Preparing Your Software Company for an Exit
A well-thought-out exit strategy is essential to realizing the full value of your successful business.
1. Grow Your Business and Optimize Certain Metrics
This may go without saying, but to maximize the valuation of your company, you should continue to grow your business, while prudently managing costs. It is much more difficult to sell a business if you only have IP and a team with lackluster financial and operational results. It is much, much easier to sell if there are certain financial and operational metrics that reflect a growing, healthy company with an in-demand product and/or service. In your daily operations, you’re likely keeping an eye on specific metrics or key performance indicators (KPIs). However, these indicators may not align with what potential buyers evaluate when considering acquisition targets. Recently, there has been a growing focus among software buyers on metrics like “Rule of 40” (or “Rule of X”), and gross revenue retention (GRR). Rule of 40 is a summation of two financial metrics: annual revenue growth plus EBITDA margins. Let’s imagine that your revenue has grown 25% over the last twelve months and your EBITDA margins over the same time span are 20%. Your Rule of 40 equals 45. The number 40 is used in the equation because a Rule of X above 40 is generally considered attractive, while a Rule of X under 40 is comparably less attractive. Just to clarify, you can still sell your business even if your Rule of X is under 40.
Like the Rule of 40, customer retention metrics also have a significant influence on overall valuation. Strong retention instills confidence during uncertain economic times and minimizes perceived risk. There are several different types of retention metrics, including net revenue retention, gross revenue retention, and logo retention. It is good to have a handle on all three, but gross revenue retention is probably the most important. We will cover these retention metrics in more detail in another post.
Buyers may ask about other important metrics, including monthly and annual recurring revenue (MRR & ARR), average sales price and/or average revenue per account (ASP & ARPA), average lifetime value of customer (LTV), and customer acquisition costs (CAC). By optimizing and accurately reporting these figures, you can facilitate a smooth M&A exit.
2. Build a Winning Team
Metrics are important, but having a winning team in place before you talk to buyers is essential. While you may have a deep understanding of every detail within your business, there are limits to what one person can handle, and scaling successfully often demands skills beyond your own expertise. Having the right team in place is even more important if one of your goals is to eventually walk away from the business. Critical roles may include a CFO, CTO, a VP of Sales, and potentially, heads for HR and Marketing. A seasoned, established team will not only support more profitable growth, it will also prove invaluable when it’s time to implement your exit strategy, position your company for sale, and compile the necessary details to complete the transaction.
3. Know Your Audience: Types of Buyers
There are essentially two types of buyers that you will engage with when selling your company:
Strategic Buyers: A strategic buyer will acquire and integrate your company (or select assets) into its existing operations for the sake of growth and improvement in the business’ overall performance. It focuses on the long-term value of an acquisition more than just the maximization of short-term financial return. Strategic buyers may offer cash and/or stock as the currency to acquire your company.
Financial Buyers: Financial buyers, such as private equity firms or growth equity firms that do majority transactions, do not acquire your company to enhance its own operations. Rather, financial buyers will look to acquire your company as a stand-alone entity, enhance its overall performance, and then sell the newly enhanced entity for a higher amount than the initial purchase price. Most financial buyers are more short-term focused; they aim to “flip” your company to a strategic or different financial buyer within three to seven years. Financial buyers typically pay cash, but they often structure deals where there is “rollover equity” for the sellers to retain some equity in the business post-transaction. This rollover equity is often positioned as the “second bite of the apple” because the second sale offers another big exit in addition to the first.
There can also be situations where a strategic and a financial buyer collaborate; often, financial buyers already own a company that can act as a strategic buyer. The strategic may acquire your company, but it is bank-rolled by the financial buyer to make the acquisition.
When preparing your exit strategy, think like a buyer. You should understand its perspective, its motivations, and why it would be beneficial for it to invest in or purchase your firm.
4. Know Your Options: M&A Deal Types
Just as it is important to know your buyers, it is also important to understand different deal types. These deal types closely align with the types of buyers detailed above.
Most mergers and acquisitions can be classified into one of these categories:
Strategic Acquisition: A strategic acquisition occurs when a larger company purchases a smaller one to achieve long-term goals such as entering new markets, expanding product lines, gaining customers and technology, and so on. Unlike financial acquisitions that focus on immediate financial returns, strategic acquisitions consider how the integration of the acquired company will fit into and support the broader objectives of the acquiring organization.
Majority Recapitalization: A financial restructuring process that occurs when one firm, typically a private equity (PE) firm, purchases a majority stake in a company but allows the original owners to continue to manage the company and retain their equity. In this way, the original owners get a new capital partner without sacrificing operational control, and the private equity firm gains a new, thriving investment. When the company is eventually sold, the new investors and the original owners participate in the sale proceeds.
Bolt-On Acquisition: Also known as a “roll-up acquisition,” bolt-ons happen in the third scenario mentioned above, where a strategic company, with backing from a financial sponsor, acquires a smaller company that can be “bolted on”. This approach enables the acquiring company to achieve greater economies of scale, increase market share, and/or improve operational efficiencies to boost its value.
5. Get Your House in Order: Prepare for Legal Due Diligence
M&A transactions are inherently complex and thus require a thorough, meticulous approach to compiling and validating a variety of legal documents. Although the finalization of these documents occurs at the closing of the deal, it’s advisable to begin assembling the necessary elements early in the process. Engaging your legal advisors well ahead of any M&A activity can help prevent last-minute scrambles for signatures and documentation.
PEAK is not a law firm. We do not give legal or tax advice, but below are pointers we have gathered from legal sources, and we’ve done our best to summarize them here. Please consult with legal and tax counsel to help you prepare for an exit.
There are 4 key areas of legal due diligence to focus on before exiting:
Employees: Buyers will expect your company to provide assignment of invention and non-disclosure agreements for all technology-affiliated employees. These employees should also sign non-competes and non-solicitation of customer agreements. All employees should be properly classified as exempt vs. non-exempt. Also, you should be careful when classifying any contractors as such—especially if they are working for you over around 30 hours/week.
Technology: A major focus on the legal side is tracing the ownership of the IP; a buyer wants to confirm you own your IP or have proper licenses for any IP used. Furthermore, you should actively maintain a ledger of any open-source software your company utilizes.
Customers: Organize customer contracts—especially any that deviate from a standard “click-through” format. Flagged items in negotiated contracts can include IP assignments, rights of first refusal, and/or change-of control provisions—all of which could affect the sale of your company.
Taxes: Many middle-market companies have gaps in sales and use taxes owed to states where they do business. Confer with a tax expert to determine what is needed to become compliant.
6. Continue to Focus on Your Business and Consider Hiring an M&A Advisor (such as PEAK)
The prospect of an M&A exit is certainly exciting, but it’s crucial not to let it compromise your regular business activities. If your company's performance begins to decline, buyers may quickly lose interest. By prioritizing growth, cost control, product differentiation, and competitive positioning, you and your management team can ensure your company is in an optimal position for sale. Since managing all of these components can be time-consuming, complex, and overwhelming, many CEOs seek out knowledgeable M&A professionals, like PEAK, who specialize in managing a sale process from start to finish, optimizing terms, and maximizing the business’ valuation—allowing you to remain focused operations.
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