Key Elements for Selling Your Company

My friend (and former VentureArchetypes colleague) Jake Kaldenbaugh turned me on to this blog post by Matt McCall. Matt is a Chicago VC and MD at DFJ Portage VP (just to throw a few mysterious acronyms at you).

"The Art of Selling Your Firm"

Matt does an excellent job of succinctly summing up the real motivations behind any acquisition. While I generally believe startup founders should build their business with a long-term vision in mind (vs. building it to quickly sell or "flip"), it never hurts to keep a pulse read on the level of your "acquisition attractiveness".

In particular, I like two of the elements he lists as creating a strong sell:

Mortal Enemies: the surest way to have a healthy process is to get two bidders that viciously compete with each other

and,

Strategically Central: if your product or service is a central component to the acquirer's future, you will get attention.

In my view, these are the two elements that can create hot-as-hell acquisitions and enormous returns for founders and investors.

I am reminded of my first job, working as a Valuation Analyst at Arthur Andersen. Our group was called in to run independent valuations on acquired companies (analogous to "fairness opinions"). This was in the mid-1990's, before the dot com bubble was at its peak, but still heady times. Large companies like Sun Microsystems were angling to provide the underlying platform on which the Internet was being built, and they were all in a mad horse race to stay at the forefront of innovation. They made numerous acquisitions of small startups developing the "picks and shovels" of ecommerce...for example, things that would make their servers run faster or their JAVA programming language be more universal.

Most times, the acquisitions were pretty straightforward, and our valuation analysis would be based on either a reasonable multiple of revenue, or in some cases a "cost to recreate" formula (i.e., what it would cost if Sun were to build the technology itself instead of buy it).

But every so often, the price paid for the target company would skyrocket. I would watch in awe as a small development shop-- often 4 or 5 guys coding away in a Palo Alto warehouse, without any revenue and sometimes without any product in the market-- would get acquired for truly insane amounts, not justifiable by any "traditional" valuation metrics.

In each of these occasions, the acquiring company had either decided the technology was critical to its future competitiveness, OR they picked up on the fact that another competitor was sniffing around (and thus it became a game of "keeping the weapons out of the enemy's hands").

In sum, it never hurts to ask yourself-- are you strategic to a larger firm's future competitiveness? And, can you begin a dialogue with multiple 'mortal enemies'? If the answer to either is "yes", your investors will love you...

(As a postscript-- and this is pretty boring stuff-- the way we justified these outsized valuations was by placing most of the acquisition price in a bucket called "in process R&D" which also had certain tax benefits for the aquiring company; building IPRD valuations became an industry unto itself.)

Some Thoughts on Term Sheets

I am often asked by the startup companies I work with for a "typical" term sheet they can use as a benchmark when negotiating with investors. It's a logical question, but a hard one to answer...the distribution curve, if it could be plotted, would show a huge dispersion around any "typical" mean.

So many factors come into play-- the macro environment, the team, the level of traction, and other intangibles such as how "hot" a given deal happens to be at a particular moment in time-- it becomes hard to find a boilerplate term sheet that works.

Yet we have to start somewhere, and this link provides a good case study of expected terms from both an entrepreneur's view and an angel investor's view:

http://blogs.wsj.com/venturecapital/2009/05/18/what-is-an-acceptable-term-sheet-these-days/

You have to give the entrepreneur credit for his chutzpah in the "ask," but there are definitely a few items that would raise red flags from investors and that have probably hindered his efforts to raise money. Among them:

#1: The salary he asks for ($225k). I build financial models that startups use to pitch investors, and one of the main cost inputs are the salary lines we plug in for both founders and employees. In almost every instance, I need to talk the founders into plugging in lower amounts for themselves, and higher amounts for key outside hires-- VP of Sales, VP Engineering, etc.

The first piece of advice is often hard for them to swallow, but it is key, as investors want the founders to stay hungry and work to build something big-- and the motivation to do so is greatly reduced if he's pulling in a fat $225k. Indeed, I know the founders of one startup that raised close to $40 million, and the VCs set the Founder/CEO's salary at $80k. He was hungry.

In addition, the implied understanding in almost any VC deal is that everyone is working toward the big payoff down the line...IPO, acquisition, etc...and that the salary is mainly just a vehicle to keep a roof overhead and food on the table until that happens.

#2: The option pool. The founder is looking to carve off 8.3% of the company to incentivize new hires. This potentially signals a couple things; either: a) he doesn't believe he'll need to hire many people; or b) he doesn't believe he'll need to raise more funding.

This ties back to the point made above-- the premise of the funded startup is that its future path will be binary: it will either fail or go big, fast. Investors do not want what they call the 'walking dead'...companies that plateau at a few million in revenue but never really grow. The subtext is that to grow fast, you'll need the best people-- and these folks usually want to have some meaningful equity skin in the game. An 8.3% option pool is not going to be enough to "pay" these people what they want.

I don't have an immediate issue with the valuation he's seeking...this is usually a function of how hot a deal is, and can take all kinds of forms. However, it's worth noting that many series A investors will seek a minimum of 30% of the company.

A few other resources for startups dealing with the term sheet process:

Terms Sheets & Valuations by Alex Wilmerding. This book is a few years old (published 2003) but it's already a classic, in my view. At 106 slim pages it's easily digestible, and for each negotiated item in a term sheet, the author presents a "Company Favorable," "Middle of the Road," and "Investor Favorable" variation of the particular term.

Wilson Sonsini's Term Sheet Generator. This is a great resource and a fun website to play around with. Essentially, it is an online questionnaire that guides you through the process and then spits out a sample term sheet based on your answers. It gets a bit technical at times, but it has good explanatory details, and it's far better to muddle through the esoteric details now, then when you're in the middle of a round and paying your attorney to 'educate' you.

What am I missing? What other resources have you found that have helped you with your term sheet negotiations?

The Best Funding Strategy Of Them All: None

This blog is generally about all things early stage capital related, but here is a good list of the best strategy of them all: bootstrapping.

http://www.webguild.org/2009/05/ten-lessons-in-bootstrapping.php

Bootstrapping is one of the mantras I repeatedly drive home to the startup companies I work with. It's one of the toughest things to do, but I truly believe it creates the best companies. Here's why:

• It forces you to be lean and mean-- pinching pennies is a good habit to get into, regardless of whether we're in boom times or a recession.

• It creates a revenue-driven mentality-- If customers--not investors-- are your primary source of funding, you begin to tune your 'opportunity radar' in the direction of where the dollars are (not the grandiose ambitions of where you want to take the company).

• It keeps you focused-- I've been through two Silicon Valley booms now, and each one was accompanied by lavish launch parties, schwag, t-shirts, etc. thrown by newly funded startups. Sure, there can be some positive PR buzz when you throw a big bash, but it doesn't last long-- and it takes a serious amount of management's time and attention to do it well. I don't have the statistical models to prove it, but I would bet there is a strong correlation between the extravagance of the party and the rate of startup failure.
  

• It gives you leverage when you do want to raise capital-- Just like a bank doesn't want to lend unless it knows you have the wherewithal to pay it back, investors tend to flock to companies that are seeing real revenue-producing customer traction. In other words, firms that don't necessarily even need their investment dollars. Concurrently, I am convinced that most VCs have a radar detector at the door than can sense when a startup is running on fumes. Even if they do still pursue the deal, they will have all the negotiating leverage when they know you are desparate.

• It lets you chart your own destiny-- And of course, perhaps the top reason to bootstrap is that it lets you keep control of your business. When you sell equity to an investor-- even if they don't gain a majority share of the company-- they will almost always take at least two board seats. After a follow-on round or two of funding, you will effectively be an 'employee', not the top dog you were when you started the business in your garage.

Don't get me wrong-- most of the startup firms I work with are actively in the hunt for outside capital, and investors can and generally do bring a lot more to a deal than just a very large check...advice, contacts, recruitment help, etc. In an ideal scenario, raising money helps you grow faster than you'd be able to otherwise, and gain a marketshare position that would be impossible to achieve by growing organically.

But the company that bootstraps itself into a position of strength will nearly always retain the upper hand-- and be a better firm for it.

UPDATE: here is a new blog post from Greg Gianforte, CEO of RightNow Technologies, giving us "7 Reasons Not to Take VC Money"

Should Government Help Fund Startups?

I've been running an ongoing, informal debate about the role government should play in encouraging entrepreneurship.

At the root, I believe that what a government chooses to spend its money on is a leading indicator of the health of a nation...is it historical or future-looking? Is it 'enjoying today', or delaying instant gratification and instead investing in the future?

And, is it putting money into things that: a) are productive; and b) leverage the country's strengths?

It's kind of like the old 'guns vs. butter' economic model that suggests any entity-- whether a country, company, or individual-- should produce that in which it has a competitive advantage, and use that output to trade for what it needs.

In other words, "play to your strengths". The U.S.'s strengths have increasingly been found in ideas and innovation, not in manufacturing.

So, I like the spirit of this Op-Ed piece in the New York Times. In short, it questions the logic of spending billions propping up GM and Chrysler, when we could be putting that money to work to launch the next tech startup or cleantech success.

http://www.nytimes.com/2009/02/22/opinion/22friedman.html?_r=1&scp=1&sq=startup&st=cse

I agree wholeheartedly. To be fair, however, it is a simplistic notion that overlooks a lot of real-world details. And my main objection is also why I have often voted libertarian: government is typically not an efficient allocator of resources. Bureaucracy, bloat, and general inefficiencies are the norm, not the exception. Here's an example:

http://www.chron.com/disp/story.mpl/editorial/outlook/6426549.html

Nonetheless, if the government is going to waste my tax dollars, I would still like it to be spent on something that has a chance of being a homerun, vs. propping up the icons of yesteryear, no?

More on M and A for Startups

Continuing the thread on M and A as an exit alternative, here is a good post from the WSJ about positioning your startup to be acquired.

http://blogs.wsj.com/venturecapital/2009/05/04/want-to-position-your-start-up-to-be-acquired-follow-these-tips/

I particularly like these tips:

"Look at it from the acquirer’s perspective."

In other words, what's in it for them? As part of my work at VentureArchetypes, I help startups develop their business plans, pitches, and positioning, and in every one of our engagements, we delve deep into "getting inside the mind" of our target customers.

The same goes for another type of customer (indeed, what could be considered the ultimate customer)-- the potential acquirer. What do they need? Where is their pain? Where are they weak in the marketplace?

In addition, although it's difficult to do, we like to try and forecast where our potential acquirers are going (e.g. with product roadmaps or in new markets) and get there first. To borrow a familiar cliche, like Wayne Gretzky we try to 'skate to where the puck will be'.

The other tip I particularly like is:

"Make sure at least two mortal enemies are bidding on your start-up."

This is critical, not only at the acquisition stage but at the VC (and even angel) funding stages as well. You need to introduce some competition into the game, or you will never get a deal done. If there's no heat on the deal, a single potential acquirer will likely drag their feet ("watch and wait") or even worse, get cold feet...if they think no one else wants you, it can be a red flag.

Having competition for a deal also gives you leverage for negotiations. In the best case scenario, a bidding war may erupt (I-bankers' ultimate dream). Of course, the toughest part is getting the first firm to bite...

Acquisition As An Exit Alternative

As a follow-up to my recent blog posting about the dearth of IPOs (and the effect it's having on the early stage venture market), here is an interesting article from the WSJ about the state of health in the M and A space:

http://blogs.wsj.com/venturecapital/2009/04/29/acquirers-back-in-the-game-but-vcs-advised-to-tread-carefully/

I particularly like this quote from Dan Williams, an I-banker at Montgomery & Co.:

“We’re advising our clients to push the scarcity value discussions, and synergy value discussion, before you ever talk price,” he said. “Otherwise you’re going to get into a situation where the buyer thinks, ‘This is a must-sell situation,’ and then they’ve got all the leverage.”

Scarcity and synergy....

In my view, the "scarcity" discussion may be hard for many startups-- particularly in the Internet space-- to argue effectively. It's never been easier or cheaper to start a company, and as a result, any good idea is immediately copied 10-fold (often with just minor variations in user interface, features, or target audience).

The "synergy" discussion-- although it's something of a empty buzzword-- may be an easier sell, particularly if the startup has something truly innovative or is gaining some real traction. A trend I've noticed recently is that many old-line firms are sitting up and taking notice of new media and social media trends as a new marketing avenue. How can they not when Oprah is pushing Twitter on her show?

But they are often rather clueless about how to wade into the social media stream without getting swept up in a backlash (think Domino's and the viral video of an employee doing, ummm, "unpleasant" things with a customer's pizza).

Here is where startups can, in fact, bring synergy. They can bring the web media experience, the look and feel, and ideally, the user base to the acquiring firm. Many startups also have a fresh design aesthetic that can be invigorating. In essence, they can make the old firms appear young again-- and who wouldn't pay a valuation premium for that?

Closing Term Sheets Quickly (+ Avoid the Co-Investment Term Sheet)

Here's an interesting post from the guys over at VentureHacks about closing term sheets quickly.

http://venturehacks.com/articles/closing-quickly

I like the advice...one of the biggest pains is to get VCs to move on your timetable. About a year ago, I was working with a startup raising a series A round; we had a ton of interest but a hell of a time getting the round to close.

On more than one occasion, we would have a solid bite from a VC who wanted to invest. They went as far as putting down a term sheet. However, they took a somewhat passive-aggressive approach by stating that they didn't want to lead the round-- just "co-invest."

In other words, they wanted to ride on another VC's coattails and wanted the entrepreneurs to bring them the coat.

This was highly disruptive for several reasons:

i) There were no-shop clauses in the term sheet, effectively giving the VC the right to approve or disapprove of who the co-investor would be. This limited (somewhat) our ability to drum up additional excitement for the deal and increase our bargaining leverage.

ii) The term sheet(s) always had an expiration date, and during that time, we would be engaged in the due diligence process with the VC. Even though we had our DD package ready-- as this article suggests-- it takes a huge amount of time, as each VC has a slightly different list of things they want to see. There is a lot of jumping through hoops, a lot of meetings and calls-- all of which can distract from the process of building the business.

iii) The fact that it was only a co-investment term sheet muted the excitement for the deal. In other words, when we would go out and meet with other interested VC firms about being the lead, they would invariably wonder why, if it's such a hot deal, the first VC didn't want to snap up the whole round (in this case the reason was valid...the 1st VC was a strategic investor-- part of a larger media company-- and rarely led deals).

In the end, it all worked out for my client; we successfully closed the round and are off to the races. But the net takeaway is, "beware the follower or co-investment term sheet" as it can really hinder the startup. For the VC putting one down, it's lke an option to invest that costs them nothing-- and it's always in their advantage to wait and watch the startup, versus cutting the check...