Guide to Mergers and Acquisitions for Startup Companies
Startup mergers and acquisitions (M&A) could be the most lucrative activity a founder ever undertakes.
However, the M&A process is complex, filled with potential risks, and often uncharted territory for many founders. It’s easy to make mistakes along the way, and because the stakes of M&A are high, many companies seek professional guidance. There are several types of advisors that a startup can work with during an exit, from lawyers to investment bankers to accountants. This guide provides an overview to help startup founders navigate M&As from our perspective, as CPAs who have worked with dozens and dozens of companies during successful exits.
Kruze Consulting clients are twice as likely to be acquired as the average startup, according to data from Carta.
Our clients are also much more likely to have raised subsequent rounds of capital!
Understanding mergers and acquisitions
M&A activities are an essential part of business, and encompass the variety of ways that different companies are combined. Entire companies or just their business assets can be consolidated into a single company. Let’s start with some definitions:
- Merger. A merger occurs when two companies combine to form a new entity. This is often seen as a mutual decision to join forces and leverage each other’s strengths.
- Acquisition. An acquisition happens when one company purchases another. The acquired company becomes part of the acquiring company, either operating as a subsidiary or being fully integrated.
Acquisitions are the most common way that companies combine. Mergers are much less common, since it’s pretty rare that two companies that are essentially equal decide to merge together. If a startup is going to exit through M&A, it’s most likely via being acquired by a bigger company. Mergers between startups do happen, but are much more rare.
When two startups are merging, both should conduct thorough financial due diligence, including reviewing each other’s financial statements, tax filings, and liabilities. Legal due diligence is crucial to ensure there are no pending lawsuits, regulatory issues, or intellectual property disputes. They should also perform operational due diligence to assess the compatibility of their business models, cultures, and key personnel. Lastly, it’s essential to evaluate the customer base and market position of each company to understand potential synergies and risks.
Reasons for M&A
The primary reason for M&A is almost always growth, but growth can occur in different ways. Companies may want to increase market share, expand into new geographic areas, or add a new product line to their business. Some of the specific reasons for M&A include:
- Growth. Growth is a top priority for business, and M&A offers another avenue to expand beyond organic growth.
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Synergy. Another major reason for M&A is to achieve synergies. Those can include:
- Economies of scale, where a larger organization can allow increased production while saving costs and producing products at a lower cost per unit.
- Revenue synergies, where companies can expand their product lines to include related products.
- Operational efficiencies, where the merged company performs better than the two unmerged companies.
- Knowledge transfer. One motive for M&A is gaining knowledge, usually in the form of intellectual property (IP), but it can also include employee expertise. This is more common among technology companies.
- Competitive advantage. A company could use M&A to strengthen market position by eliminating a competitor.
- Diversification. M&A can allow companies to expand their product lines or enter new markets, since it’s usually easier and less risky to buy a company that’s already developed a product, or a company that’s already in a geographic market, than to start from scratch.
- Vertical integration. Sometimes companies will buy other companies that are in their supply chain, letting them generate value by lowering costs of supplies.
- Tax benefits. This tends to be related to one or more of the other reasons for M&A, but it’s still important, since companies can often reduce their tax liability by taking on a company that’s operating at a loss.
- Talent acquisition. Some startups have built amazing teams, and a larger company may find value in bringing on all or part of the team through an acquisition. This can be especially true in situations where a startup’s engineering team has specific technical abilities that are hard to get in the job market.
- Brand enhancement. A large company may acquire a startup with a strong brand identity or a loyal customer base to enhance its own brand image and expand its customer base.
Preparing for M&A
Mergers and acquisitions don’t happen every day, so it’s not surprising that many founders haven’t been through the process. Every year one or more of our clients are acquired when a larger company approaches them unexpectedly with an offer. In our opinion, it’s always a great idea to be ready for due diligence - having your books, taxes, projections, legal documents, etc. in order will let you take advantage of any unprompted offers.
If you realize that it’s time to exit the business, preparation is key to maximizing valuation and the chances of a successful sale. Here is how we’d suggest approaching the process.
Summary
- Self-assessment. You’ll need to evaluate your company to see if it’s a good candidate for M&A.
- Strategic planning. Start by establishing clear objectives for the M&A, and assemble a team to help you achieve those goals.
- Engage with your investors. During the strategic planning process, make sure your startup investors are fully informed and supportive by discussing the strategic benefits, financial implications, and how the merger aligns with their investment goals.
- Finding the right partner. You’ll need to identify potential partners, making sure they’re aligned with your strategic goals and their strengths complement your company.
- Approaching potential partners. You’ll need a compelling pitch that showcases your company’s value proposition; this is a place where the right investment banker can be helpful.
- Due diligence. You’ll need to be ready for financial, legal, and operational due diligence.
- Valuation and financing. You’ll need to establish a fair market value, and make sure your investors are comfortable with the pricing and financing.
- Negotiation and deal structuring. Working with your M&A team, you’ll need to agree on a mutually acceptable deal.
- Post-merger integration. Correctly aligning both companies is important to make sure you achieve the desired synergies and expected value.
Let’s examine each step in more detail.
Self-assessment
The first step is simply determining if your startup is a viable candidate for M&A.
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Evaluate your company’s strengths, weaknesses, opportunities, and threats (also known as SWOT analysis). You need to be able to tell a good story about your startup to appeal to buyers. Things you should consider include:
- The value you create for your customers. How does your product or service address customer pain points? Do you have solid customer feedback and satisfaction? Do your customers refer you to others?
- Your product vision and strategy. Are you aligned with market trends and needs? Does your product roadmap show your ability to adapt and evolve in a competitive landscape?
- Your market size and positioning. What is your estimate of the total addressable market (TAM)? What is your market share, and who are your competitors? Attractive distribution channels and low customer acquisition costs can make your startup more valuable.
- Any “moats” or defensible market positions. How are you differentiated from your competitors? Do you have proprietary technology, a strong brand identity, exclusive partnerships? Does your market have high barriers to entry?
- Technology portfolio. Evaluate your IP assets, including patents, trademarks, and proprietary software. Having a strong IP portfolio can significantly increase your startup’s valuation and attractiveness to buyers, but even if your technology is not protected by patents it may still be valuable to an acquiring company.
- Your management team. What’s your team’s collective experience and industry expertise? Do they have a track record of successful ventures?
- Your company’s financial health. Do your financial statements show consistent revenue and profitability, and manageable debt levels? Review your key financial ratios for insights about your financial stability and sustainability.
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Understand your company’s growth potential. To do this, you need to evaluate the market demand and scalability of your startup’s business model. This includes things like:
- Size of your current and potential customer base. Do you hold a strong market position? Is your business model scalable? A solid customer base, especially if it compliments acquiring companies’ customer bases, can be valuable.
- Your pricing structure. Competitive (but profitable) pricing can attract customers and generate revenue. Flexible pricing strategies, like tiered or subscription models, can reach diverse customer segments.
- Your expansion potential. Do market trends and customer demand show potential for consistent growth?
- How efficiently you use capital. Are your processes and systems efficient and well-documented? Is your technology state up-to-date?
Strategic planning
The initial phase of any M&A deal is strategic planning, to inform your investors and set the direction and objectives for the process.
- Define clear objectives for pursuing M&A. Why are you pursuing an M&A strategy? (See the reasons for M&A section above.) Do you need to expand your market, gain strategic or operational synergies, or find a compatible technology partner? Your strategic goals should align with your startup’s business goals and vision.
- Discuss merger plans with investors. It’s crucial for startup founders to proactively engage their investors in discussions about any potential merger. Investors are key stakeholders, and their support is vital for a smooth transaction. By presenting a sound merger strategy that highlights the strategic alignment, growth potential, and financial benefits, founders can address any concerns and make sure that the merger aligns with the investors’ expectations and objectives. Additionally, early and transparent communication can help maintain trust and secure investor approval, which may be necessary for finalizing the deal.
- Identify potential acquirers that align with your strategic goals. This is a critical element – a startup can be attractive based on its performance or market position, but it needs to fit the strategic objectives of the acquirer.
Assemble a team
Your M&A team should include professionals with expertise in the legal, financial, and strategic aspects of mergers and acquisitions. A strong M&A team typically includes:
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Legal advisors. You’ll need an experienced attorney with a background in startup M&A to help you through the process. Your attorney will:
- Navigate complex legal documents and processes, making sure all legal documents are accurately prepared and reviewed, to protect you from legal disputes.
- Help you negotiate favorable terms and conditions, so you’ll get the best possible deal.
- Inform you of and ensure compliance with any applicable regulatory requirements, and help you navigate the legal landscape, so you don’t face delays or penalties.
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Accountants. Your M&A team should include experienced accountants who specialize in startup mergers and acquisitions. Accountants play a crucial role in ensuring that the financial aspects of the deal are handled accurately and efficiently. While they don’t typically get involved with the negotiations, it makes sense to ask them if the deal looks like it will include financial metrics like net working capital calculations, tax adjustments, or cash adjustments. Their responsibilities include:
- Financial due diligence. Experienced accountants can advise and guide you through the finance/tax/accounting diligence process.
- Tax implications. Mergers and acquisitions can have significant tax consequences. Your accountants will analyze the tax implications of the deal helping you minimize any potential tax liabilities and avoid any tax mistakes.
- Financial statement preparation. Accurate and up-to-date financial statements are critical during M&A - the acquiring company will ask for these statements several times during the process.. Your accountants will prepare and present financial statements that reflect the true financial health of your startup, making it easier for potential buyers to evaluate the value of the company.
- M&A advisors. An experienced M&A advisor can guide you through the process, including complex negotiations, structuring the deal, managing due diligence, and optimizing the outcomes for all parties. Your financial advisors can also help you assess the company’s valuation (a critical part of the sale – see below) and guide you through financial due diligence. Maybe 20% of startups that we work with have an investment banker involved in their sale.
Finding the Right Partner
Startup founders who are looking for the right acquirer for an M&A need to start by identifying companies with complementary strengths that are strategically aligned to the startup’s business goals. Market research and networking are crucial to find potential acquirers. Working with an experienced M&A advisor (see above) let founders leverage the advisor’s industry connections.
Criteria for selection
- Strategic fit. Founders should look for potential acquirers that are likely to support the startup’s long-term vision and potential. The acquirer should have compatible core values, company culture, and operational synergies.
- Financial stability. Founders need to evaluate a possible acquirer’s financial health by reviewing their financial statements, cash flow, and debt levels. Does the acquirer have a track record of profitability? Does the acquirer have access to capital and the ability to invest in your startup?
- Technological compatibility. Founders should assess the integration of technologies and processes between both companies’ systems, platforms, and infrastructure. If the acquirer’s technology stack integrates well with the startup, that will minimize disruptions and streamline operations after the merger. And it’s important to assess the acquirer’s commitment to technology investments and innovation – that will give you confidence they will support future growth and development.
Approaching Potential Partners
Based on your research into potential acquirers, startup founders can put together a list of companies that they’d like to approach. You’ll need a compelling pitch that showcases your startup’s unique value proposition, and outlines the synergies and highlights the mutual benefits the companies would achieve by combining. Once your pitch is ready, there are several strategies you can employ to get an introduction to the right people at the companies you’re targeting:
- Networking. Leverage industry contacts and networks. You can build relationships at networking and industry events to help you get warm introductions to potential acquirers. Many startups are acquired by larger companies that they have partnered with or that they already have a relationship with.
- Professional contacts, including accountants, bankers, and M&A advisors. Experienced professionals that work in the startup ecosystem can offer valuable access to other companies. Use their expertise to make contact with suitable partners.
- Direct outreach. This method can be time-consuming but effective. Founders can try approaching potential targets or acquirers directly with a well-prepared pitch. You’ll need to create a personalized message that explains the strategic benefits of acquiring your startup, and use social media, like LinkedIn, and websites to locate email addresses of key decision-makers.
Due Diligence
Most founders are familiar with due diligence, which involves a thorough review of the startup’s financial records, contacts, legal and tax compliance, and more to uncover any potential risks or liabilities. Founders need to provide transparent and detailed information, and be ready to address any concerns that come up. Due diligence can be broken down into several areas, including (but not limited to):
Financial due diligence
Financial due diligence is crucial to assess the financial health and viability of the target company, and involves:
- Thorough reviews of financial statements, projections, and debt structures. This lets the acquiring company identify risks or liabilities. Some of the records that may be requested during due diligence include:
- Income Statements (Profit and Loss Statements) for the past 3-5 years.
- Balance Sheets for the past 3-5 years.
- Cash Flow Statements for the past 3-5 years.
- Tax Returns for the past 3-5 years.
- Accounts Receivable and Accounts Payable Aging Reports.
- Detailed List of Assets and Liabilities.
- Inventory Records.
- Sales Records and Projections.
- Expense Reports and Projections.
- Debt Agreements and Loan Documents.
- Equity Structure and Shareholder Agreements.
- Budgets and Forecasts.
- Employee Payroll and Benefit Records.
- Legal and Regulatory Compliance Documents
- Careful assessments of the target company’s revenue streams, profitability, and growth potential.This allows the acquiring company to make sure the startup fits in with the acquiring company’s strategic goals.
Legal due diligence
Legal due diligence involves a comprehensive review of the target company’s legal standing and obligations, and includes:
- Reviewing any contracts, intellectual property, litigation history, employment agreements, and regulatory compliance.
- Identifying any potential legal risks and liabilities that could impact the M&A.
Operational due diligence
Operational due diligence consists of a thorough evaluation of a target company’s operational capabilities and efficiency, including:
- Evaluating the target company’s operations, supply chain, and technology infrastructure.
- Identifying potential integration challenges and synergies.
Other areas of diligence
In addition to financial, legal, and operational due diligence, other areas of diligence may include tax, environmental, IT, and HR assessments, ensuring a comprehensive understanding of the target company’s overall health and potential risks.
Valuation and Financing
Valuation methods
Valuation of a target company in an M&A deal determines the fair market value of the business, and involves analyzing the company’s financial performance, assets, market position, and growth prospects. Various valuation techniques are used to establish the company’s fair market value, including:
- Comparable company analysis (CCA). This valuation method involves comparing the target company to similar businesses in the same industry, and analyzing their key metrics and financial ratios.
- Precedent transactions. This method looks at the prices paid for companies that are similar to the target company in past M&A deals.
- Discounted cash flow (DCF). This method estimates the present value of a company based on its projected future cash flows, which are discounted back to their present value with an appropriate discount rate.
That being said, the most common method we see used is by negotiations. It makes sense to work closely with investors if you are not working with an investment bank to manage the negotiations on the value carefully!
Financing the deal
Financing an M&A deal for a company acquiring a startup typically involves a mix of debt and equity funding. Companies may secure loans or issue bonds to raise the necessary capital, leveraging their assets to finance the acquisition. Additionally, they might offer shares or other equity instruments to investors or even the target company’s stakeholders as part of the payment. Financing options typically include:
- Cash. The acquiring company can use internal funds or take on debt.
- Stock. The acquiring company can offer shares in their company as payment.
- Combination. The acquiring company can use a mix of cash and stock.
Many acquisitions have portions of the consideration that are paid out over time. And while most startups do use seller’s financing, it can happen occasionally.
Negotiation and Deal Structuring
M&A negotiation and deal structuring define the terms and framework of the acquisition to reach a mutually beneficial agreement.
Key considerations
- Purchase price. Based on the target company’s valuation, the parties need to balance their interests and negotiate a mutually acceptable price.
- Deal structure. This determines how the transaction will be financed and executed. Common structures include asset purchases, where specific assets and liabilities are acquired, or stock purchases, where then ownership of the entire company is transferred.
- Earn-outs. Earn-outs are provisions that tie a portion of the purchase price to the target company’s future performance, measured by financial metrics or milestones. Earn-outs help resolve valuation gaps between the buyer and seller by aligning the purchase price to the target company’s actual post-acquisition success. Earn-outs require clear terms and specific measurement criteria to avoid any disputes later.
Negotiation tactics
- Be prepared. Understand your leverage and have a clear strategy. Understanding the other party’s motivations and constraints helps to find common ground, so it’s a good idea to research the acquiring company thoroughly.
- Stay flexible. Be willing to compromise on non-essential terms, and be willing to adjust your tactics based on how the negotiations and discussions are progressing. .
Focus on key issues. Make sure you prioritize important deal points to avoid getting bogged down in details. Any of the areas discussed as part of the M&A process can be a key issue for a founder, including valuation discrepancies, liabilities, the deal structure, or even plans for integrating the two companies. Focus on what’s important to you.
Closing the Deal
Closing the M&A deal involves finalizing all contractual agreements and making sure all the conditions for sale are met. This can include completing due diligence, obtaining regulatory approvals, and transferring funds or assets specified by the final agreement.
Final agreements
- Draft and review the final purchase agreement, including terms and conditions.
- Ensure all legal and regulatory requirements are met.
Communication
- Inform stakeholders. You’ll need to communicate the deal to employees, customers, investors, partners, customers and suppliers through a formal announcement. You should explain the rationale behind the transaction, and outline the expected benefits. You should also inform stakeholders about any changes that could affect them, like a shift in business strategy or change in management.
- Manage public relations. Handle media announcements and public perception with a clear strategy focusing on positive messaging. This could include preparing a pres release, engaging with the media, and addressing any misinformation or negative reactions promptly and transparently.
Post-Merger Integration
Integrating two companies after an M&A deal is complex, requiring you to align corporate cultures, systems, and processes. Correctly integrating both companies is essential to get the expected value and synergies from the M&A. A smooth transition includes:
Integration plan
- Develop a detailed plan for integrating operations, systems, and cultures. The plan should include timelines, roles and responsibilities, and KPIs to measure the progress and success of the integration.
- Assign integration teams and set clear timelines and milestones. The integration team is responsible for managing the process and addressing issues.
- The best M&A integrations tend to have detailed integration plans that begin at the tail end of due diligence.
Change management
- Address cultural differences. Foster a unified company culture by recognizing and respecting the values and practices of both organizations. Initiatives like open forums and cross-company workshops can help improve understanding and cooperation..
- Retain key talent. Retaining key employees after an M&A is critical for maintaining business continuity and leveraging their expertise. Provide clear communication about future roles and career opportunities. Offering incentives, like retention bonuses or development programs, can help encourage essential employees to stay and continue contributing to the company’s success.
Monitor and adjust
- Track integration progress. Regularly review and assess the integration plan against the KPIs and milestones you established as part of the integration plan. Getting regular feedback from employees and stakeholders can help identify pain points and that might require changes.
- Use an adaptive approach. Flexibility during the integration process will help you make timely adjustments to address any issues.
- Measure success. Evaluate the impact of the merger or acquisition on your strategic goals. You’ll need to look at KPIs like financial performance, operational efficiency, and sales growth. Customer satisfactions and employee retention can also provide key insights into the integration’s success.
Successful M&As Require Planning
Most startup founders won’t go through very many mergers and acquisitions, so it’s important for any founders that are facing an M&A to learn about them. It’s also crucial to work with professionals that have M&A expertise. The M&A process is filled with challenges that require meticulous planning, strategic decision-making, and effective communication. When properly executed, though, an M&A can unlock opportunities and drive your startup to a stronger, more competitive position.
