M & A Rainmaker

When it all goes right !

When I started thinking about this section I have to admit that it was the pitfalls of investing in businesses that came to mind first !! Unfortunately there are lots of them!

However, I pulled myself together and started to think about what happens when it goes right. It’s probably worth knowing that venture capitalists and business angels ( ie professional investors in businesses ) reckon that one in four to seven of their investments will be a success. This is probably why when people ask me what I do I sometimes flippantly say that I am a professional gambler!!

Anyway – let’s try and stick with the positive! One of the aide memoire’s that V.C.’s and Business Angels use when evaluating businesses is that you should look at the Proposition, the People, the Profit and the Plan.

This is worth remembering because invariably when an investment turns out well it will be because you acquired ownership of a portion of a company with a good Proposition, that had good People running it, who executed their Plan well in a business that made a Profit. In addition this business developed into something that had great Potential and it was sold or floated at or close to the Peak of the market and within your anticipated timescales.

Now, it’s probably worth talking about what we might call the “ dotcom phenomenon “. We all know that some clever people made a lot of money investing early in the likes of Google, Yahoo, eBay, Amazon, Facebook etc etc. At the point of investment some of these companies had a revolutionary Proposition, good People, great Plans and a massive, albeit in some cases, somewhat unknown Potential. At this point ( and probably at the point of floatation or sale of some of the shares ) they may not have had Profit. In fact they may well have been losing money and may not have had much in the way of sales, revenue and cashflow. However they were in a Peaking and growing market.

One of the great conundrums of investing is “ How much money will it take and how long will it take before this business becomes valuable ? “ Note that a la dotcom companies, valuable does not necessarily mean profitable – at least not initially anyway.

One of the phrases that came out of the “ dotcom boom and bust era “ was “ ( Cash ) Burn Rate “ . You looked at the amount of cash that had been raised and was being generated and you compared this to the amount of cash that was being spent per month or per year. This gave you the life of the company.

With some dotcom companies burning through cash at massive rates – and no appreciable cash being generated – business failure was virtually inevitable ( unless investors kept stumping up more money ).

Some dotcoms did, as we know, survive and prosper and. So, investing massive amounts of money over long periods of time can create valuable businesses.

Personally I have had investments in businesses that have ranged from being profitable and cash flow positive almost immediately ( Voyager was one such ) to businesses that have consumed cash for a year or two.

The only time that you really know whether the investment was worth it or not is when you sell or float. ( You add up what you put in and take it away from what you got at exit ).

Returning to the positive investment scenario:

After you have acquired partial ownership ( some of the shares ) of a company the company
“ thrives “ – the management team manage the company well and the company generates increasing sales, revenues and profits. This is done in such a way that the cash demanded does not exceed that available via raised cash and generated cash. This leads to a company that has future potential ( it is scalable and replicatable ).

There is no requirement for further ( cash ) investment and therefore your shareholding is not diluted.

The company exits ( trade sale or float ) at a considerably higher value than the value of the company when you initially invested and it does so in a timescale that meets with your expectation.

The timing of the sale or float was good in relation to the lifecycle of the company and the growth of your market sector. There were no issues in you being paid for your element of the company under the terms of the sale and purchase agreement or the rules of floatation.

You made a lot of money and you had a good time !! You lived happily ever after ( or at least to invest another day ) !!

Investing in a company – what to look for.

Following the positive investment scenario many of the points that need to be considered will be apparent.

We will first ask if the company is likely to prosper and grow ?? If the company is a new start-up then there will be no financial history to look at. We can then only look at: The People who are managing the company – Are they experienced ? – Have they done this before ? – Do you believe in them ?; The Proposition – Is the product or service in demand ? – Would you buy it ? ; The Plan – Does it seem realistic ? – Is it achievable ? – Does it look at the risks as well as the opportunities? ; The Profits – Where are they going to come from ?

If all these things ( and other questions we might ask ) are right then we are ( probably ) investing in a good company.

We will only get a return if the company actually sells or floats in the future. ( It might be possible to get other sorts of return e.g. dividends, a share of the profits, a salary, a share buy back etc etc but I am focussing on the “ big return “.

We therefore want to know what the “ exit route “ is ( to sell or to float ) and when that exit route is planned . This is going to tell us when we can expect a return on our investment.

We need to look at how realistic it is to realise our investment by a float or a sale. ( there is a cost to both and a floatation is only realistic on certain markets for certain sizes of company ). Can we predict who the likely or possible trade buyers are??

We need to know what we are going to get for our investment ? How many shares will we get and what percentage is that of the company ? What type of shares are being offered ? Ordinary ? Voting ? etc etc

This is rapidly going to lead us to valuing the company now and/or in the future.

If the company in which we are investing has financial history then there are “ traditional “ methods of valuation that we can consider. If the company is already floated ( unlikely in our case ) then the share price will be publicly quoted and set by the market. If the company is a private limited company the shares are private and there is no “ market value “ to speak of for them.

We certainly want to know what sort of company we are investing in – a sole trader ? – a partnership ? – a limited liability partnership ? ( i.e. a lawyer or accountant ), a Private Limited Liability Company ( LLC ) ? or a Public Limited Liability Company ( Plc ). There are other types of entity that we could be investing in e.g. Venture Capital Funds or VCT Funds. There will be foreign equivalents or near equivalents to the U.K. descriptions ( N.B. Investing in foreign companies is and always has been very high risk. The chances of you succeeding in a legal battle under a foreign legal system are close to zero ).

For a start-up company, with no financial history, the valuation is what we and the company agree it to be. The same is essentially true of a loss making company that has been trading for some time. Viewers of “ The Dragons Den “ will note that those pitching their companies come up with all sorts of valuations ( I am looking for £x for y% of my company ). The Dragons accept some of the valuations, others they want more financial and trading information about, others they reject, haggle over or are simply insulted by ! With those that succeed in getting an offer there is a meeting of minds and valuations.

When a start-up puts a value on it’s company it is really saying “ I need to raise this amount to start up the company and fund it until it begins generating it’s own sales, revenue, profit and cash “ So they might say “ I need £1 Million funding and if you invest £250K you get 25% of the company “.

At this point, since there is no trading history, just a proposition, people and a plan to generate profits, the company is ( arguably ) worth nothing.

The calculation of how long the company takes to “ get into the black “ or “ become cash positive “ is a critical one. If this calculation is wrong and the company runs out of cash there are basically only two options: 1. Raise more, thereby diluting the initial investors ( unless they participate in the fund raising ) 2. Go into administration. Many times this calculation is wrong and therefore one of those options has to be taken.

What are the costs and risks of investing in a company ??

Depending on how much “ due diligence “ you want to do on a company there is typically a legal and accountanc y cost for the checking of the shareholders/investment agreement, the articles of association and the financial history and plans. Obviously there is a considerable amount of your time that will go into this as well.

On an ongoing basis you will want to monitor the performance of the company by getting regular financial updates and if you are going to attend Board and/or Management meetings and shareholders meetings there is a time and cost associated with this.

Typically owners of companies looking for investment feel that the risk is on their side – ie they will lose control of the company etc. Actually, there are considerable risks for the investor. Let us look at some of these risks:

Typically you will be offered a minor percentage of ownership of the company. If you were buying the shares of a floated publicly traded company then your actual ownership of the company is probably minute and although everyone has rights as a shareholder in isolation they are minimal. When shareholders join together in, for example, a class action against a company then more influence may be wielded.

If you are buying anything less than 51% of a company then your money is at risk.

The company is run by the Board of Directors, headed by the Managing Director for the benefit of all the shareholders and “ other stakeholders “. ( “ Other stakeholders “ is a term which is subject to some debate because stakeholders can include, for example, customers and employees ). Decisions are typically made by the Managing Director and/or a “ Quorum “ of the Directors. ( Quorum is usually defined in the Articles of the company ).

Shareholders are not automatically or always members of the Board of Directors. Shareholders do vote on the Board members annually and have certain rights in relation to the running of the company which can be expressed at annual or extraordinary meetings of the shareholders but this cannot be relied upon as a way of controlling the Board or the company.

To have “ control “ of a company you ideally need to be on the Board of Directors with a majority shareholding ( 51 % or more ). The other possibility is that you have terms of control written into the investment/shareholders agreement and articles. However, exercising these terms is likely to be subject to a legal battle – which may be time consuming and costly and could, of course, fail

Put simply your risk is going to increase with reduced shareholding ( after 51% the next meaningful point is 26% ), not being on the Board and not having the correct points written into the investment/shareholders agreement.

Just to give some examples of some things that you do NOT control as a minority shareholder:

As has been well publicised with the recent banking crisis you do NOT ( typically ) control the remuneration of the company Directors. In an extreme case this could mean that a significant proportion of the money that you invested goes to paying the Directors ( and other staffs ) salaries, pensions, bonus’s and cars !!

Typically you have no day to day control over where and how cash is spent. Normally you do not sign the cheques – the Directors do. You do not make detailed decisions over or have any influence on how much is spent on e.g. Marketing, Advertising, I.T. etc etc.

To even get a handle on these things you would need to get copies of Management Accounts monthly or at worst quarterly and probably attend Board and Management Meetings. Annual accounts are only going to give you an overview of the situation some months after the year has passed.

Unless you are seeing Management Accounts that detail the monthly performance of the company, including it’s cash position, you will not know whether the company has sufficient cash to avoid 1. A further cash raising or 2. Administration. The first that you might know of it is when they send you a letter saying that they need to raise more money or they send you a letter saying that they have called in the administrators!!

A good ( and honest ) management team will keep you informed about the company’s situation through Management Reports, letters and shareholders meetings. This is why it is so important to get the right people in place. They will tell you if the proposition is or is not working and if not what they are doing about it ( typically a proposition is changed in the light of experience, sometimes fundamentally ). They will tell you how the plan is progressing and where the company is in relation to that plan. They will also tell you what progress they are making in going from “ being in the red “ to “ being in the black “ – their sales, revenues and profits. They will also keep you updated on the way the market is developing and the potential of the company. They will ALWAYS have an eye on the joint objective – to time the trade sale or float of the company in line with your expectations and ideally at the peak of the market.

A poor ( or dishonest ) management team will typically communicate poorly on all of these counts. You often find an “ attitude “ from poor management teams which basically grows from the belief that their ideas, time, effort and experience is worth more than your money. They see your requests and questions as impositions on them. They forget that without the investors money there would be no company and without the company there would be no remuneration package ( Typically an investor takes no remuneration and may get no return whatsoever until the company exits ).

Investors are often viewed by these people as “ money lenders “ of which the worst image might be a “ Shylock “ who demands his pound of flesh.

Venture Capitalists and Business Angels are typically very reasonable people who are seeking to protect their investments in situations where they actually have relatively minimal control. They merely ask that the Management team perform as they said that they would.

Sometimes investors seek to protect their investment via “ ratchet schemes “. These are basically penalties for non-performance. If the management team fails to perform against the agreed targets then the investor gets additional shares. These shares probably come from the management team so that the investors control over the company grows as the management team’s diminishes.

The effectiveness of such schemes is debateable. Unsurprisingly management hate them – particularly those who have suffered under them.

If he gets control in this way the investor is then faced with the rather tricky decision of whether to try and run the company himself or to introduce new management and replace the old.

Actually, in many cases, getting rid of the old management and introducing new is exactly what is needed and often works. In many cases the “ start-up “ team needs to be replaced with a
“ continuation team “.

Returning to the risks involved in investing the next one is that the management team don’t actually do what they said they were going to do in terms of selling or floating the company ( and you don’t even get the repurchase of your shares, a dividend or any other form of remuneration ). It is either not sold or floated at all or not in the agreed timescales.

Again V.C.’s and Business Angels are often vilified because they force the sale of a company after a certain period of time. However, the fundamental conditions of the investment were probably quite clear – so much money was invested, for a specified share in the company, on condition that it was sold or floated in, say, 3-7 years.

In fairness to the management teams it is challenging to ensure that a company is developed, according to a theoretical plan, to the point where it is ready for sale or float at the predicted time.

Just as the company’s proposition changes in the light of the trading experience so the timescales may change in the light of the way that the company or market develops and the economic backdrop.

For example it has been virtually impossible to float certain companies on certain markets in recent months and years because of the global economic situation.

Typically V.C.’s and B.A.’s will allow some flexibility in terms of timescale and of course it is in everyone’s interest for the company to be sold or floated at the right time.

The risk to the investor is that the company is not sold or floated at anywhere near the approximate time that it was agreed to be and the investor cannot do anything about it. ( Of course if there is a written investment agreement to sell at a certain time then legal action would be an option if discussion does not work. However, taking legal action against the company that you are investing in is not an ideal scenario ! ).

Probably the management team will want to exit themselves and they will do so but the disagreement is about when and whether this needs to be as agreed at the outset.

It is also, sadly, possible that the exit takes place but you don’t get paid out as expected and promised with various reasons being cited as to why this is the case. This may seem like an over dramatic risk but it does happen and once again the only recourse, if discussion does not work, is legal action.

A further potential risk is that the timing of the establishment of the company was just wrong. It was either too early or too late for a particular proposition.

Closely allied to this risk is the risk that the proposition itself just did not work and it could not easily be modified or moulded.

I have certainly invested in companies where the timing and proposition turned out to be wrong.
( Actually I have invested in companies where the proposition was wrong, the people were wrong, the plan did not work and no profit was made !!!! ). Unfortunately it usually takes time, money and effort to find this out. The only option here – if you have it – is to stop putting money into the company. If you have already committed that money then you will have to write it off !!

Welcome to the world of investing in companies !!!