Spot-on article about a real-world scenario…. only a few start-up CEOs make it to this stage but those who do will be glad of this advice. Having lived this sequence and seen fellow CEOs go through it as well, here is some additional advice, especially for later-stage entrepreneurs:
As an entrepreneur gets deep into a venture he or she (and perhaps spouse as well) will experience moments of exhaustion and wish someone would just come along and buy the company. It is tempting to try to find or provoke an M&A offer! But Fred’s scenario explains exactly why you should be careful what you wish for.
As you enter the M&A process, be prepared for strife from unexpected directions. When the exit comes into view, the life of the current investment syndicate is coming to an end — and that affects people’s behavior. Investors and employees who have seemed stable for years can flip in an instant from supportive to selfish. Don’t be surprised.
In Fred’s scenario, after investors realize from the low M&A bids that they are about to be disappointed, those without cash will press you to take the best offer even if it is less than you believe the company could be worth. However everyone who still does have cash will now have a perverse incentive: to let the company suddenly run out of cash and go into distress (!) even though it is a good and somewhat valuable asset. They may even grease the skids by reassuring the CEO verbally “we know this is a tough time… don’t worry, you just focus 100% on getting better M&A offers — if it all falls through we will figure something out” …and they may even think they mean it.
But woe to the naiive CEO who completely trusts this line. When the company does come back for money it will have no alternative to accepting a reduced valuation, or even complete recap. The founders could then be washed out — even if they get fresh options, they are restarting the clock.
While some VCs have the heart and integrity to try to moderate the haircut and preserve at least some equity for founders and early investors, the more aggressive ones will hold out for more, and it’s the most aggressive investor in the room who generally persuades the syndicate and sets price.
Think about this example: your post-money on the last round was $100M. Your investors had hoped to see a 3X return or more, so they were betting on an exit above $300M. Then you get an M&A offer for only $120M… well at least you are above the post-money valuation, so things are not too bad, right? But remember, they still need 3X return… and you just proved your business is worth only $120M. So they will want to chop your pre-money valuation back to $40M before they put any more money in. That’s the only way they can feel confident of earning a 3X on the fresh money.
Even worse, they may not want to cut the valuation in a straightforward way because then they would have to mark down the investment on their books and it is human nature to defer bad news. So they may instead keep your valuation on paper at $100M, but add 3X liquidation preferences, warrants, or other extra rights for the fresh cash, that essentially give themselves a much lower price. As a result, the management team is now way out of the money in reality, if not on paper, and their options are worth a lot less than they appear.
That’s why a recap may actually be better for management than adding a new layer of liquidation preferences above an artifically high valuation, even though it means restarting the clock.
It would be wrong to lay the blame for this pattern all on the investors though! The entrepreneur’s choices may have planted the seeds of trouble in the first place.
Perhaps the company got a better valuation in the C round by agreeing to put the C round liquidation preferences ahead of the other investors, rather than pari passu with the earlier stage. If the exit price is lackluster, the syndicate now has differing motivations to sell and the Board starts to bicker. The company is unable to raise capital until too late and eventually enters distress, resulting in a fire-sale inside valuation.
Sometimes the CEO is a master of hype. Perhaps the reason the investors see the exit as lackluster is because the entrepreneur had previously over-sold the company‘s prospects to raise money at a higher valuation. After the M&A process produces only low offers, reality sets in and it’s clear the later-stage investor got a poor deal. They then feel completely justified to be more aggressive on terms.
So, what can you do to avoid such troubles at M&A time? It starts early — never take money from any investor at a price you privately think is high. Do NOT think of your job as trying to hype or haggle your way into the highest possible valuation. As you can see, it comes back to haunt you! Instead, only raise money at the highest appropriate valuation — the valuation you KNOW is fair and will make money for the investors.
What about later on, if you are later stage and about to enter Fred’s scenario?
First, the moment anyone suggests starting an M&A process as a hoped alternative to raising money, insist on having a term sheet for backstop financing in writing from insiders BEFORE you hire a bank. People are more rational before the M&A process starts. And if the sale does move ahead, the backstop term sheet is still valuable because it will give you staying power in case a buyer tries to change their offer just before closing.
Second, if you do have to walk away from an M&A, then this is the exact moment when CEO leadership is at its premium. You have to come up with a new, improved, more compelling and more exciting vision for how the company can still thrive. Then comunicate that far and wide, up and down, and get re-invigorated personally and as a team.
Who knows, failing to sell could be the best thing that ever happened to you, just a few years later!
