Getting cash out
Article Date: Feb 05 2009
Take care with cash out deals
Whether an investor wants to come on board or is seeking an exit, remixing the company’s capital base may allow you to get some money of your own in the bank and strengthen your business.
If an investor is scoping your business and wants to take a stake, but you’re worried about how long you will have to wait for a trade sale or buy-out, it might be worth asking for a “cash out” deal. For a small yet meaningful stake, you can get money in the bank from an investor and the peace of mind that brings.
It’s like a down payment on future riches, allowing you to work with that investor on the big exit. Historically, investors have been suspicious of going down the cash out route. After all, an entrepreneur may see the money as an exit in itself and vie for a two-day working week, lavish holidays and fast cars.
Donald Maclennan, a partner at venture capital firm Foresight Group, has seen cash outs happening more frequently of late. ‘I suppose, in the current climate, it is difficult to achieve a trade sale, so it is a way for the founders to be able to crystallise some value. It leaves the full trade sale for a better day when the prices are better and companies look to acquire.’
He refers to the facilities management company Covion, which was sold at the end of 2007 to construction group Balfour Beatty for £33 million, as a case where an agreement was reached early on with the initial angel investors and the entrepreneurs. ‘We invested back in 2005,’ he recalls. ‘We bought out the business angels who had backed it as a start-up and did a cash out with the founders who stayed with the business.’
Maclennan says the firm is ‘reasonably flexible’ when it comes to negotiating stakes and percentages, while being mindful that, ‘if the founders are taking cash, you don’t want them to do it to a level where they won’t want to come to work in the morning’. In the case of Covion, he says the founders settled for a ‘small seven figure sum. It’s enough to give people security, but not enough for them to stop focusing on the business going forward’.
Rob Donaldson, head of M&A and private equity at professional services firm Baker Tilly, observes that he’s noticed a rise in cash outs too, which he sees partly as a symptom of the embattled economy. ‘If an entrepreneur is looking to reduce their own risk in a business, then with a cash out deal, whatever happens, they have some money saved.’
He goes on to say that the stake has to be around ten to 15 per cent, otherwise an entrepreneur could interpret the deal as an exit, losing interest in the business.
Be direct
There will have to be some upfront discussions between the investor and entrepreneur. Steve Brown, the founder of Buy.at, an online affiliate marketing company, was in talks about selling a stake in the business to venture capital firm DFJ Esprit for a year before negotiating a deal. ‘I had got to the point where I had 95 per cent of my net worth tied up in a private company. I had worked for six years to that point and I didn’t want to end up with nothing.’
'With some risks ahead, I wanted some reward for my labour'
Brown had 30 staff when the VC firm came calling and he knew the business was at a crucial stage in its growth story. ‘There were risks ahead of us and I felt I wanted some reward for my labour up to that point. We structured the deal in such a way that the investors saw I had complete commitment to the business going forward as I still had a significant equity stake. Moreover, our management team wasn’t changing either.’
Buy.at was sold last February to web services giant AOL for around $125 million. Nic Brisbourne, a partner at DFJ Esprit, worked with the company and says the cash out was a success in this instance because the minds of those involved were properly focused on the sale. ‘By taking a small amount of cash out, it changed the personal risk profile significantly. All of a sudden, they have a meaningful sum of money in the bank. That meant that we could shoot together for the really big outcome.
‘If you look at the individual who doesn’t have anything in the bank, then they would rather be 50 per cent sure of selling a business for £20 million than have a 20 per cent chance of selling it for £100 million. It’s that shift that you unlock with a cash out deal. We need to be going for the larger outcomes.’
Not all VCs will go for the cash out option. ‘You run the risk of the entrepreneur becoming demotivated,’ admits Brisbourne. ‘They may regard this as his or her overall exit as this is their sole interest. The VCs who won’t do cash out deals like to keep the entrepreneurs’ “feet to the fire” – that’s the expression they’ll use. They want to really keep the entrepreneurs hungry and scrapping for every extra bit of outcome. That’s the school of thought a lot of people have, so fair enough.’
Good signals
It’s not all about what the entrepreneur wants either. John Bates, a director at VC firm Sussex Place Ventures and adjunct professor of entrepreneurship at London Business School, argues that ‘it’s no good just looking from the entrepreneur’s point of view, you need to look at the staff, investors and customers. If you send the wrong message at the wrong time it can lead to a significant loss of confidence – or certainly loss of trust – in terms of how committed the team is to the business.’
The pressure can really crank up when investors need to exit and there is no obvious route for a sale. ‘When you have an investor who has been on board for five to six years, or longer, and they’re a VC and they’ve invested and they are within a year, say, of the fund closing, then you have to look for a replacement investor,’ comments Bates, adding that this may have the benefit of putting a valuation on the business while also crystallising a small portion of options for those involved.
‘That is quite a nice way of turning what could be a divisive situation to one that is positive for everybody. It won’t be at a super premium price because clearly the new investor coming in is looking to make an uptick on their investment. A couple of years ago, you could pitch it as a pre-IPO round of funding but, in the current market, you can’t really say that because the IPO market is pretty cool. Historically, you bring in a new investor, take out some of the VCs who need to get out, get a little bit of liquidity, and then see that as a two-year IPO deal, which is fine. At the moment, you’re looking at replacement capital and there won’t be big premiums.’
Bates stresses that if you are remixing the capital base of a business, then it needs to be executed from a position of strength, not dire necessity. Buy.at’s Brown is an example of how it should be done, de-risking his personal finances and making the ‘business more confident of success at the same time’. He says: ‘We didn’t need to do a deal to keep the business afloat. We were doing nicely, but we had to take it to the next stage and, in doing that, I thought it was appropriate for me to de-risk myself. I went down from having a 90 per cent of my net worth in the business to 50 per cent. That allowed us to continue our aggressive growth strategy without overtrading.’
If you’re desperate for the finance, you’ll be in a weak bargaining position and may end up giving away more for less. ‘You need to do this with a long runway,’ advises Bates. ‘The company has to be strong, profitable, with cash in the bank. You need to take your time to negotiate the best deal. And there are some good secondary deals to be done out there.’
Assuming your business is as good as you think it is, don’t be afraid to ask for that little bit more. Brisbourne says: ‘People are nervy about talking about these things. [Cash out deals are] getting more common, but I think the vast majority of deals don’t have such a component and yet, rewind nine to ten years, and the whole concept was totally off the table.’
Not anymore.
