CHAPTER NINE
Managing Success at the Crossover Stage
Get acquired, merge, refinance, or IPO? It’s not obvious.
YOUR COMPANY HAS DEMONSTRATED THAT IT CAN produce and sell valuable products, and its competitive position appears, for the moment, secure. Revenues are growing nicely, and you’ve reached profitability—or nearly so.
Now is not the time to relax. You’ve reached the crossover stage. This is when management and the board need to make critical strategic decisions regarding the company’s future. Do you declare victory by selling the business, or is it time to continue big-time in business building—perhaps by acquisition or merger with other companies, or by executing an IPO?
Success brings competition, because no matter what barriers to entry you think you have, they are more illusory than real as market needs and technologies rapidly evolve. Wolves are at the door, ready to pounce on errors in product strategy, sales strategy, or customer relations. Industries do not remain static, and neither can a company. It either goes forward in its market position or eventually dies or gets acquired. This is particularly true now, when industries are being disrupted in virtually all market segments. Remarkably, if a company is in the S&P 500 and therefore is one of the top five hundred companies in the United States, its average life span is only around fifteen years or less. Look at examples such as Kodak going bankrupt, Polaroid going bankrupt, Sun being bought by Oracle after years of decline, Motorola Mobility being sold to Google and then Lenovo, and Nokia mobile being sold to Microsoft. In other words, just as the company has reached the highest level of success, it is most vulnerable.
Why You Must Make Strategic Choices
Here are some key elements that characterize a company that has reached the crossover stage.
- Management has the resources and talent to effectively manage its current business.
- There is an established customer base, with revenues that are becoming predictable, at least for one year going forward.
- Although competition has intensified, revenues have been growing at rates exceeding those of competitors. Within its targeted market, the company enjoys a strong and growing position. Products are sold with a reasonable gross profit margin consistent with industry values. Looking ahead, however, you need to enlarge the product portfolio, requiring investments beyond your available financial resources.
- Cash flow is predictable, if not yet profitable. Based on good projected revenue and performance data, the company can reach profitability within a certain projected cash use.
Such success does not come without difficulties. Companies that reach this stage have been in existence for a few years. Now important issues need to be addressed. Here are some common ones.
- There is a need for investor liquidity. The venture capital funds that financed the early years are maturing. They usually have a ten-year life, and hence there is a need for liquidity on the part of some investors. Tension exists between those influential people in the governance of the company who are seeking an event of liquidity, and those who think that the future prospects continue to be so compelling that a much bigger and more valuable company can be built.
- Developing and marketing new products will require new capital. It has proven increasingly costly to develop new products of the same importance, because new competition has surfaced that increases the hurdles for new product success.
- The company needs to invest more than it has in the past in international marketing, where growth prospects are highest.
- One solution to the future growth problem is to acquire or merge with other companies to broaden the product portfolio and the technology base in the face of new industry developments. The funds to do that on a large scale are not available in the company.
It’s obvious to informed insiders that the company cannot just continue to grow under its own momentum.
If your company is in the crossover stage, what do you do?
Here is where the role of the lead investor becomes critical; he will have the responsibility to steer the board of directors to a decision. There are four broad options. First, you could sell the company. Second, you could find a new set of investors prepared to buy out the ownership of any current investors interested in selling. Third, you could find a merger partner as an equal. Fourth, you could prepare for an initial public offering of the company’s stock to raise the capital needed.
Of these choices, the IPO route is the most demanding one because of all the regulatory issues necessary to offer shares of a company to the public. Of course, it is historically the most rewarding one in terms of building a great company. When that option is available, it is usually the one chosen, but there are many hurdles to reach the public market and build company value going forward. More about IPOs under option 4.
Option 1: Sell the Company
Most companies at the crossover stage, or even an earlier stage, are sold. The valuation of the company may be high enough to provide major financial rewards to the investors and team. Moreover, it may be hard to predict the future path to company revenue and profitability, even when the growth and market success may be encouraging.
This was the case with Siri (although arguably it had not quite reached the crossover stage). When the Siri team was originally posed with the question of acquisition versus a future IPO, we unanimously voted to continue as an independent entity. But as the acquisition offers became more attractive, the team had to consider five elements.
- Siri had created a new category of virtual personal assistant, but many major companies and competitors were racing to create their own virtual personal assistants, including Google, Nuance, Vlingo, and others. There was a serious question of how much lead time Siri had, even with its differentiated technology in AI and natural language understanding.
- The investors had a choice of accepting a high rate of return on their investments now, or taking the risk posed by future competitors and going public two or three years later.
- The executive team’s vision was for Siri to make an impact on the world, and Steve Jobs offered an opportunity to do this through Apple. The opportunity to have the product serve tens of millions of consumers through Apple was attractive to the team.
- A major consideration for the team was whether to take the certain financial reward now or take a risk for possibly greater future reward.
- Siri had demonstrated outstanding consumer acceptance, but the revenue model had not been proven. The cost-per-action (CPA) revenue model meant that Siri would be paid for leading consumers to a web service, such as buying a movie ticket, making a restaurant reservation, buying flowers, or finding a concert. When Siri was launched, however, most of the Siri functionality was used by consumers for free services, such as getting the weather report or checking the status of a flight, and therefore relatively little revenue was generated.
As a result, when Apple made its compelling offer, as we all know, the board voted to accept acquisition.
Option 2: Find New Investors
If you need new capital to fund growth and want to continue on the path to going public, but the investors or essential team members want liquidity, you can seek another round of funding. This funding can provide either partial or total compensation for the existing shares. Sometimes the investors want the liquidity because of external considerations, such as the stage of their current fund.
As for team members, it’s obvious that entirely buying out the shares of a team member is a bad idea, because it would remove the person’s financial motivation to help the company succeed. But sometimes buying a fraction of a team member’s shares will give her a level of financial security that softens the all-or-nothing potential that might result from her continuing with the company.
Option 3: Merge with Another Company in a Stock Swap
In some cases, the management and investors are excited about continuing the venture but recognize that the company needs greater scale to compete in a large market. In such situations, it’s likely that other private companies in the market have the same problem, and a merger of equals makes sense.
Here, talent selected from both companies will manage the new company, and the two boards of directors will be consolidated. The investors will not receive cash but will receive stock in the new company that is not liquid. Generally, such events are triggered when both companies are interested in an eventual IPO but each one feels that a merged, larger enterprise will command a much higher IPO valuation and will be better positioned for continued success as a public company.
These beneficial mergers face obstacles and do not happen enough. They usually involve a clash of egos and expectations of investors on the respective boards. Issues start with the selection of the CEO of the merged companies as well as a likely clash of cultures that could result in the loss of key talent. The necessity of removing some board members raises other issues, as does the possibly extended time to cash realization. Such stakeholders might rather see a sale of the company for cash and may push for a company sale rather than a merger.
Option 4: IPO
The first key step in evaluating this option is to assess the interest of the senior management team. Are the CEO and key managers excited about continuing to build a great company, and do they have the skills to meet the challenges of a public company? If the answer is no, then either selling the company, merging with another company, or finding another group of investors might be the right answer. If the answer is yes, then an IPO deserves consideration.
The second key question is whether a credible investment-banking underwriter can be found to lead the public offering. Mark Goldstein, current head of financial sponsorship at the Royal Bank of Canada (RBC), has had decades of experience in underwriting IPOs, and he led the IPO for Covad (see chapter 3). Goldstein described the process.
We had been invited by hundreds of companies seeking a sponsor for an IPO, and over my career I only selected about thirty. The reason is that few management teams coming from a high-tech background have the ability to manage a public company. I looked for CEOs able to represent their companies on the basis of vision, product strategy, and execution skills. As investment bankers sponsoring an IPO, we cannot afford to disappoint the buyers of the offered stock by poor performance. So management credibility and track record are critical. Hearing their presentation, I looked for passion for their business and past execution record as indicators of future performance. In the case of Covad, I found the right elements and had a successful IPO. Also, I looked for the quality of the board of directors and the lead investor. For Covad, the lead investor was Warburg Pincus, which gave me comfort that the company’s board was able to oversee the management of the company.1
Going public exposes the company to a great deal of outside scrutiny. Financial systems must be flawless, because errors in reporting financial results can have serious legal consequences. The public report is followed by a public conference phone call with investors who want to hear the CEO and CFO provide commentary on the financial results. Questions from the participants are answered. The CEO and CFO of public companies must be able to represent the company well in their presentations. They will also be called on to represent the company at financial conferences hosted by investment bankers for investors.
The Predictability of Revenues and Profits
Going public is not for every company. For example, a company that is subject to wide and unpredictable variations in quarterly revenues is not a candidate for an IPO, because it will have a poor trading history that will impact its valuation.
A company planning to go public needs to have reached a significant level of maturity. If it appears that the company cannot predict its quarterly revenues with reasonable confidence, investors will lose their confidence in its management and analysts will cease their reporting. The public listing will go into limbo, because the stock is without a market. A low public valuation impacts the reputation of the company as well as the morale of employees who have received stock options but see no value created.
Some fast-growing companies in hot markets simply do not belong in the public market. For example, Sensors Unlimited, founded by Greg Olsen, a serial entrepreneur, had pioneered a new electro-optic device that was being widely adopted by the communications industry. With revenues of $20 million and high profitability, Olsen was approached by credible investment bankers with a proposal for a public offering at a valuation in excess of half a billion dollars. Having funded the company with his own money, Olsen owned the majority of its shares, with employees owning the rest.
Henry counseled against a public offering for two reasons. First, Olsen had built a company with limited management depth, and it was too young to have predictable financial performance, being dependent on a single product. Second, because the company had such large personal ownership, the ability to sell stock was limited. Public investors do not like founders to sell a lot of their holdings, seeing it as a lack of confidence in their own companies. Instead, Olsen eventually sold the entire company for $600 million to a corporation and realized the full value of his venture.
The Management Team Needed for an IPO
In a small venture just getting started, the fire of creativity is lit and the basis of the venture is to realize an innovative product vision. Keeping this flame alive when a company becomes big is more difficult, and the founders must augment their creative talent with new people. Many companies have been challenged in making such an organization function effectively.
As we’ve said in earlier chapters, start-up managers have a style that may not easily adapt to managing a large organization where day-to-day management skills are vital for success. Sometimes the starting team evolves into builders of such an organization, but often it takes different people with different experience and skills to manage large organizations in dynamic industries.
Executives who thrive in such organizations are experienced managers first and technical specialists second, but they also have entrepreneurial ambitions to participate in an exciting, growing business aiming for market leadership. They might not be company founders, but they are company builders. Such people are rare, but they are the foundations of great companies that have passed the early entrepreneurial stage.
One frequent solution to the growing management responsibility of the CEO is to add a chief operating officer. Jeff Ganek, founder and first CEO of Neustar, said, “At some point in the successful growth of the company, I was prepared to hire a very talented operating executive to help me run the company, recognizing that the welfare of the company would require a new set of management skills.”2 In fact, prior to the IPO, Mike Lach, a talented manager with big-company experience, joined the company as president and COO, reporting to Ganek.
Becoming a public company puts demands on management and requires skills that are only rarely found in young start-ups. Suddenly, the company needs to communicate its plans with a large audience (including its competitors), and its stock price becomes hostage not only to uncontrollable market events but also to management decisions that impact growth and profitability. As Ganek observed, “Managing a public company feels like operating in a fishbowl. Business decisions have to be considered not only from the viewpoint of what is good for the company in the long term, but the impact they will have on investors.”3
For example, increasing your investment in product development will decrease profitability in the short term, and the reduced earnings will also reduce the stock price unless investors understand that the short-term financial impact will be outweighed by greatly increased future profitability. Hence you need a CEO capable of managing a company in a public environment, where his credibility will have a great deal of impact on the public valuation of the company. Nova CEO and cofounder Ed Grzedzinski explained:
My management style changed as we grew rapidly and needed to delegate more of my activities to my staff. However, many of the senior managers that worked for me had previously been midlevel managers in other companies. Some grew in their skills to accommodate more responsibility. Others simply could not cope and had to leave the company—well rewarded from their stock ownership—and new people with the right experience came in. It is testimony to the quality of the team that after the acquisition of the company by US Bancorp they continued to manage the business with increasing responsibility as the acquirer put its own credit card processing business within the Nova business.4
Has the Company Developed a Culture of Continuous Innovation?
If the answer is no, it does not have a long-term future as an independent public company.
Full of confidence, the CEO and founding team often assume that their own creativity will lead to pioneering new markets and products. Our experience is that frequently these people are blessed with only the initial great idea, which eventually becomes obsolete or a commodity. Since the life cycle of products is shortening and the nature of products is constantly changing, the company will have to mobilize the creative and innovative talents of the entire company in order to succeed.
This means that CEOs must learn to manage an innovative company, and this can be done only by developing an organization that monitors and rewards creative people. How well a company manages this constant evolution is critically dependent on its organization and talent pool.
Among the options—sale, new investment, merger, and IPO—the IPO is often the splashiest, most newsworthy, most attention-grabbing way that successful ventures cross over. But it’s also the most intensive and calls for careful changes to deal with the issues you must grapple with if you make it this far.