As well as being entertaining, there are also some good reasons to think ahead about who might buy your company – it will:
- help you to build your business in a way that appeals to the widest field of potential buyers
- assist you when raising capital, as potential investors will want to hear your exit strategy
- give you a head start if the pressure comes on to find a quick exit.
In this second blog in our M&A series we share our thoughts on how you can improve your chances of a successful exit by understanding who might buy your company, why and for what price.
who will buy you?
One of the fun things about working with tech startups is hearing the ideas of founders about who will eventually buy their companies.
After a tough trip to Silicon Valley, we heard the CEO of a NZ tech company say to his co-founders:
Look guys, I hate to be the one to tell you this, but there really are no pixies at the bottom of the garden…
To put it another way, it’s great to think big, but the reality is usually more mundane. Your buyer will probably come from within your market, or from an adjacent market. Obvious candidates are:
- partners/potential partners
- competitors/potential competitors
- potential new entrants from adjacent markets (who could be potential partners or potential competitors).
We suggest that you start by creating a map of the market that you operate in, focussing on your actual and potential competitors and partners. You can then enlarge the map to include adjacent markets and the potential competitors and partners in those markets.
If your product or service is a slice of a larger technology stack or work flow, we suggest you initially focus on your slice. This might be mainly about identifying competitors. Then move on to the other parts of the stack or work flow, which might be more about potential partners or potential competitors. From there, think about your geographic markets, and adjacent markets.
You can then debate with your board/co-founders/management team the who, why and what for in respect of each of the players you identified. With any luck, you will identify a few obvious potential buyers who would have a good reason to buy you for an attractive price. This analysis should help you focus your resources as you grow and market your business.
This work should also help you to:
- develop your partnering strategy. In any case, we suggest you label your map something like partner landscape as it can be unhelpful to have documents circulating that suggest you are thinking about exit
- hone your competitive strategy, including identifying threats to your business
- identify other opportunities for your business, e.g. your own future acquisition targets.
Revisit your landscape diagram on a regular basis as the tech world is dynamic. It is important to keep on top of market changes, e.g. consolidation, as you don’t want to be the one left without a name on your dance card.
Your view of the landscape will also change as you become better informed about your markets, and as your company grows. If you are successful, some identified potential buyers may be ruled out for being too small. Those smaller players may instead become targets for you to buy. In an ideal world, you will become big enough to become attractive to the big multinationals at the top of your food chain.
Understanding why another company might buy you will help you to focus on the attributes that will lead to an exit. It will also help you to prioritise your efforts – there is little point in making large investments in things that will matter little to buyers.
The following table summarises common tech company acquisition drivers. We’ve limited this list to drivers that companies can influence in the way they develop their businesses. We’ve also ranked these in a rough power order, from low to high, with product acquisition generally being the least powerful driver and market entry being the most powerful.
Obviously, an acquisition can have several drivers, so the more of these boxes your company can tick, the better.
Finally, we’ve left out acqui-hire as a category, because as a value creating event for founders, this seems to be a predominantly Silicon Valley phenomena. E.g., in New Zealand, an acqui-hire would generally occur as part of winding up or refactoring a company, for little or no value.
|acquisition driver||comments||strategic factors|
(with no IP position)
|Companies can be bought because it is cheaper, quicker, and/or less risky for the buyer to purchase a completed product/technology rather than to build it themselves. However, potential buyers often have a choice of targets and are likely to prefer companies with additional benefits such as market share or an IP position. This is generally a weak acquisition driver on its own||Generally not|
|Aggregation/roll-up||Industry roll-ups are a common strategy for private equity and venture capital funded companies. This is most likely to be a driver when a market is fragmented and targets are sub-scale. Depending on the economic cycle, roll-ups can drive a lot of acquisition activity, but potential buyers will usually have a choice of targets and the option of building market share themselves||Generally not|
|This is a relatively common driver of acquisitions. The main reasons for buying customers are to grow market share for an existing product or service (which is in essence a roll-up acquisition – see above) or to enable cross selling of other products or services to the customer base||Sometimes|
(with IP position)
|Companies are bought to enable the purchaser to access or control a product or technology with a strong IP position. Generally speaking, the stronger the IP position the stronger the acquisition driver, as it tilts the buy v build equation towards buy. The other key variable is the relevance of the IP position to a valuable market – an IP position for a product or technology lacking a meaningful market is unlikely to be a driver of an acquisition||Often|
|Partner acquisition||Big companies will acquire smaller partners for defensive reasons (e.g. to ensure ongoing access to the partner’s products, and to prevent competitors from acquiring it), or to capture a greater part of the value chain/market||Usually|
|In the old days, strong competitors acquired weaker competitors. Now, in the technology world, big companies acquire little companies as a response to the innovators dilemma. Big companies, and increasingly small to medium companies, are terrified of being Uber’d, and acquisition of companies challenging your business model is a way to get ahead of that game||Usually|
|Market entry||Entering a new geographic, product or industry vertical market is time consuming, expensive and risky. For this reason, market entry is a very common driver of acquisition activity, particularly in the tech sector where time is a precious commodity. The stronger your position in a market, the greater the driver will be for a new entrant to acquire you||Usually|
The drivers summarised in this table focus on those which a tech company can play to. E.g, securing several Fortune 100 companies as customers may not give you control of a market, but it will make you interesting to potential buyers who sell related products and services.
Of course, there are other common acquisition drivers, but they are often beyond the influence of target companies, e.g. opportunism. Within a couple of weeks of the February 2012 Christchurch earthquake, a number of Canterbury tech companies were contacted by overseas companies with enquiries about whether they were for sale. Corporate hubris can also be a driver, e.g. Amazon’s acquisition rampage in the dotcom boom in 1999-2001.
what price will they pay?
If they are honest, all company founders will admit to day-dreaming about selling their company for a Unicorn type exit price. Investors do this too.
This blue sky thinking is often reflected in pre-money valuations for startups. The thinking of founders and investors is usually strongly influenced by perceptions of the potential terminal value of the company. These valuations also need to balance factors such as relativity to capital raisings by other startups and desired cap table outcomes.
However, tech company purchase prices are not based on dreams of future glory. The price a buyer will pay will be determined by, or validated using, a financial model that reflects the buyer’s analysis of the target company’s past, present and projected financial performance. There might be the odd exception to this rule, but it would be unwise to rely upon finding such an irrational purchaser.
Valuation metrics vary from industry to industry, both in terms of the things measured (e.g. EBITDA, DCF, revenue, ARPU and user numbers) and the multipliers used. Founders should be familiar with the metrics used in their industry, and they should seek to grow their business to maximise those metrics as much as possible.
Having said that, while industry metrics are important, there are some common factors that will usually apply in most tech company purchase discussions:
- companies with positive EBITDA always have a base value that can be achieved in an exit and are therefore in a stronger position in an acquisition negotiation. More so if the company has predictable EBITDA growth
- whether or not EBITDA or DCF is the valuation methodology used in an industry, potential buyers will always use one or both of these methodologies at least as a cross check
- purchasers will generally not pay upfront for projected increases in EBITDA. The more emphasis the seller puts on their expectations of future growth, the more the purchase price will be weighted towards earn out payments
- absent strategic factors for the acquisition, buyers will usually seek to negotiate a price referencing the target’s worst performing metric. With early stage tech companies this is often EBITDA
- with strategic factors driving the acquisition, the seller is in a stronger position and can move the negotiation of the price towards better performing metrics. The more strategic the acquisition, the less the worst metric is relevant, although it is unlikely to be forgotten completely
- generally speaking, the benefit of synergies that a buyer will achieve from the acquisition will not be shared with the seller via the purchase price to any material degree, unless there are strong strategic drivers for the acquisition.
A lack of realism about these factors often leaves tech company founders disappointed in acquisition discussions.
Obviously the ideal position to be in is to have strong industry metrics, positive and growing EBITDA, and strategic appeal to potential acquirers. Simple!
As we said in our first blog, most tech companies will achieve liquidity for their founders, investors and employee share/option holders via a M&A transaction. Some will do so via an IPO, but the factors that drive M&A deals also drive listed share prices so the advice in this blog is relevant to companies that plan to IPO.
Company founders can build their companies to maximise exit opportunities and values by:
- mapping the market they operate in and adjacent markets – exits are most likely to come from these markets
- considering the likely drivers of acquirers from those markets, as founders can build their companies to play to those drivers (and to play to the higher value strategic drivers)
- focussing on hitting metrics that drive acquisition prices in their market, while ensuring fundamentals are covered as well (EBITDA in particular).
by andrew simmonds, 22 September 2015