Many
entrepreneurs seek venture capital or private equity as a way to take
their company to the next level. Consider the smart equity alternative
of having a large information technology company take an equity stake in
your company. This article discusses why that is a superior
alternative.
If you are an entrepreneur with a small
information technology based company looking to take it to the next
level, this article should be of particular interest to you. Your
natural inclination may be to seek venture capital or private equity to
fund your growth. According to Jim Casparie, founder and CEO of the
Venture Alliance, the odds of getting Venture funding remain below 3%.
Given those odds, the six to nine month process, the heavy, often
punishing valuations, the expense of the process, this might not be the
best path for you to take.
We have created a smart
equity model designed to bring the appropriate capital resources to you
entrepreneurs. It allows the entrepreneur to bring in smart money and to
maintain control. We have taken the experiences of several technology
entrepreneurs and combined that with our traditional investment banking
merger and acquisition approach and crafted a model that both large
industry players and the high tech business owners are embracing.
Our
experiences in the technology space led us to the conclusion that new
product introductions were most efficiently and cost effectively the
purview of the smaller, nimble, low overhead companies and not the
technology giants. Most of the recent blockbuster products have been the
result of an entrepreneurial effort from an early stage company
bootstrapping its growth in a very cost conscious lean environment. The
big companies, with all their seeming advantages experienced a high
failure rate in new product introductions and the losses resulting from
attempting to internally develop the next hot technology were
substantial.
Don't get us wrong. There were hundreds
of failures from the start-ups as well. However, the failure for the
edgy little start-up resulted in losses in the $1 - $5 million range.
The same result from an industry giant was often in the $100 million to
$250 million range.
For every Google, EBay,
Salesforce, or Twitter there are literally hundreds of companies that
either flame out or never reach a critical mass beyond a loyal early
adapter market. It seems like the mentality of these smaller business
owners is, using the example of the popular TV show, Deal or No Deal, to
hold out for the $1 million briefcase. What about that logical
contestant that objectively weighs the facts and the odds and cashes out
for $280,000?
As we discussed the dynamics of this
market, we were drawn to a private equity investment model commonly used
by technology bell weather, Cisco Systems, that we felt could also be
applied to a broad cross section of companies in the high tech niche.
Cisco Systems is a serial acquirer of companies. They do a tremendous
amount of R&D and organic product development. They recognize,
however, that they cannot possibly capture all the new developments in
this rapidly changing field through internal development alone.
Cisco
seeks out investments in promising, small, technology companies and
this approach has been a key element in their market dominance. They
bring what we refer to as smart equity to the high tech entrepreneur.
They purchase a minority stake in the early stage company with a call
option on acquiring the remainder at a later date with an agreed-upon
valuation multiple. This structure is a brilliantly elegant method to
dramatically enhance the risk reward profile of new product
introduction. Here is why:
For the Entrepreneur: (Just substitute in your technology industry giants name that is in your category for Cisco below)
1.
The involvement of Cisco - resources, market presence, brand,
distribution capability is a self fulfilling prophecy to your products
success.
2. For the same level of dilution that an
entrepreneur would get from a VC, angel investor or private equity
group, the entrepreneur gets the performance leverage of "smart money."
See #1.
3. The entrepreneur gets to grow his
business with Cisco's support at a far more rapid pace than he could
alone. He is more likely to establish the critical mass needed for
market leadership within his industry's brief window of opportunity.
4. He gets an exit strategy with an established valuation metric while the buyer helps him make his exit much more lucrative.
5.
As an old Wharton professor used to ask, "What would you rather have,
all of a grape or part of a watermelon?" That sums it up pretty well.
The involvement of Cisco gives the product a much better probability of
growing significantly. The entrepreneur will own a meaningful portion of
a far bigger asset.
For the Large Company Investor:
1. Create access to a large funnel of developing technology and products.
2. Creates a very nimble, market sensitive, product development or R&D arm.
3. Minor resource allocation to the autonomous operator during his "skunk works" market proving development stage.
4.
Diversify their product development portfolio - because this approach
provides for a relatively small investment in a greater number of
opportunities fueled by the entrepreneurial spirit, they greatly improve
the probability of creating a winner.
5. By
investing early and getting an equity position in a small company and
favorable valuation metrics on the call option, they pay a fraction of
the market price to what they would have to pay if they acquired the
company once the product had proven successful.
Let's
use two hypothetical companies to demonstrate this model, Big Green
Technologies, and Mobile CRM Systems. Big Green Technologies utilized
this model successfully with their investment in Mobile CRM Systems. Big
Green Technologies acquired a 25% equity stake in Mobile CRM Systems in
1999 for $4 million. While allowing this entrepreneurial firm to
operate autonomously, they backed them with leverage and a modest level
of capital resources. Sales exploded and Big Green Technologies
exercised their call option on the remaining 75% equity in Mobile CRM
Systems in 2004 for $224 million. Sales for Mobile CRM Systems were
projected to hit $420 million in 2005.
Given today's
valuation metrics for a company with Mobile CRM Systems growth rate and
profitability, their market cap is about $1.26 Billion, or 3 times
trailing 12 months revenue. Big Green Technologies invested $5 million
initially, gave them access to their leverage, and exercised their call
option for $224 million. Their effective acquisition price totaling $229
million represents an 82% discount to Mobile CRM Systems 2005 market
cap.
Big Green Technologies is reaping additional
benefits. This acquisition was the catalyst for several additional
investments in the mobile computing and content end of the tech
industry. These acquisitions have transformed Big Green Technologies
from a low growth legacy provider into a Wall Street standout with a
growing stable of high margin, high growth brands.
Big
Green Technologies profits have tripled in four years and the stock
price has doubled since 2000, far outpacing the tech industry average.
This success has triggered the aggressive introduction of new products
and new markets. Not bad for a $5 million bet on a new product in 1999.
Wait, let's not forget about our entrepreneur. His total proceeds of
$229 million are a fantastic 5- year result for a little company with
1999 sales of under $20 million.
MidMarket Capital
Advisors has borrowed this model combining the Cisco smart equity
investment experience with our investment banking experience to offer
this unique Investment Banking service. MMCA can either represent the
small entrepreneurial firm looking for the "smart equity" investment
with the appropriate growth partner or the large industry player looking
to enhance their new product strategy with this creative approach. This
model has successfully served the technology industry through periods
of outstanding growth and market value creation. Many of the same
dynamics are present today in the information technology and software
industries and these same transaction structures can be similarly
employed to create value.
Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. To view our lists of buyers and sellers click to visit our Web Site MidMarket Capital
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