How to Sell Your Startup (or not)
Successful Exit Strategies & The Due Diligence Process
In this lesson, you’ll learn about the different types of exit strategies for startups and how to conduct the due diligence process.
There are several types of exit strategies for startups. Let’s go over them.
1. No Exit or “Milking the Cow”
Your startup manages to stay independent and everyone lives happily from dividends. Companies that are able to establish a solid business model and scale might choose to stay independent and reinvest the profits in the company. In the same way that not every startup needs to raise money from VCs and business angels (bootstrapping is a viable alternative), not every startup needs to sell itself to a bigger company to provide a return to founders, employees and investors.
2. Startup Acquisition
The main exit strategy for startups is to sell the company to a bigger one for a profit. The same goes for investors. The buyer takes over the startup using cash or stock as a compensation, and key executives and employees from the startup often stay at the company for a period of time in order to be able to cash out and vest their stock. Exits provide capital to startup investors, which can then return the money to their limited partners (in the case of Venture Capitalists) or to the investors themselves (in the case of business angels).
3. “Acquihire” (Acquisition + Hiring)
In this case, the buyer is not as interested in the product as it is in the team, the talent. Acquihires often lead to the closure of the products and services that have been acquired and employees end up being transferred to a company where they usually receive significant hiring bonuses. Acquihires tend to happen at an earlier stage in comparison to big startup acquisitions, which means that they often provide less capital to Business Angels and Venture Capitalists.
There comes a time for mature and established technology companies where raising more capital from VCs or private equity firms is no longer an option. So, what comes next to raise capital and sustain the growth? An IPO. IPO stands for ‘initial public offering’ and it basically means that a company starts floating on a stock market, selling a significant number of their shares in the process to institutional and non-institutional investors. These large companies are what VCs dream of, as they often provide large sums of capital to everyone involved (founders, early employees and investors).
For most founders, selling a company is a life changing event that they have had no training for. Asking an experienced entrepreneur or VC friend can be a very good thing to do. Some training doesn’t hurt and that’s what we’ll try to provide in this course.
When to sell
Similar to raising money, the best time to sell your startup is when you don’t need to or want to. Paradoxically, you are probably thinking about selling your startup as you are experiencing a lack of traction, tough competition, or difficult time fundraising. However, this is a bad time to sell your startup: you will have few bidders and be more likely to acquiesce to the demands of anyone who does show up.
The best time to sell your startup is when you have many options. These options don’t all have to be acquisition offers, they can also be venture term sheets for your next round. You might even be operating profitably and find yourself in the enviable position of confidently being able to turn down an offer. Usually, you will have these options because your startup is actually experiencing great traction; counterintuitively, the best way to “build to flip” is actually the same as building a successful company.
When to start acquisition talks
Do not enter acquisition talks unless you are ready to sell your company. Negotiating an acquisition is very time-consuming, and it is the most distracting thing you can do in a startup: going through M&A is an order of magnitude more distracting than raising money. All of your ability to run the day-to-day operations of your company will grind to a halt. You should enter an acquisition process onlyif:
1. you are certain you want to sell the company
2. you are likely to get a price you will accept.
3. you have all the documentation of your company in order.
Don’t talk to potential acquirers “just to see what price you can get.”
The main reasons behind a startup acquisition
The reason for buying your startup differ a lot for each potential buyer. Your company will be bought either for its financial value or for its strategic value for the acquirer. Like every purchase, their is also a strong emotional part to a startup acquisition. Here are some common reasons:
1. The CEO finds it interesting, or wants to keep it away from another large company.
2. The executive that runs the relevant division of the acquirer needs to demonstrate “big moves”.
3. A competitor to an acquirer is out-executing it in a business and you can help the acquirer become better.
4. The acquirer doesn’t have or can’t retain talent in an area where you have employees.
5. Your businesses actually have some synergies.
6. The acquirer is running a similar business but you are executing much better. They are afraid of you.
If some of these reasons seem ridiculous and arbitrary, it is because sometimes they are. Remember that companies are bought, not sold: in order for a company to want to buy you, an internal champion will have to internalize one of these reasons.
Steps to sell your startup
1. Test the waters: make a list of your potential buyers from the previous list of reasons for buying a startup. Start with channel/marketing partners.
2. Commit 100% to the selling process: if you have decided to sell your startup, commit all your energy towards achieving the best possible deal.
3. Get all your documents in order: financial reports, contracts, … Make sure everything is up-to-date and that you have all required signatures from partners/shareholders and that all reports are properly filed.
4. Prepare a selling pitch that is specifically targeted to your buyer and not just for *any* potential acquirer: that allows you to use the right arguments. Sell the dream.
5. Establish criteria for evaluating offer: determine what you and your investors want in a sale: cash, stock of another company? What is the minimum salary you want in case of an acquihire? Do you want to stay with the entity, and, if so, for how long?
Negotiate the best price
A potential acquirer’s first offer is rarely its best offer. Don’t be afraid to say “no” – the potential acquirer isn’t going anywhere. There are many negotiation strategies, but in order to extract the most value you need to (1) be willing to walk away and (2) initiate a competitive bidding process.
How to get multiple offers
To initiate a competitive bidding process, or to simply improve your chances to have at least one offer, you should try to have ongoing conversations with potential acquirers about ways you can work together. These conversations usually involve many different people within a big company; you’ll only get an offer once a sufficiently high-up decision maker is convinced that buying you is a better idea than partnering with you.
What to do when you have an offer
The smartest thing to do is to call VCs and other companies (your potential acquirer’s competitors) to start a competitive bidding process. Of course, the company making the offer will dissuade you from doing that threatening to drop the entire process, but don’t be a fool, your future and your shareholders’ outcome is at stake and it is only fair and professional to try to optimize it. Simply keep the talks private.
Due Diligence – Definition
Due diligence is an investigation of a business or person prior to signing a contract. It can be a legal obligation, but the term will more commonly apply to voluntary investigations.
This process is not something specific to an acquisition of 100% of the shares of a company, but is a usual process for every meaningful investment. Unless you’re raising money from Family & Friends, you will face a more or less advanced level of due diligence from your potential investors or acquirers.
There is no single Due Diligence process. Each investor or acquirer will have its own checklist and a more or less established process. Nevertheless, in all cases you will probably start with one or several screening meetings. The goal of this first phase is to have an overview of your startup, including the product/service, the team, the customer and finances without entering into too much detail. The process is more or less the following:
1. Founders/Team: How do the founders know each other? How do they interact with each other? Are they passionate? How qualified are they? What would it be like to work with them?
2. Angle: The angle: What secret, what insight has the founding team made that the rest of the market hasn’t yet realized? What discontinuity in the market can they leverage to win large share?
3. Business: Review the Business Model Canvas or Lean Canvas: value proposition, customer segments, problem, solution, channels of distribution, current cost/revenue structure, market size, key partners and activities…
4. Traction: What traction does the startup have? Current revenue? Revenue growth? User growth?
5. Intellectual Property: Does the startup have a highly valuable patent?
The goal of this step is to have a basic understanding of your business and filter between your startup and other business opportunities.
Validating the Opportunity
The next step for the potential investor or acquirer usually consists in validating your business model and figures, double-checking the following:
– addressable market size
– competition level
– market growth
– some background check of the Founders, looking up on LinkedIn and making some reference calls.
This step allows to quickly raise possible red flags: have the co-founders invested their own money? Do they have a salary? How much? Is there a naive claim of “no-competition”? Are your forecasts grossly overestimated ?
Once your potential investor or acquirer likes your story and has validated the opportunity, the next step is to audit your startup to make sure there is no big flaw. This consists of several types of audit that we will review here.
1. Financial Audit
The goal of this audit is to answer the following questions:
– Where is the money going?
– Is there any upcoming big expense?
– Any debt? What interest rate?
– Is your business model financially sustainable?
2. Sales Pipeline Audit
– What is your Customer Acquisition Cost (CAC)?
– What is your Customer Lifetime Value?
– What is your Churn rate? (the annual percentage rate at which customers stop subscribing to your service)
– What is your revenue/customer growth?
– How do those metrics compare with industry benchmarks?
3. Team Audit
– Who does what in the company?
– What is the time commitment of each person?
– How do Founders and employees work together?
– Is there any conflict between team members?
– Are the tasks properly distributed for each person?
4. Technical Audit
– How well is the product or service designed?
– What is the feedback from customers?
– Is the product/service quality fine?
– What is your software testing approach?
– What is your product/service roadmap?
5. Legal Audit
– Are all contracts in order and up-to-date?
– Is there any lawsuit threat?
– Is there any intellectual property violation?
– Disputes with clients/providers/employees ?
– What are all the important contracts?
– Is the company legally well formed?
– Have all the reports been filed properly?
– What are your trademarks and patent status?
– Have all the relevant people (employees, partners, mentors) signed a no-competition and non-disclosure agreement?
– If yes, what is the period and scope?
– Does your startup have insurance in case there is fire/flood/lawsuit etc?
– Has the company actually paid its taxes or is a giant tax bill to fear a year from now?
6. Shareholders Structure Audit
– How many shareholders does your startup have?
– What is their respective percentage ownership?
– Do your employees have equity? Enough to motivate them?
– Basically, who has control?
– Have all securities (shares, convertible notes, debt, stock options etc.) been legally issued and documented?