November 2003

Value-ation Proposition

With the aroma of IPOs still very faint this year, privately financed technology companies looking for a liquidity event are placing their hopes on the modestly strengthening scent of M&A money. However, for many of the companies being acquired, and for their investors, that smell has not been very sweet. Too often, despite many years of hard work by the leaders of the emerging businesses, the money being offered for their companies has a diluted fragrance rather than the enriched one they had hoped for.

Private companies are selling at prices far lower than desired by owners.

Acquisition prices are often closely guarded in the information technology, communications and life sciences industries. However, a look at available details from over 250 acquisitions involving privately financed companies that have been announced through the end of the third quarter provides enough anecdotal evidence to assess the state of investment returns and some reasons for return performance:

• Very few deals earned their investors 5 to 10 times the money invested, the return most venture capital firms target for their money. For example, Massachusetts-based companies selling in this range included network software security company Okena, sold to Cisco at roughly 7.5 times the $20 million invested and Cyclis Pharmaceuticals, acquired by ArQule for 5 times the $5 million its investors put into the company.
• In other cases, acquisition prices failed to reach the investors' target return, but still represented a multiple on invested funds. Switching companies WaveSmith (to Ciena) and Winphoria (to Motorola) sold for roughly 2-3x the $85 million and $50 million (respectively) invested in them. In today's market, this multiple looks like a win, but for the amount of money invested in these companies and with few deals bringing even this level of valuation, it's hardly time to proclaim a turnaround in private markets.
• Some acquirers benefited from low valuations of exiting companies, purchasing them for less than what had been invested. Private local companies including CyOptics (optical components), Surebridge (application software outsourcing) and Emptoris (sourcing applications) bought going concerns for a fraction of the more than $50 million of venture capital previously invested in each of them.
• Finally, in the three years since the Nasdaq collapsed and VCs began culling their doomed portfolio companies, the remaining assets of start-ups such as Tenor Networks and Sockeye Networks have recently sold for pennies on the dollar invested.

The fact that a great number of this year's deals haven't been made public lead many to believe that the prices and valuation multiples were nothing to brag about, likely returning from .5 to 1.25x the money originally invested in them. Thus, while home runs like Okena and fire sales like Sockeye grab the press attention, a more commonplace, albeit understated, headline would be: private companies are selling at prices far lower than desired by owners.

What explains this broad range of purchase price multiples? In many cases, it is the strength of the acquired company's underlying value proposition. At the low end of the valuation range are companies who simply failed to establish a differentiating, compelling value proposition that attracted sufficient customers to create a business with a growing profit stream. These companies are acquired for their assets, IP, customer relationships or management, but not for their fundamental business offering.

At higher but less-than-targeted multiples, the price of acquired companies is eroded not by their value proposition, but by their inability to build a strong, integrated business model and execute a strategy to profitably deliver on that proposition. Companies like these, with value propositions that fill gaps in a more established corporation's offering, find an acceptable exit route, if not at the targeted valuation, by becoming part of a company which has the business model to deliver on the promising value proposition.

Value propositions should drive your business model, growth strategy and ultimately, your valuation

So, how do you gain the targeted valuation? An April article in The Advisor described value propositions and how best to build one. Clearly, a value proposition cannot be just a pithy marketing statement or elevator pitch that cracks open the door of customer or investor interest. Rather, it should be the essential statement of the value the company provides the customer, and must form the core of the company's business model, drive its growth and profitability strategy, and ultimately determine its valuation.

Look at the example of recently acquired Neoteris, a software company that provides network security from and for remote computer users through the applications they use rather than through the network itself. Neoteris' value proposition is straightforward – radically improve the ease and reduce the cost to remotely and securely access corporate data.

Neoteris' business model comprehended and its growth strategy was designed and quickly executed to take advantage of the fundamental market shift its value proposition would create. The company captured leadership share in just over three years by offering distinct solutions to enterprise customer needs in selected industries and with a channel and geographic expansion strategy designed to outpace existing and potential competitors' abilities in a market expected to grow rapidly.

Of course, the companies being acquired these days are often better off than many of their 3 to 7 year old still-private brethren who operate in overcrowded and over-invested market spaces. Consider the predicament of those trying to move beyond the revenue stage (to profitability), with value propositions that are undifferentiated in the eyes of enterprise customers or consumers flooded with marketing pitches.

Weak value propositions will sink many companies despite the economic recovery

Companies in enterprise instant messaging, network security software, Internet shopping, WiFi semiconductors, and wireless data software among others, are struggling to set themselves apart. Despite hope that the rising tide of economic recovery will lift all boats, the weak value propositions of many companies in these segments will sink them, as customers and investors get behind only those businesses that truly stand out.

Companies in this situation and growth stage need to carefully examine their value proposition, its alignment with the business model and growth strategy, and the valuation range the company is likely to achieve:

1. Examine your value proposition from the customer perspective. Talk to your customers, as well as your product development, marketing and sales organizations that communicate with them daily. Ask some tough questions:
   • Does our value proposition truly address common pain points that are widely recognized throughout the customer organization?
   • Does it capture the way our technology and delivery is differentiated from that of our competitors?
   • Is it stated in a succinct and compelling way that is easily communicated through marketing and sales?
2. Consider ways to further strengthen and differentiate your value proposition. Look carefully at the market and the competitive choices your customers face:
   • How does our value proposition need to evolve in the face of market, customer and competitive changes?
   • Are there ways in which we can add capabilities or bundle products or services to more fully address customer issues and distinguish ourselves from competition?
3. Evaluate the extent to which your business model and growth strategy supports your value proposition. Insure that your strategies, relationships, organization and processes are designed to maximize your ability to deliver on your value proposition:
   • Is our product truly configured and priced to deliver our unique value?
   • Are we segmenting and targeting our markets to reach those most attracted to our value proposition?
   • Do our partners and channels understand and enhance the value we provide?
   • Is our value proposition sufficiently broad to support our product and market growth strategy?

Recent M&A activity illustrates that most companies are not realizing the valuations that their investors originally expected. In many cases, the strength of the underlying value proposition, and the supporting business model and strategy, determines the prices acquirers are willing to pay for a company. In this market, the value-ation proposition is critical.