As entrepreneurs, we are anxious to see our vision come to life. We desperately want to succeed commercially and grow. Combine that with an almost unhealthy level of optimism, and you get a perfect storm for a disaster.
We often lose sight of the end game. For the lucky ones that means exiting the company and liquidating our equity: In 98 percent of the cases that would be mergers and acquisition, with 2 percent reserved for initial public offerings.
As my day job at Allied Advisers revolves around M&A, I have the rare opportunity of hearing what buyers consider red flags that may end up lowering valuations or even break a deal altogether. Many of these issues could have been solved by the founders early on if they had future M&A in mind from the start.
For the sake of readability, I will cover three simple things you can do early on to ensure a smooth exit down the road.
1. Outsourcing gone wrong
Especially after COVID, I truly believe outsourcing will become a growing, quality source of talent. In many cases these freelancers will work for a third-party agency. This is why we should learn to foresee any issues with outsourcing early on to prevent potential red flags for future buyers.
What can go wrong?
If the buyer believes these contractors hold key information and are core to intellectual property of the company, they will want to bring them in-house.
However, in most cases the agency won’t be too eager to part with its top talent, and understanding this is holding back an M&A process, and if you are short on time, they might hold the talent “hostage” until you, the seller, agree to pay outrageous fees to the agency.
How can you mitigate this risk?
Include a “liquidity event” within the original contract with the agency and the contractors, and address the exit scenario directly with a fixed price to bring any person in-house.
2. Termination by agreements
Any agreement with resellers, vendors and customers will be scrutinized by a potential buyer. In most cases, buyers will have different plans for the company moving forward. They might want to remove certain customers as they compete with them, or they might want to use their internal salesforce and remove some of your resellers or distributors.
What can go wrong?
Should your agreements not allow for such termination possibilities, the buyer might walk away altogether as they will not renegotiate and open every agreement you ever had.
In some cases, where there is only one or two agreements that pose an issue, you might be lucky and vendors might agree to terminate their agreement upon buyer request, however at a steep price which could again become a deal breaker.
How to mitigate?
Utilize proper termination clauses and roll-back clauses. Meaning cap any agreement with time and with the possibility to terminate the agreement. In some cases I would also address the exit scenario directly, in which case you need a roll-back clause which is essentially predetermined rules and terms that would allow you to terminate the agreement with no further strings attached.
3. The greedy entrepreneur or investor
Let’s start with you, the entrepreneur. I know it is rare, and in most cases mistakes are done due to lack of experience, but when raising capital you might come across inexperienced investors who will agree to unfavorable terms for them. For example, they will agree to invest a $2 million seed round for 5 percent equity. A quick calculation will bring us to a valuation of $40 million. After 12-18 months this money will run out, and you will raise a $5 million series A. So far so good.
What can go wrong?
The main problem is that your high valuations repel any experienced/good investors from joining the Series A round. Essentially you terminate your own company due to greed and lack of experience.
Let’s continue with a greedy investor. In the opposite scenario, you are tight on cash and you agree to accept a $2 million SAFE (simple agreement for future equity) with a discount rate of 60 percent and a cap of $4 million post-money valuation.
After 12-18 months you will again begin to run out of cash and raise your $5 million series A. Assuming things go well, your valuation will be around $15 million post-money valuation. So far so good.
What can go wrong?
Investors in the Series A accept that Seed investors convert under favorable terms, however there are industry norms, and in this scenario the Seed SAFE investors did not follow the industry norms. Their discount rate is too high, and cap is too low. The SAFE investors are converting at a $4 million post-money valuation, meaning they get 50 percent equity, basically taking control of the company. While the Series A investors will invest $5 million and get 33 percent equity which is too big of a difference. On top the founders are heavily diluted. This potential disaster means that good investors will likely walk away from the Series A round.
How can you mitigate?
Any behavior from either the entrepreneur or investor that is outside the industry norm, will actually hurt the long-term goals of the company. So try and follow these norms, accept and ask for fair valuations accepted by the industry. This will highly increase the chances for future smooth funding rounds and a potentially smooth exit. 1
Itay Sagie, a guest contributor to Crunchbase News, is a lecturer and strategic adviser to startups and investors. Sagie is also a senior adviser at Allied Advisers, a boutique investment bank from Silicon Valley, and founder at VCforU.com. You can connect with him on LinkedIn and follow him on Twitter at @itaysagie.