A VC in Vacationland

" Cash in the hand is worth more than promises in the spreadsheet"

I coined this phrase during a long set of negotiations involving the sale of one of my portfolio companies. The Board faced a difficult decision about maximizing shareholder value in light of two very different offers for the company.  The discussions, negotiations and evaluations lasted months.

We had two preliminary letters of interest from two excellent acquirers.  One was for an all cash deal and the other involved extensive earn out and uneven payout conditions–all detailed in extensive spreadsheets detailing the deal.  The more complex deal (with all the earn outs) was potentially worth a lot more money (25% higher payout) to both investors and employees, but was fraught with all sorts of market as well as goal attainment risks.  Many spreadsheets were felled in the process of evaluating the alternatives.  Discount factors flew back and forth. Net Present Value calculations were compared to probabilistic models.  No analysis technique was left untried.

In the end, we took the all cash deal.  Macroeconomic conditions, such as the current or pending world-wide recession (depending on your forecast), were certainly considered, but the deciding factors were more focused on deal structure than on environmental factors.  I won’t bore you with all details of the decision process and will instead share some key learnings from the process.

1. Who comes first? Customers, management and shareholders all have a stake in a potential acquisition.  One of the key decisions a Board has to consider is how will each constituency be best served going forward.  The best way to view this process, I believe, is through a doctor’s eyes–Do No Harm, or in this case, make sure that all groups are treated fairly. The biggest issue often revolves around the investors, who seek to maximize their returns.  Any clauses that would increase shareholder value are prized by the investors but can be detrimental to management.  In our case, the more complex acquisition would have paid the investors mostly up front and forced the management team to work for three more years to get their cash.  Not a great way to do no harm.
2. Encapsulate Due Diligence. Even in a straightforward, all-cash offer, the due diligence that follows the signing of a letter of intent can be used by an acquirer to reduce the acquisition price.  On one hand, an acquirer has a right to verify the management and board assertions about the value of the company, the happiness of the customer and the quality of the financials.  On the other hand, the due diligence period can be risky for the company.  If for any reason, good or bad, the potential acquirer walks away from the deal, the company may be looked on as "damaged goods" to other potential acquirers, resulting in a lower valuation.  Smart players add clauses to the letter of intent that can protect the company from such events, or restrict the ability of the acquirer to lower the acquisition price.  For example, one ploy is to only take any price reduction out of management’s share.  Few acquirers want to risk an angry or unmotivated management team going forward, unless they planned to get rid of them anyway.
3. The (Bad) Karma of Spreadsheets. The ubiquity of the spreadsheet has given them a God-like status in the hands of many investor professionals.  The most afflicted tend to be the MBA’s that work for the investment bankers.  Let’s admit it up front–you can "prove" anything with a spreadsheet. It’s numbers masturbation at it’s worst. A little tweak of the discount rate, a higher post acquisition growth forecast, synergy revenues, phony cost savings, etc. etc. can all add to the confusion. This may sound silly, but I do most of my NPV’s in my head using simple discount factors off the ultimate purchase price, with higher discount factors for complex deals and lower ones for cash deal.  Most of the time I am within 5% of the complex spreadsheet calculations.
4. It’s the Intangibles, Stupid. If everyone has done what they were supposed to do–primarily management producing a company worthy of a strategic (or at least normal) exit, then the purchase price offers should be in the ballpark of market valuations. It is the Board (and the investors) responsibility to send the company to a good home, one where the successes of the past will be built upon and result in even greater ones in the future. Many of the key factors that need to be discussed in the Board meetings about the acquistion relate to intangibles–will management be treated fairly going forward, does the acquirer share the same vision for the emerging marketplace, what levels of invesmtent monies will be available, for example. Often, investors want to skip these steps, preferring to get to the money questions. All parties must remember that they will continue to be judged in the market about the success of a sale, well beyond after the checks have been cashed. 

I am not sure if I answered the original question–Is Cash King?  I am sure that there is no easy answer and that careful evaluations, following the above guidelines, will usually lead to the right answer.  In a previous acquisition of one of my portfolio companies, the Board decided that an extended earn out of the purchase price for both investors and management was the right answer, even though we had an all-cash deal on the table. The situation was different, but the offer terms  were similar to the current deal.

Letting it ride will hopefully be better than taking the cash.  We’ll see next year when that deal matures.   

I have had a number of requests to expand my shortest Blog ever–the one the said that the biggest mistake entrepreneurs make is a failure to monetize their business model.  So here goes…and thanks for asking.

Let’s say you have this really great idea like a search engine to compete with Google.  There are sure a lot of these getting funded at the moment.  The big question an investor will ask is how are you going to make a lot of money.  Advertising, you say! Great, says the investor, how will you attract the advertisers?  And how will you get people to use your site instead of Google so that the advertisers will pay for placement? Answering those questions will help monetize the first part of your business model, and, unfortunatley, there are additional monetization challenges you must be prepared to face over the life of your company.

Let’s take the monetization question in bite sized chunks.  I will assume that you already have the great idea that people cannot live without , that you have conducted appropriate market research and that you understand how to build the new search engine, software, game, applet or whatever. Take a deep breath.  The hard part is coming.

First, your key challenge is to be able to separate people from their money, both upfront and on an ongoing basis.  Many plans I see are predicated on single purchase business models.  Not good enough.  For example, assume you want to sell a new software product. The business model may involve license fees, services and maintenance purchases.  That’s fine for the first few years, but you must also think of how you can get existing customers to buy more over time as well as attract new customers. Why?  Selling to existing customers is a lot cheaper than finding new ones, so a business model that includes additional revenues from current clients is more attractive to investors.  That’s one way to monetize your business model.

Second, Your business model must generate sufficient margins to pay off investors and reward the entrepreneurs.  Again, I see a lot of proposed models that are focused on one pay off or the other, not both.  Business plans predicting hundreds of millions in revenue in a few years are rarely believe or happen.  You need to build a company that keeps expenses well under revenues for an extended period of time to generate sufficient cash to reward the various constituents.  Start with the end game in mind.  If you have angel investors, think of how they can realize decent returns in five years or so, perhaps via a recapitalization involving venture capital.  Similarly, you need clear plans on how you and your dedicated employees with monetize their sweat and other equity.  Don’t think that both groups are not worried about these questions.  Always have some good answers ready around this issue, as it comes up frequently.

Finally, monetization often will occur via an exit and you need to have a strategy (with options) to ensure maximum rewards. A recent post of mine, Planning for Exit, discussed how to develop an exit strategy.  A key part of that strategy is understanding how equity invested will be monetized in the process.  With preferences, warrants, options and numerous other factors affecting the final numbers–not to mention earn-outs and other methods of extending pay outs into the future, figuring out which is the best approach can be tricky.  The savvy entrepreneur carefully monitors how any and all of these factors may impact the ultimate monetization of his or her business.

The reality is that business model monetization comes in many different flavors during the life cycle of a company.  You have to get the initial monetization models right up front, then you have to ensure that operational execution actually can generate excellent margins against the model and finally, that you can have the right exit to maximize return to all relevant players.  This is a tough process to execute well, but a necessary one if you are going to "monetize your business model" correctly.

Most of us have heard the fable of the chicken and pig discussing being participants in breakfast.  The chicken offers to contribute the eggs, but the pig demurs, realizing that by donating the ham or bacon, he becomes fully committed via the slaughterhouse.

Investors can also come in these two levels of commitment.  The "chicken investors" contribute the money, but often little else to the venture.  The "pig investors", on the other hand, contribute money, connections, time and often many other things to the new company. Both are important to your success.

Chickens are good because they provide needed funds and don’t tend to meddle in the business.  They could be friends and family who trust you but know little about your technology or product.  Or they could be other venture guys who co-invest with "pig" investors on certain deals.

Pigs are critical because they not only provide needed cash, but are able to make numerous connections in their networks that can help you grow the business.  The best kind of pig investor is one who really knows your space and can also advise on the evolution of your technology and products.

The worst kind of investors are chickens who think they are pigs and vice versa.  Chickens who think they are pigs and do not know much about your space can lead you in wrong directions.  Likewise, pigs who can but do not contribute anything beyond money are also trouble. Potential investors or customers will wonder why the pigs, who know a lot about the space, do not seem to care about promoting the company.

The moral of the fable for entrepreneurs is to choose the right mix of pig and chicken investors and make sure that they understand and approve of their roles up front.  Many of the board of director problems I witness are around confusion of, or of ignoring agreements on, initial "chicken or pig" roles. It is advisable to document these roles up front in the letters of agreement between investors and the company.

I have been having some animated discussions lately with some of my portfolio companies about their organizational structure, or lack thereof. The net result was Dave formalizing some overall suggestions on how to think about structuring an organization in a small, technology focused company:

1. Customer-focused–An organization needs to be, first and foremost, customer focused.  That means it needs to be designed to serve customer needs.  Generally, consulting or software companies should have two major organizational structures—one that develops solutions for specific market segments, like consumer goods companies and some cross-cut functions that support all market segments, like R&D, product service & support, finance, HR, etc.
2. Leadership Responsibilities–Senior leadership in these companies needs to have a go-to market segment as their responsibility, as well as one of the cross-cut areas.  Think about your cross cut areas as possibly administration (HR, finance, facilities, etc.), operations and marketing/sales. A senior executive needs to be responsible for one of these areas as well as a go-to-market segment.  Small companies just do not have the resources to have separate executives for all internal and external leadership needs.  Multi-tasking is a key way to provide the leadership as well as to keep expenses under control.
3. Team Responsibilities–For the next level of organization structure, having team members with both market-specific and operational responsibilities also makes a lot of sense.  In the operational generalist world, having them work part of their time with the go-to-market people, for example, keeps the operational people well aware of changing customer needs. Similarly, the go-to-market team members should have roles in the operational side of the business, contributing to customer support, product design and related functions.

There are a lot more factors that should be considered in designing and/or refining your organization structure.  My advice is to start simple:  follow the three principles outlined above, see how it works and then make changes to adapt to emerging needs and challenges as they happen.  Don’t try an design the perfect organization up front, but also do not do it once and think that your organization will last a long time.

At Accenture, now a $20 billion global IT consultancy, we changed organization structures every twelve to eighteen months. Often, this was not fast enough, given the ever changing nature of our marketplace.  But when we went to do it, we always started with the three simple principles outlined above.  It worked very well for us.

It’s a two-way street. You want the best senior executives for your start-up and the best senior executives want to make the right decision about which company to join. 

How do you make it all come together for both parties?

Here are three ways to ensure that everyone is on the right page before final decisions are made:

• Set expectations–both sides need to write out what they expect in the relationship.  The candidate should detail working relations, reporting relations, etc.  The company needs to have a clear PD as well as additional info on performance goals.
• Present the package–I may be in the minority, but I always ask senior executives what they want in their pay/ownership package.  Some demur.  I tell them that’s the only way they will get an offer.  I may pay them more or less, but they want the job, so they should tell me what they want.
• Develop the Plan–I also ask the senior executive for his or her 1-2 year plan for executing  their position and a budget supporting the plan.  How else would you know if you are both on the same page?

Getting on the same page up front is a lot easier than discovering we all were reading a different book after a few months of corporate/executive marriage.

I frequently lecture my portfolio companies (and other entrepreneurs who ask) to always be planning for exit. Why should you be planning for exit when you are trying to raise money to start your company? In simple terms, it is critical to structure your operations, customers, products and sales to make them friendly to your chosen exit strategy.

As Lewis Carroll once said, "If you don’t know where you are going, any road will get you there".  And the probability that you will exit your business before a decade is up is almost certain, unless you decide to make it a lifestyle company, so you better decide which road to exit is best for you.

So what are the likely exit options?

• IPO–Most business plans I see for companies seeking venture financing assume an IPO.  Oh, for sure, the words never appear in the business plan, but the numbers do.  The numbers I am referring to are the revenue projection "hockey stick", where the five-year forecast starts really low, then has revenues reaching into the IPO range, somewhere north of $60 million.  Of course, the entrepreneur is trying to convince potential investors that a real market exists for their idea and revenue level and growth is the easiest way to pitch the story.  I generally advise the entrepreneur to radically scale down their revenue estimates as the truth is no one will believe them.  Only 1% or so of venture-backed companies will have a true IPO exit, assuming we eliminate some pink sheet/reverse merger options.
• Merger & Acquisitions–Bruce Richardson of AMR Research recently had an interesting discussion on M&A exits with John Cooper of Montgomery & Company.  John estimates that 95-99% of all venture-backed companies will exit via an M&A.  While this number seems high, and was not supported by any empirical data in the discussion, the reality is that M&A will be the most likely way you will exit your business. The challenge is what kind of M&A exit will you have? The strategic exit, where an acquirer pays a nice revenue multiplier premium, say 5X or more, for your company’s "must-have" product, technology, platform or business model, is the one most entrepreneurs dream of.  Out of the 95-99% of M&As, perhaps only 5-10% may fall into this category.  The vast majority–perhaps 60-70%–will be a normal exit, where an acquiring company pays a 2-3X revenue multiplier premium.  Perhaps 10% will be some sort of fire sale exit–where your venture backers desperately look for anyone to buy the company, the assets, the IP, or whatever else may have value.
• Close Down/Lifestyle–A small percentage, perhaps 5-10% of venture-backed businesses are just closed down, via bankruptcy or some other shut down process.  Sometimes, the venture backers let the founders or some of the executives "buy out" the investors for cash in or less, assuming the founders have the funds to cut such a deal. Or the investors just walk away from the business, letting the founders turn it into a lifestyle business if they desire.

So, what should you plan for?

I tell entrepreneurs to work like crazy for a strategic M&A exit and hope for a normal one.  Given the probabilities and assuming no one really plans for IPOs or less desirable exits, this advice is the most realistic for most founders.  It’s easy–just design and execute the next "must-have" product, technology, platform or business model.  Of course, it’s not easy, but it’s what you have to do to get that strategic exit.

Am I too conservative?  Are my exit options numbers out to lunch?  Let me know your thoughts.