Thinking About Mergers

An Overview for Founders of Technology Startups

This article is slightly dated and is far from comprehensive, but I am leaving it up for sentimental reasons. It emerged out of a short talk I gave to a roundtable of entrepreneurs in New York City, shortly after selling my own startup.

The perspective is from an entrepreneur to other entrepreneurs, and is particularly relevant to technology startups. This overview mainly discusses the scenario where a small company is acquired by a larger one, rather than a merger of equals or a roll-up approach to winning a market.

Table of Contents

Selling your startup usually comes packaged with mixed feelings. On the one hand, an acquisition can bring great opportunities to both the company and its shareholders. On the other hand, selling means handing your baby -- and with it your history of blood and sweat, thrills and frustrations -- over to a new set of parents with new priorities and controls. Everyone's goals and decisions are different, but as the head of a startup, and thus the bearer of responsibility to shareholder, employee, and company, you will want to always keep the possibility of an acquisition in mind.

My favorite type of entrepreneur is one who truly wants to build a business, rather than engage in a quick flip, but you cannot build a business successfully without thinking about an exit strategy. Even if the founders work for love, investors and employees usually have more fiscal motivations. The most common exit strategy, by far, is via acquisition. Very few companies in any sector can actually make it to the public markets, but even in those cases, accomplishing an IPO is only the first step in the liquidity process. The public market brings a new level of accountability and public disclosure, and it can be quite difficult for a smaller company to remain important and vital in the eyes of the demanding, and faddish, public and institutional investor base.

However, beyond delivering a return to your shareholders, why do companies typically sell? Often, the motivation is growth. Startups are usually resource constrained in such areas as capital, sales staff, distribution partnerships, management, and/or product development. A strong parent company can usually bring one or more of these things to the table, plus brand recognition, customer relationships, and established sales channels. Startups typically try to augment their capabilities through strategic alliances, but these deals tend to be better on paper than in reality because the partner fails to deliver the requisite level of focus and dedication. A merger brings no guarantee of parent company support and performance, but it is inherently a much deeper level of commitment and integration.

In the case where an industry sector is highly fragmented and market share is critical, consolidation through mergers can be a desirable strategy (this article, however, mainly discusses the scenario where a small company is acquired by a larger one, rather than a merger of equals or a roll-up approach to winning a market). Lastly, when a startup has negative cash flow and additional rounds of financing are uncertain, the company goes up for sale purely for survival.

When it comes to selling your company, there is usually a window of opportunity, but the size of the window depends on the strength of the startup. One sees management teams try too early, when the company can offer little but hype and "slideware", or too late, when cash levels have dwindled to desperate levels and public attention has long since moved on. Timing is important, so while all startups require stubbornness in the face of adversity, it is critical to stay realistic about your startup's growth potential, bottlenecks, opportunities and risks.

Even when your startup is hot, it makes sense to cultivate relationships that can lead to an acquisition. The more companies that know you, the more that might be interested in making a bid. After all, increased competition for your startup leads to a stronger negotiating position and a higher price. When you are hot, acquisition offers will come to you, but in other cases, selling your company will be just like selling your product: your team will need to do the legwork.

Once you know you want to be acquired, you need to find a buyer who can afford the purchase and who has a strong need for the startup's assets. Sometimes the buyer is a company outside of your sector who anxiously wants in, but often you will find that the best buyer candidates are your best partner candidates. Whatever the partnership synergies (for example, you have a leading product and they have a sales channel, or vice versa), it is probable that you have already thought about a business development relationship with these companies. Naturally, in some cases these businesses will also be potential competitors whose product lines have not yet overlapped with your own.

Once you have identified a group of potential buyers, you need to filter the list by analyzing the business strength and currency (cash/stock/other consideration) of any potential buyers. You want to determine if they have a strong enough cash and equity position to enable them to do a deal. Especially if you expect to receive stock for your company, you want to judge a buyer's stability and growth prospects. You would hate to see the monetary value of your deal drop several months after the deal is done. Last but not least, you want to think about the culture fit -- can the two organizations truly work together as one company? Business is about people at the end of the day; cultural clashes and politics have destroyed the success of many acquisitions.

Try to get to know potential buyers long before you might want to sell, and certainly before you directly discuss the topic of an acquisition. Be careful with the information you disclose, for buyers are often potential competitors. Discrete conversations that investigate areas of possible mutual interest are usually worth the effort.

Avoid discussing your acquisition interests during these conversations unless the other company raises the topic, and even then, you usually want to play it cool at first. It is better to be bought, not sold. First steps often come in the form of a strategic partnership and/or a minority investment by the other company, but sometimes an interested buyer will skip dipping their toe in the water and try to jump right in. When it comes time to discuss an acquisition, you want your buyers red-hot, for urgency and emotion on the part of the buyer's management team leads to higher offers. The slightest whisper of desperation on the part of the startup immediately lowers its valuation.

If you have decided the time has come to sell, one can take an informal or formal approach. The informal approach starts with personal conversations with possible champions within the buyer. Like any high-end sales process, you want to identify the power players who stand the most to gain from a deal and get them excited about a partnership. You also want to adapt your sales pitch to the particular interests of your target and the synergies specific to their business.

Large companies often have a business development and finance team focused specifically on investments, mergers, and acquisitions. However, these groups are often working on a large pipeline of opportunities, and internal champions can raise you to the top of that list. Investment banks and M&A advisory companies with strong practices within your industry sector tend to have pre-existing relationships with the executive and M&A teams at major companies, which sometimes gives them inside information on the interests and priorities of potential buyers.

These bankers/consultants take a more formal approach. They will work with you to identify possible buyers and to create a selling memorandum or management presentation, which can be similar to the type of business plan/pitch you would use when talking to venture capitalists. They will leverage their relationships with management at key buyers, and approach their contacts over the phone and possibly with a short "teaser", keeping the name of your company confidential until a non-disclosure agreement (NDA) is signed. Once an NDA is signed and the interest level confirmed, the selling memorandum is sent.

It is up to your team and board as to whether your company takes these steps directly, or through an intermediary such as an investment bank or advisory firm. A selling memorandum is not always necessary, just as a full business plan is not always needed by venture capitalists. Sometimes conversations, meetings, presentations, and due diligence documentation are all that is required. In some cases, a selling memorandum can even be counter-productive, because it presents the appearance that the company is "on the market".

There are many benefits to working with a banker. They can advise on the optimal process, and since competition is usually required to get a decent price, this advice can be critical. They can raise your profile at a higher level within a buyer so that you are viewed as a strategic, not tactical, purchase. They serve as buffers during negotiation, so that neither side gets too over-heated and a good deal explodes because of the emotion of a moment.

Regardless of approach, remember to sign a non-disclosure agreement before disclosing detailed information. NDAs are not failsafe, but they offer some legal protection and highlight the need for secrecy. You must also carefully decide, even with a signed NDA, how much information you want to disclose and at what stage of the process. An interested buyer will usually want to know more than you want to share, and you will have to use your discretion at every stage to determine what level of disclosure will intensify the buyer's interest without harming your business should the deal fall through.

Tips for Approaching Buyers

- Create an executive summary that can be customized to each potential buyer and give one or more copies to your internal champions. This will help them describe your business and the reasons for purchase to fellow members of the management team with more clarity;

- If you give a presentation, have "tear-away" pages that you can hand out;

- Like any sales process, keep up communication with the potential buyer and your champions. They will have their regular jobs to perform, and you may slip through the cracks with no intention of malice on their part. As long as your level of contact does not get excessive, they will usually be thankful for your reminders and patience.

Lawyers

It is absolutely critical to have a highly-professional lawyer who has experienced many M&A deals in your industry. You want a lawyer who has seen what works and what fails in a deal structure; who knows where negotiations often break down; who can distinguish standard industry practices from the non-standard demands of the buyer (very important in such areas as vesting periods, contingencies, non-competes, reps & warranty timelines, etc.). You want a lawyer on your side free of any conflicts of interest, and whose negotiation style you trust, for on some points of the deal contract, you will want your lawyer in direct discussion with the buyer's lawyers and representatives.

Accountants

If your accounting firm has advisors experienced in M&A, they can provide excellent feedback on the deal structure and tax ramifications.

Investment Bankers

As mentioned above, investment bankers (or M&A advisory players) can bring industry knowledge and pre-existing relationships to bear that can speed the process greatly. Like your lawyer, they can provide solid advice on the best way to structure a deal. They will help determine your company's fair market value and are useful not only because they bring to bear financial skills and knowledge of valuations of comparable companies and deals, but also because they lend credibility to the price tag you are assigning to your startup during negotiations. Naturally, this credibility is dependent on their reputation in the market.

Also noted above, these advisors can also provide the invaluable service of acting as an intermediary. The sale of a company can be quite emotional for both sides, and a talented third-party negotiator working for you can keep discussions from getting too heated or too personal. Intermediary negotiators have saved many a deal that both parties wanted, but would never have accomplished had they been interacting directly because of emotional involvement. When the deal is done, everyone needs to work together as colleagues with little resentment and a strong desire to build a business together.

Investment banks and brokers often charge an up-front and weekly or monthly fee, and then a staggered percentage of the deal size, typically with a fixed minimum commission.

Tips on How to Find Good Advisors

There is no better source for finding good advisors than referrals. Talk to your investors and other entrepreneurs, consultants, and venture capitalists whom you respect and trust. Very often, the best lawyers, etc. in the field are quite busy; they might talk to you after a cold-call if your business intrigues them, but your chances of landing a hearing will be much better if you can drop the name(s) of someone they already know. When the referred party cannot take you on as a client, ask them if they can refer you to someone else. Lawyers, bankers, and consultants work together constantly, and they are always aware of who is strong and who is weak among their peers. It is in their interests to network and pass along referrals, so do not hesitate to ask.

There has been some discussion in the technology field about the dangers of taking on a lawyer whose firm works heavily with your venture capital backer. After all, a VC provides a much higher volume of work than any single startup. Indeed, there have been documented cases of a conflict of interest when a lawyer has provided advice that looked after the interests of the VC, rather than the startup. I personally believe that this situation is the exception, not the rule, but use your judgement in this matter.

Many of the best-known investment banks will only work on deals above a particular size, although they will often accept a smaller client if the startup is in the public eye or in a hot new sector where they want to establish a reputation. Even when your company is too small, however, you can often get a referral to another bank or to an independent M&A consultant who can give you more attention.

Make sure your camp is in order well before you get involved in due diligence. You want to ensure that your legal documents (options plans, board notes, NDAs, partnership agreements, etc.) are organized and in good shape, that you have completed the proper government filings, that you have adequate product and marketing documentation, and that your financial records are correct, clean, and (unless you are very small) audited by a legitimate third-party. For an example of the kinds of documentation you will need during due diligence, click here.

You should expect your prime buyer to demand a no-shop agreement once discussions reach a meaningful state. A no-shop means that you cannot approach or discuss a merger with other companies unless the buyer walks away from the deal. If your position is strong enough, you want to avoid signing a no-shop, but often the buyer will require it before they move forward. From the buyer's perspective, they want to avoid a bidding war and to protect the time and money they invest in the deal process. It is in your interest, as the seller, to put suitable time limits on the no-shop and to ask for a break-up fee to recoup your costs should the buyer walk away. The buyer may refuse the break-up fee, on the justification that they too are investing time, money, and effort, or they may insist that the fee be bilateral.

Assuming that you want to run a competitive process, as opposed to engaging in a discrete conversation with a single party, it is also in your interest to get other potential buyers as far along as possible prior to signing a no-shop. This enables you to negotiate from a stronger hand, and also speeds the process of closing a different deal should your discussions with the prime buyer fall through.

You want to eliminate due diligence surprises that could throw the deal. Carefully differentiate customers and partners where you have a signed contract versus a non-binding letter-of-intent (LOI). Be clear as to where you are in product development. Decide up-front how much you can afford to share during due diligence (and expect to have to share a significant amount of detail). Have your documentation organized and prepare multiple copies (more than you think you need), for that will speed the process immensely. Due diligence almost always takes longer than one hopes.

Many deals fall apart in the negotiation process, so you may want to stage the information you disclose depending on whether you have interest, an LOI, or a definitive agreement. Some startups can be overprotective of information. Instead, be realistic as to what truly is critical, confidential information and try to avoid frustrating the buyer with excessively elusive behavior. If you believe you need to hold something back in the early stages, communicate what you need to see accomplished before full disclosure of the information in question.

Naturally, you will want to do your own due diligence on the buyer, including discrete conversations with others in the industry regarding the company's management team, and a careful examination of their strength as a company.

[Note: if you wish to view a sample due diligence checklist covering the documentation you will probably need to provide the buyer, click here.]

Always keep the worse-case scenario in your mind. Do not let these thoughts prevent a good deal from happening, but remember that many deals go awry both before and after closing. You want to have examined all the possible outcomes, contingencies, and courses of action. As always, surround yourself with good advisors (entrepreneurs, investors, lawyers, bankers, etc.) and use them to discuss current and potential developments. When you are mired in the details, your advisors will be an invaluable sounding board, reminding you of the big picture and noticing details that may have slipped through the cracks.

During negotiations, you should contemplate the issues that might arise once the deal is done. What if the parent company gets acquired? How will the two companies work together? What will happen to the various teams? Keep in mind that once your company belongs to someone else, everything is subject to change. You may receive promises of autonomy or influence, but the parent company will act as they see fit according to changing market conditions. If a post-deal issue is absolutely critical to you, you need to build it into the contract, but most buyers will be reluctant to restrict their future flexibility.

You want to prevent any part of the deal from being tied to a dependency over which you have little control. For example, product integration requires the buyer's effort as much as your own, and revenue goals depend upon the buyer's investments in marketing and sales. Avoid situations where you live up to your end of the bargain, they do not, and you end up absorbing the financial fallout.

The devil will be in the details. The big-picture issues often get hammered out early, but you will soon find yourself arguing over small but essential points in the contact. If the buyer has not done many acquisitions, they may suddenly bring up items, such as an employment contract, that you never discussed. Try not to get too frustrated, remember that the cause may be inexperience rather than sneakiness, and keep perspective on what is really a deal-breaker versus a workable issue.

When it comes to negotiations themselves, there are many different tactics employed and the right ones often depend on the type of people sitting across the table from you. I belong to the win-win school of thought: take a strong stand, but structure a deal where both parties can be happy; make sure your opposite knows that you understand their position even while pushing for your own; keep the negotiations from becoming emotional or personal in a negative or belligerent way; avoid excessive brinkmanship but use it when absolutely necessary; prioritize the points you need versus those you can give; always be aware of what will make you walk away from the table. These points are obvious, but it is always good to remind yourself of the basics while in the heat of the moment.

Create and distribute a list of all parties involved in the transaction from both sides, and include areas of expertise and contact information including email, pager and cell phone. Try to ensure that the message and positioning coming from your group is consistent -- this will take a significant time investment, but it is critical.

As one CEO recently commented, "It will feel like herding cats. Over-communicate, clearly and logically, and from the buyer's perspective, by a factor of ten. If you don't, you'll find that the deal mysteriously slows down because key people haven't been made aware of an issue at the right time. There were, in fact, times when we felt the acquiring deal team extremely sleazy because terms seemed to be changing, but in actuality it was relatively innocent miscommunication between the many lawyers, finance people, and operating people in their own group. This almost killed the deal alone."

One of the hardest parts of negotiating a sale is the impact it has on your normal operations. Your executive team will be highly distracted, your employees and customers will be concerned about the future, and your potential customers may delay purchases until they see the outcome. Discretion with all parties is highly advised, although the amount you must share will change as the process nears completion. An organized and efficient due diligence process, with participants carefully chosen and coached, will mitigate problems here. Make sure that your essential team members (executives and extremely critical employees) and top investors are on-board and as close to one mind as possible. You may need to do some internal selling. Do your best to minimize strife in what will be a straining process for all. The buyer will probably need to feel comfortable that your best people are behind the deal and will remain with the company after the deal goes through.

There is an obvious catch-22 here: if you want to encourage competition in the sale, you need to get the word out to potential buyers, but given how talkative most industries are, it can be difficult to keep rumors from reaching your customers, competitors, and employees. NDAs and constant reminders for discretion will help, but can rarely stop the gossip. If rumors start to arise, it is better that your employees and customers hear the news (and the proper positioning) from you rather than from another source.

With most deals (and not just M&A), once you are in the thick of negotiations, you want to keep the process moving as quickly as possible. Urgency on the part of the buyer usually leads to a higher offer price. Companies are constantly shifting focus and priorities, and if you fail to strike while the iron is hot, you might find that a new interest or emergency is suddenly consuming the energies of the buyer. Your negotiations will be delayed and sometimes never get back on track. You can keep the process going by preparing for and facilitating the due diligence process, demanding the attention of your key third-party helpers (board members, lawyers, accountants, and bankers), and keeping the specter of competition looming in the mind of the buyer. The major exception to this rule is when you decide playing hard-to-get can win a higher offer price or extra concessions from the buyer.

Different industry sectors use different valuation metrics. Software companies are often valued on multiples of revenue. Distribution companies and service companies are often valued on EBITDA (earnings before interest, taxes, depreciation and amortization). For technology startups, where company assets are largely intangible and future growth is so unpredictable, discounted cash flow (DCF) analyses are rarely used. Your financial advisors, both within and without the company, will be able to guide you in this matter.

Try to keep an eye and ear out for similar acquisitions, and see if you can't learn the details of the deal not only in the amount paid but how the company was valued. You can often track this information down by tapping into the banker and venture capitalist gossip network. When a public company completes an acquisition, you can often find the financial details of the deal within their SEC filings (found on Edgar).

You can also track the valuations of publicly-traded comparable companies, calculating the current and forward revenue/earnings valuations from SEC filings and forecasts from stock research analysts. If your startup is small, your company's valuation will be guided by comparable metrics, but driven largely by competition and urgency among buyers (just as with venture capital financing rounds).

While people usually enter into deals with the best intentions, mergers and acquisitions always entail an adjustment for both companies. Many mergers fail because the buyer neglects to come up with a comprehensive and detailed integration plan, or loses their focus on the execution of that plan once the deal is done. If you want your merger to be a success, consider it to be both parties' responsibility to come up with a solid integration plan covering all the people, business, and product issues. Your control will be limited, and it may seem like a distraction when you are in the middle of negotiating price and deal structure, but the more you push on this area, the better off you will be as the two companies move forward together. To maximize employee retention, both your management team and the parent company's management team will need to be quite hands-on and communicative with employees throughout the deal-closing and integration process.

Bio of the Author:

Living in New York City, Giff Constable is currently an investment banker with Broadview, a Division of Jefferies, working with companies in enterprise software, IT services and BPO. In his entrepreneurial life, he served as Vice President of Business Development for Opus360 Corporation (New York, NY), a 350-person software company, where he focused on partnerships, strategic direction, and product design. Prior to Opus360, Mr. Constable was CEO and co-founder of Ithority Corporation (San Francisco, CA), which was acquired by Opus360. He has worked for VC-backed enterprise software startups, Envive Corporation (Mountain View, CA) and Trilogy Software (Austin, TX), in marketing and sales. Mr. Constable received a B.A. from Princeton University.

© 2001 Giff Constable. Giff Constable can be reached at theeditor - at - constable.net