In part two of this three-part article, we discussed the following critical steps that should be included in the positioning process: operations assessment, business model analysis, financials review, and preparation of a pro forma. Here we will discuss the final three of these critical steps. Whether you are seeking a full exit or looking for a capital partner who would leave you responsible for continuing the businesses operations, these activities are intended to shorten the sales cycle and improve the business’ value proposition.
Step #5: Create a Business Plan
Now it’s time to create your business plan. The business plan is the “book” that is handed to serious prospective investors. It is important because it is the takeaway they will likely take back to their board. The investment banker or broker you engage will write a plan as one of their services. Don’t wait for them! Creating a draft version tells them how you see the business, including the market you sell to and your competition. If your business model is unique, this is how you will convey that advantage. Your banker or broker will do their own analysis and write their own version, but they will start with what you provide them. This exercise forces you to put your thoughts on paper, which helps to focus your story.
Step #6: Prepare for the Due Diligence
Positioning is also the time to start preparing for the investor’s due diligence. Due diligence includes three facets: financial, legal and operations. In general, financial due diligence focuses on the past performance of the business, legal due diligence focuses on the current legal status of the business, and operations due diligence focuses on the future performance of the business.
Operations due diligence is where the most mistakes are made. Until I published my book, “Operations Due Diligence – An M&A Guide for Investors and Businesses” (published by McGraw-Hill), most investors could not correctly say what constituted an effective operations due diligence. (“Operations Due Diligence” was also the subject of another two-part article: The Benefits of Effective Due Diligence for Investors and Business Owners and 9 Critical Areas for Effective Due Diligence.)
Collecting the documents needed to support due diligence can be a daunting task. In the past this was a paper collection, but today your due diligence collection is more likely to be an online virtual data room (VDR). When there are multiple investors looking at the business this is an advantage because it cuts your paperwork production. It can also be a huge disadvantage because VDR repositories can be searched easily, meaning it is more difficult to hide the needle in the haystack to keep it from being discovered.
The ownership of many businesses gets cloudy over time. This is particularly true during the startup phase. Entrepreneurs are notorious for promising their chief engineer part of the business in return for getting their first product delivered, but they are terrible at putting it in writing. When it comes time to bring in an investor, those promises are often forgotten by the entrepreneur, but not by the engineer. Startups are not the only problem. The failure to put tight, limiting terms on options can lead to surprises when someone decides to exercise some old options now that the business is about to expand. Investors, of course, won’t accept this type of dilution. Cleaning up the ownership of the business is a time-consuming task that requires some forthright conversations that can be difficult with people you still depend on.
Step #7: Cleanup the Ownership
Cleaning up any outstanding legal issues is an absolutely critical positioning task. It goes without saying that any outstanding litigation must be brought to a close. There are also many types of contractual agreements that need to be reviewed. Many third party agreements include terms that require notice of any significant ownership change. This is VERY prevalent with software businesses where critical third party components are used. Once the third party is notified, and they know you are facing an M&A event, they will use this clause to renegotiate the price of their product. Your business model will take a big hit because it forces you either to increase development cost and product pricing or lower earnings. This has become an all-too-common form of legal extortion! If the product is being updated regularly then these negotiations should start early. Or, better yet, be aware this has become a common practice and never allow these terms when you enter into third party agreements. It will take time, but all agreements and contracts must be carefully reviewed as you position the business.
Step #8: Create a Hard Asset List
Creating a hard asset list can be time consuming and difficult to maintain, but this is also an important positioning step if you haven’t maintained a current asset list. It will not only save you time when you’re trying to close a deal, it can save you some embarrassing mistakes. This is particularly true if you are only spinning off part of the business. You must identify what hard assets are included in the deal and what remains behind.
There are many other less critical activities not mentioned here. Deciding to find a financial partner or to exit your business is not a light decision. It should always be made with plenty of forethought, according to a plan, and not when your back is against the wall. You must perform these activities before entering into the sales process. You never want the sharks to smell blood in the water. Positioning your business is not a passive activity. Make your decision early and drive toward it.