BERKONOMICS

We come to the end of this cycle of insights with a thought about how you might view your successful exit from the company you have spent so much effort to build.

You’ve worked hard for years to reach the payoff, and the money sure looks good as you contemplate the wire transfer to come, and then watch your bank account fill to a level you only dreamed of during those rough cash flow years.  You might even allow yourself to admit that you almost lost it all several times during this long run, and that only you knew how close you came to the abyss.   But you did make it, and that’s what counts.

Whether the exit was as large as you hoped, or whether your goals of taking care of all the people who helped you get to this point were realized, the exit itself generates a complex set of emotions in all of us.

[Email readers, continue here…]  First there comes a sense of relief, knowing that you no longer need to worry over daily cash or threats to your net worth.  Then you experience a feeling of guilt when you realize that not all of your early associates share the same outcome, either financially or perhaps with their continued employment with the buyer.

Then you focus on the money in your bank account, smiling at the accomplishment of accumulating assets that are tangible and can be valued, perhaps for the first time.

But what most entrepreneurs fail dramatically at is to celebrate the moment.  To celebrate with those who took the journey with you, with those closest to you who sacrificed as you spent those long hours away. To celebrate with your suppliers who helped you, especially during the rough times.  To celebrate with your customers, who worry over continuity and look to you for assurances that the transition will not negatively affect them.  And to celebrate for yourself, for making it all the way to the finish line.

Not many founders or entrepreneurs do experience the success of a favorable sale of the business they dreamed would make them rich.  Many fail multiple times.  Some fail in the first year of the attempt.  Others are diluted by subsequent investors to the point where there was nothing for them to celebrate at all in a sale.

So as you prepare to turn over the reins to another; to separate from a business that has become a part of your being,  it is time to think of nothing but the good done, the examples set, the positive company culture you leave behind.

As you begin to focus upon the future, remember the emotions, the lessons, the lasting friendships from the past.  I often advise managers, CEOs and entrepreneurs always to part on a positive note and never burn the bridges of any past relationship.  You’ll never guess whom you’ll meet in your next act, and how they will be able to contribute positively to your next success.

So celebrate your exit by reaching out to as many of those who’ve helped along the way as you can.  Close this chapter of your life on the highest note possible.  Take a long breath.  The do as all good entrepreneurs do.  Start dreaming of the next big idea.  Take with you the best wishes from those in your past, and build upon the education you received with this effort.

Write a book; I did.  Write a long hand letter to someone who helped you make it to the finish line. That extra effort will shock and please them.  Call an early key employee and take that person to dinner as a thank you for those hard times.

Hit the beach.  Pay attention to your family.  Think about investments and tax efficiency.  Go into a mental dark room and dream about your next act.  Take a long breath, or weeks of long breaths. Exhale slowly.  This is what a moment of reduced pressure and responsibility feels like.  Savor that moment.

Then if it strikes you as right, start the process all over again.  May you have only the greatest success in your next act, whatever that is and wherever it takes you.

Sometimes the end game or sale of the company is not a happy event for the early investors, including the entrepreneur or the founders.  Especially when outside investors, venture capitalists or angels have put in substantial money, and the sales price is not enough to give them a reasonable return for the time and money invested, these investors can be – in a word – greedy.

Most sophisticated investors will take either a promissory note or preferred stock, both of which come before founder or management stock in a sale or liquidation.  Promissory notes come before any equity, and most late equity investments come before early equity investments, even of the same class of security.  This makes for some head-rubbing when attempting to calculate the return on investment with a proposed sale.  Further, preferred stock holders can be recipient of accrued dividends in a sale or liquidation.  A rather common but small dividend rate of six percent becomes a massive amount after seven years, almost half again the value of the original investment.  And some preferred investors have participation rights, where they take all of the above amounts, and then also convert their shares into common stock and participate again alongside the founders and option holders.

[Email readers, continue here…]  It is in this combination of possible methods of amassing a return that greed can become a significant factor, so much so that the courts are sometimes stepping in to void some of the most onerous terms of investment agreements when challenged by those locked out of payment in a sale.

Take a situation where the VC investors finally see the chance of a return after ten years, with participating preferred and fifty percent of the ownership after several rounds.  A marginal sale at twice their original  invested amount could yield a starting value of eighty percent of the sales price to the VCs (fifty percent invested plus accumulated dividends for ten years at six percent which equals thirty percent of the sale price) and then fifty percent of the remaining twenty percent after participation. The result is that the preferred shareholders would receive ninety percent of a sales price that was double their investment, compared to ten percent shared by the founders and all others, including option holder-employees.

No-one complains if the sales price is ten times the investment, since there is plenty to go around.  It is in these marginal sales that the formula distorts returns so badly in favor of the investors.

Fortunately, and perhaps because the courts have not looked favorably upon these outcomes, many VCs will voluntarily forgive either accumulated dividends or participation in a marginal sale, especially if the sale is cultivated, planned and carried out by the efforts of the common shareholders including the founders.

Although many VCs are openly against allocating a “cutout” for management in marginal sales, practically speaking, management must be taken care of in marginal sales, or the sale might not happen at all.  In a cutout, some percentage, usually fifteen or twenty percent of the total sale, is allocated to management in order to continue operations through the closing period and help in closing the sale.  That further reduces the amount available to founders if not still in the ranks of management.

So this advice is directed to the investors.  Don’t be greedy even if you can.  You will not be moving your IRR needle enough by grabbing a few extra dollars in a marginal sale, but you will incur the wrath of a number of stakeholders who would be more than willing to spread the word far and wide about your greedy ways.  And that reputation will last for a long time in the entrepreneurial community.

Conversely, I have praised and seen others praise VCs who volunteer to eliminate participation clauses even before knowing the ultimate sales price in a deal.  It is those who receive the loudest accolades since they have given up a right for the good of the rest of the investor and management community.

Dave’s note:  Our guest author this week is John Huston,  founder of the 300+ member Ohio TechAngel Funds and a past Chairman of both the Angel Capital Association and the Angel Resource Institute.   

By John Huston

There are only two types of companies -those which have achieved positive cash flow and those which have not.  (Earnings before Interest, Taxes, Depreciation and Amortization, or EBITDA is the most commonly used definition of cash flow.)

While it is easy to divide all companies into just these two groups, this simplification ignores whether management has made a conscious, strategic choice about their growth.  Perhaps you have decided to continue growing top line revenues at the expense of cash flow (EBITDA.)  For high growth ventures being groomed for a lucrative liquidity event, this is usually a wise choice, presuming additional growth capital can be successfully raised on agreeable terms.

The issue is whether your company could pare back expenses and live within the cash it is currently generating – if you had to do so.  This should be a major milestone goal of all start-ups.  Until it is reached, survival still hinges on the kindness of outside funding sources.

[Email readers, continue here…]  But this too is an overly simplistic view.  Usually leading up to the time positive cash flow is initially reached, the management team is not taking a market wage, payables are stretched, and any slowing of receivables collections would likely cause layoffs.  The team knows their current expenses are being so closely managed, that at some point they would be unable to continue in this mode.  They have achieved a level of cash generation which enables “survival” – but it is not sustainable.

Now that you are more mature as a business, management can decide how to balance building revenues versus building cash flow.  There is a point at which building cash flow above revenues yields diminishing investor returns considering the amount of capital and time it consumes.  Furthermore, having substantial positive cash flow may sub-optimize investor returns at the exit.  This is because potential acquirers often act like mere financial buyers when they see a significant positive cash flow stream.  This prompts them to merely apply a multiple (often 5 – 8X) to the EBITDA or cash flow of the business, always a smaller number than when pricing an acquisition for strategic reasons.  So, rarely will this strategy or outcome enable investors to reap their target in a sale.

Ventures which have negative EBITDA, but could turn it positive if they chose to do so, are exhibiting the growth which attracts more bidders.  Those which generate high returns at the exit are often not sporting positive cash flow when sold, but they could dial back to be positive if required.  They are demonstrating by their actions that bidders cannot bid low, because by bidding low buyers would be assuming that a sale is necessary due to the company’s negative cash flow.

The bottom line: Looking at best example companies in a sale, their acquisition strategy was to avoid growing their cash flow before the exit.  Counterintuitive perhaps, but demonstrated to be effective.

Dave’s note:  For the second time, we invite Basil Peters, author of “Early Exits,” back as our guest – to provide more of his insight into the “when” to exit by selling your business. In future weeks, we’ll add the voices of other well-known professionals in the field of exits to my own, and try to give you a compendium of useful advice in the process. 

By Basil Peters

Most entrepreneurs wait too long to start thinking about their exit.  They usually sell their companies for much less than they could have.

That’s exactly what I did in my first company.  It was the first time I lost several million dollars, and the first of many similarly expensive – and valuable – lessons about exits.

I recently met with two bright entrepreneurs who are building a company in an exciting niche market riding on a long term trend. These two young founders chose their space well and were already global leaders in their niche. They had prototypes in the market and a respectable global mind share.

[Email readers, continue here…]   Their niche was heating up quickly – unfortunately for them.  In the previous six months, I’d read several articles in finance blogs or newsletters about yet another company that had just been financed in their specific vertical.  Most of the financings I read about were for $5 million to $20 million. In contrast, this local company had been built on something around $1 million in equity.

This is a scenario I’ve seen about a hundred times before – too much money flushing into a space the VCs think will be hot. Too many companies being founded with exactly the same business plan.

These entrepreneurs were too young to attract the amount of capital they’d need to compete in this new environment. They had only two strategic options – an early exit, or hiring a ‘name CEO’ that might be able to raise a big enough round in time. I recommended an exit because I knew the money flowing in to their space would also increase valuations – possibly by 2x to 5x over normal ranges.

You can probably guess the young entrepreneurs wanted to wait a ‘little longer.’

I don’t want to be too hard on these young entrepreneurs. They were mostly victims of their own human nature.

They just couldn’t think about selling because they were having too much fun. They were leaders in their market and big companies were enquiring about huge orders. They knew their revenues were getting ready to grow – and possibly explode.

Dave’s book on exits. See http://www.berkus.com/shop/ for this and more from Dave

Unfortunately, they couldn’t appreciate that it was also the absolute best time to sell their company. In fact, they should have started the exit process six to twelve months earlier.

Human nature also affects the buyers. They will always pay the most when everything is going perfectly and the future looks even brighter. The buyers’ human nature also means that a skilled M&A advisor can usually sell for a lot more based on the ‘promise’ rather than the ‘reality.’

And human nature works against the entrepreneurs on the downside. This one ends up costing most entrepreneurs and their investors a lot of money, because most of the time CEOs and boards wait until it’s pretty clear that the company’s value has peaked before starting the exit process.  By the time the buyers get to serious price negotiations, it’s also clear to them that the company’s best days are behind it. And another six to eighteen months have passed, usually allowing the trend to extend even further.

With exits, like many things in business and life, timing can be (almost) everything.

We are pleased to host Basil Peters, perhaps the best known name in the world of early stage company exits.  His groundbreaking book, “Early Exits” has become a textbook for angel groups and entrepreneurs throughout the world.  His Strategic Exits Corporation provides M&A advisory services, and he is much in demand as a speaker at angel and entrepreneur events worldwide.    – Dave

By Basil Peters

Selling an entire company is similar to selling shares in the public markets – how much you can get depends on how the company is doing, but also on how the overall market is behaving. For many stocks, the overall market is a bigger factor than how the company is actually doing at any point in time.
This ‘external effect’ is even more pronounced when an entire company is being sold because the market for companies is much less ‘efficient.’

At the end of 2008, near the bottom of the debt bubble collapse, the overall stock market had dropped about 50%.  If there was a similar index for the value of entire companies being sold, I am sure it would have gone down much farther than that, and stayed near the lows much longer. This is, in part, because the market for entire companies is much less ‘efficient’ and therefore more susceptible to changes in sentiment and liquidity.

[Email readers, continue here…]    How Long Does It Take to Sell a Company?  Depending on whom you ask, and whether they are trying to sell you something, you will get different answers on how long it takes to sell a company.

The time to exit depends a lot on the company – primarily on how long it will take to get the company into a salable state, and then how much time the senior team has available to work with the M&A adviser.

A good rule of thumb is that it will take six to eighteen months from making the decision to completing the sale. Therefore, in order to execute the best exit, the decision to sell has to be made that long before achieving the peak in corporate value.

Dave’s note:  We are privileged this week to host a post by Arthur Lipper, a well-respected member of the international financial community since 1954. He has served as advisor to and member of numerous financial exchanges, and was the founder and CEO of Arthur Lipper Corporation and co-founder and Chairman of New York & Foreign Securities Corporation. Today he serves as Chairman of British Far East Holdings Ltd. He has written numerous books and articles for entrepreneurs and investors, and was the publisher and editor-in-chief of Venture Magazine.  Mr. Lipper addresses the issue of exits, and whether entrepreneurs should take the long view or cash out quickly when the opportunity arises.

By Arthur Lipper

It used to be that entrepreneurs started businesses as a life’s work, a mission.  Many thought that they were starting companies for their children and grandchildren to inherit and manage.  They sought to recruit associates offering a sharing of the vision resulting in lifetime employment as an incentive for maximum effort and effective collaboration.

They financed their companies, to the extent possible, in a manner minimizing the cost of capital, planning for organic growth in the number of customers served and in associated revenues. As the business owners had a longer-term perspective, decisions were made with greater deliberation and with a more conservative recognition of risk. The businesses frequently were the owner-manager’s only major asset.

The role model for many business founders were successful companies such as Microsoft, Cisco, Federal Express, all large companies, conservatively managed and often started and still managed by an individual entrepreneurs, even if later they became public companies.

[Email readers, continue here…]  Now, when first meeting with an entrepreneur, I ask simply, “Is the business being formed as a Keeper or a Flipper?” Being one or the other is neither good nor bad, but the needs and investment considerations are very different. Keepers are financed differently than Flippers, which are started with a plan to be acquired in a few years, once the value of the technology or business model is demonstrable.

In the case of technology and Internet-related companies, competitive advantage will have only a relatively short lifespan and that therefore the window of opportunity is not infinite.

Flippers financed by venture capitalists are more likely to hire executives having high level profiles and previous exit experience. The Flipper’s executives usually have significant equity holdings, either actually owned or reflected in stock options. Therefore, all of the decision makers understand that rapid growth of revenues or customers at the expense of profit is the primary objective in positioning for a good exit early in the game.

In today’s world, especially where the Internet or technology is involved, prospective publicly-traded company acquirers sell at significant price/earnings ratios and have large amounts of capital available. They are also very competitive, and highly value the intellectual property of the Flipper. Their “make or buy” decision is heavily impacted by the time required to make and the value of the Flipper’s brand. Creating brand is or should be a major focus for companies in industries where positive and immediate customer prospect recognition results in sales.

Betting on the traditional public stock market speculator’s “greater fool theory” has been just plain wonderful for the owners of the Flippers, as aggressive acquirer’s value determinations are based on future events, rather than achieved profitability and present balance sheet values.

Keepers are more likely to be in industries with slower growth rates and lower price/earnings ratios. In other words, those intending to own and manage businesses for longer periods are more conservative and risk adverse. They also tend to have invested more of their own money in their businesses.

What does all of this say about market levels and public attitudes? I believe we are witnessing a shortened attention span by most technology and Internet company managers and controlling shareholders, who tend to be younger, as do those financing and trading in the shares of early stage companies.

When, or perhaps if, there is a downward adjustment in public company valuations, many of the younger players are going to learn some of the lessons the older game players learned in previous downturns – that valuations can revert to the mean or lower as companies mature, or as economies suffer challenges. However, in the meantime the highly publicized transactions of very young companies being acquired for enormous amounts of money will be sirens prompting entrepreneurs to be Flippers, which is fine if they have a chair when the music stops, and if they can find their acquirer before heavy dilution from financing rounds takes its toll on equity value for those early investors.