An attorney and Internet technologist with more than 20 years of experience, Donahue has worked with organizations as diverse as GE Capital and the US Army.
In his HostingCon 2009 presentation, “How to Structure Your Company Now to Sell Later,” Monday morning, Deep Web Technologies COO and corporate counsel Larry Donahue will explain how companies can build more value into their businesses in preparation for that day when it leaves their hands. In a WHIR Q&A, he answers some questions about the process of making a business worthy of sale.
(WEB HOST INDUSTRY REVIEW) — As HostingCon approaches, hosting industry professionals are gearing up to meet with industry contacts, potential partners… and even a possible buyer of their business. Hosting business valuation is a hot topic right now (the current issue of the WHIR magazine is focussed on it) and a business has a lot of preparation to do before an offer is put on the table.
In his presentation “How to Structure Your Company Now to Sell Later,” Larry Donahue will explain how companies can build more value into their businesses in preparation for that day when it leaves their hands. An attorney and Internet technologist with more than 20 years of experience, Donahue devotes his time to helping small, high-tech startups in the Internet and e-commerce sector.
Donahue is currently chief operating officer and corporate counsel for Deep Web Technologies (www.deepwebtech.com), which specializes in providing deep web search technology. Unlike traditional web searches that drag their nets across the surface of the ocean, deep web searches cast their lines far down, finding online information buried on dynamically generated sites.
In his experiences prior to Deep Web Technologies, Donahue helped FatCow Web Hosting (www.fatcow.com) drive triple-digit growth rates and oversee its sale for a higher-than-average valuation. Prior to FatCow, he spent nearly a decade as a technology consultant and Internet attorney, working with organizations as diverse as GE Capital and the US Army.
In an email conversation with the WHIR, Donahue explains what companies should do to make themselves attractive to potential buyers.
The WHIR: How has the recession and the credit crunch changed the way companies make their merger and acquisition decisions?
Larry Donahue: I think there are two aspects to this question: What are the valuations and parameters of M&A deals during these tough economic times, and how does today’s recession impact how people look at M&A as a viable exit strategy.
In my session (Monday, 11am to 12pm, Business Development Track), I’m going to focus on the latter aspect of that question.
I have found that many ISP’s and hosting companies have always had a difficult time keeping their heads above water. Many of the business owners I talk to, feel as though they are on a hamster wheel, and really have no idea how to get off. They face tougher competition from the local bells and/or the more entrenched national or international players. Many have seen a decline (or at least decreased growth) in signups during this recession, and they look to a potential sale as a means to “get out while they still can.”
The problem, of course, is that it is not a great time to sell a business. It is a buyer’s market out there. The recession has pushed a lot of marginal companies over the edge. So, unless you’re unconcerned about maximizing your valuation, it’s probably not a great time to sell.
I also see cutbacks in staff, to help trim expenditures. This oftentimes leads to compromises in business processes. I encourage businesses to really understand what their strategic strengths are, and to not compromise. For example, if your business is really known for great customer service, it’s probably not a good idea to reduce hours or cut back staff in the customer service department.
Assuming a company has created value that has sparked interest in buyers,the company may have a bright future. How does a company determine the right time to sell when it looks increasingly appealing to retain ownership?
LD: Ah, this is a great question. My advice, and something I will discuss at the session on Monday, is to really keep track of those key metrics that directly correlate to valuation, conduct a realistic assessment of how those key metrics will change over time, and then identify when the right numbers are reached, to obtain the number you’re looking for in an exit.
This may be better explained in an example. First, let’s assume we’ve talked with a number of brokers and suitors, and have a reasonable belief that our business can obtain 1.0x of annual revenue. Note that depending on the business, this can be different. For example, managed services related businesses may look at a multiple of profits. SaaS based businesses seem to be a multiple (2x to 8x, sometimes more) of annual revenue.
(let’s keep this easy)
Second, let’s assume I own 50% of the business, and that it generated $2M in revenue in 2008, and I’ve consistently grown the business 100% per year, for the past 5 years. Third, let’s assume that we understand our business model, operations, sales and marketing, and have every confidence that we can continue our outstanding growth for the foreseeable future. The business scales. All I need to do is add servers, therefore I don’t need to acquire a new datacenter or anything out of the ordinary.
Forth, let’s assume that I love my business, but that I would be willing to walk away with $10M in my pocket.
When should I sell?
(a) 2009: $4M
(b) 2010: $8M
(c) 2011: $16M
(d) 2012: $32M
(e) 2013: $64M
The correct answer is probably (d). My 50% of the business would yield $16M, right? No. First, every business usually has some form of liabilities. You need to subtract the liabilities from the final sales price. Let’s assume $2M in liabilities in this example. At 50% of the equity of the business, I need to subtract $1M from the $16M. We’re now at $15M. We can’t forget about tax. So, Let’s assume a 20% capital gains tax. We’re now down to approximately $12M that I can pocket.
If we selected (c) under the same fact pattern, I would have walked away with approximately $5.6M, and been sorely disappointed.
Note that almost all situations are more complex than this, and it’s very rare to find a business that maintains superb (and steady) growth characteristics. Almost all business have steady, but proportionately decreasing growth characteristics. Also, do you love those “pay in advance” and/or “yearly plans,” because they help your cash flow? Unfortunately, they can really come to haunt you in a sale, because all that cash is actually a liability on your books.
The point here is, an actual date can be calculated, assuming you know enough of your business metrics, and what the variables are that examine when considering a valuation.
Is it safe to assume that a company’s value is roughly 1x annual revenue? And, what other factors impact a company’s value?
LD: Unfortunately, I’m not the best one to consult on the “going rate” for valuation. My expertise is in the general factors, and I always, always, always consult with the brokers experienced in the particular businesses I either run or consult for.
With that said, 1x of annual revenue is what I’m hearing on the street for your typical, vanilla, run-of-the-mill ISP and hosting company, although there are exceptions for businesses with unique business models or extraordinary metrics. Also, every once-and-a-while a business is the lucky beneficiary of a strategic purchase (i.e. a purchase by an entity that is not currently in the specific industry, and is buying your business to either move into the industry or obtain your technology). These strategic buys are very, very rare, and generally should not be counted on.
Factors that impact value are numerous. Before I touch on some of those, we must keep in mind the ultimate goal of a successful exit: Cash in your pocket. Some golden tips to consider:
- Retain as much equity in your business as possible. Don’t be quick to give up equity for small, especially silent, partners.
- Keep liabilities low. Minimize borrowing (and deferred revenues).
- Consider investing in assets, especially strategic assets. Real estate, if you can afford it, often makes a tremendous difference for successful exits.
- Capital gains are taxed at a lower rate than ordinary income. Bonuses are considered ordinary income. If you’re asked to sacrifice on the cash paid for your business, in return for a long-term consulting project or employment contract, don’t forget to consider (1) the differing tax rates, and (2) the fact that money paid today is worth more than money paid to you over time.
So, the factors I’ve seen impact valuation fall into several major categories, with specific key metrics underneath each one.
- Financials (of course). Acquirers of your business want to see steady, predictable, proven growth in revenue. This means accurate, consistent, professional looking financial reports. Have monthly, quarterly and yearly numbers readily available. If valuation is based on profits, you better have a consistently growing EBITDA at least over the past 3 years, ideally at least 5 years.
- Key business metrics. This includes CAR (Customer Acquisition Rate), churn, signup growth, ARPU (Average Revenue Per Unit of sales).
- Brand & Identity. Is your business famous? Is your brand and identity clever, easily identifiable and easily defendable? Consider “web-hosting.com” versus “fatcow.com”. Does your brand have a strong and identifiable meaning in the marketplace? Consider Nordstrom, and what that name means with respect to customer service?
- Strategic Advantage. Do you own key patents or otherwise have difficult technologies or processes nailed? Does your business do something that is difficult to replicate?
- Key Employees. Is the success of your business tied to a few superheroes, including yourself? If so, what happens to the business when the key employees get rich on the exit? An acquirer has two options: (1) decrease the value to what they think the business may do, when the key employees leave; or (2) put in place some form of “golden-handcuffs” to keep those employees around. #1 is much more cost effective, from an acquirer’s perspective, than #2.
Obviously, if you really excel at one or more of these, it will have a strong impact on your ultimate valuation.
These factors should be matched to potential suitors. For example, if an acquirer is simply interested in ditching your brand, and sucking in your accounts into their platform, they will not value a great brand nor value any strategic advantages. In fact, strategic advantages (such as a high-end offering) may reduce the value in this suitor’s eyes, because it means they will lose some of your customers in a transition.
On the other hand, if a suitor really appreciates your brand, and wants to augment your brand with their technology, they will place a much stronger emphasis on the value of your brand and your key business metrics.
Small web hosting companies are often run by tech specialists rather than business specialists – what can these companies do to make sure they’re not getting a raw deal when it comes to selling?
LD: In general, there are three stages to selling a business: (1) building the business years before it is sold, (2) pre-sales, and (3) negotiations, due diligence and closing. My session will mostly focus on #1, which is where a business has years to focus on growing into a valuable asset for a successful exit.
My answer depends on the stage: In building the business, keep detailed, consistent and accurate financials and key business metrics. If you do not, a potential acquirer can use it to their advantage. For example, suppose you don’t have an accurate way to keep track of churn? An acquire would be all too happy to assume a number — a high number. If you sold gift certificates, and didn’t keep track of your redemptions, an acquirer is all too happy to assume you have more gift certificates out there than you do (i.e. a high liability). Suppose you just recently learned how to keep accurate track of monthly signups. An acquire might want to discount your growth, since you can’t prove it over the long-term.
Besides, if you look sloppy in the way to manage your business, keep your financials or track your key business metrics, it creates FUD (Fear, Uncertainty and Doubt) for potential acquirers. The natural, and all-too-human tendency would be to devalue such a business. It also creates anxiety in trusting all the great things you say about your business.
In the presales stage, this is where you’re actively looking for acquirers. My suggestion here is to begin to seek competent representation. This industry is blessed with some very intelligent, capable and honest attorneys and brokers. Talk to them all. Seek their opinions and counsel, and work to form a trusting relationship with someone that can represent and negotiate for you, as a sellers agent.
In the final stage, it is key to have a competent, experience transactional attorney and a sellers agent working for you. They’ve done this before, and can help you through the process.
The “dirty little secret” in selling your business is: The acquirer will produce a term sheet or offer letter for your business. You can’t start counting your riches yet. You will enter into a “due diligence” period, and this is where the acquirer has a legitimate interest to (1) not get burned, and (2) discount or devalue aspects of your business deemed not desirable or valuable by the acquirer. Competent representatives can help you navigate through this very tough period, helping you to understand what you should give or stand your ground on.
What should companies do to prepare staff for the potential sale of the business?
LD: First, I always recommend being honest and upfront about an exit. I like to tell my employees what the time horizon looks like, and what they can expect. Second, I work to provide some “skin-in-the-game” for employees, so they can look forward to an exit, as opposed view it with trepidation. If they fear an exit (actual or perceived), they will work against it. Similarly, if they can benefit — and understand exactly how it benefits them — they will work to help the business maximize its value.
Therefore, third, I believe it’s important to help staff understand exactly where the business needs to go, and what needs to be done to maximize value. I like to provide both a goal and stretch goal. “If the company sells for $10M, it means each option is worth $X.” This helps employees calculate exactly how much they can earn in an exit. For lower-paid support personnel, $10k to $20k on an exit is very appealing. On the other hand, a high-paid corporate counsel may need $250k or more, to find an exit appealing.
