Investing Through a Downturn: RegTech and Customer Onboarding (Part 2)
Of course, 2020 was a year like no other, bringing about unprecedented change in a compressed timeframe. Prior to the pandemic, deal-making was notoriously about face-to-face relationship building. However, companies have been raising capital and doing deals absent that critical element.
Recently, a few industry colleagues and I got together (virtually speaking of course) to talk about what we are seeing and how we are advising portfolio companies in this environment.
Sincere thank you to Christen and Sean for taking the time to share their unique perspectives.
Below are excerpts from our conversation.
Question: Even during the pandemic, deals are getting done – new funding rounds are being raised, M&A is happening, and sellers have not only found buyers, but excited buyers. What are your thoughts on valuations and deal activity in light of the pandemic and what do the lessons learned from this period mean for the future?
Christen: We’ve been saying for years “valuations are on the rise, but they are going to come back down. This is crazy.” At this point, there is no evidence of valuations coming down, in part because there is so much capital available, particularly for tech assets. I think COVID-19 has pulled forward some priorities for sponsors and investors, and that created an extra busy Q3 and Q4 for 2020. I expect we will see the IPO window continue to open and close. For M&A, I don’t see corporate acquisitions as being a flash in the pan. Based on the momentum in Q3 and Q4, 2020 could end up being a record year for tech M&A.
Sean: As the notable investor Michael Burry once said, “The only prudent view in my opinion, is no view.” Expectations at the height of March and April uncertainty were that software would be hit as hard any sector. On the back of both interest rate policy, a dearth of yield or attractive risk/reward in other sectors, the realization that software is in fact as “sticky” as we thought and the recognition that yes, digital transformation is in fact real, means valuations have expanded well beyond what we can reasonably underwrite from company fundamentals.
Regardless, I expect that investors will continue to reward software companies with premium - albeit often unbelievable - valuations as they underwrite companies with sustained growth models eventually generating appealing cash flows at scale. And it is because of these same trends that I believe well-capitalized buyers and software investors will continue to deploy capital in a range of deals as aggressively as they have through 2020.
Jason: For the last several years we all hypothesized that there is no way valuations and the M&A market can continue at the rate it is. And we’ve continued to be wrong. It only took years and years of being wrong for us to learn not to speculate broadly on valuations of the overall market anymore.
Before 2020 we had a market where the rising tides and euphoria were lifting all boats. You were seeing companies receive the benefit of that from an M&A standpoint. A lot of companies were being acquired for what I think maybe in historical review were not all the right reasons or for the right price.
What the last year has done is dampen that idea that all boats are rising with the tide and it is creating a bit more of a barbell effect. Both the sponsor and strategic community have wiped away the euphoria and said, “ok what really matters about this company and how do I want to value it.” They have gotten to the fundamentals, and the core thing that they care about. And that will continue.
As Christen mentioned, there is still a tremendous amount of capital sitting on the sidelines, in theory, with fewer quality businesses to invest in. So those that are good, that are fundamentally strong, their valuations have spiked, almost unnaturally higher because the supply and the demand is even further out of equilibrium than it already was.
Q: How important is it for companies to form strategic relationships, well in advance of thinking about their next phase or potential exit strategies, especially as it relates to both corporate and business development. How important was it to have these relationships with corporate strategics or other potential buyers already in place going into 2020?
Jason: In Q2 of last year, everyone experienced the freeze in investing and M&A activity but at the time it was hard to predict what would happen next. What we know now is that activity came screaming back in Q3 and Q4. What we have identified is much of that activity was with a counterparty where there was a preexisting relationship. In short, the two sides already knew each other. This is why business-to-corporate development is such a valuable strategy.
The circumstances over the last year proved what we believe - strong relationships that are built over time are differentially valuable, particularly in an exit process. For a CEO, building a business-to-corporate development strategy takes time, it is an investment of time. But we have repeatedly seen outcomes optimized when it is embraced so we partner with our companies to build business-to-corporate development playbooks as early on as possible.
Christen: We like to help companies think very strategically from the beginning of a relationship about where they want to end up and how we build a bridge to help get them from where they are today to that end goal throughout the lifecycle of an investment.
Last year, we rolled out a value creation framework designed to help Georgian’s companies begin the process of long-term exit planning. The process includes, among other things, understanding the ecosystem in which a startup is operating and identifying potentially high value strategic relationships to focus on developing for the purpose of that long-term exit plan (not to mention commercial benefit along the way). Planting seeds early with a set of key strategic parties can be a difference maker in the ultimate success of an exit event. There’s no question that parties who invested time and energy in this dialogue pre-pandemic have a running start in the acquisition frenzy we are experiencing now.
The other key aspect to the relationship development piece is to be able to tell a cohesive and compelling story about your business, its core differentiators and its long-term vision. It’s really important to take a step back and view the business through the eyes of a third party and be able to articulate its “secret sauce” in a credible way. If you can do this successfully, you lay the groundwork for a potential strategic outcome. In the course of the dialogue, you also get a window into the potential acquiror’s strategy and priorities, which can be very helpful in tailoring the messaging to align with those priorities and help them to build a potential deal thesis. This is particularly relevant where there are significantly fewer opportunities for more casual in-person interactions.
Sean: We encourage all of our portfolio companies to invest in business and corporate development. We think the time to start building those relationships begins as soon as the product fit is established companies. We truly believe that the best companies are bought not sold, and the way to create that strategic optionally is to build relationships over the long term.
Strategics love to try before they buy. Salesforce doesn’t wake up and just decide to spend billions of dollars on Slack.
Of course, you can’t realistically wake up and just start developing relationships. Planning is important. Define what objectives would benefit from business development, corporate development. Understand what the other company is trying to achieve. Are they trying to impact a marketing metric, a sales metric, or a product metric? Agree on where it makes sense to execute organically verses partner, and then we partner with them to map out the ecosystem once they know what they are trying to effect in their own business. Map out the relationships. Build an engagement model.
You don’t need to put up a for sale sign to go out and have conversations. Tell a really great story, meet product leaders, sales leaders, corporate development leaders, at businesses that could eventually acquire you.
Broadly, across our portfolio, a lot of folks are recognizing they are essentially just buying an option when they invest their time in business and corporate development.
While in the past founders might have considered corporate development discussions to be something of a free option – a nice to have but not a need to do – with the pandemic and the ensuing economic uncertainty that has changed. Now, founders are more willing to engage on building those relationships than ever before.
Thank you again to Christen and Sean. We are all passionate about how playing the long game with relationships adds value to companies, their customers and the industries in which they operate. Do not hesitate to reach out to any one of us to learn more about how we add value to startups and generally work with companies.