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Leading the Sale of an Early- or Growth-Stage Technology Business - Dave Litwiller - Mar 26 2014
1. Leading the Exit
Invited Presentation to Volta Labs, Halifax
Dave Litwiller
Executive-in-Residence, Communitech
Mar. 26, 2014
2. Overview
• Exit Vehicles
• When to Sell
• How to Get Started
• Investigations and Activities to Maximize Value
• Establishing the Valuation Target
• Selling Methods
• Process Structure
• Typical Timeline
• Post-Sale Considerations
• Earn-outs
• Partial sales
• Q&A
Copyright, David J. Litwiller 2014 2
3. My Background
• Twenty+ year trajectory of R&D, marketing, finance, M&A and
general management roles in early-, growth-stage and scaled-up
tech companies in Waterloo region
• Governance, corporate director
• Mentor to 80+ start-ups as EIR with Communitech
– SaaS (B2B, B2C), mobile, semiconductors, advanced sensors, clean
energy, aerospace, robotics, wearable electronics, medical
devices, telematics
• Author: Rapid Advance, published in 2008
http://www.slideshare.net/davidjl/rapid-advance
Copyright, David J. Litwiller 2014 3
4. A Few Facts
• Early- and growth-stage tech companies are acquired at a rate of
~1% per month. The rate is highest in SaaS and mobile apps.
• >85% of VC-funded technology start-ups achieve liquidity through
acquisition or LBO, rather than IPO. In certain sectors the
proportion can be much higher, such as clean tech, where the exit
vehicle is an acquisition as much as 98% of the time
• A substantive IPO (tier 1 exchange, liquidity, analyst coverage) now
requires:
– Revenue moving fast toward $100M
– $250M market capitalization
– $75M on the cover (float)
=> IPOs today are usually out of reach as a means of liquidity for
founders, investors and early shareholders
Copyright, David J. Litwiller 2014 4
5. Signals that it’s a Good Time to Sell
One or more of:
• Business is strong, growth is rapid, and there’s a compelling case that
things look like they will just keep getting better
• Motivated buyers are active in the market. Especially so if a land grab
mentality takes hold by larger companies to stake a claim in a technology
or market space where there are diminishing number of good properties
available, and yours is one of an increasingly scarce few
• An offer comes in from a credible buyer in the top quartile of benchmark
valuation ratios
• The industry is consolidating and maturing; technology prominence or go-
to-market innovation as the primary basis of competition is giving way to
scale or scope efficiency, channel access, critical supply control, and
geographic reach
Copyright, David J. Litwiller 2014 5
6. More Signals
• First Order: Others are better positioned to achieve or
maintain the #1 and #2 market share positions in the
industry which is consolidating
• Second Order: Lanchester dynamics suggest
competitive advantage favours others in the
competitive ecosystem
• Founders or funders need liquidity, or, are running out
of ideas, agreement, or execution capacity to keep the
business moving forward as quickly as the environment
demands
Copyright, David J. Litwiller 2014 6
7. Getting Started
• Perform a SWOT analysis on your business
– Be candid with yourself
• Do a SWOT analysis of the larger players in
your competitive ecosystem
• Then, map your S&O onto their W&T
Copyright, David J. Litwiller 2014 7
8. Identify Strategic Buyers and Rationale
Qualitative
• Understand why they need you
• Build a marketing story about how they can maximize your
company’s opportunities
• Explain why you shore up their shortcomings
• Rationalize why they can overlook your weaknesses
Quantitative
• Five plausible buyers is a bare minimum to start the selling process
• Forty is preferred practice, and strongly so. As many as eighty may
be required in tougher market conditions. More on this later
Copyright, David J. Litwiller 2014 8
10. Sell-Side Due Diligence
• Run your company through the same due diligence filter that a
prospective buyer would – the long-form checklist
• Unearth any significant shortcomings to be able to proactively
remedy them, or position the sale in such a way to diminish the
impact of those weaknesses
• Pay particular attention to:
– Intellectual property (IP) provenance, integrity and documentation
– Continuity plans for key team members
– Continued access to funding and tax incentives
– Corporate governance
– Major contracts – know what is in them
– Resolving disputes
Copyright, David J. Litwiller 2014 10
11. Common IP Soft Spots
• Founders didn’t make a clean break with their former employers
(took more than memories)
• Inability to show clean ownership and chain of title for the IP
• Lost patent rights due to filing delays or disclosures
• Overly broad technology licenses granted to early customers
– Exclusive
– “No better deal” clauses
– Change of control provisions
• Poorly understood or corralled open source licenses and
unfavourable recommitment terms to the public domain
Copyright, David J. Litwiller 2014 11
12. Valuation
• DCF is usually the gold standard for valuation of
mature businesses
– Can be tuned to the exact conditions of each
– But, the subjectivity and wide variance of required
assumptions in early- and growth-stage technology
companies weakens DCF’s utility
• Benchmark valuations and transactions tend to
have more significant weight in early- and
growth-stage M&A, both for objective value cues
as well as the social proof they offer
Copyright, David J. Litwiller 2014 12
13. Tempering Risk and Growth Factors
• Risk
– Relative size
– Breadth of customer base
– Diversity of product offering
– Diversity of geographic footprint
– Dependence on a few key people
– Leverage
– Extent to which the IP is foundational and protected
• Growth
– Industry outlook
– Reinvestment requirements
– New products in the pipeline
Copyright, David J. Litwiller 2014 13
14. Comparables Analysis
Company
Multiple A B C D Mean Median
EV/EBIT 10 52 15 20 24.3 17.5
EV/EBITDA 6 22 8 10 11.5 9.0
EV/Revenue 4 3 5 4 4.0 4.0
Price/Book 3 14 3 4 6.0 3.5
Price/Earnings 17 90 49 33 47.3 41.0
EV/Employee 1 2.3 0.9 4.2 $ 2.1 $ 1.7
EV/Patent 2 4 1 3 $ 2.5 $ 2.5
• Build a statistically significant database of benchmark company valuations
• Use M&A transactions, public companies, and private financings data
• Be careful about publicity bias of the highest value and highest multiple deals
• Generally, a database of about twenty comparables best counters selection bias
• Builds basis for objectivity and defensibility in the exit decision, as well as negotiations
Copyright, David J. Litwiller 2014 14
16. Keeping it Real – Part II
More detail about high value, high IRR deals, based
on a five year exit horizon from start:
• 50* to 100* growth in value 1.1% of the time
• >100* growth in value 0.4% of the time
=> Headline grabbing valuations and multiples occur in <2% of exits
The top company in a sector often commands 80%
or more of the buyer value for the sector, especially
in strong network effect businesses
Copyright, David J. Litwiller 2014 16
17. Keeping it Real – Part III
• Financial buyer will typically pay 3* to 6* EBITDA
• Strategic buyer will typically pay 6* to 12* EBITDA
• To get substantially higher multiples:
– Physical IP-based or Enterprise Software: >100% annual growth
– Consumer Web and Mobile: >200% annual growth
– The business is exceeding all of its internal and most peer key metric targets
– No C-suite churn
– Crystal clear accounting
• Body shop services businesses will generally only command 3* to 4.5* EBITDA
– Scale-able only as fast as people can be hired and trained
– Most of the IP walks out the door at night
– Key customer and delivery relationships tend to be strongly associated with owners
• Valuation bottom line: Establish your price target, including a go/no go number
Copyright, David J. Litwiller 2014 17
18. Three Sale Methods
• Bilateral
• Limited Number of Participants
• Competitive Auction
• The choice is a trade-off among:
– Time required from management
– Erosion of confidentiality
– Competition for the deal
– Fiduciary duty risk
Copyright, David J. Litwiller 2014 18
19. Timeline
Duration (Weeks)
Preparation Four to Six
Develop Financial Projections
Conduct Internal and External Diligence
Map Path for Management and Key Employees
Identify and Engage the Sale Team
Start Three
Prepare Collateral Documents and Data Room
Contact Prospective Suitors through Appropriate Channels
Execute NDAs with Interested Parties
Appraisal Three to Four
Suitor Review of Offering Memorandum and Data Room
Suitor Investigation of Target's Competitive Environment
Suitor Transaction Benchmarking
Management Meetings
Active Pursuit Two to Three
Receipt of Initial Bids
Initial Bid Selection
Term Sheet Negotiation
Best Offer Selection
Final Due Diligence Six to Eight
Complete Investigations
Negotiate Definitive Purchase Agreement
Establish Transaction Schedule
TOTAL Time to Reach a Signed Agreement Sixteen to Twenty-Four Weeks
Closing
Any time After Executing Definitive Purchase Agreement
Sometimes Synchronized to Achievement of Major Milestone
or the End of a Fiscal Reporting Period to ↓ Accounting Overhead
Copyright, David J. Litwiller 2014 19
20. Suitor Funnel
• Activity-based metrics during early stages provide leading indicators
• Crucial importance of achieving at least two high quality bids
• In case negotiations with one bog down, to have a hot standby
• To keep up competitive tension to drive favourable valuation and terms
Activity Number of
Remaining
Players
Stage to
Stage
Reduction
Ratio
Criteria
Candidate Suitors Forty Plausible Means and Strategic Interest, Contacted to Solicit Interest
50%
Active Appraisals Twenty Sign back NDAs and Spend Time in Data Room
75%
Active Pursuits Five Indicative Bids Submitted
60%
Suitable Bids Two Reasonable Offers to Select One for Exclusive Negotiation
50%
Executed Purchase One Deal Done
Copyright, David J. Litwiller 2014 20
21. During the Sale
• Nothing is done until everything is done
– Continue to vigorously execute at an operating
level
• No financial or strategic misses
– Revenue
– Margin
– Major account wins
– Loss of key customers
Copyright, David J. Litwiller 2014 21
22. A Few Integration Considerations
• Tuck-in or stand-alone
– Extent to which the soul of a start-up needs to be preserved
– Credentials of management
– Whether there’s a clear path to self-sufficiency, profitability, and self-
perpetuation
• R&D team apprehensions
– Provide clear objectives about revised goals in the new setting
– Be up front with people
• Catalytic technology overlap between target and acquirer
– Generally occurs when inbound overlap is in the range of 15% to 40%
– This provides enough similarity to have common language and issues to
collaborate post-transaction
– Different enough to retain individual identity without devolving to not-
invented-here conflict
Copyright, David J. Litwiller 2014 22
23. Earn-Outs
• Contingent payments based on future performance of the business
• As a broad average, only 15% of maximum formula value is obtained by the seller,
so use them cautiously and have moderate expectations when you do
• Advisors working on a contingency fee tend to dislike them. They’d rather price
the risk in to a single $ value up front and get paid in full immediately
• Be clear about budget and managerial authority with the acquirer to retain the
freedom of action to be able to deliver earn-out targets
• The longer the earn-out horizon extends, the less likely it is the acquirer can
continue to provide entrepreneurial freedom to the acquired unit’s management,
despite intentions at the outset
– For growth-stage businesses, twelve months is common, eighteen gets to be a stretch
– Difficult to work well beyond two years
Copyright, David J. Litwiller 2014 23
24. Partial Sales to Strategic Buyers
• Typically requires a provision for the acquirer to be able to later purchase 100%
– As time goes on and your business grows, the acquirer can’t be in a position that it is
increasingly dependent upon a small company over which it can’t get full control
– At the same time, if your business ends up being not as important, it can be cast off,
often in a weakened state
• Partial acquisition by a strategic buyer can scare off certain customers and partners
that your company independently would likely be able to access, especially if the
acquirer is a competitor of theirs
• Additional delicate issues that can arise:
– Extent and mechanisms for coordination and control
– Exclusivity provisions
– Commitment to a particular technology platform and marketplace approach in an
environment of uncertainty
– Reduced entrepreneurial motivation for founders and employees holding equity rights
Copyright, David J. Litwiller 2014 24
25. Using i-Bankers
• In general, it is difficult to get the A-team from an
investment bank to work on a transaction size of less
than $20 million
• Below that level, use of i-bankers often imposes high
fees in exchange for mid-grade talent and so-so
rolodexes
• Smaller deals are typically better served by
management acting as its own prime contractor to
handle the sale, calling upon skilled lawyers,
accountants and other advisors as needed
Copyright, David J. Litwiller 2014 25
26. Other Thoughts
• Selling your business is a time consuming process
for six months or longer
• CAs/NDAs notwithstanding, word will get out that
you’re for sale once more than five people know
• Identify key employees, especially team players,
re-recruit them and accommodate them
– Corollary: It is also the time to part ways with any
unproductive renegades
Copyright, David J. Litwiller 2014 26
27. Takeaways
1. An exit scenario is not a business model. Build a great
fundamental business. Everything else follows to create and
capture value
2. Nail the numbers early in the financial projection preparations to
put forward to potential buyers. The qualitative aspects of
representing the company can then be done much quicker and
better
3. The better the preparation at the front end of the sale process,
the faster it goes, enhancing value
4. Competition for the deal, real or perceived, is usually the way to
reach the best value, transaction terms, and flexibility
Copyright, David J. Litwiller 2014 27
28. Takeaways
5. Get help from advisors who have been there before when selling. You are an
expert in your business, honing your skills relentlessly. But, selling a business is a
rare event. The process follows its own set of conventions in which many
entrepreneurs, even great ones, have little experience. The boundless energy and
optimism of the successful entrepreneur can be helped at sale time from a more
dispassionate perspective about the decision, strategy and tactics of sale
6. Do as much due diligence on a prospective buyer as the counterparty does on
you. Really dig to build a detailed picture of the good and the bad of the potential
acquirer. Investigation of the buyer informs the go/no go decision, negotiating
tactics and optimal form of transaction
7. At every step of the process, keep revisiting how to maximize value for your
business in the new prospective ownership setting
8. It is far easier to react to advances than to try to turn a buyer on!
Copyright, David J. Litwiller 2014 28
