The IPO Alternative No One is Talking About
By David Frankel,
In a world where IPOs are an unlikely outcome and traditional M&A exits are difficult to manufacture, there is a new alternative for liquidity starved founders and investors — The PE exit. It’s an invisible ecosystem to most, but when you see a headline about a PE firm making an “investment” in a mature SaaS startup, and there is no mention of valuation, or even what series it represents, you’re most likely witnessing an acquisition, of sorts. The original investors are bought out, the cap table is cleaned up, and the founders are provided some liquidity, usually around half their holdings.
In the last eighteen months I’ve been involved with at least 10 startups that have sold, or seriously entertained, acquisition offers from PE firms. Acquisitions like these have primarily been B2B affairs, but earlier this month Hellman & Friedman acquired a controlling interest in IoT home security startup SimpliSafe, for a reported billion dollars so there’s no reason to believe it couldn’t expand to consumer startups as well.
Much in the way First Round Capital and Y Combinator kicked off the founder-friendly micro-seed fund, the likes of Vista Equity Partners, and their peers have created a genuinely new category of capital. What follows is a quick guide for anyone who wants to understand this mysterious new exit opportunity.
How the process works
These firms focus on promising, but sub-optimized businesses in a specific vertical, usually SalesTech or MarTech. They look for teams with:
- Demonstrated product/market fit
- Established sales processes
- $20M+ of annual recurring revenue
- category with significant TAM
Typically, a firm will buy these companies at >5X multiples, sometimes roll up multiple acquisitions, scale them up, and look to put them back on the market for a 2X gain in about three years time. It’s a surprisingly straightforward approach to tech investing.
Growth via smart operations
Historically, private equity has been criticized as “cheap” and, for founders, a far less attractive outcome than a strategic acquisition. This belief might have been accurate in years past, but today, PE firms are some of the most forward-thinking investors in operation. These PE firms hire executives from the best run big companies (it’s common to see CXO and VP level talent from Oracle, Microsoft, etc.) and then parachute them into the recently acquired startups where they immediately disperse best practices from former employers.
These executives are sharp, well-schooled, and have a level of operational experience that would be nearly impossible to recruit for at the comparatively early stage of these startups. It’s not unusual to see conversion rates rapidly improve by 20% or more and recruiting challenges that bedeviled the startups solved once the ex-Salesforce sales exec opens her Rolodex.
Learn their tricks
These PE funds don’t have access to any magical processes, but they do operate under a different set of assumptions and those lead to original thinking. Here are a few of the things I’ve seen PE-backed startups doing differently:
Permanent Trial vs. Time-based Trial: In most of the SaaS world, free, but time-limited trials are standard. However, some of these PE-backed companies employ permanent trials instead. Rather than cut a user off after a month or a quarter, they let the customer keep using the product is some diminished capacity. This approach acts as a permanent call option on the potential customer while also acting as a pre-installed bulwark to rivals. This technique isn’t markedly different than the Freemium approach favored by consumer startups, but it is surprisingly effective when deployed in the B2B SaaS universe.
Quarterly Contracts vs. Annual Contracts: Most VCs push their startups to extend contracts as long as practicable to help ensure retention. Some of the PE-backed startups I know are moving to quarterly contracts. It lowers the barriers to entry, and thus far the churn rates have not increased appreciably. Admittedly basic product has to be robust and mature to try this out. Again, this is basic stuff, but it’s illustrative of what can happen when approaching old problems with fresh eyes.
Debt vs. Equity: Where a traditionally funded startup might raise equity to fund M&A activity or customer acquisition, these PE firms are savvier at using debt as a tool. This financial acumen helps limit dilution, but it can create a host of new challenges.
Beware, old-fashioned financial engineering still exists
There is still an element of Barbarians at the Gate style financial engineering at play in some of these transactions — it’s the price of easy liquidity. The classic PE horror story of loading up on debt and using that extreme pressure to wring profits from operational efficiencies still happens. Underperforming projects, along with their teams, are cut mercilessly. The C-suite stress level at these companies is often higher than those who raised money from traditional VCs given human resource cuts (though the latter sort of CEO may not have enjoyed a similar level of liquidity.)
At Founder Collective we cherish the “weird and wonderful.” These PE firms generally like “stable and predictable.” An excellent product, a large market, and a team willing to level up with coaching from experts are expected. While initially patient, failure to deliver results a few months in is simply not tolerated. These deals also require founders to revest their remaining shares, with schedules stretching up to four years, which can add to agitation levels for entrepreneurs.
I don’t mean to make these relationships sound predatory. On the contrary, I believe the expectations of these PE acquirers are in line with the metrics that would be expected by a traditional market-leading acquirer. Still, for entrepreneurs who have only known a world of “founder friendly” funding, the difference in attitude can be somewhat jarring.
Traditional venture firms win because they receive liquidity within their traditional time horizons.
This new class of PE firms wins in that they’ve figured out a way to reasonably consistently double their money every three years or so (obviously as long as the current macro “music” doesn’t stop).
Founders are winners in this arrangement as they receive substantial immediate liquidity — far beyond what even the most generous VCs would suggest in a late-stage financing. They also have the satisfaction of being able to continue growing their business without an acquirer impeding their progress, all while retaining the opportunity to make even more money alongside their new PE partner with a second sale.
In short, If you’re a startup with a predictable, generally SaaS or SaaS-like revenue stream, stable management, and are attacking a large market, there’s never been a better time to be on the sell side. Keep your head down, grow your top line, and start talking with some of these new funds ASAP.