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Pop the Bubbly -- It's a Buyout!

By Gabor Garai Once upon a time, venture capitalists defined success in the companies they backed as an eventual initial public offering. No longer. In today's world of churning and uncertain stock markets, an IPO is the exception, not the rule, for most fast-growing private companies. Increasingly, venture capitalists invest in companies with the expectation that they will be acquired by a major corporation or an investment group.

So even though companies that go public fetch higher valuations than those that are acquired -- on the order of 20 to 30 times earnings before interest, taxes, depreciation and amortization (EBITDA), vs. 5 times to 10 times EBITDA for companies that are acquired -- venture capitalists are first and foremost realists. They understand that it's more difficult for growing companies to go public than ever before.

THREE BIG GAINS. As I've detailed previously (See BW Online, 04/05/04, "What If Your Name Isn't Google?"), smaller-company IPOs today face all kinds of obstacles, including an absence of market infrastructure in the form of investment bankers and securities analysts that once supported smaller IPOs, along with burdensome expenses for going and remaining public.

On top of everything else, being acquired actually holds some advantages over IPOs for growing companies and the venture capitalists who back them.

The money comes in quicker. Acquirers typically pay some or all of the acquisition price in cash. When a company goes public, the founders and venture capitalists often can't sell their stock for six months or more. If an acquirer pays with stock, it usually doesn't carry with it as many holding period restrictions as in an IPO.

There's less quarter-to-quarter pressure to show profit growth. This enables the management team to focus on product or service development and other activities that aid a company's long-term growth.

The chances of being sued decline. While there's some risk that a buyer will make a subsequent claim against an acquired company, the legal exposure is generally less than for a public company, which can and often is sued by disgruntled shareholders if its stock doesn't perform well.

CATERING TO BUYERS. How can entrepreneurs running venture-backed companies prepare most appropriately for being acquired? They should attune themselves to the special desires of acquirers, especially as compared to stock market investors. For example, while both groups are interested in growth prospects, prospective acquirers will be most interested in the consistency of cash flow and profits, while the public markets will generally care a bit less about current profits and more about the rate of future growth.

In addition, prospective acquirers are likely to be more interested in a company's management fundamentals in such key areas as sales, marketing, and distribution. In other words, they'll want to know about a company's depth of management to maintain it on a consistent growth path. In the public markets, the sex appeal of a company's products and the likelihood of leading-edge technology may count for more than management fundamentals.

Given these distinctions, it behooves most venture-backed companies to begin thinking about prospective buyers years long before they actually enter the picture. Who are the likely buyers down the road, and how must the business evolve to satisfy those buyer constituencies? For instance, if you are growing a technology company, then you may be better off focusing heavily on the quality and infrastructure of your technology -- making sure the source code is properly documented, that you have a high-quality support team, and other such controls and assurances of quality.

ENJOY! Your company's culture will also likely be important. If you expect to be acquired by a tightly run corporation with all kinds of financial controls in place, then you might want to think twice about encouraging a culture where employees have flexible hours and warm-and-fuzzy benefits like on-site video-arcade games.

Your company's venture-capital backers should be able to help you position yourself in advance for an appropriate backer. Being acquired is a major transition, but if well-managed, it can be financially and emotionally satisfying to the founders. Garai is a partner in the Boston office of law firm Epstein Becker & Green, specializing in the financing and growth requirements of small and midsize companies.

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