By Gabor Garai
When entrepreneurs develop business plans, venture capitalists often ask about the "exit strategy" that, some years down the road, will enable the investors to realize their gains. The answers seldom vary: We'll have an initial public offering, or we'll be acquired by a large corporation or private-equity fund.
Venture capitalists know, however, that the first option -- going public -- is an empty dream in today's depressed public markets, and is likely to remain so for the foreseeable future. That means most growing startups have only one realistic strategy: to be acquired.
Just because only one option is likely doesn't mean no opportunities exist, however. It turns out that the mergers-and-acquisitions (M&A) marketplace now stands in marked contrast to the IPO market. It has become quite active, and it seems likely to grow even hotter. According to research outfit Mergerstat, middle-market M&A rebounded from a low of 251 transactions, valued at $26.9 billion, during the first quarter of 2003, to 331 transactions, worth more than $42 billion, during the fourth quarter of 2003. This year, more than 250 middle-market transactions were announced in January, 2004, alone.
Corporations have been in more of a buying mood the last few years, as they seek to take advantage of low interest rates and fill the marketing and production gaps in their offerings. In addition, private-equity funds face pressure to use the large amounts of cash many raised during the late '90s boom years. Failure to do so within a specified period often means that investors' money will have to be refunded. This means the loss of management fees, and risks the ability to raise the next fund. Consequently, the incentive to invest is very strong.
So looking ahead over the next 12 months to 2 years, the acquisition environment for growing companies could be quite attractive. This means venture capitalists and entrepreneurs alike need to be thinking in terms of proper preparation (see BW Online, 4/12/04, "How to Sell Your Company"). Acquisitions don't just happen in a vacuum. They occur most easily when businesses have taken steps to make themselves attractive to the corporate marketplace. Here are some suggestions for getting ready:
• Get your financials in order. Preparing for an acquisition is different from readying for an IPO. The ideal IPO candidate is one showing an accelerating growth rate, even if the company may be operating at a loss. By contrast, acquirers are more interested in steady profits and predictable cash flow. Ideally, a venture-backed company would want to demonstrate at least three quarters of increasing profits.
• Make a case for unexploited product or service opportunities. Corporations are especially eager to pick up outfits whose products or services will help fill gaps in the acquirer's own offerings. Moreover, those new products or services should improve the corporation's profits. To the extent a growing company can make the case that, despite its growth and profitability, it hasn't been able to fully realize distribution, sales, and other market-related opportunities, the more likely it will be to intrigue and attract suitors.
• Plug the key slots of your management team. Corporate acquirers see certain executive roles as more important than others. Presidents and CFOs are often considered expendable, since corporations feel that they can use their own people into those roles. But the management-team roles that are seen as more central to ongoing expansion and development -- such as the heads of sales and technology -- should be filled with seasoned professionals.
• Clearly articulate near-term goals. Buyers are less interested in sexy, futuristic visions than they are in the here-and-now. They want to see a rigorous plan that spells out how you will achieve your goals over the next 12 months to 18 months.
• Put in place strict financial controls. Acquirers especially value highly predictable earnings. They want conservative accounting practices and an emphasis on steady growth.
• Demonstrate your ability to leverage financial strength. If you have the opportunity to borrow funds, it's not a bad idea to go ahead and do so, as this will be taken as a demonstration of your ability to expand the business responsibly via leverage. Since a corporation or private-equity fund will likely be borrowing to make the acquisition, it will respect your proven ability to make things happen via borrowed funds.
If your company is in a position to realize an exit via acquisition in a year or two, now's the time to begin laying the groundwork for success. Cultivate relationships with investment bankers who specialize in M&A and network with corporations that are potential acquirers. And remember, just because there's only one likely exit, that need not limit your ability to take it!
Garai is a partner in the Boston office of the national law firm Epstein Becker & Green, specializing in the financing and growth requirements of small and midsize companies