Friday, May 18, 2007

Selling/Acquiring a Startup: the Price Issue

"How can we be so far apart on price?" is the common lament of venture-backed companies who find themselves with an acquisition offer. Here's the view of one of my clients, a US company who has been an active acquiror of early stage industry players:

In the public markets, software companies are valued at predictable multiples, this acquiror says. Companies that aren't profitable trade at 1x revenue; companies that are growing, but not profitable - 2x revenues; companies that are growing and profitable - 3x revenues. By contrast, startups and their VCs are looking for purchase prices that yield 4-5X return on invested capital, minimum, regardless of revenue. Is this acceptable?

It can be, says this acquiror, if buying the target startup can jumpstart the multiples at which the acquiror is valued. Buying into the ground floor of a market with huge growth potential may increase the acquiror's share price, making the deal worth the price tag.

But a number of factors usually work against this theory, lowering the price tag. If the target startup has technology, but not a product, the price goes down. For most acquirors, (IBM, Tekelec or Alcatel excluded), buying technology is an inherently riskier proposition. It means the acquiror must create the product, the go-to-market strategy and locate the customers who will create a viral effect for the new product before the acquisition can have any impact on the bottom line. Very few software organizations have the large, well-honed sales force and go-to-market groups to accomplish all this in a speedy timeframe.

The purchase price goes up significantly if the startup has a product with a first-rate go-to-market structure and good sales support. But even here, the offer will still be discounted if there isn't yet sufficient traction with lead customers. It is not enough to have sales; are you selling to lead customers who will create a chain reaction demand for your product in the marketplace?

If not, this acquiror argues, the purchase price again should be reduced. A premium price is payable once the viral effect has started. A lower price applies if a target startup is still one step away from a viral market.

As you plan ahead, think of where your business currently sits in the value chain for potential acquirors. Having best practices go-to-market structures(and documentation), even in their early stages, can go along way in price negotiations.

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