When to Consider Mezzanine Capital

Pros and Cons of Mezzanine Capital

by Terry Stidham, President of Target Search Group

There are a number of situations in a business for which mezzanine capital may be appropriate. The following three examples would be good candidates to consider mezzanine financing:

1. Two equal partners have run a profitable business for many years and now one wants to retire and the other wants to continue working for at least another 5 years, but he does not have the money to buyout his partners interest.
2. There is a profitable, growing business that could grow much faster if it had the capital necessary to increase the amount of inventory maintained; but, the bank is only willing to advance 50% of the cost of such inventory. 
3. The president and senior management of an established, profitable company has an opportunity to buy it, but the sum of the cash that they are able to invest plus the amount that their bank is willing to lend is not enough.

Mezzanine capital is the middle (or “mezzanine”) layer of capital between the senior debt provided by banks and equity provided by stockholders. Accordingly, mezzanine capital is generally subordinate to bank financing, meaning that the bank loan has a first claim on any of the assets of the business and generally has a right to be repaid before the mezzanine capital. On the other hand, mezzanine capital is senior to the company’s equity.  Most mezzanine capital comes in the form of a loan that is secured by all of the assets of the business (in subordinate position behind the banks). However, in some instances, mezzanine capital can also be in the form of preferred equity without any collateral or requirement to receive current dividend payments. Such equity usually has a requirement that it be redeemed prior to any payments to the company’s common equity.

 

Banks will typically require that their loans be secured with assets of the company, mezzanine capital providers generally focus on the cash flow generated from the operations of the business. Accordingly, the most important aspect of a company looking to obtain mezzanine capital is that they have a proven track record of generating cash flow from their business. This generally disqualifies start-ups and turnarounds from being good candidates for mezzanine capital. In addition, how the company plans on using the capital is important.

 

As the three examples above indicate, using mezzanine capital to fund:

• Recapitalize the company
• Inventory build-up
• Facilitate a management-led, leveraged buy-out

are all good examples of when mezzanine capital is most helpful.

 

A company seeking to establish a sales and marketing organization, to cover operating deficits or to provide partial liquidity to an owner that remains active in the business are more appropriately funded with equity.

 

Return expectations are correlated with risk:

For this reason, it is best for a company to maximize each type of capital in the order of their cost. Accordingly, only after a company has obtained as much bank debt as the bank will provide (including a revolving line-of-credit and term loan) should it consider mezzanine debt. Then, only after a company has obtained as much mezzanine debt as the mezzanine capital provider will provide should it consider mezzanine equity, and so forth. Utilizing this financing strategy will minimize the company’s cost of capital and allow the company’s owners to retain ownership of as much of the company as possible.

 

The actual cost of each type of capital will depend on many factors as well as the amount of capital required.  Economies of scale apply to capital, as they do to almost all supplies. The more capital the company needs, the cheaper the cost of the capital.  Those businesses requiring in excess of $10 million will most likely pay less for their capital than a company seeking less than $10 million. This is because there are so many capital providers competing for the over $10 million deal size. One reason for so many providers to that segment of the market is because they all have a lot of money to invest; and, since the amount of effort to find, underwrite and close a large deal is not much different than it is for a smaller deal, they prefer to spend their time on the larger deals. There are still many choices of mezzanine capital providers for loans under $10 million, but the cost is slightly higher.

 

For mezzanine debt of $10 million or less, expect to pay origination fees of 1% to 3%, a current interest rate of between 12% and 16% and options to purchase equity in the company (referred to as detachable penny warrants) so that the capital provider’s total annual rate of return on their investment will be between 20% and 25%. There are many less providers of mezzanine equity of $10 million or less; but, if you can locate one, expect to pay between 30% and 35% annually for their equity investment. These yields are still less than institutional common equity investors that require more than 35% a year.

 

Advantages of Mezzanine Financing

• Mezzanine capital gives the business the ability to execute a change of control, expand or acquire a competitor
• Interest-only payment allows the company to conserve cash
• Generally there is no loss of majority control of the company
• Flexible financing can be structured to best meet the needs of the business
• Mezzanine lenders can provide strategic and financial guidance  
• Most mezzanine providers only require the right to regularly receive financial information about the company
• Mezzanine providers will accept a business with limited or no growth potential so long as the business has consistent earnings sufficient to service their debt

Disadvantages of Mezzanine Financing

• The owner may be required to give up some equity upside so the lender can achieve its required rate of return
• More costly that other forms of debt and may come with restrictive covenants
• Can be highly negotiated therefore making the process lengthy
• The lender may require a board seat (typically it would be nonvoting)

Business owners should carefully weigh all of the factors discussed above the next time they are in the market for capital. And, if they qualify, consider mezzanine capital after they have met with their banker and before they consider equity.

As always, I welcome your questions or comments. Feel free to contact me directly if you choose.

About: Terry Stidham, President and Founder of Target Search Group (TSG). Terry is a Sales and Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment. He has served as the head of entrepreneurial organizations as well as Fortune 500 companies. He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions. Mr. Stidham has instructed thousands of business owners on how to prepare for a successful exit. He improves operational efficiencies leading to significant increased value.

Challenging M&A Evaluation Metrics

M&A Deal Evaluation

by Terry Stidham, President of Target Search Group

 

Emphasis is often placed on evaluation metrics that look as if they tell the story, but they can be misleading in the world of M&A.

 

Key questions to be answered as part of a due diligence process in determining whether or not to proceed with an acquisition include the following:

• Is the target company a good fit?
• How does the synergies stack up against the risks?
• Does the target company's sector show potential for growth?

 

Can accretive earnings trump the negatives if the finding are less than encouraging? Does the fact that a deal is accretive necessarily mean that it's a good move? Conversely, are deals that dilute earnings per share (EPS) necessarily bad moves? Should EPS as a measure by which to evaluate an M&A transaction even be used?

 

Recently A.T. Kearney discussed the  findings from their research into the metrics and analyses most frequently used to evaluate proposed mergers and acquisitions. The research introduced a surprising insight: The impact on EPS is by far the most emphasized metric used to evaluate proposed M&A transactions between public companies.

 

They looked at two common and related myths surrounding EPS and demonstrated why these are at best unhelpful and at worst potentially misleading. They also examined what business leaders and market analysts should focus on instead.

 

How Do They Get It So Wrong?

"It is widely recognized that a significant percentage of M&A transactions fail to deliver value to shareholders. What goes wrong? How is it that acquisitions on average seem to create negligible returns? It can be tempting to blame poor merger integration for the meager returns, and certainly the execution of an integration can have a major impact on whether or not a transaction is regarded as successful. However, it may also be useful to consider if the deal was worth doing in the first place. Maybe some transactions should never have happened.

 

With this in mind A.T. Kearney joined forces with the UK's Investor Relations Society (IR Society) to understand exactly which metrics and analyses get the most emphasis in evaluating proposed M&A transactions. Maybe the solution to the question of "what goes wrong" lies in the tools used to filter (and one would hope eliminate) value-destroying transactions from those that create value.

 

Investor Relations professionals were surveyed to gauge the views of key stakeholders—company executives, sell-side analysts, and investors—on 10 frequently used metrics and analyses (see sidebar: M&A Metrics—Why the Difference in Emphasis?). We found that EPS analysis is used most, and by a wide margin: 75 percent of respondents ranked it in the "strong emphasis" category, fully 26 points ahead of enterprise value/EBITDA, the number two rated metric (see figure 1).

 

What Exactly Is EPS Accretion and EPS Dilution?

Before we go any further, let's define what we mean by EPS accretion and EPS dilution. A company's EPS—again, earnings per share—is simply the total profit allocated to each outstanding share.

EPS growth can be achieved either organically or inorganically through M&A activity, and few would argue that organic EPS growth is anything other than a positive indicator. EPS growth delivered through M&A activity, that is, EPS accretion, is fundamentally different. Yet there are some commonly held beliefs—or, more accurately, myths—to suggest this distinction is not fully understood by many experienced investment professionals, including some company executives.

Two myths are widely believed:

1. EPS accretive transactions create value.
2. EPS dilutive transactions destroy value.

As we will see, neither of these preconceptions stands up to scrutiny. Why then do so many executives and others persist in using EPS analysis to evaluate M&A transactions?

The answer comes down to views about valuation. A company's stock is frequently valued on the basis of its EPS by applying a price-to-earnings (P/E) ratio. Based on the assumption that an acquiring company's P/E ratio will stay the same after an acquisition, if earnings per share increase, then the company's overall value will increase, ostensibly as a result of the deal.

 

What's the Catch?

But, there's a catch. To understand it you need to consider the fundamentals of why one company has a higher P/E ratio than another in the first place. It is because the market believes the earnings of the company with the higher P/E ratio—call it Company A—will rise faster than those of the company with a lower P/E ratio (Company B).² Now suppose Company A buys Company B, using its stock as the acquisition currency. As a result of the purchase the EPS of the combined company will be higher than that of Company A had it not made the acquisition—thus the transaction is EPS accretive for Company A.

But being EPS accretive comes with a downside—and that's the catch. The newly combined company will also have a lower earnings growth rate than Company A would have had as a standalone company. So while the EPS of the post-acquisition company will be higher than that of the pre-acquisition Company A, its P/E ratio will be lower due to its acquisition of the lower-P/E rated Company B.

 

In fact, the reduction in the P/E ratio, all other things being equal, will exactly counterbalance the impact of the higher EPS. The result is that the valuation of the newly combined company will reflect the blended higher EPS and lower P/E ratio of the two original companies. In other words, no value is created.

 

A key reason for doing an M&A deal is, of course, the synergies that can result. By increasing the new entity's combined earnings, synergies can add enough value to make the combined company worth more than the two individual companies were before the merger. It is important to note that the increased value results from the synergies created, not from the deal being EPS accretive or dilutive. It is quite possible that highly dilutive deals offer the greatest opportunities for delivering synergies.

An argument sometimes put forward to support the myth that EPS accretion equates to value creation is that "people believe it does." This becomes reality as the misperception is priced into the stock.

Richard A. Brealey and Stewart C. Myers write about this idea in their seminal textbook, Principles of Corporate Finance. They call it the “bootstrap game.” If companies can fool investors by buying a company with lower P/E rated stocks, then why not continue to do so? The flaw in the bootstrap game is the need to keep the market fooled, hoping it doesn’t notice that the acquiring company’s earnings growth potential is becoming progressively more diluted.

 

The inevitable result of pursuing such a strategy to its logical conclusion by continuing to acquire lower P/E rated companies is clear: In the same way a Ponzi scheme must eventually fail due to the lack of underlying value creation, the P/E multiple of the acquiring company must fall as it becomes increasingly evident to the market that no value is created.

 

What's the Alternative for Evaluating Proposed Mergers?

Our advice for evaluating a proposed merger is characteristically pragmatic: Stick to the fundamentals. M&A can deliver significant competitive advantage and value to shareholders, but the criteria by which to assess just how much must answer fundamental business questions:

• Is the proposed merger strategically logical?
• Will it deliver cost, revenue, or other financial synergies?
• Will it build management or other capabilities?
• Is the combined company capable of delivering the synergies?

A thorough, fact-based due diligence is the best way to answer these questions (see figure 2).

Of course, there is also a role for using many of the M&A metrics and analyses described in figure 1 as part of an overall assessment. These can play a complementary role in developing a full perspective on a transaction. Used in isolation, however, and without a clear understanding of their limitations, they have a tendency to give a very limited view of the real potential for value creation.

Ultimately, any value an M&A transaction creates must translate into future cash flow, resulting from synergies in three value-creation areas: topline growth, operations productivity, and asset and capital investment rationalizations (see figure 3).³

And then there's the crucial question of how much to pay for a deal and who will realize the value it creates. If the net present value (NPV) of future synergies is paid to the selling shareholders in an acquisition price premium, even the most synergistic of mergers can result in value destruction for the acquirer's shareholders.⁵ Always consider who will be the winners in an M&A transaction—the final outcome is rarely the same for all parties.

 

EPS Myths Revisited

The moral of the story is this: Too often, too much emphasis is placed on whether a deal is EPS accretive or dilutive. These are time-honored metrics that appear sensible but in reality do not answer the most important question: Should we do the deal? Let's review the two commonly held myths and why they don't work as M&A evaluation measures.

 

EPS-accretive transactions create value. Not necessarily. Accretion is a relative measure that simply shows the company being acquired has a lower P/E rated stock.

 

EPS-dilutive transactions are value destroying. Again, not necessarily. In fact, EPS-dilutive transactions can increase value when the target company has good growth potential and the strategic logic for the deal is strong.

The fact is that EPS analysis is not a useful tool for evaluating the merits of proposed M&A transactions. Accretion or dilution is a fact of doing deals but is not a measure of potential value creation. For that, you need to examine the deal's business fundamentals.

 

Our research reveals one more insight: how the emphasis given to the different metrics and analyses has changed over the past decade. Two measures, core capabilities and cultural fit, the most qualitative among the 10 examined, are among the top measures that have "become more important" in the past decade (see figure 4). This suggests stakeholders are becoming increasingly aware of the conditions necessary for merged organizations to deliver sustained value after the deal has closed and the merger integration process begins.

Quick and Easy Shortcuts Can Be Misleading

This is not to say a proposed transaction's impact on EPS isn't important. It is something that needs to be understood and communicated to investors. The fact remains, however, that doing an EPS-accretive deal is easy—simply buy a company with a lower P/E rated stock than your own. So the next time someone says or implies that an M&A deal is a good one because it is EPS accretive, ask why the market gave the target company's stock a lower rating in the first place. To truly understand whether a proposed acquisition will create value requires evaluating the strategic rationale for making the deal, and if it will deliver enough synergies to create value. As with many things in life, quick and easy answers can be misleading."

 

Has your emphasis given to the different metrics and analyses changed over the past decade?

Here Come the CVC's

Corporations Dive In With CVC's by Terry Stidham

An increasing number of our corporate clients are setting up an in-house CVC team. The Corporate Venturing Capital (CVC) community recently had a US conference, where nearly half of the 450 represented organizations present had set up a corporate venturing arm during the previous five years. The remainder of the group is planning to set up a unit within the next 12 months. 
 

Corporate Venture Capital (CVC) - CVC as a subset a venture capital whereby a company is investing, without using a third party investment firm, in an external start-up or early stage venture that it does not own.
 

Corporate Venturing refers to when a company supports innovation and new projects internally. It is defined by the Business Dictionary as the "practice where a large firm takes an equity stake in a small but innovative or specialist firm, to which it may also provide management and marketing expertise; the objective is to gain a specific competitive advantage.
 

The London-based, Global Corporate Venturing magazine ranks CVCs and sees funds with $billions available, some (such as Google) investing $300+ million per year. Deal volumes vary from just one to over 80 per year.

In the last two years, more than 200 corporate venturing units have been launched. In 2011, over 500 corporate venturing units globally invested more than $26 billion, which is similar to private VCs at about $28 billion.

CVCs are on the way to becoming more important in providing venture capital than VCs. These figures omit business angels, who provide, worldwide, $20 billion or so.

Some will argue that this trend is cyclical, but Corporate Venturing is definitely on the ascendancy in this decade and for good reasons. Venture Capitalist funding has declined as exits are scarce and raising new funds is difficult. Despite the global problems of the last half decade, businesses in whatever stage of their lives still need funding, which may come from various sources such as customers, loans, grants and equity.

The big challenge for both VCs and CVCs with or without an internal business development team is sourcing quantity and quality opportunities that are aligned with their investment strategy, criteria, and focus.

Companies find it easier and less costly to buy innovation than to develop it in-house. This is due to a mixture of the agility of smaller organizations, the ability for a small company to motivate and reward high caliber people and the freedom from corporate structure and processes. 

There is a significant difference in the return calculation between the two funding classes. 

1. Private VCs - Measured by financial return (although a small minority also use social enterprise metrics). 
2. CVCs - Measured by an organization and even deal-specific mix of financial and strategic return.

This doesn't mean it is any easier for an investor to steer through the negotiation and due diligence process (and in fact it may be tougher, as some corporations impose internal investment processes on external opportunities), but it does mean that, if the strategic fit works, CVC money may be available where VC money is not. In addition, many VCs have time-limited funds – commonly five years to invest followed by five years to divest. Most CVCs do not have these pressures.

Both VCs and CVCs need to see a minimum monthly recurring revenue before taking it further. However the VCs then would dig deeper into the financial numbers, whereas the CVC would first look at how their own product and channel infrastructure could help with scaling their business.

Early stage or growth stage companies that are seeking $1 million plus in funding should put one or more CVCs on their list. It's important to understand the strategic aims of those CVCs before approaching them. If CVC money is available it needs to be determined if it would prevent other similar corporations from becoming customers and/or potential acquirers. 

Contact us today to discuss your needs or interests.
 

About the author Terry Stidham
Terry Stidham is the founder and principal of Target Search Group. He is a B2B Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.  Mr. Stidham has been instrumental in aiding thousands of business owners prepare their businesses for eventual sale by teaching them how to maximize efficiencies in operations leading to significant increased cash flow.

Target Search Group (TSG) is a business development firm that works with a select number of private equity investors and corporate clients to source and originate investment opportunities that fit their size, focus and strategy on both a generalist, opportunistic, and a specific search basis. 

TSG sources acquisition and investment opportunities throughout North America in companies that range from startups to businesses with revenues up to $500 million.

VC's Drive Up Tech-Valuations

Tech-Valuations Jump Published: April 10, 2013 in Knowledge@Wharton         

Venerable retailer J.C. Penney opened its doors more than a century ago and boasts annual revenues of nearly $13 billion from its 1,100 stores. Yet a three-year-old website with an untested business model and little discernible revenue is closing in on the department store chain's $3 billion market cap: 

Pinterest.

The online scrapbooking site recently raised $200 million in venture capital funds to bring its implied valuation to $2.5 billion, according to a February 20 story in The Wall Street Journal. Founded by three young entrepreneurs in March 2010, the tech start-up has 48 million users as of December 2012, up from nine million in the prior year, the article noted.

While Pinterest is wildly popular, its business model remains unproven. Users, including businesses, sign up for free accounts. The company is just gearing up to accept paid advertising and recently unveiled a free analytics tool for users with business-related accounts to track what has been pinned from their sites.

Pinterest may be thinking hard about ways to make money, but it remains unclear whether the firm's financial strategies can bring in enough revenue to cover costs and generate a healthy profit, which will be especially important once the company goes public. No matter. Pinterest has garnered the interest of such Silicon Valley blue-chip venture capital firms as Andreessen Horowitz (as in Netscape co-founder Marc Andreessen). For now, Pinterest has money to burn.

The company is one of at least 25 start-ups that command market caps of one billion dollars or more, according to a February 4 story in The New York Times. The billion-dollar start-ups club includes such familiar names as productivity application Evernote, travel rental site Airbnb, online questionnaire software SurveyMonkey and streaming music service Spotify. But such high valuations are bringing back concerns that the market is entering another tech bubble like the dot-com frenzy in the late 1990s that led to scores of Internet companies going belly up and investors losing vast fortunes.

Wharton finance professor Jeremy Siegel, who warned that Internet and other tech stocks were overvalued in 1999 shortly before the dot-com bubble burst, says the sector is not in the same kind of peril today. "It's a world of difference," he notes. Back then, tech companies -- including well-capitalized S&P 500 firms like AOL, Sun Microsystems and EMC -- were trading at sky-high valuations, Siegel says, adding that shell companies without good business ideas also were given similar pricetags simply because they were a "dot-com."

In an April 1999 editorial for the Journal, Siegel warned that tech's high valuations could not be sustained. Back then, Siegel pointed out that AOL was selling at more than 700 times its earnings for the past 12 months, an "unprecedented valuation for a firm with this market value," and one which put it among the country's 10 most highly valued firms. Yet, the Internet service provider came in only 311^th in profits and 415^th in sales against other companies. (AOL has since spun off from Time Warner and currently is valued at $2.8 billion.)

Such inflated valuations are not the norm in the tech sector today. "Big tech companies are [trading at] less than 20 times earnings," he points out, citing as examples the valuations of market leaders Google and Apple. "It's not overvalued."

At $450 a share, Apple is currently trading at about 10 times fiscal 2013 projected earnings per share of $44.19. Google is trading at $815, or 18 times fiscal 2013 projected earnings per share of $45.55. Microsoft is trading at 10 times 2013 earnings and Yahoo is at 21 times this year's profit. These price-to-earnings ratios are hardly inflated vis-a-vis the market: As of March 22, the S&P 500 was trading at 14 times forward earnings, the Nasdaq 100 was at 15 times and the Dow hovered at 13 times. The market is "nowhere near as speculative" today because investors remember the painful lessons of the dot-com crash, Siegel notes. "People have been burned. They're more cautious. Their memories are in place."

But there are several reasons why Pinterest and a select group of start-ups are getting valuations that any brick-and-mortar company would envy.

New Cycle of Growth

Social media is turning out to be a lasting tech trend, thanks largely to the success of Facebook, Twitter and LinkedIn. The exponential growth of users at Pinterest and other billion-dollar start-ups are signals that these companies could be the next tech leaders, and venture capitalists want to get in early to cash out at the time of an IPO or shortly thereafter.

On a macroeconomic level, it also helps that investor sentiment is rising as the U.S. economy recovers, according to Wharton management professor Saikat Chaudhuri. As a new cycle of growth emerges, investors are feeling more bullish. "They're optimistic now about the future and placing bets," he says.

But unlike the last tech bubble, "we're seeing investors being more critical," Chaudhuri adds. So while they are looking to invest, "they have also shown a bit more restraint." He notes that investors today are quick to ask the start-up where it is parking its money and how the business plans to "monetize" -- jargon for a business model that will lead to revenue and profits.

Venture capitalists have also become pickier, especially following a consolidation in the VC industry. The number of VC companies is down by about half from 1,000 companies five years ago, says Doug Collom, vice dean of Wharton's San Francisco campus.

VCs historically make an annual average return of 15% to 20%, but recently that figure has fallen to 6% because finding good bets has been difficult, Collom adds. Start-up investors are not being compensated enough for the level of risk they are shouldering, and there are better places to put their money.

Not only is the number of VC funds shrinking, but so is the fund size, notes Wharton management professor Raffi Amit. "The industry is in a major transition and consolidation." Mitigating the decline somewhat is that 10 to 15 years ago, several million dollars typically was needed to get a company off the ground; today, $50,000 to $100,000 can suffice, he adds.

Still, the remaining VCs are placing their bets more conservatively, watching to see where others are investing. "There is the herd phenomenon. Some sectors are considered hot, and hence a disproportionate amount of capital flows into companies in these hot sectors," Amit says.

If VCs see that other firms with proven track records, such as Kleiner Perkins and Accel Partners, are backing a tech company, they are more likely to jump in as well because the start-up has been "validated," Collom notes. As more big name VCs invest in the same company, it creates a "feeding frenzy dynamic that drives the price up, pushing valuation up beyond rationality," he adds. Hence a $2.5 billion valuation for Pinterest becomes reality as VCs wonder, "Are they the next Google?"

Don't Throw Out DCF with the Bathwater

As one of the hottest social media companies to emerge since Facebook, Pinterest could well be worth a high valuation. But how did VCs arrive at $2.5 billion?

The traditional method of valuing companies is through the discounted cash flow model, or DCF, which projects a company's cash flows out by several years and discounts it to arrive at the present value. But applying the DCF model becomes a challenge when a start-up is not making any money.

"It's difficult to value companies that are very young, that don't have positive cash flows or even revenues," says Wharton finance professor Luke Taylor. Even so, the "discounted cash flow model is simply correct finance."

David Wessels, an adjunct finance professor at Wharton, concurs. In a book he co-authored titled, Valuation: Measuring and Managing the Value of Companies, Wessels suggests that the discounted cash flow model is the best way to value high-growth companies because the core principles of economics and finance apply even in uncharted territory. But instead of using a firm's historical performance in the model, Wessels says, one should start by examining the expected long-term developments of a company's market and work backwards. Given that long-term projections are uncertain, it is critical to develop different financial scenarios.

OpenTable vs. Groupon

Wessels, with co-authors Tim Koller and Marc Goedhart, analyzed the business of OpenTable, a provider of online restaurant reservations.

The company generates revenue by charging business customers $1 for every seated diner who uses the site to make reservations and 25 cents if the customer uses the restaurant's website. There is also a monthly subscription fee of $250 for restaurants to use OpenTable's proprietary computer system that manages reservations and table seating, keeps track of guests and provides e-mail marketing. In addition, there is a one-time installation fee of $800.

From 2004 to 2008, OpenTable's revenue grew from $10 million to $56 million, a compounded annual growth rate of 53%. Subscription fees comprised 54% of its 2008 revenue while reservation fees took up 42% and the rest came from installation fees.

In 2008, OpenTable reported that 34 million diners used its service at 10,335 restaurants. That comes to about 30% of the 30,000 reservation-taking restaurants in the U.S. The authors projected that by 2018, OpenTable will command 60% of the U.S. market and also profit from a continued expansion overseas. They based the 60% prediction on OpenTable's market share in San Francisco in 2008.

If the number of restaurants increased by 2% a year, or twice the rate of population growth in the U.S., there would be 36,500 U.S. restaurants taking reservations by 2018. A 60% share for OpenTable means it would have 21,900 restaurants as clients. As for the firm's foreign operations, the authors assumed the growth would match that of the U.S., delayed by six years. By their calculation, OpenTable could record global revenue of $306.8 million by 2018.

To stress-test their projection, the authors first compared OpenTable's growth path with the first five years of expansion of Internet companies founded in the 1990s that now make more than $10 million in revenue. "Benchmark against other high-growth companies in the past to see if the projection is reasonable," Wessels says.

OpenTable's revenue grew from $10 million to $56 million from 2004 to 2008, which matched the performance of the median Internet company. The book, released in its fifth edition in 2010, forecast that by 2012, OpenTable would book revenue of $141.2 million, a bit higher than the median Internet company but within the bounds of distribution.

The authors also looked at OpenTable's target operating margin of 30% to 35% and compared the forecast to other consumer Internet companies such as Expedia, Priceline, Orbitz and Monster.com. OpenTable's margin range is higher, but the authors predicted that achieving it is feasible because the company is the leader in the online reservations market and has little competition.

Finally, they considered three scenarios for OpenTable: exceeding, meeting or underperforming expectations by 2018. If the company outperforms, its eventual valuation was estimated at $1.14 billion. If it meets forecasts, then $719 million was the calculated value. It was $545 million if OpenTable lags predictions. OpenTable went public in May 2009.

As of March 22, OpenTable had a market cap of $1.4 billion. Last year, it booked revenues of $161.6 million with an operating margin of 23%.

OpenTable exceeded expectations, as Pinterest and other highly valued tech start-ups one day might, but it also could easily have fallen by the wayside, much like what happened to daily deals site Groupon.

Before its IPO in November 2011, Groupon was valued at more than $6 billion. On the stock's first day of trading, Groupon's valuation jumped to $16.6 billion. But later on, accounting problems surfaced, profits stumbled and revenue growth fell below Wall Street's expectations. Last month, the company fired CEO and founder Andrew Mason. Groupon is now valued at $3.8 billion, a loss of $13 billion in market cap in little more than a year.

Going public is a sobering event. After an IPO, the focus of investors shifts from a company's user growth and buzz to its financial performance, testing the start-up's business model. "The real acid test is when they get out into the public market," Collom notes.

Until then, VCs make an educated guess whether these hot start-ups are worth the money -- and the dice keep rolling. Most bets do not pay off. And even among those investments that make it to Pinterest's level of funding, "there's a lot of debate about whether companies can sustain these valuations," Collom says.

Terry Stidham is the President and founder of Target Search Group. He is a Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.

 

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.  Mr. Stidham has been instrumental in aiding thousands of business owners prepare their businesses for eventual sale by teaching them how to maximize efficiencies in operations leading to significant increased cash flow.

5 Key Characteristics for a Startup CEO

Scott Johnson, Managing Partner with New Atlantic Ventures recently posted the following blog in which he identifies key habits and characteristics of what it takes to be a great startup CEO.

"Being CEO of a startup is quite similar to being the parent of a newborn.  The neighbors see a clean cooing newborn with smiling proud parents.  But we all know what goes on inside the house.  Sleepless nights, stress, no time to attend to other relationships.  You are a slave to the new creature.  It is ultimately incredibly rewarding, but parenting is very hard work and not at all glamourous.  And just the way not everyone handles parenting well, not everyone is a good candidate to run a startup.  As a matter of fact, a great startup CEO is as rare as a 70 degree day in March in Boston.

I have compiled the qualities that great startup CEOs share – you know – the CEOs that actually get multiple B-round term sheets in down markets and get that marquis exit at an unusually high multiple.  These are the ones that consistently surprise their board on the upside, investors love to back, and that acquirers pay up to bring in-house.  If you are a founder looking for a CEO to really grow your company, here are the five personal attributes you should look for:

1) Attracts Great Talent.  This is the best indicator of success, as it really encompasses all of the other attributes.  If A+ talent flocks to work for someone, that person has got something special.  Be careful though.  An orangutan could be CEO of super fast growing startup and attract great talent.  So, make sure it is the CEO who can attract talent, not someone riding the wave at a hot company.

2) Networking God.  A good CEO shortens sales cycles with contacts, shortens hiring time with contacts, and shortens fundraising time with contacts.  A CEO who networks well can hence shorten time to exit and massively reduce dilution to founders.  Give 8% to a great CEO, prevent 20-30% or more in downstream dilution.

3) High Intelligence.  The CEO is usually not the highest IQ in the room.  But he needs to be in the conversation.  At high tech startups, a certain acumen is needed to keep the respect of the troops, and gain the respect of customers and investors.

4) Strategic Thinker.  The trick with startups is to channel all of the companies limited resources in the optimal direction.  And to quickly alter course as markets dictate so not a single moment is wasted by indecision.  This requires strategic thinking, not tactical execution.  Many line executives from larger companies struggle as CEOs of startups because they  have not had the opportunity to deviate from a strategy that was handed down to them from above.

5) Stamina, Energy and Productivity.  This gets back to my point at the top about parenting a newborn.  The CEO needs to be all-in, and one of those productive people that doesn’t waste a second of his or her day.  The CEO sets the culture at a company, and that should be one of reward for achievement, productivity, hard work, and accountability.

Every founder CEO should be very honest in his or her self assessment, and then when they see someone with the above profile, move quickly to hire them.  But do your diligence. Hiring the wrong CEO can be every bit as costly as hiring the right one can be helpful."

Outlook for Mid-Market M&A

Location is to Real Estate as Timing is to Deal Making

by Terry Stidham

A unique set of factors has coalesced to form a “Perfect Storm” of M&A activity;

• A slow yet improving economy
• Historically low interest rates
• Supply and demand
• Strong appetite among many businesses for growth through acquisitions

Along with this heightened activity come opportunities and challenges;

• More competition for quality acquisitions
• The risk of cutting corners in due-diligence
• Real choices about whether to “buy it” or “build it”

RSB Citizens prepared an in-depth report on the current state of mid-market M&A activity based on a recent survey of more than 300 business owners and decision makers, supplemented by a series of in-depth interviews among U.S.-based mid-market ($5MM – <$2B in revenue) business executives that are open to or are currently engaged in some form of corporate development activity, including mergers and acquisitions and raising capital in the New England, Mid-West, and Mid-Atlantic regions.

KEY FINDINGS

OVERVIEW

The report points out that “In today’s slowly improving economy, many mid-market companies are finding it challenging to increase revenue through organic growth. As a result, acquisitions have become a common and sometimes essential strategy for increasing market share or improving distribution. Furthermore, for companies that decide to build it rather than buy it, their growth is being fueled through:

• Reinvestment
• Leveraging low interest rates
• Increasingly available sources of outside capital from private equity and commercial banks.

While it would appear that the present environment makes completing a transaction easier than ever, buyers are wary of inheriting unexpected liabilities in the process of making an acquisition, perhaps in their haste to “do a deal” or their inability to conduct sufficient due-diligence. Meanwhile, sellers struggle to fully understand their many options for achieving liquidity or fueling growth, including the possibility of selling only a portion of their business to remain in control or provide the opportunity for a “second bite.”

While not all buyers or sellers will rely on an external advisor for support meeting their M&A objectives, those that do will see a whole host of areas where their familiarity and knowledge of the process provides considerable value. While their number one concern is determining an appropriate valuation for their company, sellers (and buyers) also want:

• A better understanding of bidding strategies
• Support with due diligence
• Help to identify the widest possible set of potential target firms.

Whatever advisors, sources of capital, or course of action they elect to follow, buyers and sellers alike would be better served – especially as the expected pace of transactions accelerates – to carefully consider the increasing number of attractive options available to them in the age of transaction-driven growth.”

THE BUYER’S PERSPECTIVE

“It’s a buyer’s market!” – Or is it? Market conditions lead to opportunities for growth through acquisition, but competition is fierce and diligence is key.

• Buy, Buy, Buy! Interest in acquisitions is widespread. Nearly 80% of mid-market firms say they are currently engaged in or are open to making an acquisition. About one-quarter of these firms are currently in the process of making an acquisition, while an additional 14% are actively seeking purchase targets. The remaining four in ten firms are not actively looking to buy but would consider an acquisition if presented with the right opportunity. Regardless of their current status, all firms agree, the core objective of acquisitions is to drive revenue growth.
• Businesses have (or can readily acquire) the means to make deals happen. Mid-market firms making or looking to make an acquisition anticipate that the deals will be comprised of about equal portions
• Cash (35%)
• Debt (35%)
• Equity (30%)    Given that executives perceive debt as easy to obtain (and the cash and equity equations are largely within their control), funding deals will not hamper deal activity.
• Yet cash and enthusiasm are no substitutes for certainty or prudence. Despite their zeal for acquisitions, only three in ten mid-market firms actively seeking a deal feel highly confident they will actually complete an acquisition in the upcoming year. There are some factors that likely contribute to firms’ concerns about their ability to get the deal done, and those looking to extract commensurately greater value from their acquisitions should take heed:
• Don’t rush the deal, do your diligence. Chief among the concerns cited by all current or potential buyers is the prospect of inheriting liabilities and/or failing to conduct adequate due-diligence. Firms in a hurry to put cash to work may end up with a serious case of buyer’s remorse, or worse, buying a ticking time bomb.
• Remember, you’re not the only game in town. With more likely buyers than sellers in the mid-market, firms will need to look below the mid-market to make acquisitions where competition is high and inventory is limited. Meanwhile, the low cost of debt is giving target firms an attractive alternative to selling. Identifying the most appropriate targets, developing considered value propositions, and bidding strategically are key to success in this buyer’s market.
• Easy debt and market optimism may obscure the value of external support. Despite their trepidations, less than one in three mid-market firms intends to engage external advisors in their acquisition process. But of those bringing in an external partner, valuation is by far the top task where firms are looking for assistance.

THE SELLER’S PERSPECTIVE

“Valuation is king” — yet many sellers unknowingly hinder their ability to maximize their valuation by failing to approach the market from a position of strength.

• There’s a lot of talk about selling, but little action. Although current selling activity is low, interest is significant with one in three mid-market firms saying they are open to being fully or partially acquired by an outside investor. However, most firms open to a sale are not actively seeking a buyer, let alone entering into a full M&A process – running the risk that they will be undervalued or fail to find the best deal structure.
• Many sellers are unsure of their value, and what the market will bear. Being underpaid or undervalued is the top concern among current and potential sellers, especially among smaller firms with between $5MM and $25MM in annual revenue.
• Getting the most out of a sale means avoiding these undervaluation pitfalls:
• Misreading the market. Nearly three-quarters of mid-market executives view conditions today as a buyer’s market, and 55% believe that it will stay that way through 2013. In fact, the current market has led to a larger number – and wider array of – buyers, as well as an increasing number of appealing self-funding options.
• Misunderstanding the market. Most executives surveyed anticipate wanting or needing to sell off their entire firms. Yet, the majority of active deals in the mid-market are for a partial sale. Executives seeking a full sale oftentimes lack a full understanding of the various structures available to maintain a majority or partial ownership stake while also raising the funds they need or providing the liquidity they desire. In many cases, the parts may be worth more than the whole in terms of long-term opportunity and the ability to maintain control.
• Showing your hand. A desire for liquidity or fatigue continues to drive many to be interested in a full sale, leaving them vulnerable to taking less than they are worth, particularly if there is no formal process in place.
• Only a minority of sellers engage “the experts.” About four out of 10 sellers have or would consider having an external provider manage their selling process. Among the number of tasks these firms would engage a provider to handle, valuation is by far the most mentioned, though help with bidding strategies and due-diligence is also widely sought.

GENERAL MARKET OUTLOOK

Key indicators reveal that markets are ripe for transaction-driven growth.

Corporate development departments are firing on all cylinders. In a sluggish economy, mid-market executives clearly see corporate development as essential to driving growth. With the vast majority of mid-market firms currently engaged in or open to a minimum of three corporate development activities in 2013, all options are on the table when it comes to driving growth.

Acquisitions are clearly of greatest interest, with about eight in ten mid-market firms saying they are currently in the process of making an acquisition or are open to doing so within the next 12 months. In fact, mid-level managers say they are as likely to consider an acquisition as reinvesting earnings, further signaling that organic growth may be seen as less effective path to growth today than in previous cycles.

Buying is certainly more prevalent than selling in the mid-market, with less than one in ten reporting that they are currently the target of an acquisition. However, a sizeable proportion of the market (31%) is open to being acquired over the next 12 months.

Meanwhile, about two in ten are currently attempting to raise capital, with an additional 44% saying they are open to doing so in 2013. With current interest rates being at an all-time low, many firms see leveraging external cash as a more appealing option to diminishing their working capital.

Optimism about the future M&A market dynamics is high. More than half of respondents anticipate that the environment for raising capital and seeking outside investment will improve over the next twelve months.

Furthermore, deal volume is often driven by market participants’ view of future asset values. Over half of mid-market executives believe today’s prices will remain stable, and over a third believe they will increase.

The supply/demand equilibrium for M&A is likely to shift to support greater activity in 2013. On the supply side, demographic factors affecting private mid-market firms will emerge as a significant motivation for sales or equity offerings... Many aging baby boomers who have spent the past 20 years growing family businesses will look to monetize value for retirement. In addition, private equity firms that postponed selling portfolio companies in 2012 or took advantage of dividend recaps to return capital and buy time, will test the market for exits in 2013. On the demand side, larger companies will be under increasing pressure to show top and bottom line growth. Given current market conditions, organic growth will continue to face headwinds, resulting in further reliance on acquisitions to gain market share and/or expand operations.

What better way to grow?

Regardless of their current acquisition status, all firms agree that the core objective of acquisitions is to drive revenue growth (70%) (Figure 3). Secondary objectives, including expanding geographic reach (41%), improving operational efficiency (41%), adding adjacent products or services to core offerings (41%), and putting cash to work (40%) are viewed with about equal import. Across industries and firm sizes, increasing revenues is always the dominant motivator to acquire. Following revenue, however, firms in different verticals or with different revenue sizes tend to focus on different reasons to buy. Smaller firms with between $5MM and $25MM in revenue, as well as firms in technology or science industries, are more apt than others to view acquisitions as a means to expand their staff and purchase new talent. Meanwhile, mid-sized firms of the mid-market (annual revenues of $25MM to $100MM), and many manufacturing companies are more likely to look to acquisitions to improve their distribution capabilities.

Terry Stidham is the founder and principal of Target Search Group. He is a B2B Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.  Mr. Stidham has been instrumental in aiding thousands of business owners prepare their businesses for eventual sale by teaching them how to maximize efficiencies in operations leading to significant increased cash flow.

Contact me today to discuss your exit or acquisition strategy.