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A bi-weekly column with timely, relevant and possibly irreverent insight into the BC technology industry.

Something Ventured:
March 4th, 2005

By Brent Holliday
Greenstone Venture Partners


Heading For The Exits


"He's got something to live for,
Something so real,
He's got something to live for,
That one big deal." - Barney Bentall, Something To Live For

As greedy VCs, we have certain motherhood statements about where we want to place our money: big, fast moving markets, customer driven innovation and world class teams of people to execute on quick to market plans. We have all heard this before. But what we really want is a company that we can buy into with a team and a story that we believe can lead to a big exit a few years down the road. The 'exit' is, of course, the Initial Public Offering (IPO) or the merger & acquisition (M&A) transaction where we can sell our shares or receive cash for them.

The vast majority of 'exits' are of the M&A variety. IPOs require surging revenues and cash flow that meet stringent TSX and NASDAQ requirements. Usually, except in bubble times, this takes years of product development, customer traction and commercial success to achieve. The IPO is the most desirable outcome for everyone, but as a functioning market so beautifully dictates, it is also the least likely outcome (except in life sciences, where public markets still fund development stage companies).

There are far more M&A transactions than IPOs partly due to the fact that nearly 100% of IPOs are successful 'exits' for investors, while a great majority of M&A is the dreaded asset sale variety where the scraps of a failing or floundering company are disposed of for very little. An asset sale is an 'exit' technically, but is not the 'exit' that the VCs or entrepreneurs talk about from the beginning. There are many successful acquisitions that make some or lots of money for their shareholders and we are familiar with some local stories there:
Crystal Decisions
Abatis Systems
Datum Telegraphic
Octiga Bay
NCompass Labs

We are less familiar with the asset sales that abound in our landscape and elsewhere even though some of them wind up as functioning units of larger companies employing people well after the original business plan failed and the investors got little or nothing for their 'exit'. Some investors (not VCs) make a business out of looking for distressed assets and people paying a few cents on the original invested dollar and applying their networks and management skills to turning a floundering company around. It can be a lucrative investment business.

The process for an IPO is well understood. If the company is performing exceptionally well and has carved out a rapidly growing business, it can impress the investment bankers that do IPOs and the 9-12 month process will begin. More importantly, shareholders love IPOs and will usually not be an impediment to the process. So how do you start an M&A process? Does the company start it?

The start of the process is usually defined by how well the company is doing. If a company has an exceptional technology and customers are starting to lap it up, a competitor or larger strategic partner may arrive unannounced and say that they want to buy you. The un-solicited start to an M&A process is the best place to be. When someone wants you, you can play hard to get and if played correctly, get a premium price for your company. There are two other triggers for starting an M&A process yourself: the market you are in is starting to consolidate around you (your competition was snapped up by larger players) or you need the resources of a larger company to execute your plan because the investors are tired or won't fund your story anymore. The former is obviously better than the latter for getting a good price. The latter could also be initiated by your investor shareholders who just want out at any price.

In any of the above mentioned scenarios, inevitably, there is disagreement among the shareholders around the timing of the M&A process. Thus begins the long, arduous journey of selling a company. It is a roller coaster of emotions, a process filled with tiger traps for the uninitiated and ultimately not satisfying for everyone.

The friction in a selling process usually is between management and investors because management always believes that they can build a bigger company with more value. Investors will do the math on whether to sell now or continue to finance. If they don't believe that putting more money into a company and growing it will yield a bigger return later (especially on the last money in), they will dig in their heels. A bird in the hand often wins the argument. Interestingly, in my experience, you get investors arguing about when to sell as well. Each has a different point of view and heated debates among investor interests have also been a brutal feature of the selling process.

If an acquirer shows up out of the blue to buy your company, the best advice at that point is to hire an experienced investment banker to handle the process for you. Simply starting to negotiate a price and terms on your own with the first suitor at the door will do your shareholders a disservice. If they want you, chances are someone else wants you too and an auction always draws a higher price if done properly. It may be that the first suitor is a perfect fit and you will end up selling to them, but playing hard to get is part of the negotiating process. Another piece of advice that a banker can help you with is what to disclose about your company and when to disclose it. Opening the proverbial kimono too early may get a potential acquirer the information that they need to not bother buying you and simply attempt to out compete you. There are less than sincere (and ethical) acquirers who merely want to see what you have. Be careful.

The goal of any M&A process is to get more than one acquirer to the table with a term sheet (or letter of intent) at the same time. Though desirable, it usually does not work this way and one acquirer ends up with a "no-shop" term sheet to allow time to do diligence and negotiate final terms with you exclusively. Again, an experienced banker will help you get the best out of this process and help you avoid a lengthy no-shop period leading to an inferior price.

If you hire a banker without any bonafide offers or intent from a company, you have a harder task in front of you. Now the bankers are helping you identify potential acquirers and penetrate those companies to their decision makers. Teaser letters go out to see if there is any interest in talking about "strategic interests" together and if there is any pull, NDAs are signed and presentations given. This process marks your company as trade bait. Quickly, the industry will know you are on the block and if you have timed the market correctly (consolidation is happening) and a few dance partners show interest, you can create that desirable auction and get a good price. But timing is everything in the M&A process and if your company is not as far along as people thought on the outside or if the market has shifted towards other solutions or standards, you can quickly move into the realm of a desperation sale.

The best time to try and get a good price for your company is when you have the resources to carry on alone. Either you have money in the bank or you have a term sheet to fund if no M&A transaction happens. Too often, unfortunately, the M&A process is started near the end of the cash cycle of a company and the price deteriorates as the cash out date approaches. Any investor will bridge to a transaction to cover operating costs, but the lack of a bona fide equity round to grow the company in lieu of a transaction will mean a lower price.

So, what is a "good" price? Well, that depends on what market you are in, what stage you are at in executing your plan and what kind of interest you can generate in the market of acquirers. I can tell you this though: at the start of the process every shareholder has a higher view of the company value than the market does. I have only seen (not including the 1999-2000 bubble) prices exceed expectations when there are two or three companies fighting over your company. Here is another trap to avoid when setting internal expectations of price: the recent multiples of sale price to revenue seen in the market are biased towards the great 'exits' that everyone hears about. If Cisco paid 10x this year's revenue for Airespace, you can be sure that there are other related transactions that you did not hear about where the multiple was more modest.

As mentioned, the M&A process is a roller coaster and always takes longer than you originally expect. The best way to get a good price an avoid internal conflict is to be growing an IPO worthy company (see: Crystal Decisions for instance). But the second best way to get value is to get a good banker with tons of experience in your market. We have a string of good 'exits' in BC over the past 6 years… let's keep it going.

Letters From Last Time –

I read the article on Free/Libre and Open Source Software (FLOSS http://www.flora.ca/floss.shtml ). I am one of those people who have been in that sector since the early 1992, so wasn't one of those people that this would be new for.

I believe you may have created confusion with your explanation of the "Dual Licensing model". If your license requires that anyone (commercial or otherwise) pay a royalty at any point, it does not qualify as Open Source.

The Duel Licensing model used by Sun with StarOffice (the FLOSS version being OpenOffice.org) and MySQL offers two different licensing models for the same software, where the user of the software can pick between them. If you are happy with the FLOSS license, then that is what you use. In this case there will never be a royalty. If the license is a copyleft license <http://www.gnu.org/copyleft/copyleft.html>, it requires that any derivatives you make of that software must also be in the same (or compatible) FLOSS license.

If you are a vendor that wishes to charge royalties on your own value-add to the software, then you would want to use the Closed Source license option. In this case you would pay a royalty for the software you received.

Thank you.
Russell McOrmond

Thank you very much Russell for explaining the difference. The "dual licensing" model I was explaining was short on detail and you have provided it appropriately here. My interpretation of the "dual license" (and hence some of the confusion in my wording) was more around the choice that the original code developer makes in its business of providing software and not from the end user or value added developer perspective. Clearly, I did not have enough time or space to do this topic justice. Thanks again for taking the time to help educate our community.

There were other letters picking apart my attempt to speak to the changing landscape of software development. Some were even helpful. One reader, Michael Dyck, took the time to send a very useful link along:

"For a good discussion of the economics of open-source software, see Eric Raymond's article "The Magic Cauldron", in which he presents nine models for sustainable funding of open-source development. http://www.catb.org/~esr/writings/magic-cauldron/"

This is a much better and much more thoughtful list of the models of open source. I think I should have just linked here when discussing the models around open source for your software company! My point in the article was that I had spoken to an open source zealot who was also a VC and he was saying that all software would soon be open source. I am sorry if I then sounded definitive on the business models out there.

What Do You Think? Talk Back To Brent Holliday


Something Ventured
is a bi-weekly column designed to supplement the T-Net British Columbia web site with some timely, relevant and possibly irreverent insight into the industry. I hope to share some of the perspective and trends that I see in my role as a VC. The column is always followed by feedback (if its positive or constructive. I'll keep the flames to myself, thanks).

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