Entrepreneurs launch, employees get involved, and investors invest in start-ups for a variety of reasons and motivations. Underlying each group’s individual motivations is a desire/dream of hitting it big with an exit and getting a cash out for the hard work and belief placed in the company. It’s clearly in everybody’s best interest to ensure the company receives the maximum possible value as a result of the exit. But what is the best way to do this and when does this work need to start? To find out more, I spoke with Jim Pullen, partner at Concert Partners. Jim helps advise entrepreneurs on how to engineer value into a company to maximize exit potential. He also leads workshops on planning for exits given by the ISCM Investment Network. Previously he was managing director at Regent Associates, a European company specializing in mergers and acquisitions for technology companies where he worked in London and then Boston.
A few years ago, Regent Associates did a study of 250 M&A transactions that they were involved with in the technology space over a span of 8 years. This covered transactions in Europe, US, and Canada. Specifically they wanted to find out the key areas that buyers looked for in a transaction so they could better advise their clients on how they could best position themselves to drive a higher exit valuation. Based on this study, they developed a framework as to how they could rank and assess a company on various factors that were proven to drive exit valuation. “A good example of this framework in action is with a client that had approached us wanting to be sold,” says Jim. “We reviewed the company against the framework and felt they would be undervalued based on low scores against some of the framework areas. We advised them to develop these areas of their business and then come back to us. The company successfully improved themselves and when they came back to us 18 months later we were able to sell them for a 40% premium over the valuation we felt they would have received when they first approached us”.
The various categories of the framework are described below. When working with clients Jim typically scores the company in each factor in the framework. These scores are compared to a company’s peers to help focus on the areas where the company can improve on to optimize the value a buyer will see in the company.
This category includes basic financial metrics such as profitability and revenue growth. Companies with high profit margins and high rates of revenue growth will obviously command a higher valuation.
Other aspects include the type of revenues a company generates. Due to their nature, recurring revenues can add to the valuation of a company as it makes the company’s cash flow more predictable. “The SaaS model is the example most technology entrepreneurs would think of in terms of a recurring revenue business model,” says Jim. ?“However, even if the company does not have a business model that supports SaaS, they can look to adapt their model to provide more recurring revenues. For example, a company that sells big ticket one-off products could look to build up more of an offering around maintenance and post-sales services for their product where they can sign their clients into multi-year maintenance contracts. This will give the company more of a recurring revenue stream and insulate them from a peaky revenue steam.”
“Companies with strong cash generation are also more attractive to buyers,” says Jim. “Such a company can take on more debt that can be used to finance growth. It also makes a leveraged buy-out an exit possibility.”
Market & barriers to entry
In this category the factors include the strength of customer relationship and degree of uniqueness the company enjoys in its market. “Companies that have a direct and strong relationship with the end users/purchasers of their product will get a higher exit valuation,” says Jim. “If a company sells through a channel and fails to build up a relationship with the end client, they run the risk of the channel swapping them out for another product that may offer the channel partner a better financial relationship. Even if they sell through channel partners, it is important for companies to build up strong relationships with end users.”
“We have also found that a company’s brand plays a large role in the value a buyer is willing to place on a company,” says Jim. “We have found that a strong brand can make up to 70% of the value in a company. Companies should proactively cultivate their brand to ensure they are recognized and well regarded in their space.”
In terms of barriers to entry, companies should use many mechanisms to defend their position. This can include things such as legal protection though patents and trademarks, relationships through exclusive arrangements with key suppliers, and internal expertise through strategic hiring. “Anything a company can do to make it harder for competitors to enter their space will help command a premium on valuation,” states Jim.
In the category of human resources, the model looks at both technical skills and management skills. “In the early stages of a start-up the founders are the key people that have the technical skillset to drive innovation and the leadership qualities to drive the company forward,” says Jim. “As companies grow, it is important to distribute these skillsets deeper across the company. Often after an exit, the founders will want to leave, either since they have the largest financial gain or they just prefer to be entrepreneurs rather than work in a large corporation. As such, a buyer will place a premium on a deep management team where the company can continue to innovate and execute even with the loss of the founders.”
This factor relates to the degree that the company that is being acquired is a strategic fit into the buyer’s product portfolio. “We have seen cases where buyers are willing to pay a 50%-70% price premium for a company that fills out a missing piece of the buyer’s product portfolio and gives them access to the IP and expertise of the company they are acquiring,” says Jim. “That being said, companies should not lose sight of their customers and try to build a company that serves the needs of a few companies they feel may acquire them. There is always the risk the targeted buyers will acquire another company or develop something internally. Partnerships are an excellent way to lay the foundation with a potential buyer. A partnership is a low-commitment way that a potential buyer can start to get deeper experience with a company. If things work out well and strategic synergies start to develop then this can help lead to a deeper relationship such as exclusive arrangement or acquisition.”
The last factor involves good governance. “We have found that a strong board of directors can add a 25% premium to the value of a company,” says Jim. “This is due to the buyer having more assurance that the company was well governed and there will be no unexpected surprises the buyer needs to deal with.”
This talk has focused mainly on an exit via an acquisition because this is the most likely exit scenario. “Even in the 90’s when IPOs were more frequent, we found an exit by acquisition was 15 times more likely than IPO,” says Jim. “In this scenario, companies received valuations in the range of 0.5x to 3x revenue or 8x to 20x EBITDA. These are large potential ranges since the valuation of a private company is very subjective. As such, it is important for start-ups to be aware of the factors that drive exit valuation and to ensure they are building these up as they grow their company. The more deeply rooted that these factors are in a company will put the company in a stronger position once they start to attract acquisition interest.”
Good advice indeed. Whether you are an entrepreneur or investor, if you rank your start-up that you are involved with across these factors, there are probably going to be a few areas you identify that can be strengthened. Starting to strengthen these areas now will help the company operationally in the short term and also provide benefit in the long term by building in stronger value that a buyer will place on the company.
craig at mapleleafangels.com