The Opportunity Discontinuity In the second of his regular articles for The Sharp Edge, Paul Rivers-Latham of Cobalt Corporate Finance suggests ways of unlocking strategic value for your company

In stable markets it is reasonable to use multiples in order to arrive at what might be called the 'financial value' of a company. In contrast, in a technology market the acquisition is all about the opportunity the acquirer could tap into if only he or she were to control the assets of the target. More specifically, it relates to the fact that a small, young, entrepreneurial company will often have done a great job of innovation but lacks the resources to scale quickly enough.

For followers of chasm theory, I am talking about companies in that immediate, post-chasm phase when mainstream proof-points have been established. It is at this point the established players in a market start to take real notice of the young upstarts who are eating their lunch. Founders and shareholders now have a serious decision to make. Do they put in place the financial and human resources needed to complete the journey or do they do what most companies do, sell to someone who has plenty of cash, a well-developed sales and marketing machine and the infrastructure to support it? This is the basis of what I call the Opportunity Discontinuity.

The Opportunity Discontinuity
The opportunity for a given product or service is not a fixed number. It is strongly influenced by the capabilities of the organisation making the product or delivering the service. If we equate value with opportunity then value too is influenced by these capabilities. Therefore, the value of a company to an acquirer will depend not just on what the target company has done thus far but on what the acquirer will be able to achieve in future.

So the starting point for valuing a company should not be the revenue or profits to-date but the opportunity for the acquirer. Simple multiples just do not cut it.

All very easy to say but perhaps not so easy to do. Particularly when an entrepreneur already has their hands more than full with just running the company. To tap into strategic value requires a long-term approach and impacts on operational decisions and activities. Starting early on your 'exit strategy' is key. Indeed the more venture capitalists try to figure this out before they invest the better.

Note, however, I am not advocating that one can or should run a company to be sold. Our ability to predict the future is just not good enough for that. What I am saying is that our efforts to create the best company we can should be informed by an understanding of what constitutes value for an acquirer and, equally important, what reduces value.

At Cobalt we use our 'Mission Ready' process to help articulate and defend 'strategic value'. The basic mechanics of a sale process come later. On occasions the results of this process highlight operational outcomes that would increase value considerably but which will take several months to achieve. Rather than rush into a sale process we would much rather be patient and deliver extra value for our clients, provided this makes sense for the stakeholders.

How Do We Get To Be 'Mission Ready'?
First we clarify what aspects of your technologies or methodologies can be regarded as the source of a sustainable and advantageous differentiator. We then look at who is already gaining or losing because of your presence in the market. Typically partners or competitors, but the list can be extended by tracking their competitors and partners in turn. For instance, you might compete in the UK with a US-based company. Their US-based competitors or partners might not be active in the UK but nonetheless might very well gain by acquiring your technology.

Very often this is an iterative process and it usually brings to light new thoughts as to what really constitutes value. This should not be a surprise. All businesses are trapped by their history to some degree. Even Intel took a while to realise they were no longer 'the memory company' but had become 'the micro-processor company'. An important part of the role of any professional adviser is to hold up the mirror so that we see who we really are.

A truism of the M&A world is that companies usually get bought by acquirers already known to the company. So it's somewhat pointless to use a provisional 'buyers list' as a mechanism for selecting your corporate finance adviser. We all have access to the same research tools and come up with much the same lists. The real difference lies in how the adviser divides his list into types of buyer and how he then helps you articulate a business case for each class.

It is important to place yourself in the shoes of a potential purchaser. Imagine you are part of his business development team. What would be the internal business case if they were to own you? How would you quanitify the opportunity? What assets do you already have? What would it cost you in money and time to address this opportunity? What are the risks?

Out of this will come a view of the revenues that would accrue if they implemented this business plan.

No doubt the acquirer will seek to use multiples applied to your EXISTING revenues in order to argue his valuation. As a minimum you can use the self-same multiples applied to your informed view of his internal business case in order to argue for a much higher value. If you want to get fancy you can even discount future revenues back to a net present value but that is detail. The key is you have moved the game to talking about his OPPORTUNITY rather than your ACHIEVEMENTS.

Proof Points And Risk Mitigators
Having scoped the opportunity it is equally important to think about how easy it will be for the buyer to exploit the opportunity. Here I would divide things into
'Proof-points for Value' and 'Risk Mitigators'.

A proof-point for value would be something like having made a sale to a major customer. Clearly the revenue that results from such a sale is important, but much more important is the fact it 'proves' customers of that class exist, that we have a compelling business case for our product as far as that customer class is concerned and that we know how to sell to such customers.

Let me illustrate this with a real example. Recently we helped a client sell his business for seven times revenue, well above the value that sector multiples indicated. The team had done an excellent, well-focused job of penetrating a particular market segment. Quantifying the value to be had from this segment was pretty easy. However, there was also scope to extend the use of the company's product into similar segments that would represent further value. Unfortunately, in stressing focus they had ignored these opportunities and without proof-points, acquirors were reluctant to recognise the additional value.

The investment of a few man-months of sales effort was sufficient to capture a new customer in a new segment. This doubled the value of the business, despite the fact the additional revenue and profit were only a few percent of total. The team had 'proved' the segment valued their product and therefore the buyer could easily realise value from this new segment.

Risk mitigation would include things such as making sure your technology interfaces or can be made to interface easily with the buyer's own technology. At its best you have already built such interfaces and sold into the same account. If not, then you may have to build an interface speculatively. One way to wake up a potential buyer is to approach them for the information you need in order to build such an interface. If you have tools and/or methods that allow you to create new interfaces quickly then that too de-risks things from the buyer's perspective.

Other areas for risk mitigation would include customer/supplier/partner agreements and obligations; personnel reward structures; clarity/security of IP; management information; vendor alignment of interests and forecast visibility - pipeline documentation.

An important part of the Cobalt process is to work with you to identify what aspects of your current business would make it less attractive to the potential buyer and then to put in place operational plans to mitigate these factors.

So, let me leave you with two thoughts:

Exit strategies are not a 'quick fix'. You and your shareholders need to prepare well ahead of time and may well have to do things that compromise short-term profitability!

Running a business is hard enough as it is without the extra load of planning an exit. Far better to grow value by focusing on your operational strengths and bring in a professional adviser early.

Cobalt's value Philosophy
» Financial Value
» Most corporate finance firms rely on industry multiples of revenue or profit as a way of determining value
» Only appropriate for mature sectors
» Cobalt calls this metric the 'financial value' and regards this as merely the baseline
» Our objective is to achieve a premium by selling 'strategic value'

Strategic Value
» The opportunity for the acquirer
» Articulate his business case
» Identify/create proof points for value
» Forge relationships - demonstrate value

Value-Destroying Factors
» Ease of integration/exploitation
» Customer/supplier/partner agreements and obligations
» Personnel reward structures
» Clarity/security of IP
» Management information
» Vendor alignment of interests
» Forecast visibility - pipeline documentation