This article is the eleventh in an ongoing series on Due Diligence. To learn more about performing due diligence quickly and effectively, download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com.
Early stage investors might not view it this way, but… until a company has some form of financial exit (e.g. acquisition or IPO), you are really more like a donor than an investor! Think of it this way: since there is no liquidity in early stage company stock, you can’t sell the stock and recoup any of your original investment. You’re stuck with stock that, for all intents and purposes, has no financial value that you can monetize. As Christopher likes to point out, equity from investors is like a loan the buyer of your company will pay back.
So as part of your due diligence research, you will need to understand how the company will achieve liquidity through a financial exit for the investors. Since 95%+ of exits with technology companies are through acquisition, the most important questions will revolve around who the potential buyers are and why they want to buy the company.
The following questions are important to review with the company during the diligence process. That said, there are other topics related to exits that you should become familiar with. Start with the following introduction or download our eBook on exits for a detailed discussion.
Q: Ham, help us understand what a potential buyer looks for when they are looking to make acquisitions. What are some of the scenarios we should think about?
When you decide to invest in an early stage company, you are primarily investing because you believe you will make a good financial return on your investment. In most cases (and please note that I said “most” and not “all”), when a company makes an acquisition, it’s because they believe it will produce a good financial return for their business. There are numerous scenarios where a large company makes an acquisition, but the following 5 cases are the ones that create the most value for the acquirer.
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A new product that complements a fast growing product line of a large company
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A disruptive product that has the potential to damage a larger company’s market position or become difficult to “sell around”
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A new product that fills a newly emerging gap in a big company’s product line
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A new product with strategic patents that a buyer cannot risk having fall into a competitor’s hands
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A new product that is clearly constrained by lack of sales and would be instantly accretive and profitable in the hands of a larger sales force.
This list is not exhaustive, but it does cover the outcomes that will produce some of the greatest returns to investors. One type of acquisition that isn’t listed above is the situation where a company is acquired for the team. These so-called “acqui-hires” might produce a good financial return for the company founders (especially if the buyer creates a “carve-out” from the proceeds to be paid directly to the team as an inducement for doing the deal), but they rarely turn out to be great returns for the early stage investor.
Q: How do you determine who the likely buyers are and why they would buy the company?
First off, we expect the company will pull together an initial list of likely candidates. As part of an investor presentation, the CEO should discuss potential buyers and accompany this discussion with a brief explanation describing why each type of buyer would be interested. For example, if you are looking to invest in a data analytics company that tracks consumer behavior, potential buyers could include the following:
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Large enterprise software companies (e.g. Oracle, SAP, IBM)
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Consulting firms with analytics practices (e.g. McKinsey, Bain, BCG)
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Consumer data analytics companies (e.g. Nielsen, ComScore)
Sometimes there are many types of buyers and it takes some thought to figure out which might be the one best-positioned to pay top dollar for your startup. Let’s take an example.
Imagine a hypothetical supplier of cutting edge new technology to the trucking industry. The most obvious category of buyer which leaps immediately to mind might be a customer of the technology who would like to use the technology in their fleet (and keep it out of their competitors’ fleets). But what they will be able to pay is going to face a natural cap that is a function of their limited market share. In effect they can only pay you in proportion to the number of trucks they can reasonably expect to ever use it on.
So you could widen your aperture and look for a broader category of buyer. How about selling to one of the truck manufacturers? That is an improvement because there are fewer of them, and each is bigger than any given fleet operator of trucks. But they each still only control a piece of the market - let’s say there are five and they each control 20% of the market. They might be hungry to buy to keep their competitors from getting the technology, but each of them only controls a fraction of the market. Your technology is universal and can be used market wide. The value of your company is much greater than an individual manufacturer can justify paying - it could apply to the whole market, and yet a 20% market share holder cannot pay for the full market.
So maybe you need to go even broader still and you look at, say, telematics and electronics makers. They sell to all the truck manufacturers, so that is good, but upon inspection, you realize there are many different kinds of solutions in this market, and none of them has a business as massive as even one single truck manufacturer. So even though they serve the entire market across all manufacturers, none of them is really that big because there are so many different categories of product in the telematics and electronics market.
So you scratch your head and start over by asking yourself “who has a huge business selling to this entire industry and might be interested in our safety-related product?” With some research you learn that there are only two manufacturers of brakes for big trucks. They are both huge companies, they are fiercely competitive with each other, and they are very hungry for ways to differentiate their commodity brakes as a much more comprehensive “total safety solution.”
Now, you might have found your ideal buyer! It took some digging and some thinking, but that is what diligence is all about. In doing the research and thinking about how things might play out, you can get a much better handle on the natural maximum potential value of the company. Figuring that out might make you more, or less interested in the deal, but either way, isn’t the effort worth it?
In my view, this kind of analysis should be an important part of the investor pitch because it shows how well the CEO understands their market and the overall ecosystem they live in.
Next, starting with the 5 most likely acquisition scenarios from the above question, you should be able to add to the company’s initial list of buyers and reasons for buying. In certain cases, we will work with some of our contacts in the Investment Banking industry to help us with this research. Investment Bankers with an M&A practice are always talking to large companies and are a great source of market intelligence.
Q: When would they buy the company? What milestones does the company need to achieve before an acquisition is likely?
There is no shortcut for finding an answer to these questions. And, you can’t base a decision on gut feeling. This is where industry expertise is critical. Unless you or your colleagues have deep experience in the market, you will have to reach out to potential buyers to answer these questions. Or, once again, you can speak to an Investment Banker with contacts at the potential buyers.
You should ask buyers about key milestones they are looking for before they are willing to make a serious acquisition offer. Sometimes the milestones are product stage-based and sometimes they are company revenue-based. Examples of key milestones might be:
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Getting FDA approval for a medical device company
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Building an installed base of 10,000,000 users for a consumer-focused startup
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Getting to $10M in Annual Recurring Revenue for an enterprise software company
Q: Once those milestones are achieved, what’s a likely acquisition price?
That’s the $64,000,000 question! Wouldn’t we all love to know what that number will be ahead of time. It would make our lives so much easier. The good news here is that there should be some recent data that you can base your answers on. In almost all cases, there are prior acquisitions that you can use for comparison purposes. If you can’t find at least 2 or 3 similar types of acquisitions made within the past few years, I’d be surprised. And, lack of acquisitions might be a sign that there isn’t much buying activity going on in the company’s market segment.
So, once again, this is an area where having deep industry experience either on the company’s founding team, your investment group, or through investment banking connections is needed.
Q: Explain some more about these different categories of acquisitions you alluded to. Why is it important to understand these categories?
A few years ago, Launchpad initiated a research project to better understand how exits worked in the world of technology companies. One of Christopher and my colleagues, Bob Gervis, put together a well thought out overview for Launchpad that categorized exits into the following buckets:
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Buy the Team - Company has limited if any intrinsic value beyond the knowledge and experience of the team. Acquirer’s objective is to hire the people (i.e Acqui-Hire).
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Buy the Technology - Company has some Intellectual Property (IP) in addition to the knowledge and experience of the team. Acquirer’s objective is to hire the people and obtain control of the IP.
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Buy the Feature - Company’s technology has some proven capability, but has achieved limited market acceptance. Acquirer is adding a “feature” to its existing product line along with the people who created the IP.
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Buy the Product - Company has built a product with early market acceptance and they are nearing product/market fit. Acquirer is buying a product with some traction that they can apply significant sales and marketing resources to and increase growth.
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Buy the Business - Company has built a viable, profitable stand-alone business that is centered around one product or a series of closely-related products. Acquirer views this as the purchase of a growth business with the intent of accelerating the growth and increasing profitability.
So, why is it important to understand these categories? Well, if you understand the ultimate buyer’s motivations, you will gain insight into both the potential valuation of the company and the likelihood of its occurrence. As you might expect, a buyer will pay a lot more when they are “Buying a Business” vs. “Buying a Team”.
There are many different variables in calculating the actual price a buyer will pay when making an acquisition. We tend to use the following guidelines as we are making our estimates. These guidelines are based on our past experience, which by no means should be considered based on exhaustive research. So take these numbers with a grain of salt.
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Buy the Team - Relatively quick exit (investor return: <= 1.5x)
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Buy the Technology - Relatively quick exit (investor return: 0.5x to 2x)
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Buy the Feature - Intermediate term exit (investor return: 1x to 4x)
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Buy the Product - Intermediate term exit (investor return: 4x to 8x)
- Buy the Business - Long term exit (investor return: 5x to 20x+)
Q: Are there different kinds of exits for impact investors? How do impact investors think about exits?
When it comes to exits, impact investors carry an additional burden relative to their traditional investor peers. Impact investors must find a way to exit that does not compromise the impact mission. The term of art to describe these kinds of exits is “responsible exit.” In a responsible exit, investors take care to minimize risks to the impact mission after exit.
As the GIIN discusses in their Responsible Exits Brief, impact investors can lay important groundwork for an acceptable exit at several stages of company development. Whereas traditional investors think about having exit alignment with founders in terms of the timing and magnitude of the exit, for impact investors alignment is all about ensuring commitment to the mission at the investment stage.
Impact investors can also facilitate responsible exits by their choice of investment structure. For example, investors can use an investing structure that allows the company the ability to repay investors over time in cash rather than having to be acquired or have a change of control to create liquidity for the investors.
To the extent that an exit requires new investors coming into the company, impact investors can ensure that there is mission alignment with these new investors so that the company’s strategic decisions take “mission preservation” into account. And of course, impact investors can make deliberate choices at the time of the exit itself to protect impact, such as allowing for some flexibility on the timing the exit, seeking to ensure company management is retained after the exit, and making sure the company focuses only on transactions with aligned buyers.
Want to learn more about performing due diligence quickly and effectively? Download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com.
