Confessions of a Corporate Dealmaker

Farewell

Well, it's back to work for me.  I know I haven't posted in a month, and the reason is that I have been in negotiations for a new job.  Therefore, I thought it prudent to take time off from writing.  I have accepted the job and will now be overseeing all M&A efforts for a public company.  Unfortunately this will not allow me to continue with "Confessions." 

Thanks to all my subscribers and readers.  I appreciate all of the comments and really enjoyed electronically meeting many of you.  I have been completely overwhelmed by positive responses and support - thanks for reading!  I honestly hope our paths' cross someday.

I will keep the site live for another month, so enjoy and farewell to all of you.

Regards,

Lorne

Management Evolution - CFO Part II

One of the great things about being a privately-held company is that you don't have to worry about Sarbanes-Oxley, right?  Well, not if you are considering a sale.  The fact is if an exit is in your near-term horizon (next three years), you should take the financial controls mandated under Sarbanes-Oxley very seriously.  As part of evolving your management team, this means hiring a CFO who has experience in creating a strong control environment.  I don't think prior SOX experience is as important as prior experience putting in place and running financial systems.  The problem with SOX is not its complexity, it's the vague nature of it that makes it so hard to interpret.

As a corporate buyer, it is very important to me that a target has taken the time to implement internal control and financial reporting systems that are compliant with SOX.  In addition, those systems should be in place for more that just a few months or a year prior to the sale.  Due diligence is a disastrous time to start making your company SOX compliant.  That will surely delay the closing by several months and cost you a lot of money.

I think private targets that can prove compliance with the requirements of Sections 302 and 404 are worthy of a valuation premium that would out-weight the costs of such implementation.

Why is this so important?  Well, Section 302 requires that the CEO and CFO of a publicly-held company certify the financial results and internal controls of the company, including any acquisitions made during that quarter.  Section 404 is similar but governs the entire year and includes an auditor's assessment and examination of the company's internal controls and financial reporting, including acquisitions.  If the auditor finds any "material weakness" it must issue a adverse opinion.  In addition, the Act allow criminal charges to be brought against the CEO and CFO for falsely certifying financial results.  While there is a materiality threshold for acquisitions, it is quite vague.

Colgate Buys In

I don't feel sorry for Mainers Tom and Kate Chappell, after all they now have a hundred million unhappiness soothers.  In fact I don't think they sold out.  I think Colgate bought in.  I've witnessed many times in my career large corporate buyers drawn to the light of a small craft product or technology thinking it will change their old, tired ways.  It never does.  Within a year Colgate will be pumping its toothpaste into TOM packages, within two sales will have plummeted and by year three the brand will be gone.  Colgate will be left with a bad taste in its mouth and a negative ROI.

"We're the Wal-Mart of Investment Banking"

Here is a good interview with Paul Deninger of Jefferies Broadview on changes to the investment banking business that impact the IPO market.  I agree with Paul that the number one reason (I won't call it a problem as he does) IPOs are down has been the changing structure of investment banks.  I don't think SOX is as big of an issue as most people (including Paul) make it out to be, and I've been part of an implementation, so I have a pretty good perspective.  There were three key events during the last five years that heavily impacted the IPO market:

1. Regulation FD (2000) - This reg. is seldom mentioned as a woe afflicting I-banking, but it really did change the way that public companies communicated with research analysts.  Pre-FD, analysts got a tremendous amount of intelligence right from the company.  This information was worth every dime of commission the buy side paid for it.  After FD, companies seldom let research analysts meet with anyone but IR, and they established more formal relationships with analysts.
2. Decimalization and Electronic Trading (2001) - Ironically the push for decimalization was led by Rep. Michael Oxley (R-OH) - conspiracy theory?  This evolution took most of the margin wind out of the sales & trading business which was a key supporter of research.  Reg. NMS which was implemented earlier this year only further degraded the profits of investment banks' sales & trading arms.
3. Global Research Settlement (2003) - This event eliminated nearly all the revenue from research departments' budgets.  Formally separating investment banking and research admittedly ended a lot a abuses; however, it's too bad because the relationship, when done right, often worked out really well for companies.

I still think lack of demand by institutional investors is the primary reason for the dismal IPO market, but the above factors certainly contributed.

Top Tech Acquirers

Raise your hand if you like stats.  What I find interesting about Brad Feld's Top 16 Technology Acquirers is that during the time period (2003 - 2005) these most active acquirers completed only 34% of all venture-backed IT M&A transactions.  VentureOne and my estimates (VOne doesn't list 2003 IT M&A) show 682 tech deals done from 2003 - 2005.

Way to go Big Blue - Tied for #1 in acquisitions, opens up the patent portfolio and is the most active corporate venture investor.  IBM looks like it's building for the future.

Management Evolution - CFO

What kind CFO should you hire if you plan on selling your company?  I asked my friend Rich, a CFO and a pretty darn good one at that, who's on his third start-up (made money on one, nothin' on the next, but we've all got our finger's crossed now).  Rich says it doesn't matter because the CFO is the first one layed off after the deal closes.  Well, he's right, but I think the CFO position is a critical hire if you plan on being acquired.  BTW - it's a completely different hire if you plan on going public. 

There are two areas of significance here: (i) internal financial systems and controls; and (ii) expectations and compensation structure.  Again, there are several other important considerations when hiring the right CFO, but from the corporate buyer's perspective these are the most important, because yes, we will lay off the CFO as soon as the ink's dry.  This post will focus on setting proper expectations and compensation.

There is an uncomfortable conversation that happens to me in just about every deal, and it doesn't have to happen.  Usually a week after the LOI is signed and right when due diligence is starting, the target's CFO approaches me and asks, "Are you going to keep me?"  Many in my profession lie at that point.  I don't.  The answer is almost always no, but I go on to praise their work, give a pep talk on finishing strong and offer assistance and a reference in finding new work (that's how I got to know Rich).  It behooves me to do so, but I shouldn't have to.  An unmotivated, scared, angry CFO who is looking for a new job will never get us through due diligence.  It's rare, but I've even seen sell-side CFOs try to kill deals in order to save their jobs.  You can take care of this long before the LOI is signed:

• Set expectations right when you hire - "Our plan is to sell the company in three years.  You'll probably be out of a job at that point.  Are you OK with that?"
• Use a heavy amount of stock-based compensation.  As a buyer, I'm not a big fan of wide-spread employee windfalls as a result of a sale.  But I have no problem with CFOs getting a nice chunk of money - they earn it for what I put them through in the process.
• Pay your CFO a monthly cash bonus (25% of their salary is standard) during due diligence.  When they are working 20 hours a day and six days a week, this will keep their spouse quite and happy.

Aligning your CFO's interests with yours will make all of our jobs easier and improve the chances for success.

Management Evolution - Presidents

Last week's post on founders/CEOs hiring a President to aid in their succession and to make the acquisition transition smoother (more attractive to me the buyer) yielded a number of questions - all from founders/CEOs (isn't it great when this blogging stuff works).  The good news is none seemed to be asking why, but rather who and how to hire.  I really don't think it matters, as the process is more important than the person.  I've reflected on the companies that I've witnessed go through this process and can't tell you that there are traits, qualities, skills, experiences or degrees that are common to success.  The most important thing that this person brings to your company is process and discipline.  Corporate buyers like both and tend to have too much of the former and very little of the latter.

For the companies that have done this well - largest increase in value since time of President hire to sale of company - here are the things that stand out:

• Hire someone from outside the company.  It's better to have a little inoculation before the disease hits.
• Hire someone whose never done it before.  Don't hire a big-named suit who has "done this kind of thing before."  You'll clash, you employees will hate and it will cost you a lot of money.  Find someone who is humble and hungry.  You're not turning the whole company over, so you're better off with someone willing to risk, fail and learn.
• Hire someone who is different from, yet complimentary to you.  No suits though.
• Don't hire someone just to "prepare the company for an acquisition," everyone should be doing that.  Hire someone who will make the company better through processes and discipline.

Acquiring Tax Credits

Seth Levine makes some good points about the real lack of transferability of NOL's in an acquisition.  I think it's a little bold, especially given the current deficit spending climate.

I think a more realistic step is to make the U.S. R&D Tax Credit permanent.  In addition, it must be made more competitive with the rates and structures in UK, Canada, China and India.  The U.S. IRC is the most complex in the world, but the R&D Tax Credit is a joke - how can a concept so easy be made so hard.  Finally, unused R&D tax credits should accumulate and be fully transferable in an acquisition. 

Management Evolution - Founders

I'm starting a new series that will look at steps entrepreneurs can take to prepare for an acquisition.  Great products and/or growth will get you on the radar, but you have to have the right people, in the right places and with the right expectations to get the deal done.  Evolving to a professional management team is where I'll start the series and specifically today's topic is founder's succession.  There's been an enormous amount written on this topic - from many different perspectives.  My viewpoint is from the acquirer's seat, so it may not agree with others, but here's what I like to see:

• If you founded a company you probably did so because you got tired of working for someone else.  You had big ideas and guts to match.  Working for a big, slow, risk-averse corporation is torturous to you.  So just be honest with me about that.  Don't try to be a hero and stick around after the deal closes.  It's a lose-lose for both of us so plan ahead for succession.
• Transitioning leadership in an organization is extremely difficult.  Doing it in conjunction with an acquisition is dangerous alchemy.  Transition ahead of time - at least two years.  You don't need to give up the reins all at once.  Hire a President and keep your CEO title, then give up more responsibility and become the Chairman a year later.
• Hire the right successor, make sure they understand their role and compensate them accordingly.  The key to this, as I've written in the past, is to know your potential acquirers - how they integrate and how your product fits with their offerings.  If the companies most likely to acquire you would do so to add capabilities to their existing products and if they have a history of fully integrating acquisitions, then you should hire a President who probably wouldn't survive the transaction, whose role it would be to get the company to and through a transactions and whose compensation would be heavily equity based.  On the other hand, if it's most likely that potential acquirers see you company as complementary and have a history of only partially integrating acquisitions as decentralized divisions, then you should look for a President that would survive the transaction as a divisional manager.  It's helpful to find someone who has served and succeeded in this type of role previously within a large corporate.  This person should understand that while their role is to get your company to and through the deal, they have to keep carrying the torch.  Their compensation should not be heavily based upon equity and should be in line with the potential acquirers' other divisional managers.

Failure to Communicate

I'm a big fan of conference call transcripts.  They have a ton of information often found no where else.  I'm a hired diligence gun on a deal and just found a great piece of intelligence by searching transcripts.  In the data room you'll find lots of data, but you have to look outside what they give you to find intelligence.

I started searching the target's transcripts this afternoon [I use the company name in keyword search instead of using a ticker and you'll see why] and found nine hits for the last year.  The quarterly calls were all there and probably in the data room too.  I'll go through those later.  Next I found three instances where the target was mentioned on competitors' calls.  In each case it was just analysts asking questions about industry strategies.  That's good and interesting information to pass on to the rest of the team.  Then I hit pay dirt - a competitor stated on its call that they've hired four senior sales reps away from target to help them enter a new vertical.

That's funny I don't seem to remember this mentioned in management's PowerPoint?  Now they've got some explaining to do.

If you're selling your company, you are better off disclosing this kind of thing up front.  In the Internet Age, there are few secrets.

Projections - Talent vs. Bodies

Sorry the posting has been a little thin lately.  I'm bogged down consulting on a couple of deals, so when I received a set of projections tonight, I thought about blogging.  Before I opened the file I bet that the huge increase in sales that I would inevitably see would be primarily the result of hiring more sales people, a lot more sales people.  Right again.

This assumption usually doesn't work.  I've learned this the hard way more than once, but I think I've finally got it.  The assumption often comes packaged with words like leverage, cross-sell or exploit and always includes new markets or products, but the net-net is that a lot of new sales people need to he hired.  Unfortunately, it's in almost every set of projections I see.

Bill is one of the best Sales VPs I know.  He's been around a while and seen a lot.  We met on a deal several years ago and still stay in touch.  Oh, and he hates hockey stick projections as much as I do because he's usually on the wrong end - i.e. making them happen.  Bill hires talent not bodies, and he's always actively recruiting.  Bill knows all of the best reps in his industry - tracking them, dialoging with them, watching them.  When his company looses a competitive sales pitch, he always finds out who the winning rep was on the other side.  When he goes to trade shows, he watches other reps to find talent.  He's always asking other people who the good reps are.  In fact he even uses his SFA app to keep track of the good reps in his industry.  Bill is a smart guy and really good at what he does, but he despises hiring a bunch of bodies just to try and hit a forecast.  That usually means he folds up his tent and goes somewhere else.  BTW - the best reps usually follow him out the door.

If you were selling your company to me, I would pay you more if you rolled out someone like Bill with a reasonable revenue plan and trajectory than I would if you showed up with a bunch of bankers wielding Excel models proving that sales will increase at an increasing rate.

ROFRs

Josh had a good article and post in Corporate Tool today on ROFRs.  It's well worth the time to read.

Projections

I wrote a post recently on projections and why I don't like or use them when valuing a company.  If you are a regular reader you know my disdain for using DCF as an acquisition valuation method, and projections are the heart of every DCF.  Does that mean you shouldn't have or use financial projections?  Not necessarily.

When I'm looking to buy a company, I like to see past budgets and variance reports.  Show me the stuff put together by the line managers, sales managers and controllers; not the stuff constructed by your investment bankers.  If you're selling your company today, all I need to see is the operating budget on a monthly basis for the rest of this year.  I don't need to see a 30-sheet model detailing your financial future through 2011.  I create my own projections for targets and usually assume revenue goes down and integration costs outweigh synergies for the first year or two.

What I really find helpful is when companies document and memorialize their budgets and variance.  Here's how - when you create your company's operating budget for next year, document the detailed input from the various managers who created it.  Then you and your CFO should certify the budget with its assumptions by having it notarized.  At the end of the first quarter in your budget cycle, using your variance report, write a MD&A.  Instead of just comparing past results, also compare the most recent quarter's results to your budget for that quarter.  Go into great detail as to why you hit or missed your numbers.  Again, certify the variance report and MD&A by notarize it.  Do this every quarter.  Showing me several years of this kind of information is not only intelligence vs. data, but also gives me some insight into your managers' abilities.

Integration Blues

Here is an excellent article from CFO.com on merger integration.  If you are considering selling your company, merger integration probably doesn't matter to you.  As you can see from this article, it matters a whole lot more to buyers these days.  So why should it matter to you?  Because the things you do today to make your company easier to integrate can mean the difference between getting a deal done and being a perennial bride's maid, and it can certainly have an impact on your valuation.

Here are some topics mentioned in this article that sellers should consider in advance, and that I'll cover in more detail in future posts:

• Interviewing key managers
• Equalization of pay and benefits
• Company culture
• Talent management
• HR development

Valuation - Data Sources

Here is another email question from last week's Valuation series.  Bill is wondering where I find the data that I use for valuations?

Here's what I like to use, and please send comments if you know of any better sources, uses or ideas.

Public Comps - The first task is to find the right comps to use.  I use EdgarPro to do keyword searches on SEC filings.  I use key business words or descriptions but also look for filings where companies list their competitors.  I like that because if another company lists the target as a competitor, it's pretty hard to argue it out of the analysis.  I also use OneSource or Hoover's for competitor lists.  Google is a good tool to use as well, because most companies buy their competitor's names and products as AdWords.  To get the numbers to build the comp table, I like to go back to EdgarPro and download financial data into Excel.  I have also used Capital IQ to build quick and dirty comp tables, and it seems pretty accurate.  However, I like to touch the data and build the table myself, so EdgarPro works well for me.  I also use EdgarPro to search for fairness opinions to see what other deals have used as comparables and pre-acqs.

Precedent Acquisitions - I don't like to use the M&A databases that are out their, as I only look for a few quality matches.  Finding the deals is hard, but I find that most of the above-mentioned tools are good for sleuthing them out if you set the searches to go far enough back.  However, probably the best tool is VentureSource.  I use VentureSource to do a keyword search on industry or product names and then pick out the list of acquired companies.  Now the hard part is finding the data on these deals.  Some of the data, typically only total consideration, are usually disclosed in press releases or in 10-Q's, but the best place to mine for gold nuggets like revenue or EBITDA of the target is conference calls.  I use StreetEvents to search text of the calls to find this data.  These calls are full of data, and I use the transcripts to document my numbers.  I also use D&B to get financial data on private companies that have been acquired.

I always check VentureSource to see if I can find valuations of a target's financing rounds and to see how much money they've raised.  I also really like Factiva to search for news articles, especially stories comparing products or services.  I like finding the news about the target that doesn't show up on its Web site.

Now That's What I'm Talkin' About

No inebriated hillbillies were harmed in the making of this blog.

Valuation - Proprietary Deal Data

Since it's Friday, let's clean up the email bag with an answer to a valuation question.

Matt from New York writes that a few years ago he sold his company and the banker representing the acquirer used several merger comps, or precedent acquisitions, that the banker said were proprietary.  Proprietary in this case meant that the investment bank had done those transactions, so they obviously knew the multiples even though the terms of the deals were not disclosed to the public.  Matt is wondering if he was taken after reading my post about requiring documentation for pre-acqs.

Well Matt you probably didn't get taken, as I know the firm you mentioned and several people that work there and all have excellent reputations.  Plus Matt did the right thing by confirming that the bank did do those transactions.  Here are a few things you can do next time.

1. Weigh the Impact.  If the multiples of the proprietary comps are all at the high end, then you may have some problems.  If not, better to just let it go.
2. Get it in Writing.  Ask for letters from the represented parties to the transactions, confirming the multiples.  The acquirer's banker should be able and willing to get these.
3. Call the Bankers on the Other Sides.  The bankers on the other sides of the proprietary deals might be willing to confirm the multiples.  Your banker probably has contacts at those firms and can find out.

Valuation Round VI - Projections

Well yesterday's post has certainly been the most controversial to date.  I received a lot of emails today from readers, or maybe former readers, complaining that my tactics to "bust-up" a target's DCF analysis are "dishonest", "deceiving" or "unethical."  One reader mentioned that, "It's just a poor way to start the deal process by tricking the seller ... and doesn't build any positive goodwill going forward."  On the positive side, I'm apparently qualified to work at Gitmo (see the Comment on the post) and a very nice Excel Product Manager from Microsoft emailed to thank me for the input on manual recalc, as they are considering taking the feature out - seems no one's been using it but me.  It's amazing how blogs travel!

I don't feel like the tactics I use are meant to deceive.  I use manual recalc to simply get the selling team to focus on the granular aspects of their projection assumptions without being jaded by the end result.  What's ironic is that I'm really trying to get to the truth.  I worked in investment banking too long and saw too many DCF's reverse-engineered to achieve a pre-destined result.  Meetings like this are hard, and they often end in an uncomfortable way with the sellers feeling angry and/or embarrassed.  But I don't rub it in anybody's nose; there are no fist-pumps or high-fives on my side.  I try to act professional and treat people with respect and dignity.

I don't like having to use tactics like this, but in every acquisition I've seen, the projections were "hockey sticked".  While in almost every case post-deal revenue went down instead.  Hugh McColl always assumed that 30% of the acquired revenue would walk.  Without that assumption going in, he said the deals would have never worked.  Besides, if your projections were realistic, why would you be selling?  By the way, don't embarrass yourself by justifying your projections based on what your company could achieve as part of my company.  I don't pay for synergies that I have to make happen.

Valuation Round VI - DCF

Using some flavor of discounted cash flow to value an acquisition is by far my least favorite method.  Don't get me wrong, DCF is quite handy and preferred for doing most valuations related to ongoing business operations.  But sellers always use DCF based on projections to determine value.  It's the projections, not the DCF, that are always wrong and always wrong in the wrong direction (we'll deal with projections tomorrow).  In an acquisition, the only DCF I care about is the one I create to justify that the acquisition is more economical than building it in-house.

Note to Investment Bankers: I just flipped through a couple dozen valuation books that I've received over the last few years, and the average number of Excel sheets devoted to DCF is seven (not including projections and assumptions) with the low being two and the high being a remarkable 23.  Then I was able to calculate one of the DCF's on my HP 17b.  The point is no one needs to see seven pages of this stuff.  One sheet is perfect, two is acceptable.

Here's how I bust-up your DCF.  After reviewing your banker's seven pages of DCF calculations, I complain that I just don't understand how the DCF works thereby requesting an electronic copy of it and your projections.  Then I call back and say that the DCF looks great, but I'd like to meet to go over your projection assumptions, as I have several questions.

The work I do prior to the meeting is to change your projections and watch how the changes impact the DCF.  The trick I do prior to the meeting is to change my Excel, so I have to manually recalculate formulas (Tools, Options, Calculations).  Hitting the F9 key recalculates, but to only recalculate the active sheet hold the Shift key while pressing F9.

When we meet I suggest that we make any changes (I put your projections back to their original form for the meeting) in real-time using my laptop and a projector.  During the meeting I attack your projections, assumption by assumption, making small, subtle changes, as I know which areas to hit and how far to hit them.  But it's most important that I get you to agree with the changes (since most CEOs know that the projections are BS this isn't that hard).  You can't see the impact because Excel isn't recalculating the formulas.  If you inquire about this strange phenomena, I simply say that there is something wrong with my Excel, and we'll I have to recalculate all the formulas at the end.  When that happens, F9 is not your friend.

Valuation Round V - Pre-Acq

Precedent acquisition analysis is my favorite valuation method.  I'm not sure why.  Maybe it's because I can always find two or three golden nuggets, or maybe it's because it takes a lot of research and sleuthing to find the numbers.  Using a pre-acq has its detractors.  They say that the information is stale, no two deals are alike, the numbers are incomplete or why base valuation on past deals when at least half were incorrect.  I still think that a pre-acq done right and in the right context is a valuable tool.  Most buyers don't use pre-acqs.  I usually use them defensively and then offensively.

Most pre-acqs I see were prepared by an investment bank and include 15 - 20 deals.  The deals were pulled from special third-party databases by entering a lot of specific parameters like SIC code, country, industry, keywords, size, etc.  This spits out about 100 deals which are narrowed, as more than half the deals lacked any data and the others "just didn't fit".  So when you present this to me I focus on the parameters, and after a discussion will probably agree with your parameter selection.  Now show me the "just didn't fits".  This usually causes some fidgeting and your banker explaining that they're not relevant so they weren't included.  Great, let's call that I-banking analyst and have him/her rerun the whole thing and send it right over.  When I get the spread sheet, I find that many of the "just didn't fits" actually do fit pretty well and plenty of the 15 - 20 don't really fit at all.  This exercise always causes the multiples to decrease dramatically.

Don't wast your time with these databases.  It's the wrong approach completely.  With pre-acqs less is more.  All you need are two to four high-quality matches to make a case, and you probably know off the top of your head which deals those are.  Then spend your time building intelligence around these matches, so you can make a strong argument as to why they're a good fit.  If these matches are too low for your valuation expectations, deal with in a realistic and honest way.

The second mistake is lack of documentation.  VCs try this a lot, and I've seen some buyers go along with it.  When I get list of merger comps with acquisition multiples, I always ask to see the documentation - database sources, press releases, SEC filings, conference call transcripts, etc.  The majority of time there isn't any.  Sometimes this information just needs to be found, but often it isn't documentable.  If you can't prove it, I wont use it.  The funny thing is that a lot of the information is out there, you just have to take the time and know how to find it.

I once represented a buyer who was looking to make a defensive acquisition of a target whose two primary competitors had been acquired within the last 18 months.  All three companies (target plus two competitors) were private and the leaders in their segment.  In this case a pre-acq with only  the competitors was not only important but crucial; however, not enough information was initially disclosed.  Our valuation discussions were pretty far off, but after a week of digging I was able to find enough data to connect the dots and come up with documentable multiples.  This was very compelling information to the target, whose banker presented 32 precedent acquisitions to back their valuation.  We ended up doing the deal at a premium to our pre-acq multiples but for far less than the original value the target wanted.

Valuation Round IV - Public Comps

The three most often used valuation methods for acquisitions are public comparables, precedent acquisitions and discounted cash flow.  Remember, my two most important rules in valuation are to build a case for your argument and to do so using intelligence rather than just data.  We'll focus on public comps in this post and hit the other two methods later this week.  Public comps are the simplest to calculate and understand but are often used in a manner that violates my aforementioned rules.

Valuation meetings often get a bit rambunctious.  I always come extremely prepared, so should you, but sellers seldom do.  I always stay extremely calm, so should you, but entrepreneurs never do.  I watch closely how you negotiate valuation, as it's a good barometer on how you'll handle the rest of the deal.  If you become irrational and pull a Howard Dean, the deal will probably die, as I don't need to put up with that for the next few months.  If the meeting is not going well for you, control your emotions, take a break to regroup, come back and collect as much information as you can about my case and then say you need a few days to think about it.  Then decide if you can build a better case with intelligence applied to your data.  I'm always happy to meet with you again.

Here's is the mistake most often made with public comps.  You and you banker pick a handful of publicly-traded companies that you both feel are the best proxies for your company as a listed entity.  Oh, actually you don't, you simply pick a bunch of high-fliers and average their trading multiples, but you leave it at that.  Your picks are usually about 50x your size and chances are you rarely face or win against them.  What you do wrong is to leave out the low-liers and assume I don't know about them.  But remember I came extremely prepared and know a lot about both the high-fliers and the low-liers.  I not only know all their trading multiples, but I also have other intelligence like growth rates, win frequencies, strength in verticals, revenue per employee, R&D spends, strategies, etc.  And I'm ready to discuss how those compare to your company.  At this point CEOs usually give a speech about how the low-liers couldn't hold a candle to their company and that they win every time they face the low-liers.  Fine, get your Sales VP on the speaker phone and tell him/her that I'm from your auditing firm and what to discuss your year-to-date pipeline to find out who you competed, won and lost against.  I've yet to have a taker on that one.  This is the point in the meeting where CEOs usually go a little Howard Dean on me.

Valuation Round III - How the Buyers Do It

Since it's Friday afternoon and I'm sick of hearing myself write, I thought I would give an inside look at how two of the largest and most active technology acquirers view valuation.

First up is Brian Roberts former VP and head of Microsoft's Global corporate development organization.  Brian is now with San Francisco-based Evercore Partners and is a good guy to boot.

CCD: Brian, MSFT completed over 50 acquisitions while you ran corporate development, how did you approach valuing targets?

BR: We used a combination of techniques and then applied judgment to form a valuation opinion of a company or asset.

CCD: Which techniques did you use?

BR: One of the most powerful techniques used was to develop a free cash-flow differential between the buy and build cases.  We then could value the discounted cash flow benefit of the acquisition vs. standalone cases.

CCD: There certainly must have been cases where the cost of building would have been difficult to calculate or just too restrictive? 

BR: Even in situations where we did not plan to build, creating the analytical framework often improved our understanding of the technical, marketing and sales requirements and could even impact the stand-alone valuation of the target.

Second is a recent quote from the EVP of Corporate Development at a $7 billion Silicon Valley tech company which is also an active acquirer:

For acquisitions valued at $300 million or less, ... we determine what the valuation would be if the business went public and then apply a 20% discount.  Our own [trading] multiples become the ceiling on what we're looking to pay out there.

Are You Coming or Going?

I love finding new data points that combined with data I already know gives new meaning to something.  Today I had one of those eureka moments while reading Piper Jaffray's M&A Monitor.  If you're going to assess the IPO market you can't just look at it from the perspective of companies trying to go public.  You need to asses the other side too.  SEC form 13E-3 is what public companies file when they decide it's time to go private.  Eureka!

O CA/NDA

As usual, Brad Feld has done a nice job explaining "the dreaded confidentiality/non-disclosure agreement" with regard to M&A.  I was going to write a post on this subject in the future, but since Brad has started, let me add my $0.02.

First, from the CorpDev side I agree with Brad, as usual.  I have no problem signing a strong CA that's bi-directional.  It's usually easier and faster to use the buyer's form, but it's worth every penny in legal fees to have your attorney review and explain.

Second, if you're negotiating exclusively with one potential buyer a strong CA is important.  However, if you've decided to proactively sell your company through a process that includes several potential buyers, then the CA is imperative to both seller and ultimate buyer.

There are a couple of things that quite a few sellers forget to put in, especially if you're using the buyer's general form CA:

1. Scope - The scope of the CA usually includes everything and the kitchen sink, so the fact your company is considering selling should be implicit, right?  Don't assume so.  Make it explicit.
2. Survivability - If you are marketing to several potential buyers, the agreements have to survive the transaction.  Again, this may be implicit in the deal docs, but I need it explicit in the CA.  As a potential buyer, I will pass on a deal if the seller has signed CAs without this provision.
3. Non-solicitation - This restricts the potential buyer(s) from directly recruiting the seller's employees for a period of time.  This is incredibly important to me if you are dealing with multiple bidders.

When I am considering buying a company through a sale process where others are also kicking the tires, I will pass on the opportunity if the CA doesn't have teeth and these key provisions.  Here's why - the first thing I do after I sign an LOI is ask to see all of the CAs.  If I don't like the edits, you've just queered the deal for me.  The last thing you and I need is for a bunch of other companies telling your market and employees that the company is for sale.

Here's a good example of how it's done wrong.  It's a true story with the names changed to protect the not-so-innocent:

Big Software Co. is the leader and largest player in its segment.  Its salty-old-timer CEO (a term of endearment) got a call one day from blue-chip investment banker who indicated that a company in its segment was for sale and wondered if he would be interested?  Salty-old-timer CEO was intrigued not interested, but he was willing to sign a CA in return for a shiny book.  Very-junior banker emailed salty-old-timer CEO the standard CA, who made one minor edit and sent it back.  Very-junior banker asked over-worked Selling Co. CFO if edit was fine.  Over-worked Selling Co. CFO saw no problem with it, and the CA was done.  Now the edit was to the non-solicitation clause which had an exemption for indirect and general solicitations, including: want-ad, job boards, etc.  Our salty-old-timer CEO added two words to the including section: billboards and signs.  Big Software Co. opted out of the deal and returned its shiny book.  Meanwhile, salty-old-timer CEO hired a commercial real estate broker and quietly rented space across the street from Selling Co, which was eventually sold to Behemoth Software Conglomerate.  On the day the deal closed, a huge sign was hung from the new satellite offices of Big Software Co. announcing that they were hiring programmers, engineers and sales reps.  Sixty days later they had 41.

Valuation Round II - Intelligence vs. Data

The most important thing you should remember about valuation is that to be successful you must build a case around intelligence and not just data.  Commodity pricing is based upon data, but business value is subjective - what's worth something to me is worth something else to someone else.  Data is important, but it can't support a valuation alone.  Besides, I know how to make the data work in my favor.  Despite this, I have sat through countless meetings with potential targets whose owners say, "I'm worth $X because that's were some other companies in my industry trade," or "my company is worth $X because someone else paid a certain multiple for a similar company."  Better yet is when a seller says, "We feel really confident that we're worth at least $x," and that's it, no explanation, no data points, nothing at all.  My favorite though, and this happens a lot, is when entrepreneurs say, "I have no idea what my company is worth, but I'd never sell for less than $X!"  Now what am I suppose to do with that statement?

I think you are making a big mistake when you rely solely on standard business valuation techniques to determine your company's worth in an acquisition.  Most of these methods were developed for ongoing business valuation events like taxes, ESOPs, splits, etc.  They're not appropriate for determining value in a change of ownership and can't stand up to the scrutiny that I put on them.

Be smart and be ready - have three to five pieces of intelligence ready to discus with passion and the valuation data to tie to it.  Good examples that I've seen are:

1. A CEO used three separate research report metrics (based on actual historical data) to show increasing adoption rates for a new product due to the convergence in two of the metrics and a fall-off in the third.  Her thesis was that the company was well-positioned to take advantage of these three trends and backed it up with revenue data that showed increase sales into that market.  Beyond that, she showed emails from several new clients confirming the research data as the primary driver to purchase.  She went further and showed her SFA reports detailing an increasing pipeline of similar potential clients in various stages.  Then she says sheepishly, "Because of this, we're kinda lookin' to sell at the top of the multiple range."  Of course when I pressed her she knew the exact range.  She got her money.
2. I represented an acquirer in talks with start-up that had a very disruptive technology and a passionately aggressive founder/CEO.  When we met with him to discuss what it would take to sell his company, he simply pulled out a sheet listing all the sales deals they had lost that year.  It was an impressive list - Fortune 500 buyers and A-list competitors.  It told me that these guys could play with the bigs.  Then he handed us a stack of printed emails.  With each loss he had asked the decision maker to rank their product vs. the competition and give details as to why they had lost.  In almost every case, his product ranked #1, but they always lost due to a lack of sufficient integration resources, account management and product support.  He then showed me that he was about to close on another funding round - his largest yet.  He understood that his company's weaknesses were my client's strengths, but he also knew how much it would cost for my client to build his product and how much it would cost him to build-out his weaknesses.  He also got his money and then some, but he never once pulled out a comp table or a DCF.

Does the CIA Know About This?

Time for another edition of the ever-popular Deal Lab.  Today's deal has been bugging me since last week, so I thought I just better get it out of my system.  Similar to my post on Google's last acquisition, I thought for sure someone in the mainstream financial media or blogosphere would write about the structural issues with WebSideStory's (NASDAQ: WSSI) acquisition of Visual Sciences (or ViSci as the kids call it) for $57.3 million in cash, debt and stock.  But alas no one did.  As usual in the Deal Lab, I will only write about the structure of the transaction and not it's merits, or lack there of.

(Note to WSSI shareholders: the consideration was under-stated by at least $7.3 million, as the value of an in-the-money warrant to purchase over one million shares and newly issued stock options weren't included.)

The transaction was closed and announced after-market last Wednesday, the same day WSSI disclosed its financial results for 2005.  In fact, the two news items shared the same press release.  Therein lies the first problem for the ViSci.  WSSI missed its Q4 guidance and put out lower numbers than the street expected for 2006, thus the stock has been off almost 25% since.  Had the deal been all cash, no problem, but remember this thing is part stock.  If ViSci didn't build any price protection provisions into its merger agreement, then they just lightened the deal by $6.5 million or 11% due to extremely bad timing.  In addition, WSSI was kind enough to allocate a pool of options to ViSci's employees - oops, they're under water now, but welcome to the company anyway!

This mistake could have easily been avoided.  If you're taking public stock as consideration, pick your close date instead of just letting the acquirer choose it.  Check the buyer's earnings calendar, and ask hard questions about upcoming or planned announcements.  If you are getting public stock, hedge it immediately after the deal.  In many cases shorting the acquirer's stock or purchasing put options is a lot easier than trying to get price protection agreements.

The second structural problem I have is the unsecured $20 million note at 4% that ViSci's shareholders took back.  Since WSSI has no other debt, there was no reason for the note to be unsecured.  Especially since 27% of the total consideration was equity that's either restricted, in escrow or in a convertible form that's now out of the money.  ViSci's shareholders are now the largest creditor to a company with $20.8 million in tangible assets and $38.2 million in liabilities.  And why take 4%?  The leveraged loan market is at LIBOR + 300-400 bps, or 8%-9%, for a company like WSSI.  And even 2-year U.S. T-Notes are yielding 4.375%.

Who was the VC on this deal anyway (hint: your Federal tax dollars at work)?

Valuation - Round I

Your company is always worth more to you and your shareholders than it is to me.  Beyond the intangibles of that statement - yes you birthed it, stood by it through all the ups and downs, yes, yes blood, sweat and tears, yeah I got all of that, and no none of it factors into the valuation - there is a tangible aspect that you probably don't realize.

First on the intangibles - pride of ownership is great, but it doesn't pay the bills.  Now you know that, so be reasonable and leave it out of the valuation.  Enough said.

The tangible part of the statement is this - when you sell your company the total consideration less your selling costs is what you and your shareholders get, not including the impact of taxes of course.  However, when I buy a company, the total consideration plus my transaction costs are only part of my total investment in making the deal a success.  Integration tends to be very expensive.  Whether it's technology platforms that have to be upgraded or replaced, rich severance or compensation contracts that survive the transaction, excess space or equipment under a long-term leases or even simple HR issues, it all adds up quickly.  I don't necessarily net these off the top, but I do take them into consideration the same way I consider the amount of synergies I can achieve from the transaction.  In all of your operational planning you should always ask yourself, "Is this going to make my company easier and less costly to integrate."

Mood Lighting, Background Music

Let me set the tone for the Valuation series, because entrepreneurs often ask me why corporate buyers are more sensitive about valuation now than in the past.  Let me give you the data points first:

• In 2001, it was calculated that the 17 largest mergers, between 1997 and 2000, cost the acquiring companies more than $500 billion in market value; and
• In 2002 alone, it was estimated that $235 billion in acquired technology assets were impaired and written-off.

The reason that we're such sticklers about valuation now, is that corporate development professionals have a recurring nightmare called SFAS 141 & 142, which allows us to re-visit our valuation mistakes every year in the form of an asset impairment.  SFAS 141 & 142 went into effect in 2002, and while it allows almost every cash deal to be immediately accretive, it certainly made valuations more process-driven and less imaginative.

Valuation & Projections

Today I will start a new series on valuation and projections.  The goal of this series is to provide a better understanding of how corporate acquirers value transactions, and how you can plant seeds today that will make your company more valuable to both of us in the future.  Let me start by making some clear statements about valuation, which we'll explore further in the coming weeks:

• Sellers always value their company, where as I (the corporate buyer) always value the transaction.  The two can be very different - I'll explain why.
• Traditional valuation methods (DCF, precedent acquisitions, public comparables) are more relevant for raising money than for selling your company.  I'll show the methods that most corporate buyers use.
• In terms of projections, past performance is always indicative of future returns.  Leave the hockey sticks at the rink.  I'll explain how you can give me projections I can believe.
• Understand your cap table and liquidation preferences relative to your valuation, and make sure that your shareholders' valuation expectations are aligned (Review your drag-alongs!).
• Lean companies are always more valuable to me, as I never pay for synergies.
• The most important thing I'll write about is how to build a strong valuation case based on providing me real and relevant intelligence vs. data.

Why They Leave

Here's a bonus track for today.

Over the last few years, and especially since I started this blog, I have talked to a number of people who used to work in corporate development.  I always ask them why they left.  I think I have finally reached a statistically-sound sample size, and can tell you that the overwhelming majority of people who leave corporate development do so because they completed no deals during their tenure with the company.  It's not that they didn't complete enough deals, it's that they couldn't complete any deals.  Further, all of these people tell me there was plenty of deal flow, and they often signed LOI's and negotiated merger docs.  It's that their company's didn't have the cajones (thank you Guy) to close the deal.

Before you sign that LOI check your potential acquirer's track record, but more important look into the management team's record.  Does the acquirer have a new CEO or CFO (or even CIO) that has never done an acquisition?  What about their board - do the new members have acquisition backgrounds?

M&A is risky.  It takes a certain kind of management team to do deals.  Don't get pregnant and left at the alter.