Confessions of a Corporate Dealmaker

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.