Quick Guide: Groundwork for Exits

There’s an adage that great companies are bought not sold. Is this true?

One way to interpret the adage is that if you just put your head down and build a great company, eventually someone will come around offering you a ton of money for it. The occasional big exit that gets everyone tweeting provides reinforcement. So, yes, the adage appears to be true…in a few rare and exceptional cases.

Executing and hoping is gambling with the payoff you have worked so hard to achieve. If you are a high agency person who would rather plan than hope, this post is for you.

In this post I am going to cover:

1. the value of a competition
2. the two types of buyers
3. timing
4. the importance of knowing yourself and being prepared
5. the importance of building relationships with buyers well in advance of an exit

1/ Competition is massively helpful

Obviously a great payoff (or outcome) means a great valuation. But as someone who has spent their life doing deals, closing is what counts. The valuation is meaningless until the wires go through.

You know from experience that your negotiating position is stronger when you have other interested parties. But competition from buyers has many other often overlooked benefits in getting the deal closed. Let’s first look at a typical sale process.

Not all sale processes and buyers act in the following way, but many do and you won’t know which type you have until the very end. A typical process is:

1. Buyer delivers a vague IOI which gives them a long exclusive period in which to close the deal
2. Real due diligence kicks off and the buyer looks for issues, an understanding of how the business really works, your competence and external risks.
3. This due diligence period is also an observation period over which they get to see your performance in detail and how well you do against projections.

During this period, you have three risks to achieving your payoff:

1. The buyer changes their mind on terms/valuation due to things they find in their due diligence and market research
2. The buyer changes their mind on terms/valuation based on your performance against projections
3. Unexpected events happen on your side or the buyer’s side that cause a change in desire to close the deal or an adjustment in terms.
1. On your side, these could be:
1. a sudden downturn in the economy or global shock (Covid anyone?)
2. an issue with a vendor or distribution partner
3. the sudden departure of a key employee
4. a current investor causing an issue
2. On the buyer side, these could be:
1. threatened regulatory action from an FTC that appears to hate M&A and finds no deal too small to scrutinize or block
2. an interest rates spike or credit crunch that causes their borrowing costs to go up
3. an internal issue with their fund
4. a bankruptcy or major stumble of a prominent company in your space
5. another deal becomes more interesting causing them to pull out.

A common process of documents would be: IOI —> Term Sheet —> Final Docs including Purchase and Sale. Each step adds detail and legal obligations. The negotiating dynamics usually change from business people ↔ business people to lawyers ↔ lawyers as you go through the process and docs. Finally, there is a wide disparity in experience with the process. You might go through this once in your life while your counter party does this for a living. Even with great advisors and attorneys, it’s a little like a golf game where one team is a Pro-Am (that’s you) and the other team is a couple of US Open winners.

Competition helps you level the field and mitigate these risks:

1. You can negotiate a better IOI through adding detail and specificity so there is less wiggle room between the IOI and your Term Sheet.
2. You can provide more data upfront and disclose the most likely potential issues eliminating the buyer’s ability to use those issues to back out or change terms
3. You can reduce the exclusivity period which reduces the amount of time buyers have to hunt around for issues, reduces the time over which they observe your performance and reduces the time during which existential issues can arise
4. Enables you to negotiate harder because both sides know there are others waiting in the wings if the deal does not go through
5. Likely gives the buyer more confidence. Buyers are human and knowing other people want something tends to make us want the same thing more.

2/ The two types of buyers

There are essentially two types of buyers - strategics and financial (i.e. PE funds).

Strategics

Strategics will pay premiums when they decide your business is a good fit with their current business. Maybe you are a category leader in a new category they would like to be in. Maybe you have a channel or expertise in a channel they don’t or more likely, maybe they know they can take you from a single channel and blow you out through a channel they know well (e.g. you’re DTC and they know they can leverage their mass retail relationships to massively expand your distribution). Maybe you have proprietary technology or they know they can dramatically lower COGS through their supply chain. Maybe you have a celebrity spokesperson.

Whatever it is, they are making a business case for acquiring you that is not purely financial. And they aren’t going to bother doing a deal unless they believe the impact can be significant. While every buyer wants to get the best deal possible, the strategic buyer will usually have more incentive to move to superior valuations and certainty of close than a PE buyer would.

Your job with strategics is to understand why you are valuable to them and how much value you potentially represent.

PE Funds

PE Funds on the other hand are purely financial. You are up against smart, experienced people maniacally focused on improving IRR’s. Once they decide to move ahead, they obviously want to win the deal, but they are keenly aware of the deterioration of their potential returns from every extra million dollars in the purchase price.

Your first job with PE funds is to deliver confidence they can get the returns they expect. Your second job is to build the upside case. The more conviction they have you will deliver the expected performance and the stronger this upside case, the more the PE firm will be willing to increase valuation especially in a competitive process.

3/ You don’t always control timing

Given the two types of buyers, there are two types of inbound.

PE Inbound

If your business is going well and you are of a certain size, you are likely to get inbound interest from PE funds. Often this a junior level person whose job is to hammer the phones and emails of CEO’s. They are often doing market or competitive research. But they are also looking for signals from interesting companies that may be ready to move forward. My recommendation here is to:

1. Move the conversation to the partner level. There is no point in building a relationship with a 21 year old who graduated from college 8 days ago. “I’d be happy to schedule a get to know you call with the partner who would be working on this deal.”
2. On that call, you want to be honest about where you are. If you are nowhere near an exit, let them know and suggest checking in with each other every six months. If you are thinking of an exit, then you can let them know you are thinking about it, will be running a process and will let them know.
3. You can share your high level financial story (see 5/ below), but be careful. They are listening intently and recording what you say in order to compare it against future performance. Your goal is to demonstrate high competence in projecting and then hitting your numbers. The more projections you give, the more chances you have of missing them.

Strategic Inbound

This type of inbound has a different tenor from PE inbound. You first want to understand who is reaching out. If it’s the CEO or senior leader of a business unit in the bigger company, you want to quickly determine how serious they are. You might be kicking off a process as soon as you put down the phone.

If the inbound is from someone in Corp Dev, you have a slightly different issue. Corp Dev at large companies are often ex bankers or attorneys who are responsible for managing deals and then transitioning the acquired company into the org or at least handing it off to a team that does that. They may have some strategic role, but almost never are they deciding in a vacuum about the companies to be acquired. Those decisions are being made by the CEO and team or at a very large company by the senior most business unit leader.

Corp Dev inbound could be serious. But it also could be more similar to PE inbound where they are acquiring or thinking of acquiring a competitor in the space. In this case, I would flat out ask them. “Is this exploratory, or are you looking at a competitor, or have you decided on us?” And then I would listen and watch. Depending on how you feel about their answer, I would also work to move the conversation to the business unit leaders or CEO.

So while in an ideal world, you get to crank along and perfectly match your desire for exit with an awesome market and run the process when you decide, inbound will happen. Your timing will have been determined for you. And the question will be are you ready to respond? Which brings us to our next section.

4/ Know yourself

When opportunity comes you want to capitalize on it. To do that, you need three things:

1. Know where you are personally
2. Know your financial story
3. Have your finance and data house in order
4. Have your team lined up

Knowing yourself

An inbound offer will set off a flood of emotions and considerations. Your ego and life are completely tied up in your company. Suddenly, vague ideas of wealth become nearly tangible. The new house or vacation home goes from daydream to near reality. And a powerful psychological effect sets in which is the fear of loss. Daniel Kahneman talks about loss aversion and how it’s much more powerful than potential gain. When interest or an offer comes in, you immediately translate it into your personal gain and what was once theoretical and vague suddenly turns eminently attainable. And just as suddenly, your desire to not lose those things will powerfully drive your actions. It will be super hard to process all this and make rational decisions. The buyer knows this. In fact, they will be using loss aversion against you from here on out. They will also be expecting an answer. Asking for a couple days is reasonable. But asking for a couple weeks is not.

How much longer do you think you can continue? Are you tired and looking for resolution or energized and ready for another three years? What number would give you serious pause? This isn’t your daydream home run number. It’s the number that is going to keep you up at night debating it. Having a good sense of the answers to this question will enable you to act rationally and decisively when opportunity comes knocking.

Understanding where you are in your journey, how much longer you can keep going and what would make you seriously consider stopping will enable you to act rationally.

Know your financial story

The greatest confidence booster for buyers is proof you know how to forecast and deliver results. Several quarters of demonstrated proof of this is gold. Your financial story has two parts. It starts high level, but can go into greater depth if you are asked. And it demonstrates your journey from a previous state to an ideal promised land state.

Your ideal is to be able to say something like: “Two years ago we were here, now we are here and in two years we will be here. We have been within X% of quarterly forecasts for the past Y quarters. We have the machine dialed in and know how to grow it.”

Having your financial and data house in order

Nothing says we don’t have our shit together better than telling people you will get them financials next week. You will need strong financial reporting and data systems to deliver a story like the one above. When a process starts, time is your enemy. Being buttoned up and ready to go is a huge advantage.

Have your team lined up

As mentioned above, when inbound happens and you decide to pursue it, time is your enemy. This is not the time to be scrambling to line up investment bankers and attorneys. You are going to be relying heavily on these partners to get you the best deal and over the line. Making a snap judgement or using a firm because your buddy did is not the ideal selection process.

Get some recommendations and ask to meet with two or three bankers and attorneys. Let them know you are not starting a process, but you will eventually be looking to exit and you also want to be prepared in case of inbound. You want to have your team selected and ready to go in that event. Hear the pitches, choose the partners you want and let them know. You aren’t starting a formal relationship and don’t sign anything now. Definitely don’t pay a retainer.

When inbound happens, reach out to these partners. They will initiate the formal engagement paperwork. There is a slim chance they will be conflicted and in that case, reach out to your second choice.

5/ Relationships speed deals and increase buyership

Buyers feel better about doing a deal with founders they already know. A foundation of trust will speed the entire process. What makes these pre-established relationship more valuable is when buyers have observed your success over time. You have four goals in building these relationships.

1. You want to build an informal relationship where you can regularly check in and give an update on progress and hear more about the buyers business.
2. You want to expand inside the buyer to meet more of the decision makers.
3. You want to better understand the culture and potential fit of the acquirer
4. These relationships and conversations are terrific ways to gather insights into the market and competitors.