How And Why Subscription Companies Get Acquired: M&A Overview

The dream of most startup founders is to one day sell your company. Getting acquired is a potentially life changing event that can make millions of dollars for you and your family.

The thought of it can get you through the day to day grind of growing a company and makes all of the hard work tolerable.

In the theme of "starting with the end in mind", this week we're talking about how M&A transactions work for subscription companies.

• What are investors looking for?
• How are companies valued?
• How does the M&A process work?
• What are the things that can go wrong?

To dive into this, I interviewed Eric Crowley who is is a partner at GP Bullhound. If you want to understand how and why consumer subscription companies get acquired, there is arguably no better person to ask tha Eric.

He's the partner in charge of the Consumer Subscription Software practice, has advised on over 2 billion dollars of transaction and helped guide companies like AllTrails and FATMAP's acquisition by Strava.

I was struck by a few things during this conversation.

A lot of start ups consider an acquisition as the finish line, when in reality it is a step along the journey. The valuation of your company at will mostly depend on what will happen after the acquisition.

Companies are only buying you because they think that they can get make a lot more money by owning you than the amount that they are going to pay for you.

This feels so obvious now that I feel dumb for not seeing it before, however so much of what a company will pay to acquire you will be driven by the value that they can get from owning you.

The implication of this is how important the match making and story telling process of selling a company is. I learned a lot.

Here's the interview:

Q: What drives the value of a company?

Eric: So there are a few ways of thinking about valuation, it's both a science and an art. The science is looking at public company comparables and taking the average. So if you’re a subscription company in the dating space, you’d be compared to Bumble, Match.com, etc. 

We like public market comparables because those companies are valued every second by thousands of people. The normal method is to take the average of the comparable, but that’s a bit lazy honestly.  A better method and the art of it is diving into the individual nuances of each business. 

How fast are you growing? What are your gross margins? Are you producing original content?

Netflix for example produces a ton of very expensive content, so they have lower gross margins.

AllTrails also has a lot of content, but its user produced and allows them to have higher gross margins. This will make them more valuable at the same revenue number. 

All of that said, my advice to entrepreneurs is not to think about valuation until you are ready to sell. 

I can show a company to 10 different potential buyers and get 10 different prices, so there is no perfect answer.  Your goal is to get one perfect price from that perfect partner. And that is the price that matters. The other 9 don't matter. 

So if you use averages again, right, the averages of the 10 don't reflect the true value which is what you sold for which is with the number 10 best partner 

‍

Q: Why can valuations be so different?

Eric: So it all depends on the buyer, because your value is set by the reason they’re buying your business.  

They're not just giving you money to say to you “congrats, great job”. They are buying your business because they think they are going to make more money from it then they're gonna pay you.

For example, if the buyer is a big company and has plenty of revenue, they don't need your revenue but you have a really cool product that they can cross sell to their customer base. . 

I've seen that happen in consumer subscription where a client of mine had some fantastic technology, the bigger buyer had more users. So what they were they were able to take that technology and expand it out to all their users and increase their subscription rates. win win for everybody. 

Contrast that with a private equity buyer, right who will look at it through the lens of investment and cash flow. They'll value it based on how big it could be if we put another $5 -10 million behind it to grow. They really do care about revenue because your company is going to be one of one businesses in their portfolio that they're focusing on. 

‍

Q: When is a company big enough to start thinking about selling?

Eric: It's a great question, one that we get asked a lot and unfortunately, there's no perfect answer. 

Let's say we have an entrepreneur that has been building a company for years, it's gotten to a good scale and they are thinking about a sale. 

We typically flip the question back on the entrepreneur and want to understand more about their goals. What is their north star? Where do they want their life to be? Once we know this we can start to work backwards from there. 

Let's say that you want to have 10 million bucks in the bank and not have to work anymore. This implies a company of a certain size.  If you live in a high tax state like California, you’ll need to net 20+ million dollars from the deal and walk away with 10 million after taxes and the cost of doing the deal.  

You likely don’t own 100% of your company either, so your percentage of the company needs to equate to 20 million dollars of enterprise value.  Starting with your goals allows us to tell you if this deal is realistic or not. 

From our side, we have a minimum fee, you know, it's north of a million dollars for any deal we do, because batsman banks are the least scalable organizations out there. 

I can  only work on four deals a year, so I have to pick my deals very carefully because we only get paid if a deal closes. We do really good work, always get great reviews, but we're not cheap.

To be a client, you need to sell for large enough that you're not mad about paying a million dollars. If you're selling for 2 million, you don't want to hire us. If you’re selling for 10 million, you probably still don’t want to hire us. But if you’re selling for 50-60 million, then it starts to make more sense. 

‍

Q What should founders do when they start to think about a sale?

Eric:  If you’re thinking about a potential deal in two or three years, you want to start meeting bankers ahead of time. Don’t wait until the last minute to start that search. 

You want time to not only get references but also talk to those references. Really understand the pros and the cons, like did that advisor help you? Where do they fall apart? Where did they do great?

Start to ask around, get connected, and find the right partner because you’re probably going on a six month journey together. You don’t want to hire someone after quickly looking at their website and deciding they seem reputable. 

The main thing founders should always focus on is building a durable business.  A lot of people can get lost in the window dressing, finding ways of making their KPIs or financials look slightly better. But the most important thing from the eyes of they buyer is that they want to get a return on the business that they are buying. 

Don’t start to cut corners with marketing, product development, hiring, etc. Continue to add clients even while the M&A process is happening. 

Secondly, as you’re starting to think about a sale, really make sure you’re capturing the right data and that you’re confident in it.   Ask your banker what the top 10 KPIs an potential acquirer will want to see. We know what buyers are going to ask 90% of the time. 

‍

Q: What metrics and KPIs do investors care about? 

They want to know everything to model out how your business is performing. Funnel metrics, activation rates, the source of your traffic, where you are spending marketing dollars, the distribution of your marketing channels, partnerships, installs per month, all of the corresponding conversion rates. LTV to CAC ratios. Cohorted conversion and retention rates, how well those user retain and pay in time, churn rates in detail. 

Assume that buyers will go very, very deep into your numbers which is why its key to be confident in them. 

From our perspective, we need to know the company almost as well as you do, because we might talk to 50 different buyers, each one will look at this company through a different lens. 

The reason why you hire a banker right is to know what are the hot buttons for each one of those buyers. One buyer might really just care about how much EBITA you can produce. They might be growing 10% a year  and they need to buy somebody to get to 30% a year, so they are buying you for revenue. 

Another buyer might be interested in cross selling, so they need to understand how that might go. If they are looking to fully integrate you into the company, what to know if your running on AWS or Azure? What language is your product written in? What other systems are your 

80% of the story doesn’t change, the numbers don't change, the KPIs don't change, the product doesn't change. But the last 20% needs to address the questions of each potential buyer. 

But the story can change a little bit around what's the roadmap right? What could they build that integrates into that buyers category? In a go international expansion verse heavy, heavy focus in North America. Is the team mostly focused on English language, Android, iOS monads. All that stuff is, you know, kind of in the future. And so then consequently, you're kind of thinking about what's the story that fits with each individual buyer investor, however, it makes whatever makes sense.

‍

Q: What is the process like of selling a company?

So we generally get one of two scenarios,  a proactive process or reactive process when founders reach out. 

A proactive process is when the founder reaches out to us and wants to sell their company. They might be turning 50 and looking at a path to retire or step back. They have some sort of timeline in mind. 

A reactive process is when a company is heads down building, and someone reaches out to them about an acquisition.  It might be a private equity group that has been hearing great things about the company and wants to explore a sale. 

The thing that I tell founders is to plan for six months, but be prepared for longer. The best case scenario for running a full m&a process is about four months, that means from the first day you call me to when the money lands in your bank. 

In a six month process, the first month is typically prep. That's me and my team poring through information, looking for weaknesses, identifying strengths, really making sure we understand the story. During that time we're thinking about who could be the right buyers. 

In months two and three, we start talking to buyers, exploring buyers that might be a good fit and starting the conversations of selling the business. By the end of month three, we probably have a list of people who are interested in the company. Then there is a matching process, which is like dating and you have to get to know each other.  

There are probably some management presentations, you spend some time discussing, you have dinner together so you can feel each other out.  

You then select the right partner for you and we start the negotiation process. When that ends, you get the final offer and that kicks off due diligence. 

This could be one month, it could be three months or longer. They are looking at everything, legal, patents, technology, the product, etc.  It is really hard to predict what will happen in due diligence. 

So for example, I had a client that had a patent who patented their product in Canada and the US, but didn’t realize that their US patent lapsed. We had to refile this patent and wait until it was reaffirmed. There was nothing we could do to make the patent office move faster, the whole deal just had to wait and couldn’t close until that patent cleared, because that was a huge issue for the buyer

‍

Q: Are there common reasons that a deal doesn’t go through?

Eric: If a deal doesn't close, 80% of the time it is because the company has stopped performing. 

Either their market gets really tough, competitors come in or the founder or management team took their eye off the ball and missed re signing a key client.  

If you told the buyer that we’re gonna do $30 million in revenue this year, and you do $25 million, that's a tough conversation to have because they valued you based on the $30 million.  So now the deal might need to be renegotiated, which could bring up other issues. 

Other things that I have seen are where you’re exposing the buyer to liability, this has come up a few times around privacy. So if you’re not handling privacy laws correctly in each country. We had a a deal stall for three months because we had to have every new user go through it and accept the new privacy policy. 

If your company isn’t going to be sellable, a good banker will tell you that up front. Most legit bankers only get paid if the deal goes through, so they won’t take you on as a client because they don’t get paid unless the deal closes.