Global M&A hit a record high in Q1 of 2018, with over $1.2 trillion in deals—a 67% year-over-year increase. But with all the focus on going public, some companies may not be positioning themselves to be equally attractive for a merger or acquisition.

As a CEO is busy building a company, M&A is usually not on the top of his or her agenda. Further, every M&A transaction and story is different. Sometimes you refuse multiple offers to get acquired. Other times, you sell when you didn’t think you ever would. And then there are the times when everything falls into place at exactly the right time, like something out of a screenplay. For Apigee, purchased by Google in 2016, it was the latter.

“Very rarely as a public company do your shareholder interests, employee interests, and customer interests line up exactly the same way,” said Chet Kapoor, former CEO of Apigee. “As a management team, we put together a list of a handful of companies that we would like to land at if it was our choice. And Google was right on top of it.”

The accessibility of late-stage private capital has allowed more companies to focus on growth instead without the overhead of being a public company. The challenge: as a company matures and increasingly receives more outside capital, it may limit the number of potential buyers. Why? Strategic buyers may be limited by their purchasing capacity which includes public market capitalization, cash on hand and access to debt.

It’s important that companies develop a range of strategic partnerships to help them achieve their goals. These partnerships can eventually lead to an M&A scenario. A good example is the proposed T-Mobile-Sprint merger, where the companies hope the merger will expand their customer base and help them compete with AT&T and Verizon.

While Apigee’s M&A scenario was one in which things seemingly “fell into place”, it wasn’t just good luck and timing on their part. It also came down to being well-positioned as an acquisition target.

With this in mind, we recently brought together leaders from our portfolio companies and a slate of M&A veterans from both the buyer and seller sides of the equation. They shared their experiences and insights into how founders can build relationships that make M&A not just a possibility, but a very positive—and profitable—outcome for the entire company.

In this article, we share the collective wisdom, experience, and frameworks they shared.

What Makes an Attractive Acquisition Target?

Strategic acquisitions at higher multiples tend to occur more frequently for companies with less than $10M in revenue, and who haven’t taken much venture capital, if any. Additionally, their valuation and attractiveness to a potential partner at this level depends on three key elements:

Team. What is their experience and what are their areas of technical expertise? How well will they fit into the acquiring company and its culture? Don’t underestimate the importance of culture match as this alone can be a deal breaker or drive towards a higher exit multiple. Many companies look for their next wave of leaders from the companies they acquire.

Technology. Companies often look to acquire strategic technology that would take too long to build internally or that their existing team lacks the expertise to build. The barrier to entry for that technology also comes into play.

Market. Is the company part of a massive, growing market? How many competitors does the company have, versus how many potential acquiring companies? If a company has seven or eight competitors and only one or two potential acquirers, it’s very important to establish solid relationships with those potential acquiring companies early on to be top of mind for a future acquisition.

Smaller companies are often acquired based on their potential. But once companies are more established, with a product in the market, there are additional considerations. In addition to the above criteria, valuation also hinges on the customer base and the company’s financials. A potential acquirer will ask the following questions:

  • What’s the health of the customer base?
  • How much customer churn are they seeing?
  • How happy are the customers?
  • What’s the annual contract value (ACV)?
  • What is the top line revenue in bookings?
  • What are the gross margins?
  • What does the company’s profitability look like?
  • Is the customer base consumer, SMB or enterprise?

Successful acquisitions in the zero to $10M revenue can see valuations with revenue multiples as high as 20 times to above 100 times revenue. The difference in these ranges of valuations reflect the strategic premium the buyer places on the team, the product and technology, and the dynamics of the market. Premium valuations for M&A will go to companies with high growth, amazing technology, strong pipeline, highly recurring revenue with annual or multi-year contracts, signals of sales efficiencies, gross margins and low churn.

With such a large range of valuations, it’s easy to see why the valuation process can derail a potential acquisition. Often, a founder will have the expectation that his or her company’s valuation is aligned to close public market M&A comparables. However, this number is typically aspirational and, unless the company has similar performance parameters as its comparable, it typically does not reflect the way the acquiring company is measuring the value of the company. Lastly, sometimes public comparables make limited sense because public companies frequently have a materially slower growth rate than young, fast-growing private companies.

Revenue Type Matters

Not all revenue is considered equal. For most enterprise software companies, for example, there are four primary types of revenue: subscription revenue, license revenue, maintenance, and services revenue. License and service revenue is primarily one-time revenue and much more difficult to forecast than subscription. Subscription, because of its recurring nature, gives investors and the public markets a sense of where the company’s revenue is going. For this reason, it’s typically valued a lot higher, especially with a low churn rate.

A good example of this at work in a public company is Adobe. In 2012, 70% of Adobe’s business model was from one-time licenses, with only a small portion of recurring maintenance on top of that. In 2013, Adobe started moving its creative suite to the cloud and to a subscription model. By 2017, over 80% of its revenue is from subscription. Concurrently, the company’s revenue multiple has gone from 4X to 12X, with a $100 billion valuation.

The Rule of 40 Drives Success  

No conversation about startup valuation is complete without talking about the “Rule of 40.” It is a popular formula for measuring if your company is on track as it grows and scales.

Once the company is at $1M MRR or higher, the Rule of 40 (which is that your growth rate combined with your profit should add up to 40%) kicks in. In this equation, your growth rate = y/y growth rate of monthly MRR.

For example, if your company is growing at 20% per year, then your profit should be 20% to meet the 40% goal. At a 40% growth rate, you wouldn’t need to be generating any profit. For most startups that are burning capital, your growth rate needs to be high enough to compensate for that burn. If your profit margins are -10%, your growth rate should be at 50%.

Relationships That Position Your Company for M&A

Most mergers or acquisitions take place as an outcome of a relationship the company or one or more of its executives has with the acquiring company. Following are insights from the sellers’ panel at our event. These companies built the right relationships to position their organizations for M&A.

Before its acquisition by Salesforce, SteelBrick (now Salesforce CPQ) actively built relationships across the Salesforce organization. A key relationship was with Mike Rosenbaum, who now runs CM applications at Salesforce. At the time of the acquisition, he ran Salesforce’s Sales Cloud, the ecosystem into which SteelBrick’s product would fit.

“We got to know Mike very well, and we also got to know sales leaders [Brian Milliam and Patrick Blair] well,” said Godard Abel, currently executive chairman and co-founder of G2 Crowd.

He noted that this relationship was helpful when it came time to negotiate a deal. “We knew each other very well, and I think that made the integration much easier,” he said. “Frankly, it didn’t feel that different inside the company than it did having been a partner. So, I think that [relationship] did make it successful.”

Similarly, Bob Rosin, head of partnerships at Stripe, noted that his former company LinkedIn had built a strong partnership over many years with its eventual acquirer, Microsoft.

“There had been relationships on multiple levels,” Rosin said. He noted that LinkedIn’s executive team and Microsoft CEO Satya Nadella had built a very strong relationship, from when Satya first took the role. These ongoing relationships, built over a long period of time, forged the trust necessary for successful M&A experience.

“It’s very rare that a big M&A even happens out of the blue,” Rosin said. “These are relationships that are built over a very long period. And these relationships are personal, it’s not just about your business it’s about the people and having you join a team as a leader at that organization. It’s very important to think of the relationships that you’re building as something that you’re investing in over a long period of time.”

In June 2018, Norwest portfolio company Adaptive Insights was acquired by Workday. This wasn’t always the plan, though. Adaptive was about to go public, but it all changed when Workday called with an offer that they couldn’t turn down. Within 24 hours, Workday announced that it would acquire Adaptive Insights. The credit goes to Tom Brogan, CEO of Adaptive Insights land his incredible relationship with Workday co-founder and CEO, Aneel Bhusri.

Relationships: Also Important for Public Company M&A

It’s not just pre-IPO companies that go the M&A route. And although the M&A process differs between two public companies, Bethany Mayer, Ixia’s former CEO, shared how the existing relationship she’d forged with the CEO who bought the company was equally important.

Keysight Technologies acquired Ixia in 2017. Mayer met Ron Marcesian, Keysight’s CEO, at the Deutsche Bank Conference. The two CEOs would meet occasionally for lunch to talk shop and get to know each other.

“When Ron called me up out of the blue and said, ‘hey, we’re going to buy you’, my first response was ‘We’re not for sale’,” said Mayer. That sale did eventually occur and was successful in large part due to the relationship the two CEOs had developed. “When it came time for the actual negotiations to occur, that relationship was very important when the two companies came together, to make that work effectively,“ Mayer said.

Mistakes Entrepreneurs Make in the Acquisition Process

No matter how great the relationships are with the acquiring company or how transformative the technology, there are always mistakes on the road to M&A. Here are a few common M&A pitfalls to avoid.

Don’t Hide Bad News During the M&A Process

“There is always a story you’re afraid to tell them up front because you are afraid that it will kill the position,” said Benny Schnaider, VP of software development at Oracle. “But the sooner you tell them, the better off you are.”

Schnaider put this advice into action as CEO and co-founder at Qumranet during its acquisition by Red Hat. “At Qumranet, [our product] a button—an implementation that violated a patent. “We told Red Hat about it up front, and they took it upon themselves to find a solution.”

Mayer agrees with the importance of transparency—never underestimate the rigor of the due diligence process. “You need to be really transparent, and with everyone,” she said. “If you have a bank involved, they really need to know soup to nuts what’s going on. Then, they can help you when they’re talking with a potential acquirer. And then also, the potential acquirers themselves—do not think you can hide anything from anyone. They’re very good and, by the way, they hire advisers that are even better. They come in and, they’ll know everything about you by the time you’re done.”

For Rosin, a lack of transparency up front means a partnership conversation may never get off the ground. “A lot of times you’ll have a founder who doesn’t want to share information,” he said. “I get it, often you don’t want to share too much. But if you don’t share, if you’re not transparent about your business, then the conversation often is just going to end right there.”

Don’t Ignore Offers to Sell the Company

While some founders may seem too eager to sell, it’s more often the case that when approached by a potential M&A partner, the immediate response is to say that they’re not interested at all. But this sort of immediate dismissal can hurt a company in the long run by giving it a reputation of never being open to M&A when they could be with the right partner.

Schnaider counsels that although you will hear many casual pitches from companies asking if you are you willing to sell the company, if it is a comment that could lead to something serious, you should never ignore such a comment.

“I would say that on the one hand don’t be too eager to sell, just don’t do it,” said Schnaider. “On the other side, it’s kind of a play. One of the solutions is to say, okay, tell me what you mean? I’m only the CEO. If you have a serious offer for me, put it in writing. I’ll have to give it to the board. You may say initially, ‘I’m not interested at all, but I will have to take it to the board.’ You have to play, but don’t ignore it.”

Don’t Let Ego Get in the Way

As a founder or CEO, there can be a lot of mixed emotions when considering a merger or acquisition. But it’s important to put the company’s best interests first, and set aside egos.

“Leave ego, if you can, out of the conversation,” said Mayer. “It gets really hard. Some people call it emotion. I don’t care what you call it, but at the end of the day, even if it’s your own company, you have people whose lives are depending on your ability to manage this circumstance in an objective fashion. And for me, as the CEO of a public company, my thought was really around my shareholders, my employees, and my customer base. I had to keep that in mind all the time.”

In addition to making M&A decisions that don’t take the company’s entire best interests into consideration, ego can also cause a potential M&A partner to walk away entirely.

“If I think about all the processes we went through at LinkedIn, when we were looking at companies, many times the deal doesn’t happen because of the business itself academically, on paper it makes sense, but because of the personalities—because the founder or the CEO was really cocky, or just seemed like someone who would not fit into our culture—was not someone we could envision in a leadership role in our company, the deal wouldn’t happen,” said Rosin. He noted that in one case they’d agreed to acquire a company, but carved out the founder, due to personality fit issues, and the deal ended up falling apart.

Negotiating Valuation

Understandably, there’s sometimes a big difference between what a founder thinks the business is worth—or for what they’d be willing to sell it —and what the acquirer has landed on as a fair price. So how do you find a middle ground?

Understand the Buyer’s Valuation Methodology

Before walking away from the negotiation table in such a situation, Rosin recommended asking the purchaser to share their valuation methodology.

In the case of selling Qik, by asking for the valuation methodology, they were able to get Skype to tell them the multiple they would be looking at for revenue. “Once we had that number, and they explained to us how they would build the model, then we knew we could make it work because I had confidence in what our forecast was for the next year,” Rosin said. “Then it just becomes an exercise where I walk through everything. Here’s our entire sales pipeline, here’s how many contracts we have. I remember a four-hour meeting where I went through an entire pipeline and showed how we’re going to achieve this number next year, and based on your math, it gets us to that number.”

From that interaction, Rosin learned that even though they started from two very different places, once you agree on an evaluation framework, and you can demonstrate with data points you have how you’re going to get there, then you can make it work for both parties.

Seldom Say Your Number First

One of the first rules of negotiating anything is to never say a number. And Schnaider says this holds true for M&As as well. “We will never say any number when we are being asked,” he said. “They will always ask us, ‘what is the number at which you are willing to sell?’. We aren’t going to tell you the number.”

Schnaider counseled, however, that a serious buyer is going to continue to press for a number. If you want a serious buyer to put in a serious offer, they have to know how much you are expecting to see if they can be anywhere near your number. Looking at comparables in the market is one way to get around pinning yourself to a number.

“In most of the deals, we are in the early stages,” he said. “So, we can’t rely on revenue, and we want to get very quickly out of the formula x times revenue, x times profit or whatever it is. It has to be strategic value. So, we look at comparables and we intentionally choose the deals that we like to be compared to.”

By holding a conversation on other comparable deals, the company isn’t saying they want or expect that same valuation. But it provides a starting point for the conversation so the two parties can see if they have the same perspective and shared evaluation framework.

Your Price Isn’t The Same Number at Which You’d Actually Sell

In the public market, the valuation negotiation takes on a different element. As a public company, all of your books are open, anybody can see what your company is worth on paper.

“Your price is obviously there,” said Mayer. “But the question is, at what price would you sell, not what the current price of your stock is.”

When Keysight initially proposed purchasing Ixia, the price it offered was not one at which they were interested in transacting. But rather than wait to see if it came back with another offer, Mayer took this as the prompt to work with the board to take a look at their expectations for the stock over time. They decided to determine the potential for a different strategic outcome.

“With the help of Deutsche Bank, we created a process and ended up getting many bidders involved in the discussion,” Mayer said. “The price changed dramatically over time as a result of that.”

When Your M&A Springs a Leak

Despite the NDAs and other agreements in place, it’s all too common that M&A deals often become a matter of public record before any paperwork is signed. In some cases, a leak can cause negative information to come to light that derails the M&A process. But in other cases, leaks have proved to be beneficial for the seller. While companies must do everything they can to avoid a leak, it’s helpful to have a strategy to deal with them if they do occur.

“We had a leak. Somebody showed up at the Associated Press’ door and told them that we were going through a process,” said Mayer. “That was very disturbing for a number of reasons. One, of course, is that your employee base has no idea this is going on. So, you’re in there having a discussion, negotiating in certain circumstances, and a leak occurs. It was pretty disruptive for us.” As a well-established public company, news of the potential acquisition had the potential to be disruptive to the internal culture, and meant the leadership team had to go into damage control for a deal that hadn’t yet been finalized.

But an unexpected outcome of the process was the interest the leak generated from other potential bidders.

“Oddly, what also occurred was some more folks came into the bid process,” she said. “It didn’t change anything at the end of the day, but, everyone rushed the stage and said, ‘Okay, we’re all here, let’s all talk.’”

Schnaider similarly had a leak become a positive, although it didn’t start out that way.

“We had a situation…there was a leak going to one of the potential bidders,” he said. “Everybody was [upset]. But I said, let’s see how we can leverage it. We staged a meeting with the individual we suspected of being the leak, with the number that we wanted to convey to the other side. Sure enough, the next day, we got an offer with the number that we said in the meeting that we want to sell the company for.”

While leaks should be avoided at all costs, sometimes they are out of a company’s control.

“With our Salesforce deal, we negotiated a terms sheet at Thanksgiving,” said Abel. “The plan was to announce it after the new year. But, in mid-December, I was at a holiday dinner with my wife and kids and a reporter kept calling me, wanting me to verify the rumored deal.”

Luckily for Abel, Salesforce took the issue in stride. “To Salesforce’s credit, this stuff happens to them a lot,” he said. “They were surprisingly calm about it. We then decided to close faster. We didn’t get ten percent more, but we got it done ten days earlier, which gave everyone a better holiday.”

For more insights into the world of venture capital and the entrepreneurs we invest in, subscribe to our blog and follow us on Twitter @NorwestVP.

Also published on Medium.

Keep up with the latest.

Get the latest updates from Norwest and insights into the venture capital world.