How to Position Your Startup to Private Equity
The word is out: private equity has solidly emerged as the year’s best exit opportunity in SaaS. When I wrote about the trend last November, the top private equity firms had rapidly ramped up the pace of deals, raised record funds, and become much more comfortable with growth rather than just EBITDA.
PE firms haven’t shown any signs of slowing down. Over the course of 2017, private equity buyers officially spent as much as large strategic acquirers on buying SaaS companies. What’s more is that they’ve been paying attractive prices (9.1x and 7.1x revenue for SolarWinds and Cvent, respectively) while continuing to offer best-in-class deal dynamics like a faster and more predictable closing.
This inevitably begs the question, how should SaaS companies position themselves to be attractive to private equity buyers?
To find out, I sat down with two experts. The first was Darren Abrahamson, Managing Director at Bain Capital Private Equity in the Technology, Media, and Telecoms (TMT) vertical. Bain Capital’s investments have included Blue Coat Systems, Navicure, Vertafore, Viewpoint Construction Software, BMC Software, and NGA Human Resources. The second was John McCullough, OpenView’s VP of Corporate Development and former Director of Corporate Development at Rocket Software, where he led the execution of 10 acquisitions.
Why Private Equity Firms are Betting Big on SaaS
Darren, who started at Bain Capital back in 2005, noted that there’s been a massive shift in how private equity views software. Back when he started, PE firms were mostly interested in vertical market applications, on-premise deployments, and high margin businesses that could be levered.
Now, the pace of innovation and change has accelerated. Far more deal flow has shifted to emerging cloud and SaaS businesses that are disrupting industries and growing rapidly. “In the last three to four years, the number of smaller, high growth SaaS businesses that we have started to see in our pipeline has gone up exponentially,” he explained.
And these companies aren’t all profitable. Many are lower margin or may even be losing money given their current stage of growth. This shift from profitability to growth + profitability has been facilitated by lenders, who have gotten more comfortable underwriting against recurring revenue as opposed to EBITDA.
What Makes Private Equity an Attractive Exit Option for Founders
“I think CEOs need to be thinking more and more about PE as a great exit path, especially considering the prices that deals are getting done at,” John underscored. From his point of view, private equity firms are attractive because they’re very good at doing deals. They move quickly and offer a high certainty of close. A private equity deal is cleaner than going public and there’s a chance to roll equity, meaning a founder can keep equity in a company if they believe in the thesis that the private equity buyer has put together.
From Darren’s perspective, there are some nuances depending on the type of business. A SaaS company operating in a very large market – think ServiceNow or Workday – might find that public markets are their best path (at least under current conditions). Meanwhile, a strategic acquirer might be attractive because they can sometimes pay a premium if there are the right synergies and the target company helps them move into new business models.
Private equity, on the other hand, is an attractive place for a founder to keep building their business, make the right long-term investments, and continue to innovate. PE buyers can facilitate more transformative M&A and help companies expand into new areas, without the quarterly earnings noise or the watchful eye of corporate parents.
Darren gave the example of Navicure in the Healthcare IT space. When Bain Capital bought Navicure, they were relatively small and growing nicely, and had plenty of exit options. But they had a unique opportunity to become a platform to drive consolidation in the industry. Bain Capital helped them combine with an even larger company and create a clear market leader. That would’ve been much more challenging to achieve outside of PE.
What Private Equity Buyers Look For
Both Darren and John agreed that PE buyers want to see solid business fundamentals, similar to what a VC investor would look for. These include good unit economics, a strong product, clear competitive differentiation, experienced operating talent, and a sizable enough addressable market to leave runway for growth. If anything, business fundamentals are more important for PE compared to corporate acquirers, since PE will most likely view the company as a standalone business as opposed to a technology that fills a certain product gap.
There’s an important distinction to make between a PE platform acquisition such as Navicure versus a tuck-in or add-on acquisition, which gets folded into the broader platform. Tuck-ins tend to be smaller companies with lower valuations.
With platform acquisitions, private equity buyers tend to want to see signs of scale. For some PE firms, that might mean $15-20M in ARR. For a firm like Bain Capital, that tends to mean closer to $100M in ARR.
A common private equity strategy is to use strategic M&A to create scale and market leadership for their platform companies. To be attractive to private equity buyers, then, it’s important to do homework upfront to know the other players in the market and be prepared with an M&A thesis that would drive up combined value. It also becomes more important to be able to extend and integrate with other companies across the relevant partner ecosystem.
Efficient growth and the ‘Rule of 40’ is more important than absolute growth. That could mean growing at 15-20% while being profitable, or it could mean growing 40-50% without being unprofitable. Importantly, the customer economics need to support the business’ ability to continue to grow and become profitable in the future.
Signs of ‘stickiness’ are also critical and having a churn problem could be a deal killer. That probably means gross retention rates above 85% and net retention rates above 100%. The product and market position should be defensible with clear competitive differentiation.
When to Start Talking to Private Equity
John recommended talking to private equity buyers regardless of stage. “It’s never too early – it’s the CEO’s job to create optionality for the business,” in his view.
The biggest mistake he sees CEOs make is that they ignore this type of activity because they’re so heads-down focused on their business. They wait too long, such that their cash runway is short, they don’t have financing options from existing investors, and can’t raise capital. Prospective buyers will leverage that desperation to drive prices down.
To get started, first understand who the relevant audience is and who the ideal private equity partners would be. Then, try to get on their radar. This often means leveraging networks, venture backers, and even investment banks – with their great relationships and ecosystems – to get in front of the right folks. It could even mean cold calling, if needed, to create that top of the funnel and start building relationships. From there, it’s about nurturing on an ongoing basis until the company is ready to consider an exit.
The time investment doesn’t have to be huge: it might be only a few hours per month for a really young company.
How to Select the Best Partner
Great SaaS businesses may find themselves choosing between multiple term sheets. Besides valuation, what should they consider in a partner?
It requires spending time with the people at each firm and understanding their objectives, according to Darren. Some firms and individuals are extremely hands on and prescriptive, while others may be totally hands off.
He urged founders to pick up the phone and call folks who’ve actually worked with each private equity firm. That’s the best way to cut through the noise and understand what it’s actually like to work with these people, how they respond if the company misses a quarter, and how much support they provide.
Darren likened the decision to a marriage, only potentially harder to get out of. “Like marriage,” he said, “you want to pick a partner that’s got alignment around vision and goals, the right cultural fit.”
Looking to up your chances of being acquired by a PE firm? Check out our Strategic Corp Dev Playbook or listen to the BUILD podcast episode that inspired this article here.