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With Scott Orn

A Startup Podcast by Kruze Consulting

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Scott Orn

Scott Orn, CFA

Will Hawthorne of Code Advisors on M&A for Startups

Posted on: 09/27/2017

Will Hawthorne

Will Hawthorne

Managing Director - Code Advisors

Will Hawthorne of Code Advisors - Podcast Summary

Will Hawthorne of Code Advisors discusses M&A for Startups. Will explains how a startup can create leverage with multiple buyers, the importance of reliable financials and accounting and important deal points every Startup CEO should know.

Will Hawthorne of Code Advisors - Podcast Transcript

Scott Orn: Welcome to Founders and Friends with Scott Orn of Kruze Consulting, and before we get to an excellent podcast Will Hawthorne of Code Advisors, this is a really good podcast folks, I want to just give the couple shout outs; first Kruze Consulting, we are the number one startup accounting firm in the country, we now have an office in New York, we have 22 people, we’re growing really fast, and we’d love to work with your company or your friend’s company, so if you need help on anything from monthly accounting to finance, to even HR questions, especially taxes because tax day is coming up for companies on September 15th, give us a call, we also do R&D tax credits. And that’s a nice little segue to a shout out to Gusto who is doing a great job processing, basically submitting to the IRS the R&D tax credits, as accountants, we prepare them we do a bunch of work for the clients, we figure out how much the credit is for and then we give it to Gusto and Gusto is doing a great job on those submissions, so thanks Gusto. All right that’s it, let’s get to Will Hawthorne of Code Advisors. Welcome to Founders and Friends podcast with Scott Orn at Kruze Consulting, my very special guest day is Will Hawthorne from Code Advisors, welcome Will.
William Hawthorne: Thank you Scott, I appreciate it, glad to be here.
Scott Orn: Yeah, so Will and I are old friends, actually I used to work for Will, so I had many of late nights at J.P. Morgan, Hambrecht & Quist, sitting in his office; you were just a young fresh associate at the time.
William Hawthorne: I miss those days, is was a lot of fun. You were great to work with.
Scott Orn: Did you have like a putter in your office or something? I kind of can’t remember?
William Hawthorne: Yeah, I always have a putter.
Scott Orn: So Will now is a partner at Code Advisers, one of the top emanate people in the valley, for startups, he’s a friend, we actually have used some of his materials to educate the Kruze Consulting client base about the importance of M&A, what to think about, what to worry about, and so we thought it would be a great idea to have him on the podcast.
William Hawthorne: Thanks for having me, I’m excited about it.
Scott Orn: So tell the audience, just retrace your career, like how did you get to Code Advisors, what’s your background?
William Hawthorne: Sure. So right out of undergrad, I did accounting for two years, got my CPA, which was a good kind of financial background to get started with. I had to bug a little bit early for it to move to something a little more exciting and moved to DirecTV back in 1995, when it was still a startup, so we had under a million subs, it was still owned by huge GM, and there I went into the finance group and was focused on the NFL contract major league baseball NBA, so really building out the sports franchise from the finance side.
Scott Orn: I didn’t know you did that, that’s amazing. The NFL like helped really make DirecTV right, because everyone wanted the package.
William Hawthorne: Absolutely, it absolutely did, people that didn’t even want to watch the NFL or buy the package, bought DirecTV because we had the NFL brand name, that contract was I think 450 million dollars and we weren’t a large company at the time.
Scott Orn: It was like you sign in and you hope you can sell it.
William Hawthorne: That’s right, it was our biggest content play for sure.
Scott Orn: That’s amazing, so you did DirecTV finance and then how did you get into investment banking?
William Hawthorne: Sure. So at DirecTV I worked with the CFO a lot, and he said listen, your skill set and your finance background, you might want to think about investment banking, and at the time we worked with Goldman Sachs a lot so he’d let me sit in those meetings, I decided to go back to school and I went to Kellogg for grad school.
Scott Orn: I didn’t know that, I am Kellogg too.
William Hawthorne: And so I spent two years there, I spent the summer at J.P. Morgan in New York, in the FIG group so financial institutions covering banks and insurance, and obviously technology was getting pretty hot at the time, it was 2000, so transferred that offer from New York to San Francisco came out to J.P. Morgan in 2000, that’s when you and I met; and at the time our M&A group was combined with H&Q, it was 53 people and we went down to seven people over course of three years.
Scott Orn: No, really? That’s crazy, because we were 35 I remember our revenue per employee was something ridiculous, like three million dollars per employee or something, like the M&A group and H&Q was incredibly profitable, but of course, that was like 1999/ 2000, and the music stopped and everything changed. So you stayed, how long did you stay with J.P. Morgan for?
William Hawthorne: For 11 years.
Scott Orn: Okay, wow. And then, what happened, how did the Code Advisors appear?
William Hawthorne: Sure. So David Golden, who was running TMT, obviously H&Q, probably one of my favourite people in banking was helping Code get started, so Quincy and Mike that founded the firm had been in and around banking, but were also operators and so they kind of reached out to David and had David help them set up the firm, and so David reached out to me and said, hey there’s a few guys that I think are interesting, they have a new unique angle on banking, and started dialogue from there.
Scott Orn: Yeah, David Golden for folks who do not know, he’s like one of the most patient, nicest people you ever meet, and he’s so patient; we would always go against these like screaming investment bank people, who like thought they could like yell and scream their way into a better deal, and David and Paul Cleaver were both so patient, than never rattled, and we were like always in all of these two guys. I didn’t know that David helped you get there, that’s awesome.
William Hawthorne: Absolutely, yeah. And so the idea really was, I enjoyed JP Morgan, and I still obviously have a lot of friendships there, at JP Morgan I was running the internet and digital media group for M&A, partnering with Noah who you know well, but I was working with so many internet companies I was getting the bug of should I start something or should I go to a startup. And in the end, after 11 years my skill set really was M&A, and partially equity raises but more M&A, and so Code was an opportunity to do both, which is to help go to a startup, that was a bank grow that company but also use my skill set.
Scott Orn: I agree with you 100 percent, like I never got the personal fulfilment investment banking because I didn’t have a sense of ownership, in the same way that now you have that at Code Advisers, like you are a major partner in the firm, you guys have a brand name, so your name is not on the door, but effectively your name is on a door, everyone who comes in who is working with Will Hawthorne knows that you are someone who gets stuff done, so you have that sense of ownership and I’m sure you love it.
William Hawthorne: Yeah, it is fun, it’s a much different feeling at JP Morgan I think no matter how big of a year I had, it didn’t really move needle and at Code you can really move the needle, everybody that we hire I’ve interviewed or talked to or brought on board, so you do feel like you’re building something. The other thing that was interesting about Code is we do deal with smaller deals, and at JP Morgan while I did enjoy the work a lot of times when you represented a public company, you’re given a fairness opinion, you’re not really negotiating the deal, the CEOs, the CFOs, the boards are so experienced at M&A that they don’t really need advice, a lot of times you’re getting a fairness opinion or an M&A print because you loan them money or there’s a broader relationship. At the level we do it a Code, our sweet spot is probably a 100 to 500 million dollar sell sites, and at that level most of the founders have not done an M&A deal before, they have not raised money at 50 million or more, a lot of them don’t even have CFOs, so you feel like they really need you, which is good.
Scott Orn: And you match up with our client base so perfectly, and you know and we know that like they’re really looking for advice from their trusted partners, like they will listen— whether it’s accounting or whether it’s investment banking and doing M&A deal, they are going to listen to every single thing you say, they’re going to implement everything, because it is their first time usually and even if it’s not their first time, usually they’ve had that experience of an investment banker helping them raise the value of the offer, and, I think sometimes the investment bankers get kind of a raw deal, but many, many times in my experience, I have seen investment bankers like you come in and raise the purchase price 25 to 50 percent just by saying a few magic words, and giving like a legitimacy to a process and letting the buyers know that there’s other people looking in a kind of an artful way. So I am a huge fan of what you do, and this is not meant to be a commercial for Code Advisers, but you guys are one of the best firms and we refer our clients to you happily, we know that you are going to take care of them.
William Hawthorne: Well, we appreciate you doing that. A couple of things there, so one back at you a lot of the people out here are great at product, they’re not great at finance. And they don’t pay attention to it until it’s too late, and we go into these companies many times, there is no CFO, people haven’t kept track of things, and the buyers care, right, they’re going to roll you into much bigger organization, they want to know that you have a handle on what’s going on with your business financially, even if it is a pre-revenue company. And so, the service you guys provide obviously helped us out, we worked on a deal together, we won’t go through the name of that company but it worked out really well, and Kruze did a great job and prepared them and we were able to handle all the due diligence which is important.
Scott Orn: Thank you. And that’s really the credit, they were Vanessa’s clients, and Kevin’s so they deserve all the credit, I think I just looked pretty in the meeting.
William Hawthorne: One other thing, you did bring up a point that investment bankers’ reputations are kind of well deserved just over the years on some things; I will say that I feel like every deal that I’ve been involved in, especially at Code we more than pay for ourselves, so when the fee looks expensive, but let’s say investment bankers getting three million dollars on a fee, if they raise the price by ten million which is not a big move, they paid for themselves 3x, so I do feel like we do that on almost every deal.
Scott Orn: Yeah, and I’ve seen it, like I’m not exaggerating, 25 to 50 percent like it’s a huge ROI, and we didn’t really talk about like the higher probability of closing, like I think that’s something that people don’t always understand, like most M&A deals actually never close, I mean when I was working with you at H&Q and JP Morgan, I would maybe have 20 percent of close and it was frustrating for me, because I would do all this work and a lot of stuff never really happened, and no one even knew that this stuff was going on, but working with a really good investment banker helps smooth out the edges, helps the communication, there’s always a back channel it’s not just between two CEOs or a corporate development group and a CEO, there’s someone who’s experienced right there with the company, who can translate what the requests are, what they mean, and help the deal really congeal, so I think it is not even about the dollar sometimes, it is about higher probability of close.
William Hawthorne: I agree with you, that is well said. I think the other thing that has changed is back in 2004, 2005, 2006, when we were selling internet companies to a lot of media companies, they weren’t really doing it for the team, they didn’t understand how much the team meant and the reason why you guys are successful and these companies around here are successful because there’s a focus on the business, it is the life for this founder or CEO, and so now when they’re buying companies, they lock up the team, right, and so if you know you’re going to go work for that company, you don’t want to be in the front line negotiating the whole deal with them, so you’re basically negotiating with your future boss, and arguing with them over these points, and then you’re going to go work there for four years, so that alone should want you to have somebody in the middle of these conversations.
Scott Orn: Yes, you’re totally right, and the acquisitions were saying are there’s always the financial exciting revenue opportunity component of it, but you’re right, they’re buying the teams just as much as they’re buying the future revenue streams, like they are buying these teams because they want the teams to hire more aggressively and build out better products and then also bring that DNA to the rest of the organization, so it’s not just like a present value calculation in the future revenue, there are so many more intangibles involved, and you’re totally right. So, a couple of things we were going to cover, you have a good slogan, why M&A is different, can you talk about that?
William Hawthorne: Sure, yeah, so in our universe we generally deal with high growth companies, that’s our sweet spot and the founders and the reason why these companies are growing like that, almost every founder I know they’re just good at getting things done, you tell them that can’t be done, they do it, they just run through the wall and they get things done, and that’s kind of the way they run their business, there are a lot of young hard charging people that I admire a lot, and M&A is completely different, you cannot force someone to buy you, raises are the same, you can’t force someone to give you money to your company, you want to be pursued, and it’s very hard for founders that are action orientated to let the process come to them. And you need a coach to say back off, you don’t need to email that person today or call them back today, let them come to you, pretend you have other things going on, which you do, you’re building a business. But they really want to force the M&A and it’s the number one mistake, as soon as buyers in our universe, Google, Facebook, Amazon think you’re selling and want to sell, they want to know why; now, if you have such a great company and you’re so excited about it, why do you want to sell. So you have to pretend like you don’t want to sell, and they’re forcing you to sell through their actions, and it’s really key, it’s nuanced and every day when you’re talking to a founder on a deal you need to coach them on what to do and what not to do, and people miss out on that stuff when they try to do it themselves.
Scott Orn: The other thing is, you may have one offer and you have this temptation to like go out to everyone else and demand an offer from another buyer, right, and you have to do that in a very artful way and you can’t be perceived as a CEO of shopping the company too much, because it’s exactly what you are talking about the warning signals go up, but if you’re the one doing it, you’re not spending time on your business, so that could be going off the rails why you are the middle of this; and you have this reputational thing you have worry about, so that’s another way investment bankers are really valuable, because they have time and an incentive to go talk quietly to the right buyers, and see if anyone else is interested.
William Hawthorne: Yeah, that’s right, and I think what I would tell— founders are getting the offer you’re about ten percent of the way there, at that first offer, you then are going to negotiate that term sheet for probably three to four weeks, and then you’re going to go into real due diligence, and it can fall apart there at any point.
Scott Orn: Yeah, that’s so true. And what are the points you see deals falling apart at, like what’s causing that?
William Hawthorne: Yeah, the biggest thing that we advocate to our clients is to get the information out before you get the offer. So a lot of people are like I’m going to show you a little bit, and then I want an offer, and then you’re going to go into exclusivity with that party, so you’ve lost the rest of the process and the rest of the kind of checks and balances of other people being around and you’re exclusive with that party for sixty days, and then they learn a bunch of stuff that you didn’t tell them and most of it is negative stuff. And so clients are always asking me should we tell them yes, get it out in front, right, and that way you know it’s incorporated in the offer, they know the good stuff and they know the bad stuff. Every startup has issues. And so, you get it out in front, you make sure it’s incorporated in that first offer, and therefore the deal doesn’t go sideways when you’re locked up in exclusivity.
Scott Orn: Yeah, and you have multiple offers ideally, so you’re only going to exclusivity with the best buyer and probably correct me if I am wrong but you have maybe instead of the sixty day exclusivity, you’re getting a thirty day exclusivity, so you have some leverage on that because one of the worst things that can happen is, it’s not always bad if the exclusivity run out, but if it does and that buyer who had the shot starts kind of talking trash behind your back, you may have a hard time bringing another buyer to the table.
William Hawthorne: Yeah the word spreads fast, and it’s very difficult to go convince people, in the back of their mind is they do due diligence there are like well why did that other party drop out. So it makes it very difficult.
Scott Orn: So M&A is different, because you can’t do it through sheer will, you actually have different process you need to be pursued, that’s really good advice. You had another, we were talking on the phone like two or three weeks ago when we were planning to do this, you said there’s kind of a phenomenon happening with the buyer market, like what’s happening there?
William Hawthorne: Sure, so again, because some of our deals are smaller and the buyer universe has consolidated the buying power, right, if you look at where Apple’s market cap is in cash position or a Google or Amazon, Amazon I think is like a 750 billion dollar company now, going to them and selling a hundred million dollar company there’s not— one company that I have in that range that is going to sink Amazon or Google if they don’t get it, and so you’re already behind because everything for them right now is a nice to have, their businesses are so good, and they have such great market share and you know, the names I am talking about keep investing in their business, so they’re really making a decision can I build this myself over time, whether do these guys have something unique and do I want to buy it. But none of them push the process, they won’t play in auctions, they’re not going to be the first to bid and say oh here’s my Amazon bid, go shop that to four other parties, they’ve all gotten smart, Facebook, everyone. So it’s much more difficult to get something done, and it’s just a process of sticking with it, giving them the right information, the right time, but not too much time, and then trying to bring the process together at ahead were all decision makers on the outside can make a decision around the same time frame.
Scott Orn: And those processes at Facebook, Amazon, all these companies you are talking about, are run by like specialized teams, corporate development teams, who have tons of deal experience, so they know that they can apply pressure at different points and try to spoke out a founder who maybe needs to sell for the wrong reasons, or maybe is willing to take 50 percent less, they’re doing a lot of testing through that process, right?
William Hawthorne: That’s right, so I would say at those companies that you’re mentioning, most of their corp dev teams have more experience than almost every M&A on the street, they see more stuff, they participate in more processes and so they know M&A, and they know when you’re overselling a process, and it’s difficult, you have very much a worthy adversary on the other side now. It used to not be that way, but now for sure.
Scott Orn: Yeah, how do you combat that as someone who is advising your clients, do you have certain kind of guidelines for your client to interact with the corporate development team, how do you do this?
William Hawthorne: The biggest thing is in this business, you have to tell the truth, right you’re building relationships and I’m talking about right now the bank with all the buyers, that’s the same of a founder starting a process. If you are caught early in a process, saying hey I’ve got another bid, right so you call up Google and say I have another bid, you need to move fast; and then, four weeks later, you have nothing to hit them with, i.e. there is no offer, they sniff through that really quickly. So starting a process and overselling it, or a white lie or whatever that it is, you will get caught, so the best thing is the truth— if you don’t have anything, then you don’t start an M&A process, what you start is a hey, they want to get to know you better, they think you can work together on business development, not corporate development, and you let them lean in, that’s why we at Code, if someone comes to us and says, hey we don’t have any offers, we don’t have anything really going, we just want to start a broad process we won’t do those kind of deals. And so you have to have something real to ignite the others. Once you have something in hand, if you’ve built the right relationships over time, if we call those companies and we say we have an offer they believe us, and if they have any interest they’ll go to work over those couple of weeks, all of them are so sophisticated and have such big teams, if they want something they can move in weeks to come down, visit the company or the company goes and visits them, get a full management presentation, and I’ll tell you really quickly if it has legs or not.
Scott Orn: Yeah and that’s a great point, because you have to maintain your credibility with them, you have this repeating game where you’re talking to them probably once a week, and I am ever back in the day in H&Q, we had some clients who like wanted us to burn our own credibility and we’d be like are you crazy, like they’re going to see through it, and it doesn’t help the company, because once the buyer knows that games are being played, they start asking are games being played in the revenue, are games being played in the burn projections, do I actually want to sign up to bring you into my corporate company and be responsible for you hitting your number. So, there’s all this like kind of honesty and being forthright is so important because eventually, you are going to become part of their company, and they are going to be the person who signed that deal, who basically say like, yes let’s do this, so their name is on it.
William Hawthorne: Absolutely right.
Scott Orn: How do you communicate with the business, the corporate development guys to get— maybe someone has an inbound offer but they’re not really, they don’t really want to sell, like this happens a lot with our clients, they’re having a lot of fun, because they’re really successful ones, like things are really going well, VCs are throwing money at them, but they’re kind of just curious, like do you have kind of the little soft bat phone that you call them on and say hey, if this company was interested, what would be the range, or how do you handle that?
William Hawthorne: Yeah, so on those you can’t just be curious, once you turn on that switch, the switch is on. And it’s really hard to get away from it, you now, and again you can always put the pressure back on them to make it more serious before you explore it, but the answer always is I’m not for sale, I have the stand alone path and I appreciate the interest, but I’m not for sale. If at some point you want to entertain it then you can open up that dialogue a little bit by saying I might be interested, I have investors, I have other stakeholders, so I’m always willing to listen to something attractive because I have other people that have ownership in this company, so you play it that way, but leaning into a conversation, it’s hard to pull back from those, so you shouldn’t do it until you’re ready to do it, and you know the buyer is real.
Scott Orn: That’s really great advice, because like the founders are often working on their companies for like five years before they even get to that point where it’s even interesting to anybody, and there is this like little germ of curiosity where they are like I wonder…— it helps fantasizing to get through the day and build the company, but you basically, you are saying like, hey you just got to keep your head down, you’re not for sale until that moment when you are for sale.
William Hawthorne: Absolutely, I think if you look, and I’m using Amazon example because I think they’re really solid at their M&A strategy, they haven’t done a ton, but what they’ve done has been really smart, they probably get 150 inbounds a month, right, from companies that want to be sold to Amazon, and so you know they prioritize it based on urgency, so if I call them and say wink wink, these guys might be for sale, they could be well I don’t have time to look at that. So it has to be this is moving, now if you’re in a space that they really want, and they’re really interested, and you are a top priority space, they probably found you before I did right, ok? Then there’s priorities two, three, four, five that I can bring to them that they’re not actively trying to buy somebody, that then it’s going to be gone, so they’ll move it up in priority just because of scarcity value, because it could be gone to another buyer.
Scott Orn: And they found a company early because they have a lot more resources, they have lot more people to like just scout and see what’s happening, right?
William Hawthorne: Yeah, I mean their work for us is engaging with companies every day, right, and in the end corp dev does surface a lot, but it’s generally the employees that are actually operating the business that see other interesting things and bring it to the attention of corp dev and say, we’re working with these guys, they have a really smart solution here, have you talked to these guys, and that’s the way it comes up.
Scott Orn: This is good man, you’re dropping a lot of knowledge here. One of the other topics we were going to cover was employees versus investors.
William Hawthorne: Sure, this is a difficult one, and it’s a difficult one for Code because the smart buyers, as we just talked about, are really, they are buying the product and the technology, but they’re also buying the founders and the employee base. And, in these deals, there’s a lot of the sophisticated buyers are trying to allocate more and more dollars to the employees out of the purchase price and less and less to the investors. So I’m not going to use any names but let’s say I’m company b and I want to buy this company and I want to pay a 100 million, ok, the best thing I can do is allocate like 10 million to the investors and then 90 million for glue to keep these employees around for the next four years where they earn out every year. That obviously doesn’t work in a good company, because the investors would never accept that, and a lot of times the founders own a big stake as well.
Scott Orn: That’s like the extreme example.
William Hawthorne: That’s extreme example. That’s what they’d like to do. But for a good company, where there is real interest from other people, I am seeing like 20 to 25 to 30 percent of the purchase price going to employee glue to keep them going in the future.
Scott Orn: And to give some context, it used to be like you just bought the company and then you would sign up the manager team for like an options package after the deal, could be nowhere near that, right it would be minimal.
William Hawthorne: Yes, no one does that anymore. Generally the first kind of four, five, six key employees that obviously had a lot of equity in the startup or having to re-vest around half of that over three to four years.
Scott Orn: So what they, even if they’ve already vested, they’re having to re-vest, basically sign up for the deal again.
William Hawthorne: That’s right.
Scott Orn: Wow. So how do you handle that, how does that affect you guys, how does that affect the buyers, how does it affect the VCs?
William Hawthorne: Sure, there is a couple of things; we are representing the company, but in probably like 90 percent of the cases, we really formed a type bond with the management team, but you have to be very careful because the management team now is pitted a little bit against the investors. Now what I would say about most of these founders is they are good people, and they care about their investors, they care about the guy that gave me the first two million or five or ten million, so they’re not doing anything untoward and saying hey I want this to go to the employees, but the buyer is saying specifically this is what I want, and so they stuck in the middle, and we’re stuck in the middle a little bit. Our job and duty is to the overall company—
Scott Orn: And you have a reoccurring relationship with the investors too, you care about them as well.
William Hawthorne: That’s where most of our deals come from, right. So it’s just a tricky thing, where you have to be seen as someone that’s doing the right thing for the company, and most founders are doing the right thing too, they’re not trying to cut side deals with the company to get more for themselves. In terms of the revesting and things, we let clients know before the offers come that that’s going to be a part of it, and they just have to understand that that is part of the game, the key there is to make sure it’s time based and not an earnout. In seven years at Code I’ve never signed up my company doing earnout.
Scott Orn: Can you talk about what earnout is?
William Hawthorne: Sure, so the difference is an earnout out could be— listen you’re going to put this 50 million aside for these employees, and over the next four years, you need to reach a certain level of revenue or profitability or a certain product milestone and if you do that, then you get this payment. That’s not what I’m talking about and no one should sign up for those, because earnouts are very hard to collect, because once they own you, then they want you to do what their mission is, which could be in direct conflict with the earnout.
Scott Orn: They might move your whole team to an earnout division, there is no way you can ever hit that earnout. I totally agree, like never sign up for an earnout.
William Hawthorne: What we’re talking about is taking that 50 and saying employee you are ten million of that over the next four years you’re going to get two and a half million a year as long as you’re employed, and oh by the way if we fire you without cause, you accelerate and get that money, so it’s really just about sticking around for those four years.
Scott Orn: That makes total sense. How do you navigate that kind of request from the buyer to do the 20 percent to the team out of the purchase price, like what are the steps there?
William Hawthorne: What you do is you obviously show the term sheet to the entire board and you talk about it as a board, and then you get everybody’s input on what they want to go back with, so you can’t do it in a vacuum just with the founder or just with the investors, you have to bring everybody together in one room and everybody just, you know here’s what we think. And, there’s a trade-off when you go back to those people, you know that for certain companies getting money to the employees that are really important, so if you want to ask for more money in places you know where you can ask for that. So maybe we feel like we’ve tapped him out on the overall price, but maybe we think there’s a few more they’d give to the employees and therefore we can adjust something else that’s going to the investors. So you can do things like that, but in general, it’s just being honest with everybody, this is where they’re at, this is important to them, how hard do you want me to push to move dollars back from the employees to the investors, or how hard do you want me to add to bucket a or bucket b.
Scott Orn: Yeah, are you seeing that, because the late stage market has been pretty hot for the last three or four years, and a lot of startups are raising like big rounds of big valuations, and my hypothesis would be this is coming into play for that reason too, and that may be like the last round of investors are not in the money, in this acquisition or something like that; how do you navigate that situation where there is like a liquidation preference, or the valuation is just too high?
William Hawthorne: Yeah, so in those situations, in general, you are stuck with a situation where the investors are going to have to give back something to the employees to make it happen. So a part of the conversation we have been talking about is how important the employees are, and the founders. So they have a lot of leverage in this process, and what happens is if you have a company that’s kind of under a preference and somebody wants to do the deal, then the investors are going to have to get together and say hey, we need to carve out out of our stake because our preference is going to take the whole purchase price, we have to carve something out of our stake to give to the employees otherwise there is no deal, because the employees won’t go, they won’t sign up to it and then therefore it won’t be bought.
Scott Orn: Yeah, how do you bring that kind of ahead, because I’ve seen a lot of companies over the years that just everyone talks about it, everyone knows that needs to happen but no one wants to make the first step, like—
William Hawthorne: No one does anything until there’s an offer. In some cases, where you have a company that you’re saying hey we want you to go out and sell the company, because we’re not going to be able to raise more money, they’ll put a package in place for management, it’s very customary, we’re generally not involved in that conversation, the investors get together with the CEO and others and say what about this number, what about this number—
Scott Orn: They might not be your target clients anyway.
William Hawthorne: Those are tough situations, but there are many companies that are good companies, and this is another thing about a little more about raising money rather than M&A is they try to top tick price and they take bad structure for that.
Scott Orn: Can you explain that?
William Hawthorne: Sure, so your client tell you know, somebody could come to you and say I’ll give you ten million at a 20 per [31:52 inaudible] right, and I’m just going to use that as example, clean.
Scott Orn: Sold 33 percent of the company in this round?
William Hawthorne: Yeah, but it’s clean. When you go to sell the company, I get the higher of my equity ownership or 1x right, there is no coupon on it, and there’s no other kind of big bells and whistles, it’s pretty clean. Then I have another client, the same client gets an offer from somebody that says I’ll put in ten million at a 40 pre but I want a 2,5X on my liquidation preferences and I want a guaranteed eight percent coupon return over the life of the investment. And, the founders looking at it and going I really like the 50 and my company is always going to go up, so that liquidation preference is never going to come into play, and let’s go that route. And that’s fine, as long as the company keeps going up to the moon, but at some point those liquidation preferences catch up with you. The other thing is, the next round whatever you gave to the last round, they want it, so they’re like—
Scott Orn: I was just going to say that, like they are going to see it and they’re going to want it too, so it makes it harder to do another round.
William Hawthorne: And then the liquidation preference really starts to add up until it becomes kind of unmanageable and therefore the common gets sunk down to almost nothing and that’s hard for retention and recruiting.
Scott Orn: It also is bad for like the series A investor, the first money in, because they’re getting squashed like how common it is getting squashed and most of the people who like to do those kind of highly structured term sheets are usually like hedge funds or people who are not really that incentivized to be a good actor in the VC ecosystem, they’re usually like a hedge fund or some other institution that like thinks they figured this out and is going to do this, and what they end up doing is they end up getting kind of in the not so greatest deals, and then it becomes a self fulfilling cycle, because then they need to enforce those preferences, so that they can get their money back or make a little bit of money and the system turns negative kind of faster, it’s like this feedback system that’s really kind of scary to get involved in.
William Hawthorne: You’re right, and it’s hard to get away from it once you accept that first deal like that. I would say it sometimes is the investor, but it’s also sometimes the founder, and one of the things about the founders, their biggest issue is recruiting good talent. So if you can have a press release that you had a significant up round, that leads to a lot more resumes, a lot more inbounds, and a lot better hiring, and so sometimes people try to stretch those terms to get that headline price to recruit talent so there’s a reason for it, but I would tell you that every time you should just take a lower valuation, clean and move on.
Scott Orn: I totally agree. We should be honest there’s a little bit of ego involved on the founders, it’s not just they’re trying to recruit better, it’s like they want to go to a cocktail party and talk about it, as everyone would, but just be smart about it, take the more conservative route, it pays off in the end. The final kind of topic we’re going to talk about was, how you guys work with both the companies and the VCs to make sure that the investor group is doing the right thing for the company? And we talked about that a little bit, but it’s kind of a tricky situation.
William Hawthorne: Yeah, almost every company we work with has a board filled with VC investors, and the issue there is they come in at different times, and they also sometimes have different goals and objectives than the management team. And when you start to see offers come in or tricky situations come into the company, how people act, are they board members and therefore acting on behalf of all shareholders, all employees, all stake holders, or are they an investor and they’re worried about what they’re going to get for the series A or the series B, or the series C for their LPs. And in fairness to them, it’s very difficult, because the reason why LPs invested in them was to get a return, those are their customers, right, they made an investment here but they’re sitting on the board. And so I think it’s very difficult to separate in certain meetings for people, should I be doing this for the company or should I be doing this for my investment. And I will tell you, probably 30 percent of the time those are in conflict. It just happens.
Scott Orn: Yeah, we were talking about those like structure term sheets, one temptation for that is maybe venture capital funds out raising their next fund right now, and so it’ll look a lot better on paper if the company had a 100 million dollar valuation, even if it was highly structured versus a 50 million valuation, they look like they are two times smarter, and have two times the return on paper. And so, they may be willing to kind of take a highly structured term sheet in that scenario, because they know it’s going to make their fund raising for the next fund easier. So there’s a lot of like, it’s tough, like I don’t envy you and I don’t envy the VCs actually, because they know they need to do the right thing for the company, but they also have these kind of near term pressures to make their numbers look good, or dress things up, things like that.
William Hawthorne: Yeah, I’m on a transaction right now that’s a little difficult and right now, we have a board call and then there’s a shareholder called right after, and so they’re really doing a nice job of trying to separate their two duties, because the shareholders can vote whatever they want regardless of what the board decides, but they’ve realized it’s tricky enough and we do have one of these waterfall issues with liquidation preferences and a management, and so they have a side meeting after every call to try to discuss and work through these issues. I think the biggest piece of advice is to get good independent people on your board early, and I know people don’t want a large board, but you’re going to want people that are really thinking just for the company and the strategic direction of the company, and aren’t thinking of it from an investor hat.
Scott Orn: Yeah, that’s a great advice, and I’ve sat in a lot of board meetings and oftentimes the independence, they own a little bit of stock in the company but they’re usually like a friend of the founders or they are a professor, or they are industry expert and they have a lot of experience usually, and they can help guide the conversations; they can also take the emotion out of the conversation, which is really underrated. I’ve seen like board meetings where people almost gone into a fight, and it’s like crazy, you wouldn’t think that would ever happen, but it does, because these like dollar amounts get so big. And having a strong, independent can really help you navigate that.
William Hawthorne: Completely agree.
Scott Orn: Yeah. Any other big topics, like one of the things that you even coached us on is making sure that company is prep for that, they’re not prepping like they’re going to sell the company immediately, but like always have that mindset of being prepared to sell the company, if that inbound comes in, like how do you advise companies on how to do that?
William Hawthorne: Yeah absolutely. So I think the process is overwhelming, if you have a fast growth company you probably are just surviving, and so the M&A or raise gets thrown into your life and now you got to worry about that, and run your business. And it becomes just too much, which is obviously I think good advisers will be helpful, but in the end, you always want to be prepared especially on the legal and finance side. That is stuff that you don’t think about every day, you don’t care about, it’s not top of mind while you’re growing your business, but it’s like the number two or three item on the due diligence, and it’s those two topics take up probably 80 percent of the due diligence. The technology people can get there like you either have it or you don’t, and the product people can understand whether you have it or not, and how well its protected, but in the end, all of the legal and financial stuff takes a really long time and if you’re not prepared for it, they can delay the transaction significantly.
Scott Orn: Yeah, having a good lawyer is worth its way. And sometimes people will say how sometimes investment banker get grief further fee structure, but like a good lawyer may seem expensive, but they’re actually very inexpensive, those dollars you spend on having your legal framework set up correctly, having all the option paperwork done, stock purchase agreements done, it’s so valuable. It also just projects like this professionalism to the buyer, that they know that lawyer or investment banker, or accountant would never let this company do something totally off the wall and make sure they’re kind of tidied up, and it really does help quite a bit, it’s amazing.
William Hawthorne: You’re right, I mean, buying a company is about confidence, it’s first in kind of the founder management team and then it’s in the product technology and then it’s in everything else, I’m going to buy your company, I’m going to integrate it into my company, and I want to know that you have control of your company, right, and that comes down to finance and accounting and legal in the end.
Scott Orn: This has been a great podcast, I feel like we need to do another one like in two weeks, there is so much that we didn’t cover, and it is so good. Maybe you can just tell everyone where they can find you and how to reach out the Code Advisers?
William Hawthorne: Sure, will@codeadvisors.com is the easiest way, and I will say that at Code, we probably spend 60 to 70 percent of our time doing things for free, for small companies, that’s what we like to do, that’s where we get our clientele from, so if you have questions about trying to get to the right person for business development in a big company, if you have questions about board members that you’d like to hire or anything else about processes that we’ve run, I’m happy to take those calls or emails and I’ll give you the best answers I can.
Scott Orn: Yeah, and I can personally vouch for not only Will, but Code Advisers, Will is an amazing guy, I have known him, I can’t even believe I am going to say this, but I have known you for like 17 years, which is terrifying to me, because I remember us being so young and handsome, and carefree. But he’s really incredible, he’s a great investment banker, so definitely look him up if you are thinking about selling your company or that offer he just gave is very generous, like if you have questions or you maybe just need a little bit of advice, he’s there, he’s been wonderful doing that for Kruze Consulting clients, and I know he’ll do it for other people too.
William Hawthorne: Thanks Scott, I feel the same about you guys and what you’re building here, and look forward o working with you in the future.
Scott Orn: Cool, alright man, thank you so much.

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