How do you plan for M&A?

Happy St. Patrick's Day. Please find below my guest post on start-up company M&A from Ask the VC.

Question: How do you plan for M&A? Trying to build our company, thus far we went the regular path – market research, sales projection models, expenditure / P&L models, potential products/product lines and the like (text book?), but many people we met told us ("shouted") that we should plan for a strategic partnership/ M&A, how do you do that? Should there be a special business plan?How does a P&L look in that case? How do you plan the selling of your IP to a large company? Selling after you have a finished product? Selling the company after initial sales? Letting the company grow a bit more? Is it good practice / healthy to plan your business on somebody buying you? Will it be acceptable to prospective investors/ VCs?

Plan for Independence. There is a famous VC saying, "companies are bought and not sold." Accordingly, the best "plan" is to plan for success as an independent company.

The company’s operating plan, technology road map, and executive team should not focus on unnatural acts, in the hopes of attracting a buyer, but rather on building a company with the potential for independence. Companies built to "flip" often flop. They often flop due to the fact the team is not truly committed but, instead, looking for a quick buck. Bad motives drive bad behavior.

A fundamental concept that helps focus management on building to independence is optionality, or BATNA – which is MBA-speak for "best alternative to a negotiated agreement." BATNA is a fundamental tool for understanding negotiating leverage and strategy. If you work to ensure you have a BATNA – for example continued independence or a higher offer – the company is able to negotiate from a position of strength. If no BATNA exists (i.e. the choice is between a fire sale or running out of cash), the company is at the mercy of the buyer and the negotiation becomes an exercise in Russian roulette. Always have a BATNA.

Be Prepared for Acquisition: Sourcefire ("FIRE") went public this week. Since the last security company went public – NetScreen – there have been over 250 security M&A transactions.

So what?

While the security software market is an extreme example, it is far more probable that a successful tech company will be bought rather than go public. Accordingly, while no special plan for sale should be developed, it is highly logical to expect M&A to emerge as the path to liquidity.

While VCs believe "companies are bought and not sold," acquirers tend to believe that "successful partners make the best acquisition targets." Successful partnerships are characterized by

• a history of successful joint customer engagements,
• successful technical integrations and co-deployments,
• a joint roadmap,
• co-marketing and sales traction, and
• management teams and team members with a track record of collaborating to reach shared objectives.

A great example of the partner-to-buy model is SAP and Virsa, although there are many such examples.

Keep Good Records: Finally, M&A is a diligence driven exercise. The final cliché is that "good record keeping makes for good diligence and good diligence makes for expedited outcomes." Good records include:

• Articles of Incorporation/company charter
• all Board minutes, contracts, signed employee assignment of IP forms
• capitalization table
• option plan records
• prior financing documents
• audited financials
• patent filings
• documentation relating to litigation, assessments, or claims

Any material gap in records will either 1) delay the sale process and/or 2) will lead to a higher escrow to offset potential liabilities that may "appear" post-close.

In summary, all clichés are common sense and the M&A related clichés noted in this post are no different:

• build companies for independence (always have multiple BATNAs),
• partner well,
• keep good records

Hedge Funds and Venture Capital

Brad Feld and Jason Mendelson kindly asked me to serve as a guest blogger on Ask the VC.

Today's question and my response follow. The original post can be found here.

Question: As the alternative asset classes continue to converge, there has been growing evidence of hedge funds looking to be more involved in venture (both passively and actively). As an early stage venture capitalist, what are your thoughts on this? Are you seeing the trend? Have you considered partnering with any hedge funds, and if so do you view hedgies as primarily a source of passive capital or are they demanding/receiving strategic places at the table?

Economic theory can be used to explain the phenomena described above. The theory in question, "economies of scope," states that a reduction in per-unit costs is possible via the production of a wider variety of goods or services. For platform funds, the incremental cost of the nth fund is significantly less than the cost of establishing and managing the first.

Accordingly, alternative asset platform funds – Carlyle, Bain Capital, Pequot Capital, Blackstone - are aggressively pursuing economies of scope in raising funds that leverage their LP relationships, back office systems, strategic relationships, etc Platform funds are aggregating assets in ways that maximize their resource base and economic interests. Whether the interests of LPs and the platform fund’s principals are aligned remains a more complicated question.

See my earlier post on alternative asset platform companies here. In short, I am not a big fan.

The center of gravity for platform players largely falls into two camps- private equity firms and hedge funds. The question above accurately reflects the fact that hedge funds are increasingly showing up in later stage deals. As an example, see $60m Brightcove financing led by Maverick Capital.

First, this is reminiscent of the late 1990s when the mezzanine market proved to very lucrative. Hedge funds piled into pre-IPO rounds in hopes of buying six to twelve months ahead of the IPO.

Second, one needs to separate the strategic vs. opportunistic players. Carlyle and Pequot, for example, have made long-term commitments to the venture category. The two firms built dedicated venture teams investing dedicated venture funds; not hedge fund managers investing "cross over" funds in one-off private deals. The opportunistic players’ presence in the market is tied to the economic cycle rather than to a secular commitment to the asset class – ie. fast money in, fast money out.

Finally, the decision to consider an investment from a hedge fund needs to be context sensitive. If the company is looking for mezzanine financing, a passive hedge fund investment makes perfect sense. The goal of the round is to raise expansion capital at the highest valuation and most company-favorable terms possible.

If the company is several years away from a liquidity event the decision is more complicated – I would suggest weighing the following variables in evaluating a hedge fun investor– will the investment be made from a dedicated venture fund, is there a dedicated venture team, does the fund keep adequate reserves for follow on rounds, does the company need an active net new board member, if so, could the partner in question add value, do they have referenceable portfolio companies and CEOs that can speak to their strengths…? The investor must be judged on their merits as value-added private company investors, not as easy sources of capital.

We would absolutely consider working with a hedge fund in a later stage round, however, we prefer to syndicate A round deals with likeminded investors with a successful history of A round investing and a long term commitment to the early stage venture asset class.