Managing Liquidity
Get Paid for Your Work

Inexperienced sellers leave money on the table all the time. One investor I know once told me, “We’re going to get the vacuum cleaner out and suck all the money off the table. Then, we’re going to stick that vacuum into their pockets and make sure we’ve got every last cent.” Needless to say, his words left a lasting impression. Although you may not come from the Vacuum Cleaner Investor school of deals, there’s no reason not to get paid for your work.

Liquidity Events

When I was first starting out, I met a very successful entrepreneur who told me, “I never met an acquisition offer I didn’t like.” I thought this guy was nuts. What was the point of starting a company if we were just going to be bought? We were going public, and that was the end of that. Of course, it was late 2000, and the public markets had all but completely dried up.

The reality is, 90% of liquidity events are acquisitions, not IPOs. For a tech company to go public, the IPO window has to be open, institutional buyers—known as the buy side—have to be interested, and the company must meet key metrics, such as specific revenue levels and sustained growth rates. The management team has to be able to credibly sell the story. And the company must have avoided being acquired along the way. After all, many of the same characteristics that make a company attractive to the public markets also make it attractive to other, larger companies. Those companies often seek to augment organic growth with growth via acquisitions.

You put all the hard work into your startup well before a liquidity event takes place. But how you manage the liquidity process can have a dramatic effect on how others value all that hard work. Just as with private fundraising, the environment surrounding the liquidity event can have a significant impact on your company’s valuation as well.

Big companies are experts at buying smaller companies. That doesn’t mean they’re always (or even often) wise at choosing those acquisitions or good at integrating them once acquired.

But it does mean they’ve been through the process hundreds, if not thousands, of times. Some acquisitions are tiny—say, a small group of engineers bought for their team and technology. Others are huge mergers of near-equals. Big companies have in-house legal teams, in addition to outside counsel; corporate development departments responsible for deal execution; and, typically, a business owner who drives the desire for an acquisition to occur.

The art of the deal is to know when to say “no” and when to say “yes.” Sell too easily or to the wrong buyer, and the value of years of hard work can evaporate in an instant. But the first question you should ask yourself is: do you want to be bought?

Don’t assume that your potential acquirers know your company—especially if your company is smaller. The delicate art of getting bought is that you’re not for sale. But you do need to be visible—highly visible. You need to be on the radar of potential acquirers. That means being visible in the press and at conferences, spreading the word about your company through your network, and personally getting to know people at those companies that might acquire you.

One entrepreneur I know took a strategic investment from a much larger company. Although it prevented him from running out of money and gave him a partner to work with, other potential acquirers viewed the startup as already spoken for. That is, by investing a relatively small (for them) amount of money in the startup, the big company effectively owned the startup without having to buy it outright.

The entrepreneur and his team kept having to deliver on the demands of their strategic partner to such an extent that they didn’t have the bandwidth to serve the rest of the market.

The entrepreneur considered breaking the contract with the larger company multiple times, but the startup had become so dependent on the larger company that changing course was impractical. One of the startup’s competitors eventually acquired it, providing little return.

Another entrepreneur took a much different approach. He started with a business partnership with a potential acquirer that involved marketing their products together. It took a lot of effort on the startup’s part to make the relationship productive—the bigger company had lots of other partners.

Ironically, the first partnership led to partnerships with other large companies in the industry, one of which eventually bought the startup. By managing and finessing these business relationships, the entrepreneur was able to capitalize on them from a marketing perspective without becoming encumbered by them.

Why Acquisitions Fail to Go Through

There are a number of reasons acquisitions fail to go through, many of which can be avoided with proper planning. Becoming visible, building relationships, and engaging with multiple potential acquirers are all activities that take time and preparation.

Selling, Not Buying

As with many of the other business transactions discussed earlier in the book, the best deals are those in which you’re buying, not selling. That means the best acquisitions occur when someone wants to buy you when you aren’t actively selling.

But often, companies that are short on capital are trying to sell. Investors, management, or both may be tired. Many deals fail to go through because the CEOs are trying too hard to sell the deal. They may end up with a sale, but it’s frequently for a low-ball price that could have been avoided.

Not Being on the Radar

One CEO had the networking skills of a hermit. A talented inside guy, well-liked and respected by his team, he didn’t excel at networking. As a result, his company didn’t get the call when larger companies pursued acquisitions in his space. His potential deals failed because they never got started.

The reality is that he didn’t want to sell. Although his company was growing very slowly and not becoming more valuable, he enjoyed the relatively comfortable position the company was in and his role as CEO. He had previously been a senior executive at a large, public tech company and wasn’t eager to take on a similar role.

Lack of Relationship

Not dissimilar from this was another CEO who, although a great product guy, was so disinterested that he failed to connect with the teams at potential acquirers. He entered into multiple potential acquisition discussions, but was outmaneuvered twice by other CEOs who had better relationships.

There is no substitute for having a longstanding business relationship with someone, but relationships are built over time. You may have worked with someone in a previous job or gone to school together, or you may be neighbors. The relationship-lacking CEO placed very low value on relationships and as a result failed to get engagement with potential acquirers, even though some of them were genuinely interested in buying his company.

Acquirer Strategic Shift

One CEO’s deal was put on hold when the Senior VP sponsor at the company that was going to acquire him changed roles. In a cliché blame game, investors argued that the CEO should have had his finger on the pulse of the acquirer so he wasn’t blindsided by the change.

Although they’re often slow to move, large companies change strategies and reprioritize frequently. They defund projects and reorganize departments and divisions. Sometimes sponsors are blindsided by CEO or board-level directives, other executives, or market changes. Other times, they either don’t have their ducks in a row or don’t command sufficient influence to get a deal done.

That said, it pays to get to know all the potential players at an acquirer, not just your direct sponsor. Other groups or executives may feel threatened by the prospect of their company acquiring yours, or they may suffer from NIH—not invented here syndrome—in which they believe they can do whatever you’re doing better by building it internally. Ultimately, however, it’s your responsibility to know as much as possible about what’s going on with your sponsor, other players, and your potential acquirers.

Expectation Mismatch

The CEO of Company X repeatedly turned down offers because management and investor expectations about price and deal terms didn’t match those of potential acquirers. The CEO of the company was operationally excellent but didn’t paint a strategic vision that an acquiring team could buy into to justify his and his investors’ lofty valuation expectations. As a result, the company was valued purely on a multiple of its revenue rather than viewed as a critical, must-have, strategic acquisition.

In particular, the CEO of Company X failed to help each potential acquirer understand why his company was a possible cornerstone of an existing strategic initiative the larger company had underway—one of the best ways to get a higher-value outcome. The CEO failed to frame discussions properly from the beginning because he focused purely on the numbers rather than on the strategic needs of potential acquirers.

As much as executives feel pressure to beat the numbers, many feel just as much pressure to “be someone.” CEOs of companies, large and small, want to be successful and want to be known for that success. It’s not only about money. It’s also about power and ego. No CEO wants to go down in history as an unstrategic, failed leader. Most want to be recognized not only for having driven growth but also for having been great leaders. Not only did the CEO of Company X fail to invest in the strategic vision of his potential acquirers—he also failed to understand how he could help his sponsors and their CEOs be stars.

In contrast, the CEO of Company Y, with just a few million in revenue, was able to sell his company for hundreds of millions of dollars. Both companies were in spaces where larger companies were incredibly acquisitive, but the more-strategic CEO went to great pains to understand the strategies and initiatives of his potential acquirers. When he met with executives at a potential acquirer, he didn’t only talk operations—he talked about the acquirer’s key strategic needs. What’s more, acting as a peer, but without being arrogant, he had candid conversations with senior executives about their challenges in the organization. He knew so much about his potential acquirers’ businesses and about the executives themselves that they asked him for his input on their plans. When one of the companies decided it needed to make an acquisition, he was the first person they called.

Lack of a Competitive Bidding Situation

This is by far the most painful cause of deal failure and nearly ensures you won’t get an optimal price. It also makes it regrettably easy to become emotionally attached to a particular acquirer. If things are going well and a company is in high demand, getting into a competitive bidding situation is easy.

The challenge, of course, is getting a competitive bidding situation going when a company is running short on cash and needs money quickly. Big companies are always sniffing around for technologies and teams they can acquire on the cheap. If they sense tired capital or tired management, they’ll toss in a lowball offer on the off chance it will be accepted.

Tired investors and management, operating in fear mode, are eerily susceptible to low-ball offers. If you have investors, the dance is an especially delicate one. Some investors may be willing to chip in more capital to help buy you time until you get a deal done. Others may have already written off your company. Find out where they are early in the process so you’re not surprised.

Lack of Chemistry

The CEO of Company Y had a personality issue. Although multiple larger companies wanted to buy his company for hundreds of millions of dollars, his personality got in the way of the deals getting done. Some people called him antagonistic; others described him as always having to be the smartest guy in the room. He never failed to show up the employees and executives of potential acquirers. Although acquiring his business made sense from a business perspective, acquirers decided they couldn’t work with the CEO. Failing to swallow his pride personally cost him tens of millions of dollars. After three such failed acquisition discussions, his investors brought in a new CEO.

Hiring Employees Instead

This is an age-old tactic of ruthless acquirers: rather than buy the company, hire some of the key employees. More than one CEO has been known to say, “These guys would never do that,” only later to come to a board meeting saying, “Those bastards! They’re trying to hire my best people!” If you’re entering into serious discussions, it isn’t unusual to specify a no-hire provision in your memorandum of understanding (MOU) with the potential acquirer.

Granted, the provision may not be enforceable, and it’s not likely you’ll spend the time or money to take serious legal action. However, it allows you to have the discussion and set the expectation up front that you won’t tolerate bad behavior. It also gives you strong moral high ground to fall back on, should your acquirer try to hire any of your employees while you’re engaged in discussions or shortly thereafter.

Due-Diligence Issues

Some acquisition discussions fall apart during diligence. In exchange for capital very early on, the founder of Company Z entered into a license agreement with another company that gave that company the right to use Company Z’s technology in a different market segment. As it was structured, the business partner had rights to all future versions of Company Z’s technology. Although Company Z was almost acquired, the deal failed because more than one potential acquirer didn’t want to take on the obligation of having to provide updates to the business partner.

Over the next year, the founder of Company Z restructured the contractual relationship with his business partner. He convinced the partner that encumbered by the unlimited license agreement, Company Z might not be able to sustain its business, and so it was in the business partner’s best interests to restructure the relationship. That, combined with some financial incentives the founder put in place to compensate the business partner in the event Company Z was acquired, enabled Company Z to restructure the contract. Free and clear to operate, the founder of Company Z decided not to sell. Instead, he raised an additional $14 million in venture capital to scale the business.

Getting the Deal Done

Anyone who has been through an acquisition (or acquisition discussions) has been faced with more than a few roomfuls of the acquirer’s people—sometimes a roomful of executives, other times a roomful of engineers, finance, or legal people—or a mix of all of the above.

Many acquirers try to extract as much information as possible from you and your team during acquisition discussions. Some are on fishing expeditions, trying to pick your brain to inform their strategy. Others know they want to make an acquisition in a particular space but don’t know which company or companies they want to buy. Although you’ll ultimately end up disclosing a lot of information if things get serious, it’s critical to have checkpoints at every step of the way.

As with investment discussions, framing is crucial in acquisition discussions. Don’t just ask how things are looking on the acquirer’s end—if you do, you’ll be selling, not buying. Instead, let them know how things are looking on your end and that you have some concerns—now you’re buying, and getting the acquirer selling you on why they’re the right buyer for your company.

Although it can feel flattering to have a big company approach you and to be in meetings with employees of that company, there is no need to divulge too much detail before both sides are ready to engage in serious discussions.

Understand the players, what their goals are, and what your goals are, for every meeting and every communiqué. Think of every interaction as both content (what are you learning, and what are they learning?) and signaling (what messages are they sending you, and what messages are you sending them?). Silence, of course, can be a very powerful message. You can also leverage your board, as in, “Joe, our board won’t budge on that issue.” However you pursue a deal, figure out what you care about. Don’t be deceived by the offer of a big title, flattery, or wining and dining.

Understand who the key decision-makers are, and get to know all of them. Get clarity on the acquisition process. Whether that turns out to be the actual process or not, it gives you something you can hold the acquirer to when discussions speed up, slow down, or stall.

Failing to Get Paid

Given the right situation, everything about a liquidity event is negotiable. When it comes to an acquisition, the purchase price itself, the deal terms, your earn-out, your compensation (and termination) package, and benefits at the new company are all up for discussion. You can even carve out technology or intellectual property that may not be relevant to the acquirer so you can do something else with it in the future. On the other hand, getting too fancy can kill a deal.

Earn-outs are compensation that management and employees receive separate from the purchase itself. They’re frequently based on hitting specific future revenue or profitability targets. They can also be very deceiving. More than one management team has taken what seemed like a huge earn-out, only to find out later that they and their acquirer had different understandings of how the earn-out would be calculated.

Take, for example, an earn-out based on hitting certain revenue targets. The first question to consider is how those revenue targets were set. In all likeli-hood, the acquirer asked you for three- or five-year financial projections. The minute you handed those over, you were setting—perhaps unknowingly—a critical component of your earn-out.

The second question is how much control you’ll have over hitting your revenue goals, after the acquisition takes place. Your product might depend on direct sales. Suppose that all post-acquisition sales must be made by the acquirer’s existing sales force. That sales force must be educated about your product, learn how to sell it, and be incented to sell it—assuming they’re equipped to sell it at all.

Profit-based earn-out goals are even more challenging. Until you spend significant time with a company’s CFO, you don’t know for sure how expenses are allocated across the organization. You may also find that the cost of salaries and benefits the acquirer pays are significantly higher than what you were paying as a startup—thereby driving up all the costs that go into your profitability metrics.

Although you may be on the same page as your acquirer during the deal process, things can change quickly post acquisition. Prior to being at a company, you have relatively limited visibility into what the company is really like, no matter how much time you spend with executives and employees there. What’s more, big companies go through reorganizations and restructurings all the time. The business owner who did your deal may switch roles or go work somewhere else. The CFO who talked you through the numbers may be fired. The CEO who told you everything you wanted to hear while the deal was getting done may be a completely different person to work for.

Many seemingly successful acquisitions have turned into financial failures for entrepreneurs after the deals were consummated. The best way to avoid that kind of failure is by working out the specifics, in detail, before your deal closes.

Secondary Markets and Interim Liquidity

Liquidity can and does occur before a company goes public or is acquired by another company. Sometimes, some portion of newly invested capital goes out the door. It’s not used to fund the capital needs of the company but rather to provide liquidity for existing investors, founders, and employees. This kind of founder liquidity often occurs as part of a larger financing, but it can happen separately.

Proponents of founder liquidity argue that it helps entrepreneurs continue to take extreme risk because they have a nest egg. Opponents argue that it makes entrepreneurs less hungry and reduces alignment with investors. Invested capital should be used to fund the growth of the business, not line pockets. Regardless, this kind of liquidity occurs in some deals because the deals are so hot that founders can make participation in the financing contingent on them taking out some cash—in some cases, very significant amounts.

Secondary transactions have existed for years, but they have gained significant visibility recently due to the emergence of secondary marketplaces like SecondMarket and SharesPost. In these cases, the marketplace acts as an intermediary, lining up buyers and sellers. However, unlike public-market stocks, such transactions are only available to accredited investors (that is, investors who meet certain income or net worth requirements) or institutional funds. Although the number of transactions has grown, they occur in a relatively small universe of companies, typically those that are very well-known, such as Facebook.

People often ask why existing investors (also known as insiders) sell a portion of their ownership if they’re still bullish on a company. A lot of it comes down to portfolio and fund management. By getting some early liquidity, an investor can reduce risk—although the upside is somewhat reduced, taking a small amount off the table mitigates the downside.

In addition to reducing risk, general partners in venture-capital funds derive some big benefits from small amounts of early liquidity. Whether they can recycle (that is, reinvest the capital) depends on the stage of the fund. But the bigger benefit is that they can return capital to their limited partners—those investors who invest in venture-capital funds. They can raise more money based on having already returned money, as in the old saying, “Success begets success.” And, they can take some gains off the table.

IPOs

I won’t spend a lot of time on initial public offerings (IPOs). If you’re considering an IPO, you’re surrounded by advisors, board members, bankers, and others who can help manage the process and coach you through it.

The CEOs I know who have gone from being private to public company CEOs consistently complain about one thing: the focus on short-term results. They may have new ideas or want to make major strategic changes, but the pressure to hit the number every quarter makes making big changes challenging.

Some of them, of course, use this as an excuse for not being able to hit the numbers they promised. But many are frustrated—not only do they have to contend with a large organization that has evolved over time, but they also must deal with public-market individual and institutional investors. Although it may sometimes not seem that way, private companies and their management teams have a lot more flexibility.

When Your Company Is the Product

Ultimately, great liquidity events are built on product-market fit. By this I don’t mean building a technology product that users want to use or customers want to buy, although that, of course, is critical. I mean your company is the product, and the market consists of potential acquirers and the public markets.

A great liquidity event occurs when the product you’re marketing—your company, with its vision, team, products, customers, revenue, growth trajectory, and other assets—matches the needs of a buyer who wants the product that is your company.

Summary

To achieve a great outcome:

• Plan your way to liquidity.
• Be bought, not sold.
• Get paid for your work.