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.

M&A strategy is highly dependent on your company’s overall business strategy.  In fact, it is practically impossible to develop an M&A strategy unless a basic 3 to 5 year strategic business plan is in place.  Good M&A strategies are extensions of your business strategy – M&A is simply one tool that can be used to achieve your overall business objectives.  You should do a comprehensive update of your M&A strategy in conjunction with your annual business and budget planning.  The strategy and your progress against it should be reviewed each quarter as a part of your normal quarterly business review process.

There have been thousands of books and blogs written about M&A.  This presentation does not hold itself out to be the definitive work on the topic.  Instead, the presentation provides a basic overview of the topics and analytical techniques you should use to build and maintain your M&A strategy.

There are dozens of high profile firms like Cisco, IBM, Microsoft, Oracle, & Google that are experts at using mergers, acquisitions, and divestitures to create market leading positions and tremendous wealth for shareholders and management alike.  These companies have the teams, financial resources, and connections that make them the absolute top dogs in tech M&A.  The last thing these companies need is advice on M&A strategy and execution.

If you are not one of these Goliaths, then are you locked out of leveraging M&A to build your company?  The answer to that question is clearly no.  Many small to mid-sized tech companies, however, do not have a lot experience or expertise in mergers, acquisitions, divestitures, or exits.  As a result, they tend to shy away from using classic corporate development techniques to grow the value of their business or to achieve a significant exit.  Over the next six weeks DevelopmentCorporate is going to publish an eleven part series that is designed to provide a basic introduction to corporate development techniques.  The series will cover the following topics:

1. How to Build a M&A Strategy
2. How to Build an Exit Strategy
3. How to Build an Acquisition Pipeline
4. How to Divest a Business
5. How to Analyze an Acquisition Candidate
6. How to Pitch an Acquisition to a Board of Directors, Private Equity Firm, or a VC
7. How to Work with Private Equity, Venture Capital, & Investment Bankers
8. The Art of the Initial Management Meeting
9. Operational Due Diligence or What the Lawyers & Accountants Can’t Tell You
10. Acquisition Integration Planning the Sterling Software Way
11. Acquisition Cultural Integration.  Horror Stories & Best Practices

I won’t claim to be the industry’s leading expert on these topics, but I have a fair amount of experience to bring to the table.  I’ve spent the majority of the past 15 years serving as a corporate development executive for public companies, private equity-backed firms, and even a few venture backed firms.  Some of my credentials include

• Served as trusted advisor for four public company boards of directors as well as three large private equity firms.
• Led 4 major acquisitions that closed for over $200 million in consideration. Played a supporting role in 4 other acquisitions that closed for over $300 million in consideration.
• Led 8 major divestitures that generated over $30 million in consideration
• Led the approach, initial management meetings, and due diligence for over 40 acquisition projects
• Developed over 325 in-depth analyses of public and private technology company acquisition candidates
• Led over 12 major corporate restructuring projects

In addition to my successes I’ve also had some blazing failures including joining two venture backed startups that flamed out and trying to create a startup that was totally unfundable.  I am not an investment banker or business broker.  Instead I focus on providing the highest quality, pragmatic advice to management teams, boards, and investors from an operator’s perspective.  I have over 25 years of experience in the technology market place including functional and executive positions in marketing, product management, sales, research and development, customer services, network operations, business development, general management, and corporate development. 

The first post in this series will describe the basics of building an overall M&A strategy.  A key starting point in any M&A strategy is to understand the Enterprise Value of your own company. 

How to Calculate the Enterprise Value of Your Company

Decisions about mergers, acquisitions, divestitures, and exits are typically made in context of your firm’s enterprise value.  Enterprise value is the amount of cash that would be required to purchase your company.  It takes into consideration the value of your equity (market cap for public companies), cash and cash equivalents, debt, preferred stock, and liquidation preferences.  If you are a public company it is easy to calculate your enterprise value.  All you need is a copy of your most recent publicly filed financial statements and your market cap. 

If you are a private company there is a pretty straightforward way to estimate what your enterprise value is.  Here is the basic formula to calculate enterprise value:

Enterprise value =

 common equity at equity value
 + debt at market value
 + minority interest at market value, if any
 - associate company at market value, if any
 + preferred equity at market value
 - cash and cash-equivalents.

Most of the information required to calculate your enterprise value is contained in your financial statements.  Cash and cash equivalents are the easiest since they are right on your balance sheet.  If your firm has debt, you need to calculate not only the outstanding balance but any prepayment or other charges that you would incur if you settled the debt today.  The same thing is true about preferred stock and liquidation preferences.  The value of preferred stock and its associated liquidation preferences should come right off of the stockholders equity section of your balance sheet.  If you have venture capital or private equity invested in your firm you should have a deep understanding of the impact of liquidation preferences.

The challenge with calculating enterprise value for private firms is the value of your common stock or equity.  For public firms this is easy – market capitalization is simply the current share price multiplied by the number of outstanding shares.  For private companies, however, there is no public market to value your stock on a daily basis.  Instead, you have to estimate its value by comparing yourself against other public companies.  You can do this by analyzing at least three public companies in your market place and applying some of their metrics to your situation.

To make this process a little clearer, let’s assume that you are a private provider of ERP solutions for the wholesale distribution marketplace.  Here is a snapshot of your business at this point in time:

To estimate your enterprise value, you need to compare yourself to some other public technology companies that are similar in size and nature to your business.  There’s no point in comparing your company to SAP or Oracle since those firms are 75 times the size of yours.  Four good candidates in the ERP space are MSC Software, i2, Epicor, and QAD.  Once you have identified some firms to compare against, develop a summary matrix of some key indicators, like the one shown below:

Next, develop a comparison matrix where you look at the ranges of key valuation metrics and decide where your company fits into the continuum, as shown below:

Another source of comparable statistics is the fairness opinions developed by investment bankers to support the paid by an acquirer for a particular company.  Often, summaries of these documents are included in SEC filings associated with a public company involved in an acquisition.  Any time a public company in your market is involved in an acquisition, you should review the filings to see what tidbits you can learn.  Recently, Golden Gate Capital and Infor announced the acquisition of SoftBrands.  In conjunction with the deal, SoftBrands filed a pretty extensive proxy statement that included detailed information about the fairness opinion rendered by Piper Jaffray.  You can read the filing here.  The following table presents a list of 33 transactions between 2004 and 2009.  It is interesting to see how valuations changed over that time period.  The Enterprise Value / EBITDA multiple is a good bellwether metric that reached a peak in late 2006.

 The goal of this exercise is to leverage information about the valuation of the companies you are comparing yourself to so you can develop an estimate of your enterprise value.  A couple of notes.  First, you generally should base your calculations off of trailing twelve months (ttm) numbers.  This provides a better insight into your actual performance.  Management teams always have high expectations for the future and basing your enterprise value on anticipated performance is a bit of a crap shoot.  Also, most investors prefer to look at actual performance instead of management’s future projections.  Second, you need to have some logic to justify where you value your firm in the continuum of valuation metrics.  In this particular analysis I felt that the mythical ‘My Company’ was closer in nature and performance to MSC Software and Epicor than i2 or QAD.  Some of the factors in that decision making process were the relative strength of “My Company’s” EBITDA and its relatively strong cash/debt position.  If I were asked to estimate the enterprise value of ‘My Company’ based on the limited information presented here I would estimate a range of $275 million to $325 million. 

The approach to calculating enterprise value for your private company presented in this post is a quick and dirty technique.  It will get you into the relative valuation ballpark.  You can always hire an investment banker or a specialized valuation firm to develop a comprehensive analysis of your value.