Lessons from the inside

Most people looking at an M&A transaction from the outside just see the deal announcement. What they don’t see are the hundreds of decisions that led to that point, the issues that nearly derailed the transaction, or the months and sometimes years of preparation that made the deal possible.

Having spent more than 25 years advising technology businesses on M&A transactions, my view is that deals rarely succeed or fail because of one particular issue that was unforeseen or unforeseeable. More often, the outcome is affected by a series of decisions made both before and throughout the process. Valuation expectations that are detached from market reality, the wrong positioning of an attractive business that fails to resonate with buyers, inbound approaches that are mistaken for commitment, misaligned shareholder objectives, or historic legal and financial issues that are overlooked and then emerge during diligence.

Our SMART framework divides a transaction into five stages: Strategic Insight, Marketing, Access, Rigorous Negotiation and Transaction Close. This is a 5 part series of articles using those stages to look at some of the recurring patterns we have seen across successful and unsuccessful transactions, and at the practical lessons founders and shareholders can draw from them.

This article is Part 1: Strategic Insight.

 Strategic Insight: Why some deals are destined to fail

When founders think about selling their company, they often worry about what might happen once a process is under way. What if the market learns about the process? Will they get the right valuation? How will they manage due diligence while also running the company? Will the price be chipped at the last minute? These are all valid concerns, but in my experience, many of the things that could derail the process are already present before the first buyer is approached.

The first stage of our SMART dealmaking framework is Strategic Insight where we look at the strategic positioning of the business, who the buyers are and what is valuable to them. We need to understand what the shareholders want and what process would optimise around the preferred outcome, as well as advise whether that outcome is achievable based on a view of market conditions and buyer appetite and whether the timing is right. And we do a transaction readiness assessment to proactively identify and address potential issues, to reduce risk of problems later in the process.

Shareholder objectives – can a deal actually be done?

One of the first questions we ask clients is why they are contemplating a transaction in the first place, and what is an acceptable outcome. It’s easy if it’s a fantastic outcome, but if that is not on the table, where can a deal actually be done?

There may be different stakeholders, e.g. founders, management, angels, institutions etc., so are they aligned? We often hear that shareholders have agreed that they should “explore strategic options”. Often this hides a lack of alignment and is a way of avoiding difficult conversations. If the stakeholders have not really agreed what outcome they are actually looking for and the objective isn’t clear before the process starts, it is just storing up problems for later. By that stage many months have been expended and either someone is disappointed or frustrated and may feel coerced into accepting a transaction that they do not want, or they decide to block it and the transaction falls over.

Before starting a process, you need to ask some uncomfortable questions. Does every significant shareholder share the same objective? Who ultimately decides whether to sell and who can block? If a buyer proposes rollover equity, deferred consideration or an earn-out, does everyone view those things as value in the same way? If the answer is no, it is much better to discover that before the process starts rather than halfway through exclusivity, when it might cause significant delays and loss of momentum, or even that the deal falls over.

What is the right valuation?

Valuation is one issue where many deals flounder. Founders tend to think about value in the context of where they have come from and how long it has taken to get here, all the years of problem solving for below market pay, or the valuation of the last round.

If the company has raised capital at high valuations in the past, that can be problematic. We often see companies with high historic valuations deciding to wait for a higher price in the future, but you need to ask yourself, what is going to be different in 12-24 months? What is the execution risk or the risk that the competitive environment changes. Does that outweigh the possible benefit? What do you need to be able to show in terms of a material change that will drive the valuation multiples higher and is that achievable/realistic?

We’ve worked with some great businesses in the past with profitable but modestly growing core businesses, where all of the growth comes from new initiatives that are planned or in development. Founders want to be paid for the upside, while buyers will argue that these are unproven. If your valuation expectations involve a strategic premium for revenue streams or products that are nascent or do not yet exist, then it may not be right time to sell. The more that you can provide evidence that newer revenue streams are actually real and that there is meaningful commercial traction, the more likely you are to be able to convincingly argue that they are sufficiently proven to support a higher valuation. If the message is that we “could” do this with the buyer’s support, then you are very unlikely to get them to pay for the opportunity.

The important thing from a deal perspective is to identify the valuation gap early enough and recognise what would need to change to close it. If the gap is not too wide, it can be addressed with deal structure (e.g. an earn out), but where the gap between market value and shareholder expectations is too wide a deal cannot be done and the process falls over. This wastes a lot of time and resource, taints the company with a failed process and may have been prevented with a more realistic view of the market and buyer demand.

Is it the right time?

Timing is particularly important where a company operates in a new or developing category. You can be too early in a market, as well as too late. We’ve had clients which have developed impressive technology and have achieved early customer traction. However if this is not translated into repeatable sales motion beyond early adopters, and the market is not sufficiently developed, you may find potential acquirers have not yet committed strategically to the market. That makes the acquisition difficult to champion internally, especially where there isn’t a business unit where this fits, or where it just isn’t high enough up the strategic priority list to action.

If there are too few buyers developing serious interest, the problem may not be that you are talking to the wrong people, but that more fundamentally the market is just not ready and there aren’t enough buyers for whom the asset is both strategically important and financially compelling at that point.

The Strategic Insight lesson

Strategic Insight is not just an exercise in setting an ambitious valuation and assembling a list of buyers. It is an honest assessment of what the market is likely to value, where strategic interest may come from and whether the evidence is sufficiently strong to support the outcome shareholders want.

Company readiness, market readiness and buyer readiness all need to be considered together. Strong execution can improve a transaction, but it cannot compensate for weak alignment between those three factors. The strongest signals in terms of timing are when the buyers are ready, willing and able to buy but the best deals are where all three factors come together.