Buyers and Investors In Pre - Revenue Companies are an Endangered Specie

Before you dismiss my premise and label me as one who is out of step with the highly publicized social media mega deals, I am excluding them from my population. I am excluding them because they have a very important characteristic of value and that is broad customer acceptance. That acceptance was generally accomplished virally and very inexpensively. The owner of that technology will, the wisdom goes, eventually figure out a way to monetize all of those valuable users.

For purposes of this article I am limiting my population to technology based products and businesses that are aimed at the B2B marketplace. A good example might be application software. I may need a little help from Charles Darwin here with his theory of natural selection or may borrow from the saying that there are old pilots and there are bold pilots but very few old bold pilots.

Technology companies that buy other companies or professional investors that buy technology based companies generally have a first gate that all acquisitions have to pass in order to be considered as an acquisition candidate. Those targets must have real paying customers producing revenues, not necessarily profits, but that also is an often used helpful gate. 

Another gate is the level of revenues. We have small software companies approach us and say that Microsoft or Google or Apple should buy them. They have $5 million in revenue. Unless they are in the massive user base category or have a quantum leap technology, there is no chance. The corporate development people in those organizations are under instructions to only consider move the needle opportunities. It takes as much resource to complete a $300 million acquisition as it does a $5 million acquisition. Where do you think these giants are focusing their resources?

In working with entrepreneurs we see several recurring themes. They are wonderfully optimistic. With the odds of succeeding  in a start-up business not in their favor they must employ emotional blinders in order to press on. They believe their product compares very favorably on a feature/functionality basis with the leading competitive solutions on the market. Their estimate of both the TAM (total addressable market) and their eventual share of that market are highly aggressive. They under estimate the difficulty of reaching a critical mass of paying customers. And most importantly, they believe in their mission and deliver their message with the passion and commitment of a Billy Graham sermon.

We know from first-hand experience having represented several of these promising companies over the years. With this arsenal of optimism, these entrepreneurs have been pitching the corporate development departments, angel investors, venture capital funds, individual investors, friends and family, etc. You know what the buyers and investors all found out (even the super stars from Silicon Valley fail on 8 out of 10) was that they were not particularly good at picking the winners pre-revenue or pre- critical mass revenue.

Getting back to my Charles Darwin reference, the survivors evolved. They developed a characteristic that has enabled them to prosper. They no longer try to predict the winners pre-revenue. They let the market do it for them. No guru, no survey, no analytics is ever going to match the predictive power of the wisdom of crowds casting their economic vote to identify the winner. 

The second gate, the size of revenue also performs a very important function especially when it comes to information technology or emerging technology. A large company will often expend as much internal resource in integrating a new product into their organization and rolling it out to their sales channel as they originally spent for the company acquisition. Given that backdrop, they want to eliminate or reduce as much as possible, the technology risk. In other words, does the stuff work and will it stand up to the rigors of thousands of users. A product that has achieved a critical mass of users has been subjected to the quality control of paying and renewing customers with other choices. The major bugs have been worked out and the product has gone through a continual feedback loop of improvement.

The company buyers/investors survivors recognized that it was too difficult to predict the winners pre-revenue, even with the smartest guys in the room, without a natural market vetting process. The economic vote of a critical mass of customers has proven to be the best of all predictors of success. When a technology entrepreneur hits this gate with his targeted buyer and gets quickly dismissed, it doesn't mean that he has a bad product, it means that he has one more step to take before the money starts to flow. Focus your resources on generating sales.

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

Bridging the Valuation Gap between Business Seller and Business Buyer

Statistics show that a surprisingly low percentage of businesses for sale actually sell during their first attempt. The major reason for that is the valuation gap between the buyers and the seller. This post discusses how that gap can be breached resulting in completed business sale transactions.

In an earlier article we discussed a survey that we did with the Business Broker and the Merger and Acquisition profession. 68.9% of respondents felt that their top challenge was dealing with their seller client's valuation expectations. This is the number one reason that, as one national Investment Banking firm estimates only 10% of businesses that are for sale will actually close within 3 years of going to market. That is a 90% failure rate.

As we look to improve the performance of our practice, we looked for ways to judge the valuation expectations and reasonableness of our potential client. A Mergers and Acquisitions firm that fails to complete the sale of a client, even if they charged an up-front or monthly fees, suffers a financial loss along with their client. Those fees are not enough to cover the amount of work devoted to these projects. We determined that having clients with reasonable value expectations was a key success factor.

We explored a number of options including preparing a mock letter of intent to present to the client after analyzing his business. This mock LOI included not only transaction value, but also the amount of cash at closing, earn outs, seller notes and any other factors we felt would be components of a market buyer offer. If you can believe it, that mock LOI was generally not well received. For example, one client was a service business and had no recurring revenue contracts in place. In other words, their next year's revenues had to be sold and delivered next year. Their assets were their people and their people walked out the door every night.

Our mock LOI included a deal structure that proposed 70% of transaction value would be based on a percentage of the next four years of revenue performance as an earn out payment. Our client was adamant that this structure would be a non-starter. Fast forward 9 months and 30 buyers that had signed Confidentiality Agreements and reviewed the Memorandum withdrew from the buying process. It was only after that level of market feedback was he willing to consider the message of the market.

We decided to eliminate this approach because the effect was to put us sideways with our client early in the Mergers and Acquisitions process. The clients viewed our attempted dose of reality as not being on their side. No one likes to hear that you have an ugly baby. We found the reaction from our clients almost that pronounced.

We tried probing into our clients' rationale for their valuation expectations and we would hear such comments as, "This is how much we need in order to retire and maintain our lifestyle," or, "I heard that Acme Consulting sold for 1 X revenues," or, "We invested $3 million in developing this product, so we should get at least $4.5 million."

My unspoken reaction to these comments is that the market doesn't care what you need to retire. It doesn't care how much you invested in the product. The market does care about valuation multiples, but timing, company characteristics and circumstances are all unique and different, when our client brings us an example of IBM bought XYZ Software Company for 2 X revenues so we should get 2X revenues.

It is simply not appropriate to draw a conclusion about your value when compared to an IBM acquired company. You have revenues of $6 million and they had $300 million in revenue, were in business for 28 years, had 2,000 installed customers, were cash flowing $85 million annually and are a recognized brand name. Larger companies carry a valuation premium compared to small companies.

When I say my unspoken reaction, please refer to my success with the mock LOI discussed earlier. So now we are on to Plan C in how to deal with this valuation gap between our seller clients and the buyers that we present. Plan C turned out to be a bust also. Our clients did not respond very favorable when in response to their statement of value expectations we asked, "Are you kidding me?" or "What are you smoking?"

This issue becomes even more difficult when the business is heavily based on intellectual property such as a software or information technology firm. There is much broader interpretation by the market than for more traditional bricks and mortar firms. With the asset based businesses we can present comparables that provide us and our clients a range of possibilities. If a business is to sell outside of the usual parameters, there must be some compelling value creator like a coveted customer list, proprietary intellectual property, unusual profitability, rapid growth, significant barriers to entry, or something that is not easily duplicated.

For an information technology, computer technology, or healthcare company, comparables are helpful and are appropriate for gift and estate valuations, key man insurance, and for a starting point for a company sale. However, because the market often values these kinds of companies very generously in a competitive bid process, we recommend just that when trying to determine value in a company sale. The value is significantly impacted by the professional Mergers and Acquisitions process. In these companies where there can be broad interpretation of its value by the market it is essential to conduct the right process to unlock all of the value.

So you might be thinking, how do we handle value expectations in these technology based company situations? Now we are on to Plan D and I must admit it is a big improvement over Plan C (are you kidding)? The good news is that Plan D has the highest success rate. The bad news is that Plan D is the most difficult. We have determined that we as Mergers and Acquisitions professionals are not the right authority on our client's value, the market is.

After years of what are some of the most emotionally charged events in a business owner's life, we have determined that we must earn our credibility to fully gain his trust. If the client feels like his broker or investment banker is just trying to get him to accept the first deal so that the representative can earn his success fee, there will be no trust and probably no deal.

If the client sees his representatives bring multiple, qualified buyers to the table, present the opportunity intelligently and strategically, fight for value creation, and provide buyer feedback, that process creates credibility and trust. The client may not be totally satisfied with the value the market is communicating, but he should be totally satisfied that we have brought him the market. If we can get to that point, the likelihood of a completed transaction increases dramatically.

The client is now faced with a very difficult decision and a test of reasonableness. Can he interpret the market feedback, balance that against the potential disappointment resulting from his preconceived value expectations and complete a transaction?

Dave Kauppi is a Merger and Acquisition Advisor and President of MidMarket Capital, providing business broker and investment banking services to owners in the sale of lower middle market companies. For more information about exit planning and selling a business, click to subscribe to our free newsletter The Exit Strategist

Financial Advisors – It's Time for Some Difficult Discussions with Your Business Owner Clients

If this recent market meltdown has taught us anything it is to make sure you are diversified over several investments and asset classes. Would you recommend that a client put 80% or more of their assets into a single investment? Of course not, but a large percentage of your clients actually have that level of concentration. Your clients that are business owners likely have 80% or more of their family's net worth tied up in their business. On top of that, privately held businesses are illiquid assets often requiring one to two years to sell. So for your baby boomer business owner clients, it is time to have some tough discussions. It is time to move your financial advisory practice beyond the scope of a provider of financial products to an advisor on family wealth maximization solutions.

Business owners are typically not proactive when it comes to exit planning or succession planning in their business because it forces them to embrace their own mortality. Well, they just need to get over it. If an owner has a sudden debilitating health issue or unexpectedly dies, instead of getting full value for the company, his estate can sell it out of bankruptcy two years later for ten cents on the dollar. This is a punishing financial result for the lack of appropriate planning.

Statistics on Business Exits

• According to Federal Reserve's Survey of Consumer Finances, in 2001, 50,000 businesses changed hands. That number rose to 350,000 in 2005 and is projected to increase to 1,000,000 by 20015. Some estimates place the value of businesses transitioning to new leadership over the next ten years at $10 TRILLION. The Price Waterhouse Trendsetter Barometer Survey shows that nearly 65% of CEO's plan to retire within ten years or less: 
• 42% within 5 years.  51% of those plan on selling to another company while 18% plan on a transition to family members and another 14% plan on a management buyout.

·         Only 22% have done a great deal of succession planning and another 26% have done some. But 24% have done little, and 19%, virtually none.  9% did not report.

·         Only 39% percent of CEO's have a likely successor in mind, but less than two-thirds of them say that person is ready to take control today. 

But among those planning to sell their business, far fewer have explored the following opportunities:

·         Only 36% have planned how to increase after-tax proceeds;

·         Only 35% have developed an investment strategy to protect and manage their monetized wealth

Questions You Should Be Asking of Your Business Owner Clients

In your role of providing a holistic approach to maximizing your client's wealth, you should be asking these questions:

       What are your plans for your business when you retire?

·         Do you have children that you want to take over the business?

·         Have you determined how you are going to transfer the ownership?

·         Do you know how much your company is worth?

·         What % of your family's net worth is in your business?

·         In your business life, what keeps you up at night?

·         If you were hit by a bus tomorrow, God forbid, what would happen to
your business?

In your role of trusted advisor, you simply must ask these difficult questions and guide your client in exploring options and planning for his eventual exit. Before he just assumes that the  torch will be carried by the next generation, make sure that the next generation even wants to run the business.  Imagine the loss in value that would have occurred if the real estate billionaire from the western suburbs of Chicago had turned his empire over to his son who simply wanted to produce plays.

Are his heirs even capable of running the business?  Has he held on to the reins so tightly that the kids involved in the business have not been able to develop their decision-making or leadership skills?  Do they command company respect because of their personal strength and skills or are they grudgingly granted respect because they are the child of the owner?  If that is the case, the odds are not good for them taking over when he retires.

The business owner must make some difficult decisions when he or she decides it is time to retire. Why did he create this business?  Was it to keep this business in the family for generations or was it to provide for his family for generations?  If the desire and the capability of the children are not evident and the company is large enough, it may be the right decision to first get outside board members actively involved as step one.  Step two would be to hire professional management to run the business. A second alternative is to sell the company while he is still running it and it can command its highest value. If he has children that want to remain in the business for the immediate future, incorporate that into the sale agreement with employment contracts.
Another way to ask your client to think of it is, while I am running the business, the best ROI is to keep the bulk of my net worth invested in this company.  If I am no longer running the company what is the best risk reward profile for my net worth?  Would my heirs be better off if the business was sold and the value converted to financial assets?

Many financial advisors feel uncomfortable having these types of discussions with their clients. Because of the business owner's reluctance to plan for his business exit, you should actively get out in front of the process with your client. This decision and how it is executed will be the single most impactful event in your client's financial future. You can take on the quarterback position in assembling a multidisciplinary team that can include:

The Financial Advisor – Coordinate all the pieces for a holistic wealth maximization plan

Attorney – Create the necessary documents, wills, trusts, family LLC's, corporate structure, etc.

Estate Planner – work with financial advisor and attorney to create the properly documented estate roadmap

CPA/Tax Advisor – review corporate structure, analyze after tax proceeds comparison of various transaction structures, create tax deferral and tax avoidance strategies

Investment Banker/Merger and Acquisition Advisor – Analyze the business, create value creation strategies, position the company for sale, and create a soft auction of multiple buyers to maximize selling price and terms.

As your business owner clients approach retirement, you need to help them with investment decisions that employ sound diversification and liquidity strategies. Their business is generally the largest, most illiquid, and most risky investment in their total wealth portfolio. Their successful business exit should be executed with the same diligence, knowledge, experience and skill that you regularly apply to their other asset class decisions.

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