The picture of a profitable startup exit is likely to be ringing the bell on the inventory alternate. However the commonest path to exit remains to be an acquisition: in 2022, 10 instances as many US startups had been acquired than went public.
As with every deal, the acquirer — which may very well be one other startup — goes to do in depth due diligence.
JP Morgan’s botched acquisition of US fintech Frank is a latest reminder of simply how excessive the stakes might be when a goal firm isn’t what it appears. So how can firms seeking to purchase startups keep away from disaster with good due diligence? And what kind of scrutiny ought to startups be ready to face from an acquirer?
Purchase-side due diligence, outlined
The data-gathering course of accomplished by an organization seeking to purchase one other is named buy-side due diligence.
What this appears like in follow can range broadly, relying on the character of an acquisition and an organization purpose’s for doing it.
Many parallels might be drawn between the buy-side due diligence course of for startups and shopping for a home. A homebuyer will typically fee a surveyor to establish points with a constructing after which decide about shifting ahead with a purchase order, renegotiating the worth or taking out indemnities to insure in opposition to losses, and a startup may fit with a number of third events to undergo very comparable processes.
However earlier than all this may be accomplished, firms want to determine why they’d be doing M&A within the first place.
First, interrogate your personal technique
Startup advisers say that although there could also be cheaper offers available proper now, warning must be utilized to development by way of acquisitions.
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“I believe a very powerful factor is knowing why you are doing M&A,” says Lisa Chang, company M&A associate at Linklaters.
“When firms have an excellent strategic rationale as to what they’re making an attempt to realize because of an acquisition, it then drives plenty of how they method the transaction. Having that clear defines what you do by way of due diligence.”
Targets might embody:
Entry to a specific know-how or IP that one other startup has which may assist the acquirer speed up the expansion of considered one of their very own merchandise.
Entry to new merchandise that one other startup has already constructed.
Entry to new markets. Chang says she sees this notably in regulated sectors (like many areas of fintech), the place it could be faster for a startup to amass a goal firm that already boasts the related licence in a brand new market than attempt to apply for a licence itself.
Entry to individuals and expertise.
One good tactic for figuring this half out is historic acquisitions that went improper, says Alvise Fasolo, M&A advisor at secondhand garments market Vinted, which has acquired 4 rival startups within the final 4 years.
“A standard function that we frequently discovered is that these acquisitions didn’t make quick sense from a strategic perspective. Their rationale was not clear, nor intuitive,” he says. “If this ‘is smart’ issue is lacking, we frequently received’t proceed additional.”
Are you truly a vendor?
For some firms, this introspective due diligence might reveal that in truth, they’re a vendor, not a purchaser.
“Within the present local weather, each firm must be asking themselves the existential query: are we a consolidator or will we get consolidated?” says Aman Behzad, managing associate at advisory agency Royal Park Companions.
This choice will likely be influenced by the danger urge for food of a startup’s shareholder base — what sort of buyers they’re and the way way back they invested.
In well-resourced scaleups, M&A-related processes are sometimes led by the corporate C-suite or in-house company improvement groups. However typically, earlier-stage and smaller firms might rent specialist startup advisory corporations to assist them determine this out.
And in all instances, as soon as a startup has discovered its M&A technique, it’s time to rent exterior assist.
Consultants, legal professionals and bankers are all wanted for various bits of due diligence, however their involvement will rely on the target behind the transaction, the kind of transaction and the dimensions of the transaction.
Second, start market mapping and high-level due diligence
As soon as a startup has determined it needs to purchase one other, it’s going to begin market mapping for potential targets.
Once more, relying on its inside assets, a startup’s personal in-house M&A or company improvement crew might do that itself, or it could rent specialist advisors.
Then it’s time to work out the kind of due diligence that is related for that acquisition. There are 4 varieties, and sometimes offers will mix a number of:
Business due diligence
Authorized due diligence
Tax and monetary due diligence
Product due diligence
The sort and extent of investigation is dependent upon components akin to firm dimension and stage, geography, sort of enterprise and regulatory necessities.
For instance, within the case of a low-value acquisition for a particular product or tech, full monetary due diligence might not be crucial.
For Vinted, which is 15 years previous and boasts a $4.1bn valuation, a specialist in-house M&A crew handles plenty of the method. Fasolo says it normally splits the method as follows:
“For tax and authorized DD, we frequently search specialised help from native advisors. Tech is a crucial element as effectively and we run a product DD through advisors the place relevant.”
“For business and integration DD, we are inclined to do it in-house (until restricted by regulatory elements). We imagine that the customer is finest positioned to evaluate the enterprise mannequin of the corporate, and whether or not the acquisition is smart strategically.”
Alternatively, a much less well-resourced startup might go to an advisor like Royal Park Companions’ Behzad to get the preliminary dialogue with one other firm going.
“Often, this includes establishing a CEO-to-CEO chat, or one shareholder from every startup has a chat with us to get the lay of the land,” says Behzad. “Then we agree some form of high-level info sharing, which focuses on key diligence gadgets to teach every get together on one another’s firm in a brief time frame.”
The rule of thumb is to give attention to acquiring particulars from the final two years. Behzad says preliminary high-level due diligence ought to embody:
Two years of economic statements
24 months of administration accounts
Info on a startup’s prime 10 prospects and the way their revenues have advanced during the last two years
Full buyer lists (might be anonymised)
For product and tech acquisitions
Within the case of some smaller acquisitions for product and tech, which will suffice on the finance facet of issues. So then it’s time to instruct legal professionals to examine that the goal’s product is legally compliant.
Attorneys will examine:
Who owns the IP rights for the product or tech
How is the IP protected
Is the product compliant with licensing rules
Is the product compliant with some other knowledge or digital rules
Will or not it’s compliant with any new rules coming down the road
For hearth gross sales
Sadly in capital-poor funding climates like the present one, not all acquisitions are between two wholesome startups. Analysts predict that a big proportion of the subsequent yr’s consolidation will likely be so-called hearth gross sales, when a startup is offered at a really low value to keep away from chapter.
Current examples in Europe have included the gross sales of French insurtech Luko to Admiral and Railsr to a consortium of buyers.
In these situations, the buying firm already is aware of its goal is closely loss-making. So as soon as it’s bought maintain of a correctly attributed set of financials, it ought to give attention to understanding profitability per buyer.
“Right here, it is best to diligence the income sources fairly extensively,” Behzad says. “So specializing in the important thing prospects and cashflow; ensuring you’ve got bought an excellent grasp of what the funds phrases had been for these key prospects; how typically they paid and whether or not they paid; and the way lengthy they’ve had their buyer contracts.”
For bigger acquisitions
The bigger and extra advanced the deal and its financing, the extra due diligence is required.
In a number of the largest and most intricate instances, startups should rent a correct monetary diligence supplier, which tends to be one of many huge 4 auditors (Deloitte, EY, KPMG and PwC).
They are going to be appointed to place collectively a correct FDD (monetary due diligence) report. This may increasingly vary from what’s dubbed a “pink flag” report, which is usually round 20 pages and may take round 4 weeks to compile, to a full monetary paperwork train amounting to 250+ pages, which may take six to eight weeks.
Common authorized due diligence
As soon as a startup has determined it needs to go forward with a deal, there are a number of final bits of authorized due diligence that it should instruct legal professionals to do. These embody:
What contracts does the goal firm have and do they have to be terminated?
What are the termination rights when the corporate adjustments management?
Has the goal firm bought any ongoing claims in courtroom in opposition to it?
Who will personal the shares of the goal firm?
What are the worker returns from the deal?
Do you need to maintain the workers or terminate their employment?
If and when startup M&A dealmaking reaches its peak within the subsequent 12 months, legal professionals say startups shouldn’t lose sight of that first step — their introspective due diligence — or skim over particulars to snap up an excellent deal.
“There’s at all times that strain between getting the deal accomplished rapidly and ticking all the appropriate packing containers,” says Chang. “However being clear on the outset after which asking the appropriate questions is a very powerful factor.
“Correct due diligence shouldn’t be one thing you’ll be able to rush.”
