Acquisitions: Pulling Back the Covers
To many entrepreneurs, the process of getting acquired seems like a black box. I suspect this is because far fewer acquisitions happen than, say venture financings (about which a lot has been written), so there are a lot less data. Also there are generally very strong confidentiality agreements in place protecting the terms of these deals.
I'd like to write a little about this topic since it's something I'm often asked about, but bear in mind I too am bound by confidentiality agreements regarding the sale of my company, so I won't be able to go into the specifics of our deal. This post is based on my own experience and the experience of friends who have been through the process.
Context
To set the context, I'll say up-front that my advice is aimed at technology companies (particularly web and software companies) who are selling quite early in their lifecycle. The reality is that acquisitions of this type are usually talent acquisitions. We've seen a huge amount of acquisition activity this year, with large companies picking up small teams working on cool new products. This is in large part due to the fact it's very difficult to hire good engineers right now. Big companies and small startups alike are feeling the pain. One avenue available to big companies with deep pockets is to acquire early stage startups in order to hire their engineers and product folks, effectively paying them a very nice signing bonus.
Take a look at this graphic depicting Google's acquisitions, and notice how the small acquisitions far outnumber the large ones. Keep in mind that acquisition prices are almost never disclosed so these are just rumored prices, but likely in the right ballpark. This graphic chalks up most of the smaller acquisitions as 'technology' acquisitions, but I'm willing to bet most were actually done to acquire talent (I don't have any inside information on this fact).
What exactly is a talent acquisition? Usually it involves valuing the company based on the number of engineers and product folks that will join the acquiring company. Something like $1-$2M per engineer would not be unheard of. The money is generally paid in installments, with some paid upfront and some paid out over a period of 2-4 years. From the acquiring company's perspective these are basically signing and retention bonuses, although the deal may be structured formally as an acquisition (stock purchase). If the company has outside investors, they will probably get paid their share upfront with no payments held back, since they aren't joining the acquiring company.
So that sets the context for the rest of this post. If you are running a rapidly growing business and/or one generating a healthy cash flow, then you are in a different ballpark and other posts will probably be more relevant to you.
Should You Sell?
A lot has been written lately about the good and bad of selling out early vs swinging for the fences and trying to create the next billion dollar business. I don't want to rehash the philosophical and macro-economic arguments, but instead focus on the personal decision of the entrepreneur. This is a very important personal question that every entrepreneur who finds themselves in this position must answer.
Despite the current thread of "dipshit companies selling out early" reverberating in the blogosphere, I don't think any entrepreneur should ever feel bad about selling his or her company. If you look at the range of possible outcomes for a startup, selling early is still on the high-end. Sure you could do even better and have a YouTube sized exit, but those are very rare. Selling, even for a small amount, still puts you FAR above the majority of startups whose likely outcome is failure. Remember that you are the entrepreneur and this is your company. You took the risk to start it, you worked hard, and now you are rewarded with the option to sell should you wish to. This is your decision to make, you earned it. Theodore Roosevelt summed up this sentiment brilliantly in 1910:
"It is not the critic who counts; not the man who points out how the strong man stumbles, or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood; who strives valiantly; who errs, who comes short again and again, because there is no effort without error and shortcoming; but who does actually strive to do the deeds; who knows great enthusiasms, the great devotions; who spends himself in a worthy cause; who at the best knows in the end the triumph of high achievement, and who at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who neither know victory nor defeat."
So with that out of the way, should you sell? First look at your motivations as an entrepreneur. You may be in this for the money, or to change the world, or more likely some combination of both.
If your primary goal is to change the world, you need to decide if you can best achieve your goal by continuing with your current company or taking an exit and then starting something new in a few years. Some inputs to this decision will be how passionate you are about the work you are currently doing, and how good the offer is. The best laid schemes of mice and men often go awry, and it's certainly possible that a year or two into your business you aren't achieving the success you imagined at the start. You have to really try and evaluate whether continuing what you are doing now is your best shot vs starting from scratch again. At least you have some sense of the odds with what you are working on now; starting afresh is a shot in the dark.
If money is your primary goal, it's important to realize that we don't have constant utility of money. Going from a net worth of zero to $1M, $5M or $10M feels a lot different than going from $10M to even $50M or $100M. There are several life changing thresholds you can cross, for example getting out of debt, owning your own house outright, never having to worry about work again. These things can significantly change your life, and beyond that the differences are more like do you own your own private jet or your own island chain. Going from 'starving entrepreneur' constantly worrying about making rent and skimping on food, to being comfortable and free to do whatever you want - that's a big deal. Taking an early exit can put you in this position, and give you the time and flexibility to start whatever company you want next time around. In fairness, if you stick with your current company you may also have an option to take some cash off the table when you raise a VC round. This practice is becoming more and more popular.
I'll end this section by saying it's definitely not an easy decision to make. It wasn't for us. We ended up weighing a bunch of factors like those above, as well as the prospects for our company going forward given we were pre-revenue and the funding environment was looking quite shaky (we were one of the last companies Google acquired before the economy collapsed, and so in hindsight our timing impeccable). We also worried about potentially competing with Google/YouTube because we knew they were developing similar products internally.
As you can see there's no simple answer to the 'should you sell' question. It's very complex and nuanced. The important thing to remember is that it's your decision to make as an entrepreneur. Don't listen to the people on the sidelines who really have no idea what you are going through.
Closing Doors
This seems like an appropriate point to mention that there are certain actions you can take as an entrepreneur that will prevent you from even getting the opportunity to make this decision. Specifically, if you decide to take VC funding, or perhaps even angel funding, you may close the door to an early stage exit.
In a talent acquisition, the acquiring company is paying for you to join them. If they have to pay large amounts to outsiders who aren't going to join the company, that means they either have to pay more for the deal overall, or pay the founders less making them less incentivized to take the deal and/or stay at the company. VCs almost always have the power to veto a sale of your company, and will likely do so for an early exit because the nature of their portfolio investing approach means they need companies to swing for the fences.
In our case we hadn't taken much external investment and the founders owned most of the company, which meant that we at least had the option to sell if we wanted to. When raising money it's always good to think about what implications it will have on your exit opportunities.
How to Sell Your Company
If you've decided you want to sell your company and you don't yet have an offer on the table, you are surely wondering how to go about getting one. Unfortunately, the answer is don't try.
As the saying goes, "companies are bought and not sold". This means it is best to focus on building and managing your company as an independent and successful business, rather than trying to convince other companies to buy you. In this way it's kinda like dating. The more valuable you are as a company, the more interest others will have in you. Also keep in mind that you can't control the circumstances of other companies, such as whether they are acquiring or not and what type of deals they are looking for. What you can control is your own company, so focus on that.
Of course, it's not just that simple. Companies have to somehow find out about you if they are going to approach and make an offer. Big companies are often looking for diamonds in the rough, but there's a lot of rough out there so you have to somehow get their attention. This is where the value of a startup hub like Silicon Valley is quite evident. A large number of deals happen based on who you know. The initial introduction of your company to a potential acquirer is likely to be by a mutual acquaintance, which is why networking is so important as I mentioned in my previous post. Of course you can't really plan for this, but you can make it easier for serendipity to strike by simply getting to know a lot of people while you build a great company.
These days there are certain places acquisitive companies can look that have a higher concentration of diamonds, such as programs like Y Combinator. Being part of a program like this is good way to get the attention of acquiring companies. While the folks at Y Combinator don't encourage founders to sell early, they do encourage the founders to make their own decision and so you do see a number of Y Combinator companies getting picked up quite early.
What would be considered a diamond? Acquiring companies are generally looking for a cool product/technology that is somewhat synergistic with their business. However, this is more of a proxy to prove that the team is smart and capable of executing, and shares a similar vision. It is quite possible that the acquiring company will not want to continue offering your product once you join.
Pick a Number
So you've got tentative interest from an acquirer, what should be your first step? You should absolutely sit down as a team and come up with 'the number'. This is the absolute minimum price you will accept for your company. How much it's going to take to give up on your dream? Once your company is acquired, you will no longer be in control and the acquiring company can do anything they like with the product - which includes shutting it down. Come up with your number under the assumption that this will happen. Your baby is gone. How much is it gonna take? And really think about what your minimum is - if you would take even $1 less that is not your minimum. It's important to have a very open discussion with your cofounders, and have this number set in stone. Later during the heat of negotiations you will face serious temptations, but if you've thought about this minimum number in advance in a calm and rational way you confident in walking away from the deal if the acquirer does not meet your price. I mean this - you have to be prepared to say "thanks for your time" and walk away, which I can tell you is damn hard to do. But it's never a good idea to start lowering this number during the negotiation process when you might not be thinking clearly. Don't succumb to temptation and do something you may regret later.
Of course 'the number' is not just a single number. There are terms attached, such as whether the payment is in cash or stock (and how you value the stock of the acquiring company), how much is paid upfront and how much is held back, the period over which it is paid, your new role, salary and terms of your employment etc. It's also perfectly rational to have a different 'number' for each acquirer, in the case that you have multiple offers. Naturally you will be more excited about working at some places than others.
Be sure to hash all of this out with your team before you embark on the actual negotiations.
Negotiations
A lot has been written about negotiation strategy and tactics, and I'm far from an expert, so I'll let you research the general stuff on your own. In the context of a potential acquisition, the first thing you need to do is get a strong internal sponsor/champion at the acquiring company. This is probably the person who found and approached you, unless that person is not very senior in which case it may be his or her boss, or further up the chain of command. Usually it's someone in the product or engineering team who really understands what you have achieved, and really wants you to be part of the company. Find this person and do everything you can to make them love you. They will be the one who tells the M&A team to go ahead and get a deal done.
You will probably have a bunch of meetings at the company demoing your product, talking about the technology and your shared vision. Hopefully there's a strong synergy between your vision and theirs. Hopefully they like your architectural choices and the technology stack you have chosen. Hopefully they are impressed by how much you have accomplished with so few resources (this is where startups really shine compared to large companies). If all goes well, at some point you will be introduced to the M&A team, sometimes called the corporate development team, who will take over and handle the tactical negotiations from here on.
Acquisition negotiations are a strange things. At first no one seems to come right out and say just what is going on and what the purpose of the discussions are. Often companies are just 'exploring how we could work together' - but there seems to be a shared understanding that a potential acquisition is really what's being talked about, and eventually someone, usually from the M&A team, will come out and say it. This is when things move into high gear!
You'll want to quickly assemble your team of lawyers and advisors (which I discuss below) who will help you through the negotiation process. Before you have this team assembled, there are a couple of things you should make sure you do from the beginning to start out on the right foot. First, don't immediately sign a no-shop agreement. A smart acquiring company will ask you to do this right away, but you need to resist. Explain that you'd be happy to sign an NDA and keep the details of your discussions confidential, but you aren't ready to sign a no-shop agreement until the discussions progress and you have a better understanding of the actual terms. In my opinion it's ok to sign a no-shop once you have agreed on a termsheet, but before you reach that stage you should not.
Secondly, have your BATNA ready ("Best Alternative to a Negotiated Agreement"). You need other options if you are going to have any leverage in the negotiation (again, much like dating :) This could be other interested acquirers (which is why it's important to not sign a no-shop agreement, so you can go out and get in front of other acquirers now that you have interest from one), it could be investors interested in funding your company so you can continue independently, or it could be simply walking away and continuing to do what you do best. You have to show that you don't need this deal, make them want you as much as you want them. And even if you don't have other options yet you need to be projecting this attitude.
The negotiations will progress through a few phases. There will be a due diligence phase where the acquirer digs deeper into your product and technology. They may even put you through a formal interview process (since they are basically hiring you). Next you will begin negotiating a termsheet - this is a short document (usually 4-6 pages) that outlines the key terms of the deal, and streamlines the process by ensuring you have agreement on all the important stuff before engaging expensive lawyers (I talk about some of the key terms below).
Eventually you will reach agreement and sign the termsheet. This could happen relatively quickly over a week or two, or could drag on for a couple of months depending on how closely your expectations match and how hard you negotiate. Term sheets are not legally binding, but they aren't usually broken if both sides have been honest in the negotiations thus far. For this reason (because the deal has a reasonably high likelihood of going through), it's ok to sign a no-shop agreement at this point.
The final phase is negotiating the definitive agreement. Whereas a termsheet is only a few pages, the definitive agreement may be well over 100, and is mostly legalese that lawyers on both sides will relish the opportunity to argue over. Depending on how thorough you were at the termsheet stage and how hard you decide to negotiate, this phase could again drag on for months.
If the deal doesn't fall through, then at some point everyone on both sides is happy and signing day arrives! After penning your autograph on stacks of documents you can sit back, relax and let your writers cramp subside. But you're not quite done yet. Usually there's a bunch of administrivia that needs to be taken care of after signing and before the deal is officially 'closed'. This can take a few days or a week or so. Closing day will eventually arrive, you'll login to your online bank account and a huge smile will appear on your face, techcrunch and a hundred other blogs will write about you, and you will join the ranks of entrepreneurs who have successfully sold a company.
Of course come Monday you'll have a new job and a new adventure to embark on, so relax while you can.
Lawyers and Advisors
I mentioned above the importance of assembling your team to help with negotiations. This basically boils down to lawyers and advisors. I first want to explain that lawyers and advisors are very different - you need to make sure you have both. To put it simply, lawyers are focused on minimizing risk. They will pore over the details of an agreement and make sure you aren't exposing yourself to things that could come back to hurt you. They want to protect you. What lawyers generally won't do is present you with creative ways to reach a better outcome. As an entrepreneur, you are not only interested in minimizing your risk, but also in maximizing the upside of the deal. This is where having experienced advisors is key. Hopefully your advisors have done a few deals in the past and have a few tricks up their sleeve that that can be used during negotiations. To give an example, one of our advisors was a very experienced tax accountant and figured out a way to structure the deal that helped us minimize the tax we would owe to the government. Venture Hacks explains this well in their article Lawyers are referees, not coaches.
In case you are wondering whether you can just do this yourself - why you need a team at all: first, it would be absolutely crazy not to have a legal review of the agreement you are about to sign, preferably from a lawyer experienced in dealing with these sorts of transactions (not Uncle Bob who has a small family law practice back home). Secondly, consider that this is probably the first time you have ever sold a company. Your acquirer may have already acquired dozens of companies this year! The M&A team you are negotiating against lives and breathes this stuff every day. You are at a massive disadvantage if you don't bring some experienced folks to your team to even things up. It's particularly advantageous to have advisors on your side who personally know executives on the other side. Having a back-channel in addition to your formal negotiations can be tremendously useful in streamlining the whole process.
I talked about the negotiation process above, and how moving from term sheet to definitive agreement can last a month or more. This is the time when your lawyer really becomes engaged, and is the time you need to be very careful about where your lawyer spends his or her time (aka billable hours). It's often joked that lawyers are the ones who make out best in an acquisition. Legal fees are high, and lawyers just love arguing over minutiae and charging you for it. You will have to actively manage your lawyer, keep them reigned in and focused only on what you mutually decide are the most important points. Set an expected budget upfront. Ask what they can get done for this amount. Tell them not to worry about arguing over minor points that you don't care about. Keep in mind that they are probably used to negotiating big deals where legal fees can easily run above $500K, they aren't necessarily used to your small early stage exit. Legal fees of $50-$100K for an early stage deal are not unusual.
The Nitty Gritty
Here I'll outline some of the key terms you will be negotiating. Again, I'm bound by confidentiality agreements so I won't be discussing the specifics of my deal, but just some general terms to give you an idea of what to expect.
- Consideration - the amount you will be paid, the form it will take (cash, stock or both), how it will be paid out (usually some percentage up-front and some percentage over time tied to continued employment, perhaps tied to milestones)
- Structure of the deal - usually either a stock purchase or an asset sale. You should consult your lawyer and tax accountant on how this will affect you.
- Employment arrangements - the types of jobs founders will be offered and an indication of salaries etc
- No competition - an agreement preventing the founders from competing with the acquirer for some period of time
- Non-disclosure - requiring parties to keep terms of the deal (or maybe even the fact a deal exists) confidential
- No-shop - preventing the company from meeting with other potential acquirers or investors for some period of time (usually the expected time for the definitive agreement to be negotiated).
- Due diligence - outlining the information the acquirer will need from the company.
- Indemnification - outlining the representations and warranties the company is making to the acquirer, and requiring the company to reimburse the acquirer if they are sued for any breach.
- Escrow - some portion of the consideration may be held in escrow for a period of time to cover the indemnification mentioned above.
- Expenses and fees - who is responsible for legal fees (usually each party pays their own, but you may be able to play the 'starving entrepreneur' card and get some help)
It is important to understand all of the terms in your term sheet before signing. I would recommend paying specific attention to the structure of the payments and possible tax consequences. As I mentioned we were able to structure our deal in a way that helped minimize taxes owed.
While negotiating the definitive agreement, your lawyer will really dig into the indemnification clauses and make sure you aren't signing yourself up for more risk than necessary. To give you an idea, you will be asked to represent that you fully own all your IP, have not breached others intellectual property rights, have not made any fraudulent claims etc. In order to satisfy these representations, and as part of the due diligence process, you should expect an audit of all the code in your product that was written by third parties, which includes all open source libraries and the licenses attached to them. You need to make sure you clean from an IP perspective.
Keep Working
I'll end this post with one piece of advice that was drilled into us by Paul Graham, one of our advisors. Keep working. Assume that the deal is going to fall through (deals often do). Keep building the company, developing new features, gaining new customers etc. Not only will this leave you in a comfortable position if the deal actually does fall through, but it will also help with your negotiations when the acquirer sees your company continuing to grow during the process (which may be several months). In our case we launched several new features and received a bunch of press during the negotiations, which I assume helped reassure the acquirer that they were making the right decision.
I hope this post has pulled back the covers and shed a bit of light on the acquisition process. If you are going through the process I'm happy to answer any questions - drop me an email.
