With so many M&As in the offing, as well as many new start-ups seeking venture capital, many executives ask us what it takes to attract an investor or buyer, and ask us if an investor would be interested in them. After working with many private equity and venture capitalist firms (and entrepreneurs), I have seen how these firms pick or pass on companies. Many CEOs, after a great career building their companies, often want to exit — to the golf course or world travel, leaving the companies in new hands.
A few points about the investment community, in my simple view: The investment world is divided into Venture Capitalist firms (VCs) and Private Equity (PEs) firms. And there is a life cycle, or investment phases:1
Early stage investors, often called Angel funds, are idea or seed funders. At this stage, investments are considered extremely high risk, so often the amount of capital can be quite low or the amount of equity they take for their investment quite high. The more established your company and product is and the more credibility you have in the market (i.e. validated though closing important sales) the more you are a candidate to pursue first round investors. The need/purpose for capital varies a great deal with young companies, and you may find that you need multiple rounds. (And as such, the VC industry often categorizes themselves as early-stage, mid-stage and late-stage investors.) But one thing is certain: VCs are looking, ultimately, for an ‘exit’ (a high return on equity) by selling the company or going public. And this need to exit introduces a lot of complexity in their investment decisions. Extremely valuable companies often cannot get this type of funding, since a high return on equity does not seem likely.2
Private Equity companies, on the other hand, are more interested in value. Most often, they buy out a company, but others just take a majority equity share and still have other shareholders. The PEs are patient investors, unlike the corporate raiders portrayed in the media — like Danny DeVito’s character in Other People’s Money.
Although the investment community is awash in cash, funding is not as easy as it looks, from both sides: investors or CEOs seeking funding. So if you’re getting your company in shape to attract buyers or investors, here are 10 things you must have:
- Your innovation must be scalable. Anyone looking to acquire a company wants assurance that they don’t have to rewrite the code in all the new tool sets. Although the company being acquired may be mature, their technology must be current and scalable.
- The value you provide is bedrock essential to your customer. Your company may do cool things and have plenty of great ideas, but will an enterprise tolerate internal disruption to purchase your technology? In other words, where is the sustaining ROI/ROA you deliver?3
- The application is sticky. That is, once the solution is in, it is unlikely to get yanked out.
- Your solution is a catalyst for partner sales. This is a big area to think about. How does your product financially complement other applications? PEs or other software firms often buy their partners because of this fact — you may be small, but you might be a real door-opener.
- Your market is a growth market — target rich with potential prospects.4
- You have an attractive and loyal customer base. Changes in ownership structure or a new killer app in the marketplace will not unseat the application from the customer.
- Location, location, location. You may be in the geography the investor is looking to land in.5
Until now, I have not mentioned the newest trend, or the coolest or latest thing. Somehow, that shows up lower on the priority list for many investors. I have found it very interesting that this is quite important to some investors, while others are looking for stability and growth. And that brings us to the differences between Venture Capitalist and Private Equity investors.
- You generate cash, and still have growth. Cash is always king. Private Equity investors are looking for profits. But often, VCs are looking to funnel cash back into products and growth and may be less interested in profits in the short run.
- Venture Capital investors want youth — a new, fresh face. Of course everyone wants to make more money, but VCs are looking for significant growth in a short amount of time: Skyrocketing growth, in the current sizzling, buzzword markets. The ‘now’ technologies. Currently, for example, cloud computing, social networking, and virtual computing are hot in the venture community. A few years ago it was green tech. Desire and current fashion come together here.
- Private Equity firms (PEs) tend to look for mature companies. Your company has been to the dance before and knows steps that the young have not learned. Your company still has a lot of life in it. Though there may be some graying in the temples, but you have proven yourself over time and can generate cash for a long time to come.
Many private equity firms with whom we have worked further divide mature companies. For example, some invest in ‘distressed companies.’ Though lately, with poor economic growth, this approach is not as appealing. Often an orphan division, which is not core to a parent, might be better off in other hands, getting focus from a new owner. For instance, a company with a great history, acquired by a mega-enterprise that can’t absorb it, might flounder in the mega-enterprise environment but thrive back on its own again. These companies make great candidates for PEs.
PEs also look at size. Some PEs specialize in small companies, others in mega. You can easily learn this from the portfolios on their web sites.
Often, the strategy of building a portfolio of multiple synergistic companies can create new value. But don’t count on pitching that to an investor if you want to be bought. Your company‘s value needs to ‘stand on its own two feet’ to be attractive. If an investor needs to invest more in a company it has just purchased before it can generate revenue, that company definitely will be passed by on the dance floor.
One other critical point — VCs and PEs don’t mix well. So if you are a company with VC backing, it’s not likely you will find a PE partner willing to invest.
Ultimately, the CEO or founders need to come to terms with themselves as to whether the path to investment is even for them. There are many issues besides pure valuation that should be considered: company values, culture, and customer and employee care. Many companies have not found the right mix of financing and the relationship they are seeking to close the deal.
Though investors often state they are looking for market leaders (your top-in-the-industry), these types of companies don’t come on the market very often. If you are a market leader, why would you want to sell? But there are reasons. For example, you are a market leader with a family-run business and you’re looking to retire,6 PEs will definitely want to talk to you. You are amongst the hot. This is J. Lo territory.
VCs, think Lady Gaga — young and innovative. PEs, think J. Lo. Lady Gaga in the early stage was a risk brand. But J. Lo! Though no longer 20, J. Lo is one of the top earners in the entertainment industry.
1 I will not provide a dissertation on the sector. There is plenty to learn on the web, if you want to check it out. Return to article text above.
2 Often to do with the trends or fickleness of the public markets. Return to article text above.
3 PEs will look at this more as a rate of revenue growth. VCs may look at the rate of subscriber growth and the value of that base of subscribers (ultimately leading to revenue, such as Google, Gilt Group, etc.). Return to article text above.
4 This issue has a real impact on your valuation. Return to article text above.
5 Depending on the business model of the investor, the more they want to be involved with the operation, the more they would be interested in a firm within their geography. Return to article text above.
6 Or if you feel the company has needs beyond what you can provide, look for a PE firm that is synergistic with your vision for the company.
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