For some founders, the end stage they seek is a merger or acquisition (M&A) by a larger entity rather than fundraising toward a liquidity event. They may want to move on to another project or get access to the broad legal, financial, and operational umbrella that comes with falling under a new parent company.
No matter the reason, some founders also see M&A as an easy button to bypass the laborious deal flow process and multiple fundraising rounds. This isn’t the case, though. M&A comes with complexities, and, in many cases, founders must be more mindful and diligent of details as they’re negotiating with a more experienced entity with greater leverage in the discussion than venture capital may have. It isn’t a quick transition either, as most M&A processes take as many as 18 months to close completely.
Because of this and the many factors unfamiliar to founders when entering M&A, most startups work with M&A consultation or advisory firms to help guide the process. To best prepare for an M&A process that’s smooth and leads to the best positioning for both founders and firm, ensure that these systems are solid.
Due diligence is as much a part of M&A as it is venture capital financing. And in this case, the prospective parent is also evaluating your systems and processes to see whether they’re well-organized and can fit or adapt to their own. If you’re running a loose ship or are too rigidly attached to your way of doing things, a buyer might pass on the opportunity because they don’t see you or the company as good business partners.
To that end, build, maintain, and audit your core operational systems, including:
- Operating plans and business plans. Your standard operating procedures should be codified and clear. You may be retained as an employee or consultant post-M&A, but the company is also determining whether the machine can keep running without you. Clearly defined and published plans are part of this. Those plans should be broken into near- and long-term projections. The buyer will need to see what’s envisioned for the immediate future so they can plan for that themselves. A cogent long-term vision also increases the likelihood that the company will keep you on the team after the buyout.
- Hiring processes and hierarchical design. There is often consternation and frustration when merging two companies but having clear and defined processes can help the new parent company soften the landing when adjusting HR and reporting processes. Even if current systems don't fit into the new company culture, the potential buyer wants to see a degree of planning and management when hiring and setting a chain of command.
- Intellectual property and legal claims to products or services. This goes without saying, but the buyer will check whether your core products and services are properly registered and protected. Beyond that, they will expect that renewal and maintenance schedules are accounted for and that you have all documentation on hand.
Valuation is the most challenging part of M&A for both parties. The startup wants to maximize the payout, but the buyer must ensure they’re not overpaying. Since the buyer, in most cases, has more negotiating power, it’s vital to have a concrete and defendable valuation.
Private companies are complicated to value for M&A, as competition is often private, and incomplete data hinder comparables analysis. This is why hiring help is vital, as they often have a depth of experience in the industry and equivalent experience in assessing and valuing startups in a relative information vacuum.
But comparables analysis is insufficient, as buyers will need multiple justifications for a valuation. Discounted cash flow analyses, book value pricing, and scorecard valuation are just a few tools and methods. The buyer may have a methodological preference, so sticking with one can mean selling yourself short when they independently value your startup with their preferred technique. It’s best to value the startup with as many methods as possible.
Accretion and Dilution Analysis
While most startups have experience generating financial models, far fewer are familiar with analyzing accretion and dilution, but this analysis is critical in M&A. Accretion and dilution analysis considers nearly-innumerable factors to develop a “yes or no” binary decision to inform whether buying the company is worth the effort.
In short, the analysis measures whether post-M&A earnings per share (EPS) is higher or lower than it currently is. The new EPS shows whether the action increases or decreases shareholder value. When running an analysis, buyers or startups (or outsourced help) run through these steps, although not sequentially and often concurrently:
- Generate pro forma financial statements - This underlies why hiring help is so important. As a startup, you likely have no idea of the buyer’s underlying financials, so industry experts who understand standard income and metrics must build an accurate pro forma statement.
- Estimate value for combined synergies, whether through cost-saving or increased income.
- Build out increased taxation or interest payments in the projections, especially if you face a leveraged buyout.
- Calculate the new share count based on multiple scenarios of varied dilution, and break that equity into buyer/founder shares if applicable.
- Divide projected income by projected shares to find the new EPS and compare it to the old.
This is very complicated, and inexperience can make the process inaccurate and costly in negotiation for founders. External assessors and consultants with experience in the industry and M&As often make the accretion and dilution analysis a breeze for founders and buyers alike, ensuring both get accurate and reliable information.
M&A isn’t the shortcut to payout that some think it is and involves arduous work over time, even if the founders intend to leave after the deal closes. Many stumbling blocks, from due diligence to valuation and beyond, can halt the progress of M&A even months into the process.
It’s critical to success that you ensure systems and assessments are straightforward and reliable before considering an M&A, and if the prospect arises, you may want to hire help before embarking on the journey alone.