Cash-burning startups increasingly employ merger and acquisition (M&A) strategies to fast track their growth and hit milestones faster, but acquiring another startup comes with risks. Knowing what they are, and structuring the deal to accommodate the cash positions of both parties, is key.
Key Points:
- VC-backed startups typically pursue M&A to accelerate their growth and meet aggressive milestones set by investors.
- Startups may acquire other startups to increase revenue and annual recurring revenue (ARR), boost their customer base, add product offerings, or secure competitive talent.
- Key considerations of an M&A transaction between cash-burning startups are impact on runway and increased cash burn, whereas public companies or mature businesses focus on how M&A will affect their earnings.
- Instead of all-cash acquisitions (common for public and mature companies), startups may choose to structure M&A deals using cash and stock, or contingent payments, called earnouts.
Startups and M&A growth strategies have long sat at opposite ends of the table. Acquisitions have typically been reserved for more mature companies because these transactions require purchasing power (typically positive cash flow with enough cash on the balance sheet to make the purchase). Most public enterprises and more mature businesses are well-positioned to scoop up smaller companies given they have underlying positive cash flows to finance deals. But cash-burning startups are also increasingly joining the M&A game, to fast track their growth and hit milestones faster. Through 2023 (to Q1 of 2024), 80 per cent of acquired venture-backed startups had exited to other startups, according to Crunchbase.
While startups have traditionally avoided the expense—and risk—of an acquisition, many are motivated by the potential outcomes that result from acquiring a promising startup. Recent research by McKinsey that included interviews with founders of scaled companies, Monday.com, Unity, and Tipalti, found M&A to be a viable source for scaling from $10 million in ARR to $100 million. Some participants report even doubling revenues after a merger or acquisition, with one CEO quoted saying, “Tech companies should develop the M&A muscle early. If you don’t create the right DNA to enable M&A, you won’t have it when you need it.”
Is M&A the right move for every startup? Not necessarily. Short of a crystal ball, it’s difficult to ascertain whether an acquisition or merger will succeed in the long run. That’s why weighing the risks against the rewards is key to making an informed decision, as well as using a financing structure that makes the most sense for both sides of the bargaining table.
Why tech startups acquire other startups
Just like all roads lead to Rome, M&A initiatives should improve growth in one way or another. For mature companies, it’s not uncommon to experience diminishing returns on their organic growth strategies over time. Acquiring other companies makes good business sense if it can open doors to new revenues, products, and markets that are otherwise inaccessible or could take years to achieve on their own. When large and public entities conduct M&A, they’re typically concerned with the effect on their earnings. This often determines if an acquisition is considered successful or not. An analysis of the world’s largest global public companies by McKinsey indicates enterprises that execute an M&A strategy (comprising three or more small- to mid-size deals per year over 10 years) experience a median increase of 2.3 per cent in shareholder value in excess of organic growth alone.
For VC-backed startups, however, the appeal of a merger or acquisition is often less about earnings impact (as the buyers and targets are typically cash burning), and more about fast tracking growth to meet ambitious milestones set by investors. There’s no guarantee organic growth efforts alone will pan out, whereas the acquisition of another startup can offer near-term, tangible outcomes.
Higher level of combined revenues
Revenue and annual recurring revenue (ARR) are critical metrics for most startups and SaaS-based companies as they measure how much revenue is earned every year from customers. Venture investors focus on metrics like ARR to evaluate the scale and growth of the company they’ve invested in, and often set ambitious topline goals to ensure the company is scaling at the expected pace.
In a perfect world, the acquisition of another startup can allow the acquiring company to combine the target’s revenues with their own (provided they’re not cannibalizing shared customers). Theoretically, they can increase their revenues via M&A rather than organic growth alone. Additionally, it may help the startup avoid a potential down round if investors’ expectations are not met within the specified time frame (typically 18 to 24 months). The pressure to hit these growth goals can be a strong motivation for M&A activities.
Boost customer base
In the race to increase revenues, startups typically focus on increasing market share through sales and marketing tactics or new product launches. Acquiring a smaller startup with a significant customer base that’s complementary to the acquiring company, or in direct competition with it, offers a direct path to boosting market share and increasing revenue through tactics such as regional expansion or bundling synergistic products.
Add product offerings
Building new products can be a time-intensive process for startups (especially if it entails developing bona fide IP). The acquisition of another company with products/IP that fit within the acquiring company’s strategy can drive product development and even accelerate time to market.
Secure competitive talent
Competition for tech talent can be cutthroat and a significant pain point for scaling companies. Finding, hiring, and training talent can be a challenging process that uses up precious time the startup would rather invest elsewhere. The faster the team is built out, the sooner they can reach their associated milestones.
Acquisition strategies are nuanced at each of the startup stages, offering potential benefits to acquiring companies based on where the target sits on the funding continuum. The acquirer’s strategy (IP, talent, sales generation) will help determine the right stage to target. For acquirers seeking existing product and revenue expansion, Series B companies are the most common target, while strategies directed at talent acquisition are more likely to target Series A companies. For M&A strategies to acquire IP, pre-seed and seed stage companies are the likeliest targets for acquirers.
Financial and cultural implications of M&A for startups
Given the many potential benefits to merging with another startup, why wouldn’t every company invest in the strategy? One of the primary reasons is cash. The impact on the acquiring startup’s balance sheet may be reason enough to walk away from what initially seemed a promising acquisition. Here are some key implications to an M&A between cash-burning startups.
Impact on runway
When large companies and public enterprises conduct M&A, their main concern is often the effect on earnings which can determine whether an acquisition is successful or not. However, with most startups operating at a loss, their measure for success is often not tied to earnings. Their cash positions are typically the single source of runway to continue operating the business and scaling rapidly. So, for most venture-backed acquirers, a critical factor is the resulting impact that M&A has on runway.
Assuming more cash burn
Most acquisition targets for scaling tech companies are less scaled than the acquirer, and will have a cash burn of their own. This is a primary concern for the acquiring company, which has to assume the extra burden upon their own liquidity. They must be prepared to manage it along with investors’ expectations. Once the acquisition has been completed, the increased cash burn will inevitably shorten the acquiring company’s runway. The trade-off in these cash-burning M&A scenarios will be whether the deduction in cash runway is worth the growth in revenue or product expansion.
Risk of breaking covenants
Startups that have secured debt should be fully aware of the covenants included in their loans’ terms to avoid breaching their obligations. In general, lenders want to ensure cash-burning businesses maintain adequate runway and liquidity. Understanding the milestone-based funding continuum, lenders will want assurance that the acquisition in question won’t impair runway and the resulting impact to liquidity is compliant with any covenants.
Culture shock
Acquiring companies should not overlook the critical importance of culture fit for the target company. Synergies following an M&A deal can fail to materialize due to an inability to protect the inherent culture. Roughly 72 per cent of mergers that focused on maintaining the target startup’s momentum and worked to limit the disruption of change after close were able to mitigate any drop in revenue during the first year, according to a post by McKinsey.
Structure M&A deals to accommodate cash positions of both startups
Cash-only deals may be common for large or public companies, but that’s not the case with startups that have limited cash to finance operations until the next equity raise. Startups, therefore, are more likely to structure M&A deals to accommodate the cash positions of both the target and acquiring companies. Thankfully, there are options beyond cash-only payments, but choosing the ideal combination depends on a variety of factors, such as those described above. Here we outline three possibilities that include cash-only, cash and stock, and contingent compensation.
All-cash acquisition
In a cash-only acquisition, the purchase is paid in full by the acquiring company using the cash available on its balance sheet. This valuation price tag will directly impact the company’s runway and cash burn, which causes a ripple effect that companies should fully assess when considering an M&A deal.
Example:
Techco is a scaling B2B SaaS startup with $20 million in ARR and is burning $1 million in cash per month. It’s looking to acquire Compco, a struggling competitor with $2 million in ARR, burning $250,000 in cash per month. Techco has $24 million in cash on their balance sheet, while Compco is debt and asset free.
Before the acquisition, Techco has 24 months of runway, and a goal to reach $25 million in ARR prior to their next equity round.
Techco negotiates a purchase price of $8 million in cash which equals 4x the current ARR (current multiples are roughly 6x ARR).
As a result of the deal, Techco’s ARR will increase to $22 million (provided no cross-cannibalization has occurred), bringing them closer to their goal of $25 million. However, cash burn has increased to $1.25 million per month, and there’s $8 million less cash on the balance sheet. Cash is now at $16 million and, with the new burn rate, its runway shortens from 24 months to 13 months.
Implications:
Yes, the company is closer to achieving its goal of $25 million in ARR, but it comes with a corresponding increase in cash burn that has significantly shortened the runway. Additionally, the acquisition cost means less to invest in the sales and marketing engine of the original acquiring business. This is where synergies of the potential acquisition must also be considered, such as new markets and clients, product offerings, and optimizations.
Cash and stock acquisition
For startups, combining cash and stock is often a more appealing and practical structure for the purchase price as it has less impact on the cash position of the acquirer. It’s a typical play for growth tech companies as their shares are likely valued higher than the target’s shares. For shareholders of the target company, this means a portion of their compensation will remain illiquid until the acquiring business exits.
Example:
Instead of an all-cash acquisition, Techco’s board has greenlit an offer of 50 per cent cash and 50 per cent stock. Techco pays $4 million in cash, leading to a cash position of $20 million, and $4 million in Techco shares that will remain illiquid until Techco exits. The cash burn rate increases to $1.25 million per month (as in the all-cash scenario) and from 24 months of runway to 16 months of runway (versus 13). This isn’t a big difference from the all-cash deal but an extra quarter of cash runway can make a big difference when raising an equity round.
Implications:
The cash and stock deal will marginally dilute the existing shareholders (the cap table will have to absorb the $4 million in shares if directly issued from the acquirer and not via a secondary transaction with an existing shareholder), but will alleviate some runway erosion compared to the cash-only deal. It also ties the success of Techco to the interest of Compco’s shareholders, incentivizing the target company to help with the integration and growth.
If runway is such a major concern, why don’t companies make acquisitions using only stock?
The target’s shareholders usually want some form of liquid compensation. Startup stock is not publicly tradable and ties up the seller’s remaining compensation until the acquiring company exits, which creates uncertainty. This type of deal can also incentivize the target to perform some due diligence on the acquiring company as the founders of the target company weigh how successful they anticipate the acquiring company will be. This tends to complicate deals and can compel the target company to request a premium valuation as compensation for the increased risk they will assume. Meanwhile, the acquirer must consider the rights attaching to the shares that will be issued to the sellers, such as liquidation preferences, which will have implications upon exit of the acquirer.
Contingent Payments & Valuation Bridging
To make any deal, there needs to be agreement on the value of the target company. However, calculating the worth of a startup is more art than science, and the target company may not agree with the valuation determined by the acquiring company. As with any bargaining proposition, reaching an agreement on the purchase price can lead to an impasse in negotiations. To help bridge valuation negotiations, many startups turn to earnouts, wherein a portion of the purchase price is paid upfront, and the remainder is contingent on the acquired company’s future performance.
The contingent payments are typically based on the target company’s achievement of milestones, or triggers, to earn the remaining compensation. Triggers can be based on financial milestones, such as revenues or EBITDA, or non-financial metrics, such as IP development or commercialization, or the retention of key personnel.
Earnouts can be invaluable in bridging valuation negotiations when two startups can’t agree on the worth of the target company. Rather than walk away, an earnout offers a compromise that both parties can agree on. While earnouts are less likely for smaller deals (less than $5 million), they can average 10 per cent to 25 per cent of the total price for deals ranging from $5 million to $50 million.
As popular as traditional financial earnouts are, the buyer is effectively shifting execution and growth risk back onto the seller—significantly, according to a recent report by SRS Acquiom, only 59 per cent of earnout payments are actually paid to the target’s owners. An acquisition using earnouts ties the original delta in the target’s valuation to its own growth interests rather than the acquirer’s if stock was used for the purchase. Therefore it’s imperative the target business is able to maintain its entrepreneurial culture to avoid a dip in revenue and achieve the earnout goals.
While an M&A strategy can help startups achieve ambitious milestones faster, it comes with some risks. Acquiring another startup can significantly impact runway and increase cash burn—both of which could outweigh the potential upside. How startups structure a deal can help accommodate the cash positions of both the target and acquiring companies to potentially minimize the risk and ensure the M&A, ultimately, improves long-term growth.
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