Cost Of Buying and Selling Cheap In the Startup Ecosystem: The Dos and Don'ts
Buying cheap and getting the same team to run the company is more of a hostage deal
If you’re a founder who has survived 2020 and now an M&A is a pragmatic way forward for you, remember: ‘don’t sell cheap if you’re planning to run the company’.
If you’re an acquirer, wisdom lies in not striking a cheap deal since you only get what you pay for. At a low bargain, you might get the company but not the founders’ loyalty. A company might not turn out to be as promising without the team leading it.
Buying cheap and getting the same team to run the company is more of a hostage deal. You buy the assets and the presence of the founders and the team. Nevertheless, without loyalty and drive into the mix, everyone is likely to escape at the first opportunity. Imagine a forced marriage where the bride might just runoff, that’s what an unsatisfactory M&A deal looks like.
Money is not always the core ingredient of M&As and there's more selling to be done by the acquiring company than the target startup. The alignment of business vision and operational freedom are among the main components of a fair sale. The profits should at least cover the opportunity cost as well as net investment in the startup while delivering a minimum of 25 per cent upside.
The trick to ensuring a win-win deal for all is to re-sell the dream that the founders have conceived. Acquirers only need to scale it and make it more realistic while ensuring that the founding team is in charge. That said, they also need to be mindful before greenlighting the deal. Here are some errors that they must avoid.
1. Irrespective of adversity, a founder who sells cheap might also lack the ability to deliver robust ROI in the long run.
2. A lot of startups are distressed and 2021 is going to be the year of M&As followed by down rounds, debt financing, and the emergence of revenge VC.
3. Investors, acquirers and startups must understand that the ultimate goal of the transaction is business success. A bargain sale mentality is contrary to achieving this end. The golden rule is that ‘any item bought in a bargain sale has a short shelf life’.
There is a simple litmus test for every M&A in the startup land: Are the founders happy? Will they remain happy? If not, the deal is far from optimal.
How to calculate at a fair price for a stressed startup
Arriving at the vantage of a startup in an unstable economic landscape is challenging. However, it is not impossible. To arrive at a fair evaluation, concerned stakeholders need to consider the following factors:
· Take into account the years in operation, the market value of founders, and the willingness to take a discount on their salaries.
· Total amount invested. Is the amount used resourcefully? Is there any resulting product or process IP or an internal innovation mechanism at work? If so, the entire investment must be factored in with the addition of a premium. Often, what an acquirer terms ‘waste’ is a process of trial and error. In absence of such processes, innovation cannot be achieved.
· You must write-off overfunded startups where there's no defensible IP on the table. Founders are typically used to drawing high salaries and making big spends. They might not be willing to transition out of their comfort zone. Easiness gets into the founders’ DNA and they do everything traditionally with large spends. In reality, frugalness is what creates innovation while availability kills it. Most founders typically operate in the ‘delegate mode’ rather than getting something done themselves.
There should be a benchmark funding number. A figure above INR 50 lakh in tech space gives everyone a huge runway to make mistakes and start over again while creating defensible IPs in the journey. If founders find it difficult to manage the company using this amount, then it’s unlikely that they would be able to do so post a discount buy. Moreover, it could be indicative of incompetency and the mentality to pivot.
Founders, at the same time, should never be on a weak wicket on an M&A deal. True founders are committed like the Samurais for whom death is an alternative but dishonor isn’t. Their strategic competence is like Chanakya’s with an escape plan always in place. This approach ensures that they can fight another day when the situation is optimal, and use the M&A as a canteen break.
Likewise, clever acquirers mostly avoid the professional fundraiser-type founders and startups. Why? Because such startups are overvalued and overfunded. Founders of such enterprises are prone to spending 80 per cent of their time raising funds instead of focusing on their product, tech, stakeholders and business.
What comprises an ideal M&A?
A win-win deal happens when the vision of the acquirer aligns with the product and market roadmap of the startup, with the acquisition supplementing the ‘big picture’. The acquirer hard sells and is passionate about the startup’s vision and mission fulfillment. The startup is sold to the acquirers: the founding team and the senior management find a connection with the acquiring company. Both see the ‘big picture’ and share the way forward.
Most acquisitions and funding rounds in 2021 will take place at a deep discount as compared to their existing valuations. Stocks swaps might turn out to be a vehicle of preference. Acquirers should remember that a step valuation cut can be a great bargain deal. However, it raises compliance eyebrows and regulators can question you. If the down round is at a 30 per cent-plus discount, then an NCLT route should be taken.
All contradictions, anti-dilution, and investor protection clauses have to be clean slated for enablement. The standi to the present term sheet being redundant have to formally be arrived at and legalized. To kickstart the M&A, a pre-merger consent document citing changed circumstances and an en-passe of previous investor rights along with the endorsement of the new deal must be signed. M&As are best understood by the startup and acquirer. However, it’s also essential to ensure that such measures are also comprehensible to the regulator.
About the author: Ashwin Bhambri is the CEO of PhoneParLoan; Anand Kumar is the founder of Pier Counsel