Structuring Founder Liquidity Events
Going public should not be the goal for every successful startup and small business. Founders need to plan for a variety of alternative liquidity and profitability options to maximize payouts and even lifestyle.
Many companies may want or need to pivot towards profitability and focus on being acquired by another firm or funded by private equity. Founders must be prepared to negotiate and structure these deals because their ability to plan and negotiate will have a massive impact on the founders and employees. These transactions can have multiple moving parts and become increasingly complex so it’s important to start early. Below are a few financial and nonfinancial factors to consider both before and during these types of transactions.
Non-Financial Considerations
Goals
When considering a private equity partner, merger, or acquisition, it's important for both parties to define and be transparent with their goals and objectives. If you're both on the same page and aware of mutual expectations, the likelihood of success increases significantly. For example, if the seller wants to exit the organization after the transaction completes, but the buyer wants them to stay on, or vice versa, this can significantly impact the potential offer on the table. All deals will be different, so make sure your goals are aligned.
If you’ve agreed to stay on post-acquisition, it’s important to determine your precise role in the new organization. There are usually opportunities as an employee or an advisor. Each path will come with different compensation packages and involve differing levels of independence and responsibility.
The engagement duration should also be agreed upon - some acquiring firms want you to stay on for the short-term, while others might see you as part of the long-term strategy. Either way, setting clear expectations is prudent so there's cohesion, otherwise this will probably lead to conflict down the road.
Another possible scenario is a complete exit where you would not participate post-acquisition. This might happen if you wish to work on a new startup or your services just aren’t required after the sale. Whatever direction you go, it’s important that you’re in agreement to both maximize your enterprise value, but also continue leading a fulfilling and fruitful life.
Company Culture
It’s difficult to measure company culture, yet it remains as one of the most important parts of any M&A transaction. This is especially true if you and your current team are joining the new organization or rolling over equity. Dedicate sufficient time to determine if you’re a good mutual fit. Ask tons of questions. Just as you would when dating or interviewing for a new job, make sure you get to know your potential future partner. While there is no standardized process in evaluating a buyer’s culture, there are many traits to look out for. As your conversations progress, you should reflect on some of these perspectives:
Research: How much can you discern from your own research, starting with their online presence?
Alignment: Is there a common focus and direction in the acquiring company? Will they continue to take great care of your team and your clients?
Communication: Do they communicate effectively, transparently, and promptly with you and your team?
Trust: Do they appear to have trust or do they micromanage?
Observe the work environment: Talk to people and see how they interact together and with you. Is this somewhere you could see yourself and be fulfilled over the coming years?
Observe the non-work behavior: Are they good people? If possible, seeing their behavior in non-work settings can be helpful too. For example, if you’re at a restaurant together and their order is wrong, how do they deal with it?
Mergers and acquisitions are strenuous to undo after the fact, so you want to do your diligence here and not overlook the significance of culture and alignment of values.
Financial Considerations
Valuation Methods
There are many different valuation methods that a buyer might use. If your company's growth and financials are strong, it is more likely you can successfully negotiate your objectives. Everything is negotiable and should be coordinated with your goals. On the other hand, if there has been slow or no growth, or you don’t have as much flexibility on time frame, you may not have as much leverage and negotiating power. Some common metrics to extrapolate enterprise value are EBITDA, free cash flow, gross margin, and gross revenue.
While most company valuations are based on their earnings, the startup tech world has sometimes relied on subjective valuations and not entirely based on company fundamentals. Over the last 10-15 years, there has been an insatiable demand for high growth companies. However, this trend may be changing with the rapid increase in interest rates and subdued global economic climate. There does not seem to be as much appetite for unprofitable companies with only the promise of future exponential growth and adoption. Instead, preferences have been shifting towards companies that are already or soon to be profitable. Nonetheless, there are still many investors on the sidelines and deals waiting to be completed.
Knowing what potential buyers prefer is helpful for startup founders. In addition, while there may be numerous valid methods for valuing private companies, the process is not an exact science. Many assumptions and guesses are often part of that process. When the time comes to start exploring and gearing up for a potential sale, working with a knowledgeable business broker with specific industry experience will be impactful.
EBITDA
EBITDA, which stands for Earnings Before Interest, Tax, Depreciation and Amortization, calculates a company's financial performance. A company’s EBITDA can be useful as a valuation method because it measures how effectively it can generate cash flow. The EBITDA multiple can also help with determining a company’s enterprise value. This is especially applicable when targeting and planning for a future sale.
Comparing to Competitors
Analyzing comparable companies is another common method to estimate the value of a company. With this method, buyers will be searching for similar companies to establish a correlation in value. If there are similar public companies available to compare, the valuation is substantially easier. However, if there are no similar companies, some assumptions will need to be made. Some common comparison criteria are company size, market share, growth rate, scalability, perceived risks, recurring revenue, cost to replicate or barriers to entry, age, and industry. Analyses will often use several examples, take an average of those company’s revenue multiples, and apply this to the target company.
Upfront Cash Payout
From a financial perspective, if you are not yet financially independent, you should probably prioritize a larger upfront cash payout instead of rollovers or earnouts. Unless you have a very high risk tolerance and are also willing to delay or jeopardize your other high priority financial goals, an immediate cash payout represents the least amount of risk. There are no guarantees on when or if future payouts will be available. Even though a buyer may give you less favorable terms or valuation, there’s no assurance that your rollover equity or earnout will be enough to offset your lower upfront cash. With that said, there’s always unique circumstances to a deal. For example, sometimes a bad quarter will impact your overall acquisition value, and it might make sense (or you might be required) to structure the deal with less cash upfront and more via potential earnout.
From a tax perspective, you might also qualify for special opportunities or strategies. If you were granted equity early after the company’s inception, you may meet the rules for Qualified Small Business Stock (QSBS). This tax treatment can provide significant tax benefits by excluding up to $10 million of Federal capital gains. Additionally, it might be beneficial to consider structuring your transaction via an installment sale, especially if your company has significant assets. With this strategy, you are deferring part of your gains from the transaction to future tax years. Be aware that there are several risks that can be present with an installment sale. For example, the seller could default on payments, inflation could be higher than expected, and tax rates could increase.
With both strategies, it’s important to start planning for them years ahead, as there are several criteria that need to be met. The earlier you start to plan, the higher the likelihood of a favorable outcome.
Rollover
Buyers and acquiring firms often prefer having the management team roll over a meaningful share of their company equity. The rollover component in an acquisition is a powerful way to align the current management team’s interests with those of the new owners. Rollover equity can represent a significant part of the overall deal, especially when the deal has an aggressive valuation.
When considering rollover equity, you should think carefully about a few possibilities:
If the new company is private, what is their expected liquidity timeframe?
Will I be okay if the new company never has a liquidity event, declines, or fails?
Do I believe in the vision of the new company?
Are they capable of taking it to the next level and achieving or continuing sustainable growth?
The amount of current equity you want or need to rollover can be an important part of the negotiation process, especially since you may be walking away with less cash upfront. More rollover increases your ability to participate in the new company’s success, which can be a positive or negative, depending on how the new company performs in the future.
Earnout
Earnout is where future payouts are structured in a transaction to pay the seller if and when certain targets are achieved or maintained. Having an earnout component as part of an M&A transaction can offer many benefits to both the buying and selling parties. It can be an effective tool for bridging the valuation gap. Earnouts can also provide protection for the buyer by shifting some risk onto the seller.
Earnout criteria is often based on revenue or cash flow targets. It can also be based on other metrics such as team retention, product development, product launches, and resolution of legal proceedings.
Earnout is similar to rollover in terms of risk to your personal financial plan, as you may not have as much control over many of these criteria, and none are guaranteed.
Percentage Stake
Some transactions do not result in a complete sale or investment, but instead investors may opt for a minority stake. This will allow them to still participate in the future profits and growth. A majority sale will allow the seller to significantly diversify their company equity but they will have less control in future decisions. However, this can be a positive if the seller no longer wants this responsibility. On the other hand, a minority stake sale will allow the seller to maintain more control and the majority of their equity.
Work with a Professional
Merger and acquisition transactions can be complicated and have numerous variables. They can conclude your years of hard work in many different outcomes. Every deal and company is different, and the exact terms vary widely by industry. It's highly recommended that you begin working with a professional early to formulate an effective strategy. Also make sure to work with a professional who has expertise with your unique situation and understands the dynamic frameworks you need to be aware of.