Mind Games: How the Big Guys Think
For this week’s article, we are going to pivot away from the healthcare system and talk about something else – companies who want to partner with or sell to a large, established player.
Over the years, I cannot count the number of times I’ve sat across the table from the CEOs of smaller, private companies who were interested in some level of partnership. Maybe they wanted to raise money and were seeking an equity investment or wanted a commercial partnership so they could distribute their products through our sales organization or, even more simply, they were looking to get acquired.
Maybe you are a company in one of these positions, either now or you will be at some point soon. If so, let’s take a look at a few different scenarios that will hopefully provide some insight into how big companies think.
Scenario 1: The Minority Investment
In this case, you are likely at an earlier stage of your company’s life cycle. You need access to cash and want to raise some money. You are considering going to a large, established player in the industry to see if they are interested in investing. Maybe you are talking to their venture arm or even their M&A team. Let’s also assume that whatever your company offers / does is of particular interest to the large, established player. With all these elements at play, here are some of the things to consider:
They are not (yet) as excited about your technology as you are … you may believe you have the next biggest, transformative product that will change the world. The big company may be intrigued, but they won’t have anywhere near the same level of excitement and enthusiasm as you do. They have seen this movie many times before and especially if you are an earlier stage company, they mostly see risk. Technology risk, regulatory risk, commercial risk, operations risk … you name it. Know this going in, accept it and try to structure your discussion around what is required to retire risk in a logical, methodical way.
They will seek smaller, more bite sized bets … under most circumstances an established player isn’t going to want to place a large bet at this stage. It’s hard to define “large bet” precisely but usually for an established multinational, anything over $10MM-$15MM is mostly likely going to require a meaningful internal discussion. Making your job even more challenging is that sometimes a $5MM investment for a 50% stake can be more problematic for a large company than a $15MM investment for 10%. In most cases, though, the large company is going to want to invest a little (<$10MM) and see how things go before investing more. Ideally, this will be in the 5-10% range of ownership and almost certainly not more than 20% to start. If you are trying to raise more than what they are willing to invest as equity, be willing to get creative and think about alternative structures, like convertible debt for example. You may get a greater reception and perhaps even more investment.
They can be open to a structured approach … a good way to deal with the potential issues identified in 1) and 2) is to structure the investment in tranches. In other words, ask the established player to put up a small percentage today. Then, if milestone X is hit, they agree to put in another small investment. Then, another subsequent investment if milestone Y is delivered, and so on. This doesn’t need to go on forever, and if done right and structured around the right milestones, you will do it to the point where the next logical discussion is acquisition / outright sale (see below).
They will provide input … I’ve seen a lot of smaller companies resist having bigger companies participate on their boards. They don’t view their bite-sized investment as big enough and therefore only want them as observers versus active board members. In my opinion, this is a mistake. As a small company, you want access to the big company’s input and advice. Even more importantly you want access to their teams, their experience and their assets. Demanding a passive investment is unlikely to bring you any of those things. Now, you need to beware as there are potential conflicts and accounting limitations that come into effect here that govern the extent of an investors participation on a Board. However, there are also other potential approaches beyond Board seats that I have seen work to drive dialogue and collaboration, but the bottom line is that more often than not you will want the big, established player to have an active role in driving your success.
Scenario 2: The Distribution Partnership
The pitch for the partnership goes something like this: “We have this great solution. We think it would be an outstanding addition to your sales teams’ portfolio and allow you to further differentiate versus your competitors. For us, it gives us access to your sales channel and allows us to grow our business without having to invest a lot of time or money in building our own commercial group. And, who knows, maybe after a period of time if you see value in our solution, you can consider acquiring us.”
If this is the scenario you find yourself in, here are some potential perspectives from the vantage point of the established player:
How real is the synergy? … the established company’s sales team is already busy selling their own products. If they add one more thing to what they need to sell, it will distract them from selling the things they really need to focus on. In addition, they will almost certainly get a lower margin selling your product as a distributor than they currently get selling their own products. Bottom line, they are not going to jeopardize their own revenue (and margin) for the sake of yours. There are two factors that could change this dynamic in your favor:
If your product is so complementary and synergistic to an established company’s existing product(s) that by selling your solution, they will also sell more of theirs.
If your product is so disruptive that it is a massive cannibalization risk to their existing product.
Minimums? … an established company doesn’t know your product. They have no experience selling it. There is no data on how enthusiastically their customers, or their sales team will embrace your product. An established company won’t feel they know enough to be able to control their own destiny, therefore signing up for a minimum sales commitment is essentially blindly accepting risk. If you walk into these types of discussions expecting to secure a minimum sales guarantee, be prepared to be disappointed.
My pain, your gain … another consideration is that every time an established company’s sales team sells your product, your company becomes more valuable. Let’s say after a few years of selling your product, the big guys knock it out of the park and beat every sales projection you jointly set. Your company’s value has undoubtedly increased as a result of that success but, from the established company’s perspective, it has to do with all the work their sales team has put in. By asking them to now acquire you, their view is that they would essentially be paying you for value that their team created in the first place. You, on the other hand, will be understandably arguing that the value was always in the underlying product. Bottom line, it will be hard to change their mind and you will likely find yourself in a never-ending argument on where and how value was created.
Given this, here are some ways you can make the discussion resonate:
Understand how your product fits in their portfolio. If your solution allows them to sell more of their core offerings or is a major risk to their core offerings, you have a real opportunity to make something work. Otherwise, recognize that this has a better than average chance of being only marginally successful.
Be willing to get creative. If, for example, the established player’s products and position are really strong in the U.S., but really weak in Brazil, they may want to add your product to the portfolio in Brazil even though their biggest market is the U.S. Another example is that if they reject your minimum sales guarantees, there are others ways (e.g., tying exclusivity to sales targets, etc.) to drive engagement. Ultimately you need to be ready to be nimble and think out of the box if your “plan A” fails.
Be prepared for a fixed exit price discussion. If you want the established player to entertain a sale at some point down the road, then you need to be prepared to discuss a pre-determined, fixed value for the future sale now. You will undoubtedly be tying your horse to one wagon and giving up upside if your product is a massive commercial success, but that’s the trade-off you need to consider versus the risk of trying to go it on your own.
In the end, these partnerships usually fall into the category of “try before you buy” from the point of view of the established player and are often quite challenging to execute – even into the same call point. The key to success is creating an environment and a mechanism that ensures the established player is motivated to sell your solution and stays focused on the relationship. You should also understand that this type of arrangement isn’t without some level of risk for you. If sales don’t go well in the hands of a large, proven company there’s now market data suggesting your product is commercially underwhelming. This doesn’t bode well for you if you want to find a new partner, investor or acquirer. So, my best advice is to slow down and think hard before you engage in this type of conversation.
Scenario 3: The Outright Sale
At this point, your company is likely (though not exclusively) at a later stage and you probably already have a product that has been commercially proven. Customers like it, you’ve generated revenue and are now in a position where you want to sell – ideally a buyer who is in the industry and can take the product and the business to the next level.
The pitch here is usually a bit different: “We have a proven solution. We think our company would be a great fit with yours and, with our two teams together, allow you to further differentiate versus your competitors and grow.”
To an established company, this is a more compelling pitch. You have done a great job retiring risk and proving commercial viability. Where these things almost always break down is either around culture or price.
In my view, the culture component is the more critical element of the two. It also applies equally to the buyer and the seller. Both need to be 100% sure that this partnership is the right fit.
For the seller, you may get your money, but without the right culture, all you have built will be put at risk and, more importantly, you will be potentially impacting the employees who have trusted you with their professional careers. For the buyer, without the right cultural fit, you will have paid for, and then likely destroyed, a lot of value. At its core, the right cultural fit means making sure the strategic goals and values of the companies are aligned, the way the companies think, act and operate are complementary and the senior leadership of the two companies see eye-to-eye.
So, if we are sitting across the table from each other, I am thinking a lot about how these two organizations will fit, and how they will work together. As part of this I am also very concerned about employee retention post acquisition and ensuring we keep the team intact. You should know that these things are at the top of my mind. And quite frankly, I would be very concerned if they weren’t also at the top of yours.
The other element is price. When sitting across the table from a big company, you likely have big dollar signs in your eyes. Maybe you are thinking: “Here is a major company, with deep pockets, who can write a big check.” This could certainly be true, but here are a few key things to understand:
Dilution is a major concern … if you are trying to negotiate with a big public company, understand that these companies have made earnings commitments to Wall Street. If buying your company causes them to miss those earnings commitments, that’s not a good thing. Wall Street can usually tolerate – and perhaps even expect – some level of dilution from an acquisition, but not for long. Therefore, getting to a point, quickly, where the acquisition is additive to earnings (both dollar and rate) is critical. There are a lot of things that will weigh down the earnings from an acquisition. These can be both operational and non-operational, like:
You may be losing money and the acquiring company now needs to take on your losses
A large cash outlay to purchase your company will reduce interest or investment income a company is generating from their cash.
If the company finances the deal through debt, they will incur interest expense they don’t have today (the dilution challenges also apply to equity raises too)
Certain assets you have will either need to be re-valued or amortized as part of the sale process and can impact earnings
If restructuring is required (consolidating operations, eliminating redundant functions, etc)
The amount of investment required after the acquisition to achieve the selling company’s full potential.
The margins of the product may be substantially lower than the profit margins of the acquirer’s products.
Some of these things extend out over time, meaning that they need to be covered for multiple years. You have probably heard the cliched expression “1 + 1 = 3” when it comes to the value created when combining two companies. At the early stage of an acquisition though, “1 + 1 = 0” (or worse). As a seller, you need to understand this dynamic and that it’s not all upside.
Earn-outs may not excite the buyer … to alleviate the dilution / price dynamic, some sellers offer a lower up-front purchase price with an opportunity for additional upside via an earn-out. An earn-out is a future cash payment that is contingent on the successful completion of certain pre-negotiated milestones (like hitting future revenue targets, or product development milestones, etc.). It’s a good way to keep the initial price down and provides the seller with some great potential upside later. Sellers like it, most buyers don’t. Whether you are the buyer or seller, understand that earn-outs potentially subject the parties to contentious discussions later. First, what incentive does the buyer really have to hit those milestones in the future if it means an additional cash outlay? Second, what happens if those milestones were achieved but substantially more cost was required to achieve them? These are just two questions of many. In the end, for many large buyers, earn-outs are more trouble than they are worth and are not the preferred answer. You should understand this going in.
They know when you are bullshitting … “we have multiple interested parties”, “the purchase price needs to start with a 4”, “there’s another buyer who is willing to pay substantially more, but we would prefer to continue with you”. These are just a few of the things you hear from a seller (or their banker) during a negotiation. My opinion is not scientific at all, but based on what I have seen from sellers, I would say 8 times out of 10, an established player knows when this is all a bluff. If you are negotiating with a big company you should assume that they know their space, know their competitors and know all the comps – even better than you or your banker. Heck, they probably know your banker better than you do. Depending on the stage of the negotiations, and especially if they’ve been to your data room, they can do your discounted cash flow (DCF) analysis and all the different upside and downside cases in their sleep. They know what your company is worth. It doesn’t mean they won’t pay a premium, but that largely depends on both offensive and defensive reasons for acquiring the asset, and much less because of some clever negotiating tactic on your part. In fact, transparency and credibility are critical to the final outcome. If I ever felt during a negotiation that you were trying to bullshit me, it was a huge strike against you because it goes back to the culture component. “How can I trust you later, if I can’t trust you now?”
So, if you want to sell to a strategic partner in the industry, here are a few things to consider:
A. Know why they are interested in you – is it for offensive reasons, is it defensive? Does this augment / accelerate their product development? How critical is what you have for their strategic agenda? The more you know, the better.
B. Test for fit – it is essential to ensure there is cultural and values alignment for long-term value creation. This point, and the previous one, require you to perform diligence on your potential acquirer vs. only expecting it to occur the other way around.
C. Help the big company think through retention – depending on the size of your company, an outright sale could lead to a large personal financial event for some of the key players within your company. These are the same players the established company is going to need to ensure value can be created post-acquisition. Helping a big company think through how best to secure the key talent will go a long way.
D. Understand that your DCF is not their DCF – do what you can to understand their economics, particularly around the level and extent of dilution.
E. Avoid complicated structures – simple transactions are better.
F. Don’t bullshit – there’s a saying: “pigs get fat, hogs get slaughtered.” Don’t be a hog by trying to be cute during the negotiations. Most of the time, they will successfully (and rather easily) call your bluff. Build trust through transparency and candid dialogue.
I have obviously given you one side of the equation here. The buyer / investor clearly also has some things they need to understand about you, which I obviously didn’t go into. But I hope these three different scenarios and the points around them have been instructive so that at least you have perspective on what the big company on the opposite side of the table is thinking.
Good luck!
