Category: Entrepreneurship

One of the more popular questions I’ve received after selling our startup to ExactTarget (see ExactTarget and Pardot Join Forces) is how we arrived at the valuation. Valuation, especially in the context of a strategic acquirer, is much fuzzier than a financial buyer that pays a multiple of profits. Pardot, according to the Inc. 500 awards site, reported 2011 revenue of $7.4 million on a cash basis (source), which is far lower than the acquisition price.

Here are some factors when thinking about the value of a startup at exit:

• What are the growth rates like?
• How much faster will the business grow with expanded resources?
• How are the gross margins now? Are they expanding with scale?
• How cost effectively does the startup acquire customers?
• What’s the renewal rate for customers?
• What are public market multiples for similar companies?
• How strategic or complementary is the startup to the core business?

Answering these types of questions can result in valuations that are 1x revenues to 20x revenues, in rare cases. There’s no correct answer — a startup is only worth what someone will pay for it.

What else? What are some other factors in thinking about the value of a startup at exit?

After a potential acquirer has built a serious level of interest in the business, and is ready to attempt to get a deal done, they will provide a letter of intent (LOI) outlining the characteristics of the proposed deal as a starting point for negotiations. LOIs are like being almost pregnant — it really doesn’t mean much. It is an understanding of the deal two parties are working towards, much like a term sheet, but slightly more detailed and involved.

Here are a few notes when thinking through the letter of intent:

• Standard due diligence and no shop periods should be of reasonable length (e.g. 30 – 45 days) to promote focused work by both parties (if things are going well, and more time is needed, it’s easy to ask for an extension)
• Financial considerations around the cash and stock mix, if applicable, are very important, especially if there’s a lock up on the stock where it can’t be sold for a period of time (in this current market of uncertainty, cash is much more desirable)
• Net working capital adjustments (e.g. the price goes up or down based on current assets) are always present, and should be considered carefully, especially if there’s serious deferred revenue (it’s a liability! — also note that debt will reduce the purchase price)
• Escrow funds (the amount set aside in the event of an issue) as a percentage of the deal and how long they are held should be aggressively negotiated (e.g. 7% of the deal held for 12 months might be normal depending on the industry)
• Other important, but less commonly discussed, items include things like indemnification where you agreed to defend the potential acquirer against future lawsuits for a period of time related to aspects of the business they are acquiring

A letter of intent is a major milestone in the process to sell a business. Once signed, both parties should work hard to get a deal done. The key is to not rush into signing the LOI, rather take your time and get the terms right up front, resulting in a much smoother process going forward.

What else? What are some other thoughts on the letter of intent process in the sale of a business?

Continuing with the theme of selling a business (see ExactTarget and Pardot Join Forces) I wanted to spend some time talking about the due diligence process. Due diligence is the time after the letter of intent (LOI) is signed until the deal actually closes. For us, we signed up for a 60 day due diligence period (usually there is a no shop clause which means once you enter due diligence, you can’t talk to other potential acquirers) but it only took 45 days until we closed.

Here’s how the six week due diligence process went (roughly 1-2 days per spent spent on each thing):

• Start – 250 item due diligence Excel spreadsheet requesting every piece of information you can imagine (e.g. all legal documents of any sort, employees, customers, partners, financials, source code, etc)
• Week 1 – accounting review on-site with finance people from the potential acquirer talking through the audited financials (note: AICPA independent audits are different from SEC independent audits), discussion of our financial models for next calendar year including key drivers, and review of areas needing more investment
• Week 2 – technical review on-site with engineering, infrastructure, and product management from the potential acquirer talking through the product architecture, database schema, hosting infrastructure, and source code
• Week 3 – HR review on-site with the head of HR from the potential acquirer talking through every single employee on staff, hiring process, corporate culture, and how to bring the companies together
• Week 4 – the most senior leadership from the potential acquirer come on-site and talk about the shared vision, potential, and alignment
• Week 5 – iron out the purchase agreement, employment agreements, disclosures, releases, and timing of everything for close
• Week 6 – close the deal!

All this while still running the business, and, unfortunately, not being able to talk about it with all but a handful of employees. Coordinating and delivering the necessary information for the due diligence process is nearly a full-time job. So, if you’re thinking about selling your business and are serious, go ahead and start getting everything that’s ever happened in the business in order and digitize anything in paper form.

What else? What are your thoughts on the due diligence process in the sale of a business?

Yesterday I wrote the post ExactTarget and Pardot Join Forces detailing how we had just sold our company and were super excited about the future. Today, I want to talk a bit about the human side of selling a business — it’s incredibly emotional. With Pardot, we never set out to build a company and sell it. In fact, I believe the best companies are bought and not sold (e.g. a buyer approaches you). Our goal for years now has been to work hard at being the best place to work and the best place to be a customer.

Looking back over the past several months, here are some of the emotions from the process of selling a company:

• Excitement – an email out of the blue saying that a large, public company is interested in talking about “partnerships” (look at the person’s title and if it says “Corporate Development” that’s code for mergers and acquisitions).
• Frustration – the initial conversations went well but there’s little activity and visibility as things usually don’t move very fast while the potential acquirer is reaching out to a number of different companies.
• Intrigue – the potential acquirer reaches out again and wants you to come on site and meet their executive team (I hope they like us!).
• Anxiety – the potential acquirer says they want to make an offer. What will it look like? Will it be a good valuation?
• Anxiety – the offer is good but we can do better. How many times do we get to say ‘no’ before we cross the line and are no longer desirable?
• Anxiety – negotiations continue for a couple weeks (high quality sleep at night is no more as the mind is racing with tossing and turning becoming the norm).
• Anticipation – a deal is struck! Now, for the hard part: due diligence.
• Anxiety – due diligence means incredibly detailed audits of all aspects of the business, not just accounting, and it isn’t the most fun.
• Relief – due diligence is almost done and there’s light at the end of the tunnel for the deal to close.
• Worry – now that the deal is going to close, what will the employees think?
• Panic – what happens if the press finds out about the deal and publishes reports on it before it closes? That will make conversations with employees, partners, customers, etc. very awkward.
• Excitement – the deal has closed and it’s done. Time to party? Not quite yet.
• Anxiety – it’s big announcement time for the employees and other constituents.
• Relief – the announcement went well and the secrecy of everything is finally gone.
• Anticipation – it’s time to get to work integrating the teams, products, and companies.
• Sadness – like a child going off to college, it’s sad knowing that chapter one is done and it’s time for chapter two to begin.
• Nostalgia – what we did was pretty special and we’re super proud of it.

Selling a company is a very emotional process. As much glamor and excitement is presented in press articles, behind the scenes it’s an emotional roller coaster.

What else? What are your thoughts on the emotions from the process of selling a company?

Albert Einstein said, “Compounding is mankind’s greatest invention because it allows for the reliable, systematic accumulation of wealth” (source). This statement is often used in the context of investing in public company stocks with a set-it-and-forget-it approach. Money compounding annually at a single digit percentage rate (e.g. 5%) will generate a significant return, especially in the context of decades (invest $100 at a 9% interest rate and it’ll double in value in eight years based on the rule of 72).

Now, for fast growing startups, the stakes are even higher. If the business is growing at a sustained 50%+ per year over an extended period of time (e.g. 5 – 10 years), the scale and enterprise value of compounding growth becomes even more dramatic. Want to see what crazy growth rates look like at super scale? Load up Google Finance for Apple’s stock and set the timeframe to 10y (10 years).

Compounding is an impressive phenomena for regular growth assets. For startups with traction and explosive growth, the increase in enterprise value is unbelievable. Pay close attention to growth and don’t forget the power of compounding over time.

What else? What are your thoughts on the enterprise value from compounding growth in a startup?

One of the things I recommend to entrepreneurs, but didn’t do well myself early on, was to reach out to mentors for help and advice. My daughter likes to say “sharing is caring” when parroting what she hears from her pre-school teacher. Sharing is caring fits perfectly with a mentor/mentee relationship — the more you give, the more you get.

One of the oft repeated YPO lines is “nobody, nothing, never” when talking about confidentiality. The same confidentiality applies to the mentor/mentee relationship. Building a foundation of trust and confidentiality is critical to get past the high-level content and really go deep with the core challenges and opportunities.

The next time you meet with a potential mentor or as a mentor with a mentee, bring up confidentially, in a graceful manner, and set the tone for “nobody, nothing, never.” The other person will appreciate it and likely reciprocate.

What else? What are your thoughts on confidentiality in a mentor relationship?