What makes a high-tech startup a worthwhile acquisition target?

A lot of startups in Europe develop innovative breakthrough technologies. True innovation involves high risks, the incentives for startups to take these risks and disrupt the status quo are normally higher than in larger corporations. For established companies, acquisitions are a way to secure promising technological innovation. The second aspect is new and disruptive business models. Here, the incumbents are often, not only slower than startups but also held back from experimentation by their existing businesses they don’t want to cannibalize. The third important aspect is that a successful startup consists of a self-contained team that has cutting-edge talent and a proven ability to deliver.

What makes a startup unsellable or difficult to sell?

Signing any form of an exclusivity agreement with broad applications makes it harder to sell the startup. If clients get exclusivity for narrow geographies or applications that can be ok. But often potential strategic buyers try to establish exclusivity rights as a way to buy a company on the cheap. The same goes for corporations as investors in a startup. If they use generally accepted standard terms to invest, as other venture capital firms do, there is no problem with that. You can even see competitors investing in a startup at the same time, and that’s not a reason to worry. However, if a strategic investor starts to demand special rights, for example, the right of first refusal, which is the right to match any buy offer by an outsider, this can make the startup very difficult to sell. Unfortunately, less experienced founders sometimes fall for this. M&A advisors might refuse to work with the startup as well. Again, as a founder, you should only agree to such a clause as a last resort. The last point to take into consideration is intellectual property. Founders need to be careful that the relevant IP is owned by the startup and not any other entity like, for example, a former company of a founder. The way that European university spin-offs are sometimes organized, where they have an exclusive license for the IP from the university, makes everything a bit more challenging for some acquirers. US buyers want to see that the Intellectual Property is owned by the company and not licensed. Still, there are ways to work around this issue.

Verve tries to establish connections between founders and M&A professionals early on, as a way to increase the chances of successful exits. But what do you think is the right time for a first discussion?

It really never is too early. At Woodside Capital Partners, we’re happy to start discussing with founders and boards at the early stages already, since a relationship takes time to build and there are things you should know years before you enter a formal M&A process.

Such as?

The overwhelming majority of exits, more than 90%, are trade sales, not initial public offerings. You can improve the chances of a trade sale by partnering with potential buyers and building leverage, rather than them getting too much leverage on you, for example, when you try to sell a company with a short cash runway. Another point to keep in mind is how to maximize the outcome for the founders, and this is something to be considered before every financing round. It is crucial to understand your cap table in detail, which means knowing who gets how much in a given exit scenario. Corporate buyers are very sensitive to valuations by nature. Trying to raise as much money as you can at ever-increasing valuations is not how you maximize your outcome as a founder, because it can make your startup more difficult to sell, your shareholding is likely to get more diluted, and the common stock held by the founders moves further down in the preference stack.

You allude to the fact that new investors often get preferential rights in case of an exit, which means they get paid before older investors, which get paid before the founders. The resulting payment waterfall can result in founders walking away with a pittance even if an impressive price was paid for a startup. Professional investors will be mindful of valuations. At the time of an investment, they need to be in a healthy relationship with the exit potential of a startup. But how much are corporate buyers really willing to pay for what?

You’ll agree that valuing startups isn’t an exact science. We’re not selling bottles of milk, a startup can be better compared to a unique work of art. One way to think about it is the difference between financial and strategic value. A later-stage startup that has established a lot of commercial traction and makes more than, say, 15 million in annual revenues, can be valued using multiples and comparisons with public companies. Early-stage startups that have developed great technology or an interesting business model will be bought for their strategic value, which means that this small piece of technology can have an outsized impact for the buyer. An example would be a sensor technology that gives a mobile phone company an advantage for its next generation of smartphones. The difficulty with this strategic value lies in capturing it. If nobody knows about this technology, and the start-up has not developed meaningful relationships with at least a couple of strategic partners it often means a more time-consuming sales process because potential buyers will need time to get to know the start-up.

The question is then, how to make potential buyers aware of your existence?

Ideally, you establish partnerships early on. As a startup, you should be working with a number of potential buyers. If you’re able to do this, you should also know who the people are that really believe in your idea. These will be the same people that will champion the acquisition internally in the future. If you don’t have them, it’s easy to get lost in the maze of a big company with 100’000 employees. The more potential buyers see you as a vital piece in their strategy, the better are your chances to establish a competitive buying process that drives your exit value. We have recent experience of selling a company with no revenues for well over $100 million, the key is knowing which strategic buyers have businesses in the billions which could depend on the novel technology for their future competitiveness. This is the benefit of working with an M&A Advisor that really understands both the technology and the industry sector.

Before a startup enters a formal M&A process, there can be other challenges, for example, the simple fact that not all the founders may be happy to sell the company.

We do advise founders to align early on before they start a process and refine it on an ongoing basis. Most founders not only care about what is economically good for them, but also about what will happen to the team and their product in the future. As the outcomes are unevenly distributed, there should also be common ground with investors. You don’t want to be in the middle of a negotiation and then realize that the Series B investors are happy to sell at 40 million while the founders are aiming for 60 million. An M&A advisor will help you figure out who is looking for what.

Verve has working relationships with several M&A boutiques, and helps guide portfolio startups to the right addresses. But in more general terms, what should one look for in an M&A advisory firm?

The most important thing is to talk to advisors that understand your business. WCP was founded by an entrepreneur that was fed up with spending weeks explaining to different advisors what his company was doing. We pride ourselves on being tech experts with operating experience. We provide valuable advice within 30 minutes of starting the first conversation. The second aspect is to talk to someone who specializes in the size of deal you’re aiming for. We’re working in the so-called mid-market segment, which is between 30-500 million in transaction size. If your exit is going to be in this range, your transaction won’t be that to a large investment bank, so they will not give it their full attention and you will most likely just get their most junior staff. Finally, as I mentioned before, it’s good to establish relationships with advisors early on, so you can work with people you know.

The tactics of negotiation will differ a lot from one case to another, but is there a commonality worth mentioning?

Going from a letter of intent to closing a transaction is a tricky and time-consuming process that needs to be carefully managed. One central theme is to keep the momentum going and try to go as fast as possible. However, corporations can only operate at a certain pace. I’ve worked in corporate M&A and know the many hoops a transaction needs to jump through before it happens. Especially in a later phase, when M&A lawyers try to hash out the final agreement, there is a certain danger of the process stalling, and getting locked in technicalities. Making sure the initial motivation to buy the company doesn’t turn stale is important at that point.

What about the macroeconomic environment and its impact on the transactions you specialize in? Is now a tough time to sell a company?

The macro situation certainly is tougher, and it clearly affects the number of the big transactions that are usually featured in the news. While the pressure to grow your business never disappears, most companies don’t want to risk big acquisitions in these economic times. Hence, they turn their attention to smaller ones. If we look at historical data, we see that the lower end of the middle market is quite stable through ups and downs. The number of transactions varies only by about 10-15% even in downturns. The explanation also has to do with the supply side. These are clearly tougher times for startups to raise funds for future growth, so founders are more willing or even forced to sell. This balancing mechanism keeps the number of transactions in this segment stable, even while the overall M&A volume is down due to the reduced number of billion-dollar-plus transactions.

Since last year, growth at any cost has clearly fallen out of favor with investors who are all of a sudden urging startups to be mindful of their cash runway and cut costs. I guess that is also a very relevant point from a buyer’s perspective.

If you’re burning through a million a month as a startup and a long way from profitability, today it will indeed be a tougher sell. Corporations are sensitive to the question of how much money and time will be needed before a target becomes accretive to their profitability. So yes, anything that reduces cash burn is important. But this is a tough question for startups, who never have enough employees to do everything they want. If you have three salespeople and let one go, this might have a devastating impact on your revenues. You need to cut unnecessary expenses without harming your business. I sometimes wonder why industrial startups think they can afford very fancy office space, for example, offices that are plushier than anything I ever saw at a large established industrial company.

Once a transaction is over, successful founders don’t go golfing, but rather become part of the buyer’s organization. Often, the financial consideration includes deferred payments linked to the achievement of milestones. How do these points influence an M&A transaction?

After the sale, the founders are expected to stay on for at least two, more commonly three or more years. Buyers should strive to make this attractive from a career perspective, ideally, the founders become leaders of something even bigger than what was sold. Financial incentives such as earnouts or other mechanisms are usually part of the package, but they can also lead to a lot of frustration on the part of the founders. Once you’re 100% owned by another company, you’re no longer fully in control of what was your start-up. Strategies can be changed, pricing decisions altered, and sales forces reassigned. For such reasons, our job is to maximize the initial payment and minimize future payments. These issues can be compounded if you get bought by a private company and paid in shares. What are the future prospects of this company and when will there be a liquidity event? On the other hand, it can also be a big opportunity if the acquirer has positive momentum going. As a founder, you can keep the appreciation of your wealth ongoing instead of being paid a lump of cash that might be challenging to invest at the moment.