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M&A: The prudent exit strategy for VCs and entrepreneurs

Fact: The IPO market has significantly rebounded in 2004 -- over 180 IPOs have priced thus far, with an average return of approximately 30 percent, thanks in large part to Shanda, Volterra and Google.

Fact: There will be nearly as many IPOs priced in 2004 as there were in 2001, 2002 and 2003 combined.

Fact: A U.S. venture-backed company is still more likely to achieve an exit through a strategic trade sale, rather than an IPO -- probably 90 percent of the time. The current market environment requires VCs and entrepreneurs to not just consider M&A as a viable path to liquidity, but plan for it.

Even with the rebound in the IPO market, the M&A market continues to offer greater flexibility and options for entrepreneurs and investors. While venture-backed M&A activity in 2003 recovered substantially over the previous two years, 2004 has shown even greater improvement.

According to Thomson Venture Economics and the National Venture Capital Association, the first three quarters of 2004 have revealed a 59.7 percent increase in total transaction value and a 12.7 percent rise in transaction deal volume as compared to the first three quarters of 2003.

Furthermore, an analysis of the relationship between transaction values and invested capital by VCs highlights the improving strength of the M&A market this year. For the first nine months of 2004, 42 out of 134 transactions with disclosed valuations were at least four times greater than the amount of VC capital invested. These exits are 31.1 percent of the total thus far this year, while over the same period in 2003 they represented only 20.2 percent of the activity. The transactions that returned valuations greater than 10 times the amount invested have been more prevalent in 2004 as well, accounting for 13.4 percent of the disclosed transaction valuations. During the same time period in 2003, they comprised only 4.5 percent.

The catalysts for growth in venture-backed M&A transactions include a recovering equity market, strategic buyers leveraging stronger cash positions, and a renewed focus by corporate executives on future growth rather than reducing costs and capital expenditures.

As market capitalizations improve, public companies again find themselves in position to utilize their stock as currency to finance acquisitions. Conventional wisdom suggests that M&A activity would drop when stock prices are high, but in fact M&A activity tends to be positively correlated with bull markets.

In addition, the events over the last two years focused many companies on internal cost control and organic growth. As a result, steadily increasing profit margins at many large corporations has created cash surpluses that are now being used for acquisitions.

The dynamics driving venture-backed M&A market activity for the first nine months of 2004 are expected to continue into 2005. The growth will likely be moderate, as issues regarding the rate of economic expansion, stock market volatility, and the effects of Sarbanes-Oxley regulation on corporate M&A activity are difficult to accurately predict.

With respect to Sarbanes-Oxley, legislation requires that by the end of 2004, corporate executives of U.S. public companies will be required to represent that their company's internal controls operate effectively, are properly designed and sufficiently in place. These regulations will lengthen due diligence periods associated with nearly all acquisitions, as public buyers ensure that proper controls are in place surrounding the acquired companies' operations.

However, it's evident that the associated increased costs for acquisitions are now viewed as a standard part of the price related to the process rather than an inconvenience, so it should not derail a buyer's acquisition strategy.

Strategic M&A makes the most of a company's value through careful planning that ensures the highest return possible in a given market environment. Successful acquirers rely on strategic fit, careful execution and the right timing to accelerate product and service development, increase profits, and ultimately, increase their market valuation. By and large, acquirers look for all or a subset of the following:

* To acquire products, services and/or technology which are in line with their own, and can be sold to the same customers through the same sales channels.

* To extend their reach regionally or into new markets.

* To stay ahead of consolidation trends within certain industries.

* To take advantage of a new market opportunity through the combination of two or more products or services.

Negotiating deal value is the most critical issue in the M&A process. Acquirers conduct a high level of due diligence as they seek to bring every potential liability to light before closing a transaction.

In order for selling companies to receive favorable valuations in today's stringent environment, executives must be focused on achieving key milestones, generating revenue, driving customer relationships in rapidly growing markets and demonstrating strong leadership in their industry.

A key to achieving a premium valuation is demonstrating significant traction as evidenced by appropriate market metrics, depending upon your company's industry.

For example, in the software industry, revenue growth and gross margin are important metrics, but in the semiconductor industry, multiple design wins drive valuation for companies that haven't earned a dime in revenue. There are a number of characteristics that directly impact valuation, but the following are typically universal for venture-backed companies:

* Offering disruptive technology, products or services that create rapid increases in overall market share.

* Intellectual property -- unique capabilities that acquirers can leverage to gain a market advantage.

* Products or services that allow acquirers to accelerate their growth in revenues or profits.

* Leverage provided by adding blue chip customers and strong sales channels.

In sum, because it is likely that venture-backed companies will be acquired by or merged with another company, VCs and entrepreneurs are wise to consider M&A in a positive light early in the start-up process, rather than just planning for an IPO.

M&A activity can make capital markets more efficient by bringing buyers and sellers together to maximize business valuations, and ultimately increase shareholder value. Ultimately, the most significant advantages that an M&A strategy can offer is the potential for 100 percent liquidity in cash at close and access to an alternative source of liquidity when an IPO isn't in the cards.

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