Value creation is an outcome of building a successful business, not an objective to be set in its own right, says Steven Dunne of Frog Capital Limited.
A business that is sustainably growing, profitable and cash generative has intrinsic value, whether that is as an independent private company, a public company or integrated into a larger group. Whilst it is good to pursue early alignment between stakeholders on valuation ambition and exit timing, realising the value created is often difficult to manage to a specific timetable and so it is important to know how to give yourself the best prospects of having options available when you want them.
Some founders have exit ambitions when they start but few have a clear strategy for how it will happen. Most are caught up in the excitement of exploiting a market opportunity and are rightfully focused on creating a business first and believe that an exit will naturally come when the time is right. Early stage VCs are also often agnostic about exit given their portfolio approach allows them to wait and see what happens in each individual case
Utilising the scale-up phase
The scale-up phase is a great time to re-assess this thinking and scale-up investors like Frog will encourage a debate about exit expectations and alignment between investors, founders and other executive management. Good tech companies can provide early transparency of their progress towards sustainable profit and growth, encouraging both investors and corporates to pre-empt demonstrable value creation in an attempt to gain access to the asset at a lower entry price.
This leads to the first and most important lesson in realising value; you must always be ready if you want the option of taking advantage of an opportunity that arises – it’s never too early to start preparing.
The discipline of the scale-up methodology assists the business to grow from start-up to mature business and it is the same process that makes you fit for exit. The basics of executing on good customer acquisition and retention are still vital to provide the visibility on future growth, but in addition, building a forward-looking value proposition requires actionable strategy, a growing pool of talent and a scalable organisation structure. Many of the risks that a due diligence process would focus on become very easy to address if the company already has good corporate governance procedures documented and adhered to.
The key to both scale-up and exit fitness is being ahead of the curve in investing in high level capacity to spread the load, reduce individual reliance and provide succession planning. As a portfolio director in private equity, one of my most frustrating situations was dealing with an MD who, after his third PE buyout, would simultaneously complain that he had made money for lots of investors but never got to take his own money off the table, whilst at the same time resisting the recruitment of a suitable successor that would enable him to step away.
Build a comprehensive dataroom early
Investor or purchaser due diligence is often seen as test to pass with the equivalent of last minute cramming. This runs the risks of distracting key people from running the business and leaving gaps that can be exploited in the M&A game but also invests time in creating some important documentation and structure at a point where it is a separate exercise from helping the trading of the business. In both the companies I joined as a CFO, I started the process early of overlaying a dataroom request list and identifying what was and was not available to build an in-house dataroom. We then prioritised filling in the gaps in a methodical way based on the assessment of where the changes would have the most positive impact on trading, employee welfare and productivity or legal risk.
Preparation is vital because purchaser due diligence is an order of magnitude tougher than for fundraising.
In one of the companies, a contingent debt collection business, we differentiated ourselves by the integrity and quality of the process, but only by introducing Total Quality Management techniques did we create a comprehensive documentation of what we did differently. This made it easier to ensure consistent adherence and provide a simple confirmation of the difference in due diligence. Preparation is vital because purchaser due diligence is an order of magnitude tougher than for fundraising and you will be very exposed if you haven’t developed sufficient capacity in your senior team and resilience in the business to continue high level performance despite distractions.
Assess progress with sustainability in mind
Many growth businesses get focused on the valuation of the next funding round and treat each uplift as a success in its own right. Of course, it is important that investors see progress, but they are looking forward, not back, and high valuations put large expectations on a business. An easy way to assess progress is to understand the minimum growth needs after a funding round to justify the post money valuation excluding the cash. Based on some heuristics on the relationship between growth and multiple, a £10m round on a 7 times revenue multiple for a £5m revenue business requires revenue to grow by 43% to justify the post money valuation, a £15m round would require 54%. This calculation provides the theoretical minimum required to have a next funding round at an increased valuation.
Being in control of your own destiny is the only way to ensure that value creation is sustainable and not a bubble.
If you don’t yet have visibility on sustainable, profitable business then the journey from one funding round to the next can become the whole focus, knowing that if the growth isn’t sufficient to demonstrate a value uplift there is a good chance the previous value creation is impaired and in the extreme (but not that uncommon) scenario, lack of funding sees the company fold with zero value. Being in control of your own destiny is the only way to ensure that value creation is sustainable and not a bubble.
At Frog, we believe that encouraging our portfolio to be fit for exit is wholly aligned with the broader scale-up methodology principles that helps build resilient businesses where CEOs have control of their own destiny.