The business of buying or selling a startup is a murky world that most folks have no concept for. We hear about the end result – one hot company gets bought by another. But we rarely know what goes on behind the scenes to get to that point.
Let’s talk about just that.
I’ve had a fair bit of experience on both sides of this equation, as I’ve sold a few companies and have also purchased a few (Launchrock, Clarity.fm, and KillerStartups) quite recently. At Startups.co we talk to a lot of companies about potential acquisitions. (If you’re in the startups space and have a great product, feel free to email me about it.)
In the past six months, I’ve explained our process of acquisition to dozens of companies, and it has become clear that people don’t know where to find the domain knowledge about this process.
So, in an effort to be as open as possible about how we go through this process, here are some of the key deal points we always walk through. As always, your mileage may vary.
If you know me—or my writing—you know that I always start with the short version (the “Too Long; Didn’t Read” version). So here is a summary of how we approach acquisitions:
Start with Transparency. Agree from the start that, in order to align the goals of the Founders as well as identify what serious problems there will be going forward, both parties need to be completely honest. And yes, there will always be serious problems.
Be Realistic About Valuation. As a seller you need to avoid faulty valuation tactics. Instead, derive the baseline value by focusing on the most valuable aspect of your business as the key selling point. Modify accordingly from there.
Find a Balanced Structure. There are lots of ways to structure a deal – getting a big lump sum of cash is in many cases the least likely outcome. Once you start to understand the mechanics of how payouts work, you’ll see there are many ways to get a deal done.
Startup acquisitions are like relationships – people don’t think realistically and they often end poorly.
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START WITH TRANSPARENCY
There’s a tendency to approach the acquisition game like poker, where both sides hold their cards close to their vests and hope they can out-bluff the other. But this can often backfire.
We err on the side of transparency and it really hasn’t ever failed us.
Our goal is to let Founders know exactly what we’re thinking. We’ll flat out tell you where we think the problems are, what our own problems are, and the detail around how we’re making decisions.
If you’re looking to sell, establishing a certain level of trust and transparency goes a long way. Bring all of the issues to the surface early. I get a lot more comfortable when someone tells me all the problems than when they just espouse the benefits. I’m guessing you do too.
Aside from building trust, being transparent is also the fastest way to get both parties to a “no” as quickly as possible so they can use their precious time trying to find a “yes” elsewhere.
Determine Founder Goals
Before we get into a long discussion on valuations, assets, and exits, we always start with a simple question to the Founder (or team):
“What’s important to you?”
We ask this question first because, ultimately, if the acquisition isn’t in line with the goals of the Founder, the rest of it doesn’t matter. Obviously we all want to pay back investors, take care of the team, make sure the product grows, and so on.
Acquisitions are more about personalities and emotions than facts and figures. It’s a major life decision which is often surrounded by a whole set of life concerns that are critically important. So we start with those.
The answers to this question range from
“I just want to see the startup grow as fast as possible,”
“I am so burnt out – I just need a crazy long break.”
Both answers are perfectly OK. What we look for are honest reactions and goals, and then we try to find a way to work toward those goals. As a Founder, it certainly helps to have thought through your motivations for selling. Even if you’re not asked to elaborate on them openly, they can help guide your actions and conversations.
Identify the Problem Children
In virtually every deal there is some stumbling block that is going to be a giant pain in the ass. It could be a wonky convertible note that needs to be unwound, an ex-employee that has some litigation pending, or an investor who thought you should have sold for 100x more.
We usually start that conversation like this:
“In 100% of the deals we’ve worked on there has been some critical stumbling block. What do you anticipate yours to be?”
It’s basically like saying:
“We all have a crazy cousin in the family – what is yours like?”
Instead of trying to pretend this problem doesn’t exist, we tackle it head on. We do this because we know Founders have a tendency to not want to talk about those issues until it’s too late.
By shining a spotlight early, you at least have a reference point to work into your parameters. We also want to disarm the notion that your deal has to be unrealistically free of issues in order to work together. That deal doesn’t exist.
It would be far worse to find out at the end of the deal that the 35th person in the cap table is waging war on the deal and won’t sign. Let’s get to these problems early and figure out a solution.
BE REALISTIC ABOUT VALUATION
Everyone sweats the valuation. At some level it’s the scorecard we use to evaluate the outcome of the deal. But getting there is often enormously difficult, mostly because expectations are often improperly set.
Unlike funding, where the information about valuations and the mechanics are pretty well shared, exits are often very murky. As such, people have no idea in most cases why a company sold for what it did. And as we all know, in the absence of information, people make pretty awful decisions.
Avoid Faulty Valuation Premises
It’s often really hard to know the value of what you have unless you’re generating a meaningful amount of revenue over a long enough period of time. Everyone understands revenue.
But when you aren’t just talking revenue, when you’re talking intangibles like intellectual property, brand, team, user base, and growth, the conversation gets super confusing and this is where I think most deals fall apart.
Remember that the value is relative to what someone is willing to pay for it. But to arrive at that value you’ve got to be clear about what you’re actually selling and why it has value.
Here are the top 4 most common challenges we run into:
1. The value to Google/Facebook/Amazon isn’t the value to us. They may not care about revenue whereas we may only care about revenue. A seller needs to focus on how the value maps back to each particular buyer.
2. What you invested into the business doesn’t necessarily drive the value of the business. I can spend $100 million to build the most awesome roller coaster in the world but if no one pays to ride on it, the value as a business is zero… although it’s likely a pretty sweet roller coaster.
3. Whatever price one company got sold at doesn’t automatically make that the price for us. If I walk into a McDonald’s and Ronald charges me $1 million for a Happy Meal it doesn’t mean everyone will now be willing to pay a million bucks for a kid’s meal. Some deals will help drive comparable sales, but it’s only a yardstick, not an absolute.
4. “I need to get at least a million out of this for it to be interesting to me.” That’s not value, that’s a desire. The desire to get a million dollars doesn’t make the product itself more valuable. If it did, you should desire $1 billion and we could both retire together!
Of course there are exceptions to each point – this only underscores how important it is to not hang your hat on these common misconceptions.
Isolate the Value Points
But talking only about what doesn’t drive the valuation doesn’t help you to figure out what does drive the valuation. We call this “isolating the value points.”
We want to avoid wasting cycles talking about stuff that isn’t really driving the core of the deal. For example, we hear this a lot: “We think people would be interested in our amazing team and technology.” Both are probably pretty amazing.
But that may not be what’s driving the value of the deal. And if we can’t agree on a driving valuation for the most critical asset to us, the fact that Kevin is a fantastic CTO isn’t going to seal the deal!
The value could be the rate of user sign ups, or traffic, or month-over-month subscription growth. Think about the value in terms of how the acquiring company will extract value, because that’s most certainly how they are thinking about it.
Remember, the key is to be transparent. We try to point out where we think the value is (and isn’t) as fast as possible. As a startup you could do the same. You could simply say:
“Here are the top 3 things we think have value – which is most important to you?”
Think of how much time that saves. Once you’ve isolated the value points and agreed to a baseline for valuation, then you can start figuring out what other assets may increase the price.
Translate Key Value to Price
So now let’s say we’ve both agreed that the size of the user base is the most valuable asset to us. Cool. At least we’re focusing the conversation on the same thing.
Now we have to translate that into a price we’re willing to pay.
I’m not going to bother getting into complex math around how to do every type of value calculation of every possible asset – that’s a whole other post, preferably written by someone who enjoys writing in such meticulous detail.
Instead, let me explain some key scenarios we use to help us establish some price parameters. Again, every company works differently. This is how ours works.
Worst Case Value. We always establish a value that says, “If everything goes to hell, what would it still be worth?” What if people mostly stopped using the service, the tech fell apart, or revenue plummeted? We use this so we can at least agree on a price floor to build from.
This is a more valuable exercise than you may realize, because it sets the stage for how low the price could go, and why. By the way, sometimes that number is zero – and that’s a valuable conversation to have as well, because most folks don’t think about the risks of the transaction creating negative value.
Guaranteed Asset Value. There are certain things that we can almost guarantee the value of, like revenue channels, user acquisition, traffic and technology. While there is a great deal of variability in those assets (the users could be of low quality compared to our other sources) we know this part of the business very well.
We make a detailed list of “guaranteed assets” and can often attribute true price value to those because we pay for these assets already. As a seller, if you’re not asking questions like, “What do you pay per user acquired?” you could literally be selling your most valuable asset for pennies on the dollar.
Acceleration Value. There are certain products that have a great deal more value in our hands versus the seller’s. For example, if you have a product that helps entrepreneurs—our core audience—and you are earning $500 for every 1,000 user registrations, we think about the value if we accelerated that to our user base of nearly 1 million users.
In some cases, a product that does very little revenue currently could be a monster hit for us, so we attribute a speculative “acceleration value.” Frankly this is probably our most important metric, because if we can’t accelerate the business in some meaningful way, it’s probably not a great fit for us anyway.
That said, be wary of the argument that says “If Google bought us and distributed the product to its millions of customers the product would be worth $5 billion – so that’s what we’re worth.” In that case, Google may be the one creating the value, not you. If Google grows by 10x this year that doesn’t necessarily make your business 10x more valuable.
Upside Value to Seller. If the net result of this deal is you get 0.001% of our company, and that’s really the value at present, we look at that and say, “This just doesn’t have enough upside value to the seller.”
Technically this shouldn’t matter because the value should be the value and that’s that. But the world doesn’t work like that. If the seller doesn’t have a meaningful upside in this deal it is almost always likely to fall apart.
Therefore sometimes we’ll increase the value to create seller incentive, not because the deal itself has that demonstrable value today. For what it’s worth, this can also be a red flag.
Insane Crazy Facebook Value. If all the stars align and this thing becomes the next Facebook, then what does that value look like? Unfortunately, this is where most sellers start the conversation.
The “We’ve never made any money but we want you to pay $10 million because someday this might make money” strategy is a horrible way to value a company because it’s based on fantasy, not reality.
There are ways to align potential upside value, like earn-outs and bonus goals, but structuring the entire price based on hopes and dreams makes for a really awkward discussion. All that said, we still do put a separate value on the “insane crazy” part of the deal if we think it’s a meaningful discussion.
Here at Startups, we go through each of these exercises to start to net out some value parameters but also to isolate the moving parts of each value point. If a deal could be worth $100k (worst case) if all goes to hell, or $10 million (best case) if it skyrockets, that’s a significant delta.
But having gone through detailed exercises around each scenario gives us the ability to evaluate each of those scenarios separately, so we can start figuring out a target price. The answer is always a blend of each of these methods, not reliant on just one.
FIND A BALANCED DEAL STRUCTURE
The reason I wrap up with the concept of “Find a Balanced Deal Structure” is to emphasize the concept of “balance” and “structure.”
Deal veterans know that the structure of a deal is almost always more important than the price. If you’ve ever raised money from a professional angel or venture capital investor, then you know that deciding on the valuation of your company was the easy part – the structure of that deal is what really matters.
Fundamentally, we’re afraid of paying too much and the seller is afraid of selling for too little. Every now and again you arrive at a perfect settlement price and it’s a clean, easy deal.
For every other instance, here are the cornerstones of deal structuring.
When two people can’t agree on the future value of an asset they usually turn to an “earn-out.” I always say:
“Earn-outs are the convertible notes of M+A because people use them when they want to get a deal done but can’t agree on price.”
On paper, earn-outs make sense because they provide a hedge for both sides. But actually making them work is a different story.
One of the most common scenarios you hear about in deals is the “team earn-out” where the team stays on board for some period post-acquisition to make sure the deal goes smoothly and perhaps some agreed upon value is recognized.
There’s one small catch: what if the team doesn’t want to be there? Like even a little bit?
This maps back to the very start of the discussion – what does the Founder (and their team) personally want out of this deal? If it’s to stay on and build something bigger and better, awesome. If it’s not, or more specifically, if they aren’t 100% dying to do that – then we’d never consider asking them to.
In all three deals we did last year (Launchrock.com, Clarity.fm, and KillerStartups.com), each of the Founders left sometime after the deal was done. Had the conversations at the beginning of the discussions gone differently, revealing that Founders wanted to work under a different team and structure, we would have certainly been open to that.
We just don’t believe in indentured servitude, especially among startup Founders. We think it creates unrealistic alignment. On paper it’s, “We’re both working to maximize the value here,” but in practice it’s more like, “I’m going to invest the least amount of energy in here to realize the most out of my particular deal.” At a deal level that might make some economic sense, but at a broader cultural level post-deal? It’s toxic.
The way we handle this is simple: we negotiate the deal as if no team is involved whatsoever. That way, we minimize our own exposure if a Founder leaves, and maximize the Founder’s options by not being inextricably tied to their deal. Then we negotiate, where necessary, on Founder and team involvement.
Removing the indentured servitude of the team still leaves an option for creating a sliding scale of earn-out potential to help align price to future performance. Simply put: we can agree that if things go amazingly well, we’ll pay the seller more money.
The tough thing about this structure, especially without the original team to drive it, is that it leaves the future potential of the earn-out in the hands of the acquirer (us).
What if we really screw it up?
And that’s actually it. If we do amazingly well, like we thought we could when we sent you lots of money, then there’s no real problem. So really, we’re asking: “How do you protect against us doing a crappy job with the asset?”
We solve that by adding a premium on the base price that we pay. For example, if we were to say your company is worth $1 million at present value, but it has a future potential to be worth $5 million in the next 2 years, we may increase the price beyond $1 million initially. This helps you manage the downside of us messing things up, but still leaves us with some protection in case the asset isn’t what we hoped it would be.
The key is to make sure there is some upside and downside protection for both sides, in a balanced way, in terms both parties can reasonably measure.
In some cases, the most meaningful aspect of the deal is the actual payment terms, not the total payment itself.
Think of it like this: if auto manufacturers only sold cars for full sticker price, cash on the barrelhead, they really wouldn’t sell many cars. But if they break the payment terms out to synchronize with the income of their buyers, they can sell millions of them.
At some point, asking for too much all up front is actually counterproductive to getting a deal done. I’m not saying it’s not easier – if you can get paid up front, by all means, do it. But consider the fact that how you charge your customer can dramatically change the likelihood of getting a deal done at all.
We’re a small company, so our economics don’t work nearly the way a company like Google or Apple works. If we think the price of a deal is more than we can swallow today, we may ask a company to consider terms that sync with our own growth or capital demands. It’s actually a really easy conversation to have, but most folks never think to do it.
Stock Versus Cash
The last meaningful deal point we spend time on is the use of stock versus cash in a deal. We can probably agree that cash is king. If we can settle on a cash price for the deal and be done with it on terms we can both accept, then that’s always a clean deal.
When you get into stock, that’s when things get funky.
Stock is often a speculative instrument so accepting that currency requires you to have a certain amount of faith in it. To put it more plainly, if you’re converting the value of your company into stock in our company, you better be damn sure we’re a good bet.
To that end, we spend a lot of time talking about the future of our business and what we intend to accomplish. This is where we believe the alignment needs to be bi-directional. It’s not enough that we believe in your business – we need to know you believe in ours.
At Startups.co, we believe the conversation around our business and what we want to achieve should be a big part of the conversation from the outset. We invite hard questions. We go out of our way to introduce as many of our team as possible so you can see exactly who we are.
We pitch dozens of startups just like we would pitch investors. We want people to believe strongly in our vision and value.
GETTING IT DONE
If we’re fortunate enough to make it through all of these steps (and it takes time), we end up in a place where it’s time to get a deal done. Fortunately, we’ve had lots of cycles on this at Startups.co, so we have a pretty repeatable system for walking through diligence, contracting and getting final sign-off.
If this is your first time going through this process, I cannot stress enough how important it is to find an attorney who has experience with sell side transactions. The last thing you want in this process is guidance from someone who has very little real world experience in getting M+A deals done. At the very least you should have good counsel on what’s “typical” and what’s “a really big red flag.”
Aside from good counsel, the only other key piece of advice we always offer is, “Get it done quickly.” Time is the enemy of all deals, whether sales or venture financings. Nothing good comes from bickering over trivial points and running through endless rounds of revisions. We always emphasize a close that gets things moving as quickly as possible so we can all move on to the next chapter sooner than later.
A topic like this leads to lots and lots of derivative questions, so as I’ve said before, if you want to drop me a line, let’s chat. And who knows, maybe one day we’ll be working on the same side of the table!
“What concerns should I be worried about when thinking about selling my startup?”
Wil Schroter is the Founder + CEO @ Startups.com, a startup platform that includes Bizplan, Clarity, Fundable, Launchrock, and Zirtual. He started his first company at age 19 which grew to over $700 million in billings within 5 years (despite his involvement). After that he launched 8 more companies, the last 3 venture backed, to refine his learning of what not to do. He's a seasoned expert at starting companies and a total amateur at everything else.