How a Strategic Buyer Will Value Your Business
by Glover Lawrence
Congratulations! Your discussions with a strategic buyer have progressed to the point where they float the idea of an acquisition. Maybe it started with a partnership in which both parties got to know each other and explored the value your company’s solution brings to their portfolio and their customers. Perhaps someone from the Corporate Development team contacted you as part of their search to fill a product or market gap. Or maybe you engaged an advisor to help you sell your business. In any event, both parties are interested in discussing an acquisition.
Naturally, you wonder how the potential buyer would value your company. How much is my company worth to this buyer? What factors will the buyer consider when purchasing my company? How will I know that I am getting a “fair” deal?
Undoubtedly, you have read about other start-ups selling to a strategic buyer. Naturally, you compare what you know about the acquired companies and yours and impute your value.
What’s the difference between strategic and financial buyers?
Traditional valuation methods
If you search for articles on how to value a business, you will come across the concepts of income, market, and even asset-based valuation. These include common approaches used in finance and taught in every MBA program.
Discounted Cash Flow Method: A DCF estimates the net present value of the target company's future cash flows, considering factors like growth rates, discount rates, weighted average cost of capital, and terminal values. This approach focuses on the intrinsic stand-alone value of the business based on its expected future cash flows and generates a net present value.
Comparable Company Analysis: This method compares the financial metrics of the target company to those of similar businesses which are publicly traded firms. Key metrics like price-to-earnings (P/E) ratios, enterprise value-to-EBITDA or revenue ratios, and others are used to impute the valuation of the target based on the prices of comparable public firms.
Precedent Transaction Analysis: This approach looks at similar acquisitions to determine how other buyers valued similar targets. The valuation metrics from these acquisitions are then applied to the target company's financials.
Traditional approaches do not work for early-stage software companies
As the founder of an early stage, rapidly growing company, you inherently understand that these approaches are not suited to your business. How could the parties agree on a five or ten-year growth rate for an emerging technology in a rapidly evolving area? How are the trading values of mature, slower growing public companies applicable to an emerging technology in a new space?
Given this, the customary approach is a simple revenue/ARR multiple: price divided by run-rate ARR. This rule-of-thumb is widely used for startups or high-growth businesses that may have hit key product or customer adoption milestones but do not yet have substantial revenue or earnings.
But how do you ensure that you get the highest revenue multiple for your current ARR? Or if your ARR has not hit an inflection point, can you get a buyer to ignore current multiples and pay a strategic value of your business that reflects its true potential?
The short, frustrating answer is “it depends.” It depends on the underlying factors driving the strategic interest of the right buyer. In contrast to financial buyers who are often focused on traditional valuation approaches and customarily target more established firms that have scale, strategic buyers of emerging companies will build an investment case that incorporates many other factors. Understanding these factors and highlighting the ways in which your company addresses these needs is vital to capturing the maximum value.
What drives strategic buyers’ interest?
Strategic buyers acquire other companies for multiple varied reasons. Understanding which reasons are driving interest from strategic buyers in your business is critical to your exit strategy and maximizing the value you capture in the sale process. The most common reasons are:
Gain access to new products or technology: Established software firms often cannot rapidly develop or take advantage of innovative technologies. They have product roadmaps and budgeting cycles that are set quarters or years in advance and cannot shift rapidly. And they have installed bases of customers and products that need to be maintained. This pattern repeats itself year after year in the software world, most recently in the areas of machine learning, data science, and generative AI. Acquiring a company with proprietary products and technology can prevent a buyer from falling behind or give the acquirer a competitive advantage.
Acquire talent: Buying a company can be a way to access key talent. This can be especially helpful if the acquiring company is looking to expand its technical capabilities or other key domain expertise. In the technology industry this is often referred to as an “acquihire.” The buyer acquires a team of skilled professionals they lack. In these situations, buyers sometimes value the company on a multiple of engineers. This does not mean that the current product is not useful, but it does often presage a change of focus for this team once the deal closes.
Address competition: Buying an emerging company or disruptive technology can help the buyer reduce competition and defend market share under the threat of innovative technology. This is a common rationale if the buyer is facing strong competition in its industry segment and believes that a competitor is outpacing their own innovation.
Achieve economies of scale: Acquiring a company may come with opportunities for the buyer to achieve economies of scale. This happens through increased operating efficiencies such as shared overhead costs, more efficient resource utilization, combined marketing efforts, or avoided investment in innovation.
Expand into new markets: Acquiring a company may be a quick way to enter a new geography or market segment not currently addressed by the buyer. This can be especially motivating if your company has established a customer base in the new market segment or has penetrated a geography the buyer seeks to enter.
Diversification: Buying a company in a different industry can help the acquiring company diversify and reduce its risk. This is especially important for larger companies exposed to a single segment or industry.
Deciphering the drivers of the buyer’s interest is a process of discovery and research. Most founders launched a company knowing the product gaps or strategic weaknesses of incumbent players in same industry. The important trick is to diligently probe strategic priorities during all conversations with potential buyers to fit the puzzle pieces together.
Articulating your value to strategic buyers
For early-stage software businesses, buyers primarily focus on new technologies and innovative products, talent, response to competition, and customer acquisition, or a mix of all these. The smaller scale of emerging companies limits the opportunity for material diversification or meaningful economies of scale.
Developing a clear thesis for what is driving the buyer’s interest lowers the odds of leaving money on the table. This thesis often includes an analysis of the buyer’s existing products, key trends impacting the buyer’s industry and customer base, or even new regulations that may be changing the landscape. An experienced advisor can help you articulate the strategic message. Clearly defining and articulating your company’s value to the larger company serves three important purposes.
Value expectations: You demonstrate to the interested buyer that you understand your strategic value to them, and that you expect to be paid an appropriate value to sell your company.
Competition: You make it clear to the buyer that you understand that other acquirers would similarly benefit from owning your intellectual property. The fear of missing out is a powerful motivator for buyers, especially with emerging technology and solutions.
Internal Investment Rationale: You help the buyer craft an investment thesis that they can use to build their business case. Do not underestimate the role this plays in helping the business champion create the investment thesis that details the way your business addresses their strategic goals. Helping the business sponsor articulate the rationale and benefits of the acquisition makes the process smoother for them and easier to sell internally.
Build vs. Buy
If you have been in discussions with a prospective buyer for some time, then you likely have gained important insights. However, if you were contacted by Corporate Development or engaged an advisor who contacted the prospective buyers on your behalf, then you will likely have less insight. Having an appreciation for the internal processes that lead to the decision to acquire can help you navigate the journey effectively.
As technology evolves and product and operating model innovations create opportunities for other businesses and risks for incumbents, larger companies ask many questions which informs a buy vs. build analysis.
Should we build this product or imbed this emerging capability into our existing offering? Will it create value if we do?
What is the market demand and market growth for this innovation?
Do we have the time and skills to develop the intellectual property and product on our own?
Does the solution exist that we can acquire?
If we acquire the solution, can we effectively integrate the target solution into our offering and sales process?
Preliminary discussions with your company may have been part of the buyer’s build vs. buy analysis. Emerging companies must navigate a delicate journey as they seek routes to market and partnerships with larger players. Many discussions with strategics do not lead to acquisitions. More than one emerging vendor has explored strategic partnerships and even an outright sale with an incumbent only to later see that company offer a similar product. Working with an advisor who has been down this path can be very helpful and could help you protect your IP.
Ideally, however, having worked with your products and determined the potential to integrate your solution into theirs, and evaluated the existing management team, the partner concludes that building it on their own is not the best course of action.
Perspective on the buyer’s acquisition process
If a strategic buyer has come to the point that they are preparing to make an offer, they have determined that they should buy, not build. Whether the purchase is due to a lack of resources or skills, time-to-market considerations, proprietary technology that you have developed, or the market position of your company, the buyer has determined that they will create more value via an acquisition. That said, the decision to buy rather than build does not translate to an open checkbook.
The buyer will evaluate many factors as they create the investment thesis and financial model that reflects their strategic rationale and due diligence findings and leads to a perspective on the acquisition target. Their financial model will begin with your stand-alone financial statements including income statement, cash flow and balance sheet data that you provide them with as part of their diligence.
From this starting point, they will make assumptions and projections about what benefits could be gained by combining the companies and the costs to achieve these benefits. These considerations include sales synergies, cost savings, integration costs, retention costs, and transaction costs.
Sales Synergies: The strategic buyer makes estimates of revenue upside such as:
Cross-selling and up-selling the target’s existing products to the buyer's installed base
Bundling products or services of the combined companies to sell to existing and new customers
Changes in pricing of the existing solution if the buyer has a different business model or enhanced value proposition post-acquisition
Value of the expanded customer base that the acquired business brings
Enhanced market position relative to the competition due to the addition of the target product
Geographic expansion into desired market segments
Cost Savings: When larger companies combine, the list of potential cost synergies is long and can generate extensive savings such as production and distribution synergies. However, potential cost synergies in emerging software companies are usually limited to redundant functions (e.g., Finance, HR, IT) and office space.
Integration Costs: Strategic acquirers will incur and will model the impact of both one-time (e.g., product integration to an existing portfolio, employee benefits, IT integration, re-branding) and ongoing integration costs (employee training, synergies implementation). Depending on the scale of the target, these can be material to the buyer.
Retention Costs: Buyers of early-stage software companies know that they must retain the key employees or risk losing the value and purpose of making the acquisition. Retention costs can include changes in base compensation and benefit structures to bring the acquired employees into alignment with the buyer, equity compensation for specific integration deliverables, or time-based retention incentives.
Transaction Costs: These are one-time costs that a buyer incurs to complete the transaction. At a minimum, this usually involves legal fees of outside counsel. On larger transactions, this could include fees from financial advisors and diligence and integration assistance, among others.
Having read earlier about the limitations of discounted cash flow for valuing early-stage companies, you might wonder why the buyer would go through all this work. Are they building a multi-year financial model to calculate the value of my company? Will they use this model to calculate the price they are willing to pay for my company? Yes and no.
The detailed business plan will be part of the internal analysis of what incremental earnings and cash flow the buyer can expect to generate from the combined business. It also serves as a summary of all the diligence findings and integration planning that the buyer has done during their evaluation. The business plan will highlight the risk involved for the buyer and detail the company's earning potential because of the acquisition. In the end, the business sponsor will be held accountable for delivering on a plan that justifies the acquisition.
The Corporate Development team will use this business plan as a basis for calculating an implied value of your company. They will use whatever method implies the lowest price for your company when speaking with you. In the end, they may talk about a discounted cash flow and the implied net present value of the current operations of your business or refer to precedent transactions to negotiate value. In these discussions, they are not likely to focus on the value of your intangible assets.
However, they will simultaneously use the same model to analyze the highest price they could pay and still get an appropriate return on their investment. Since the buyer seeks to keep all the value of synergies, but must fund the integration and transaction costs, they have a different perspective on the value of the acquired company to them versus its stand-alone value. This is one of the primary reasons strategic buyers can pay more for a company than financial buyers.
Maximizing what a strategic buyer will pay for your business starts with building a company that solves a real customer problem and properly captures that value with a compelling business model. Once you capture the interest of a potential buyer, you materially increase the odds of getting the maximum price they are willing to pay by analyzing the strategic reasons a buyer would acquire your business and the value creation you bring to their operations.
At this stage, you need to have a perspective on how important your company, its products, intangible assets, and team are to the buyer's overall strategy. Finally, putting the interested buyer in a position where they conclude they must pay a strategic value is a function of creating legitimate alternatives for your business. These are: (1) remaining independent and continuing to build value as you grow and (2) selling to a competitor. In the first case, the strategic buyer believes they could have another bite at the apple, but at a higher price with lower execution risk. In the second, they conclude it is now or never and they will have to be aggressive or risk losing the opportunity.