As founders, you are pursuing your vision and mission to achieve impact in whichever manner you define it, including improving the lives of millions of consumers or changing the way people work in enterprises around the world. The dream is to build long-term independent companies.
What we have observed in deep sustained downturns, such as in 2000/2001 (globally), 2008/2009 (globally) and 2016/17 (in India), is that despite best efforts on all sides, companies sometimes start facing hard choices between sustaining independently at sub-scale levels of activity or merging with other entities.
We have outlined key actions items to undertake to increase the probability of good M&A options, should you choose to exercise it. We believe that these relationships and knowledge will stand you in good stead even if you do not choose to exercise this option.
Managing Through an M&A Process
- Managing your company through a sale process is a tough assignment. You have to balance operating the company productively with retaining high-value employees while keeping your fiduciary duty to your shareholders and stakeholders such as employees, suppliers, creditors and customers.
- Work with your investors and advisors who have been through these situations before.
- Manage cash very carefully so that you have a graceful process to complete the sale of the company in an orderly manner.
- Always keep a list of liabilities (employee vacation outstanding, accounts payable, debt, prepaid revenue from customers etc.) and manage this carefully. Please make sure that you always have enough cash on hand to pay down all your liabilities.
- Manage internal communications and morale proactively. Rumors spread very easily and so it is important to be clear and as transparent as you can be, in order to retain employees and continue to operate the company effectively.
Self-assessment/ Self-awareness and Timing
- Be clear and realistic about how you are going to be perceived by potential acquirers.
- If you are a sub-scale team with technology and engineers, you may be perceived as an acqui-hire by larger companies where they acquire you for your engineers and technology only.
- If you are a sub-scale team with technology and engineers but also significant product/IP and some early customer traction, you may be perceived as a tuck-in where the acquirer uses their distribution clout to significantly expand the revenue from your product.
- If you are a scaled company with customers, revenue and a strong team, you may be perceived as a strategic asset/high value.
- Be deterministic. This sort of transaction does not happen by itself – it needs strong and sustained focus. Be clear about the help you need to get this done. Work with your investors and perhaps an advisor/banker to drive the process forward deterministically.
- Be clear about the time you have available to get this done and start early. In other parts of the document, we have talked about scenario planning and fundraising. Typically, you will need 6 to 12 months to produce a properly-valued M&A transaction. Anything less than that is likely to be more of a firesale.
- It is unlikely that several offers will appear at the same time. Typically, offers appear at different times and have to be either engaged with on their own merits, without knowing whether other offers will appear. If you can manage your interested suitors to provide offers in a similar time period, you will be better off in terms of creating a bidding war that could drive a better price and terms for your company and its shareholders.
- Be prepared for a couple of months time between term sheet/LOI for M&A and signing of definitive documents.
- In most cases, mergers and acquisitions happen between leaders of companies that have gotten to know each over a longer period of time. Generally, these M&A transactions are not between strangers who just looked at spreadsheets and decided to go through with a transaction. Relationships, trust and knowledge have to be built up on both sides, at multiple levels.
- Make a shortlist of companies that you think would value your customer base, revenue, technology/IP, people and operational capabilities. Divide these into tier 1, tier 2, tier 3. These companies could be in India or could be based elsewhere.
- Tier 1 are most likely to want to merge with you and are large public companies with solid balance sheets and a history of making acquisitions. Your business model and their business model match. These companies are most likely to value what you have and provide fair consideration for your assets. These may also be scaled private companies with solid balance sheets that are looking for strategic bolt-ons.
- Tier 2 are companies that may be large and well capitalized but in adjacent areas of the market. Their acquisition of your company may not seem to be an immediately obvious thing for them to do. Perhaps you business models do not match currently but they may be looking to extend into your space/model.
- Tier 3 are private companies that are not at scale and will most likely pay in equity only. You may also run the risk of collectively not being at scale or viable in the long term. Only target this tier as a last resort.
- Reach out first to the Tier 1 and Tier 2 companies that you already have relationships with. You will likely get the most traction with these existing relationships as opposed to brand new relationships that you try to start now.
- Be careful about your insertion point. In some companies, M&A decisions are strategized and made by the product/engineering teams with execution support from corporate development teams. In other companies, the corporate development teams scour the market for interesting companies and then make recommendations to the business unit/product heads and then drive execution. In some cases, you may choose to start with the strategic investments team at these larger companies – this is sometimes a low-pressure way to start discussions and allow them to get to know you in the context of an investment discussion which could turn into an M&A discussion at a later point, if you choose.
- Consider working with an advisor/banker to drive this process for you. If you have not done M&A previously or do not have the strategic relationships to tap into, this may be a productive way to go about.
- Be clear about what value the banker will provide you. Think carefully about what you would like your advisor to do for you – two dimensions here to think about are strategic relationships and process management. In some cases, you may already have all the strategic relationships but do not have time to manage the process. Or it may be the other way around. Evaluate potential advisors on the dimensions that you are not going to drive yourself. For example, if you are an enterprise software company selling globally, you may not have the relationships in the US and so a banker that has relationships with large enterprise software companies in the US may be useful for you.
- If you need to figure which bankers to contact and how the commercials with them are set up, consult with your investors or other founders who have done this before.
M&A Types and Considerations
- There are a number of different variations in terms of the types of offers you can get. We will outline here some of the main variations we see. Please consult with your investors, advisors/bankers and tax advisors to understand what your options are and the consequences of each type of offer.
- Equity only – the consideration offered for your company is the common stock of the acquirer. If the acquirer is a private company, understand the cap table of the acquirer, especially items such as the preference stack above common (generally equal to the amount of capital that investors have put into the company). Also understand what a realistic valuation of the acquirer company’s stock is – for example, in the recent downturn in the market, the acquirer’s valuation or market cap may have decreased substantially from the valuation of its most recent financing.
- Equity + cash – the consideration offered for you company is the common stock of the acquirer plus cash. The higher the proportion of cash in your offer, the more solid the offer is, unless it is a very liquid public stock that you believe will maintain or increase in value.
- Cash only – it is uncommon to have these sorts of transactions unless you have engineering a bidding war amongst several cash-rich companies.
- Asset purchase – in some cases, the acquirer may only want to acquire your assets (customers, IP, people etc.) and pay your company in equity and/or cash in return. You will then be left with liabilities on your balance sheets. Once you dispense with these liabilities (including tax), anything left over will be distributed to the shareholders of your company. In general, this is a less favorable outcome for you compared to a stock purchase. However, this could be a faster transaction to execute as the acquirer does not have to take the risk of known/unknown liabilities on your balance sheet.
- Stock purchase – the acquirer buys the entire company by purchasing all shares in the company. The acquirer taken on the risk of any known/unknown liabilities in your company and will likely diligence this heavily before signing any definitive documents. The acquirer could also ask for an escrow where a certain portion (typically 10-30%) of the transaction consideration is set aside for 1-2 years to be paid out to the acquirer in case any liabilities appear that were not initially disclosed or anticipated.
- Some other considerations as you think through this process:
- Earn-out – the acquirer will typically want to lock you into their company for a certain amount of time, usually ranging for 1-3 years. They will aim to compensate for this over and above your regular salary/ESOPs by provide an earn-out which could be cash payments based on the time you stay at their company or on deliverables you achieve. These payouts could be every quarter or year, depending on the structure of the deal. Earn-out amounts and structures are negotiated at the same time as the acquisition transaction but are two separate and distinct things.
- Management carve-out – if you and your investors embark on a sale process for your company, have an early and clear discussion with your investors on whether there will be a management carve-out. The purpose of the management carve-out is to incent the management (including founders) to stay at the company and productively focus on a sale outcome, especially in low-value outcomes. A management carve-out is typically structured as soon as you start a sale process. In the carve-out, you and your investors will collectively decide how much of the sale price is set aside for the management of the company (typically 10-20%) and how this amount will be subdivided between the management team members and employees of the company. Be clear what this is, write this down and get sign-off from your investors and management team.
- Tax – work with your investors and tax advisers to understand all the tax ramifications of a sale. Complications can occur due to international structures (e.g. US C-corp with India subsidiary), asset vs stock sales, different types of taxes that become applicable etc.