The Most Common Transaction Process Mistakes

Founders are often told what to do prior to and during a transaction process…what about what not to do? Here are some of the most common mistakes we observe B2B software companies make not only during a poorly run process but leading up to one (which can sometimes be just as important if not more!). This isn’t meant to be an exhaustive list just what we’ve observed as the typical hiccups that can lead to a suboptimal outcome…and more justification for hiring a good advisor!

Most Common Pre-Process Preparation Mistakes

1) Failing to get your financial data in order

Early-stage companies usually have messy financial data. They’re operating with lean teams (especially for the finance function) and tend to prioritize growth above all else which can lead to data integrity issues. Investors get this…to an extent. They’re not expecting public company quality financial reports but there’s still a quality threshold below which a few problems usually arise. If the data is very messy worst case an investor may bow out completely because they’re worried the data they’re bidding on isn’t reliable enough to ascertain an accurate valuation. Even if an investor gets comfortable with relatively messy data it can eventually lead to an elongated exclusivity period as they clean it up with their own third-party accounting firm (time kills deals!). Messy data can also lead to re-trading during exclusivity if investors discover the P&L / KPI data they relied upon for their initial bid was inaccurate. Founders often say something like, “don’t worry we have audited annual financials for tax purposes”. Unfortunately, this usually isn’t good enough. You need an accurate P&L on a monthly basis - this is vital to a bunch of different financial diligence topics such as: analyzing KPI trends by customer cohorts, figuring out what the bookings to cash flow waterfall looks like, determining how P&L line items are trending, examining seasonality, etc. So how do you properly prep your financials? We highly recommend engaging an accounting firm with experience in SaaS specifically to perform a light-touch Quality of Earnings report (“QoE”) ahead of launching a process. SaaS experience is important as the accounting firm well be well-versed in what KPIs investors will be looking for and how to properly account for GAAP revenue according to various software-specific accounting rules (e.g. ASC-606). While somewhat expensive it almost always pays for itself and then some in terms of a more efficient process with a higher valuation. We have close relationships with some of these QoE firms and can provide intros.

2) Poor data room preparation for eventual diligence

Founders often underestimate the level of diligence that will be encountered during a process. Sometimes even worse founders that have raised a seed round or perhaps small Series A end up with false confidence on what to expect without realizing that for a large minority check or majority recap the level of diligence is much more stringent. There are four major buckets of diligence: financial (alluded to above), business, technical, and legal. Each one can lead to their own process pitfalls and so it’s critical to prepare for what’s coming ahead of launching. Regarding legal diligence, are all your third-party contracts current? Do you have any lingering legal disputes that have open ended financial exposure? Regarding technical, are all third-party licenses being paid for? Are there any data security vulnerabilities? When was the last time (if ever) you conducted a code audit to make sure? These are just a few example topics that we’ve seen lead to major issues during a process. Business diligence is the largest bucket and tends to be the most idiosyncratic to the company and sector. Per above financial diligence relies upon clean data. Investors will certainly hire their own QoE firm to validate any work you’ve done pre-process but regardless having your own QoE done will go a long way towards ensuring smooth financial diligence.

We can help with providing an example diligence list (ideally well ahead of launching a process so you can put systems in place 18+ months ahead of time to track data investors will be asking for) and guiding you through what might be considered material vs. not so you have a sense for the scope and detail of what will be required vs. “nice to have”. Just before launching a process, it’s prudent to pre-populate a data room with the most important headline items. This also prepares you to be nimble if parties float preemptive offers. Remember - time kills deals. It’s best to maximize process speed where you can.

3) Overweighting inbound interest

A common refrain we hear from founders is “I’m not sure I need to go to market, I’ve already got a handful of firms circling who seem super interested. I get emails every day from other firms who want to meet.” What founders sometimes fail to realize is in recent years investment firms have doubled down on trying to source proprietary deals. What does this mean? Deals sans advisors. Why? A speedier, more certain close with a better (i.e. cheaper) valuation. What does this mean in practice? It means once you cross a certain employee threshold you’re almost guaranteed to get bombarded by investment firms telling you how great you are, how they’ve been tracking you for years, how they have a thesis in the space, etc. etc. There’s nothing negative about this per say but you shouldn’t conflate it your company being particularly unique or attractive to these firms especially if they haven’t done much diligence or seen much data (which we wouldn’t recommend providing at this stage anyway). They’re in the business of building proprietary deal pipeline and reaching out to founders directly is integral to this strategy. How can we help manage this inbound? We’re more than happy to opine on which firms might be worth having a conversation with based on what sort of transaction and partner you’re aiming for as well as help you craft a script in order to ensure you don’t taint your process with messy messaging. Which leads us to our next common mistake…

4) Divulging too much information to investors too early on

Say you chat with an investor and the conversation goes well - what almost always happens next? A request for data. Historical and projected P&L and revenue by customer are the most typical requests. Investors often say something like, “just share whatever is off the shelf no matter how messy, we’re happy to take a look at what’s easily available.” We cannot emphasize this enough - it is very rarely a good idea to provide data at this stage. There are a few reasons why…first off, you’re usually degrading your negotiation leverage by seeming too eager. Secondly, and related to point #1 above, your data is likely messy and inaccurate. Third, specific to projections, you will almost always be held accountable to whatever forecast you share no matter how preliminary. You told an investor you’d grow 75% this quarter and it ended up at 60%? Still a great growth rate but now they’re spooked. All that said, if you really like a certain investment firm and want to whet their appetite by providing some data there are methods to ways to arm them with enough information to propel them towards a potential preemptive offer while retaining your negotiation leverage. We’re more than happy to help here in walking you through the best ways to engage at this stage.

5) Retaining a general corporate counsel

Many founders have a corporate counsel they’ve worked with on general corporate matters and so are inclined to have them handle the legal work associated with a transaction too. Makes sense - they’ve built a trusted relationship and the lawyer usually says, “I can do M&A, no problem.” This is not a good idea. You’ll be interfacing with sophisticated M&A attorneys representing the other side - you need someone in your corner who is just as well versed in the complexities specific to capital raising or M&A. Attorneys specialized in deal work for a reason - deep domain is hard to obtain as a general corporate lawyer. Negotiating a term sheet or stock purchase agreement (“SPA”), reviewing and negotiating post-close management contracts, assisting with legal diligence…these are all skillsets that only attorneys that specialize in transaction work will be good at. Using a general corporate attorney at best will likely bog down the process (again, time kills deals) or at worst could result in off-market terms in the term sheet or SPA that end up cost you millions down the road.

Most Common Process Mistakes

1) Failing to properly position (with data)

Many founders believe they are better equipped than any advisor to properly position their business, after all, they are the one in the trenches living with their strategic successes and mistakes on a daily basis. It makes sense, at least on the surface. The issue is that marketing your business to customers or even seed investors is a completely different motion vs. marketing to larger check growth equity / private equity firms and/or strategic acquirers. A good advisor has a sophisticated understanding of exactly what KPIs will matter most to which parties (and so, in turn, how to optimize the investment story with data) and how to best mitigate against any perceived weaknesses based on pattern recognition from past deals and deep knowledge of how each counterparty type assesses opportunities. This is almost always beyond the purview of founders who tend to have little experience in this realm. A good advisor understands that the financial model that may have functioned fine operationally is likely to need significant retooling to be presentable to investors who have a very specific framework for how they expect to see a software P&L. Beyond the basics, there are a myriad of other positioning nuances that founders might not be familiar with - e.g. how to best convey growth strategies, communicating management’s preferred go-forward roles, potential for competitive threats, the total addressable market vs. serviceable market, selling the potential for a buy and build M&A roll-up play, educating investors on possible acquirers at the end of the hold period, etc.

2) Missing Budget

Founders often ask what the single biggest threat is to a successful transaction process is. The answer is easy - poor business performance vs. budget while in market. What does “poor” mean? For most investors it means underperforming your forecasted budget (both topline and margins). This is why it is of paramount importance that your forecast deftly balances (a) not leaving money on the table by vastly overshooting your forecast with your actuals during the process and (b) avoiding the ignominy if having to explain away missing budget. This is a tough bargain to strike. A good advisor will work with you to build a bottoms-up forecast with credible data justification (e.g. historical pipeline conversion that feeds into forecasted S&M spend) that aims to be slightly conservative whereby you end up exceeding budget by 5-10% or so. This provides nice process momentum while not leaving too much money on the table as investors don’t tend to up their bids dollar for dollar if you exceed by a huge percentage. This brings us to the execution piece that feeds into actual performance after the forecast has been released to investors. Founders who are bogged down with running their own transaction process very often become too distracted to ensure the team is executing per usual and so we’ve seen countless examples where business performance starts to flag as the time dedicated to running a process ramps. A good advisor protects against this by giving you massive time leverage. Creating marketing materials, interacting with numerous investors on multiple calls, managing a dataroom, negotiating offers, etc. is extremely time consuming. You’re already busy as is, imagine layering this atop your day job.

3) Failing to have a crisp, consistent message on desired transaction

As a founder who may have talked to investors you’re probably accustomed to hearing this question: “so what are you guys looking to do?”. This question is intended to figure out how prescriptive you are in knowing what type of transaction you’re seeking. It is important that your answer to this question become more specific as you move deeper into a transaction timeline. I.E. if you’re 12-18 months away from launching a process and just getting to know folks it’s totally fine to say something like, “we’re not quite sure yet - just beginning to explore what our options are and depending on what we learn we could lean minority growth or majority recap”. If you’re a week out from initial bids and investors are digging into diligence, then being vague has downside. Investors’ time is finite - they don’t like to spend it on companies that are unsure about what transaction they’re seeking. So you need crisp messaging on this. But you also need consistency - unsurprisingly the early-stage SaaS investment community is pretty tight knit - if you tell one firm you are committed to a majority deal and another than you’d prefer a small minority round odds are word will get around that you’re spreading conflicting information. We’ve seen this many times - investors that may otherwise have been bullish on a business decide to disengage because they’re worried the company isn’t sure what it wants to do. That said, we understand that sometimes it’s hard to have a cut and dry answer on exactly what type of transaction you’re seeking - even deep into a process. In that instance we’d be happy to delve into the nuanced ways you can optimize your messaging to ensure maximum optionality without sacrificing investor interest.

4) Glossing over the differences in investment firms

We get it - whether growth equity, private equity or anything in between these firms can seem like carbon copies of each other. Similar sounding names, website slogans, email verbiage (how many are “operationally focused”?)…that said there are actually huge differences that are extremely important to appreciate as you structure your process. Each founder tends to have a specific transaction goal in mind (or at least should especially by the time the process launches, see above) and so it’s critical that the founder and/or advisor on behalf of the founder has a detailed understanding of which firms should be included in the process outreach and why. Some firms are efficiency / EBITDA focused; others may be more inclined to prioritize aggressive growth. Some firms will pay premium multiples but only for companies with sterling metrics, others may be lower on valuation but be willing to look past certain hiccups. Some have better sector expertise than others. Certain firms will take a more active Board role; others will be more passive. If you’re rolling equity you should know what their track record is like. You need to ensure your process considers all these differences, so you don’t waste time talking to firms that aren’t a fit or, even worse, end up transacting with someone that unbeknownst to you isn’t aligned with you strategically. Too often founders or subpar advisors run cookie cutter processes that don’t take into account these considerations.

5) Underappreciating the impact of various investment structures (and/or rights)

This particular issue is usually more of a minority growth one. For a majority recap deal anything other than common equity that’s “pari-passu” (e.g. treated equally) with existing equity should almost always be considered off-market. Any investor telling you otherwise is probably being less than forthright. So then…minority deals…usually marketed as “founder-friendly”, right? You get to retain control and sometimes there’s even a higher headline valuation! Well, it’s not quite that simple…sure, you get to retain control…and the valuation looks enticing…but these things come at a cost. These deals are usually structured with liquidation preferences that protect the downside of the investor at the potential cost of common equity to other shareholders (and so that high headline valuation has set a really high bar for the exit). Additionally, anti-dilution provisions and cumulative dividends (i.e. preferred shares with a PIK) can further erode the founder’s ownership over time, especially in down rounds or if the company raises additional capital. Not only that, but investors also sometimes insert veto rights or drag-along provisions that constrain the founder’s strategic flexibility, making it more difficult to control the timing or terms of an exit, further eroding the founder's final payout. These are just a sample of some of the clauses in a minority term sheet that founders need to be wary of and protect themselves against with a good advisor on their side who can negotiate in-line with what “market” is.

Conclusion

Hopefully this post was helpful in illuminating what not to do before and during a process…if you can avoid most of these pitfalls you’re doing better than most. That said, there are plenty of other obstacles to navigate which we’d be more than happy to dive into with you…as always please reach out anytime.