• The Pmarca Guide to Startups, part 1: Why not to do a startup
• The Pmarca Guide to Startups, part 2: When the VCs say “no”
• The Pmarca Guide to Startups, part 3: “But I don’t know any VCs!”
• The Pmarca Guide to Startups, part 4: The only thing that matters
• The Pmarca Guide to Startups, part 5: The Moby Dick theory of big companies
• How to hire the best people you’ve ever worked with

The job of a VC is really weird. Imagine convincing someone to part with his money that you would sink into something that is almost certain to bomb (80%-90% of cases). Then imagine sifting through 100s of half baked-wild ideas to find those very few, typically 1%, that you feel (yes feel – there is no formula or model to make your life easier) are worth investing. Then imagine praying patiently 4-6 years for those ideas to hatch that would get your money back, may be with some return. So every time you are going to raise money, every investment that you are making, basically, you are putting your credibility at stake – past performance is not indicative of future results. How would you feel when one after other your investees are vanishing in thin air?

Is this job envious? Well may not be for most. But it certainly is for some, including me. There is this thrill of identifying something that is going to change the world (various degrees of changes from Google and Facebook at one end and 100s of unnamed ventures on other end). There is this urge to connect the dots, see the pattern and figure out the changes that are going to happen couple of years ahead in future. You know how it feels when you realize a dream? When you make this your job to realize dreams of others? Well, a VC’s job feels something like that. Never mind that there is a little chance of you getting wildly rich.

At a more worldly level, VCs usually work in a team. They invest someone else’s money and, thus, have fiduciary responsibility towards those investors. Since they don’t know which 1% of the 100s of business plans landing into their inboxes are going to click, they have to go through any and all that come through. Once they evaluate a plan (I would be writing later on this), they talk to entrepreneurs and their clients and potential clients. They rationalize the assumptions that entrepreneurs usually make, run the numbers themselves and analyse to assess the size of the opportunity, market growth and competitive intensity. Once they invest, they provide the mentorship and support to the entrepreneurs.

Mentoring and support is an important element that a VC investment brings on the table, unlike other flavours of investments. VCs bring with them a huge network and rich operational experience. Especially for technology ventures, may be because of the tech background of the entrepreneurs, there is this need to fill the gap for sales and marketing expertise. VC can assist in providing such strategic directions. They can introduce the entrepreneurs with potential clients, vendors and partners.

VC s do monitor whether product development cycles are on track, how the initial customers are responding to the product or service, how the competitive landscape is shaping up etc.

Entrepreneurship is a journey that has highest of high and lowest of low in rapid succession. If you are an entrepreneur, you would immediately understand the need for a shoulder to cry on once the tide turns against you. Well, VCs do provide the shoulders to cry on. In fact VCs who are an entrepreneur themselves are better able to relate to the situation of an entrepreneur and are able to empathise with them.

With their huge experience, VCs are able to advise entrepreneurs in deciding when to go for funding and how much fund do they require. They also help entrepreneurs in deciding when to go for IPO or accept an M&A offer.

At the same time, it’s worth mentioning that a VC, especially a good one, understands that it’s the entrepreneurs who are creating value and not them. Hence it’s the entrepreneurs who would take the final decision on any matter of the venture and not the VC. The VC is only there to provide support and advice and not to take any decision on behalf of the entrepreneurs. A VC who starts forgetting this role-division would not be a successful one in the long run.

Because of the higher failure rate of startups (8-9 failures out of 10), a VC expects a return of at least 10x on his investments. Once a startup fails, VC has to write-off that investment. At times, he may be able to find someone who still sees value in the venture that this VC thinks as a failure (or not going anywhere) and he may be able to sell his stake for 2x or 3x, whatever he is able to negotiate.
Given the risk involved and his responsibilities towards the investors, big financial return (at least 10x return) is the prime motive of a VC’s investment in a venture. Since a VC would have to return the money to the investors, all his investments must have a clear exit opportunity.

For example, if there is some venture that is valued at Rs 5 crore today and becomes Rs 30 crore at the end of 5 years, it won’t be of an interest to a VC since he won’t be able to get at least 10x return on his investment, even if he owns 100% of the start-up, which itself is impractical.

Similarly, suppose there is a venture with 50% profitability at the revenue of Rs 20 crore year-on-year (assuming no growth). Though this is a great business, such a venture is of no interest to a VC because there is no clear exit opportunity for him.

Hence, for a venture to be interesting to a VC, it should be in a fast-growing potentially large market with a very few players. Such a venture would not only present an opportunity for big financial return (priority 1 for a VC) but also have clear exit opportunity (priority 2 for a VC) through IPO or M&A or some other means.

By looking at a proposal, a VC would be able to figure out the potential gain from the investment or the exit scenarios. But that is the single most important thing that could risk an investment? That is the quality of the entrepreneurs a VC is banking on. No wonder, you would hear VCs saying that they are investing in the entrepreneurs and that if they are not comfortable with the entrepreneurs, there won’t be any deal, whatever be the potential of the business idea.

To minimize his risk further, a VC may insist on some revenue traction or some customer of the product or service of the venture. He would feel more comfortable if there are some other VCs lined up to fund that particular idea. He may further add some protective clauses in the agreement.

Discounting from the original forecast may reveal significantly greater capital requirements than first expected. However, this revised capital requirement could guide the venture’s long-term financing strategy. How much must be raised now? When will the next financing be needed? What significant milestones will be accomplished during that time? An understanding of the long-term financing strategy is crucial. A seasoned entrepreneur would work with his investors to develop a financing strategy based on building value from one financing to the next and understanding how value will be measured.
Following are the different stages of financing a venture:

• Seed financing: The seed financing will provide the capital needed to support salaries for founders /management, R&D, technology proof-of-concept, prototype development and testing, etc. Sources of capital may include personal funds, friends, family and angel investors. Capital raised is limited due to its diluting impact at minimal valuations. The goal here is to assemble a talented team, achieve development milestones, proof of concept and anything else that will enable the entrepreneur to attract investors for the next financing.

• Series A Financing: Typically the Series A is the company’s first institutional financing—led by one or more venture investors. Valuation of this round will reflect progress made with seed capital, the quality of the management team and other qualitative components. Typical goals of this financing are to continue progress on development, hire top talent, achieve value-creating milestones, further validate product, initiate business development efforts and attract investor interest in the next financing (at an increased valuation).

• Series B Financing: The Series B is usually a larger financing than the Series A. At this point, we can assume development is complete and technology risk removed. Early revenue streams may be taking shape. Valuation is gauged on a blend of subjective and objective data—human capital, technical assets, IP, milestones achieved thus far, comparable company valuations, rationalized revenue forecasts. Goals of this financing may include operational development, scale-up, further product development, revenue traction and value creation for the next round of financing.

• Series C Financing: The Series C may be a later-stage financing designed to strengthen the balance sheet, provide operating capital to achieve profitability, finance an acquisition, develop further products, or prepare the company for exit via IPO or acquisition. The company often has predictable revenue, backlog and EBITDA at this point, providing outside investors with a breadth of hard data points to justify valuation. Valuation metrics, such as multiples of revenue and EBITDA, from comparable public companies can be compiled and discounted to approximate value.

Each financing is designed to provide capital for value-creating objectives. Assuming objectives are accomplished and value is created, financing continues at a higher valuation commensurate with the progress made and risk mitigated. However, problems can and will arise during this time that may adversely affect valuation.

The study above found five fundamental root cause of failure:

1. The absence of a winning strategy for the combination
2. Not integrating quickly or well
3. Expecting synergies that don’t materialize
4. Cultures that aren’t compatible
5. Leadership that wouldn’t play together in the same sandbox

I have discussed above failure reasons in earlier post on Post-Merger Integration, quoting that post:

Buying a company is easy. Making that purchased company succeed in the post‐purchase environment is something else altogether. Just as anyone can get married, anyone can buy a company. But not everyone can make a marriage successful, and many companies wind up selling (divorcing themselves of) the very companies they initially enthusiastically acquired, often selling for a fraction of the original purchase price.

Further I discussed various topics Value Creation Strategies, Vision & Leadership etc in successive posts that outlines similar issues elsewhere and details aspects that should be kept in mind.

Coming back to P&G case, once above root causes were identified, the company worked on issues such as how should it organize each phase of acquisition, what processes should be in place, which interim measures would indicate whether the acquisition process is on track. So this is a disciplined approach with clearly identified  in-charge for each phase of the process.

These insights were used in the $57 billion USD acquisition of Gillette in 2005. The company identified all the value creation elements. It identified the integration the integration sequence and elements. It put a pretty senior manager in charge of every value creation initiative. It tracked progress for every value-creating initiative using a simple red (indicating not on track), yellow, green (indicating on track) process. It drove every phase of integration, every building block of value creation, to completion.

Above efforts resulted in delivering more than 150% of the originally estimated cost synergies. So the cost synergy alone created enough value to make the Gillette acquisition a success. The revenue synergies – such as in combining Crest and Oral-B brands and innovations in oral care products – all come on top of the cost synergies.

Source: Interview of A.G Lafley, Former CEO, P&G, HBR April 2011

Reference for survey and investment period: July 2009

In a stock-for-stock deal, the acquirer’s share price may drop before the deal is closed for various reasons including overvaluation of acquirer’s shares, market perception about over-payment, and weakening of operating and financial performance of the acquirer. This would reduce the deal value to the target shareholders. There are other risks to shareholders of the target such as exchange ratio may change or deal may not go through at all because of regulatory disapproval or walking away of the acquirer.

Similarly there are various risks to the shareholders of the acquiring company. The target’s operating or financial performance may deteriorate. There may be hidden liabilities in the balance sheet of the target. There is always a chance of paying too much, a competing bid or deal not going through at all because of regulatory disapproval or social issues. For example, target’s employees may go on strike fearing job loss post-acquisition.

The risk sharing is affected by the method of payment. In case of all cash deal, all pre-closing risk is entirely born by the shareholders of the acquirer company whereas in case of all stock deal, the risk is born proportionately by the shareholders of the acquirer and the target shareholders. During the negotiation phase, the buyer and seller maneuver to share the perceived risk and potential return. In doing so, substantial differences arise between the expectations of the buyer and seller.

There are several mechanisms of managing such risks and consummate the deal aimed to alleviate asymmetric information and provide incentives when the buyer and seller cannot reach agreement on purchase price. The following diagram shows risk management strategy in various stages of a deal:

Termination Fee

The target may agree to pay a termination fee to the acquirer in case the deal doesn’t go through to compensate for the resources invested by the acquirer for the deal. This makes it difficult for the target to walk-out and make the deal expensive for the competing bidder by the termination fee amount.

Lock-up Options

This option gives buyer right to buy targets shares (usually < 20%) or some key assets in case another bidder shows up.

No Solicitation Clauses

Through this arrangement, the target commits not to hold-up the acquirer by not soliciting outside bids during negotiation with the acquirer. But target can pursue negotiation with unsolicited bidders.

Earn-outs

Earn-outs are to ensure the target performs post-acquisition. Suppose a target claims a growth of 25% for next 2 years but acquirer estimates no more than 15% of growth in those years. So acquirer may propose to pay part of the deal value right away and remaining when and if target achieves some agreed-on future earning level or some other performance.

Such an arrangement is called earn-out agreement and is aimed to protect buyer from post-closing risk due to underperformance. It is used to retain and motivate key target firm managers and diminishes the buyer’s upfront financial commitments. It also screens out sellers who misrepresent the earning potential of their business. The earn-out normally requires that the acquired business be operated as a wholly owned subsidiary of the acquiring company and be managed by the former owners of key target executives. Earn-outs can be of different types: payable only if certain performance threshold is reached, based on average performance over a number of periods, involving periodic payment depending on achieving interim performance measures. Earn-outs are most common in high-tech and services industry or unlisted targets where its difficult to value the firm, and target and acquirer are from different industries.

The acquisition deal with an earn-out agreement sends a positive signal to the market. Investors perceive that with such arrangement acquirer is less likely to overpay and more likely to retain key target firm talents.

Earn-out can create some perverse results during implementation. The target management may have an incentive to take actions not in the best interests of acquirer. For example, they may cut back on advertising or training expenses or stop capital expenditures and take measures to improve short-term profit to improve the cash-flow. Similarly the acquirer may put hurdles in the form of bureaucracy or delay in approval for new investments. To avoid some of the complications, a multi-criteria performance benchmark based on revenue, income and investment target could be used although this would add to the complexity.

Contingent Value Rights: to protect against fall in share price

CVRs are commitment by the acquirer to pay additional cash or securities to the seller if the share price of the acquirer falls below a specified level at some date in future. The buyer issuing CVR believes that its shares are undervalued and share price would rise in future. By issuing CVR, the buyer sends signal that it is confident about the future success of the transaction. CVRs can be exercised only at maturity, are generally transferable and treated as unsecured debt.

CVRs are different from Earn-outs. CVRs are put options limiting downside risk of payment to the seller. Whereas Earn-outs are call options for the target representing claims on future upside performance and are employed when there is substantial disagreement between the buyer and the seller on the price because of information asymmetry.

Collar Arrangement: to preserve shareholder value

In a fixed or constant share exchange agreement number of acquirer’s shares for each target share is unchanged between the date of announcement of the deal and the date of closure of the deal. However, the share price might change during this period. So the acquirer may find that the transaction is much more expensive than anticipated if the value of its shares rise. Whereas the seller may be greatly disappointed if the acquirer’s share price declines. Most of the stock mergers have a fixed share exchange ratio.

In a fixed value agreement (or floating share exchange), the value of the price per share is fixed. With the fluctuation of share price, the number of acquirer’s share per share of the seller would vary. For example, a decrease in share price would lead to issuance of additional shares to the seller. This, in turn, would dilute the shareholding of acquirer.

To compensate for uncertainty in the value of the deal, share exchange rate is allowed to fluctuate within limits called collar.

A floating collar agreement involves a fixed exchange ratio for variation in acquirer’s share price within a pre-determined range. For share price outside the range, there would be a ceiling or floor as the case may be. For example, the buyer may offer its 0.5 share for each share of the seller for share price between Rs 80 and Rs 120. So as long as share price is within the given range, the seller would receive Rs 40 to Rs 60 for each of its share. Further, the buyer may offer to pay Rs 40 for any price of its share below Rs 80 or Rs 60 for any price of its share above 120. Rs 40 and Rs 60 act as floor and ceiling to the seller’s payoff. This is more common that other alternate of fixed collar agreement.

In a fixed collar agreement the payoff to the target is fixed over a range but is variable beyond that range. The seller would receive a certain amount of money in terms of acquirer’s stock as long as the acquirer’s share price remains within a narrow range and a fixed exchange ratio if the acquirer’s share price is outside that range. There is a floor and ceiling on the exchange rate. For example, the acquirer may offer to pay seller Rs 120 as long as acquirer’s share price is within Rs 80-100. This would be achieved by adjusting the number of acquirer’s shares that would be exchanged for each target’s share. If the acquirer’s share price increase above Rs 100, the target would receive 120/100 shares of acquirer for each of its share and if the share price falls below Rs 80, the target would receive 120/80 shares of acquirers for each of its share.

Collar agreement protect the acquiring firm from overpaying in case its share price is high or seller’s share price is lower on the date of agreement of the deal. Similarly, the target is protected from receiving less than the original agreed-on purchase price if the seller’s stock declines in value by the effective date of the merger.

The buyers may want to pay only reasonable price, use stock in stead of cash, sign non-compete agreement, retain key employees or make a certain percentage of the purchase price contingent on realizing some future events to minimize risk. For example, seller may claim an aggressive growth rate of the business. In this case the buyer may want to hold a certain percentage of payment till the claimed growth is realized.  Seller may be interested in fetching maximum price, tax advantages, rights to license patents or other assets or future reputation of the business.

Whether acquirer would assume all, some or none of the liabilities, disclosed or otherwise, of the target is about sharing of risk. This process can become fairly complex in a large transaction involving a number of parties, payment modes and source of financing.

Form of Payment for an M&A deal

Payment for an M&A deal can exclusively be in cash or shares or a combination of both cash and shares. On an average, cash accounted for 45%, stock for 30% and cash-stock combination for 25% of the total transaction between 1980 and 2006 in USA.

What mode of payment is selected is judged on risk involved and each mode sends different signals to the world outside. A cash payment requires lots of free cash or a strong balance sheet of target or acquirer that could be used to raise capital to finance the deal. The cash can be generated by raising debt or equity or selling some of the assets.

There is usually a negative market reaction to stock purchase resulting in fall in stock price. An acquirer usually pays a premium in an acquisition in anticipation of realizing synergy post-acquisition. If an acquirer is confident of realizing the synergy, he would prefer paying in cash and thus avoid dilution of ownership and reduction of earning per share (if number of shares increases, earning per share will go down) by issuing shares in a stock purchase. Hence cash purchase indicates confidence of the acquirer in the deal.  An acquiring firm with high growth opportunities would prefer using stock for acquisition otherwise it would have to raise debt to finance a cash deal that would limit its flexibility in use of funds.

However, cash transaction has tax implication for seller and hence he may not favor it. Additionally, a seller may have emotional affinity to the business and he may not be ready to cede all control and go away with a pile of cash. So he may ask for a stock deal to retain at least some of the ownership. Some sellers may be concerned about growth prospect of the buyer’s shares, high risk due to historical volatility of the buyer’s share or illiquidity of buyer’s share due to small size of resale market.

Both buyers and sellers may find convertible preferred stock or debt as an attractive option.  A convertible stock offers a seller downside protection by continuing dividends and upside potential if the share price goes up. It also offers benefit of tax deductibility of interest payment to the buyer. However, a seller may perceive debt instruments as less attractive because of high default risk of buyer.

Since a share deal results in fall in share price, an acquirer may 1^st buyback some of the share from the market that would soar the share price. And then he may go for a share deal. This would cancel out the negative reaction associated with a share deal. Typically both buyback and acquisition announcements are made at the same time. Those shareholders who would want to exit would leave at that stage. But in India, an acquirer can’t buyback 1^st and then issue shares within next 24 months. Usually buyback happens when a company has surplus cash whereas share is issued to raise capital. As per Indian law, a company should plan its capex for the next 2 years and then, if still has surplus cash, go for buyback. Buyback followed by issuing shares shows poor financial management of the company. If a company needs capital within 24 months of buyback it can always go for borrowing. So in this sense this rule is good. However, there is no such restriction in USA or UK and hence companies there are allowed to effectively trade in its own shares.

A buy-out firm buys 100% of the target by levering it up and takes it private i.e. shares of LBO no longer trades in the open market. After improving operational efficiency and lowering leverage, the target is brought for IPO or is sold. The buy-out firm usually exits in 3-4 years. A large portion of the buy-out is financed by debt.

Characteristics of good target company

A good target for buy-out would preferably have low debt with high level of “bankable” assets and high growth potential with scope for operational improvement. The target’s cash flow should be stable and sufficient to meet interest and principal payments on the debt and provide adequate working capital. The target’s cash flow should also be protected by patents, strong brand or market leadership.

Though difficult to estimate, the financial distress cost of the target company should be low. When debt is very high suppliers may get concerned about company going bankrupt, stop giving credits and start working with competitors having better chance of survival. For example, if there is a high requirement for after-sales service and the customer think that company may not be able to make spare parts available in future; she would not buy at all – resulting in high financial distress cost for such a company.

The management should be cooperative and receptive for changes required for turn around.

Sources of value in LBO

Usually a buy-out firm, with its experience in monitoring and operating a company with high debt, is skilled in transitioning the acquired company to a more favorable state.

The buy-out firm brings specialists to identify and improve operational efficiency of the acquired company. Since target is taken off the stock market and made private, the compliance cost associated with public company is saved. Increased debt and re-evaluation of assets at current market price result in higher tax benefits. Higher debt brings better discipline in the company. Under the scrutiny of lenders and the risk of collapsing, the employees and management usually are more responsible and serious about their business. High debt also serves as a bonding mechanism within the company by focusing everybody on optimally utilizing all resource, minimizing wastage and facilitating negotiations such as salary re-negotiation, contract with suppliers etc.

Valuation of LBO: Adjusted Present Value Method

The APV method estimates values from investment and financing decisions separately and then adds the two to find the total value of the firm. The total value of the firm is the sum of present value of the firm’s free cash flows to equity investors (as if there is no debt) and the present value of future tax savings discounted at the unlevered cost of equity.  Tax savings are subjected to risk since the firm may default on its debt or incur operating losses and fail to use tax saving. Hence unlevered cost of equity is used to discount tax savings.

High debt increases cost of financial distress. So the tax benefit of higher leverage may be partially or entirely offset by the higher probability of default associated with an increase in leverage. The cost of financial distress can have direct cost component such as cost of reorganization in bankruptcy and ultimately liquidation and indirect cost component such as loss of customers (and hence revenue), employee turnover, difficulty in credit from suppliers and higher borrowing cost.

Using APV, value of a LBO firm would be

Present Value(LBO) = Present Value (Unlevered Firm)+ Present Value (Tax     Shield) – Present Value (Financial Distress)

Interest payment on debt = (Rate of interest) X (Face value of debt)

Tax shield = (Tax rate) X (Interest payment)

Using perpetuity formula,

Present value of tax shield = (Tax shield) / (Rate of interest)

= (Tax rate) * (Face value of debt)

Use unlevered cost of equity to discount cash flow during the period in which the capital structure is changing. During the firm’s terminal period, the debt-to-equity capital structure is assumed to be stable and free cash flow is projected to grow at a constant rate. The terminal value is calculated using WACC but it is discounted to the present using the unlevered cost of equity. Annual tax saving resulting from tax deductibility of interest is projected and discounted at the firm’s unlevered cost of equity.

When the project’s D/E is known WACC should be used, whereas when level of debt is known (i.e. LBO cases) APV should be used.