaaS or Recurring Revenues?
- Do You Have >10% Profitability and Is Profitability Growing?
- Does Your Company Have Industry Recognized #1, #2, or #3 Market Share in Core Markets?
- Is Your Company Recognized Leader (not a Visionary) by Gartner and at Least Two Other Leading Industry Analysts?
- Does Your Company Have a Demonstrated Track Record of Using New Capital to Drive Material Growth in Revenue, Profits, and Valuation?
- Does Your Core Technology Represent a True Game Changing Event for the Market Place?
If you answer no or maybe to any of these questions, then most likely you are not a good candidate for an IPO or a strategic acquisition. In and of itself this not a bad thing – your company can still achieve a valuable exit for your investors, management, and employees. In fact the vast majority of tech companies achieve great exits without IPOs or strategic acquisitions. The next thing you have to decide is which of the remaining options you wish to target, the sequence in which you wish to pursue them, the valuation levels you would require to execute on any option, and the timeframes by which you wish to achieve specific exit scenarios.
An important starting place is to determine what an acceptable exit valuation would be at various points of time over the next five years. This is best expressed as a premium to your current enterprise value. If you need some help calculating your enterprise value check out this post How to Calculate the Enterprise Value of Your Private Company. You should build a simple matrix, like the one shown below, to clearly document the expectations of your management team, board, and investors. The cells highlighted in yellow are assumptions you can modify based on your understanding of the market for your company’s business. You can download a copy of the spreadsheet here.
This model helps to put the various options into perspective. Using this model, management teams and boards can identify the priority by which they wish to pursue a specific exit strategy. From a strictly financial point of view a financial sponsor sale would yield the best result for this company, followed by a 30% minority investment.
Developing & Working a Specific Exit Strategy
There are a couple of key components associated with building an executing an exit strategy. These include developing an exit messaging platform, building an exit network, developing revenue alliances, executing exit networking events, , and finally monitoring progress and adjusting the strategy.
The first element focuses on developing and exit messaging platform. When you engage with potential investors or acquirers, a key challenge is explaining the value of your business. An exit messaging platform enables your company to deliver a succinct and comprehensive explanation of your company’s value. It is something that executive management and boards of directors can use on a consistent basis to educate the market about your company. A messaging platform is typically delivered as a short, two page executive summary of your business coupled with a short, investor-centric PowerPoint presentation (<10 slides). Usually, the executive summary includes: Company Vision, Corporate Chronology, Target Markets (Structure, Size, Growth Rates, Key Trends), Product / Service Overviews, Competitive Positioning & Differentiation, Executive Management/Board/Investor Summary, and a very high level financial summary. The PowerPoint presentation typically contains the same information with some added detail. Additionally, the PowerPoint often includes a basic explanation of how your technology works and the value it brings to customers. Often, investors do not have a detailed understanding of the mechanics of specific technology markets so you need to make it easy for them to understand how your company’s solutions fit into the overall technology ecosystem.
The second step in this process focuses on building an exit network. This is basically a set of specific contacts at targeted strategic / tactical acquirers, investment bankers, venture capital firms and private equity firms. At the end of the day, most successful exit transactions are initiated via trusted contacts that have been built up over a long period of time. Cataloging your existing contacts is a good start and then you should identify specific firms and individuals that could be of assistance in an exit scenario.
The third step focuses on building revenue alliances with potential strategic or tactical acquirers. A high percentage of acquisitions are between companies that have existing revenue-centric alliances. Revenue alliances, where companies package and resell their partner’s products/services play a critical role in exit scenarios. These alliances enable the participants to develop a solid understanding of each other’s business, customers, and management teams. A recent example of this approach was Facebook’s acquisition of Friendfeed.
The fourth step in this process is to conduct various exit networking ‘events’. Typically, this involves short personal meetings between your CEO or head of business development and one of your exit network contacts. The goal of these events is to educate the network contact on the basics and value of your business and to provide a steady stream of updates over time. The executive summary document and presentation described earlier are often used in these meetings. An effective tactic is to combine travel by your CEO to remote offices or customers with visits to contacts in your exit network. Additionally, it is often helpful to make an annual ‘tour’ to major cities where your networking contacts reside (New York, San Francisco, London, etc.) to provide an annual update on your company’s progress. Additionally, your company should seek to get exposed to as many acquisition opportunities as possible. Even if your company is not in a position to conduct an acquisition, getting exposed to deal flow from investment bankers will help raise the visibility of your company in the marketplace as well as help you keep track of trends in market valuations and the interests of strategic acquirers and various financial sponsors.
The final step in the process is to develop a regular process for monitoring the progress of the overall plan and adjusting your strategy as appropriate. It is recommended that you include a status update for your exit strategy in the regular quarterly review of your business. You should also do a comprehensive update in conjunction with your annual business plan.