There’s so much talk about unicorns but 99% of all M&A transactions happen with almost nobody noticing, and 40% die before they had a chance to get started. Here’s what two decades of selling companies worth $5-to-$50 million teaches you, according to the Practical Founders Podcast.
Types of M&A buyer
Most M&A deals involve one of three different buyer profiles:
- Entrepreneurs looking to “buy-and-build” – these usually offer a mixture of cash and equity, as they want the seller to have skin in the game.
- Financial buyers / private equity – also typically want the seller to retain some skin in the game to de-risk the transaction.
- Strategic buyers – these are usually the preferred type of buyer. May be an all-cash deal, and may provide a higher multiple if the target is perceived to be worth more to the buyer than it is as a standalone company (e.g. if the buyer can sell the target’s product to its existing client base).
All-cash deals versus carried equity - what's better?
While all-cash deals have the obvious benefit of instant liquidity (DQ cofounder, Oliver, is evidence of this), you shouldn't underestimate the value of carried equity when you sell to the right buyer. If and when the buyers sells, founders can enjoy a second bite of the apple, which may be even better than the first. Listen to the story of Jeremy Clarke of WebMerge, who received two payouts - the first $30m, the second $70m!)
What revenue multiple can you expect for your SaaS startup?
Public market valuations and VC funding rounds aren’t the only thing to tumble since 2021, M&A multiples have dropped too. Where SaaS multiples of 10-20x were common in 2021, according to M&A expert Chris Kern the range is now 3-to-10x, with most SaaS deals going for 5-7x revenue.
As well as a general cooling in price and expansion expectations, the following are also contributing factors:
- Most M&A deals are funded at least partly by debt. The rising cost of capital (and the unprecedented rate of increase) has made buyers more circumspect about taking on debt.
- Banks themselves have become more stringent at underwriting deals.
- Many buyers look for “valuation arbitrage”. If they can buy a company at a 4-5x multiple while they themselves trade at 6x, they get an instant multiplier on valuation when the deal closes. If the buyer’s multiple has dropped, so must the target’s.
What pricing factors are often misunderstood by tech founders?
Here are some common truths recognised by people within the mergers and acquisitions industry:
- Companies with greater than $20m top-line revenue trade at higher multiples than those with less than $20m. Aside from any economies of scale they can exploit, financial buyers can enjoy an instant bump in valuation simply by merging a group of smaller businesses into one larger one.
- Transaction-based revenue tends to be more susceptible to external market factors than subscription-based revenue, so transaction-based revenue is generally valued lower than true SaaS.
- Annual contracts are typically valued higher than monthly renewals, as they they function a little like an “order book” of guaranteed future revenue.
- B2B tends to be valued higher than B2C, partly because consumers tend to churn more, and partly because you need a lot more volume when you’re selling small ticket sizes, which can make B2C revenue harder to grow.
- Cap tables can influence valuations in both directions:
- Complex cap tables can make it harder to close a deal, which puts downward pressure on valuation.
- Having a well-known VCs on the cap table might IMPROVE the valuation, as buyers sometimes assign value to the credibility and future opportunity provided by a relationship with the investor.
- Buyers will chip valuation if there’s any kind of desperation. Unsurprisingly, inbound enquiries from buyers can lead to an easier close than shopping a deal (outbound).
If I sell my SaaS company, will I need to join the acquiring company as an employee?
Although there are exceptions, in most cases founders need to stick around for a period of transition, knowledge transfer, and to ensure business continuity. This is especially true in the case of smaller teams, where the founder is integral to the day-to-day business. These transition periods tend to range from two to six months, but they can last several years. Not all founders want to leave, especially where they see the potential of a second large payout.
What obvious mistakes should founders avoid when selling their company?
Try not to look desperate. It probably won't come as a surprise to hear that, when buyers know a founder needs to sell, they're more likely to make a low-ball offer. This is by no means an unusual situation, either. Distressed sales occur regularly, usually due to one of the following:
- Founders lacking the appetite or skills to take the company to the next level, i.e....
- Building a team
- Raising capital
- Building out the product
- Founder health issues.
- Founder or shareholder disputes.
- Founder legal or financial issues (such as a divorce).
- Founder burnout.
What are the main reasons for companies not selling?
Two factors stand out here. Not only will these often prevent buyers from making offers but, in extreme cases, they may prevent M&A advisors from taking on the mandate in the first place:
- The founder isn’t organised;
- The founder’s valuation expectations are unreasonable.
What are the main reasons deals fail to close after an offer has been accepted?
Once a buyer and seller have shaken hands, there's still time for a deal to come undone. The most common causes for this are:
- Unpleasant surprises during due diligence.
- Leverage might not come through for the buyer.
- Downward pressure on valuation or a change in strategic direction caused by wider market forces (e.g. economic, seller’s strategy, another business had a problem, big hit to group revenue within the buyer's organisation, etc.)
What should founders know about appointing an M&A advisor?
Here are some factors to consider:
- Research conducted into 10,000 US-based deals found that deals involving an M&A advisor outperformed those that involved none, so the argument seems to hold water that an advisor will get you a better deal that you'll get alone.
- However the same research showed that appointing more than one advisor generally resulted in a worse outcome than having no advisor at all!
- If you do appoint an advisor, they may or may not charge a retainer.
- They will most definitely charge a percentage of the deal, with the market norm being somewhere between 2% and 6% of the sale price.
- It’s common for advisors to ask for a ratchet, which gives them a financial incentive to outperform on valuation.
- It’s rare that an advisor will turn down a deal but, as mentioned above, if this happens it’s usually a result of the founder's lack of organisation or unrealistic expectations on valuation.
- If you do appoint an advisor, there’s a high probability of closing a sale because there are many buyers out there with a lot of capital waiting for a good deal at the right price.
What simple advice applies to any startup founder who wants to sell their business?
- Get your numbers straight.
- Get standard operating procedures (SOPs) in place, so the business can operate without out.
- Do some benchmarking to ensure you have reasonable valuation expectations.
- Allow at least six-to-eight months to get a deal done
What levers can founders pull to maximise their exit valuation?
A focused, clean, organised, systems-based operation that’s not dependent on the founder will typically get a premium over a business with flaky metrics and a messy structure. If you’re preparing your business for a sale, focus on the following:
- Grow top-line revenue.
- Try to ensure your rate of growth isn't slowing.
- Consider the sustainability and profitability of your business. Generally speaking buyers no longer believe in "growth at all costs".
- If you're carrying debt, make sure your debt service coverage ratio (DSCR) is above 1.25.
- Reduce churn and increase net revenue retention. Nobody wants a leaky bucket.
- If your churn is high, figure out what's required to fix it (this is likely to be a key consideration for the buyer).
- Figure out the potential for growing revenue.
- Figure our the potential for growing margins (do you pass the rule of 40?).
- Nail down your SOPs and KPIs, so the business isn't reliant on a few key individuals.
- Consider applying for a patent. Perhaps surprisingly, even in software patents can be a major driver of valuation.
- Work with an M&A advisor, who can guide you through the acquisition process while you continue growing the business.
Why employ an M&A advisor?
At first glance, the fees charged by M&A advisors can seem unfairly high and off-putting, but there are some very good reasons for working with a professional.
- They can bring in more buyers and create competitive tension, which will often result in a higher purchase price and more money in your pocket.
- They understand deal structuring, so can help you negotiate terms that suit your personal preferences (e.g. a higher cash component and less equity, or vice versa).
- They can help you avoid unpleasant terms, such as overly severe warrants.
- They can set realistic expectations between the buyer and seller and ensure the acquirer understands what they’re buying.
- Selling a company is a totally different skill set, nerve racking, and stressful.
- They’ll help founders with the psychological side of selling their baby.
- Perhaps most important of all, they can allow the founder to continue running the business, growing revenue and optimise the other factors that will lead to a higher valuation. Selling a company is a full-time job. If you do the work yourself the performance of your business might suffer. Worse still, if the deal doesn’t close, you may find yourself in a significantly worse position that you were before the process began.
Chris Kern is a US-based M&A specialist, who’s been doing mid-market deals for the last 20+ years. This article is based on his interview with Greg Head on the Practical Founders Podcast (link at top).
– Featured image by Romain Dancre.