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Invest to Exit

A prAgmAtic strAtegy for Angel And venture cApitAl investors

INVEST to EXIT is a highly pragmatic strategy for Angel and Venture Capital investors which focuses the investment, business development and harvest activities on strategic value.

Investment decisions are targeted towards those ventures which can create a strategic buyer exit.

The period of investment is often shorter, operational execution risks are lower and return on investment is higher.

The author hereby gives permission for any recipient to forward this publication to others for their personal use. The recipient is authorized to reproduce, store in a retrieval system, transmit in any form or distribute by any means for the personal use of any recipient. This publication may not be sold or resold for any fee, price or charge without the permission of the copyright owner.

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“This book is a must read for the Angel Investors who wish to have profitable exits.” John Mactaggart Chairman, Australian Association of Angel Investors

“ Every entrepreneur seeking to work with outside investors should first stop, read Invest to Exit, and then proceed. Angel investors and venture capitalists want a partnership, a spousal relationship while they grow scalable companies – but there must be an exit, a separation agreement at some point of the investment relationship. Tom McKaskill provides the blueprint for discussing and analyzing those exit options and I recommend both parties use Invest to Exit as a guide.”

John May Chair Emeritus, Angel Capital Association, USA Co-author, “Every Business Needs an Angel” Crown Business:2001

“Tom McKaskill’s insights into the ‘art of the exit’ provide a great roadmap for all Angel and Venture Capital investors. In a misguided investment world that relies too heavily on IPOs, mega-exits and too much quantitative analysis, McKaskill has taken an enlightened and straightforward approach to a topic that should be foremost on startup investors’ minds.”

Joe Platnick, Pasadena Angels, USA

“After reading Tom’s latest E book, Invest to Exit, I not only have a deeper understanding of what an angel investor should be looking for in an investment but it has given me a mind shift on how I think about an exit strategy for my current business and any businesses I might invest in..”

Michael Valitutti, Angel Investor, Gold Coast, Australia

“Tom provides explanations of how to connect the fundamental drive for an exit to strategy in each phase of investment, management and exit. His easy to read, conver- sational style leads the reader to challenge cherished preconceptions, consider new approaches and develop better strategies. This is a valuable read for the first time entrepreneur or investor, as well as for those of us with more experience.”

Jordan Green Founder/Chairman Melbourne Angels, Co-Founder/Deputy Chairman Australian Association of Angel Investors

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Invest to Exit is a must read for the Investor looking to maximize their returns from their private equity investments. Tom McKaskill’s latest book concisely distills the merits of Investors focusing on strategic exit from inception. This book provides a solid foundation from which to understand the difference between a financial and a strategic sale for a company and how to build a plan to maximize the returns for both. Understanding the significant value in focusing business resources towards the execu- tion of the strategic sale will enable earlier and higher exit returns for Investors and Entrepreneurs alike. A successful exit may be achievable much sooner than originally anticipated and with significantly less capital requirement.”

Andrew Loch Chair Gold Coast Angels Angel Investor & CEO of the Gold Coast Innovation Centre

“The high-growth model has claimed many casualties, especially in smaller economies such as New Zealand where companies pursue growth from a very limited human and financial resource base. While there is nothing wrong with high-growth strategies, they are often inappropriately applied as the only strategy. The world has changed, its time to take a fresh look at investable assets and investable exits before committing.

While working with several hundred technology companies I noticed that patterns began to emerge. Tom McKaskill not only reads these patterns, he connects these themes to offer new insight and he creates pragmatic linkages through to investor returns. If you can’t get him in person, I suggest you get across McKaskill’s body of knowledge in this self-contained book. It is a `must read’ for investors, advisors, founders, managers –anyone charged with the creation of value. I have introduced Tom to more than 50 local firms and advisors and will continue to do so because of the amazing feedback he generates.

There is a huge opportunity cost in failing to apply these patterns. There are limited investment candidates with the true hallmarks of success and while we might start with the right material, it can go horribly wrong from there. This book emphasizes tactics-backed strategy and focuses the reader on drawing the narrowest line between an investable exit and the present.”

Matt Yallop, Repertoire Management, New Zealand
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“Goal setting is part of life. Athletes set themselves goals – say, winning the triathlon at the next Olympics. Companies set themselves goals – say, doubling revenue by introducing a new product line. However, setting goals is a meaningless fantasy unless you also devise a methodical approach to achieving that goal.

Yet surprisingly, goal setting and planning are often missing from venture capital investing where investors often become intrigued by the initial concept to the point that they completely overlook the endgame. Investors have an obvious goal – to make money via a highly profitable exit. So why is it unusual to find investors focusing on exits from the very beginning. If done properly, mapping out a methodical plan to achieve a profitable exit, brings a host of benefits as well as removing much of the risk from venture capital.

Tom McKaskill provides the “how to” in his usual accessible style. In fact, it must have been tempting to call the book “Exit Planning for Dummies” since the book provides a step-by-step approach which can be understood and followed by anyone investing in technology-based start-up ventures. Not only does the approach improve the risk/return for the investors, but the roadmap it provides removes much of the uncertainty and angst from the post-investment period which often sees investors become disenchanted with an investee’s progress.

In my view, the book should be compulsory reading for all entrepreneurs and inventors who should work through the book before fronting investors. Their fund-raising prospects would be greatly enhanced if their presentation began with: “Let’s talk about our technology later. I want to start by describing our exit scenario and our plans for getting there .....”.

Ergad Gold Principal and Executive Director Momentum Investment Group “For the professional Angel and Venture Capital investor, Invest to Exit is the first book to succinctly capture the importance of aligning the combined interests of inves

tor, management and shareholder when making the investment to produce an optimum result on exit regardless of underlying economic conditions. Commencing exit plan- ning much earlier in a company’s development, combined with planning and then flawless execution will always produce an outcome better than starting later and hop- ing a buyer “will be just around the corner”.

Dr. McKaskill has captured the essence of the issue, providing examples which clearly highlight the challenges and issues faced along the way.
This is compelling reading for investor and companies alike as they work collaboratively to achieve a superior result when they sell.”
Greg Sitters, Sparkbox Investments Limited, New Zealand

“Tom is undoubtedly one of the foremost thinkers on what it takes to achieve strategic value in a business. With the strategic end game firmly in mind right from the outset, investors can focus their money and management resources on the right activities which drive this value and lead to significant investment out-performance.

Tom’s hands on experience in this area comes through clearly in his writing, including focus on the importance of establishing strong personal relationships with the decision makers in potential buyers. I apply many of Tom’s principles on a daily basis in my investment and advisory activities – these principles are timeless and not dependent on the vagaries of short term market movements.

I strongly recommend Tom’s latest book for all investors looking to profit from a stra- tegic value mindset.”
Barry Palte CEO EQ Capital, Australia v 00001.jpg

Dr. Tom McKaskill

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lobal serial entrepreneur, consultant, educator and author, Dr. McKaskill has established a reputation for providing insights into how entrepreneurs start, develop and harvest their ventures. Acknowledged as the world’s leading authority on exit strategies for high growth enterprises, Dr. McKaskill provides both real world experience with a professional educator’s talent for explaining complex management problems that confront entrepreneurs. His talent for teaching executives and his pragmatic approach to management education has gained him a reputation as a popular speaker at conferences, workshops and seminars. His approaches to building sustainable profitable ventures and to selling a business at a significant premium, has gained him considerable respect within the entrepreneurial community.

Upon completing his doctorate at London Business School, Dr. McKaskill worked as a management consultant, later co-founding Pioneer Computer Systems in Northampton, UK. After being its President for 13 years it was sold to Ross Systems Inc. During his tenure at Pioneer, the company grew from 3 to 160 people with offices in England, New Zealand and USA, raised venture capital, undertook two acquisitions and acquired over 2,000 customers. Following the sale of Pioneer to Ross Systems, Dr. McKaskill stayed with Ross for three years and then left to form another company, Distinction Software Inc. In 1997 Atlanta based Distinction raised $US 2 million in venture capital and after five years, with a staff of 30, a subsidiary in New Zealand and distributors in five countries, was sold to Peoplesoft Inc. In 1994 Dr. McKaskill started a consulting business in Kansas which was successfully sold in the following year.

After a year as visiting Professor of International Business at Georgia State University, Dr. McKaskill was appointed Professor of Entrepreneurship at the Australian Graduate School of Entrepreneurship (AGSE) in June 2001. Professor McKaskill was the Academic Director of the Master of Entrepreneurship and Innovation program at AGSE for the following 5 years. In 2006 Dr. McKaskill was appointed to the Richard Pratt Chair in Entrepreneurship at AGSE. Dr. McKaskill retired from Swinburne University in February 2008.

Dr. McKaskill is the author of eight books for entrepreneurs covering such topics as new venture growth, raising venture capital, selling a business, acquisitions strategy and angel investing. He conducts workshops and seminars on these topics for entrepreneurs around the world. He has conducted workshops and seminars for educational institutions, associations, private firms and public corporations, including KPMG, St George Bank, AMP, AICD and PWC. Dr. McKaskill is a successfulcolumnist and writer for popular business magazines and entrepreneur portals.

To assist Angel and Venture Capital investors create strategic exits for their investee firms, Dr. McKaskill conducts seminars, workshops and individual strategy sessions for the investor and their investee management teams.

Dr. McKaskill completed a number of e-books for worldwide, royalty free distribution. He has also produced over 150 YouTube videos to assist entrepreneurs develop and exit their ventures.

Tom McKaskill is a member of the Apollo 13 Angel Group on the Gold Coast and of the Australian Association of Angel Investors.
Dr. Tom McKaskill Australia
April 2009
info@tommckaskill.com www.tommckaskill.com
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00002.jpg00003.jpg00004.jpg00005.jpgThe Ultimate Deal 1 Selling your business

This book is aimed at those businesses which need to maximise their profit and growth opportunities for a sale to a financial buyer to leverage the best sales price. It sets out a breakthrough process which includes reducing risk, improving sustainable profits and building growth potential in the business to maximise the sales price. This world first process can increase the value of the business between two and ten times the conventional sales value of a firm.

The Ultimate Deal 2 Get an unbelievable price

This book uncovers the secret of how to leverage strategic value in the business to create a large revenue opportunity for a strategic buyer. Dr. McKaskill’s is the world’s leading authority on selling a business to a strategic buyer and sets out a comprehensive and systematic process for selling a business to a large corporation. Sales values of 40 times EBIT and/or many times revenue are highly probable using his Strategic Sale Strategy for a business with underlying strategic assets or capabilities.

Angel Investing Wealth creation through investments in entrepreneurial ventures

Designed to help high net worth individuals become successful Angel Investors. Angel investing involves active mentoring and coaching of an early stage management team towards sustainable profitability or additional funding, probably from a venture capital firm. This book sets out a comprehensive and rigorous process that will help the Angel generate deal flow, evaluate investment proposals and manage the investment and subsequent harvest. The book also provides a useful guide to managing operational risks in the venture.

Get A Life! An inside view of the life of
entrepreneurs - from around the world

This book is a collection of stories from entrepreneurs around the world where they describe their work and their lives. They explain what it is like to be an entrepreneur, how they got started, the successes and failures of their ventures and the highs and lows of their personal and business lives. The stories are rich in content and provide deep insights into how entrepreneurs think. If you are an entrepreneur this will resonate with your inner being. If you are not, this will provide you with a great understanding of entrepreneurs.

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00006.jpg00007.jpg00008.jpg00009.jpgFinding the Money How to raise venture capital

The purpose of this book is to educate the entrepreneur on how Venture Capital firms work, what they seek in an investment and how they manage that investment through to an exit transaction. It helps the entrepreneur judge whether they have a venture suitable for VC investment and whether they wish to be part of such an activity. It lays out a comprehensive process that the entrepreneur can follow which will assist them in raising VC funding.

Winning Ventures 14 principles of high growth businesses

Explains the major contributors to high growth success. Includes a comprehensive Growth Check list for each principle as well as a robust Growth Potential Index to help the reader judge the growth potential of their venture. Based on established theories of growth, venture capital selection criteria and the author’s personal experience, this is a must for entrepreneurs.

Masterclass for Entrepreneurs
Creative solutions for resilience, growth
and profitability

This book is a collection of published articles by Dr. Tom McKaskill. This volume expands on 30 of those articles to provide a wide-ranging guide for entrepreneurs on how they can manage their businesses more effectively.

Fast Forward Acquisition strategies for entrepreneurs

In this book, Dr. McKaskill sets out a systematic and pragmatic process for identifying, evaluating, valuing and integrating financial and strategic acquisitions. He draws extensively on his own experiences as a CPA, entrepreneur and academic, as well as his experience with acquiring and selling his own businesses. He brings a systematic and comprehensive approach to growing business through acquisitions.

Order e-books from www.tommckaskill.com

Raising Angel & Venture Capital Finance
An entrepreneur’s guide to securing
venture finance

This book is aimed at those entrepreneurs who have high growth potential ventures and seek to raise finance to assist them to develop their business. To secure the finance, the entrepreneur will have to demonstrate that their business is capable of achieving a premium on exit, usually through a strategic sale. The book provides a checklist for the entrepreneur to assist in developing a strategy to raise finance.

00010.jpg00011.jpg00012.jpg

An Introduction to Angel Investing
A guide to investing in early stage entrepreneurial ventures

Designed to help high net worth individuals become successful Angel Investors. Angel investing involves active mentoring and coaching of an early stage management team towards sustainable profitability or additional funding, probably from a venture capital firm. This book sets out a comprehensive and rigorous process that will help the Angel generate deal flow, evaluate investment proposals and manage the investment and subsequent harvest. The book also provides a useful guide to managing operational risks in the venture.

Invest to Exit
A pragmatic strategy for Angel and Venture Capital investors

Investors in early stage ventures need to focus on strategic exits if they are to achieve a high return on their investments. This book explains the characteristics of strategic value, how the investor should negotiate the investment and how they should manage the process to a strategic trade sale. The book includes a very detailed discussion of the problems of high growth ventures, the unrealistic expectations associated with IPOs and the advantages of investing in strategic value ventures.

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Published by:
Breakthrough Publications RBN B2173298N
Level 1, 75A Chapel St.,
Windsor, Melbourne, Vic 3181

www.tommckaskill.com
Copyright © Tom McKaskill 2009

All rights reserved. This publication may be reproduced, stored in a retrieval system or transmitted in any form by any means for personal use without the permission of the copyright owner. This publication may not be sold or resold for any fee, price or charge without the permission of the copyright owner.

Every effort has been made to ensure that this book is free from error or omissions. However, the Publisher, the Author, the Editor or their respective employees or agents, shall not accept responsibility for injury, loss or damage occasioned to any person acting or refraining from action as a result of material in this book whether or not such injury, loss or damage is in any way due to any negligent act or omission, breach of duty or default on the part of the Publisher, the Author, the Editor, or their respective employees or agents.

National Library of Australia Cataloguing-in-Publication data: McKaskill, Tom.
Invest to Exit - A pragmatic strategy for Angel and Venture Capital investors. ISBN 978-0-9806458-0-4 (on-line), 978-0-9806458-1-1 (CD/DVD) 1. Investments. 2. Investment analysis. 3. Entrepreneurship. 4. Business enterprises - Finance. I. Title.
332.6
Cover design: T. McKaskill Page design and production: T. McKaskill

Table of Contents

Preface ..................................................................................................... xiii
Acknowledgements .................................................................................. xiv
1. Begin with the end in mind................................................................... 1
2. High growth - high risk........................................................................ 13
3. Spot the IPO........................................................................................ 34
4. Financial v.s strategic exits .................................................................. 53
5. Threats and opportunities .................................................................. 72
6. Identifying strategic value................................................................... 92
7. Finding strategic buyers .................................................................... 124
8. Enabling the opportunity.................................................................. 142
9. Reducing risks to the buyer .............................................................. 158
10. Setting up the exit deal ..................................................................... 178
11. Evaluating potential investments...................................................... 198
12. Executing the exit strategy................................................................ 217
13. Structuring the trade sale deal ......................................................... 231
14. Selecting professional advisors ......................................................... 249
15. Conclusion - impatient capital ......................................................... 259 xii

Preface

Over the last few years I have advised countless entrepreneurs, Angels and Venture Capital fund executives on exit strategies. Almost without exception, I have found that they have a poor understanding of strategic value or how to set up a strategic trade sale. Far too many are consumed with the goal of an IPO even though this is rarely achieved by an early stage venture.

I have taken the opportunity in the book to set out what I believe is the best way for an Angel or Venture Capital investor to approach an investment opportunity. Basically, don’t invest unless there is a clear path to a strategic sale. A focus on a highly probable premium exit aligns investor and venture management interests, provides a very clear path to a harvest for all parties, significantly reduces the business development hurdles and usually results in a much shorter investment period.

I hope you find this book of great value in your investment program and look forward to receiving your feedback on its implementation.
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Acknowledgements

A very large number of people have contributed to my knowledge of this topic. This includes hundreds of entrepreneurs who have been through my classes and workshops, Angels who have attended my training sessions and discussed their investee firms with me and VC executives who I have worked with on exit strategies for their investee firms. Each conversation, question and problem has helped me refine the strategic sale model.

My life partner, Katalin Johnson, has been with me every step of the way, participated inthe seminars, workshops and most of the conversations. She has assisted me greatly by asking the hard questions, reviewing the material and making her own contribution to the content.

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1
Start with the End in Mind

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t seems very obvious that an Angel or VC investor will ultimately seek an exit, whether that be a trade sale or an IPO. It therefore makes sense to keep this objective in mind as the investment is progressed as this would hopefully improve the outcome and thus the return on the investment. While that might seem obvious, few Angels or VCs actually approach their investments this way. Most seem content to build the company with the expectation that, when they are ready, a buyer will be found or an IPO achieved. In reality, the outcomes are poor and few deals achieve high returns.

But lets go a little further. What about planning the exit from the outset. That way the manner in which the business is developed continually keeps the exit in mind and this ensures that we don’t veer off track in terms of meeting our major objective. Some Angels and VC investors do this but they are in the minority.

Now lets get even more radical. Why don’t we change our investment criteria to only focus on investments where we have a high probability of a premium exit. In order to do this, we have to have a very good idea of what creates premium exit conditions, that is, what do we have to do to set up the conditions where a premium exit is highly likely, whether this be an IPO or a trade sale? What would we have to do to make this happen?

At the same time, we want to reduce our risks of failure, ensure that we can extract maximum value if the business gets into trouble and be ready to take advantage of an opportunistic exit.

A tall order – actually no. My personal experience and my research into strategic exit strategies over the last several years has shown me that you can set out to create the conditions for a premium exit. This book will show you how to do it.

You have no doubt heard of highly successful exits, the stuff legends are made of. There are enough examples of trade sales of 10 times revenue or better, 100 times EBIT or 50 times investment to know that such deals happen. We also know of IPOs which gave staggering returns to the early investors. Was it just luck? Was it simply a matter of ‘right time – right place’? Probably. But there is enough evidence around to show the underlying patterns for why these results occur and under what conditions.

If that is the case, can we turn luck into a systematic process for achieving a high return on exit? I will show you how.

My own experience has shown me that the process isobvious and that it can be applied with a high probability of success. But there are some pre-conditions. You have to start at the right place if you are to get the result you want. You can’t turn lead into gold and you can’t create a premium exit unless you have the right material to work with. Thus getting into the right investment at the outset is a precondition to achieving an outstanding return on the investment.

You would be right at this point to ask the question – if this is so obvious, why don’t I know about this already? I have asked myself this same question many times over the last few years.

What we first need to accept is that the VC investment model of the 1970s through the millennium is a flawed process. It was built during the periods of boom markets, focused wholly on IPOs and had a fallback plan of a trade sale. All this happenedin large population markets which made it easier. Our investment environment is radically different now. That is not to say that we won’t see these conditions again as they do tend to repeat themselves with each new breakthrough innovation, but you can’t bet the farm on that happening. We need a different approach which will work in the current economic environment with greater resilience to changing conditions.

Even so, we know very little about how to set up a successful IPO outside boom markets. I have done enough research in this area to provide a more reliable guide to IPO exits which I will cover in a later chapter.

But what about trade sale exits. This is one area where you would think we would have considerable documented experience but, in fact, the opposite is the case. When I first started my research activities in the area of trade sale exits, I discovered that there was not a single published piece of research in this area. Not one! I canvassed a number of highly reputable scholars in venture capital investments and entrepreneurship and was informed that it was a black hole. Not so the acquisitionliterature which has thousands of published articles.

The literature which is available on selling a business is aimed at very small businesses and very much takes a consulting or business broker approach. But if you want to sell a high growth venture or if you want to sell to a strategic buyer – there is nothing for you.

There is no question that there are people who understand the trade sale process very well and even some who are very skilled at setting up premium deals and strategic deals, but they had never documented their experience or developed a process for others to follow.

My objective over the last several years has been to fully understand the exit process and to document a best practice model which would have a high probability of success. I have now published this in many articles and several books. In this book I wish to focus on one specific issue – how can the Angel and VC investor use this process to achieve a high return across a wide spectrum of economic conditions.

In this book I will articulate how to choose the right ventures to invest in and then show how to progress them towards a premium outcome.

Firstly, let me explain how my personal experience in trade sales has shown me that the conventional Angel and VC exit models are far too limited and fail to take into account strategic value exits.

For over 20 years I was involved in setting up, buildingand selling companies, first in England and then later in the USA. Since then, I have been teaching graduate students about harvesting their firms and have come to see just how unique my journey through the years has been.

The firsT company i started, pioneer computer systems (pcs), which was started in 1979 by three partners in my dining room, took us 13 years to build to 160 staff located in three offices; Northampton and London in england and san Diego in the Usa. The company developed and sold enterprise resource planning software (erp) for discreet and process manufacturers. in 1985 we raised Us$1.5 million in venture capital to buy out a 4GL supplier in order to gain control over a critical part of our r&D. around 1990 we decided that we wanted to be able to take out some of our hard earned wealth. in order to do so we needed to sell the business. at the time of our initial enquiries valuations in our sector were running at about 4 x eBiT. We were generating about sTG500,000 in eBiT at the time and so it looked like an attractive exit. however, by 1991, the UK headed into a depression. We were still interested in selling the company but found that acquisition prices were down to around 2 times eBiT. Unfortunately, by then we were also in decline and looked like barely breaking even that year.

We turned to the USA in order to find a buyer.

We looked for a company that needed us. it needed to have its products based on the same computer operating system as we used as that was a significant factor in being able to integrate our software. We looked for a company that could take us into a larger market and could benefit from our development of the first fourth generation soft- ware development language (4GL) based erp system for the process manufacturing sector. We identified Ross Systems Inc., a firm gener- ating about Us$40 million in sales.

We made an approach and were asked to come and present a case to them. We did not learn until after the acquisition that they had identified us as their best acquisition possibility. However, at the time of our approach to them, they were unlisted and we determined the risk was too high to sell out to a private company but as they were proceeding to an ipo, we decided to wait. a few months later we signed up their asian distributor. This provided ross with a way of evaluating the software through the sales and implementation processes. it also proved to them the global potential of the software. five months later they listed and within a week we had someone come to the UK to undertake due diligence on the software and our operations. six weeks later we had negotiated a deal worth 10 times our prior year eBiT.

Within 9 months of the purchase, our software was the flagship for the combined business and our technology was used on every new software development. ross increased the sales of our product by a factor of 5 in the first 18 months of the acquisition. Twelve years later, ross was still based on the same software and had made few changes to the basic functionality. ross was subsequently acquired by chinadotcom.

In hindsight, it is easy to recognize this as a strategic acquisition by ROSS. What they really wanted was our manufacturing software and they were able to considerably increase the sales of the product because they had a much larger sales force, a number of key strategic partnerships and the funding to undertake a significant push into an emerging market. They bought the product with its supporting infrastructure, not the customer base, the revenue or the profit (or lack of it). When you are making a loss, it is difficult to see how an EBIT multiple can give you a positive value on sale. However, when you see it from the buyer’s viewpoint, the price paid was small compared to the market potential of the product suite.

My next venture was an even greater radical departure from conventional valuation.

TWeLve of The pcs key employees relocated to atlanta in 1992. in my last year with ross, 1994, and before my contract expired, i established a consulting firm in Kansas. I had already helped to establish an affiliated firm in New Zealand of which I was a small shareholder. The Kansas operation would trade under the same name, cimDec systems, but be mostly owned by myself and two local executives. about 6 months later and before we had started any operations, the NZ firm was acquired by a Scottish listed company. In order to expand their operations into the Usa, they needed to buy back my distribution rights to the cimDec software. i had it – they needed it. We settled on a price of Us$1 million for the business. i had made Us$500,000 from an investment of Us$10,000. our Usa business had never undertaken any work, never entered into any contracts and never generated any revenue.

Basically, the new owner purchased the NZ and USA operations to generate new revenue from outside their core construction business. They combined several businesses into a global IT company. Entering the USA through Kansas was a key factor of the deal.

When you consider that the normal approach to valuation is to multiply an EBIT by an industry norm, it is hard to see how you can get $1 million from a zero position. But it does tell you that the existing paradigm is lacking if it can’t explain how this outcome was achieved.

in 1995, soon after i left ross, i co-founded Distinction software inc. with Us$200,000 and about 12 people that joined me from ross systems. We started building a forecasting package and gradually expanded it to a full suite of supply chain optimization modules. our intention was to build the ‘missing piece’ of the erp solutions in the process manufacturing software applications sector. our intention was to sell back into our old customer base and then use this as a platform to grow the business in the sector.
about a year or so after we started, a small scheduling software company, red pepper, was acquired by peoplesoft for something like 26 times revenue. peoplesoft wanted to move into manufacturing software and needed an icon product to launch their campaign. red pepper was the product they used to do so. it gave them the momentum and market credibility to become a major player in the enterprise wide manufacturing software market. We used the red pepper deal to demonstrate that our sector was now in a high growth phase. it allowed us to raise Us$2 million in venture capital.

In order to generate sales, firms in our sector typically partnered with very large application software companies like sap, peoplesoft, JD edwards, Baan and oracle. however, we came badly unstuck when a few years later sap announced the development of a suite of products across this space and terminated our partnership arrangements. Within a few months all their competitors announced similar developments. The market for the likes of Distinction software evaporated.

We decided to sell rather than retrench most of the staff. in one day i contacted 8 firms who were potential buyers and all were interested in negotiating. a week later, armed with two large boxes of documents which described every part of our operation, i met with peoplesoft. They were given 7 days to come up with a deal. The deal was negotiated over the phone and 2 weeks later we sold the company for Us$12 million.

By the time of the sale, Distinction software was hemorrhaging badly and running at about a $1 million loss. We effectively had zero prospects and only about 6 months worth of cash left. Basically we were dead.

however, this was a great deal for peoplesoft. They had just written off Us$13 million on a failed forecasting software product. We provided them with 5 modules of which forecasting was one. instead of spending 5 years to develop a suite of products (even if they could), they entered the market with one of the few complete, proven solutions. none of their competitors had anything to match it and were probably some years away from having a competing product.

In hindsight, we sold out cheaply. The public relations value alone was worth the US$12 million we achieved for the business. Then, of course, there was the potential sales just into their existing customer base which could easily have earned them 50 times their investment in a few years.

What is remarkable about this story is that it was possible to achieve a great outcome for the Distinctionshareholders in just a couple of weeks in a situation where it was truly a fire sale.

As a Professor of Entrepreneurship, I used these personal experiences to look at the entire process of preparing a business for sale. What I found was that very few advisors understood how to value the strategic value of a business and no one I talked to had ever implemented any systematic process for preparing a venture for a strategic sale.

The existing literature on selling a business takes the same approach for every business, simply increase the profits and sell out on an EBIT multiple. This approach to selling is typically promoted as a series of steps in a linear process that ends up with a sale to a buyer. It is very much a ‘one size fits all approach’. Not only does it not do justice to those businesses which are capable of proactively changing their operations to increase their profits and growth potential, but it seriously undervalues those businesses that have assets and capabilities that can create large revenue opportunities for potential buyers.

In the conventional approach there is a serious lack of strategy. No attempt is taken to alter the business to suit the buyer or to proactively change the external environment in which the business will be sold. Historically, selling a business has been managed predominately as a real estate transaction and this approach has failed to develop or utilize any underlying theory about how value is created for the buyer.

The literature on IPO preparation is similarly lacking. Not only is there a complete lack of understanding of what it takes to be a successful listing but the only guidelines available are about the listing process not the strategy to follow to create a listing opportunity.

If we are to improve the probability of successful investments for Angel and VC investors, we need a much more sophisticated and systematic approach to the exit, whether it be a trade sale or an IPO. Our literature and our training is seriously lacking in this area. While we spend a lot of time on showing investors how to get into an investment, there is little to show them how to get out successfully. What is apparent is that the exit event itself is not linked back to the criteria for investment and the development strategy of the investee firm.

The conventional model of business development focuses on revenue and profit growth and yet little attention is given to the risks associated with high growth enterprises. If the only model going is high growth, then where is the literature on how to manage a high growth enterprise. What I have seen is that it is seriously lacking. Our understanding of what it takes to generate high growth and how to manage it is very immature and yet the dominant model for Angel and VC investment are built on the premise that high growth is the only way to achieve a high return on exit. As I will show later, high growth is not only high risk but rarely has good outcome.

VC and Angel investors experience a reasonably high rate of write-offs and negative returns. Even their positive exits rarely achieve high returns. It is only the exceptional investment that achieves returns in double digits. This is partly due to an outdated investment model fixated on high growth but also because they fail to plan for an exit under less than ideal conditions.

Very few firms choose the timing of their sale. Most are forced into a sale by external events or through poor management. A smaller number are approached by a potential buyer and take the opportunity to sell. Only a very few control the timing of their sale by taking the initiative to find a buyer when they are not under pressure to sell.

If you cannot reliably predict when the business will be sold, you need an investment approach in which the business is able to be sold at any time, if you need to or want to. Being prepared to sell at any time is the only way to protect the value in the business.

You need to sell

Not everything is going to go according to plan. Sometimes market conditions change and the business is no longer capable of reaching the targets initially set or may no longer be viable. Rather than let the firm become insolvent or bankrupt, the exit plan should be set up so that there is little delay in executing a trade sale. This way the maximum benefit can still be extracted from the failing business.

Often time is against you. If the management team has not put an exit strategy in place and they have little time to prepare or to set up discussions with potential buyers, you will have a fire sale as an exit. If they have not already set up the relationships in advance, especially with overseas buyers, it probably is not going to happen the way you would like. Without the planning, the ability to attract the buyer that will pay a premium value for the company is significantly constrained.

By setting up relationships in advance and by knowing why the corporation would want to buy the firm, management can executethe acquisition discussion quickly. As long as the firm has several potential buyers, the competitive tension in the deal can still result in a very attractive sale price.

The firm is approached with an offer to buy

Many Angel and VC funded firms are targets for acquisitive corporations. However, when the offer comes management may be unprepared and are unsure what the price should be. If management are unprepared and need to go through extensive due diligence, this not only takes considerable time, but it uncovers risks to the buyer. Instead of closing a good deal, the firm will end up with a disrupted business, staff who are stressed due to uncertainty and a price that the shareholders would normally not have accepted. Now management has taken their eye off the ball and have a lot of work to recover their prior momentum. They may also have talked themselves into the deal.

How much better would the firm be if they had already lined up several possible buyers? They can now announce that they are prepared to sell and consider all offers. Management will have prepared the due diligence files and can execute the deal quickly with little disruption. The staff understand the process and have incentives to ensure the best deal is done. This should be canvassed with staff from an early stage so that they understand the need for a planned exit for the external investors.

You and management decide to sell

Experienced Angels, VC investors and a good management team should already know of the best potential buyers and through its business strategy it should have already put itself in a position to actually know those parties. If management have prepared the company for sale over many years then they are best placed to be able to drive the exit process rather than have it drive them. You and management simply need to decide on the timing.

You decide to list the business

What is clear is that there are many advisors who want to help you. Rarely do they tell you not to list as they all get the chance to charge you high fees and commissions, whether you make it to the IPO event or not. Even if you do list, you may not have a positive experience afterwards if you don’t have the right business model. It is an expensive process if it goes wrong.

A New Approach

As an Angel or VC investor you need a better process. Not only should you have a systematic method of preparing an investee firm for a good exit but you also need to have better criteria for selecting the businesses you invest in.

If you want to invest in growth businesses, then you need a much better understanding of what drives sustainable growth. You should also have a better appreciation of the risks associated with high growth. If you desire to take a business to an IPO, then make sure you get into the right business from the outset.

However, if it is simply a high ROI you seek, then take a new approach. Stick to strategic value deals. Not only are these less risky than conventional growth investments but they can be exited earlier with a much higher probability of positive returns. If you do decide to take this approach, then you need to ensure that the investments you do make have strategic value potential, thus you need to have a very good understanding of how strategic value is created and harvested but also, how to identify it before you invest.

Whether it is an IPO or a trade sale you seek as an exit objective, you need to invest with the exit in mind. This informs everything you do from choosing your investments to managing the business and securing the premium on exit.

In the next chapter, I will look at the process of high growth, what creates it and the risks associated with pushing a venture into a high growth mode of operations. Following this discussion, I will look at the IPO process and how this can be achieved.

The remaining chapters of the book will examine the nature of strategic value, how it is identified, developed and used to structure a strategic value trade sale.

2
High Growth High Risk

A

lmost without exception our measure of business worth is expressed in terms of profit; even better if that is growing year on year. Thus any small firm interested in raising finance is going to be asked to show revenue and profit growth and be able to demonstrate that its ‘business concept’ has substantial future potential in these areas. Without exception, by business concept we usually mean the entrepreneur has to demonstrate how the business is going to make money. The future profitability of the business can then be readily translated into an IPO or trade sale valuation.

Since an IPO exit has been historically seen as the preferred exit route, the conventional investment approach taken by Angels and VC investors is to invest in companies which have higher growth potential. They see the business as a stand-alone entity increasing in value through revenue growth and increasing profits. Value is seen as a direct multiple of EBIT and so getting to higher levels of revenue and profits is the business development strategy.

What this means is that the new investee firm has to develop a stand alone profitable growing business in order to be a ‘good’ investment in the eyes of the investor. An even better business is one that grows faster and generates higher profits.

Actual growth or potential growth, especially high growth, is seen by Angels and VC investors as an essential component of all successful exits, i.e. trade sales and IPOs. However, to get a reasonable return on the investment, the venture will have to post relatively high growth rates. Even then it will take some time to achieve the levels of profit required for a good exit.

Lets start with some basics, time, growth rates and ROI. If you look at the basic relationship between time and valuation, the time element is critical to a healthy return on investment. The longer it takes to achieve the same exit valuation, the lower the ROI as the following table demonstrates.

Example:

The venTUre is currently generating an eBiT of $100,000 on revenue of $1 million. The investors agree a $1 million pre money valuation and invest $1 million for 50% equity. The funding will be used to undertake market development, fund working capital and complete product development. Thus, while revenue rates will kick up, the venture still has to mount a sales and marketing campaign, close deals and deliver quality products. Let us assume that they are able to grow the business to $5 million revenue and $500,000 in eBiT. at this time the business is sold for 10 x eBiT or $5 million. The return to the investor will depend on how long it takes the business to achieve this result.

ROI to investor
Year 9 10
ROI 150% 58% 36% 26% 20% 16% 14% 12% 11% 10%

In this specific example, the IRR also represents the growth rate of revenue and profit. Since most Angel and VC investors look to a risk hurdle rate of 25% or higher, only an exit before year 5 will achieve that. That means very high growth rates during the early years of the investment. However, we know from the research on high growth ventures that only a fraction are able to generate double digit growth rates, so growth rates above 20% would seem to be exceptional. A more realistic growth rate of 10% to 12 % which, over time is still difficult to achieve, only provides a reasonable return after 8 years. Few Angels or VC investors would wish to invest on this basis.

It would seem unrealistic to expect an early stage venture to develop to a point where it can generate reliable profits within a few years. What is clear from this example is that investee firms need to get to a reasonable size if the venture is to return a good ROI to the investors. The research would suggest that this only occurs in exceptional situations.

A lower exit price, which is more realistic, dramatically reduces the returns. Also, the longer it takes to exit, the more likely returns will be poor. The only way such a result can be offset is if the entry valuation is pushed down aggressively. While that is possible it does create considerable tension between the investors and the founders.

A large proportion of Angel investments and a small percentage of VC investments are at a very early stage in a venture’s life, often when it has only a few employees. Firms at this stage are especially vulnerable to failure. Early stage ventures are characterized by high levels of uncertainty due to a combination of factors:

• The product is often unproven
• The management team is inexperienced
• There are gaps in the management team
• The market is developing and yet to be established
• Competition is still uncertain with new products emerging

Thus the business has to first survive and secondly, grow to achieve a reasonable return on investment. So why do companies fail and why is growth so hard to achieve?

Let’s start with an understanding of what causes early stage firms to fail.

 

Understanding the causes of failure

The major causes of business failure are now well documented and there are modeling techniques that are able to predict with considerable accuracy whether a particular business will fail. While there is no one characteristic of a business that will, by itself, cause a business to fail, a combination of weaknesses can create a situation where failure is highly likely.

Let’s start with some data on failures.

Although there are definitional problems in measuring what is meant by ‘failure’, the data on the rate of failure is open to speculation. Even so, while ‘exits’ are not the same as failures, the data is enlightening. 1997 ABS report of business exits in Australia, reported that exits accounted for 8.5% of all business per annum (their definition of exits included cessation, liquidation, receivership, change of ownership and mergers). They report a much higher exit rate in new businesses. The ABS data provide the following rate of exits of new ventures; 18% exit after 2 years, 24% after 3 years, 35% after 5 years, 55% after 10 years and 65% after 15 years.

Several Australian and overseas studies have measured start-up failures. David A. Garvin writing in the Harvard Business Review (July 2004) in an article entitled ‘What every CEO should know about creating new businesses’ states that , during the 70s and 80s, 60% of small business start-ups failed in their first 6 years. Similar studies over different periods and in different countries have found similar rates of failure. There is, however, some level of disagreement across all these different studies as to the primary causes of failure. It is thus difficult to be definitive and arrive at a simple predictive model which could be universally applied. There also appears to be distinct differences between the causes of start-up failures and failures of established business. Even with this reservation, it is instructive to see some of the conclusions.

David A. Garvin stated in his HBR article that start-up failures demonstrated one or more of the following problems:
• Customer failure (unwillingness of customers to pay for product or service, or insufficient demand)
• Technological failures (inability to deliver the promised functionality)
• Operational failures (inability to deliver at the required cost or quality levels)
• Regulatory failures (institutional barriers to doing what’s desired), and
• Competitive failures (a competitor’s entry changes the rules of the game).

He concluded that success rates rise substantially when a new business targets familiar customers and is staffed by people well acquainted with the market. His test of survival was being able to clearly answer the following question; “What’s the pain point for customers and how does our offering overcome that pain?” I will return to this point when I discuss the underlying drivers of high growth, especially an attribute termed ‘the compelling need to buy’.

In more established businesses, the consensus of opinion suggests that the primary causes of failure are; a lack of adequate funding, a failure to recruit good quality personnel, the lack of a written business plan and a failure to use professional advice. Characteristics such as being the sole founder, not having parents who own a business, a lack of prior management experience and the younger age of owners have all been found to explain venture failure in some studies but are not supported in others and thus do not seem to have general applicability.

What all these studies do show is that there are some very good predictors of failure. While individual characteristics might not be decisive, there can be no question that the more of these deficiencies a firm has, the higher the likelihood of failure.

The overwhelming evidence does show that it is possible to predict in advance that a specific business idea has a limited chance of success. Thus a market that has too few potential customers, where the customer’s don’t have any money, where the technology is unproven, where competition is fierce, where costs are highly uncertain or where the entry costs are prohibitive, are situations where the idea should be rejected. Opportunity screening models or ‘investor ready’ models and checklists used by Angels and VC investors greatly help avoid investment decisions that have low probabilities of success. Even so, market conditions can change, especially in emerging markets and thus failures often cannot be avoided.

Given our knowledge of business failure, the more sophisticated investor should be able to avoid the obvious mistakes. Even so, some Angel and VC investments do fall into these traps, perhaps due to unforeseen changes in market conditions. Ventures that fail end up being closed down and the investment written off or put into a fire sale where the investor loses most of their investment.

Smart investors can usuallyavoid these basic flaws. Their risks are much more to do with aggressive growth. As far as the Angel or VC investor is concerned, it is not sufficient for the venture just to survive, it must generate sufficient profit and revenue growth to create a good exit event. However, as we will see, high rates of growth are difficult to achieve. What is often forgotten in the drive for high rates of growth is that growth itself is a high risk game and is often the cause of business failure.

Achieving high growth is challenging

Private businesses which grow beyond a few employees are in the minority. Achieving a size which can generate a significant sale price is challenging. Just how challenging – check out these statistics from the ABS – similar data would exist for all major developed countries.

As at June 2007, there were 839,938 (42%) employing businesses and 1,171,832 (58%) non-employing businesses in Australia. Thus over half the registered business had no employees. Of the employing businesses, 755,758 (90%) employed less than 20 employees. This comprised 527,445 (70%) businesses with 1-4 employees and 228,313 (30%) businesses with 5-19 employees. Of the larger business, there were 78,304 (9%) businesses with 20-199 employees and 5,876 (<1%) businesses with 200 or more employees.

If we assume that any reasonable sale price is going to need a business with over 20 employees, you can see from this data that you have a 1 in 10 chance of building a business to this size. Size of business by annual revenue shows a similar challenge.

As AT June 2007, there were 501,467 (25%) businesses with turnover between zero and $50k and 742,288 (37%) businesses with turnover from $50k to less than $200k.This was followed by 646,458 (32%) businesses with turnover from $200k to less than $2m, and 121,557 (6%) businesses with turnover above $2m per annum.

Source: Australian Bureau of Statistics 8165.0 - Counts of Australian Businesses, including Entries and Exits, Jun 2003 to Jun 2007

You would certainly want to invest in a business which was capable of growing to more than $2 million in revenue in order to have a good exit, but this seems to be somewhat difficult to achieve based on this data.

Clearly if growing a businesses was easy, there would be many more larger businesses. Since the data shows that this is not the case, it begs the question – why is growth so difficult?

What the research demonstrates is that the growing business has to go through major changes as it copes with the challenges of increasing size. The business of 2-5 employees will not look the same when it has 5 times the number of employees and/or 5 times the revenue. It is almost inevitable that it will have to change the way it does business in order to manage the increased complexity of a larger business. Different stages of grow will require it to change fundamental aspects of the business. Too many businesses fail to plan for these changes and put the business at risk by trying to make major changes on the fly.

Entrepreneurs who have grown a business from a start-up will tell you of the transitions that they had to go through as the business grew. I discovered major transition points in my own business at 12, 50 and 100 staff. The business also went through a major organizational crisis when it undertook an acquisition 12,000 kilometers away.

Complexity increases dramatically with the volume of staff, customers, products and locations. In order to achieve 5 times the level of the current business, most of these size attributes will increase significantly. What is not so obvious to most entrepreneurs is that the business will need to be managed differently with each additional level of complexity.

Almost without exception, small businesses face a crisis of management as they grow. In the start up phase, the entrepreneur is able to drive the business through sheer energy, passion and vision. He or she knows everyone and the staff are motivated because they are part of the grand adventure.

As the firm adds staff, new people come into the business who were not present when the grand vision was created and their motivations and needs are likely to be different. They may see it more as a job that a mission. They have different needs and thus management styles have to change. At the same time, the growth brings with it specialization of tasks and more formal organizational structures. Reporting lines become more rigid, job descriptions become the norm rather than the exception and performance targets and monitoring is introduced. Soon there is a new layer of management between the CEO and the operations. What was once a project has now turned into a real business.

As the business grows further, communication becomes increasingly formalized as communication lines become longer. The left hand no longer knows what the right hand is doing. Customer service quality may fall as new customers no longer have the advantage of personal links with the founders. Problems escalate with the second location and daily face to face communication is not physically possible. External shareholders and/or external Directors force more transparent decision making and thus the entrepreneur can no longer make decisions on the fly. Larger numbers of staff, customers and other stakeholders now depend on the business for their livelihood.

As the business develops the entrepreneur discovers, often too late, that they have the wrong organizational structure for the more complex, larger business. They will almost always find that some of their best staff are unable to make the transition to the larger enterprise. They may lack the skill, personality, work ethic or experience to work effectively in a more complex situation.

As the business grows, the entrepreneur will also find that the data collection and reporting systems are inadequate for a more complex, larger business. The same may well apply to the distribution channels, alliance partners, manufacturing processes, professional advisors and so on.

Many entrepreneurs simply are not able to make the transition. They may not have the skills, personality, drive and energy, leadership skills, knowledge or business acumen to be effective in the growing firm. Just because a person is a natural entrepreneur does not mean they have any business training or skill. The inventor may be great at the discovery of new products but that does not make them a good business leader. Thus the person in place as the business manager may well be the source of its failure or its lack of capability to grow.

The drive, skill and experience of the CEO is only one of the many elements which have to work effectively for the business to grow successfully. The business still has to deal with getting its products, markets, distribution channels, financing, recruitment and training and many more things right to drive successful growth. Each one of these many facets can undermine growth processes.

We also know from the research into high growth businesses, the ‘Gazelles’, that very few businesses are able to maintain double digit growth for more than a few years. Even the best companies have difficulty managing the exponential complexity of an integrated growing business.
Let me demonstrate the high growth problem with a simple example:

i recaLL revieWinG a budget projection for one of my businesses where we were examining the cost of recruitment. The recruitment cost seemed somewhat low. When i queried the underlying assumptions, i was told that it represented the cost of recruiting an additional 20 staff, a 40% growth. however, the numbers did not take into account that, of the current 50 staff, we had replaced 12 in the last year. some had moved interstate with partners, some had gone back to full time education and a couple had taken maternity leave. in fact, we had actually only dismissed two for poor performance. Thus instead of recruiting 20 new employees, we had to recruit 32, 64% of our current staff.

When you look at average retention rates, you can expect some percentage of the employees to leave, not because they did not perform well, but because they have personal and family plans that might take them on another path. Thus recruitment and training in a high growth business becomes a real challenge. If you are growing at 100% and replacing 20%, you are recruiting 150% of those that are left at the end of the year. Now, add to that the cost of training and the impact on the productivity of the remaining staff who have to work with large numbers of new employees.

If you think that is a daunting task, work out the cost and work involved in putting in place the infrastructure needed to support them. Accommodation comes in discrete sizes, so when you run out of space you can’t simply add enough space for one more person, you might only be able to acquire space in blocks able to accommodate 10 or 20 staff.

aT one sTaGe I ended up with three separate offices in Northampton in england as we kept growing out of space. since i could not predict the growth further than about 6 months ahead, i was not prepared to invest in too much extra space, thus i ended up in a completely suboptimal spread of staff with people in three separate offices around the town. i had the same problem with the phone system. it came in discrete sizes, up to 12, 64 or 128 extensions. however, when you moved up to the next system, all your investment in the prior system was wasted and you started again. other infrastructure costs include computers, desks, meeting rooms, storage space and so on.

When firms grow quickly they have great difficulty managing the basic operations. Quality often suffers as firms grow quickly. Staff are recruited too quickly, job descriptions are loose, reporting lines are blurred, performance metrics are ill conceived and systems for dealing with complaints are poorly established. IT systems take a long time to choose, implement and bed down. People simply haven’t got the time to figure out how to work together. Often one part of the business does not know what another part is doing.

By far the biggest problem is financing the growth. Very few businesses are able to fund the growth through internally generated funds. When you consider the costs that are incurred in recruitment, training, accommodation, computers and supervision, few firms generate the level of profit margins that can cope with more than a 15% growth rate. For most fast growth firms, external funding is an imperative. Even if some of the investment is in equipment, inventory and buildings, only a portion of that investment is going to be covered by traditional asset financing. What can’t be covered by internally generated funds has to be sourced from public or private investors. That activity will also take senior executive time away from running the business. Cash management is probably the most critical activity for the high growth emerging firm.

These factors not only make it hard to sustain growth but the constant changes being forced on the organization sow the seeds of failure. Not a lot has to go wrong with such a finely tuned engine for it to collapse or get into serious trouble. Most will recover, but they will lose a lot of the gains made in prior years. Others will not be able to turn the ship around in time and will end up insolvent, unable to raise debt to fund operations or will have lost key customers and employees during the disruption.

For the investor waiting to reach a stage and size where an exit can be successfully undertaken, these setbacks are not uncommon. Very few growth ventures exit successfully. Many are written off and a good portion of the remainder are exited with losses or low positive returns. It is only the exceptional venture which gains a significant return on investment.

What is the probability of success?

I wouldthink there are very few Angels or VC investors who would not desire the investee to grow to at least $2 million in revenue and yet we can see from the ABS data that only 6% of all private businesses exceed this threshold. I very much doubt that the same investors would wish to enter into an investment which would not see employment numbers exceed 20 and yet only 10% of all businesses in Australia in the 2007 data exceeded this number.

We can see from the prior explanation that there are significant challenges in growing the business and no doubt this is the underlying reason for such results. Another way of looking at this problem is to see it from a predictive approach. If we know that there are certain characteristics which have to be present for success, it is possible for us to rate any venture in each of these elements and then calculate the overall chance of success. The venture capital sector has been using this technique for decades to decide when to invest. However, even the best rated ventures are still problematic.

In this next example, each of the important characteristics had a relatively high score – but look at the combined outcome.
Individual Event Probability Company has sufficient capital 80%
Management is capable and focused 80%

Product development goes as planned 80% Competitors behave as expected80% Production and component sourcing 80%goes as planned

Customers want product 80%
Pricing is forecast correctly 80% Patents are issued and are enforceable 80%
combined probability of success 17%
Source: Article published in Harvard Business Review November - December 1998

When we see the probability of success in these terms, we can understand the level of complexity that must be managed in order to achieve success. This specific model was developed to explain VC investments where the investment is typically made when the business has already developed some traction in the market. Most VC investments are at the market expansion stage where products are already proven and a management team substantially in place, thus we would expect these ventures to have lower risks than early stage ventures.

To understand the risks of earlier stages of growth, we need to look at a wider range of growth attributes.

What are the Drivers of Growth?

As part of my research into high growth businesses, I reviewed the available entrepreneurship literature, the various theories of business growth, the venture capital investment models and my own 20 years of experience managing growth ventures. In the end, I identified 14 characteristics of high growth businesses.

This work has been published in my book ‘Winning Ventures – 14 principles of high growth businesses’.
Those fourteen attributes are:
the market:
1. Right place, right time

It is not just luck. The best ventures are based on a dramatic change in technology, regulations, the economy or in the way society operates. That change generated an opportunity for a new product or service, a new process or a new way of delivering an existing product or service to meet an unmet need or solve an existing problem in a much more effective manner.

2. The compelling need to buy

Business is driven by transaction revenue. The best high growth businesses solve a problem that has high urgency, high utility or resolves a high physical or psychological need for the customer. Situations where customers have extensive choice, can delay buying or are indifferent about buying the product or service are very difficult situations in which to drive a high growth business.

3. The right customer

While it is possible to sell to everyone, the successful high growth business typically has a very tight definition of the ideal customer and knows how to go find them. The best customer is easily identified, able to be approached and is willing and able to purchase. Businesses that rely on the potential customer finding them have difficulty proactively influencing their growth.

4. Channels to market

High growth businesses develop and/or secure capacity in the necessary distribution channels that allow them to reach their target customers. This might be through a wholesale or retail distribution system, direct through a sales force or via an e-commerce facility. Without the bandwidth of the distribution channel(s) the enterprise is not able to sustain its growth plans. Since many channels have pre-existing agreements, finding ways to access the appropriate channel is an essential key to successful growth.

realizing the opportunity:
5. Innovation as the driver

Innovation is the fuel of the high growth enterprise. This could be an invention such as a new or enhanced product or service. It might be in a new way of working such as a new manufacturing process or a different consulting technique. Lastly, it could simply be a new way of delivering an existing product or service to market – a new businessconcept. Innovation either creates more value by reducing costs or by enhancing customer utility or experience.

6. A competitive advantage

Obviously the best place to be is to have no competition, however, few businesses have such a luxury and, of itself, is no guarantee of success. High growth requires that the business is able to carve out a place in the market which allows it to have some freedom around it’s target market. Along some dimensions of user utility and customer experience, the business needs a superior position that matches the needs of its focal market.

7. Sustainability

While the initial conditions for high grow can be created through innovation, ultimately competitors will chip away at that advantage. Only by establishing long term barriers around the business can the venture hope to secure its existing customers and ward off competitors. Sustainability requires the business to find new ways of protecting it’s entire supply chain as, over time, competitors will find ways of eroding any single advantage.

8. Scalability

High growth, by its nature, requires the business to solve the problem of scalability. Many businesses are constrained by the shortage of skilled staff or essential ingredients. Only by developing a robust process where the business can be expanded through scalable systems and/or processes or be readily replicated, can the business grow rapidly over an extended period. This also means that knowledge has to be codified, decisions have to be devolved and organizational structures have to be built that will cope with the demands of such growth.

making it Work:
9. A clear vision

Knowing who you are, what you are doing and where you are going is an essential ingredient to a successful enterprise. Too many businesses fail to have a focus that clearly sets out their position in the market place. This lack of vision results in taking them in the wrong direction and away from the conditions that will drive their growth.

10. A long term strategy

Sustained growth requires the business to set out a path of product/market activities over a medium term horizon. High growth firms typically create ideal future scenarios that they want to achieve and then develop the tactical plans to get there. Constraints to growth then become apparent and investment can be made to overcome them. Often acquisitions are used to underpin growth. Acquisitions can bring new products, new customers, experienced staff and new competitive advantages. 11. Robust margins

Almost without exception, high growth businesses have above industry average gross margins. This may have come from their product, process or business concept innovation or may simply have come from superior management that has enabled the business to be run more effectively and efficiently than it’s competitors. Where a competitive advantage can be created around a compelling need, especially in a growing market, prices are less sensitive and thus higher prices and better margins can be achieved.

12. Management of risk

There are always going to be bumps in the road, but sustained growth requires that the management team anticipate what might go right and what might go wrong and plan for contingencies. Successful ventures mitigate their risks by involving partners, building resilience, putting in place options, shoring up their risk exposures and staying on top of events as they unfold. They undertake continual risk scenario planning so that they understand the likely impact of different assumptions on their business and work to reduce the negative impact of things that might go wrong.

turning the Wheel:
13. A capable management team

No one person can do everything and, as the business grows, many specialists will be required to support the operation. Senior management of the business must collectively represent the set of skills, knowledge and experience necessary to carry the business through the growth phases. They must also work as a team rather than a collectionof individuals. High growth businesses are driven by entrepreneurial activity – an opportunity focus that stimulates and drives activity.

14. Profitable

Any business that is well funded can sustain a period of losses, but ultimately the business has to make a profit to survive. The basic business concept must generate a healthy return on investment for the shareholders for it to have a future, otherwise the investors would be better off selling out and putting their money somewhere else. Profitable operations over time require the business to have very good performance setting and monitoring systems, clear lines of responsibility, accountability and authority and a proactive attitude to fixing problems. The fundamental economics of the business must be able to support a long term positive cash flow.

With this insight, I have restated the earlier table but used the 14 principles as the elements to estimate the probability of growth success. You can see the result on the next page.

Under this scenario, even if you did everything reasonably well at 80% of excellent, you would only have a 4% chance of achieving high growth. This result lines up well with the earlier data from the ABS on firm size where only 6% of all businesses had revenue exceeding $2 million. At 90% on each of these elements, the success rate jumps to 22%, but for that to occur, the venture would have to be exceptional across a wide range of attributes. You can see from this model that one weakness, say at 40%, can substantially undermine the outcome.

Clearly to be attractive as a potential IPO, the business would have to greatly exceed $2 million in revenue. Even for a reasonable trade sale, you would want to aim for revenues well in excess of this threshold. From what we can see from the ABS data, the VC success model and my own 14 principles is that high growth is a challenge and few enterprises are capable of meeting the necessary preconditions to create substantial wealth using revenue and profit growth as the yardstick.

Individual Event Probability Right place, right time80%
The compelling need to buy80%
The right customer 80%
Channels to market80%
Innovation as the driver 80%
A Competitive advantage 80%
Sustainability 80%
Scalability 80%
A clear vision 80%
A long term strategy 80%
Robust margins 80%
Management of risk 80%
A capable management team 80%
Profitable 80% combined probability of success 4%

Where to From Here?

My own experience over several ventures has shown me that growth can be elusive. My first business, Pioneer Computer Group, grew from 3 partners working in a dining room to 160 employees over three continents 12 years later, a compound growth rate of 36%. However, during the early years, we were close to insolvency several times. This was a classic case of feast or famine due to the size and timing of large deals. During the middle years our business was disrupted by litigation which we brought against the prior owners of our subsidiary in the USA. Just before we sold out, we were faced with a significant decline in revenue and profit as the UK went into recession. Some years we would grow dramatically and in others we would go backwards. But recall that this business was still able to raise US$1.5 million for a 20% stake.

In the case of my last business, Distinction Software, we also raised venture capital. In that case, $2 million for 20% equity. That business had all the attributes necessary to assure success. The business was staffed by very experienced managers and employees. It sold back into a known niche market. The product suite had a very rapid payback for the customers. Basically, it looked like a very good VC investment. However, sales were slow because customers could do without the product – a low compelling need to buy. In the end, the business went into severe decline when new competitors entered the market.

It is impossible to foresee everything that can go wrong. All we can do is use the best information we can access at the time of investment to ensure we get into the best deals. Given the risks associated with these types of ventures, the more rigorous the evaluation, the greater the chance of success.

My personal experience suggests that you cannot fix most of the fundamentals of a business. If you have the wrong product or the wrong market going into the business, it is doubtful that you can fix it later on. However, if the market characteristics are right for growth, a lot of the execution issues can be dramatically improved with good people, good advice and good internal monitoring and governance systems.

Without exception, high exit values are created when growth potential is a dominant characteristic of the venture. But as we have seen, ventures which pursue high growth are more likely to fail than succeed and more likely to stall than sustain long term growth. Only the exceptional venture has the characteristics to get to a size which allows an IPO or a good EBIT based trade sale.

From my own observations, Angels and VC investors fail to put a priority on creating the exit event. Given the risks associated with high growth ventures, it is critical to have a very tight focus on the exit so that the business is directed towards that outcome and does not become sidetracked into suboptimal deals or markets.

3Spot the IPO

S

ince the 60’s the private equity market has been mesmerized by the IPO exit. This can be tracked back to the early days of venture capital. Fortunes were made by Silicon Valley entrepreneurs and their investors in the rapid growth of the computer industry. Because of the size of the market and the ever increasing demand for computers, peripherals and software and services associated with the sector, it wasn’t difficult for a venture to be taken to an IPO. There was sufficient pent-up demand that most reasonable businesses could generate the revenue to support a push into a stock exchange listing.

The IPO became the yardstick to measure the worth of a venture as well as the success of the VC fund. Entrepreneurs wanted to list as they saw this as a measure of their own personal success as well as providing an exit for themselves and their investors. VC funds selected investee firms on the basis of their likelihood of delivering an IPO exit rather than a trade sale. Even so, not all ventures made the grade. Even in these years of staggering market growth, only about 20% of investee firms achieved an IPO.

Even in recent years when markets were very receptive, the number of IPOs was relatively small.

In 1999-2000,24 companies were sold,12 companies went public, four companies were bought back and 19 investments were liquidated.The value of exits during the year 1999-2000 was $536 million.The average trade sale was $3.7 million, while the value of all IPOs was $346 million.

(Source: Venture Capital in Australia (Research Note 28 2000-01) (http://www.aph.gov.au/library/pubs/rn/2000-01/01RN28.htm. Accessed 31/12/2004)

Data from Q3 2005 from the NVCA showed that there were 19 IPO exits compared to 76 trade sales (25%).
(Source:http://www.nvca.org/pdf/2005Q3IPOreleasefinal.pdf Accessed 5/12/05)
Angel Investor Exits by the Tech Coast Angels, 1997 – 2001 NumberActivity
Investments 52
Operating independently 32
Exits 20
• Out of business (-1 X) • 10
• Partial return of capital (0 to -.9X) • 5
• Sale to private companies - • 3exit pending
• IPO (2X to 3X) • 1

• Sale to public companies (+120X) • 1 Exit data from the UK for 2004 show that, by value, 28% was from trade sales, 20% were sales to another private equity firm, 13% were write-offs and 10% was from IPO flotations.

Source: William H Payne and Matthew J Macarty, 2002, The anatomy of an Angel investing network: Tech Coast Angels, Venture Capital, Vol. 4

(Source: www.bvca.co.uk)

Angel investors have not been as fixated on the IPO as an exit path preferring trade sales as the preferred exit event. However, some ventures were still able to make an IPO exit, but as you can see the percentages are relatively small.

UK experience suggests that IPOs happen less often for UK Angels.
Exit Route UK Angel Investments
Technology Firms Non-Technology Firms

%No. % No.
Flotation 14.3 3.9 Trade Sale 12 28.6 19 24.7

Sale of shares to 7.1 16 20.8 existing shareholders
Sale of shares to third 14.3 7.8 party
Written off/shares 15 35.7 32 41.6 have no value

Asset break-up - 1.3

Total 42 100 77 100 We should expect Angel and VC investee firms to have a higher probability of an IPO than the average private firm. After all, VC investees are selected in the first instance for their growth potential and these firms will have professional advisors along the way. The USA experience suggests that about 25% of new listings have had some VC investment. That being the case, we can estimate the chance of a startup going public.

Source: Colin Mason and Richard T. Harrison, 2004, Does investing in technology-based firms involve higher risk? An exploratory study of the performance of technology and nontechnology investments by business Angels, Venture Capital, October 2004, Vol 6. No. 4

In most western economies about 4 in 10,000 firms will have venture capital investment. If the VC sector achieves an IPO in only 20% of their ventures and about 25% of new listings have VC finance, we can expect any start-up firm to have about a 4 in 10,000 chance of getting to an IPO. Thus an IPO is a fairly rare outcome for a private venture.

The possibility of an IPO for an Angel or a VC investment, however, needs to be taken with a dose of reality. Many of the IPOs by VC firms over the last 40 years happened during periods of boom markets. Take out the IPOs which occurred during the computer boom of the 70s and 80s, the application software boom of the 70s and 80s, the internet boom of the 90s and the biotech boom of the turn of the century and the number of IPOs is reduced to a much smaller number.

We also need to adjust for IPOs undertaken through large private equity deals. These are typically large family businesses, MBO and MBI projects and public to private to public turnarounds. In addition, there were a number of rollups and consolidations which would be classed more as a PE deal than a VC investee exit.

Once we make these adjustments to the IPO data, we find that the number left as ‘normal’ IPOs, even over a long periods of time, is insignificant. It is indeed a very rare venture which can be taken to an IPO, even when the market is receptive.

Achieving an Initial Public Offering

Attribute Requirements for long term attractive public listing

Revenue $20 million + ($100+ the most successful)
Net Profit Profitable for three years with minimum of $2 million in the year prior to listing. Projected profits growing over next few years
Scope National or international markets
Portfolio
Potential
Management
Board
CEO
R&D
Cash

Funds Use Range of products with some in different markets

Major national leadership or global markets
Majority with public corporation experience and some with experience in larger corporations Significant industry and public corporation experience
Able to deal with market analysts, institutions and shareholders
Products in various stages of development to ensure continued market leadership
Sufficient funds to meet forecast plans without further capital raisings

Funds raised to be used for market development, innovation, overseas expansion, acquisitions, working capital, repayment of debt

Attribute Requirements for long term attractive public listing

Advantage Clear competitive advantage based on strong intellectual property and/or proven innovative business model
Public Awareness

Support Products and their benefits are easily understood by the public.

Listed shares are large enough in value and number in institutional and public ownership to encourage market analysts to track the stock. Generally this means a market capitalization of at least $100 million.

The table above shows the types of characteristics that best suit an Initial Public Offering (IPO) (excluding speculative ventures such as biotechnology and resource ventures).

The requirements for listing a firm are quite onerous and expensive. Unless the listing results in a share price that can maintain a position at least as good as the sector index, the listing will not achieve the exit the private equity shareholders anticipated (assuming the private equity shareholders hold shares in the listed company). Just having liquidity of the shares via a market listing does not in itself guarantee that the value achieved by the shareholders will be greater than they would have achieved in an outright sale to a corporation.

Since few companies in private ownership can meet these requirements, an exit strategy aimed at an IPO is not a viable option for most privately held firms. That is not to say that smaller company investors cannot exit through an IPO, but without being able to satisfy the above attributes, it is highly unlikely that an IPO will be possible.

Instead of a formal listing, many firms have taken an indirect path to a public listing by taking advantage of a dormant listed company or a currently listed company which is willing to undertake a merger to reinvigorate the business.

The dormant company approach, referred to as a ‘back dor listing’ is often seen to be quicker and cheaper but it is not without its problems. Typically, back door listings are done with smaller listed companies. The firm undertaking the activity has to deal with a seond group of shareholders and their advisors which can be problematic when it comes to valuation and shareholder rights.

Example:

Mr Scrinis paid $350,000 to Infosentials creditors last year for the right to approach shareholders with an offer. But negotiations with investors, corporate advisers and other interested parties slowed down the process and forced Moonlighting to postpone its original plans of floating by the end of 2001.

Source: Accessed 22nd April 2008 http://www.smh.com.au/ articles/2002/04/02/1017206193858.html Example:

Global Approach and the vendors of Teys agreed to revisit the acquisition structure, including the consideration.Additionally, given the growth of the business and the anticipated future growth, Teys shareholders said they wanted to have a higher equity position in the enlarged company.

Source: http://www.businessspectator.com.au/bs.nsf/Article/GlobalApproach-and-Teys-revise-backdoor-listing-p-D9K2U Accessed 22nd April 2008

An alternative indirect approach using a reverse merger can be just as problematic. Again, the firm has to deal with another group of shareholders and their advisors. While this may seem attractive as a quicker path to an IPO, the results are somewhat dubious as it can bring on additional problems. Both backdoor listing and reverse mergers also inherit whatever issues are inherent within the other business. The additional due diligence, negotiations and delays may not be worth the cost of disruption to the firm.

Example:
29 January 2007

SunFuels, Inc., and its operating subsidiary Blue Sun Biodiesel LLC, are executing a reverse merger transaction with M-Wave, a publicly-traded printed circuit board supplier. When the transaction is complete, SunFuels execs will assume control of M-Wave, which will change its name to Blue Sun Holdings, Inc. The operating subsidiary will be renamed Blue Sun Biodiesel, Inc.The resulting company will continue to be publicly traded.

Source: http://www.greencarcongress.com/2007/01/blue_sun_ biodie.html Accessed 22nd April 2008

Some private companies undertake an IPO, or a backdoor listing, with the intention of using it to raise funds or to sell off shares. However, unless the size of the shareholding in public hands is significant, generally thought to be above $100 million, there will be insufficient liquidity to create a market to sell shares.

Generally it will take a minimum of $500,000 in legal and accounting expenses for even the smallest and simplest IPO. According to KPMG Corporate Finance’s 2004 Australian Capital Markets survey, the average cost of raisings up to $10 million was 10.1%, falling to 4.7% for raisings greater than $500 million. If only a small amount is to be raised, this cost is very high for the funds received. At the same time, an IPO usually involves significant work for the top executives. This has often been thought to be 50% of the CEO and CFO’s time over the six months prior to the IPO. This is a very significant burden on the firm and requires that the rest of the management team bear the burden of day-to-day management during this time. A USA listing would be more expensive and more costly in annual expenses due to greater disclosure requirements.

It is very difficult to get unbiased, objective and knowledgeable advice on what it takes to prepare a venture for an IPO. The market has a wide variety of IPO listings from very small businesses to quite large family businesses coming on the market. The mix includes highly speculative resource stocks, high stakes biotech drug discovery ventures to the conventional retail and manufacturing concerns. Even then, the number of IPOs is still relatively small. Thus it is hard to get sufficient data to be able to build a predictive model for a specific type of enterprise. Another difficulty is that the market itself can be very fickle, usually driven at the lower end by a herd mentality and a desire for quick returns which creates a feeding frenzy in limited markets for short durations. It is this greed factor which perhaps explains why VC firms are able to list quite limited ventures in boom markets.

There is also the problem of objective advice. Too many advisors earn fees or commissions whether the listing occurs or the after market is successful, thus it is somewhat difficult to find any advisor who will say no.

During my time as Professor of Entrepreneurship, I conducted many interviews with professional advisors on IPO readiness and undertook a survey of a large number of advisors to discover some insights into the preparation process. The overall consensus of private equity advisors is that only four factors are considered critical to a successful IPO.

The first factor is that the venture should have a strong competitive advantage and sufficient growth potential to achieve a $100 million capitalization value within about 5 years of listing. Neither the current level of revenue or profit is considered significant compared to anticipated revenue and profit. This factor alone goes a long way to explaining why low growth firms that have low margins either don’t make it to a listing or have to be significantly larger before they can.

The next major factor is the depth and experience of the management team and the industry experience of the Board of Directors. Again, this is not surprising when you consider that the shareholders are backing a group of individuals to take them to the size necessary to support a $100 million capitalization. Thus, a new management team or one that has significant technical depth but little management depth is not going to be received well.

Knowledge of the IPO process itself by the management team is a major factor. This demonstrates just how important the roadshow to the brokers and the presentations to institutional investors are. Achieving significant share purchase commitments up front is almost a necessary condition for a float. Knowledge of retail and institutional investor risk and return requirements and being able to convincingly show growth potential is an imperative. Investors are typically risk averse and will quickly zero in on potential risks in the venture. The management team must be able to convincingly demonstrate during the roadshow a deep knowledge of their business, their industry and of how to mitigate possible risks.

Finally, the firm must have the best possible advisors it can attract. The best advisors and investment bankers are expected to have the best due diligence processes, require the highest standards of preparation but also carry the highest level of credibility to the market. Thus they tend to be very selective in who they represent.

A firm that wants to undertake an IPO exit needs to build out the IPO profile above. So, to the extent that it cannot meet the requirements organically, the additional attributes need to be developed or acquired. With 3- 5 years to execute the IPO strategy and especially with Angel and VC financing, a firm may be able to achieve the necessary characteristics given the right starting point. Many companies which attract Angel funding have already identified strategic acquisition opportunities to bring economies of scale and growth to the company.

Often in emerging markets, there will be several firms with complimentary products, often selling to the same customers or working with the same alliance partners. These could be brought together to provide a platform for an IPO vehicle. However, there needs to be an obvious and demonstrable synergy between the products and the firms. Just lumping a number of firms together to reach the revenue and profit targets is unlikely to convince the institutional investors that they are investing in a sound platform of future growth.

At the same time that the underlying product portfolio is being built, the firm needs to construct the management team that is capable of running a growing public corporation. Public corporation experience, experience with larger businesses, deep experience in the industry and a good track record, are all essential characteristics for the IPO management team.

The IPO strategy needs to show in considerable detail how the IPO prospect profile will be achieved. Underpinning the plan should be documented representations from respected accountants, lawyers, bankers and brokers who are willing to work with the firm on building the IPO strategy.

For an explanation of the USA IPO process and the costs associated with it see:

Note on Exits Prepared by Fred Wainwright and Angela Groeninger Center for Private Equity and Entrepreneurship, Tuck School of Business at Dartmouth University 12/2004

What is obvious from this analysis is that high growth and, especially high potential growth, is a key factor in an IPO. What is also critical is that the growth potential must have a high degree of resilience and predictability to secure the market capitalization needed for successful listing. Thus firms ideally should have strong IP, multiple distribution channels into multiple markets, good recurring revenue, a strong pipeline of future products and experienced management for a successful IPO. Given the challenge of high growth, these additional attributes simply make it even more challenging to create a venture which can successfully undertake an IPO.

Timing is Critical

The IPO market is very sensitive to economic conditions and investor confidence. Even though there have been large numbers of VC backed ventures for which an IPO exit would have been attractive, the number which have successfully listed varies greatly over the years. The table below shows that years with strong economic growth have had significantly larger numbers of IPOs, but when the market is depressed, very few IPOs occurred.

Periods of higher numbers of IPOs also coincided with ‘hot markets’ in specific sectors. The 1970s and 80s were dominated by computer hardware related IPOs. The 1990s had large number of internet related IPOs and the late 90s by biotech venture IPOs.

Going Public Since 1970
Initial Public Offerings USA 1970 - 2003

1970 138 1981 348 1992 597
1971 253 1982 122 1993 808
1972 495 1983 685 1994 631
1973 95 1984 357 1995 570
1974 9 1985 310 1996 853
1975 9 1986 726 1997 615
1976 6 1987 548 1998 370
1977 40 1988 288 1999 541
1978 32 1989 251 2000 446
1979 38 1990 213 2001 99
1980 62 1991 400 2002 92
2003 87

Source: http:// www. ipovitalsigns.com/Content/Going%20Public%20 by%20Year%20since%201970.htm. Accessed 26th April 2009 Hot markets, or boom markets, have a number of characteristics in common.

• The initial fuel is provided by a breakthrough innovation (e.g computer power, disc capacity and memory chips in the 70s and 80s, the internet in the early 90s and the genome project of the late 90s).

• The breakthrough innovation has to be widely available with relatively low cost of entry for new ventures.
• The innovation has to support numerous applications, many of which have global potential.
• New ventures need to be open to external investment, especially through IPO activity.

• The applications have to be understood by the general investing public.
• Early entrants into the market have very high revenue growth rates.

You can see how these conditions were met by the various computer, internet and biotech booms in the last few decades. In these conditions the public investor sees high growth potential in every venture and wants a part of the action. Putting a startup into an IPO in these conditions is not difficult and certainly explains the high rate of IPOs which occurred during those periods. However, in a market downturn and in the absence of a breakthrough innovation, IPOs are very infrequent for early stage ventures.

The difficulty for the investor is guessing the length of time the boom conditions will last. If it takes 18 months to 2 years to prepare a venture for an IPO, the critical question must be how long the boom will last. If it dies before the venture can list, the investor might be left with a lemon.

Boom conditions do tend to close quickly and are usually associated with an event which questions the high growth expectations of the retail investors. Typically a boom will end when one of the following occur:

• A market leader fails to meet a revenue forecast.
• A market leader is found to have misrepresented revenue recognition or has some other significant reporting irregularity.
• A potential market leading product fails to satisfy a major milestone such as FDA approval or a product release date.
• The whole market enters a downturn because of a major economic crisis. Example:

Remember the good old 1990’s - Webvan, Kozmo, Pets.com and all the other spectacular IPOs that raised hundreds of millions in the dot.com boom? (Pets.com raised $82.5 million in an IPO in February 2000 before collapsing nine months later.)

Source: http://www.rumormillnews.com/cgi-bin/forum. cgi?noframes;read=144096 Accessed 27th April 2009

When such events occur, the market revises the growth prospects of the market leaders and scales back their revenue and profit expectations. Given that significant potential growth underpins the valuations, any major downturn in growth will seriously negatively impact share prices. This usually creates a selling frenzy as retail investors dump the stock. This in turn creates a downturn across the entire sector with a mass sell off of investments. Once this happens, the IPO market in that sector is basically dead.

Without the demand from the retail investor, early stage IPOs are near impossible. Given that market collapses cannot be predicted with any accuracy, any Angel of VC investment in a boom sector has to be something of a gamble.

More recently, the global financial crisis has seen only a trickle of IPOs. VC firms with potential IPO exits have had to wait or seek a trade sale as an exit.
Example:

The number of U.S. initial public offerings (IPOs) decreased 73% for Q1 2008 compared to the same quarter a year ago, as reported today by Hoover’s Scorecard. In Q1 2008, only 12 companies went public on the major U.S. stock exchanges, raising $18.9 billion,compared to Q1 2007 when 44 companies went public, raising $8.5 billion. However,Visa Inc.’s mega IPO contributed the lion’s share - $17.9 billion - of that Q1 2008 total.This represents the first year-over-year decline in the number of U.S. IPOs since Q3 2006 and is a far cry from the 70 IPOs of the immediately preceding fourth quarter of 2007.

Source:http://resourceshelf.com/2008/04/15/statistics-businesshoovers-ipo-scorecard-reveals-major-year-over-year-in-newofferings-for-q1-2008/ Accessed 26th April 2009

What we are also seeing in recent times are more withdrawals from the IPO process, that is companies which intended to list but have pulled out, probably due to the lack of market interest in IPOs at this time.

Example:

GlassHouse Technologies is the latest in a long string of companies withdrawing IPOs. The IT consulting firm had been in registration for 15 months before finally pulling the plug, citing “market conditions.” The company has raised $64 million through six funding rounds (presumably a seventh is on the horizon). $30 million of that is already gone: the company did four acquisitions last year.

Source:http://lawshucks.com/2009/03/11/ipo-withdrawals-comingfast-and-furious/ Accessed 26th April 2009 Example:

2008 was the year of withdrawals from the initial public stock offering, with eight New England tech companies pulling their plans to go public, up from as little as one in 2007.

Source:http://masshightech.com/stories/2009/01/05/weekly18-IPOwithdrawals-increased-in-2008.html Accessed 26th April 2009 Many of these companies had already incurred significant costs in IPO preparation.
Example:

But going public can require many painful changes for a company — in addition to the considerable regulatory and reporting burdens, say executives. BioTrove already had strong governance and adequate financial accounting processes in place before it ever filed the S-1, said Luderer. However, he noted companies that have prepared for an IPO incur several millions of dollars’ worth of legal, accounting and other costs.

Source:http://masshightech.com/stories/2009/01/05/weekly18-IPOwithdrawals-increased-in-2008.html Accessed 26th April 2009

Angel and VC investors need to be very wary of planning an IPO exit. Even with the best high growth venture, many things can go wrong both internally and externally. Basically the investor needs to be able to wait until the market is receptive, however, this can significantly delay the exitas markets can sometimes take several years to bounce back to a situation where IPOs are attractive. Even then, if the market is then flooded with a backlog of IPO candidates, the chances of listing are marginal at best.

But what about post IPO?

 

(When is an IPO not a successful exit?)

Most VC investors believe the IPO is the holy grail of exits, however, this is a hangover from the days of the computer and internet booms. With the hindsight of a lot of failed boom ventures, the public investor is much more wary of being ripped off by misleading forecasts and management who trade on insider knowledge. Quality Investment Banks and professional advisors are reluctant to put their name to a firm with a poor chance of a successful post IPO performance. Without the right advisors behind the firm, it is doubtful that the IPO itself will get the underwriter support to successfully list.

Also, just because you have managed to get the venture to a public listing is no longer sufficient to guarantee you can exit, or at least when you want to, at an attractive price.

My own experience with the sale of Pioneer Computer Group certainly demonstrates the IPO trap.

When We soLD oUT to ross systems, they had only just listed on nasDaQ. We received all our shares at the market price at the time of Us$13.50. ross had carefully planned their revenue over the next two quarters following the listing in order to show increased revenue and profit. This pushed the share price to $18.50. During this period, I was an officer of the company and subject to the purchase agreement escrow and then, later, the blackout dates which applied to any officer of the company.
Even though ROSS had generated significant new sales of the PCG products, they had not planned for the complexity of installing the pioneer software and thus they were unable to successfully complete the installation of the large number of systems. By the third quarter after the acquisition the early sites were complaining about missed deadlines and budget blowouts on implementation consulting. The effect of this was that we lost nearly all of our reference sites in the Usa. By 18 months after the ipo, ross was unable to sell anything like the earlier volumes and the revenue and profits declined and so did the share price.

i decided to start selling my shares when the price hit $17. however, i was immediately asked to withdraw the sell instruction on the basis that i could trigger class action litigation against the Board and the senior managers. Basically, if the share price continued to fall, it would be held that i knew of impending doom and the market should have been informed of the information that i clearly had. i was forced to hold off selling my shares and eventually was only able to sell out after i resigned some 18 months later. i then sold all my shares but at a price of $3.50.

What you have to be sensitive to in a public company is that the market has to be told everything relevant to the decision to invest or sell the shares. Thus you may not have the ability to sell whenever you feel like it. A large block of shares being sold by a founder or a key investor can have a very negative effect on the shares. This can trigger an investigation or a class action if the shares decline further.

There is also normally a block on founders and key investors selling shares for some period after the IPO, called the escrow period. If this is one to two years, this extends the lockup period of the investment. A lot can happen in that period and not all of it will be positive. You might find your shares have seriously declined in value.

An effective IPO exit needs to not only achieve a successful public listing but it must ensure that revenue and profit performance over the next few years meets retail and institutional investor expectations. Failure to manage the post IPO performance can result in delays in exiting or a drop in the exit value.

Professional advisors who I consulted on post IPO management identified the following as the most critical aspects of post IPO performance.

• The business must meet or exceed its financial and non-financial prospectus forecasts. Generally over 70% of recently listed IPO firms fail to meet this goal.

• Investor relations need to be managed carefully.

• Current investors and prospective investors need to be encouraged to invest in the company in order to create a liquid market. Many newly listed firms believe that the brokers will continue to support the business after the listing which is often not the case. The firm needs to be proactive about communicating with the market.

• Investor and market expectations have to managed. This means an effective public relations activity as well as frequent communications with current and interested prospective investors.

The problem which many newly listed smaller firms face is the lack of an active market. Where there are few transactions, prices tend to fall. Even if the earnings multiple is relatively high at the time of listing, the share price can be expected to fall back to sector norms within a few quarters as the market absorbs the actual financial results. Unless the firm can post significant growth in earnings quarter after quarter, the market expectations will be reset and a more normal PE ratio will apply.

Founders and pre-IPO investors who expect to exit on a high PE who are locked in for some time in an escrow arrangement are likely to be disappointed if the price falls significantly due to the lack of an after market support program or if results do not meet expectations. It is only an exceptional business which can sustain a high PE.

An IPO exit is almost always going to perform better for the early investors than a financial trade sale, however, as I will demonstrate in later chapters, a strategic sale will almost always outperform both in terms of investor ROI. More importantly, there is usually no delay in receiving the exit funds nor is there a requirement to manage the business beyond the exit event to ensure your return.

4
Financial v.s Strategic Exits

T

here are basically two types of exits. Financial exits create value on exit via a financial trade sale or an IPO, by assigning a value to the future profit generating power of the entity being sold. Alternatively, a strategic exit assigns value to the entity, not on the basis of what profit it could inherently generate, but on the basis of what future profit could be generated by the buyer exploiting the underlying assets or capabilities of the entity being acquired. These are fundamentally different views of how value is created for the selling shareholders and the preparation for sale needs to align with the creation of value.

In order to assess the potential exit value of any entity, we must first understand how the business creates value for its buyer (financial or strategic sale) or its future public shareholders (IPO). Those businesses that deliver inherent profitability must create value for its future owners through enhanced profitability and future profit growth. By contrast, strategic value businesses create value by enabling a large corporation, the strategic buyer, to exploit a significant revenue opportunity enabled through the combination of the two companies. The strategic seller builds value by developing strategic assets and capabilities which the large company will exploit.

In the case of a strategic sale, it may not matter whether the selling business is making a profit, has revenue or is growing. This is in direct contrast to a financial exit which is entirely based on revenue and profit growth which the business itself must deliver to its new owners.

Because these outcomes are very different, the manner in which Angel and VC investors should plan the exit for their investee business depends greatly on which type of exit will generate the highest exit value.

I have grouped financial trade sale and IPO under the financial exit as they both have the same basic value creating process, they both need to generate a future stream of positive earnings to create a successful exit event. As we have seen, the IPO exit is an extreme situation where the projected revenue levels and the projected market capitalization needs to be relatively high. While the IPO exit requires a more sophisticated organization to be successful, the fact is that both the financial sale and the IPO require a proven high growth potential business concept to generate a successful exit value.

Smaller firms and firms with limited growth potential which create value through projected net earnings need to be directed towards a financial trade sale as they will not be able to meet the rather high threshold of revenue and potential growth requirements needed for a successful IPO. Given that only a very small percentage of firms are able to achieve IPO status, the vast majority of firms need to be prepared for a financial sale. For the purposes of this discussion, I am going to refer to all financial exits as a ‘financial sale’ with the understanding that some exceptional firms will be able to achieve an IPO. But for the purposes of this discussion, I am going to assume that all financial exits will be to an individual or corporation, that is a ‘financial buyer’, and that the buyer is setting the purchase price based on the anticipated future stream of earnings from the acquired firm alone. That is, the buyer is not assigning any synergy or benefit to the acquisition based on what is happening, or could happen, in the rest of the buyer’s organization.

The financial sale is very different from a strategic sale where value is created through the combination of the buyer and seller businesses. We have all heard of businesses that were sold for many times revenue and staggering multiples of profit. These situations are all cases where the business being acquired had something that the large corporation needed to counter a major threat or to chase after a major new revenue opportunity. Most of these acquired businesses had unique intellectual property, deep expertise or well established brands or rights (e.g. to exploit forests, minerals, fishing etc). The assets or capabilities being acquired were considered by the buyer to be too expensive to copy, build or develop, or would take the buyer too long to assemble or to create internally. The delay in acquiring the asset or capability may also expose the acquiring corporation to an unacceptable level of risks.

In a strategic acquisition, a small business can often provide the means by which a large corporation can quickly generate many times the purchase price by leveraging its own assets and capabilities alongside those being acquired. Such acquisitions are bought, not on the basis of the profits of the acquired business, but on the value that can be generated within the combined entity. Few acquisitions, however,fit this profile. I will use the terms ‘strategic sale’ and ‘strategic buyer’ to describe a situation where a business is sold on the basis of its strategic value to the acquirer.

Businesses that are typically sold to a strategic buyer are those in biotechnology, information technology, research and development, designer fashions, mineral exploration, agricultural science, computer hardware and telecommunications. Also companies in consumer packaged goods with strong brands or with manufactured products that have global market potential can often secure significant premiums on sale. Acquisitions which can deliver very significant synergies in operating costs through integration would also fit into this category.

Probably about 95% of all private businesses which are sold are acquired by a financial buyer. In some, there will be synergies in the acquisition but these will be minimal and not sufficient to override the need for the acquired business to show its inherent profitability. Most companies don’t have the type of assets or capabilities that can leverage large scale opportunities for an acquirer. Instead, they build profits through their own inherent competitive advantages for a local customer base.

A financial buyer seeking an acquisition will often have many choices of similar businesses, although sometimes geographically separate. The buyer may simply be buying a business to own and manage or a corporation undertaking a consolidation strategy by acquiring many businesses of a similar type. What the financial buyer is acquiring is a profit stream and so the basis of the purchase is simply how much profit the firm makes now and is likely to make in the future. Purchase value is calculated almost purely on the inherent profitability of the acquisition with little regard to the combination synergies in the acquisition, the seller to a financial buyer must put effort into increasing profit and profit potential.

Businesses that would normally be sold to a financial buyer are professional services firms, marketing firms, management consultancies, distribution companies, trucking companies, most retail businesses, wholesalers, import/ export companies, agricultural enterprises, printers, professional practices, builders, construction companies and so on. Non complex manufacturing also attracts a high proportion of financial buyers. Basically any business that does the same as many other businesses will fall into this group.

Businesses acquired to be operated as a stand alone business will be purchased on the basis of their inherent profitability as there are no synergistic benefits in the deal for the acquirer. Therefore, a business bought by an individual who wants to invest retirement or redundancy funds to buy a business to manage will be a financial sale. Similarly, a business purchased by a private equity fund that intends to increase its profitability through new management, increasing its debt level and refocusing the business will also be a financial sale.

Businesses acquired by corporations can be expected to have both financial and strategic contributions. Many acquisitions are undertaken for roll-up, consolidation or expansion purposes. These businesses typically are purchased to add revenue and profit generation through their own inherent operations although the acquirer may gain some synergistic benefits from operating at a larger scale or some benefits through reducing duplicate functions, but the prime consideration is generating operating profit from the business purchased. The purchase price would be driven by the current and potential profit of the acquired business itself. While the additional synergies may make it more attractive, the seller would need to prepare the business for a financial buyer.

Acquired businesses which are expected to contribute significant synergistic benefits to the acquiring corporation may contribute little inherent profit. They are acquired because of the benefits that the acquiring corporation expects to achieve through the combination of the businesses. In most cases, these acquired businesses bring some asset or capability to the acquirer that the corporation is able to leverage through their own operations generating significant future revenue and profits for the acquirer. A seller who was able to make such a contribution would seek out a strategic buyer.

Some firms will be able to do both. That is, they will have good profit capabilities and also be able to provide strategic benefits to the acquirer. But one will be more significant than the other. To the extent that strategic value benefits are greater than inherent profitability benefits, the seller would be much better off seeking a strategic buyer. Financial sales are always going to be limited by the profit generating capability of the seller. A strategic sale, however, is only limited by the size of the opportunity generated within the acquiring corporation. Thus, a very large corporation that can significantly leverage the strategic contribution of a small acquisition may be prepared to pay many times its financial sale value to ensure it receives the benefits of the acquisition rather than allow it to be acquired by one of its competitors.

I have extensively examined the process of a financial trade sale and have documented a methodology in my book, The Ultimate Deal 1, which can be used by business owners to significantly improve their sale value.

$ $
inancial Value
F
trategic Value
S
Strategic Value
Financial Value
time Financial Trade Sale
time Strategic Trade Sale
My book, The Ultimate Deal 2, examines strategies that owners of businesses which have strategic value will use to sell their businesses to a strategic buyer.

 

Financial or Strategic sale – Which one?

I often confront entrepreneurs with a stark choice – what is the best strategy to prepare your business for a sale – build up the profits or develop underlying assets and capabilities for a strategic sale. You might well ask ‘Why can’t you do both?”.

Financial v.s Strategic Buyer Strategies
Attribute Financial Buyer Strategic Buyer

Source of value to the buyer
Profitability, risk
minimization, growth potential.
Threat elimination and/ or revenue potential in the combination of the two businesses.

Value created by Increasing profits, reducing risk, future growth and proven growth potential, rollup or consolidation opportunities.
Underlying assets and capabilities that the buyer will leverage to eliminate a threat or exploit a large revenue opportunity.

Additional value created by
Increasing current profits, increasing growth rate,
developing additional substantiated growth potential.
Reducing integration time, increasing rate of scalability and speed of exploitation, adding additional strategic assets and capabilities for the buyer to exploit.

Buyer Individual, investment

trust, private equity firm, corporation
undertaking a roll-up or consolidation strategy. Large corporation which can exploit the strategic assets and/or capabilities in a large customer base. Impact of Major impact on value. May be irrelevant. Profits increased profitability are only needed to
ensure survival prior to a sale.

Size Any size. Large acquisitions

may have difficulty creating sufficient new incremental revenue.

Existing growth Significant impact on value. Size must be sufficient to allow a critical mass platform for opportunity exploitation. Growth itself may not be
important.

Growth potential Significant impact on value.
May have no impact on the buyer’s opportunity.

Underlying assets and capabilities Must deliver
competitive advantage within the seller’s
business as a stand alone entity.
Must deliver a
sufficiently large and robust base for exploiting a strategic opportunity in the combination of businesses.

Inherent risks Must be eliminated wherever possible. Must be eliminated wherever possible.

Succession planning
New buyer must
be able to run the business if the senior management leave. Key manager and key employees needed to exploit the opportunity must be retained.

Advisors Business broker, Large professional professional services services firm, investment firm, business advisor banker

Preparation time18 months to 2 years Normally 2 years or more

Level of Most often continues as integration a sole business or might be loosely integrated
bolt on acquisition.
May contribute
administrative
synergies in a
consolidation
Varies. Often fully
absorbed. Sometimes integrated into only one part of the business. Could be left as a stand alone entity passing products, IP or processes to group.

I am sure that some companies can, but when you look at the processes involved and the priorities which will determine where to use your surplus cash, you often see is a clear choice – you don’t have the resources to do both so you need to decide which strategy is going to give you the highest exit price.

Companies which are sold on an EBIT multiple are those which provide the buyer with a platform which enables the buyer to generate a stream of future earnings through the use of the resources contained within the acquired business. While these might be augmented by the buyer through the insertion of better processes, more capable management and better funding, essentially it is the same underlying business which is generating the profit stream. Thus any acquisition valuation will be based on net present value of those future earnings. Most businesses fall into this category. Thus financial buyers typically buy retail, wholesale, light manufacturing, transport, property and services based businesses.

You increase the value of such businesses by reducing the inherent risks for the buyer, improving the visibility and reliability of future earnings forecasts, improving on-going profitability, building growth into the business and finding ways to create growth potential for the buyer.

By contrast, those businesses which appeal to strategic buyers have some underlying assets or capabilities which a large corporation can exploit through the buyer’s own organization. Small companies will often develop products or services which can be sold by the acquirer through the buyer’s very large distribution channels. In the right circumstances, a buyer might be able to scale the revenue by 50 to 100 times that of the seller just by having the right access to global customers. The key to a strategic sale is to find a large corporation which can exploit the underlying asset or capability of the seller to generate very large revenues. In these situations the size, revenue, number of customers or employees or level of profits of the seller may be entirely irrelevant. It is the size of the revenue opportunity of the buyer which is the key to strategic value.

Thus a business which has the right type of assets or capabilities which can generate strategic value may be much better off putting additional effort into developing those assets and capabilities to provide greater or earlier revenue generating power for the intended buyer. A higher exit price will be achieved if the buyer can scale or replicate the asset or capability faster and can integrate the seller’s business quicker. The only size consideration for the seller is to be big enough to provide the launch platform for the buyer to fully and quickly exploit the strategic value.

Traditional Sale Process

Very few firms take the time to develop a strategic plan for selling their business. Most arrive at a decision to sell their business because they have to. This may be due to external or internal events that have forced the sale or simply because the owner has no natural successor or does not wish to continue involvement in the business. Time pressure often determines the pace at which the sale needs to be made. Even where there is no need to sell, the owner may feel that he/she simply wants to have the process over and done with.

Many Angel and VC investee firms end up in fire sales through lack of sale preparation. Often this is the result of the firm being pushed towards and IPO and, when that fails, the groundwork has not been put into a sale process. The firm is often exhausted of reserves having spent significant funds preparing for the failed IPO. At this point the investors don’t wish to put any more funds in and instead put it up for sale.

The seller may go to a conventional business broker and put the firm up for sale to the highest bidder. Alternatively, the seller may use the services a professional advisor who has wider networks and greater capacity to find a more strategic buyer. However, in both circumstances, the seller is unlikely to have planned for the sale. The impediments to the sale include:

• Little or no evaluation of actual or potential risks to the buyer
• No preparation for after sales integration or disruption
• Documentation for due diligence needs assembling or is unavailable
• Little or no thought has gone into selecting potential buyers
• There is little time to develop relationships with potential buyers
• It may simply be bad timing for the better buyers
• Financial records may be ill prepared or out of date

• Little thought has been given to developing strategic assets or capabilities for sale
• Key employees may be lost due to the future uncertainty of the business

The professional advisors are typically under pressure to perform but are given little time and funding to achieve the best outcome. The net of potential buyers is limited by the speed by which the advisors can establish interested parties and by their own existing contacts. Little time is available to develop overseas interest or to encourage wider participation in the bidding. Many potential buyers will be put off by the pressure to respond quickly and because they have inadequate time to undertake their own internal evaluation of how the acquisition may be integrated and value garnished.

Even if more time is available, the firm may simply not have positioned itself correctly for the best of the potential buyers. A potential buyer that is approached over a possible acquisition may have no knowledge of the selling firm and may simply be busy with other ventures. Alternatively they may feel pressured to make a decision.

Preparing a Business for Sale

The objective of a Proactive Sale Strategy process is to position the firm for sale well in advance of the actual sale event. You can see from the chart below that the early stages are to prepare the internal aspects of the business for sale. This means ensuring an agreement between all the stakeholders as to the merits of the sale as well as reducing or eliminating risks to the buyer.

These activities should be undertaken over time where they can be absorbed into the normal development of the business. Many of the business processes which are reviewed and improved are basic to efficient and effective operation of the business and should be undertaken anyway. However, in this strategy, they are undertaken with a view to how the potential buyer will integrate the firm into a larger corporation.

Financial and Strategic buyers rarely arrive at the office door. They need to be identified, investigated and tracked. Formal trading relationships and/or informal relationships need to be developed over timeso that the potential buyer knows of the firm, its capabilities and how the operations may be integrated (if required). Of particular importance, both parties need to understand how additional value may be extracted from the business.

When it comes to selling the business, the seller does not have to go cap in hand and plead to be acquired. Rather, the firm is put up for bid among several possible buyers, each of which understands the nature of the acquisition. At the same time, the preparation work undertaken by the firm in conjunction with their professional advisors will have eliminated or reduced the potential acquisition risks to the buyer.

The key to a successful sale is to be able to execute the deal quickly with both parties being fully aware of the value to be acquired. At the same time, the buyer can appreciate the effort that the seller has taken to prepare the business for sale. The seller can show a full appreciation for the acquisition issues and risks and can show how these have planned for and, where possible, minimized.

You can see from the chart below how much more effective the process is and how much less effort isrequired at the time of sale. This process empowers
Alignment of interests

• Directors, Manager and key employees
• Build after-sale scenarios
• Agree trade sale objectives

Due Diligence

• Audit contracts
• OH&S
• Business plan
• Develop incen- tives
• Standardize Agreements
• Audit infrastructure
• Protect IP
• Professional Tax advice
• Due diligence files

Strategy

• Review assets and capa-• Build additional value
bilities
• Select potential buyers
• Build valuation model
• Understand acquisition
processes
• Build scalability

Sale Negotiation

• Define value for buyer
• Create competitive tension
• Negotiate contracts

the seller and allows them to have a much greater level of control over who is likely to buy the firm. It also allows them to dramatically improve their ability to extract a premium for the business.

Lastly, this process greatly aids the professional advisor who can fully employ their expertise to ensure the Proactive Sale Strategy is applied effectively. This will greatly help them to support a sale. By helping to create a more robust set of circumstances and better positioning, the professional advisor can help to ensure that the selling shareholders maximize their return.

Selling to a financial buyer

If you have invested in a conventional business then you will almost certainly be selling to a buyer who will value it based on some multiple of earnings, usually EBIT (earnings before interest and taxes). Part of the process of increasing the valuation is to generate higher sustainable profits. Easily said but how can this be achieved in a systematic manner?

The difficulty here is to find approaches which can be used across a wide variety of businesses. What I am going to recommend are a set of processes or approaches which can be applied to any business.

If you have the time to refocus the business or restructure it, you might start by working through the 14 principles of high growth businesses which I have documented in my book, Winning Ventures. Even small changes to products or target customers can have a positive effect on sales productivity and margins. However, once the nature of the business strategy is stable, you need to follow a strategy to increase sustainable profits and growth.

Firstly, simply focus on getting rid of significant wastage. I don’t mean to imply that your business might be frivolous when it comes to expense control but you would be amazed how much can be saved with a different perspective. So get rid of obsolete inventory and equipment and review how you use warehouse and office space. Ask the hard questions about your use of travel, marketing and entertaining expenses. Simply adjust your lenses to saving money – you will be surprised what can be achieved.

Now list all your expenses, largest first down to the smallest. Start with the largest. What can be achieved over a 12 to 18 month period if you concentrate some effort on negotiating new agreements, improving productivity or paying more attention? Small reductions in large expenses add up to some sizeable cost reductions over time.

Now find out what you do well and what can be improved. Join a benchmarking program for your industry or subscribe to some benchmarking results. What are you doing which is better than the industry average? What are you doing which is clearly below par? Now look at the industry best practice. Find out how that can be achieved. Once you can isolate practices which can be improved, you might spend some time reading, attending seminars, talking to peers or hiring a consultant who can help you with improving aspects of your business which increase revenue or increase productivity.

For those parts of your business which are unique, consider introducing a continuous improvement process. The convention here is that – if you don’t measure it, you can’t improve it. The methodology behind this technique is to establish performance metrics so you can see what happens period on period. You can expect variation in performance and your task is to discover what creates improved performance. You may need help with implementation but at least you know where the problems are.

Improving profits over time so that you can benefit from a higher valuation is not that difficult but to be sustainable, those changes need to be done in a systematic manner which can be demonstrated to produce reliable long term improvements.

Any premium paid above conventional value for a business is recognizing the unrealized potential in the business. The reason why this is not already built into the value of the business is that it will require the buyer to exploit this potential. That is, the potential will only be realized by the buyer and not by the current owner. The essenceof this argument is that the buyer will need to bring something new to the business, such as new funds, energy, knowledge and/ or synergistic relationships and so on, in order for the potential to be realized. If this is the case, why would the buyer pay for something which only they can realize?

Almost without exception, professional advisors will tell you that buyers will not pay for what they bring to the enterprise. At best, they are only willing to pay a fair value for what the business, as a going concern, can produce. Look at this from the buyer’s viewpoint. Let us imagine that I am smarter than you and I have worked out how to increase the growth rate of your business to double what you, the vendor, are currently achieving. I should be able to buy your business on the basis of your growth rate, make the changes and then benefit from the increased rate of growth which I can achieve. Any subsequent increase in value surely must be mine since you, the vendor, were not able to do this previously. Without a doubt, this latter position will be heavily supported by knowledgeable buyers.

If I as the vendor were unaware of how to extract future potential out of the business, I would certainly not expect any buyer to pay above the conventional going rate. But what if I knew exactly how the business could be exploited and therefore knew that the business would be worth a lot more in the hands of the right buyer. My challenge would be to try to extract part of that future value for myself. The critical point here is that, if they don’t buy, the buyer does not get the opportunity to extract the additional value. Thus, what I need to do is to hold off selling until the offer price goes up or get the business into a competitive bid so that the buyers are forced to bid up the price in order to be the successful acquirer.

The smart vendor works out how the business could best be exploited and lays the foundation for that prior to sale. They then identify those potential buyers who can best exploit the potential in the business and bring to their notice the possibilities which might accrue to the successful buyer. Finally, they put the business into a competitive bid to ensure that the buyers have to compete for the opportunity to gain the additional value. While it is unrealistic to expect that all the potential will be passed back to the vendor, sufficient will to result in a premium on sale.

Selling to a strategic buyer

Just after I started my last business in the USA in 1995, a company called Red Pepper was purchased by Peoplesoft for 25 times revenue. Since then I have seen numerous examples of such deals in the internet space and in biotechnology. Every time I mention these deals to friends I get the same response ‘luck and timing’ and these things happen only in the internet and biotech sector.

So if told you that I assisted a small sports travel business to achieve 40 times EBIT you would start to question this view of the world. The fact is that any business which has the potential to enable a large corporation to exploit a large scale revenue opportunity can gain a significant premium on sale.

However, very few people understand how to set up such a deal. We have spent most of our lives believing that our businesses are worth some meager multiple of EBIT. In fact, if you talk to most professional advisors, investment bankers and business brokers they will focus their analysis of your business on what profit you are achieving now and what your likely revenue and profit growth will be in the near term future. I will freely admit that such analysis makes good sense when you are dealing with conventional businesses where the only value they contribute is the generation of revenue and profits through their own resources but what of the business which can enable a large corporation to exploit a national or global opportunity?

Most private business are heavily constrained throughlack of finance, limited capacity, poor access to large distribution channels, lack of skills and so on. The inhibitors to growth often prevent them from exploiting their underlying potential. In the hands of a better resourced and more capable buyer, the underlying potential can be more quickly achieved. Even so, most companies can only generate reasonable increments of growth due to the competitive nature of the market they are in. But what if you had a world class product or service which had a clear competitive advantage? Could you find a large corporation which could exploit this advantage on a national or global scale to achieve 50 or 100 times your revenue in a relatively short period? This is the basis of a strategic value sale.

The fuel for such an opportunity lies in the assets and capabilities which a large corporation can exploit, usually within an existing large customer base. The process of setting up such a deal starts with an examination of your own assets and capabilities. What do you have or do which could provide the basis for resolving a serious threat or enabling a large scale revenue opportunity for a large corporation? Often these are things which currently provide your competitive advantage but they may also be things which you are not exploiting in your own business but which some other business could. Next, you need to determine whether you can provide the buyer with some reasonable period within which they can exploit the asset or capability without it being copied, eroded or negated by an aggressive competitor. Something that can be easily acquired, assembled, developed or negated is of little interest to a large corporation.

Next you need to identify which large corporations can exploit the opportunity. Now you have the basis for setting up a deal where you potentially could achieve a sale price of many times EBIT or revenue.

These different stages of the strategic sale will be examined in greater detail in subsequent chapters.

 

Focus on strategic sales

You have already seen that generating a reasonable return in a financial sale requires the investee firm to develop a successful business capable of generating increasing revenue and profits in its own right. On the other hand, a business targeted at a strategic buyer has a very limited objective, simply develop an asset or capability which a large corporation can exploit.

Remember, that in the case of the strategic sale, it is the business concept of the buyer which is key to execution, not that of the business being sold. As you will see from the table below, basically you have a 12 times greater chance of a successful outcome since you will be targeted by a buyer who already can deliver on the rest of the attributes needed for success.

But it can be better than that. If you set out to invest only in ventures which have already developed the key strategic asset or capability, your probability of success will increase. What is really critical to the Angel or VC investor is that, even if the business is a financial failure, this will not by itself prevent a successful strategic exit. My own sale of Distinction Software to Peoplesoft clearly demonstrates that point. I will also be showing how such sales can dramatically reduce the period of the investment. It should also be obvious at this time that the risks of execution in a strategic sale are significantly less than those involved in financial sales or IPOs.

In the next few chapters I will examine in greater detail how a business is selected and prepared for a strategic exit. I will not be returning to the preparation of a business for a financial sale or an IPO.

If we use the 14 principles of the high growth business as a metric, you can see how dramatically different this hurdle is.
Individual Attribute Financial Strategic Sale Sale Right place, right time 80% 80% The compelling need to buy 80% 80% The right customer 80% 100% Channels to market 80% 100% Innovation as the driver 80% 100%
A Competitive advantage 80% 80%
Sustainability 80% 100%
Scalability 80% 80%
A clear vision 80% 100%
A long term strategy 80% 100%
Robust margins 80% 100%
Management of risk 80% 100%
A capable management team

Profitable
80% 100%
100%80%

combined probability of success 4% 51%

In the case of a strategic sale, the buyer completes the business concept. The buyer already has the distribution channel, the management resources, the operational discipline, the ability to scale the product or service and so on. Thus the task of venture development is significantly reduced.

Basically, strategic ventures are easier to exit with a premium, often involve less business development and the sale can usually be achieved in a relatively short period from the time of initial investment.

Multiple Exits

There is the possibility that a single venture can throw off more than one exit. This can happen where the firm has developed IP across multiple markets which solve quite different problems. It may be worth separating the business into distinct product/market ventures and preparing each for an exit.

Another possibility is that a single venture may have quite different activities each of which could be directed towards their own sale, perhaps with some being financial sales and others being strategic sales. This can happen, for example, where IP underpins a product sale but is then followed by maintenance or service activity. The IP may appeal to a global corporation but they may have no interest in the local services business. In such a case, it may be worthwhile splitting the business and selling the different parts to different buyers.

5
Threats and Opportunities