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Selling Your Information Technology Company Why Hire an Advisor

People who start software and information technology companies are generally very smart people. When it comes to representing yourself in the sale of your business, the key issue is not smarts, but experience. The purpose of this article is to highlight the intelligence versus experience issue and give examples where experience trumps intelligence. Some very well-known examples were the experiences of the great author, George Plimpton as he stepped into the boxing ring against Joe Louis, put on the goalie pads for the Boston Bruins or barked out signals as the quarterback for the Detroit Lions in a pre-season football game.

These experiences resulted in some great reading. The competitive outcome for the inexperienced combatant, however, was not a happy ending. Curious George was totally outmatched. Admittedly, I had earlier written self-serving articles and Blog posts on the benefits of business seller representation by a Merger and Acquisition Advisor or Business Broker. There are hundreds of similar articles out there from our competitors. The message is pretty much the same:

They know the market and the valuations.

They have an active database of identified buyers.

By representing yourself, you alert the market, your customers,     your competitors, and your employees that you are for sale.

Running a business is a full-time job. Selling a business is also     a full-time job.

A business owner normally conducts a serial process (one buyer at     a time) which dramatically reduces his market feedback and negotiating     position.

It is complex, you may only sell one business in your lifetime     and the buyers are much more experienced than the sellers.

I really want to dissect point number 6 because I don’t believe most business owners fully embrace either the complexity or the consequences of the disparity in experience. First of all, as a generalization, successful business owners are really smart people and have solved myriad complex problems over the years to make their businesses prosper. To many of them, selling their business is just another of those complex problems that they have routinely solved to their advantage. Well, I am a pretty smart guy (my kids might differ), but if my doctor presented me with my lab test results from my physical and asked me to prescribe my treatment, I would refer him to a mental health professional. The point here is not my intelligence, but my level of experience.

Joe Louis spent 10,000 hours perfecting his craft under extreme conditions of competition and pressure. George Plimpton worked in a gym for a couple of weeks with a boxing trainer. If you asked Joe Louis to write a Pulitzer Prize winning novel, you might have to duck a right cross. Both Joe Louis and George Plimpton were geniuses at their craft. They were inexperienced in other areas and were at a distinct disadvantage when trying to compete in another field against the experts in that field.

As I retrieve my third golf ball from the water hazard, I rationalize to myself, “Well at least Tiger Woods can’t run an HP 12C present value calculator like I can. Knowing Tiger Woods, he actually probably can.

Let me try another example of the value of experience to illustrate my point. Have you ever tried mounting a new door? The first time I did it, it took me several hours – getting the special hole drill for the knob and internal mechanism, measuring for hinges, chiseling the slots for the hinges, propping the door and securing it for mounting, etc. Each one of these steps was something new to me and I wasn’t very good at any of them. By my third door mounting, I was starting to become pretty competent. For a business owner, your business sale is your first door.  By the way, that is one very important door.

Now let’s look at the buyers. The first category is the Private Equity Investor. They buy businesses for a living. Ask an average PEG (Private Equity Group) how many deals they look at for every one they actually acquire. They will tell you it is well over 200 different companies. Most of these 200 are dismissed at the start of the process with the teaser or blind profile. They can judge whether the target meets their broad criteria of revenue, EBITDA, profit margins, industry segment, and others.

Many businesses pass their initial screen and they enter the excruciating process of conference calls, detailed data requests on customers, vendors, gross profit by product/customer/vendor, sales by product/customer, top ten customers, top 10 suppliers, percentage of business in the top ten, and on-and on. Many more companies are eliminated in this process. We then proceed to the indication of interest letter (broad statement of the economics of their proposed deal) followed by corporate visits. Once through that process, the surviving targets get additional data requests and follow-up questions. This is not always a one-way elimination. Sometimes the PEG IOI letter is not high enough to make the seller’s cut and they will be eliminated from the process.

The home stretch is submitting a Letter of Intent with a much tighter presentation of the final deal value and structure. This is a competitive process and the seller winnows the suitors down to 1 finalist through back and forth negotiations. Once the highest and best LOI is countersigned by the seller, there is an exclusive period for due diligence. Often the deal blows up in due diligence when a material issue is uncovered and the buyer attempts to alter their original offer in response to this new data. Often times the seller will simply blow up the deal. So the process starts all over.

The point here is that these Private Equity Groups have vast experience, not only in closing deals, but vast experience with every stage of the deal process. So for every deal completed they originally look at 200 teasers that result in the execution of 50 confidentiality agreements and the review of 50 memoranda. 20 of those deals warrant a conference call with the owners and follow up questions. 8 companies survive that process and result in 8 indications of interest letters and 5 corporate visits. 3 companies survive to due diligence and 1 makes it to the finish line. This is a continual moving pipeline of deep deal experience.

As a business owner, by the time you connect with a PEG, they have pretty much seen every twist and turn a deal can take.  Their approach resembles an apartment owner’s rental agreement – tremendously one-sided in their favor. For a PEG, a deal that blows up in the eleventh hour becomes an expensive lesson learned and war story. For a business owner, it can dramatically negatively impact their future business performance.

Wait, you say. I am a software company with the next big thing. My buyer is not a private equity group, but one of the strategic buyers – IBM, Google, Facebook, Adobe, and Microsoft (pick your giant). Let me give you a humbling dose of reality. We have represented some world class technology companies and just getting one of these blue chippers to take a look at them is a monumental task. The primary objective of the M&A department of the giants is to protect the mother ship. They want to prevent entrepreneurs from getting into any potential legal claim on the Blue Chip’s intellectual property.

Therefore they institute a screening process designed to surround the company with a corporate moat around the castle. That moat has different names at each company. At one it is called the “Opportunity Management System”. At another it is the “Partnership Management Department”.

Here is how it works. The individuals in this department are very hard to find and very seldom answer their phone. You are directed to a Website and are required to fill out an exhaustive 16 page submission form. You are then issued a submission number. You then go into the black hole and may be reviewed by a junior level screener that does not have the breadth of experience to judge a Twitter versus a Pets.com.

It gets worse. Every day 100 more “Opportunities” get submitted and piled on top of your number. The only way to get attention is from the Division Manager who owns the functional area where your product fits.  Convince him to go rescue your number and to get your form to a senior opportunity manager to process and vet the idea.

Just like with the PEGs, this is a relentless process of deal flow for these company buyers. Sellers in this environment are on their heels right from the start and struggle to garner any negotiating leverage. If your technology is strong enough to be rescued for a more comprehensive look, the guys on the other side of the table are the heavyweight champions of M&A deals. They have seen it all.

Not to minimize the first 5 benefits identified earlier in this article, but balancing the experience of the buyer’s team with the experience of the seller’s team is critical to enhance, protect and preserve the value of your transaction.

In its purest form, a letter of intent is a document designed to define the economic parameters of a transaction that, pending completion of due diligence, will be memorialized in a definitive purchase agreement and a deal closing. In its practical use, a letter of intent is like an apartment renter’s agreement with every subtle advantage benefitting the author of the document. An inexperienced seller will agree to a seemingly innocuous clause about working capital adjusted at closing according to GAAP accounting rules. If you are the seller of a software company with annual software licenses or prepaid maintenance contracts, that could be a $ million mistake. It is a rare attorney that would ever catch that. Well, not actually. They are all representing the experienced buyers.

 Dave Kauppi is the editor of The Exit Strategist Newsletter and a Merger and Acquisition Advisor and President with MidMarket Capital, Inc. MMC is a private investment banking, merger & acquisition firm specializing in providing corporate finance and intermediary services to entrepreneurs and middle market corporate clients in information technology, software, high tech, and a variety of industries. Dave began his Merger and Acquisition practice after a twenty-year career within the information technology industry.  His varied background includes positions in hardware sales, IT Services (IBM's Service Bureau Corp. and Comdisco Disaster Recovery), Software Sales, computer leasing, datacom, and Internet. The firm counsels clients in the areas of merger and acquisition and divestitures, achieving strategic value, deal structure and terms, competitive negotiations, and “smart equity” capital raises. Dave is a Certified Business Intermediary (CBI), is a registered financial services advisor representative and securities agent with a Series 63 license. Dave graduated with a degree in finance from the Wharton School of Business, University of Pennsylvania. For more information or a free consultation please contact Dave Kauppi at (630) 325-0123, email davekauppi@midmarkcap.com or visit our Web page http://www.midmarkcap.com

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Business Sellers – Avoid These Ten Mistakes

Selling your business is the most important business transaction you will ever make. Mistakes in this process can greatly erode your transaction proceeds. Do not spend twenty years of your toil and skill building your business like a pro only to exit like an amateur. Below are ten common mistakes to avoid: 

1. Selling because of an unsolicited offer to buy – One of the most common reasons owners tell us they sold their business was they got an offer from a competitor. If they previously were not considering this business sale, the owner has probably not taken some important personal and business steps to exit on his terms. The business may have some easily correctable issues that could detract from its value. The owner may not have prepared for an identity and lifestyle to replace the void caused by his separation from his company. If you are prepared, you are more likely to exit on your own terms. 

2. Poor books and records – Business owners wear many hats. Sometimes they become so focused on running the business that they are lax in financial record keeping. A buyer is going to do a comprehensive look into your financial records. If they are done poorly, the buyer loses confidence in what he is buying and his perception of risk increases. If he finds some negative surprises late in the process, the purchase price adjustments can be harsh. The transaction value is often attacked well beyond the economic impact of the surprise. Get a good accountant to do your books. 

3. Going it alone – The business owner may be the foremost expert in his business, but it is likely that his business sale will be a once in a lifetime occurrence. Mistakes at this juncture have a huge impact. Do you understand the difference in after tax proceeds between an asset sale and a stock sale? Your everyday bookkeeper may not, but a tax accountant surely does. Is your business attorney familiar with business sales legal work? Would he advise you properly on Reps and Warranties that will be in the purchase agreement? Your buyer’s team will have this experience. Your team should match that experience of it will cost you way more than their fees. 

4. Skeletons in the closet - If your company has any, the due diligence process will surely reveal them. Before your firm is turned inside out and the buyer spends thousands in this process and before the other interested buyers are put on hold – reveal that problem up-front. We sold a company that had an outstanding CFO. In the first meeting with us, he told us of his company’s under funded pension liability. We were able to bring the appropriate legal and actuarial resources to the table and give the buyer and his advisors plenty of notice to get their arms around the issue. If this had come up late in the process, the buyer might have blown up the deal or attacked transaction value for an amount far in excess of the potential liability. 

5. Letting the word out - Confidentiality in the business sale process is crucial. If your competitors find out, they can cause a lot of damage to your customers and prospects. It can be a big drain on employee morale and productivity. Your suppliers and bankers get nervous. Nothing good happens when the work gets out that your company is for sale. 

6. Poor Contracts – Here we mean the day-to-day contracts that are in place with employees, customers, contractors, and suppliers. Do your employees have non-competes, for example? If your company has intellectual property, do you have very clear ownership rights defined in your employee and contractor agreements. If not, you could be looking at meaningful escrow holdbacks post closing. Are your customer agreements assignable without consent? If they are not, customers could cancel post transaction. Your buyer will make you pay for this one way or another. 

7. Bad employee behavior – You need to make sure you have agreements in place so that employees cannot hold you hostage on a pending transaction. Key employees are key to transaction value. If you suspect there are issues, you may want to implement stay on bonuses. If you have a bad actor, firing him or her during a transaction could cause issues. You may want to be pre-emptive with your buyer and minimize any damage your employee might cause. 

8. No understanding of your company’s value – Business valuations are complex. A good business broker or M & A advisor that has experience in your industry is your best bet. Business valuation firms are great for business valuations for gift and estate tax situations, divorce, etc. They tend to be very conservative and their results could vary significantly from your results from three strategic buyers in a battle to acquire your firm. When it comes to selling your company, let the competitive market provide a value. 

9. Getting into an auction of one – This is a silly visual, but imagine a big auction hall at Sotheby’s occupied by an auctioneer and one guy with an auction paddle. “Do I hear $5 million? Anybody $5.5 million?’ The guy is sitting on his paddle. Pretty silly, right? And yet we hear countless stories about a competitor coming in with an unsolicited offer and after a little light negotiating the owner sells. Another common story is the owner tells his banker, lawyer, or accountant that he is considering selling. His well-meaning professional says, “I have another client that is in your business. I will introduce you.” The next thing you know the business is sold. Believe me, these folks are buying you business at a big discount. That’s not silly at all! 

10. Giving away value in negotiations and due diligence – When selling your business, your objective is to get the best terms and conditions. I know this is a shocker, but the buyer is trying to pay as little as possible and he is trying to get contractual terms favorable to him. These goals are not compatible with yours. The buyer is going to fight hard on issues like total price, cash at close, earn outs, seller notes, reps and warranties, escrow and holdbacks, post closing adjustments, etc. If you get into a meet in the middle compromise negotiation, before you know it, your Big Mac is a Junior Cheeseburger. Due diligence has a dual purpose. The first is obviously to insure that the buyer knows exactly what he is paying for. The second is to attack transaction value with adjustments. Of course this happens after their LOI has sent the other bidders away for 30 to 60 days of exclusivity. If you don’t have a good team of advisors, this can get expensive 

As my dad used to say, there is no replacement for experience. Another saying is that when a man with money and no experience meets a man with experience, the man with the experience walks away with the money and the man with the money walks away with some experience. Keep this in mind when contemplating the sale of your business. It will likely be your first and only experience. Avoid these mistakes and make that experience a profitable one.

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For More Details please visit our website at http://www.midmarkcap.com/mmc and subscribe to our Exit Strategist Newsletter.

Call Me at: 630-325-0123

Email Us: davekauppi@midmarkcap.com

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Understanding the Letter of Intent (LOI) in the Sale of a Business

By David M. Kauppi, CBI, President MidMarket Capital

 The letter of intent is an essential step in facilitating the sale of a business. The purpose is to establish the economic framework for buyer and business seller to move to the due diligence phase. It basically says that with all the available information I have thus far seen and if that all stands the scrutiny of due diligence, I am willing to buy your business for X dollars under Y payment terms. It is however, non- binding pending the execution of mutually acceptable purchase agreements.

 If I am a seller, I am going to insist that I have this letter establishing the economics of the deal before I agree to allow my company to be turned inside out with buyer staff and advisors. If, as the seller, I want $5 million and the LOI specifies $4.5 million, I am going to attempt to negotiate up before I counter sign this letter.  If I am still short on price and terms, I continue to sell the company to other interested buyers.

 If I am the buyer, I want the seller to commit to my economic parameters before I spend thousands going through due diligence. The other important element of the LOI from the buyer’s perspective is exclusivity. The buyer will lock up this company for a period of from 30 days to 90 days to complete their due diligence and execute mutually agreeable definitive purchase agreements.  That means that in return for the time, effort and expense of due diligence, the seller and his business broker or merger and acquisition advisor are not allowed to actively market the business to other interested parties.

 If you are the seller and you get your LOI, don’t celebrate yet. Make sure the financials that the buyer is analyzing to come up with his offer are professionally done using GAAP.  Normally a measuring point is established in the LOI with those financials for net working capital. There will be an adjustment made to the transaction value (post closing adjustments) depending on the new net working capital balance post close.

 If the buyer is looking at sales forecasts prior to submitting his LOI, make sure they are conservative and accurate. If you have some major sales losses or the pipeline moves to the right (they always do) some buyers may attempt to call that a material adverse change and look for an adjustment in purchase price.

 Finally, the LOI is normally a three to seven page document without a lot of legal boilerplate. The purchase agreements that follow will take care of that. So expect 30 pages or more. Focus your efforts on the economic parameters and conserve your legal budget. You will need your attorney most for his help with the purchase agreements.

Dave Kauppi is the editor of The Exit Strategist Newsletter and a Merger and Acquisition Advisor and President with MidMarket Capital, Inc. MMC is a private investment banking, merger & acquisition firm specializing in providing corporate finance and intermediary services to entrepreneurs and middle market corporate clients in information technology, software, high tech, and a variety of industries. Dave began his Merger and Acquisition practice after a twenty-year career within the information technology industry.  His varied background includes positions in hardware sales, IT Services (IBM's Service Bureau Corp. and Comdisco Disaster Recovery), Software Sales, computer leasing, datacom, and Internet. The firm counsels clients in the areas of merger and acquisition and divestitures, achieving strategic value, deal structure and terms, competitive negotiations, and “smart equity” capital raises. Dave is a Certified Business Intermediary (CBI), is a registered financial services advisor representative and securities agent with a Series 63 license. Dave graduated with a degree in finance from the Wharton School of Business, University of Pennsylvania. For more information or a free consultation please contact Dave Kauppi at (630) 325-0123, email davekauppi@midmarkcap.com or visit our Web page http://www.midmarkcap.com

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Valuing The Growth Rate in the Sale of a Technology Company

By Dave Kauppi, President, MidMarket Capital, Inc.

In the sale of privately held businesses there seems to be no mechanism and certainly no attempt on the part of buyers to account for the selling company's growth rate. In the public market this factor is widely recognized and is accounted for with an improvement on the PE multiple, the PEG or Price Earnings Growth multiple. Because there is no exact translation between EBITDA multiple (the primary valuation metric for privately held companies) and Earnings Per Share and PE multiple (the primary valuation metric for publicly traded stocks), the purpose of this article is to try to calculate an adjustment factor that can be applied against the EBITDA valuation metric in order to present a more accurate accounting for differences in growth rate for the valuation of privately held companies.

Experienced business buyers are masters of setting the rules for how they calculate the value of a business they are attempting to acquire. You may think that a 5 X multiple of EBITDA or 1 X Sales would be pretty cut and dried, but in practice it is open for creative interpretation. For example, if you just had your best year ever and your EBITDA was $2 million and the market valuation was 5 X, then you would expect a $10 million offer. Not so fast. The buyer may counter with, "That last year was an anomaly and we should normalize EBITDA performance as an average of the last three years." That average turns out to be $1.5 million and like magic your purchase offer evaporates to $7.5 million. On the flip side, if you just had your worst year at $1 million EBITDA, you can bet the buyer will use that as your metric for value.

The three owners paid themselves $100,000 each in salary, but the buyer asserts that the fair market value salary for a replacement for each senior manager is really $150,000. They apply this total $150,000 EBITDA adjustment and your valuation drops by another $750,000. If the family owns the building separately and rents it to the business for an annual rent of $200,000 when the FMV rental rate is $300,000, the resulting adjustment costs the seller another $500,000 in lost value.

Another valuation trap for a seller is that they want to hire additional sales resources to pump up their sales just prior to the sale. This is almost always a bad move. Most technology sales reps take a year or longer to ramp up to productivity. In the interim, with salary and some draw or guarantee, they actually become a drain on earnings. The buyers do not care about the explanation, they just care about the numbers and will whack you with a value downgrade.

The least understood valuation trap, however, is there seems to be no mechanism and certainly no attempt on the part of buyers to account for the selling company's growth rate. In the public market this factor is widely recognized and is accounted for with an improvement on the PE multiple, the PEG or Price Earnings Growth multiple. The rule of thumb is that if the stock is valued with a PEG of less than 1 then it is a good value and if it is over 1 it is not as good.

Because there is no exact translation between EBITDA multiple (the primary valuation metric for privately held companies) and Earnings Per Share and PE multiple (the primary valuation metric for publicly traded stocks), please allow me a measure of imprecision in my analysis. My purpose is to try to calculate an adjustment factor that can be applied against the EBITDA valuation metric in order to present a more accurate accounting for differences in growth rate for the valuation of privately held companies.

I have chosen two stocks for my analysis, Google and Facebook. The reason I choose these two is that they are widely known, very successful, in the same general market niche, and are at different stages of their growth cycle. Google sells at a PE multiple of 33.37 while Facebook sells for a PE multiple of 113.71. The PEG of Google which = PE Multiple/5 year growth rate is 33.37/16.85 for a PEG of 1.98. I actually backed into the growth rate using the readily available PE multiple and the PEG from my Fidelity account.

Facebook sells at a PE multiple of 113.71 and has a PEG ratio of 3.62 (may be some irrational exuberance here), which translates into a 5 year growth rate of 31.41%. For our comparison we should also include the average PE multiple for the S&P 500 of about 15. Let's make the assumption that on average, this assumes that these companies will grow at the growth rate of the U.S. Economy, say 3%.

So to calculate a normalized PE ratio for these two companies, we are going to create an adjustment factor by dividing the 5 year compound growth rate of Google and Facebook versus the anticipated 5 year compound growth rate of the S&P 500. For Google the 16.85% growth rate over 5 years creates a factor or 2.178 or a total of 217.8% total growth over the next 5 years. The S&P factor is 1.16. So if you divide the Google factor by the S&P factor you get 1.878. If you multiple the market PE multiple of 15 by the Google factor, the result is a PE of 28.2. Not too far off from the current PE multiple of 33.37

Facebook is a little off using this method resulting in a normalized calculated PE of 50.65 versus their current rate of 113.71. This will appropriately seek a level over time and settle into a more rational range. My point here is that the public markets absolutely account for growth rates in the value of stocks in a very significant way.

Now let's try to apply this same logic to the EBITDA multiple for valuing a privately held technology company. If the rule-of-thumb multiple for your company's valuation is 5 X EBITDA but you are growing at 10% compounded, shouldn't you receive a premium for your company. Using the logic from above we assign a 3% compound growth rate as the norm in the 5 X EBITDA metric. So the 10% grower gets a factor of 1.61 versus the norm of 1.16. Dividing the target company factor by the normalized factor results in a multiple acceleration factor of 1.39. Multiply that by the Standard 5 X EBITDA multiple and you get a valuation metric of 6.95 X EBITDA.

A little sobering news, however, you will have a real challenge convincing a financial buyer or a Private Equity Group to veer to far away from their rule of thumb multiples. You will have a better chance of moving a strategic technology company buyer with this approach.  A discounted cash flow valuation technique is superior to the rule of thumb multiple approach because it accounts for this compound growth rate in earnings. If the technique produces a higher value for the seller, the buyer will keep that valuation tool in his toolbox.

Perhaps the best way to negotiate a projected high growth rate and translate that into transaction value is with a hybrid deal structure. You might agree to a cash at close valuation of 5 X EBITDA and then create an upside kicker based on hitting your growth targets.

So for example, your EBITDA is $2 million and your standard industry metric is 5X EBITDA. You believe that your 10% growth rate (clearly above the industry average) should provide you a premium value of 6 X.  So the value differential is $10 million versus $12 million. You set a target of a 10% compounded growth in Gross Profit over the next 4 years and you calculate an earn out payment methodology that would provide an additional $2 million in transaction value if you hit the targets. It is a contingent payment based on actual post closing performance, so if you fall short of targets you fall correspondingly short on your earn out. If you exceed target you could earn more.

Successful buyers do not remain as successful buyers if they over pay for an acquisition. Therefore, the lower the price they pay, the greater their odds of chalking up a win. This is a zero sum game in that each dollar that stays in their pocket is one less dollar in your pocket. They will utilize every tool at their disposal to convince the seller that "this is market" or this is "how every industry buyer values similar companies."  It is to your advantage to help move them toward your value expectations. That is a very hard thing to accomplish unless you have other buyers and can walk away from a low offer. Believe me, if they are looking at you, they are doing the same dance with at least a couple of others. You must match their negotiation leverage by having your own options.

 Dave Kauppi is the editor of The Exit Strategist Newsletter and a Merger and Acquisition Advisor and President with MidMarket Capital, Inc. MMC is a private investment banking, merger & acquisition firm specializing in providing corporate finance and intermediary services to entrepreneurs and middle market corporate clients in information technology, software, high tech, and a variety of industries. Dave began his Merger and Acquisition practice after a twenty-year career within the information technology industry.  His varied background includes positions in hardware sales, IT Services (IBM's Service Bureau Corp. and Comdisco Disaster Recovery), Software Sales, computer leasing, datacom, and Internet. The firm counsels clients in the areas of merger and acquisition and divestitures, achieving strategic value, deal structure and terms, competitive negotiations, and “smart equity” capital raises. Dave is a Certified Business Intermediary (CBI), is a registered financial services advisor representative and securities agent with a Series 63 license. Dave graduated with a degree in finance from the Wharton School of Business, University of Pennsylvania. For more information or a free consultation please contact Dave Kauppi at (630) 325-0123, email davekauppi@midmarkcap.com or visit our Web page http://www.midmarkcap.com

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An Alternative to Venture Capital for the Technology Entrepreneur

By Dave Kauppi, President MidMarket Capital, Inc.

 If you are an entrepreneur with a small technology based company looking to take it to the next level, this article should be of particular interest to you. Your natural inclination may be to seek venture capital or private equity to fund your growth. According to Jim Casparie, founder and CEO of the Venture Alliance, the odds of getting Venture funding remain below 3%. Given those odds, the six to nine month process, the heavy, often punishing valuations, the expense of the process, this might not be the best path for you to take. We have created a hybrid M&A model designed to bring the appropriate capital resources to you entrepreneurs. It allows the entrepreneur to bring in smart money and to maintain control. We have taken the experiences of several technology entrepreneurs and combined that with our traditional investment banker Merger and Acquisition approach and crafted a model that both large industry players and the high tech business owners are embracing.

 Our experiences in the technology space led us to the conclusion that new product introductions were most efficiently and cost effectively the purview of the smaller, nimble, low overhead companies and not the technology giants. Most of the recent blockbuster products have been the result of an entrepreneurial effort from an early stage company bootstrapping its growth in a very cost conscious lean environment. The big companies, with all their seeming advantages experienced a high failure rate in new product introductions and the losses resulting from this art of capturing the next hot technology were substantial. Don’t get us wrong. There were hundreds of failures from the start-ups as well. However, the failure for the edgy little start-up resulted in losses in the $1 - $5 million range. The same result from an industry giant was often in the $100 million to  $250 million range.

 For every Google, Ebay, or Salesforce.com, there are literally hundreds of companies that either flame out or never reach a critical mass beyond a loyal early adapter market. It seems like the mentality of these smaller business owners is, using the example of the popular TV show, Deal or No Deal, to hold out for the $1 million briefcase. What about that logical contestant that objectively weighs the facts and the odds and cashes out for $280,000?

 As we discussed the dynamics of this market, we were drawn to a merger and acquisition model commonly used by technology bell weather, Cisco Systems, that we felt could also be applied to a broad cross section of companies in the high tech niche. Cisco Systems is a serial acquirer of companies. They do a tremendous amount of R&D and organic product development. They recognize, however, that they cannot possibly capture all the new developments in this rapidly changing field through internal development alone.

 Cisco seeks out investments in promising, small, technology companies and this approach has been a key element in their market dominance. They bring what we refer to as smart money to the high tech entrepreneur. They purchase a minority stake in the early stage company with a call option on acquiring the remainder at a later date with an agreed-upon valuation multiple. This structure is a brilliantly elegant method to dramatically enhance the risk reward profile of new product introduction. Here is why:

 For the Entrepreneur: (Just substitute in your technology industry giant’s name that is in your category for Cisco below)

  The involvement of Cisco – resources, market presence, brand, distribution capability is a self fulfilling prophecy to your product’s success.

For the same level of dilution that an entrepreneur would get from a VC, angel investor or private equity group, the entrepreneur gets the performance leverage of “smart money.” See #1.

The entrepreneur gets to grow his business with Cisco’s support at a far more rapid pace than he could alone. He is more likely to establish the critical mass needed for market leadership within his industry’s brief     window of opportunity.

He gets an exit strategy with an established valuation metric while the buyer helps him make his exit much more lucrative.

As an old Wharton professor used to ask, “What would you rather have, all of a grape or part of a watermelon?” That sums it up pretty well. The   involvement of Cisco gives the product a much better probability of     growing significantly. The entrepreneur will own a meaningful portion of a  far bigger asset.

 For the Large Company Investor:

  Create access to a large funnel of developing technology and products.

Creates a very nimble, market sensitive, product development or R&D arm.

Minor resource allocation to the autonomous operator during his “skunk works” market proving development stage.

Diversify their product development portfolio – because this approach provides for a relatively small investment in a greater number of opportunities fueled by the entrepreneurial spirit, they greatly improve the probability of creating a winner.

By investing early and getting an equity position in a small company and favorable valuation metrics on the call option, they pay a fraction of the   market price to what they would have to pay if they acquired the company once the product had proven successful.

 Let's use two hypothetical companies to demonstrate this model, Big Green Technologies, and Mobile CRM Systems. Big Green Technologies utilized this model successfully with their investment in Mobile CRM Systems. Big Green Technologies acquired a 25% equity stake in Mobile CRM Systems in 1999 for $4 million. While allowing this entrepreneurial firm to operate autonomously, they backed them with leverage and a modest level of capital resources. Sales exploded and Big Green Technologies exercised their call option on the remaining 75% equity in Mobile CRM Systems in 2004 for $224 million. Sales for Mobile CRM Systems were projected to hit $420 million in 2005.

 Given today’s valuation metrics for a company with Mobile CRM Systems' growth rate and profitability, their market cap is about $1.26 Billion, or 3 times trailing 12 months revenue. Big Green Technologies invested $5 million initially, gave them access to their leverage, and exercised their call option for $224 million. Their effective acquisition price totaling $229 million represents an 82% discount to Mobile CRM Systems' 2015 market cap.

 Big Green Technologies is reaping additional benefits. This acquisition was the catalyst for several additional investments in the mobile computing and content end of the tech industry. These acquisitions have transformed Big Green Technologies from a low growth legacy provider into a Wall Street standout with a growing stable of high margin, high growth brands.

 Big Green Technologies' profits have tripled in four years and the stock price has doubled since 2009, far outpacing the tech industry average. This success has triggered the aggressive introduction of new products and new markets. Not bad for a $5 million bet on a new product in 2009.  Wait, let’s not forget about our entrepreneur. His total proceeds of $229 million are a fantastic 5- year result for a little company with 2009 sales of under $20 million.

 MidMarket Capital has borrowed this model combining the Cisco hybrid acquisition experience with our investment banking experience to offer this unique Investment Banking service. MMC can either represent the small entrepreneurial firm looking for the “smart money” investment with the appropriate growth partner or the large industry player looking to enhance their new product strategy with this creative approach. This model has successfully served the technology industry through periods of outstanding growth and market value creation. Many of the same dynamics are present today in the high tech industry and these same transaction structures can be similarly employed to create value.

 MidMarket Capital, Inc., MMC is an M&A Advisory firm specializing in providing corporate finance and investment banking services to entrepreneurs and middle market corporate clients in the high tech, and select niche markets. The firm counsels clients in the areas of mergers, acquisitions and divestitures, creative transaction structure, valuations, corporate growth and turnarounds. Dave began Mergers and Acquisitions practice after a twenty-year career within the financial and information technology industries. Contact Dave Kauppi (630) 325-0123 http://www.midmarkcap.com davekauppi@midmarkcap.com

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Business Sellers – What are Qualified Buyers?

By David M. Kauppi, CBI, President Mid Market Capital

If you are a business owner considering selling your business most likely you will interview several business brokers or merger and acquisition advisors. In the process you might hear, "We have lists of qualified buyers." Some potential business sellers find this phrase almost hypnotic. It congers visions of this group of well funded, anxious buyers who can't wait to pay a generous price the moment they are made aware of this great opportunity.

Let's lift up the covers and look a little closer. If this is a business broker who handles main street type businesses like convenience stores, dry cleaners, salons, and restaurants, he is typically selling to an individual who is buying a job. If the broker is one that does not charge an up-front or a monthly engagement fee, he is agreeing to work for a success fee only. To improve their odds of getting some success fees these contingent fee brokers take on dozens of clients.

With dozens of clients, the broker can't really afford to engage in the labor intensive M&A process. Instead he can only list the business. Listing would include posting it on several "business for sale" web sites, placing an ad in the business opportunities section of the paper and putting the word out to his network of professional contacts and lists of "qualified buyers". These lists are the result of capturing the contact information from individual buyers that resulted from years of this passive listing process.

They have lists because these people almost never buy.  Here is why. The business has to be priced low enough and generate enough cash so that it will provide debt coverage (assuming the business has enough hard assets to collateralize a loan), provide a generous return for the buyer's equity, and finally exceed their career high salary when they worked for the fortune 500 employer. On top of that, the business should have a healthy growth rate and not be in a commodity type of business.

The business brokers do qualify these buyers by requiring them to complete a financial disclosure form and a confidentiality agreement. They make sure they have some money, but they have no way of qualifying whether they will actually part with that money. Individual buyers typically pay the lowest valuation multiples when they do buy a business.

For the larger business owners that are interviewing M&A firms, this "qualified buyers" claim takes on a different meaning.  These M&A firms have lists of hundreds of private equity firms with their buying criteria, business size requirements, minimum revenue and EBITDA levels and industry preferences. All M&A firms have pretty much the same list. There are subscription databases available to anyone. The better M&A firms have refined these lists and entered them into a good contact management system so they are more easily searchable.

The approach these M&A firms with these Private Equity lists employ is to blast an email profile to their list and if they get an immediate and robust response, they will focus on the deal and work the deal. What happens to the 90% of sale transactions that clearly do not fit either the minimum EBITDA and revenue requirements or the conservative valuations of this group of buyers? Those deals requiring contact with strategic industry buyers usually go into dormant status. They will not be actively worked, but will occasionally be presented in another email campaign, mail campaign or at a private equity deal mart (industry meeting where many M&A firms present their clients to several PEG's).

For the business owner that has paid a substantial up front engagement fee or healthy monthly fees, this is not what you had in mind. The way to get a business sold is to reach the strategic industry buyers. That is not easy. Presidents of companies (the buyer decision maker) do not open mail from an unknown party. So, mailings do not work. Let me repeat that. In a merger and acquisition transaction, mailings do not work.

Presidents of companies do everything possible to keep their email addresses confidential, so email blasts on a broad scale are not possible. Telemarketers are not skilled enough to pass through the voice mail and assistant screening gauntlet. If you have ever tried to present an acquisition opportunity to IBM, Microsoft, Google, Hewlett-Packard or Apple, let's just say it would be easier to get into a castle with a moat full of alligators.

The investment bankers from Morgan Stanley or Goldman Sachs can generally get an audience with any major CEO. However, the fees they charge limit their clientele to businesses with north of $1 billion in revenues. So how do $15 million in revenue businesses get sold? You need to locate a boutique M&A firm that will provide a Wall Street style active selling process at a size appropriate fee structure.

What does this mean? The approach that consistently produces a high percentage of completed transactions is the most labor intensive and costs the most to deliver. It is an old fashioned, IBM, dialing for dollars effort, starting at the presidential level of the targeted strategic buyers. It usually takes ten phone dials and a great deal of finesse to penetrate the gauntlet and get a forty five second credibility opportunity with the right contact.

If you are able to pass that test and establish their interest, you ask them for their email address so you can send them the blind profile (two page business summary without the company identity) and confidentiality agreement. This is a qualifying test. The president will not give you their email address unless they have real interest and you have established your professional credibility.

If the president is not the appropriate contact, his assistant will generally direct you to the correct party. When that happens, we update our contact management database with this information so on the next M&A engagement we go directly to the proper contact.

Our first engagement in an industry requires a great deal of this discovery process. With each subsequent engagement in an industry, we become increasingly efficient and improve our credibility and brand awareness. There is generally an advantage of engaging an M&A firm that has experience in your industry. After several transactions in a niche, we become that more efficient and effective. Our list truly becomes a list of "qualified buyers."

For example, by our fourth engagement in healthcare information technology, we know the specialty of the top 300 players, we know the lead on M&A deals, we know his direct dial number, email address, and most importantly he knows us.

So there are lists of qualified buyers and there are lists of qualified buyers. When selling your business, make sure that you engage a firm that truly has a list of qualified buyers.

Dave Kauppi is the editor of The Exit Strategist Newsletter and a Merger and Acquisition Advisor and President with MidMarket Capital, Inc. MMC is a private investment banking, merger & acquisition firm specializing in providing corporate finance and intermediary services to entrepreneurs and middle market corporate clients in information technology, software, high tech, and a variety of industries. Dave began his Merger and Acquisition practice after a twenty-year career within the information technology industry.  His varied background includes positions in hardware sales, IT Services (IBM's Service Bureau Corp. and Comdisco Disaster Recovery), Software Sales, computer leasing, datacom, and Internet. The firm counsels clients in the areas of merger and acquisition and divestitures, achieving strategic value, deal structure and terms, competitive negotiations, and “smart equity” capital raises. Dave is a Certified Business Intermediary (CBI), is a registered financial services advisor representative and securities agent with a Series 63 license. Dave graduated with a degree in finance from the Wharton School of Business, University of Pennsylvania. For more information or a free consultation please contact Dave Kauppi at (630) 325-0123, email davekauppi@midmarkcap.com or visit our Web page http://www.midmarkcap.com

[davidkauppi-blog]

SELLING YOUR TECHNOLOGY COMPANY WHY EARNOUTS MAKE SENSE TODAY

The purpose of this article is to present earnouts to sellers of technology companies as a method to maximize their transaction proceeds.  Sellers have historically viewed earnouts with suspicion as a way for buyers to get control of their companies cheaply.  An intelligently structured earnout not only can facilitate the closing of a deal, but can be a win for both buyer and seller.

 The purpose of this article is to present earnouts to sellers of technology companies as a method to maximize their transaction proceeds. Sellers have historically viewed earnouts with suspicion as a way for buyers to get control of their companies cheaply. Earnouts are a variable pricing mechanism designed to tie final sale price to future performance of the acquired entity and are tied to measurable economic milestones such as revenues, gross profit, net income and EBITDA. An intelligently structured earnout not only can facilitate the closing of a deal, but can be a win for both buyer and seller.  Below are ten reasons earnouts should be considered as part of your selling transaction structure.

 Buyers acquisition multiples are at pre 1992 levels. Strategic corporate buyers, private equity groups, and venture capital firms got burned on valuations.  Between 1995 and 2001 the premiums paid by corporate buyers in 61% of transactions were greater than the economic gains. In other words, the buyer suffered from dilution.  During the 2008 - 2013 period, multiples paid by financial buyers were almost equal to strategic buyers multiples. This is not a favorable pricing environment for tech companies looking for strategic pricing.

 Based on the bubble, there is a great deal of investor skepticism.They no longer take for granted integration synergies and are weary about cultural clashes, unexpected costs, logistical problems and when their investment becomes accretive. If the seller is willing to take on some of that risk in the form of an earnout based on integrated performance, he will be offered a more attractive package (only if realistic targets are set and met).

 Many tech companies are struggling and valuing them based on     income will produce some pretty unspectacular results.  A buyer will be far more willing to look at an acquisition candidate using strategic multiples if the seller is willing to take on a portion of the post closing performance risk. The key stakeholders of the seller have an incentive to stay on to make their earnout come to fruition, a situation all buyers desire.

 An old business professor once asked, “What would you rather have,     all of a grape or part of a watermelon?”The spirit of the entrepreneur causes many tech company owners to go it alone.The odds are against   them achieving critical mass with current resources.  They could grow organically and become a grape or they could integrate with a strategic acquirer and achieve their current distribution times 100 or 1000. Six % of this new revenue stream will far surpass 100% of the old one.

 How many of you have heard of the thrill of victory and the agony of defeat of stock purchases at dizzying multiples? It went something like this – Public Company A with a stock price of $50 per share buys Private Company  B for a 15 x EBITDA multiple in an all stock deal with a one-year restriction on sale of the stock.Lets say that the resultant sales     proceeds were 160,000 shares totaling $8 million in value.Company A’s stock goes on a steady decline and by the time you can sell, the price is $2.50.  Now the effective sale price of your company becomes $400,000.Your 15 x  EBITDA multiple evaporated to a multiple of less than one.Compare that result to  $5 million cash at close and an earnout that totals $5 million over the next 3 years if revenue targets for your     division are met.Your minimum guaranteed multiple is 9.38 x with an upside of 18.75x.

 Strategic corporate buyers are reluctant to use their devalued stock as the currency of choice for acquisitions.Their preferred currency is cash. By agreeing to an earnout, you give the buyer’s cash more velocity (ability to make more acquisitions with their cash) and therefore become a more attractive candidate with the ability to ask for greater compensation in the future.

 The market is starting to turn positive which reawakens sellers’     dreams of bubble type multiples.The buyers are looking back to the historical norm or pre-bubble pricing.The seller believes that this market deserves a premium and the buyers have raised their standards     thus hindering negotiations.  An earnout is a way to break this impasse.     The seller moves the total selling price up.The buyer stays within their guidelines while potentially paying for the earnout premium with dollars that are the result of additional earnings from the new acquisition.

 The improving market provides both the seller and the buyer growth     leverage.When negotiating the earnout component, buyers will be very generous in future compensation if the acquired company exceeds their projections.  Projections that look very aggressive for the seller with their pre-merger resources, suddenly become quite attainable as part of a new company entering a period of growth.An example might look like this:  Oracle acquires a small software Company B that has developed Oracle conversion and integration software tools. Last year Company B had sales of  $8 million and EBITDA of $1 million.Company B had grown by 20% per year.  The purchase transaction was structured to provide Company B $8 million of Oracle stock and $2 million cash at close plus an earnout that would pay Company B a % of $1 million a year for the next 3 years based on their achieving a 30% compound growth rate in sales. If Company B hit sales of  $10.4,$13.52, and $17.58 million respectively for the next 3 years, they would collect another $3 million in transaction value.The seller now expands his client base from 200 to 100,000 installed accounts and his sales force from 4 to 5,000.  Those targets should be very easy to hit.Lets assume that through     synergies, the buyer improves net margins to 20% of sales and the     acquisition produces $2.08, $2.70, and $3.52 million of additional profits respectively.They easily finance the earnout with extra profit.

 The window of opportunity in the technology area opens and closes     very quickly.  An earnout structure can allow both the buyer and seller to benefit.  If the smaller company has developed a winning technology, they usually have a short period of time to establish a lead in the market. If they are addressing a compelling technology gap, the odds are that companies both large and small are developing their own solution simultaneously.The seller wants to develop the potential of the product to put up sales numbers to drive up the company’s selling price.They do not have the distribution channels, the resources, or time to compete with a larger company with a similar solution looking to establish the industry standard.A larger acquiring company recognizes this first mover advantage and is willing to pay a buy versus build premium to reduce their time to market. The seller wants a large premium while the buyer is not willing to pay full value for projections with stock and cash at close. The solution: an earnout for the seller that handsomely rewards him for meeting those projections.He gets the resources and distribution capability of the buyer so the product can reach standard setting critical mass before another large company can knock it off. The buyer gets to market quicker and achieves first mover advantage while incurring only a portion of the risk of new product development and introduction.

 You never can forget about taxes. Earnouts provide a vehicle to defer and reduce the seller’s tax liability. Be sure to discuss your potential deal structure and tax consequences with your advisors before final negotiations begin.  A properly structured earnout could save you significant tax dollars.

Smaller technology companies have many characteristics that make them good candidates for earnouts in sale transactions: 1. High growth rates 2. Earnings not supportive of maximum valuations 3. Limited window of opportunity to achieve meaningful market penetration 4. Buyers less willing to pay for future potential entirely at the sale closing 5. A valuation expectation far greater than those supported by the buyers.  It really comes down to how confident the seller is in the performance of his company in the post sale environment.  If the earnout targets are reasonably attainable and the earnout compensates him for the at risk portion of transaction value, a seller can significantly improve the likelihood of a sale closing and the transaction value.

 Dave Kauppi is the editor of The Exit Strategist Newsletter and a Merger and Acquisition Advisor and President with MidMarket Capital, Inc. MMC is a private investment banking, merger & acquisition firm specializing in providing corporate finance and intermediary services to entrepreneurs and middle market corporate clients in information technology, software, high tech, and a variety of industries. Dave began his Merger and Acquisition practice after a twenty-year career within the information technology industry.  His varied background includes positions in hardware sales, IT Services (IBM's Service Bureau Corp. and Comdisco Disaster Recovery), Software Sales, computer leasing, datacom, and Internet. The firm counsels clients in the areas of merger and acquisition and divestitures, achieving strategic value, deal structure and terms, competitive negotiations, and “smart equity” capital raises. Dave is a Certified Business Intermediary (CBI), is a registered financial services advisor representative and securities agent with a Series 63 license. Dave graduated with a degree in finance from the Wharton School of Business, University of Pennsylvania. For more information or a free consultation please contact Dave Kauppi at (630) 325-0123, email davekauppi@midmarkcap.com or visit our Web page http://www.midmarkcap.com