When we’re evaluating a possible investment, it is easy to neglect how the strategic value premium will be determined and how this impacts on what we can expect as an exit value. Our initial focus is generally on target need, customer and competitive advantage but while these protect the business they don’t guarantee high growth rates. It is high growth rates in the hands of the buyer which will determine how large the strategic premium will be.

I recently evaluated a software company which ticked all the normal boxes. It satisfied a critical need, targeted a very addressable corporate market, had a proven integrated solution with considerable deep expertise in its functionality and a proven management team. No question that the business would be successful and they would capture a reasonable market share. However, the key to a high strategic value premium is in the ability for the buyer to rapidly scale the solution in the first two years after the acquisition.

I put myself into the shoes of the buyer and asked the question ‘how rapidly could I deploy the solution?’ Even if the acquirer had access to the prospective customers and the funds to ramp up the marketing, sales and support effort, I could not see how they could scale rapidly.

The problem in endemic to a lot of application software ventures. A highly technical solution requires the business to recruit and train very specialized sales staff, pre-sales consultants and implementation staff. This alone tends to inhibit growth rates. In this case, the solution was also customized which would slow down the sales and  implementation processes. Sales cycles in high value integrated applications are slow because of the evaluation and approval cycles and there is little the vendor can do to speed up the process.  At best, I could see the acquirer doubling the business each year in the first two years after the sale but it would be a stretch to grow faster. If that is the case, the strategic premium would be relatively low.

If the growth rate is limited by the length of the sales cycles and the rate of adoption, the business will increase in value slowly. Thus, it will take many years for an investment to achieve 5 times investment on exit. If the growth rate is constrained in the hands of the acquirer for similar reasons, the value to the buyer is not much greater than if the business were sold as a financial exit. The key to any strategic exit is that the buyer can rapidly exploit the business through their own organization. If that is not possible or is limited, the strategic premium will be small.

An outstanding strategic value investment demonstrates the capability of very rapid deployment within a short period after the sale. Not only do you want the compelling need, the highly targeted niche market and the strong competitive advantage but you want short sales cycles and very low marginal cost of sales. Standard products which can be sold through the internet or easily installed or distributed via high volume channels are what you look for.

I prefer to seek out investments where the acquirer can scale the business 20, 50 or 100 times after the sale. If the strategic premium is generated from revenue in the first two years after the sale, it is the rate of growth in this period which is critical to a high strategic value premium.

With any exit, we need to focus on what the buyer will do with the product or service being acquired. Just because something has a market leadership position does not of itself mean that it will generate a high strategic premium on exit.