Technology Business Sales - Animal Spirits Create Strategic Value

There is no more effective approach to driving up your tech company selling price than to get buying companies in a competitive bidding process. In this short video we discuss how we were able to do this for one of our information technology clients to drive her strategic value in her company sale.


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 learn more about our services for technology business sellers click to visit our Web Site MidMarket Capital

The #1 Cause of Middle Market M&A Deal Failures

New Article just published on Divestopedia https://www.divestopedia.com/2/7767/sale-process/negotiation/the-1-cause-of-middle-market-ma-deal-failures

I believe one of the biggest reasons for M&A deals blowing up is a poorly worded letter of intent (LOI). The standard process to solicit offers from buyers in the form of an LOI includes terms and conditions that are negotiated until one winner emerges and the seller and buyer dual sign the LOI, which is non-binding. This basically gives either party an "out" should something be discovered in the due diligence process that is not to their liking or is not as presented in the initial materials. Buyers Have the Advantage of Experience

When I say poorly worded, what I really should have said is that it is worded much to the advantage of the buyer and gives them a lot of wiggle room in how the letter is interpreted and translated into the definitive purchase agreement. The best comparison I can make is a lease agreement for an apartment. It is so one-sided in favor of the landlord and protects him/her from every conceivable problem with the renter.

Business buyers are usually very experienced and the sellers are generally first-time sellers. The buyers have probably learned some important and costly lessons from past deals and vow never to let that happen again. This is often reflected in their LOI. They also count on several dynamics from the process that are in their favor. Their deal team is experienced and is at the ready to claim that "this is a standard deal practice" or "this is the calculation according to GAAP accounting rules." They count on the seller suffering from deal fatigue after the numerous conference calls, corporate visits and the arduous production of due diligence information.

When the LOI is then translated into the definitive purchase agreement by the buyer's team, any term that is open for interpretation will be interpreted in favor of the buyer and, conversely, to the detriment of the seller. The seller can try to fight each point, and usually there are several attacks on the original value detailed in the dual-signed LOI that took the seller off the market for 45-60 days. The buyer and his/her team of experts will fight each deal term from the dispassionate standpoint on one evaluating several deals simultaneously. The seller, on the other hand, is fully emotionally committed to the result of his/her life's work. He/she is at a decided negotiating disadvantage.

The unfortunate result of this process is that the seller usually caves on most items and sacrifices a significant portion of the value that he/she thought he/she would realize from the sale. More often than not, however, the seller interprets this activity by the buyer as acting in bad faith and simply blows up the deal, only to return to the market as damaged goods. The implied message when we reconnect with previous interested buyers after going into due diligence is that the buyers found some dirty laundry in the process. These previously interested buyers may jump back in, but they generally jump back in at a transaction value lower than what they were originally willing to pay. How to Even the Playing Field

How do we stop this unfortunate buyer advantage and subsequent bad behavior? The first and most important thing we can do is to convey the message that there are several interested and qualified buyers that are very close in the process. If we are doing our job properly, we will be conveying an accurate version of the reality of the deal. The message is that we have many good options, and if you try to behave badly, we will simply cut you off and reach out to our next best choices. The second thing we can do is to negotiate the wording in the LOI to be very precise and not allow room for interpretation that can attack the value and terms we originally intended.

We will show a couple examples of LOI deal points as written by the buyer (with lots of room for interpretation) and we will counter those with examples of precise language that protects the seller.

Sample Earnout Clause Within an LOI

Buyer's Proposal

The amount will be paid using the following formula:

-75% of the value will be paid at closing

-The remaining 25% will be held as retention by the BUYERs to be paid in two equal installments at the 12 month and 24 month anniversaries, based on the following formula and with the goal of retaining at least 95% of the TTM revenue. In case at the 12 and 24 month anniversaries the TTM revenue falls below 95%, the retention amount will be adjusted based on the percentage retained. For example, if 90% of the TTM revenue is retained at 12 months, the retention value will be adjusted to 90% of the original value. In case the revenue retention falls at or below 80%, the retention value will be adjusted to $0.

Seller's Counter Proposal

The amount will be paid using the following formula:

-75% of the value will be paid at closing

-The remaining 25% will be held as earnout by the BUYERs to be paid in four equal installments at the 6, 12, 18 and 24 months anniversaries, based on the following formula:

We will set a 5% per year revenue growth target for two years as a way for SELLERS to receive 100% of their earnout (categorized as "additional transaction value" for contract and tax purposes).

So, for example, the TTM revenues for the period above for purposes of this example are $2,355,000. For a 5% growth rate in year one, the resulting target is $2,415,000 for year one and $2,535,750 in year two. The combined revenue target for the two years post-acquisition is $4,950,750.

Based on a purchase price of $2,355,430, the 25% earnout would be valued at par at $588,857. We can simply back into an earnout payout rate by dividing the par value target of $588,857 by the total targeted revenues of $4.95 million.

The result is a payout rate of 11.89% of the first two years' revenue. If SELLER falls short of the target, they fall short in the payout; if they exceed the amount, they earn a payout premium.

Below are two examples of performance:

Example 1 is the combined two years' revenues total $4.50 million - the resulting two-year payout would be $535,244.

Example 2 is the combined two years' revenues total $5.50 million - the resulting two-year payout would be $654,187.

Comparison and Comments

The buyer's language contained a severe penalty if revenues dropped below 80% of prior levels, the earnout payment goes to $0. Also, they have only a penalty for falling short and no corresponding reward for exceeding expectations. The seller's counter proposal is very specific, formula-driven and uses examples. It will be very hard to misinterpret this language. The seller's language accounts for the punishment of a shortfall with the upside reward of exceeding growth projections. The principle of both proposals is the same - to protect and grow revenue, but the results for the seller are far superior with the counter proposal language.

Sample Working Capital Clause Within an LOI

Buyer's Proposal

This proposal assumes a debt free cash free (DFCF) balance sheet and a normalized level of working capital at closing.

Seller's Counter Proposal

At or around closing, the respective accounting teams will do an analysis of accounts payable and accounts receivable. The seller will retain all receivables in excess of payables plus all cash on cash equivalents. The balance sheet will be assumed by the buyer with a $0 net working capital balance.

Get the Specifics

The buyer's language is vague and a problem waiting to happen. So, for example, if the buyer's experts decide that a "normalized level of working capital" at closing is a surplus of $400,000, the value of the transaction to the seller dropped by $400,000 compared to the seller's counter proposal language. The objective in seller negotiations is to truly understand the value of the various offers before countersigning the LOI. For example, an offer for cash at closing of $4,000,000, with the seller retaining all excess net working capital when the normal level is $800,000, is superior to an offer for $4.4 million with working capital levels retained at normal levels.

These are two very important deal terms and they can move the effective transaction value by large amounts if they are allowed to be loosely worded in the letter of intent and then interpreted to the buyer's advantage in translation to the definitive purchase agreement. Why not just cut off that option with very precise and specific language in the LOI with formulas and examples prior to execution by the seller? The chances of the deal going through to closing will rise dramatically with this relatively easy-to-execute negotiation element.

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

Valuing Your Company for Sale - The Market Dynamics of Pricing

How much are you expecting when you sell your business? I always ask this question of our clients. The answers are as different as the businesses. "We need $5 million to give us the type of retirement we want. We have invested $2 million in the product. Our investors have put in $3 million so far. It should sell for $5 million. I heard that xyz Company got $30 million for their company." Well, my response to my clients doesn't necessarily endear me to them, but it is the truth. The market doesn't care. The market doesn't care how much it cost you to develop the product or how much your investors have in or how much you need to retire or how much you think it is worth.

The market looks at what the ROI is for its investment in a company. If you are fortunate enough to have a technology that can be leveraged, the market may look at the future returns of that technology in stronger hands.

For most businesses, there are benchmarks that are often used as a starting point. The most common in a merger and acquisition situation is an EBITDA multiple. That is the gold standard for privately held companies, similar to what a PE multiple is as a business valuation metric for publicly traded stocks. One of the measures that has come into vogue on Wall Street is a PEG multiple or Price Earnings Growth. It is essentially a way to attempt to quantify the difference in PE multiples between two firms in the same industry that have a much different future growth scenario.

Buyers of businesses that are privately held attempt to ignore this factor when making their purchase offers.

One small company was in an industry characterized by slow growth of about 4%, had commodity type products and consequently very thin gross margins, and had little pricing power. This company introduced a new product that was unique, had very healthy margins, retained some pricing power, and was experiencing 50% year over year growth.

The industry benchmark valuations were at 4.5 X EBITDA. The three largest players in the industry were all interested in the acquisition and each one put out an initial bid that was, surprise, about 4.5 X EBITDA. Another factor was that our client was in rapid growth mode so a good deal of their costs were front end loaded as they launched a few big box retailers during this period. The effect of this was to depress their EBITDA performance. This made these offers even more inadequate.

The result is that we have a classic valuation gap between business buyer and business seller. This is the biggest reason that many merger and acquisition transactions do not happen. The clients are terribly disappointed and suggest that these buyers "just don't get it." The buyers have experience in making several acquisitions in their space and have their business valuation metrics pretty much in stone and think our sellers are being unreasonable in their expectations. Game over, right?

Not so fast. One of the most important roles of a business broker, merger and acquisition advisor or investment banker is devise a transaction value and structure that works for both parties. We pointed out to the buyers that their traditional way of looking at these transactions is appropriate for their prior acquisitions with standard growth metrics, lack of pricing power, and commodity type products.

 We suggest to business sellers that as a small company with a few big box retailers comprising 80% of company sales with essentially one main product, that they have a great deal of small company risk. For example, if the retail buyer from xyz Big Box Retailer changes and is replaced by a buyer that has a consolidation of vendors bias, then they could lose 30% of their business with one decision. A bigger company, however, with 30 SKU's would be much harder to replace with a change in buyers.

We have established a platform with both buyer and seller to consider alternatives to their hard and fast valuation positions. Here is an example of a business sale transaction structure that could be a win for both buyer and seller:

1. $1,000,000 Cash at Close which is approximately a 4 X EBITDA multiple for the year 2007.

2. An Earn out (Additional Transaction Value) based on Seller Company's Sales Revenue beginning in year 1 and ending at the end of year 5. The earnout is at risk, but is set to net the shareholders a 6 X EBITDA multiple on 2008 projected sales (sales $6 million and EBITDA margin of 16.67% or EBITDA of $1,000,000).

This is the transaction structure we are recommending to balance a low EBITDA valuation on a company that will grow revenues by 50% next year. If they don't, then the earn out will be less. Most of the transaction value is in future performance based earn out. Our projection is that with Buyer Company cost efficiencies, Buyer Company can improve operating performance by an amount that covers the entire earn out amount and maintains or even improves Seller Company's historical margins.

Most business buyers that approach a company with an unsolicited interest in acquiring them are bottom feeders and will attempt to buy way below the market. They will attempt to draw out the process and pursue several acquisitions simultaneously hoping that one or two sellers just cave and sell out at a discount. They may start out at a decent valuation, but as they go through their due diligence process will find one issue after another that makes them reduce their offer. They often throw out the term "material adverse change" in an attempt to justify their value reducing behaviors. Some business development directors get judged or paid bonuses on how much below the original offer they can ultimately close the deal.

What is the way to combat this bad buyer behavior? The best way is to have options. Those options are multiple interested buyers. We feel very uncomfortable when we end up with only one buyer. We have taken them through the entire marketing phase and end up with only one legitimate interested buyer. You bet that buyer recognizes the issues and the likelihood of limited interest and will attempt all of the maneuvers to drive down the buying price and terms. Our negotiating position on behalf of our seller client is severely weakened and we struggle to preserve value in spite of doing this every day.

Think about how effective you will be in this single buyer scenario. We tell our prospective clients that contact us after an unsolicited offer, "When it comes to business valuation, if you have only one buyer, he is right.

Dave Kauppi is the editor of The Exit Strategist Newsletter, a Merger and Acquisition Advisor and Managing Partner of MidMarket Capital, providing business broker and investment banking services to entrepreneurs and middle market corporate clients in information technology, software, high tech, and a variety of industries. Dave graduated from The Wharton School of Business, holds a Series 63 and is a registered business broker. Dave began his Merger and Acquisition practice after a twenty-year career within the information technology industry.  Visit MidMarket Capital to learn about maximizing your selling price, valuation of intellectual property, minimizing taxes, negotiating tactics, Letters of Intent, how to select an advisor, and much more.

Grow or Sell Your Information Technology Company - A Crossroads Decision

Thinking of taking your information technology company to the next level with a major marketing campaign or by hiring additional sales resources? These are decisions that can impact your company's future. It might be time to consider the alternative of selling your business.

We are often approached by software company or information technology business owners at a crossroads of taking the company to the next level.  The decision in most cases is whether they should bring on the one or two hot shot sales people or channel development people necessary to bring the company sales to a level that will allow the company to reach critical mass. For a smaller company with sales below $5 million this can be a critical decision.

For frame of reference, prior to embarking on my merger and acquisition advisor career, I spent my prior 20 years in various sales capacities in primarily information technology and computer industry related companies from bag carrying salesman to district, regional, to national sales manager and finally Chief Marketing Officer.  So when I look at a company, it is from the sales and marketing perspective first and foremost. I am sure that if I had a public accounting background, I would look at my clients through those lenses.

So with that backdrop, let's look at what might be a typical situation. The software company is doing $3.5 million in sales, has a good group of loyal customers, produces a nice income for its owner or owners, and has a lot more potential for sales growth in the opinion of the owner. Some light bulb has been lit that suggests that they need to step this up to the next level after relying on word of mouth and the passion and energy of the owner to get to this stage.

I have spoken with more than 30, primarily technology based companies over the years that have faced this exact situation and can count on one hand the ones that had a successful outcome. The natural inclination is to bite the bullet and bring on that expensive resource and hope your staff can keep up with the big influx of orders. The reality is that in most cases the execution was a very expensive failure. Below are several factors that you should consider when you are at this crossroads:

1. The 80 20 rule of salesmen. You know this one. 80% of sales are produced by 20% of the salespeople. If you are only hiring one or two, the likelihood is that you will not get a top performer.
2. The president of the company and decision maker has no sales background so the odds of him making the right hiring decision are greatly diminished. He will not understand how to properly set milestones, judge progress, evaluate performance objectively, or coach the new hire.
3. To hire a good salesman that can handle a complex sale requires a base salary and a draw for at least 6 months that puts him in a better economic condition than he was in on his last job. So you are probably looking at $150,000 annual run rate for a decent candidate.
4. If you have not had a formalized sales effort before, you are probably lacking the sales infrastructure that your new hire is used to. Proper contact management systems, customer and prospect databases, developed collateral materials and sales presentations, sales cycle timeframes and critical milestones and developed competition feature benefit matrixes will need to be developed.
5. Current customers are most likely the early adapters, risk takers, pioneers, etc. and are not afraid of making the buying decision with a small more risky company. These early adaptors, however, are not viewed as good references for the more conservative majority that needs the security of a big company backing their product selection decision.
6. Your new hire is most likely someone that came from a bigger information technology company and may be comfortable performing in an established sales department. It is the rare salesman that can transform from that environment to developing the environment while trying to meet a sales quota. Throw on top of that the objection that he has never had to deal with before, the small company risk factor, and the odds of success diminish. Finally, this transformation from a core group of early adapters to now selling to the conservative majority elongates the sales cycle by 25% to as much as double his prior experience. If you don't fire him first, he will probably quit when his draw runs out.

With all this going against the business owner, most of them go ahead and make the hire and then I hear something like this, "Yes, we brought on a sales guy two years ago who said he had all the industry contacts and in nine months after he hadn't sold a thing and cost us a lot of money, we fired him. That really hurt the company and we have just now recovered. We won't do that again."

What are the alternatives? Certainly strategic alliances, channel partnerships, value added resellers are options, but again the success rate for these arrangements are suspect without the sales background in the executive suite.  A lower risk approach is to outsource your VP of Sales or Chief Marketing Officer function. There are a number of highly experienced and talented free lancers that you can hire on a consulting basis that can help you establish a sales and marketing infrastructure and guide you through the staffing process. That may be the best way to go.

An option that one of our clients chose when faced with the six points to consider from above was to sell his company.  This is a very difficult decision for an entrepreneur who by nature is very optimistic about the future and feels like he can clear any hurdle. This client had no sales background but was a very smart subject matter expert with an outstanding background as a former consultant with a Big 5 accounting firm. He did not make the hiring mistake, but instead went the outsourcing of VP of Sales function as step 1. When their firm wanted to make the transition from the early adapters to the conservative majority, the sales cycle slowed to a crawl. Meanwhile their technology advantage was being eroded by a well funded venture backed competitor that had struck an alliance with a big vendor.

They engaged our firm to find them a buyer, but then we encountered the valuation gap. Our business seller thought his company was worth a great deal and that he should be paid with cash at close for all the future potential his product could deliver. The buyer, on the other hand, wanted to pay based on a trailing twelve months historical perspective and if anything was paid for potential, that would be in the form of an earn out based on post acquisition sales performance.

With a well structured earn out agreement and the right buyer, our client will reach his transaction value goals. His earn out is based on future sales, but his effective sales force has been increased from one (himself) to 27 reps. His install base has been increased from 14 to 800. Every one of the buyer's current customers is a candidate for this product. The small company risk has been removed going from a little known start-up with $500 K in revenues to a well known industry player, publicly traded stock with a market cap of $2.5 billion.

He avoided the big cash drain that a bad sales person hiring decision would have created and he sold his company before a competitor dominated the market and made his technology irrelevant and of minimal value.

My professional contacts sometimes tease me and suggest that I think every company should be sold. That may be a slight exaggeration, but in many instances, a company sale is the best route. When a information technology business owner is faced with that crossroads decision of bringing on a significant sales resource that will be faced with a complex sale and the executive suite does not have the sales background, a company sale may be the best outcome.

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

Valuing The Growth Rate in the Sale of a Technology Company

If you are selling a rapidly growing business, especially one based on technology, using an EBITDA multiple will not provide an accurate valuation metric. This article presents an argument that these businesses should more appropriately be measured like the concept of Price to Earnings to Growth (PEG) Ratio that is used for rapidly growing public companies.

In the sale of privately held businesses there seems to be no mechanism and certainly no attempt on the part of buyers to account for the selling company's growth rate. In the public market this factor is widely recognized and is accounted for with an improvement on the PE multiple, the PEG or Price Earnings Growth multiple.

 Because there is no exact translation between EBITDA multiple (the primary valuation metric for privately held companies) and Earnings Per Share and PE multiple (the primary valuation metric for publicly traded stocks), the purpose of this article is to try to calculate an adjustment factor that can be applied against the EBITDA valuation metric in order to present a more accurate accounting for differences in growth rate for the valuation of privately held companies.

Experienced business buyers are masters of setting the rules for how they calculate the value of a business they are attempting to acquire. You may think that a 5 X multiple of EBITDA or 1 X Sales would be pretty cut and dried, but in practice it is open for creative interpretation. For example, if you just had your best year ever and your EBITDA was $2 million and the market valuation was 5 X, then you would expect a $10 million offer. Not so fast. The buyer may counter with, "That last year was an anomaly and we should normalize EBITDA performance as an average of the last three years." That average turns out to be $1.5 million and like magic your purchase offer evaporates to $7.5 million. On the flip side, if you just had your worst year at $1 million EBITDA, you can bet the buyer will use that as your metric for value.

The three owners paid themselves $100,000 each in salary, but the buyer asserts that the fair market value salary for a replacement for each senior manager is really $150,000. They apply this total $150,000 EBITDA adjustment and your valuation drops by another $750,000. If the family owns the building separately and rents it to the business for an annual rent of $200,000 when the FMV rental rate is $300,000, the resulting adjustment costs the seller another $500,000 in lost value.

Another valuation trap for a seller is that they want to hire additional sales resources to pump up their sales just prior to the sale. This is almost always a bad move. Most technology sales reps take a year or longer to ramp up to productivity. In the interim, with salary and some draw or guarantee, they actually become a drain on earnings. The buyers do not care about the explanation, they just care about the numbers and will whack you with a value downgrade.

The least understood valuation trap, however, is there seems to be no mechanism and certainly no attempt on the part of buyers to account for the selling company's growth rate. In the public market this factor is widely recognized and is accounted for with an improvement on the PE multiple, the PEG or Price Earnings Growth multiple. The rule of thumb is that if the stock is valued with a PEG of less than 1 then it is a good value and if it is over 1 it is not as good.

Because there is no exact translation between EBITDA multiple (the primary valuation metric for privately held companies) and Earnings Per Share and PE multiple (the primary valuation metric for publicly traded stocks), please allow me a measure of imprecision in my analysis. My purpose is to try to calculate an adjustment factor that can be applied against the EBITDA valuation metric in order to present a more accurate accounting for differences in growth rate for the valuation of privately held companies.

I have chosen two stocks for my analysis, Google and Facebook. The reason I choose these two is that they are widely known, very successful, in the same general market niche, and are at different stages of their growth cycle. Google sells at a PE multiple of 33.37 while Facebook sells for a PE multiple of 113.71. The PEG of Google which = PE Multiple/5 year growth rate is 33.37/16.85 for a PEG of 1.98. I actually backed into the growth rate using the readily available PE multiple and the PEG from my Fidelity account.

Facebook sells at a PE multiple of 113.71 and has a PEG ratio of 3.62 (may be some irrational exuberance here), which translates into a 5 year growth rate of 31.41%. For our comparison we should also include the average PE multiple for the S&P 500 of about 15. Let's make the assumption that on average, this assumes that these companies will grow at the growth rate of the U.S. Economy, say 3%.

So to calculate a normalized PE ratio for these two companies, we are going to create an adjustment factor by dividing the 5 year compound growth rate of Google and Facebook versus the anticipated 5 year compound growth rate of the S&P 500. For Google the 16.85% growth rate over 5 years creates a factor or 2.178 or a total of 217.8% total growth over the next 5 years. The S&P factor is 1.16. So if you divide the Google factor by the S&P factor you get 1.878. If you multiple the market PE multiple of 15 by the Google factor, the result is a PE of 28.2. Not too far off from the current PE multiple of 33.37

Facebook is a little off using this method resulting in a normalized calculated PE of 50.65 versus their current rate of 113.71. This will appropriately seek a level over time and settle into a more rational range. My point here is that the public markets absolutely account for growth rates in the value of stocks in a very significant way.

Now let's try to apply this same logic to the EBITDA multiple for valuing a privately held technology company. If the rule-of-thumb multiple for your company's valuation is 5 X EBITDA but you are growing at 10% compounded, shouldn't you receive a premium for your company. Using the logic from above we assign a 3% compound growth rate as the norm in the 5 X EBITDA metric. So the 10% grower gets a factor of 1.61 versus the norm of 1.16. Dividing the target company factor by the normalized factor results in a multiple acceleration factor of 1.39. Multiply that by the Standard 5 X EBITDA multiple and you get a valuation metric of 6.95 X EBITDA.

A little sobering news, however, you will have a real challenge convincing a financial buyer or a Private Equity Group to veer to far away from their rule of thumb multiples. You will have a better chance of moving a strategic technology company buyer with this approach.  A discounted cash flow valuation technique is superior to the rule of thumb multiple approach because it accounts for this compound growth rate in earnings. If the technique produces a higher value for the seller, the buyer will keep that valuation tool in his toolbox.

Perhaps the best way to negotiate a projected high growth rate and translate that into transaction value is with a hybrid deal structure. You might agree to a cash at close valuation of 5 X EBITDA and then create an upside kicker based on hitting your growth targets.

 So for example, your EBITDA is $2 million and your standard industry metric is 5X EBITDA. You believe that your 10% growth rate (clearly above the industry average) should provide you a premium value of 6 X.  So the value differential is $10 million versus $12 million. You set a target of a 10% compounded growth in Gross Profit over the next 4 years and you calculate an earn out payment methodology that would provide an additional $2 million in transaction value if you hit the targets. It is a contingent payment based on actual post closing performance, so if you fall short of targets you fall correspondingly short on your earn out. If you exceed target you could earn more.

Successful buyers do not remain as successful buyers if they over pay for an acquisition. Therefore, the lower the price they pay, the greater their odds of chalking up a win. This is a zero sum game in that each dollar that stays in their pocket is one less dollar in your pocket. They will utilize every tool at their disposal to convince the seller that "this is market" or this is "how every industry buyer values similar companies."  It is to your advantage to help move them toward your value expectations. That is a very hard thing to accomplish unless you have other buyers and can walk away from a low offer. Believe me, if they are looking at you, they are doing the same dance with at least a couple of others. You must match their negotiation leverage by having your own options.



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

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

Selling Your Information Technology Company - A Do It Yourself Job - NOT

People who start software and information technology companies are generally very smart people. When it comes to representing yourself in the sale of your business, the key issue is not smarts, but experience. The purpose of this article is to highlight the intelligence versus experience issue and give examples where experience trumps intelligence. Some very well-known examples were the experiences of the great author, George Plimpton as he stepped into the boxing ring against Joe Louis, put on the goalie pads for the Boston Bruins or barked out signals as the quarterback for the Detroit Lions in a pre-season football game.

These experiences resulted in some great reading. The competitive outcome for the inexperienced combatant, however, was not a happy ending. Curious George was totally outmatched. Admittedly, I had earlier written self-serving articles and Blog posts on the benefits of business seller representation by a Merger and Acquisition Advisor or Business Broker. There are hundreds of similar articles out there from our competitors. The message is pretty much the same:

1. They know the market and the valuations.
2. They have an active database of identified buyers.
3. By representing yourself, you alert the market, your customers, your competitors, and your employees that you are for sale.
4. Running a business is a full-time job. Selling a business is also a full-time job.
5. A business owner normally conducts a serial process (one buyer at a time) which dramatically reduces his market feedback and negotiating position.
6. It is complex, you may only sell one business in your lifetime and the buyers are much more experienced than the sellers.

I really want to dissect point number 6 because I don’t believe most business owners fully embrace either the complexity or the consequences of the disparity in experience. First of all, as a generalization, successful business owners are really smart people and have solved myriad complex problems over the years to make their businesses prosper. To many of them, selling their business is just another of those complex problems that they have routinely solved to their advantage. Well, I am a pretty smart guy (my kids might differ), but if my doctor presented me with my lab test results from my physical and asked me to prescribe my treatment, I would refer him to a mental health professional. The point here is not my intelligence, but my level of experience.

Joe Louis spent 10,000 hours perfecting his craft under extreme conditions of competition and pressure. George Plimpton worked in a gym for a couple of weeks with a boxing trainer. If you asked Joe Louis to write a Pulitzer Prize winning novel, you might have to duck a right cross. Both Joe Louis and George Plimpton were geniuses at their craft. They were inexperienced in other areas and were at a distinct disadvantage when trying to compete in another field against the experts in that field.

As I retrieve my third golf ball from the water hazard, I rationalize to myself, “Well at least Tiger Woods can’t run an HP 12C present value calculator like I can. Knowing Tiger Woods, he actually probably can.

Let me try another example of the value of experience to illustrate my point. Have you ever tried mounting a new door? The first time I did it, it took me several hours – getting the special hole drill for the knob and internal mechanism, measuring for hinges, chiseling the slots for the hinges, propping the door and securing it for mounting, etc. Each one of these steps was something new to me and I wasn’t very good at any of them. By my third door mounting, I was starting to become pretty competent. For a business owner, your business sale is your first door.  By the way, that is one very important door.

Now let’s look at the buyers. The first category is the Private Equity Investor. They buy businesses for a living. Ask an average PEG (Private Equity Group) how many deals they look at for every one they actually acquire. They will tell you it is well over 200 different companies. Most of these 200 are dismissed at the start of the process with the teaser or blind profile. They can judge whether the target meets their broad criteria of revenue, EBITDA, profit margins, industry segment, and others.

Many businesses pass their initial screen and they enter the excruciating process of conference calls, detailed data requests on customers, vendors, gross profit by product/customer/vendor, sales by product/customer, top ten customers, top 10 suppliers, percentage of business in the top ten, and on-and on. Many more companies are eliminated in this process. We then proceed to the indication of interest letter (broad statement of the economics of their proposed deal) followed by corporate visits. Once through that process, the surviving targets get additional data requests and follow-up questions. This is not always a one-way elimination. Sometimes the PEG IOI letter is not high enough to make the seller’s cut and they will be eliminated from the process.

The home stretch is submitting a Letter of Intent with a much tighter presentation of the final deal value and structure. This is a competitive process and the seller winnows the suitors down to 1 finalist through back and forth negotiations. Once the highest and best LOI is countersigned by the seller, there is an exclusive period for due diligence. Often the deal blows up in due diligence when a material issue is uncovered and the buyer attempts to alter their original offer in response to this new data. Often times the seller will simply blow up the deal. So the process starts all over.

The point here is that these Private Equity Groups have vast experience, not only in closing deals, but vast experience with every stage of the deal process. So for every deal completed they originally look at 200 teasers that result in the execution of 50 confidentiality agreements and the review of 50 memoranda. 20 of those deals warrant a conference call with the owners and follow up questions. 8 companies survive that process and result in 8 indications of interest letters and 5 corporate visits. 3 companies survive to due diligence and 1 makes it to the finish line. This is a continual moving pipeline of deep deal experience.

As a business owner, by the time you connect with a PEG, they have pretty much seen every twist and turn a deal can take.  Their approach resembles an apartment owner’s rental agreement – tremendously one-sided in their favor. For a PEG, a deal that blows up in the eleventh hour becomes an expensive lesson learned and war story. For a business owner, it can dramatically negatively impact their future business performance.

Wait, you say. I am a software company with the next big thing. My buyer is not a private equity group, but one of the strategic buyers – IBM, Google, Facebook, Adobe, and Microsoft (pick your giant). Let me give you a humbling dose of reality. We have represented some world class technology companies and just getting one of these blue chippers to take a look at them is a monumental task. The primary objective of the M&A department of the giants is to protect the mother ship. They want to prevent entrepreneurs from getting into any potential legal claim on the Blue Chip’s intellectual property.

Therefore they institute a screening process designed to surround the company with a corporate moat around the castle. That moat has different names at each company. At one it is called the “Opportunity Management System”. At another it is the “Partnership Management Department”.

Here is how it works. The individuals in this department are very hard to find and very seldom answer their phone. You are directed to a Website and are required to fill out an exhaustive 16 page submission form. You are then issued a submission number. You then go into the black hole and may be reviewed by a junior level screener that does not have the breadth of experience to judge a Twitter versus a Pets.com.

It gets worse. Every day 100 more “Opportunities” get submitted and piled on top of your number. The only way to get attention is from the Division Manager who owns the functional area where your product fits.  Convince him to go rescue your number and to get your form to a senior opportunity manager to process and vet the idea.

Just like with the PEGs, this is a relentless process of deal flow for these company buyers. Sellers in this environment are on their heels right from the start and struggle to garner any negotiating leverage. If your technology is strong enough to be rescued for a more comprehensive look, the guys on the other side of the table are the heavyweight champions of M&A deals. They have seen it all.

Not to minimize the first 5 benefits identified earlier in this article, but balancing the experience of the buyer’s team with the experience of the seller’s team is critical to enhance, protect and preserve the value of your transaction.

In its purest form, a letter of intent is a document designed to define the economic parameters of a transaction that, pending completion of due diligence, will be memorialized in a definitive purchase agreement and a deal closing. In its practical use, a letter of intent is like an apartment renter’s agreement with every subtle advantage benefitting the author of the document. An inexperienced seller will agree to a seemingly innocuous clause about working capital adjusted at closing according to GAAP accounting rules. If you are the seller of a software company with annual software licenses or prepaid maintenance contracts, that could be a $ million mistake. It is a rare attorney that would ever catch that. Well, not actually. They are all representing the experienced buyers.

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