“Everyone lives by selling something.”
–Robert Louis Stevenson
In the previous article, I discussed some of what happened to lead up to having an offer on the table for the company I co-founded. My partner made a better offer than the potential purchasing company had made, leaving me to decide whether or not to take the offer or keep going with the company.
Spoiler Alert! I sold a majority stake and retained a minority stake, which completed our journey to financial independence.
I asked you to play along, and here’s what you had to say about the decision:
I’d make the deal based on these factors:
– The valuation of the company currently in relation to my reasonable expectation of future growth (which you analyzed).
– My alternate career choices and what income that would bring in (I’m assuming your goal would be “to be done” but if I enjoyed running the company, why would I want to “be done?”
– THEN I’d look at whether the amount offered helped me meet the two criteria above.
It’s tough to know what number to take without making some assumptions. Does the offer allow you to take a path that’s more beneficial to you but still provides an income: like, I don’t know, creating a new business?
If that’s the case, I’d say the offer you got would be too good to pass up since, as you noted, it made you financially independent. [Financial Independence] plus a chance to do something else that you love, maybe something you enjoy more, and still has income potential. That’s a sweet deal.
Note, the second commenter wasn’t me and wasn’t paid to say that!
Even if you have an offer on the table to buy your company, it’s rarely a cut-and-dry decision. OK. If you get an offer of $3 billion for Snapchat, you say yes faster than your vocal cords can actually utter it. The soundwaves of your acceptance should travel faster than the speed of light to the ears of the offeror.
But, for the rest of us entrepreneurs who will probably never see a $3 billion no brainer offer, there are a lot of factors to take into account when you have an offer on the table.
There are two components of the same number. First, does the number that you receive in the offer meet the valuation of the company? We used a crack former Merrill Lynch sell-side consultant to help us understand what our company was actually worth. In some industries, buyouts occur at a premium to fair value, and in some industries, buyouts are below fair value.
The simplest valuation model is to use discounted cash flow, where you project out future profits, use an assumed rate of return, and then discount the future money to present dollars.
A more nuanced and accurate market valuation is to use revenue and EBITDA multiples.
If you’re looking at a substantial offer for your company, it’s worth spending the money to get a highly skilled sell-side advisor. We do not regret one penny of the substantial fee that we paid to our advisor for his services. If you’re in a position where you need a sell-side advisor, contact me, and I will gladly connect you.
The second aspect of the offer is how it relates to your personal financial situation. You should know your priorities for your money How close does the offer get you to the target? Does it get you over the finish line with plenty to spare? If not, how much longer would you have to work?
The first offer that we received from an outside purchaser had a significant buyout component, and part of the offer was in cash and part of the offer was in equity.
Simply put, we could take some cash now and reduce our risk and trade our upside for our buyer’s upside.
When you trade equity, you have to think about the following:
- Whose upside is greater? In this case, it was a toss-up. They were a bigger company with a stronger sales and marketing team and we fit a gap in their offerings. On the other hand, we were growing at a decent pace in a growing market. We had some product innovations that were in incubation that could change the revenue and EBITDA multiples – a services company will generally sell for lower multiples than a product company.
- What do you have to do to earn the equity? Earnouts are generally going to be based on a combination of what you think that you could earn in the future and what your buyer thinks that you can earn in the future. The anchor will be your projections, but the buyer will probably set that as a baseline and make the really sweet offer at some higher multiple of that initial projection, arguing “that’s what you could do alone, but you should be able to do better when you have [our sales team/our back-end infrastructure/better recruiting/cool corporate swag] helping you out!”
- Will you be a division or integrated into the company? This relates to the previous point. If you’re operating as a separate entity, then you shouldn’t expect as much corporate help in achieving those buyout targets. If you’re merged, then you’ll have access to more resources, but it becomes more difficult to measure how you reached earnout targets.
- Do you like the management team of your acquirer? In this case, we really liked the senior team and we were expected to play a significant role in management of the company. It wasn’t a stretch at all seeing us all integrating harmoniously. This might not always be the case. Sometimes, the management team is jettisoned after the acquisition or kept with golden handcuffs through the earnout. Which leads to…
- What restrictions are placed on you as a result of the buyout? Are you expected to work for the acquirer for a certain number of years? Are you limited by what you could do afterwards by a non-compete? What’s the vesting for the equity? What sort of liquidity does the equity have? This last question is critical if you’re being bought by another privately held company. You’ll want to have liquidation provisions in place to allow you to capture the value of the equity that you traded your equity for. If you own your company, then you have access to the profits and can distribute them to yourself and your shareholders. When you’re just a shareholder in another company, you don’t have that access, so you need some way to convert the equity into cash.
Risk tolerance and risk aversion
This has two components to it: looking forward, and looking backwards in the future.
The first part is your current risk tolerance. How much money do you want to take off of the table and bank compared to keeping that money invested in your company to see if it can continue to grow at the pace that your company has grown? In our situation, the offer was enough for us to reach financial independence while still maintaining a small stake in the company, providing some further potential growth. Since we already knew our target number and our goals in life, we considered anything beyond what we received in cash as gravy.
The second part is potential regret aversion in the future. This cuts both ways. You could turn down the offer in hopes that the company grows, only for the company to have hit its apex right when you received the offer. If you receive a future offer, prospect theory will kick in, and you’ll hold out, trying to get back to the place that you used to be.
On the flip side, you could sell and the company could continue to grow. This is what happened to us. I sold a majority stake to my partner, and now the company is worth about 2 ½ times what it was when I sold. Had I not sold…
We made a decision that we were quite comfortable with. Prospect theory says that the pain of loss is greater than the joy from an equivalent gain. If we do a coin flip with $100 on the line, you’ll be more upset at losing the coin flip than you will be happy at winning the coin flip. The projected pain of the prospect of watching financial independence slip through our fingers and be delayed by years was far worse to us than the potential gain of holding on to double our return. Each case is personal, and, as the Internet meme states, YMMV.
If your goal as an entrepreneur is to have your business acquired, it’s rare that you’ll get an offer that is a snap call. There will be a lot of variables to incorporate into the decision. That’s where it helps to have an outside set of eyes to guide you through the decision-making process to answer the question:
Deal or no deal?
Are you an entrepreneur? What’s your exit strategy? Let’s talk about it in the comments below!