Selling the Intangible Company

How to Negotiate and Capture the Value of a Growth Firm

Thomas Metz

• Publisher: Wiley
• Year: 2008
• ISBN:
  9780470456903
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

In Selling the Intangible Company, Thomas Metz helps entrepreneurs and venture capitalists to better understand the process of selling a company whose value is strategic. He addresses all the key issues surrounding the sale of a company in which the value is in its technology, its software, and its know-how–but has not yet shown up on its balance sheet. Filled with in-depth insights and expert advice, this book provides essential information for business professionals and technology CEOs who need to understand the nuances of selling a company with intangible value.

1

Intangible Companies—Who are These Guys?

An intangible company is a real company, one with real employees, and with real products and services that it sells to its customers. An intangible company is just like other companies except for one thing—the company’s value is strategic. The value is strategic because the company has strategic assets such as technology, software, intellectual property, and know-how. This strategic value might also be called intangible value; and a company whose value is intangible is termed an intangible company.

An intangible company can be any size, but most have less than $30 million in revenues. These companies are typically in the software, technology, and the service industries. More and more of these technology companies are providing services to their customers rather than selling technology to them.

In this chapter we explore the concept of intangible value and examine the reasons that intangible companies are sold, when they are sold, and what are their sources of value. We will also take a look at the nuances of selling an intangible company and how these deals differ from other types of transactions.

Many intangible companies sell early in their life cycles. Companies sell for a number of reasons including shareholder reasons, market reasons, and management reasons. In addition to the good reasons to sell, there are some bad reasons to sell; there are also bad reasons not to sell.

The best time to sell is when the market is hot and buyers are willing to pay top dollar. Many companies wait too long before they consider selling. The first company to sell in a particular market sector will have an advantage because there are more good buyers who need those strategic assets. Of course, the best situation is to have multiple buyers.

The nuances of selling an intangible company are interesting and we will explore several examples. Small transactions, those under $30 million, are different from large transactions for a number of reasons.

WHAT IS AN INTANGIBLE COMPANY?

An intangible company has special sauce of some kind. Its strategic assets include items such as technology, software, patents, intellectual property, know-how, brand name, market position, customer relationships, development team, etc. For an intangible company, the value of the strategic assets is greater than the financial value that is based on the firm’s profits. These firms are often young and have not had time to translate their technological edge and market insight into profits. To be exact, the company itself is not intangible, but rather its value is intangible.

A software firm is probably the most typical intangible company. Its primary assets are its software technology and its development team. A company that manufactures instruments incorporating proprietary technology is also an example of an intangible company. A shoe company that has innovative designs is an intangible company as well. A consulting company with proprietary best practices on how to convert manufacturing companies into 24-hour operations is an intangible company. The common thread among these types of companies is that they have significant value in their technology, know-how, and customer relationships.

Intangible Value and Elvis’ Guitar

Intangible value is like the value of Elvis’ guitar. How does one measure this kind of value? Is there an objective measure? What is the value of Elvis’ guitar?

Intangible value is truly in the eye of the beholder. The value is extrinsic. The guitar’s value is not a function of its “guitarness” but a function of how badly a collector wants to own it. The market for one of Elvis’ guitars is not just collectors of Elvis memorabilia; it also includes people who wish to become collectors of Elvis memorabilia.

The value of technology depends on how effectively a buyer can incorporate that technology into its products and services and then sell those products and services in the market. The size of the market also impacts the value.

Similarly, value is extrinsic for an intangible company. If a company’s value is intangible there is no objective way to place a value on the company. For most companies, tangible companies that is, value is a function of the company’s profits, its rate of growth, and its risk. This value can be determined by comparison to other companies with similar profitability, growth potential, and risk. However, it is difficult to compare two intangible companies because there are too many differences between them. Even if two intangible companies are similar, valuation comparisons are difficult because the markets change too quickly. Chapter 7 will explore the concept of value in more depth.

By the way, Elvis’ guitar sold for $180,000.

How Big Is an Intangible Company?

Most intangible companies sell for transaction values less than $30 million. Occasionally companies with revenues from $30 to $100 million will have significant intangible value and will sell for a price that reflects the importance of these intangible assets. Once in a while a company with revenue greater than $100 million will sell because of its intangible assets; however this is generally the exception.

Most companies with $30 million or more in revenue have been in business for a number of years and they likely are generating meaningful profits. A company with $3 million in operating earnings (earnings before interest and taxes) certainly has meaningful profits. Such a company will be of considerable interest to buyers from a financial standpoint. Its financial value will most likely be greater than its intangible value. This is the crossover point where the value shifts from intangible to tangible.

The Tech-Service Company

Software, technology, and other intangible companies have been shifting to become more service-oriented than in earlier years. This shift to service will continue. In my opinion, software is essentially a service. That is how most customers view it. It makes no difference whether the words and images that appear on their computer screens are delivered from their own hard disks or over the Internet from a provider’s hard disk.

Two aspects of technology companies distinguish them from non-technology companies—invention and change. A technology company invents new types of technologies: hardware, software, and other varieties of technology. The second characteristic of a technology company is rapid change. By rapid change I am referring not just to the company’s technologies but also to the company’s rapidly changing markets.

Many companies invent and apply technology in a wide variety of industries and application areas—chemicals, instruments, biotechnology, plastics, automobile technology, and even clothing. It is important to think of technology companies not just with respect to computer-related technology companies.

More and more technology companies are providing their customers with the benefits of their technologies not by selling the technologies but by providing services that utilize them. A good expression for these companies is tech-service companies. A tech-service company is a technology firm that has a large service component to its business. Software as a service is the quintessential example of a tech-service company. Now it even has an abbreviation—SaaS.

The success of Salesforce.com underscores the escalating popularity of software as a service. Salesforce.com exemplifies the tech-service company because all of its revenues derive from the service aspect. The company is a leader in customer relationship management (CRM) services and has changed the way that customers manage and share business information over the Internet.

It has taken years for customers to get comfortable with the idea of software as a service, but it is catching on and will continue to become more prevalent. This business model also makes better sense for the software companies. It provides them with ongoing service revenue, which is preferable to the old model in which software firms regularly released new versions. Many software firms could not release versions fast enough to generate sufficient revenue. This model created grief for customers as well because they had to install new software on a regular basis. Software as a service will continue to gain acceptance because it is better for all parties.

Even IBM is a tech-service company. In recent years the service component of IBM’s business surpassed the sale of its hardware and software products. IBM’s Global Business Services Division, which includes technology services and consulting, now accounts for more than 50 percent of the company’s revenues.

The Service Model

Selling a service is a more subtle and sophisticated business model than selling products. As the American economy matures, more and more companies will be providing services rather than just selling technology. There are a couple of reasons for this: one, services are what the customer wants. The customer wants their problem solved. Second, customers are gaining trust in service providers to maintain the accuracy and confidentiality of their data. A few years ago many customers did not want an outside company to be in control of their data. Now customers are more comfortable with this idea. In addition, the service provider can probably do a better job of keeping the data secure than the company can itself. The provider has better backup systems, better redundancy, and more sophisticated data management software.

A good example of this shift to service is an e-mail direct marketing company. Initially this particular company sold its software to customers so that the customers could perform their own e-mail marketing. The company usually provided the service for the first six months to get the customers up and running. Six months later when the time came for the companies to take on the work themselves, they preferred to let the software company continue providing the service. At the outset customers bought the software fully intending to utilize it in-house. However, very few of the company’s clients ever performed their own e-mail marketing; they continued to let the software company perform their e-mail activity. It was much easier to simply pay for the service.

WHY ARE COMPANIES ACQUIRED?

Let’s look at the sale process from the buyer’s eyes for a moment. An intangible company may be acquired for a price greater than $100 million or possibly greater than $200. However most of the time intangible companies will sell for less than $30 million; I regard these as small acquisitions.

Making a small acquisition can be an excellent strategy for an acquirer to gain a foothold in a niche market, gain new customers and new talent, acquire new capabilities and technologies, and serve as a platform to build upon. Small acquisitions are less expensive, easier to integrate, and often simpler to transact than large acquisitions.

A $5 or a $10 million acquisition will be important to a company with $175 million or less in revenue. To a $500 million company, a $10 million acquisition is usually too small to get their attention. Only if the assets or technology are highly strategic will a very large company acquire a small firm.

The market opportunity for small acquisitions is significant. Many small companies need to be part of larger companies in order to grow and thrive and to gain economies of scale in marketing and sales. Often the best firms are not seeking to be acquired and may be under the radar. The market for small acquisitions has not been picked over. The smart play for an acquirer is to make a small acquisition, get a foothold in a niche market, and then grow it.

The search for small acquisitions can provide a resourceful window into new growth areas. Even if an acquisition is not completed, the search process brings new market knowledge. Appendix A illustrates the beauty of small acquisitions in more detail.

WHY ARE COMPANIES SOLD?

A company that is thinking about selling needs to examine the reasons that it is considering a sale. These reasons may be shareholder reasons or market reasons. A primary driver for the sale of a company is that the shareholders desire liquidity for their shares. A second reason is that the company lacks the capital for effective marketing and sales and it can grow faster as part of a larger company with established sales channels. A third reason, although less common, is management problems. Timing is a critical aspect of the decision to sell. Some companies wait too long to consider selling and others sell for the wrong reasons. Let’s examine the reasons to sell.

Shareholder Reasons

Shareholders include the founders, individual investors, and venture capital firms. Each group has both similar and different objectives in seeking liquidity. If the founders are the major shareholders, they may desire liquidity because they’ve been working for a long time and they would like to pursue other challenges or retire. This period of time may be as short as five or six years or as long as 10 to 15 years. The founders would like to cash in on their efforts; plus many are simply ready for a change.

If a company has been performing extremely well, the shareholders may think it is a good time to sell the company and realize an excellent return on their investment. They will likely hire an investment banking firm to assist with selling the company and negotiating a transaction. In some cases a buyer will approach the company out of the blue. The company may end up selling to that buyer or it might approach other buyers as well. A company with exceptional performance is in a strong negotiating position and it can command a top price. A top-performing intangible company with revenues from $15 million to $30 million might sell for a price of $30 million to as much as $150 million.

The second situation is one in which there are outside investors: either individual investors or venture capital investors. If individual investors are the primary shareholders they may desire liquidity because they invested a number of years ago and now it is time to recognize a return on their capital, even if it is not a stellar return.

In some cases companies have both angel investors and venture capital investors. The situation in which the company has venture capital investors is a little different than a company with only individual investors because venture capital firms tend to own a greater percentage of the company’s equity than do individual investors. The result is that the venture capital firms will often have a greater influence on the decision to sell the company.

Venture capital investors seek liquidity for three primary reasons. First is that the company has achieved spectacular results and a sale enables the venture capital firm to cash out and realize a return on its investment. In this situation it is likely that the company was approached by a strategic buyer who made an extremely attractive offer to acquire the company. The second reason is that the venture capital investors do not want to invest additional capital in the company. They may be weary of the investment and do not see the company becoming a major success. The third reason is that the venture capital fund is at the end of its life and it must return the funds to its limited partners.

Let’s take a closer look at these reasons to sell. The venture capital backers may have decided that they are unwilling to invest additional capital in the company. It is their judgment that the money will not generate a sufficient return given the upside potential and the risk involved. Investing additional capital raises the bar and requires the company to be even more successful in order to generate the required return to the venture firm.

Venture capital firms may have invested $10 million in a company to develop its technology and now the company is seeking an additional $10 million to build out its marketing and sales capabilities. At some point almost every company must become a sales- and marketing-driven company. This significantly raises the stakes to the venture capital firms because now they will have $20 million invested in the company. This means that the company must be an even greater success in order to provide an adequate return to the venture capital investors. Now the company must sell for $200 million rather than $100 million, for example, to provide the desired return.

The venture capital backers decide at this point that they would rather earn a moderate return and not invest additional capital in that particular company. So, they instruct management to sell the company. If the venture capital backers own more than 50 percent of the company, they can dictate that management go forward with the sale. If the venture capital firm owns less than 50 percent, they can still have significant leverage. The terms of the shareholder agreement can also give the venture capitalists more clout.

A venture capital firm may also want to achieve liquidity because it is losing patience with the company. It realizes that the company will never be a home run. The venture fund may have maintained its investment in the company for five or six years and is becoming weary of the investment. The venture capital partners no longer want to spend time overseeing the investment and attending board meetings for a portfolio company that will generate only a mediocre return. They would rather focus their limited time and energies on portfolio companies with greater promise.

A venture capital firm may be closing down an older fund that has reached the end of its economic life. A venture capital partnership typically has a life of eight to ten years with an option to extend it for another two years. At the end of the partnership’s life, the general partners are required to return the capital to their limited partners. A venture fund that is near the end of its life will seek to liquidate the remaining companies in the portfolio. I have worked on a number of transactions in which the primary driver for the sale was that the venture fund was nearing the end of its life.

Market Reasons

Many intangible companies sell because the firm has reached an inflection point at which it needs to either expand its sales force or join a larger company that already has a sales and distribution infrastructure. The problem is that they don’t have sufficient marketing and sales resources to penetrate thei...

Table of contents

• Praise
• Title Page
• Copyright Page
• Dedication
• Preface
• Acknowledgements
• Chapter 1 - Intangible Companies—Who are These Guys?
• Chapter 2 - Debunking the Myths of Selling the Intangible
• Chapter 3 - The Sale Process
• Chapter 4 - Preparing a company for Sale
• Chapter 5 - Who are the Best Buyers?
• Chapter 6 - Public or Private—Pros and Cons
• Chapter 7 - The Concept of Value
• Chapter 8 - The Poker Game of Negotiations
• Chapter 9 - The Challenges and Opportunities of Selling
• Chapter 10 - The Problem with CEOs
• Chapter 11 - Structuring the Transaction
• Chapter 12 - Documenting the Deal
• Chapter 13 - Earnouts
• Chapter 14 - Using Investment Bankers and Third Parties
• Afterword
• A - The Beauty of Small Acquisitions
• B - Notes on International Deals
• C - How to Select an Investment Banker
• About the Author
• Index