Anthony: What are the odds that a technology start-up realizes a liquidity event by way of M&A rather than an IPO? 

Jeff: CEOs and Boards of technology start-ups are constantly challenged by the hard strategic and financial choices they need to make in order to maximize the value of their company. Should they position it for an acquisition, or should they seek additional funding in order to maintain their independence? As these choices are being made, one must keep in mind that M&As have been more common than venture-backed IPOs. In fact, historically, there have been roughly 9 M&As for 1 venture-backed IPO, except during the Internet bubble when we experienced an unusually higher percentage of venture-backed IPOs. Currently, it is virtually all M&As, but going forward, I expect us to go back to a 9 to 1 ratio when the IPO market recovers. 

I should also add that the M&A alternative is looking increasingly more compelling, as it is taking significantly longer for companies to go public, and the IPO criteria have returned to the more stringent historical standards of: 

Finally, there have been more than 12,000 companies funded by venture capital since 1998. Only a few thousand have failed to date, which leaves an enormous overhang of companies, some of which will go public, but the majority of which will either be acquired or dissolve.  

Anthony: What is the profile of an attractive acquisition target nowadays? 

Jeff: Buyers are looking for transactions that a) add revenue, b) are accretive to earnings, c) are core to their strategy, d) provide cost synergies, and often e) are multi-stage. They are avoiding transactions that add to their expenses or involve pre-revenue technology companies unless they are priced at distressed levels. 

Anthony: There are a variety of valuation methods used by investors. What are the most common methods and which factors drive the use of one vs. another? 

Jeff: There are four main valuation techniques:

1.  Discounted Cash Flow

2.  Financial benchmarks including multiples of sales, earnings, cash flows, and EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization)

3.  Comparable M&A deals

4.  Liquidation or replacement value 

Depending upon the situation, any one of the above methods may rise to the top. What will determine the method used depends on various factors including whether: 

Anthony: How can entrepreneurs create more value for their companies? 

3.  Roll-up with Platform Focus – acquire or merge with competitors or complementary players.

We do expect acquisitions of technology start-ups by European companies to pick up in the next 12 months, however.  Given the attractive economics and significant appreciation of the EURO against the Dollar, especially in the last quarter, it’s a great time to acquire US technology companies.

Anthony: Do you have a winning formula for early stage start-up entrepreneurs who would like to prepare their company for an acquisition from the start and optimize valuation? 

Jeff: Focus not only on what the customer wants to buy, but also on trends, products, and strategic direction of your largest competitors, as those competitors are the most likely buyers of your company. Simply building products that compete directly with your largest competitors won’t make you an attractive acquisition target. Your competitors can easily go after your market share by throwing an armada of salespeople your customers’ way.  

You need to map the ecosystem and know your buyer and the market you are addressing very thoroughly. You also need to have a new and unique competitive advantage, which will make you a financially more compelling alternative over developing such an advantage in-house. Identify every strategic partner and build the type of business that is as attractive to the ultimate corporate buyer as it is to the customer. Finally, make capital efficiency a top priority and seek to minimize your time to profitability. 

If incorporating your business in Delaware is in your future plans, this article may help you save thousands of dollars.

The Delaware Franchise Tax can be a sticker shocker if you have not planned your capitalization properly, or if you are not aware that there are two methods allowed to compute the franchise tax.

When you receive your Delaware Annual Report, you may see a significant amount of tax due - don't panic just yet. You might be able to compute your tax using a different method which could result in a substantially lower number. The tax is due by March 1, with a current quarterly installment requirement for taxpayers owing more than $5,000.

As of the date of this article, there are two methods allowed for the computation of the Delaware Franchise Tax:

1-     the Authorized Shares Method

2-     the Assumed Par Value Capital Method

In the Authorized Shares Method, you only use the number of authorized shares to compute the tax.  In the Assumed Par Value Capital Method, you must also use all issued shares, the par value, and your company’s total gross assets (as reported on the U.S. Form 1120, Schedule L, or your federal corporate tax return.)

The website for the State of Delaware offers a clear explanation of how these two methods work (visit http://www.state.de.us/corp/frtaxcalc.shtml.) It also includes an excel spreadsheet that estimates the tax based on your parameters for 2003 (visit http://www.state.de.us/corp/taxcalc2003.xls). If you are reading this article several months or years from now (Feb. 2004), please check that the above due dates and links are valid and applicable to the calendar year you are interested in analyzing.

Below is an example illustrating how, for the same company, the Authorized Shares Method can result in a franchise tax of $68,800 as compared to $500 for the Assumed Par Value Capital Method.

Let us consider the case of a start-up, which for the entire 2003 year had 7,000,000 issued shares and 10,000,000 authorized shares of common stock respectively, with a par value of $.01. It also had 1,000,000 in issued and authorized shares of Series A Preferred Stock with a par value of $.01. Its total gross assets as of 12/31/2003 were $1,000,000.

Using the calculator provided on the website of the State of Delaware, the estimated tax is:

$68,800 for the Authorized Shares Method

$500 for the Assumed Par Value Capital Method, and you are allowed to select this method to compute your tax liability.

What caused such a big difference was the company’s choice to assign a par value for its stock, and the careful selection of that par value in addition to the relatively small magnitude of its total gross assets. Without the par value, the company’s tax liability would be $68,800 - not a trivial expense.

If you like to play what-if-scenarios with spreadsheets, I suggest you open the calculator and input the above parameters, then start changing the number of shares, the par value, and the total gross assets. You'll notice that the tax amount will fluctuate dramatically all the way up to the maximum tax for 2003 of $165,000.

Please click to see a table illustrating the sensitivity of the tax to the various parameters. The numbers in yellow correspond to the parameters I have modified from the above example and the resulting updated tax amounts for each method.

Venture Momentum, Inc. is a financial management firm that assists early stage venture entrepreneurs in building a strong financial organization and laying the foundation for successful fund raising. To learn more, give me a call or visit http://www.venturemomentum.com