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.

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.

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.

It's All About R&D Spending

I often get asked by start-ups planning for a future sale if it is better to invest in the business' infrastructure or should they just put all money back into R&D?

In just about every case I err on the side of R&D; however, I do promote infrastructure spending around people (and processes) in three areas: (i) your CFO (finance & accounting); (ii) your HR manager (people & culture); and (iii) your CTO (IP development & management).  You should plow everything else aggressively into R&D.

Now many are probably wondering what about sales & marketing, facilities, integration or customer support?  Those are important, but I wouldn't invest heavily in them and certainly outsource them if possible.  My thesis is this: don't make long-term infrastructure investments in assets that an acquirer already has, instead invest in assets they don't have and need your product, IP, customers and market share.  Let me give you some examples of how this works.

I recently did some consulting for a  young software as a service (SaaS) company providing cost-management solutions to the health care industry.  Instead of building an installation and integration consulting group internally, they created partnerships with several leading VARs and SIs in their industry.  They received a percentage of the outside integrators' revenue for work the company brought to them and reciprocated on new deals sourced by the integrators. 

By contrast I once worked with a start-up providing software solutions for patient and document management in the health care industry as well.  The difference here was that this company did invest heavily on creating a internal consulting group for installation and integration.  The consulting group worked virtual with clients and partnered with the company's sales force to complete its projects.

Here is why the first company would be (and is based upon current overtures) more valuable to me as a corporate acquirer.

• The VARs and SIs working with the first company are specifically in the business of installing and integrating.  They are extremely efficient at it, are highly trained and can scale to respond quickly to customer's needs.  But the three most important things are that they work at the customer's sight and charge for every second they are there, customer's tend to be more satisfied with the install and they can create customer applications on top of your solution.
• The other company spent a lot of money and time recruiting, hiring and training its integration team.  Since the team worked virtual, its integrations tended to take much longer.  They also had a billing problem, as their consultants were not as efficient and billed for only a portion of their time.  Also, customers tended to use their consultant for ongoing support, instead of the much lower cost support team.  In addition, they didn't work as well with their sales brethren compared to the outside integrators, due to lack of experience and internal conflicts.

In the long-run it was probably much more economical to build the integration team internally.  But as an acquirer I am looking for a fast run-rate on revenue and more money put into R&D.  The first company was able to do this - they were able to get a lot of smaller chunks of revenue very quickly and put a substantial amount of capital behind product improvements.  They got market penetration and traction a lot quicker in addition to being the industry's leading innovator.  Besides, as a larger company I may already have an integration team, so the management and the processes you've built are a waste to me, they're redundant, as I will just install my own.