How to Buy Companies That Aren't Profitable Yet

23:56That difference in the approach of the VC is really important. I'm not actually coaching an entrepreneur through their valuation at that point. I am coaching them through their own risk tolerance, their own view of their market. And I'm trying to shape their view of when do you think you'll be worth a hundred million? Because as soon as I can start to get them to think about that horizon. And I can say, look, as a scaled business, you're only going to trade at five to eight times or eight to 10 times revenue, which means to get to that hundred million, you know, you got to be 12, 14,$15 million.

24:38Do you think you can get there in 18 months? That's a lot. I don't know where we're going to. And that's when I can start to have the conversations of, okay, so under the scenario where you spend$10 million in two years, you're worth$100 million. In that situation, you're only going to take 90 % of the cap table, and actually you're going to take less. Let's say you execute that plan, and now I start to talk to them about the dynamics of the deal that they're actually agreeing to, which usually has liquidation preference, it has voting rights preferences, it has different tools, where even if they hit that plan, the entrepreneur, their share is lower than they would get in a direct deal.

25:20Said another way, a$25 million M &A deal today can be just as valuable to a founding team as a$125 million deal three years from now that a VC has funded. Because of the mechanisms of that liquidation preference, the mechanisms of the overall venture exit plans. What I try to explain to them is that difference of a VC valuation, again, tells you what you need to sell for in two years to be equal to what you would take today. And then you start talking about the view of, well, is$25 million now equal to the$100 million two years from now? Or can I make that$100 million, 400 million, and you really do come back to that risk tolerance of the entrepreneur, and you start to whittle away at the belief in the certainty of the VC promise, which is, I'll give you 10 million today, and you'll be worth 100 million two years from now.

26:26Matt Arsenault:Again, a little bit of this math. So if we had, let's use that first example, you have like 4 million revenue, you get valued at 100 million. And then the push is, I can do another round. I guess in that case, how much would you raise? You'd raise what? 20, 30 million? So usually series A is about a 20 % kit. So depending on the company. This would be more of a series B then. Exactly. So what would be our series A raise? If it was like a million, then they probably raised. They probably raised anywhere from 7 to 25 and it would take 20 % of your cap table. Yep. So call it 7 on 35 all the way to 25 on 100.

27:05Matt Arsenault:Then we're looking at the next round where it's okay, 20, 25 million. That's kind of where that point you're looking at right now in the example of, hey, you've got seven. If you did a deal now, even if it was only at 25, realize something versus if you raise a 20, hey, don't move that needle. Again, that risk is factored in and you end up going one, maybe you get up to four. Then you're still at that same spot where you've got a lot more raised out. But if you look at the correlation... That's the risk. So let's say the company doesn't go from the 1 to 10 to get to the valuation. The liquidation preference of the VC means they take their 10 plus their return first.

27:46Matt Arsenault:Yep, exactly. So if you only go 1 to 4, and I'm multiplying that by even 8 times, now you're 32 million of value. And the VC takes their liquidation preference of 1 times or 1.1 times. So their 10 comes right off. So now you thought you were worth$100 million. You sell for$32 million. The VC takes their$11 million. Now you are only getting$21 million as the founding team, not the$25 million I would have offered you two years ago. Before we keep going, that math Matt just walked through is the conversation most corp dev people are not prepared to have. You're in a deal with a venture-backed founder whose growth has slowed, but their valuation expectations are still anchored to the last round or the version of the company they believe they can still build.

28:35Matt Arsenault:You have to figure out how to close that gap without blowing the relationship or the deal. And it's not just the math. You have to understand the founder's risk tolerance, the investor preferences, the cap table, the retention packages, and what deal structure actually gets everyone to yes all at the same time. That's what DealPilot, powered by M &A Science, was built for. Hundreds of practitioner conversations organized into practical deal guidance you can use when you're in the middle of a situation like this. Valuation frameworks, stakeholder mapping, negotiation patterns, and deal structures that help you think through the trade-offs before you have to make the call.

29:16Matt Arsenault:If you're staring at a bid-ask spread right now, or no one is coming, check it out at M-A-Science.com. All right, back to it. So there's painting that picture out. So starting with the relationship, you got to at least have that relationship that they're actually going to listen to you and have some trust. That part's key. Then you're having a conversation about, well, here's your scenario. Let's explore what the risk appetite is. Because yes, you can keep doing another round, but then there's some factor of risk to it. And I've seen this before. I've actually surprised in the past year, founders I've known a surprising amount that actually took the exit instead of doing the series b and think of two companies actually that opted to go ahead and do a flight and they got you know it's a great market so they end up getting good valuation exited out the three companies i know now i worked out well for them even one actually was i was really surprised because they raised in 21.

30:06Matt Arsenault:i guess that's another scenario that's the model right there is anything else i'm missing in terms of the relationship trust kind of think through risk then you get the financial picture then you sort of really look at the more of a viability of exiting now versus continuing the VC track and raising more? The old adage, a bird in hand is worth two in the bush. Some people believe it and will go with it. And others go, yeah, you're telling me there's two in the bush. I see four. I'm going to go get the four. And I go, look, come back to me two years from now. My duty as the corp dev leader is to then find more assets.

30:40If the preferred asset is looking for those four birds in the bush, You let them go chase the four birds in the bush, but we have to look for the second competitor in the space or a new approach in the space or different alternative that is willing to take that one bird in hand. There's a lot of sifting that is happening right now because you have to find that right entrepreneur that still wants to grow the company and the product and still wants to provide that value to the customers, but doesn't want to take the risk of having an investor.

31:14Matt Arsenault:How does that play out? I feel like most companies have multiple co-founders, and then you have a board that represents the investors. How does that play out? Is it like, get one co-founder that's, yeah, this makes sense. I'm ready to do something that this would give me more stability and the other one doesn't want to do it. Then you have a board that we believe in you and want to keep investing in. How do those dynamics actually play out? It really depends on voting power. How do you get to that? Do you just say, hey, can I see your cap table? How do you understand that for a company? Because sometimes they're shy about talking through that.

31:46Well, anytime I'm engaged in either a fundraising effort or an acquisition effort, part of that is understanding the cap table. Who is going to get paid what and what does that mean? You don't get that upfront by any means. But you have an ability to understand, are there five co-founders and they each own 10 % of the company? Or are there five co-founders and one owns 40 and the others own two and a half percent? You have to start to build that relationship and trust to understand who the key influencers and decision makers are. And then you have to involve the other parties. That's why I said earlier, you have to understand the different investors, the different profiles of those investors.

32:24You have to have relationships where you can with them in order to unlock the ability to influence and say, look, I know you think that there's a lot of upside here. Here's what I'm seeing in the market. This is why we want to act on this now. What's your... You have to stakeholder manage the best you can. And that's where the buyer-led M &A approach, Kisan, that you've been talking about really does kick in. If this is a pure auction that I never get to talk to the investors, I never get to talk to the management team, you can't take these approaches. You're just paying what is, quote unquote, perceived as fair market value.

33:03By doing it this way, building those relationships, you actually have to help the CEO or founder manage their stakeholders. So one of the first conversations I have when we are starting this conversation around risk profile, your goals, is I very clearly point out to the founder, there's kind of seven or eight different key stakeholders you need to think about. And a lot of them sit back and go, how many? And I go, well, You got to think about your investors. You got to think about you, but not just you, you as an employee or you as someone who has created this, you as a supervisor, your family.

33:45What is this going to mean for your family as a founder? The team. A lot of folks have built this with very loyal people that they want to take care of. They want to make sure they're going to have a job. How do you value the team and their future work or their future safety in a job? You've got to think about the customers, the customers that you've made, the traction. You've got to think about, in some cases, the vendors or the key contributors that were in the process of building. And you've got to put that picture together as an entrepreneur. And you, for the first time, realize it's not win-win-win.

34:21There's always a sacrifice. If you do better by your investors, you do worse by your employees.

34:28Matt Arsenault:Yes. It doesn't get talked about. Yeah. You start to think about those different stakeholders. And to be clear, for some of these entrepreneurs, even second-time entrepreneurs, managing all those stakeholders through a deal process, it puts a magnifying glass and a bright light on it. When you're doing it on a day-to-day operating perspective, you're making those choices. You're not really thinking of those trade-offs. When there's real money on the table, you have to, or you're not actually preparing yourself for the exit. Have the conversation, help them think through. I think the big part of the story, making sure you're aligned.

35:03Matt Arsenault:You have an interested principal that wants to do a deal. You have the story, then helping him manage that story so it can be carried through these other stakeholders and helping him, coaching him, know like what's that reception going to be. Then some of these other dynamics that do get more tricky that people don't immediately think about. There is no clear making everybody winner and happy. There's going to be trade-offs and you got to figure out where that right balance is. And then there's other ways that the bigger companies do corp dev, which is just put an obscene amount of money in front of everybody.

35:32And you just hope that people stick around.

35:34Matt Arsenault:What about the situation when they're underwater? They've already raised a bunch of money. Now their growth has stalled. Now they can't get another round of funding. But you value this business less than what they've raised, which makes it awkward. Those are really hard conversations. I know. How do you do those deals? Because you still want to do the deal. There's a point they come to realization. Maybe they hired a banker, the banker runs a process. And even after running a process, they still haven't concluded to a buyer. It's just that situation. And I guess there's like a curve of, hey, I'm still optimistic that we can get value or at least get our money back.

36:11Matt Arsenault:And then over time, I feel like time kills deals, but time sets the expectation reality over time. How does that play out for you? How do you sort of accelerate that area of diminishing expectations to get the deal done? I don't think you accelerate. You let time. Let them suffer a little bit. It's not just let them suffer. Those are hard conversations because then deal structuring is the only way to do it. Meaning, again, come back to your stakeholders. How much do I have to get to the preferreds for them to vote yes? How much do I have to make sure flows through to the common shareholders for them to put some money in their pocket?

36:45What are the retentive packages that I have to offer those founders or those employees? How much severance is in the deal of people who just simply are not going to make it through? That becomes a very complicated calculus. And that's where you have to be intentional. You have to be thoughtful. Those processes, I know you say accelerate. You actually have to be very calculated and patient in that process, or you will leave a key stakeholder group behind. And as a corp dev team that has to operate that asset post-closing, there's more risk of damaging the asset in decisions. You haven't run it, you don't know it, than there is in the turnover.

37:28So those are the situations that generally will take longer. And you have to spend a lot more time with the bankers, with the founders, with the investors to truly understand the willingness of each stakeholder and how can you put a deal together that actually allocates value across the different stakeholders in a way that you still get a team that's operating at a high level and is excited to come work for the company that is acquired.

37:56Matt Arsenault:Would you be excited to work for a company when your stock options go to zero? Unless you got something new, you have to create some new. You have to refresh, you have to think about it. That communication is really hard, let's be clear. But there's assets out there where the team who operated it, like the team hanging around knows that something is wrong. Is there a kind way to kill hopes and dreams? Yes. It's never fun. But there are kind ways to do it and there are brutal ways to do it. One of the most formative experiences of my career was coming out of EY, I went to an automotive parts manufacturer.

38:32This was my first job where I was in the company. I was so excited to get there. And the first deal I was working on, the day it closed, our executives walked into the factory and fired all 512 people and said, your jobs are going to be eliminated. In that communication, they then said, but we need you for up to two years. We will provide you quality and production level bonuses that will double your salary over those two years. If you hit targets, we will offer resume help and job search coaching. We will give you up to four hours a week paid after the period of notice where your line is accelerating the factory for you to conduct interviews at other companies and to think through your next steps in your career.

39:19And we will be part of your journey to your next spot in your career. At the time, I was like 28 years old. And that hits you as that is just brutal. Like you just walked in and you laid off 500 people. And then I got to spend a lot of time in that factory with those people as we were resetting costing and we were trying to make sure production was hitting targets and whatnot. And that element of understanding the difficulty that you are putting someone in and being a part of the solution is really important. When there is severance activities throughout my career, I have thought back to that.

40:00How do you make it as palatable as possible? And again, this is a stakeholder trade-off. There are conversations that I've had where I say to the sellers, I am carving out under our severance policy. I don't care what your severance policy says. So I'm going to subtract severance from my enterprise value, keep it as a pool, and that will be paid directly to the employees based on our policy, which is more generous than yours. Those are not easy conversations. They can kill deals for sure. But you have to think about that balance of taking care of the employees with the voting power of the shareholders and founders' interests.

40:40And so by understanding that stakeholder, you then are able to do it in a way that is compassionate and supportive versus the PE walks away with all their money and the employees head to the unemployment lines without any cushion.

40:57Matt Arsenault:Definitely a conversation and mapping out the stakeholders and then being more sensitive with the case. Have you done it before? You got examples? Let's do the positive. Let's do the positive. All right. Let's do the positive. I'll see you next week so you can tell me the other one. The bad deals, Kisan, it's important to know how to do them, but they don't come by that often. It is contingent on business cycle. It is contingent on growth cycle of targets. Those are the deals I seek out. Those are the ones I can afford. Exactly. Those are hard. There are deals we have lost as corp dev in a given round where we have gained a good partner.

41:35We've gained a good advocate. We've gained a good knowledge of a space. Part of the view of measuring the deal is having that ability to communicate with your executive team, your board, your stakeholders on your side. You're not going to win every deal. Sometimes losing gracefully is an important piece to the puzzle. Some of this is there are places where we have lost the M &A, but we've gained a great partner that we've built through an OEM agreement, or we've done joint marketing with, or we found ways to grow together. There are others where we've been able to convince the team that their growth prospects are not what they had hoped, and they have become part of the organization, whether that be, again, Everbridge, Jamf, or before that, even GD Digital, where we were able to convince the founders that their next round of fundraising is not worth the risk of that, trade off that risk for certainty in the cash.

42:33Matt Arsenault:You got any example you can talk through? One of them, and it is pretty funny, people have seen in the news a couple of key acquisitions that have been made in the cybersecurity space. Some of them are companies that we've talked to through their Series A fundraise, through different partnerships. They've been on our marketplace and they end up going to another cybersecurity company. And those are a little less interesting. But again, it is absolutely... part of the journey is to be potentially in their series A, but not win. That framework is definitely something that I learned at EMC with EMC Ventures and reinforced while I was at GE with GE Ventures.

43:10There are deals that you lose from a corporate dev perspective. You put the time in and you build the relationships. I'm thinking Foghorn Systems way back in the GE days. Cinex, which was a very interesting hardware components company where the venture fund took a stake, but I help coordinate business relationship with the company. The corporation realized the value through the partnership. The VC firm within the corporation realized the value through exit. And I do think that there are some that we have at Jamf now that are there where we've had good partnership. We've tried it out. We're going to make more of a financial return than a market-based return and others where we are making a better market return than a financial return.

43:54It's hard to talk through some of the examples in specifics, only because a lot of them still stay on the table for me right now.

44:01Matt Arsenault:Okay, one thing I want to ask is valuation gaps. Beyond using earnouts, equity rollovers, what structural terms are you using to bridge valuation gaps with a bid-ask spread? It depends on which stakeholder. And that's where each deal is different in how you're doing it. If the founder is more worried about their go-forward compensation or their founding team's go-forward compensation, the employee base, more valuation in retention bonuses or RSUs or equity in our parent company. That goes a lot longer than an earn out or a deferred payment. When you are truly trying to close a valuation gap with the equity holders, that is the hardest one to close because the expectations of the sellers are set by what they believe is market.

44:48you really have to start to understand your bid power in the process. Sometimes you're closing the valuation gap on your own side saying, hey, if we really want this asset, I know this is a robust process because there's things showing up in the data room I'm not asking for. So I know that they are adding it because someone else is asking for it. So you can start to gauge that process. You can start to gauge where you are in the process. You have the conversations with the people you have the relationship with on the management team. Talk to the bankers. Closing the gap with the financial sponsors is the hardest one to do.

45:25And it is usually done through the mechanisms you talked about. Deferred payments, earnouts, carve-outs, or other ways to share the risk of the upside.

45:34Matt Arsenault:Big thing is figuring out who the stakeholders are. Which valuation gap are you trying to close? Yeah, you might have an internal versus with the target. I like the internal dynamics. That could be a whole content, just about that. And then with this target company, because I feel like there's always high expectations on it. And that's the way, I don't know, that's like the default lever. Do you just start saying, okay, we'll structure this deal somehow. We'll put it in earn out. We'll roll over equity. That's like what I tend to go to. Or is there other ways around it? Do you convince them to go down to their value?

46:03The beauty and curse of finance is it truly is all math. And it's really risk-based return. You're either trading value or you're trading risk. It truly is the negotiation around those segments of the contract. And in any negotiation, you have to figure out where someone is more dug in. What's most important to them? Is it top line number or is it certainty of payment? Is it timing of payment? Is it shared liabilities? Is it escrow? There's so many different mechanisms within the contract you can actually negotiate on that you have to find out what they are most seeking so you can understand where you can make those trade-offs.

46:47And that's the beauty of the corp dev job is you're solving that problem across two organizations at the same time.

46:53Matt Arsenault:What if you have the CEO? Is there an operator you're talking to, but then you know there's like a key investor? Are you getting that conversation? How do you approach that? Trying to. Trying to? How do you do? Do you go through the CEO or do you just go around and... Go around and... Go around and... Now, that's the preferred is to go around. In that, I will say there are processes where the CEO very early will introduce us to their investors, their key board members. But that's where as you build your reputation over time, you build your connectivity over time. It's just natural for you to talk to some of the investors anyway.

47:27That's really been a concentration for me and my team is finding ways to seek out the investors in the spaces we're interested in. and have a quarterly check-in or semi-annual check-in anyway scheduled so that it's not awkward when I reach out to say, hey, I'm really interested in this asset and I want your perspective on how this process is going. Again, it comes back to those relationships and those pieces of that relationship and making sure that you preserve that right to have a direct or hard conversation at that level to say, look, I am on this one, I'm going to allocate more value to the employees.

48:03That base is more important. It does come back to that long-term relationship with the venture capital or the investors as well. A lot of them do understand in this community of M &A, of deals, of financing, especially in software, cybersecurity, the community is so small that the chances of you doing one deal with a firm are very low over a whole career. So a lot of those firms have a longer term view. And if you're a known entity to them, if you're taking the time to build that relationship, you can have a hard conversation that says, look, this deal, I have to take care of the employees more, or I need you to give on your preference because the founder is getting squeezed too much.

48:44We can do another one later where we'll have different circumstances, different terms, but I do need this now. If you don't have that relationship, if you don't have that long-term view with the VCs, you're never going to be able to ask for a concession. And that's another important thing that I learned along the way from my big company days. They always had the relationships with the NEAs, the batteries, the Bessemer Ventures, because we were a natural acquirer for half of their portfolio. If you're not that big, you don't have that, but it doesn't mean you can't take the time and effort to build those relationships.

49:20Matt Arsenault:Yeah. One more question to wrap up. What should entrepreneurs raising venture capital today be thinking about if they want to actually close a strategic deal later? It comes down to a real hard view in the mirror of how steep and how fast do you want the treadmill to be. And the biggest logos in VCs may not be the best fit for you as an entrepreneur. So knowing what type of journey you want to take as an entrepreneur, as a leader, founder of the company, that's an important step to take first. and then it is really hard for me to say this as somebody who is full-time employed, the first check might not be the right.

49:58Think about as you're shopping that the interviews that they're doing with you and the investment committees that are interviewing you to give you an answer, you are just as much interviewing them for them to be your board member or your advisor or your partner in growing the business. don't get blinded by the first yes and do your homework on the firms before you start to get to

50:26Matt Arsenault:the investment committee meetings yeah that's a good point like references because you're going to have to live with them on your board that's the tricky part with the vc capital it's like you have a short period to learn these investors and then also they're on your board for this like long-term period versus later on it gets no folks over a longer period of time and know how they're going to be on your board. Last thing I'd ask you is, what's the craziest thing you've seen in M &A? We've done this a couple of times. I know. If I get any more stories out there. I got to come up with a new one.

50:53Matt Arsenault:Good thing you've worked on more than a few deals. One of the craziest things that I've seen, it usually happens around tax or IP. A deal we looked at had a couple of individuals that had built software and we did a code scan and the code scan had copied and pasted notes in it that didn't make any sense to us. We started to ask and it did lead to conversations around IP, like who else contributed? Why would they have pasted in some of these things? Usually the oddities in any deal come from detail of the diligence. And that's where going slow is important. Make sure you're finding these types of things where you wouldn't expect the developer notes section of a code base to have things that you have to ask questions on.

51:42But even there, you can find things. Not to throw out a full promotion at the end of our conversation, but we've been working very closely with SEMA software and they've got some really interesting tools and some really cool things that I find fascinating when we go through their reports. And that's one of those weird things that you do get in getting a full code scan is developer notes. Why would developer notes matter? But they do in establishing IP ownership for small companies.

52:10Matt Arsenault:Yeah, I've heard good things about them. If you reach out to them, tell them M &A Science sent you. They're a great team. I enjoy working with them. So that's cool. That's great to know. That's how you actually found it, was doing the scan with SEMA. Yep. SEMA software. That's a good one to check out if you got to do your deep dive into the code. Those of you listening to this podcast, I just want to thank you so much for taking the time, my fellow women's scientists. I appreciate any feedback. We got topics I haven't covered yet, some criticism. I'll take it. Connect with me on LinkedIn. Until next time, here's to the deal.

52:43Matt Arsenault:What Matt walked through today, the VC valuation mechanics, the liquidation preference math, how to coach a founder through their own risk tolerance, that's not stuff you pick up in a single deal. That's someone who's paid close attention across a lot of deals and kept building on what they learn. That's what an M &A scientist is to me. Someone who treats every deal as something to learn from, not just clothes. And that's the practitioner DealPilot was built for. 400 conversations with people who work exactly that way, the patterns and the judgment calls they refined over a career, organized so you can learn from their experience, not just your own.

53:21Matt Arsenault:If that's how you think about this work, check it out at mascience.com.

53:39Matt Arsenault:Thank you for taking the time to explore the world of M &A with our podcast. We love hearing feedback. Tag us on a LinkedIn post, add a review on Apple Podcasts. We'd love to hear from you. If you need help standing up an M &A function or optimizing one that you already have, we're here to help. And if we can't help you, we probably know someone that can. You can reach out to me by email, Kisan, K-I-S-O-N, at mascience.com, or you can text me directly at 312-857-3711. If you just want to keep learning at your own pace, visit mascience.com for a lot more content and resources. That's where you can also subscribe to our newsletter.

54:24Matt Arsenault:Again, that's mascience.com. Here's to the deal.

54:38Matt Arsenault:Views and opinions expressed on M &A Science reflect only those individuals and do not reflect the views of any company or entity mentioned or affiliated with any individual. This podcast is purely educational and is not intended to serve as a basis for any investment or financial decisions.