Funding & Exits — Chapter 14: The Strategic Acquisition Exit
Over the past seven years, more than eighty percent of all exits have been via strategic acquisition. When your company exits, it’s most likely that it will be to another company. Private equity buyouts comprise about fifteen percent of exits the past few years, though growing (19% in 2017). When strategic acquisitions by companies owned by private equity are included, however, that number is significantly higher. IPOs have averaged about five percent of exits since 2010.¹
In this chapter, we look more closely at the strategic acquisition alternative. It’s helpful to start by defining the four different types of strategic acquisitions. They are:
- Round out
The Scale Acquisition
In a scale acquisition, the acquiring company purchases a company that offers a similar product with a similar business model. The acquisition thesis is based on revenue growth, competitive advantage and cost synergy savings. It is assumed that customers of the acquired company will be transitioned over to the acquiring company’s product platform — at least at some point. In a scale acquisition, it’s not uncommon for the CEO and top team to be let go right away or soon after close of acquisition; the acquiring company’s management takes over. Even if team members stay, it’s the acquiring company’s playbook that rules — and acquired company employees are expected to learn and conform. The incremental revenue and profit, augmented by synergy savings, drives the ROI analysis and acquisition premium. Roll-up strategies are grounded in a scale acquisition thesis, whereby there is valuation arbitrage available to the acquirer by unlocking cost synergies (G&A, platform consolidation, etc.) that may not be available to others.
The Scope Acquisition
On the other hand, in a scope acquisition the acquiring company expands its scope via the purchase. It’s a strategic move. The thesis for a scope acquisition is grounded either in the filling of a strategic gap, or in a strategic business extension. In both scenarios, the acquiring company’s product suite is significantly enhanced as a result of the acquisition. Since the acquired company’s capabilities and competencies do not exist in the acquiring company, scope acquisitions usually involve significant retention incentives for key executives and employees. The synergy created by a scope acquisition is more likely to be revenue synergy — such as leveraging the buyer sales force.
The Round Out Acquisition
The round out acquisition is similar to the scope acquisition, but more targeted. It’s a tactical move. The acquired company has a product capability or feature that enhances a product offered by the acquiring company. Here, the thesis assumes that a small number of key employees must be retained, in order to support and continuously improve the feature of interest. But many executives and functional team members (such as finance, sales, marketing and operations) may not be needed. The ROI thesis depends on revenue and profit impact, incorporating savings from synergies.
The Talent Acquisition
Sometimes a company is purchased simply to acquire a team of employees. The acquiring company compares the task of recruiting skills it needs one by one, versus buying the company and getting the whole team at once. The cost of time and the dollars needed to recruit is compared to the savings of time and dollars needed to buy. In a talent acquisition, the acquiring company will require strong retention packages for the employees it wants, and will immediately terminate everyone else. A variant of this is the “tech and team” type of transaction, whereby IP acquired in the deal accelerates buyer product initiatives. In such situations, a higher valuation can be justified than with a pure talent acquisition.
Implications Post Acquisition
Each of these alternative acquisition theses has different implications once the acquisition is closed. It’s helpful to compare them side by side:
Strategic Acquisition — Key Considerations
As you prepare for an exit, start with objectives. What are your investors’ valuation objectives? How about you — what company valuation is your minimum? Is that valuation in line with market comparables? What cash do you need to take off the table? Do you want to sell the company and move on? Or do you prefer to sell and stay? If the latter, what are your expectations, both financially and in terms of your post-deal role and authority? What are the goals of your management team? Make sure you understand where stakeholder interests are aligned. Understand too where they diverge, and deal with those up front. You don’t want to go into the exit process with incentives out of alignment, or with unachievable goals.
Your exit will look very different depending on whether the acquiring company is the same size and stage of growth as you, is a Fortune 500 company, or somewhere in between. Public companies face more pressure to prove acquisitions are accretive. Private companies may face cash constraints, and may prefer a cash-plus-equity or all-equity deal. The more you understand about the acquirer’s objectives and constraints, the better.
Once you are clear on your goals and those of your investors and management team, and you’ve considered the objectives and constraints of potential acquirers, you’re prepared to engage the process itself. The next critical step is to plan for failure. Yogi Berra once said, “It ain’t over ’til it’s over.” Keep this in mind as you enter the strategic acquisition process. Decision dynamics inside acquiring companies constantly shift. The acquisition advocate championing your deal might be fired or might leave for greener pastures. Too often, CEOs have found themselves sucked into the vortex of a promising strategic exit, pouring time and money into it, without a backup plan. When things shift on the acquirer’s side, an acquisition can switch from ‘done deal” to “dead.”
I know a company who agreed to sell to a household-name enterprise. The two parties flew past term sheet, slogged for four months through deep due diligence, hacked through a thicket of tough negotiations to finalize the definitive closing documents, completed a comprehensive post-acquisition integration plan, prepared and approved the press releases, set the date to wire funds and finalized the date of announcement. Four days before the close, the acquiring company’s board voted the acquisition down. This startup CEO had invested the better part seven months and six figures in legal fees, was down to seven weeks of cash runway in the bank, and had no other funding lined up. As of this writing it looks like this company will survive — but only through a highly dilutive emergency inside round executed under duress.
So the biggest advice of all is this: don’t initiate an exit process without at least ten months of cash in the bank. And if the exit is not complete (funds wired) within six months, put the sale on hold and shift your attention to raising another funding round. At no point in the sale process should you allow your cash position to fall below four months of cash runway — all the way up to and including the day of close.
Here are some of the key terms that could arise in a strategic acquisition:
- Valuation and management carve-outs
- Percent cash vs. equity
- Treatment of options if partial equity
- Post-deal employee retention
- Post-deal management compensation
Valuation and management carve-outs
You should prepare for all conceivable valuation scenarios. If an exit is board mandated, and the worst case scenario places valuation below the preference threshold, then you will need to negotiate a management carve-out with your board. You must ensure management gains a benefit for the work of mobilizing the successful exit.
If a sale is preferred but not mandated, you need to establish your walk-away threshold — the valuation point below which the answer is “no deal.” Take the time to figure out the proceeds for each investor (including management) under different valuation assumptions. This will help you devise the exit plan, and determine what to ask of your board.
Percent cash vs. equity
If the acquiring company proposes to include equity in your purchase price, then let’s be clear: you are buying them as much as they are buying you. You must not only establish the valuation of your own company; you must also establish the valuation of theirs. Not all acquiring companies are equal in their growth prospects. Equity is great if the acquiring company grows quickly subsequent to the transaction. If not, equity can quickly prove to be a poor substitute for cash.
Treatment of options if partial equity
Lawyers get paid a lot of money to deal with complexities. One that will come up in a partial-equity transaction is how to deal with employee stock options. Vested shares will need to be exercised and converted into cash and stock. The valuation of the acquiring company will need to be explained and substantiated. Then the unvested options and plan will need to be terminated, or substituted into the acquired company’s options plan.
Sometimes acquirers will bridge a valuation gap by proposing an earnout: “we’ll agree the company is worth that price, as long as you prove you can hit your projections.” The acquirer pays a baseline amount for the company, and then promises more once the team delivers the numbers promised in the plan.
Be careful with earnouts. Once you have sold the company, you no longer have governance over it. If cash is being held hostage to the future results of a business unit you no longer fully control, you are playing tennis with two hands tied behind your back.
Post-Deal Employee Retention
It’s not uncommon for acquisitions to include employee retention incentives and conditions. When the acquisition thesis is based on the capabilities of key team members, you can count on it. In the negotiation of these terms, be sure to include the affected employees. You want to ensure maximum alignment at the outset, to avoid problems down the road.
Post-Deal Management Compensation
Before you get too far, nail down your own compensation plan. You have maximum leverage before you have signed the binding LOI with its no-shop clause, so it’s best to figure it out before then.
What’s your base? What’s your bonus? What does the payout table look like? What factors will drive the at-risk part of your pay? Once you’ve clarified your own compensation, do the same for the rest of your management team.
Creating Success Post Deal
In my book People Design, I dedicated a chapter to integrating acquisitions.² It is worth reading. Suffice it to say that before an acquisition is finalized and announced, the integration should be completely planned. Most importantly, make sure your acquiring company fully understands the implications of the acquisition type (scale, scope, round out or talent). The integration of an acquisition will be radically different depending on what type it is.
1. PitchBook Data, Inc. and National Venture Capital Association, “Venture Monitor | 4Q 2017”, 2017, 26.
2. Tom Mohr, “On Integrating Acquisitions”, People Design, 2018, https://medium.com/ceoquest/chapter-20-330-desks-on-integrating-acquisitions-6f5e091e1e65.
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