2016’s quieter funding and IPO markets will drive more tech private mergers than ever before. These mergers can support successful growth companies through a volatile funding environment, and accelerate creation of a future group of enduring unicorns.
Tech leaders created through private mergers include, surprisingly, PayPal. PayPal was created from the merger of Confinity and X.com; David Sachs its former COO recalled that “immediately after the merger, we raised $100 million at a $500 million (pre-money) valuation because the combined company was the undisputed market leader.” More recently, we helped Boku and mopay combine to create the undisputed leader in carrier billing, backed by A16Z, Index, Benchmark and Holtzbrinck Ventures.
Merging two successful private tech companies of similar size has the reputation of being hard to do; it’s a reputation at odds with reality. Properly structured, a private merger could drive more value for shareholders than a cash M&A sale in a volatile valuation environment, and enable growth companies to get through any downturn comfortably.
Why would high growth private companies consider potential mergers in 2016?
- Merging to create a segment “winner” – Many emerging segments are over-crowded with well-funded aspirants competing for leadership. The exit value of a segment leader is several times the one of smaller competitors. So merging to create a potential leader that leapfrogs others does not only create scale, but it can also increase a merged company’s valuation multiple. For example, if two $50m revenue companies combine to create a $100m player growing towards $200m, that $200m leader could be worth 5x revenue whereas each smaller company might only be worth say 3x revenue. The whole then becomes distinctly more valuable than the parts.
- Merging can eliminate funding risk – Funding is becoming harder for growth companies, and many have not yet transitioned to a break-even self-sustaining stage. Combining cash resources, and cutting duplicated functions, can enable two successful companies to stretch their “cash runway” significantly.
- Avoiding write-downs is a driver – In an unstable valuation environment, merging two companies avoids either set of shareholders having to write down the company’s value versus the last (probably inflated) round. Put another way, few cash acquirers in 2016 will be prepared to pay the same prices VC’s paid in 2010-15, and few VC’s want to see their portfolio value reduced through a “successful” exit.
- PR value could be dramatic – Companies are looking for credible opportunities to “declare victory” in crowded, hot segments. In the recent past, this has been done via raising eye-popping funding rounds. Going forward, a well-publicized merger could have the same, or even more, perception value. And properly communicated, it can resonate most strongly with the group that matters most: customers.
In doing a private merger, there are a few lessons we have learnt, some the hard way:
- Avoid valuing either merger partner. The surest way to nix a merger is start an argument about “what each of us is worth.” Often we have seen this when the merger partners have raised money at very different valuations, even if it was years before. The only way to execute a merger is by relying on RELATIVE valuations, looking at each company’s performance (historic) and momentum (current/future). It always comes down to the same few metrics; revenue, EBITDA, pipeline, cash resources etc. Agreeing the approach to valuation upfront can determine if a deal proceeds or not.
- Even so, merging multi-round cap tables is just plain hard – An agreed relative valuation (X is worth 60%, Y is worth 40%) needs to be translated immediately into a combined cap table, with each company’s preferred share series combined and integrated. In practice the relative valuation percentages “move around” at different prices (for example, X shareholders get say 55%-62% of exit proceeds depending on exit valuation, not exactly 60%). This gets highly technical, and not helped by the fact we very often find cap table “bugs” along the way. The faster a headline relative valuation is expressed in share amounts and prices the better. Left to “be worked out in due diligence” it can blow up a deal.
- Agree on leadership up front. You cannot solve who will be CEO by more due diligence, or by changing valuation. Where one company CEO feels she/he must run the combined company, and it’s a deal-breaker, then lay that out upfront. Where the approach is to choose the best person for the job, agree that mechanism upfront. 99% of the time any form of power-sharing is a recipe for disaster; millions of pages have already been written about why.
- Ensure are cash resources to support an inevitable 6-9 month post-deal slowdown. Post-merger integration is hard even for the best acquirers with unlimited resources. For smaller companies it will absorb and distract the senior leadership team; our rule of thumb is it will be twice as distracting as the CEO expects.
- Use the same best-practice integration approach larger buyers adopt. Communicating a clear vision and strategy, developing a 100-day plan, quickly merging sales teams, choosing leaders for key functions, and articulating incentives are all basic requirements for any successful deal. A merger should be treated the same as a cash M&A deal; everyone needs to know where they stand early on, and what is expected of them.
- Use a private merger negotiation to explore if there’s a better M&A sale. Arguably the best private merger is one that leads to a large buyer stepping in to buy one or both businesses for cash. Its essential merger partners explore their alternatives aggressively, using merger discussions as a stalking horse to trigger strategic M&A interest. Having said this, the majority of the time the merger deal just moves too fast, and has the potential for too much value creation to be shelved for a more speculative cash sale. Especially true where the merger partner has raised money at a very high valuation, and selling for cash triggers a significant loss for investors.
The more challenging the funding environment, and the greater the value being placed on a specific segment winner, the more growth companies can benefit from a private merger.
For many investors, its not going to be a question of if, but how.
Posted by Victor Basta @MaExits