When a VC jumps on the board of a company they have invested in, beyond overseeing management decisions and corporate governance, they often play a significant role in shaping the company’s strategy, such as Go-To-Market, Product Development, HR, and Exit.
Regarding Exit Strategy, nailing the timing for an M&A move is essential in securing an optimal outcome, especially for VC-backed companies.
Compared to bootstrapped or PE-backed companies, VC-backed companies exhibit the highest value-to-price gap.
In essence, when I engage in discussions with VC-backed companies, I often find the most substantial difference between what they believe they’re worth and what they can get in the market.
Suppose a company raises $10m at a $50m valuation with a $300m Series A fund. In that case, the value expectation is at least $1.5bn, assuming the VC maintains his ownership stake throughout the company’s journey.
Here, the value expectation isn’t rooted in fundamental factors such as financial performance, but in the unique set of capabilities, this company has to become a market leader.
These unique abilities, known as ‘intangibles,’ are the company’s most valuable assets.
The moment an increasing number of buyers recognize and acknowledge these unique capabilities is when VCs make money.
In fact, it’s all about bridging the value-to-price gap.
There are two complementary strategies to bridge the value-to-price gap:
Revealing intrinsic value
Leveraging supply and demand dynamics
Most VCs focus on the intrinsic value and overlook the supply and demand dynamics.
By revealing intrinsic value, I mean investing heavily in Go-To-Market, Product Development, and HR to build an Ultimate Software Company.
An Ultimate Software Company possesses a business model with operating characteristics leading to a high level of growing, predictable and durable cash flows.
I’ve written before that the more a company has a business model tending toward the Ultimate Software Company, the more the estimated intrinsic value will be, and the more an investor will be eager to pay a premium for this business compared to their peers.
As intrinsic value becomes increasingly apparent over time, potential buyers will naturally come for the company, offering prices well above initial expectations.
Unfortunately, such situations are rare.
In most cases, buyers may express interest but offer prices well below the value expectations, or worse; no serious buyers show interest before the exit date stipulated in the shareholders’ agreements.
In both scenarios, an M&A advisor is hired to leveragethe supply and demand dynamics - essentially setting the stage for a competitive bidding.
The key idea here is “leverage”.
An effective competitive process relies on certain factors that can be used to our advantage. These factors aren’t related to building an Ultimate Software Company but are about the supply and demand dynamics.
These factors are necessary for VC-backed companies to avoid ending up stuck in a long, drawn-out M&A process, and they might not get the best deal.
Photo de Towfiqu barbhuiya sur Unsplash
Enough suspense: The crucial factor I’m talking about is having active business partnerships with potential buyers.
As an M&A advisor, I’ve written before about the importance of having active business partnerships with potential buyers. These relationships are a big deal for me when I’m trying to create a competitive bidding environment, and getting the timing right is essential.
Beyond the overall economic climate, wars, inflation, and multiple valuation drops, these working relationships are actually critical indicators of our ability to make the market competitive.
That’s why we like to work early with VC-backed companies on a pre-marketing process to create the condition to leverage supply and demand dynamics while they are working on revealing intrinsic value.
We call this pre-marketing process Corporate Development — it’s a 3-step process to bridge the value-to-price gap effectively.
Before diving into the 3-step process, it’s essential to consider the logic behind most M&A transactions.
Price is what you pay. Value is what you get. — Warren Buffet
Imagine you invest $5m in a software company that, after several years, generates $5m ARR, and you get an initial offer from a potential buyer. In this offer, the buyer is strongly interested in gaining access to the company’s market, client base, technology, or team to create synergies.
This initial bid from the buyer is likely to be around 15% of your value expectation. Naturally, this may seem insulting, and you may wonder why these potential synergies are valued at only 15% of your expected value.
The reason behind this valuation is that the buyer isn’t primarily pricing your business based on the synergies it could bring, as those benefits will unfold over time.
Instead, they’re evaluating it based on the immediate accretive potential — what they can gain right away.
For instance, if the buyer is a $100 million ARR software company valued at 8x ARR, which equals an $800 million enterprise value, making a 4x ARR offer for your company means that after the transaction, they’ll have a $105 million ARR still valued at 8x ARR, i.e., a total enterprise value of $840 million.
By paying $20 million, the buyer directly gains a $40 million increase in valuation.
I refer to these buyers as opportunistic buyers as they follow the principle of acquiring a business at 50 cents for every dollar of value, a strategy associated with value investors — the most famous of them is Warren Buffet.
These opportunistic buyers usually stop bidding once the opportunity for a significant bargain diminishes.
Those who continue to engage beyond this point typically do so because gaining access to the company’s market, client base, technology, or team holds particular importance to them. In essence, they become more defensive in their approach.
This is where Corporate Development comes into play. It’s all about turning opportunistic buyers into defensive ones.
This might sound like a Voldemort’s Imperius curse, but it’s actually a 3-step process that draws from the principles of behavioral economics, as pioneered by Daniel Kahneman.
I won’t dive into all the details of behavioral economics, but here’s the key concept to remember: We, as humans, feel the pain of losses about twice as much as we feel the joy of equivalent gains.
This emotional response significantly influences our decision-making.
In M&A, it’s more effective to incentivize a buyer to keep synergies rather than making them pay to initiate these synergies.
Moreover, positioning yourself as the less risky option to address a specific need is more powerful than relying on the Fear of Missing Out, a strategy commonly used in fundraising but often ineffective in M&A.
With that in mind, let’s look at our Corporate Development process. Behavioral economics principles guide it and involve three steps:
#1 Raising Awareness: Implementing a use case based on your company’s intangible assets with a potential buyer. It’s about translating potential synergies into tangible ROI.
#2 Gaining Insights: Leveraging the multiple interactions from the use case to understand a buyer’s business and competitive dynamics. This helps us transition from being a nice-to-have option to a must-have M&A opportunity in the buyer’s eyes.
#3 Building Momentum: We put steps #1 and #2 into action with multiple buyers. It’s about harnessing loss aversion with several buyers, ensuring the M&A process isn’t a slow-motion auction but turns into a bidding war.
If you still bear with me, I’ll dive a little into each step.
#1 Raising Awareness: From Potential Synergies to Tangible ROI
Or bringing value first.
As mentioned earlier, a company’s most valuable assets often lie in its unique capabilities, which may not appear on a balance sheet.
The goal of step #1 is to bring to light these invaluable intangibles.
Whether it’s a proven Go-To-Market engine that rapidly secures key account customers within two months instead of the typical 9 to 12-month benchmark or a distribution engine that provides streamlined, exclusive access to premium digital media, these intangibles can offer substantial advantages to the right buyers.
A conventional M&A approach focuses on building an equity story centered on how a buyer can benefit from these unique assets. However, this approach primarily leverages the potential for gain.
A more efficient strategy involves establishing business partnerships that capitalize on the Go-To-Market engine to help a buyer close key account customers faster or the distribution engine’s capacity to make a buyer become 10x better with fewer resources effectively.
For step #1 to be highly effective, it’s crucial to implement it selectively, targeting specific types of buyers.
I’ve written about the various categories of buyers, each with distinct dynamics. In the context of step #1, there are different types of strategic buyers, each with a unique approach to M&A activity:
Firstly, there are the Serial Strategic Buyers with dedicated internal M&A teams. These entities recognize M&A as a potent growth catalyst and, much like Financial Buyers, are constantly looking for promising investment opportunities. However, their numbers are limited.
Next, we have the M&A-friendly Strategic Buyers. These buyers don’t have an internal M&A team but have recently undertaken acquisitions or raised funds expressly for M&A pursuits. While not actively seeking opportunities, they are receptive and open to engagement when presented with an M&A prospect. Their presence in the market is relatively modest.
Then, we have the M&A-opportunist Strategic Buyers. These buyers have little or no acquisition history and view M&A as more opportunistic than a well-defined and proactive strategy. Typically, they have minority financial shareholders. Engaging with this category can be challenging due to their cautious approach, though they are relatively numerous.
Lastly, we have the M&A-resistant Strategic Buyers. These buyers have never ventured into acquisitions.
Engaging with them is challenging as they tend to be risk-averse toward M&A or have ample opportunities for organic growth. However, they make up the largest group of buyers.
To make step #1 efforts most productive, it’s better to focus on Serial and M&A-friendly Strategic buyers as they are the most likely to engage in a competitive bidding process.
#2 Gaining Insights: From a nice-to-have to a must-have opportunity
Or leveraging opportunity cost.
Understanding why companies pursue acquisitions is crucial, as these motivations can be unique.
They might be doing it because they’re facing unexpected problems when trying to enter a new market, or they’re losing their loyal customers to new, tech-savvy competitors.
But you won’t get insights into these specific reasons unless you’ve engaged in multiple interactions with the sponsor at the potential buyer.
The sponsor is the person who will oversee your company post-acquisition and will be responsible for pitching the acquisition opportunity internally.
The stronger the sponsor creates a sense of urgency within its organization to secure your company, the more acquiring your company shifts to a defensive strategy.
Having these ongoing interactions means you gain a deeper understanding of their specific challenges.
When you’re in business together, it creates a sense of being on the same side, which makes them more inclined to share their company’s problems and urgent needs with you.
With this knowledge, you can strategically position your business and determine the best timing to present your M&A opportunity as a defensive move rather than an opportunistic one.
#3 Building Momentum: From an auction process to a bidding war
or teaming up against several defensive buyers
When you’re working with defensive buyers, things get a bit tricky. You can’t always tell how much they’re willing to spend.
They tend to play it cool by bidding just a little more than opportunistic buyers.
To get them to bid even higher, you’ve got to make them believe you have a better option on the table.
I’ve seen some cowboys claim, sometimes falsely, that they have a far superior alternative. Their confidence was based on their strong belief in their company’s high opportunity cost.
When this tactic succeeds, they’re hailed as geniuses. But when it doesn’t and the presumed defensive buyer decides to back out, well… it’s like reliving David Trezeguet’s missed penalty during the 2006
World Cup Finals against Italy — still a painful memory.
To me, M&A is not poker.
For instance, when a buyer is failing to break into a target market competes against another buyer whose business has been substantially impacted by the long-lasting effects of COVID-19, all sorts of sparks fly in the bidding process!!
In conclusion, the game VC-backed companies are playing is bridging the value-to-price gap.
I’ve had the privilege to see firsthand that a winning strategy combines revealing the intrinsic value and leveraging supply and demand dynamics before diving into an M&A process.
Building active business partnerships with at least three potential buyers is the key to success. It may sound simple, but it’s often overlooked and is the primary reason behind some pretty disappointing exit experiences.
In a nutshell, our 3-step Corporate Development process, designed to turn opportunist buyers into defensive ones, is
In the high-stakes world of Venture Capital and M&A, adopting this proven strategy can make the difference between a mediocre outcome and a successful one.
See you!