Tuesday, 6 October 2015

Sell-side M&A

Know your buyer - how to strike the right note on your big deal

Exits are the most rewarding stage of your company's growth journey, in more ways than one. The planning process for your exit starts at the very earliest stages, and will continue if you take on third party investment, as you seek to demonstrate to potential backers that there is a realistic prospect of a lucrative exit in reward for the faith required of them.

When you do come to start a more proactive marketing and sale process, it is critical that you have a good understanding of how your potential buyer will approach its decision making process. You should be looking to put yourself in their shoes so you can pre-empt any concerns they may have, and tailor your approach to negotiations to ensure that you get the best deal.

A key differential, if a broad one, is that some buyers will be trade buyers and some will be institutional investors who will be buying your company as a financial investment.

Trade Buyers can offer a great fit
  • The classic trade buyer is a company which is looking to make acquisitions in its own industry. Commonly, trade buyers are motivated by the prospect of synergies which can give rise to economies of scale. However, synergies can extend to other strategic objectives, including the need to enter new marketplaces, the need to grow market share and other subtler synergies such as complimentary intellectual property. These tend to be longer term goals than those of purely financial buyers.
  • Trade buyers will often have a deep practical knowledge of your business, arising from its own activities. This means that they may place less of an emphasis on retaining and incentivising an existing management team. Trade buyers will also make thorough plans for integrating your business into an existing outfit. 
  • From a valuation perspective, the trade buyer will need to get comfortable that their agreed valuation reflects the value of identified synergies less integration costs. Their diligence will tend to reflect this.
  • If your most likely exit route will be to a trade buyer, you should focus in your planning on how you can make their deal easier. You need to show them how your business can be transplanted as seamlessly as possible into theirs - shared culture, functional systems and management, and a dovetailing between your strengths and their weaknesses.

Financial Buyers can offer great firepower
  •  Financial buyers will need to see growth potential in your business as it stands. They will also generally be attracted to targets with the strong annuity revenues required to support leveraged finance and where they have a good prospect of a short to medium term profitable divestment. If it essentially an MBO deal or variant which is proposed, then there will be a strong focus on the management team of their target. Unsurprisingly then, a financial buyer will focus much of its diligence on revenues and on management.
  • Increasingly, private equity houses are able to finance their deals from more sophisticated funding products on a global basis via multiple sources. By contrast, trade buyers without the benefit of a cash war chest for acquisitions may find it much harder to access finance for their acquisitions.
  • In recent years, trade buyers have powered the M&A market in the wake of private equity retrenchment since 2009 in the aftermath of the credit crunch . However, PE is well and truly back on the scene. It is likely that PE buyers will take back their place at the head of the M&A market: as confidence amongst institutional investors continues to grow and the availability of finance continues to improve, trade buyers will struggle to match PE valuations.
  • If your most likely exit route will be a private equity buyer, you need to show strong cashflows, long term contracts with the "stickiness" necessary to underpin revenue forecasts. You should also consider how to help them plan their own exit - what are the areas for organic growth? Your PE buyer will need to see something left for them in terms of hot future prospects for the business.

Hybrid buyers can offer fit plus firepower
  • Increasingly we are seeing buyers who are part-trade, part-financial entering the market. Essentially, these buyers are pursuing variants of the "buy and build" model. Activity amongst hybrid buyers is a particularly noticeable trend in capital-intensive sectors where PE players can see a case for investing in economies of scale synergies. There are more and more PE-backed investors who are specialising in this approach and targeting highly focused niches.
  • Hybrid buyers will often seek to make acquisitions on the strength of their own balance sheet. However, you should be aware that some hybrid buyers will be negotiating with their own financiers  concurrently with closing the deal with you. In these circumstances, it is especially important that timetables are adhered to such that your buyer can in turn progress its own financing transaction.
  • Hybrid buyers are particularly noticeable in certain IT sub-sectors at present. However, it would be no surprise to see this trend on the increase in other capital-intensive sectors, such as cleantech and biotech.
As a seller, you do need to recognise the nature of the buyer or buyers you are dealing with. If you are running a competitive process with both trade and PE buyers, you will be struck by the difference in their approach. Ultimately, if you and your deal team have this level of strategic understanding of the drivers behind buy-side behaviour, this will translate to tangible value. Once you know where your buyer's buttons are, you can start to push them!

Thursday, 11 June 2015

Why SAFEs are increasingly being entered into the UK…

Increasingly, founders of tech start-ups in the US are issuing simple agreements for future equity (“SAFEs”) as an interim equity fundraising instrument. In turn, we are starting to see these instruments creeping into the UK start-up scene. So what are these SAFEs, and why would you use one?

All too often, I am witness to painful valuation discussions at pre-Series A stages which distract founders and can taint their relationship with the early investors. In the right circumstances, SAFEs provide a useful alternative.

SAFEs are simple equity subscription commitments which are used instead of conventional seed equity issues or convertible loan notes. They are a helpful tool in that, unlike convertible loan notes (which commonly carry an interest rate and a redemption mechanism for the period that the notes remain unconverted), they are contracts for pure equity. The key benefit over a share issue though, is that the valuation need not be fixed at the time the SAFE is put in place; rather it is commuted into the next funding round when the equity committed by the SAFE is actually issued, potentially with a discount or cap on valuation attached. SAFEs contain basic reps and warranties, and provide for the SAFE holder to get customary investor protection in proportion to that offered to future investors. As a result, SAFEs tend to be much quicker to negotiate and close than the alternatives.

In the UK, while we have seen a number of SAFE proposals in recent months, they have not quite entered the mainstream. We do have something similar, in that the practice has developed for SEIS/EIS investors who need to provide ad hoc financing to companies to enter into “advance subscription” commitments with companies. These advance subscriptions developed as a practice owing to the restrictions in the SEIS/EIS legislation on use of convertible loans. So effectively, the advance subscriptions are irrevocable commitments for future equity. They are not always simple (compared to a SAFE agreement which can be just 5-6 pages long) but they operate in a similar way.

So, as the funding environment remains strong in the UK, I predict that we will see more and more of the hottest early stage companies deferring difficult valuation discussions during seed stages, and instead doing SAFE financings, which can be structured in such a way as to take advantages of the sought after SEIS and EIS tax reliefs.

Investors who may be tempted to agree to a SAFE will need to get comfortable that the Company is in good shape, and that matters like founder vesting/ leaver provisions and other basic protections have been provided for by the Company. While the funding climate is strong at present, a five page SAFE will rarely by itself give enough comfort to first time investors. Either (i) the SAFE needs to be put in place alongside a customary governance regime containing typical investor protections; or (ii) SAFEs will be used more as emergency or bridge financing where a conventional round has already taken place.

However, as long as the funding climate remains strong, we will surely be seeing more of these.