CHAPTER TWENTY-NINE

THE ROLE OF M&A

“Mergers and Acquisitions” may seem more appropriate as the title for an MBA course than a chapter in this book. “Startup M&A” isn't the oxymoron it sounds like. It's one of the most important tools in every startup CEO's strategic arsenal, as is its flip side: divestiture.

USING ACQUISITIONS AS A TOOL IN YOUR STRATEGIC ARSENAL

Many entrepreneurs are afraid to do acquisitions. It's usually a combination of being daunted by the task—and it is daunting—and fear of introducing something that was not invented here. At Return Path, we're at 10 acquisitions and counting. Not all of them have worked but a couple of them have been transformational, and most have been relatively small and good tuck-ins.

Every merger is unique but I have found that you can usually place them into one of four categories:

1. Buying technology. Many strategic plans involve the expansion of a company's capabilities by creating a new product. The classic question you have to ask is: “Is it cheaper to buy it or build it?” If you answer the former, it could make sense to buy a small company in order to acquire technology that they have already built or simply to buy the rights to that item of technology. (Once you have it, of course, it's your job to sell it.)
2. Buying teams. Even if you decide to “build” rather than “buy,” you may need to hire an entire team to execute on your latest project. Buy an entire team (a strategy that's recently been dubbed both “doing an HR deal” and “acqui-hiring”) and a single acquisition could take the place of months of recruiting.
3. Diversifying your business lines. Buying teams or technology are special cases of M&A. The classic scenario involves buying an entire company and there are two possible reasons for doing so. The first is to diversify into a business you're not currently in. The challenge is to find a new line of business that complements your core business and plays off your current strengths. Anything else simply leads to dissipation and a lack of focus.
4. Expanding your market share. Finally, you might decide to purchase a direct competitor in order to expand your market share. If you're locked in an internecine battle with a competitor for years at a time, this option could benefit both parties by creating that one, great company that neither was able to build on their own.

THE MECHANICS OF FINANCING AND CLOSING ACQUISITIONS

The mechanics of M&A are complex enough to merit an entire book. (Those books have been written; when you're ready to pull the trigger, read them.) It's still worth reviewing the broad strokes.

When you're public, acquisitions are easy: you use stock, maybe a little cash. When you're small and private, it's a lot harder. Startup acquisitions are usually a mix of stock, cash and—to keep key employees engaged through an integration period and to optimize business results of the acquired business—earn-out.

Stock

For the acquiring company, the best option is to pay with common, private stock. It's also the hardest option to sell, because it trades one illiquid security where the insiders have control for another one where they do not. You may be able to convince an acquisition target to take your common stock on the basis of your company's track record and reputation and numbers; you may be able to do the same by talking about upside. The company being acquired may want hard cash and you almost certainly want to part with as little as possible unless you have a lot of it relative to the price of the deal—and unless you'd rather not inherit the acquired company's shareholders.

There are two options that could help make a mostly stock deal work when the acquisition target isn't loving the idea of your common stock. If you have a real preference stack, finance the deal with a mix of common and preferred stock, ratcheting up the preferred stock as you take cash off the table. This at least blunts the criticism that the new shareholders are second-class citizens, especially if some of them are venture capital firms that currently hold preferred stock in your acquisition target. For big enough deals, you can also offer observer rights or a full seat on your board.

Cash

Cash is king and you should protect yours as carefully as a chess grandmaster defending his title. The founder of the company you're acquiring knows that as well as you do, so you will have to offer something tangible. Too little and you could lose the deal. Too much and there's not enough incentive for future performance.

Earn-Out

Fixed shares and fixed dollar amounts are indisputable. Once the deal is signed, there's nothing more to discuss. Earn-outs for future performance are messier but they are sometimes required to bridge the “bid/ask” gap in a negotiation. Done well, they mean that you pay more for the deal but only if it's working out. Done poorly, they can lead to bad feelings—or even legal battles—down the road.

There are ways to mitigate this risk. First and foremost, an earn-out's criteria have to be as clear and quantitative as possible. Second, those criteria have to be things that will remain in the control of the acquired company for the length of the earn-out; asking an entrepreneur to agree to an earn-out based on sales, for example, when your sales force will be doing all of the selling, doesn't make sense. Finally, an earn-out can't be too high a percentage of the deal. The preponderance will have to be cash and stock. Otherwise, the process of judging performance should be shared by both parties. In one of our largest deals at Return Path, each side appointed representatives who met quarterly to agree on performance metrics, adjustments, and so on. We also designated a third representative in advance who was available to adjudicate any disagreements. We never had to use him.

Whatever mechanism you put in place, trust plays a huge role here. If it's not there, this acquisition might not be a good idea.

THE FLIP SIDE OF M&A: DIVESTITURE

When Return Path turned six years old in 2005, we had gone from being a startup focused on our initial ECOA business to the world's smallest conglomerate, with five lines of business: in addition to change of address, we were market leaders in email delivery assurance (a market we created), email–based market research (a tiny market when we started) and email list management and list rental (both huge markets when we founded the company). Some of this diversification was the result of mergers and acquisitions; a lot was the result of internal growth and development.

Five years later, we were back down to a single line of business. It just wasn't the one we started with.

A divestiture has as much potential to transform your business as M&A—and it's just as complex. In fact, there's some additional complexity. If your businesses are entangled—sharing internal resources like HR, IT, and finance—pulling apart the threads can be a hard, messy process. (As we will see in a moment, that's also one of the best reasons to divest an under-performing business.) Business complexity is something any startup CEO should feel comfortable with. Admitting failure is harder.

A divestiture might be cause for celebration: your team created an exciting new product or service with good market potential, then they did it again (look at Occipital selling off Red Laser to eBay). You want to keep your company focused, so you sell one of those businesses off, allowing you to focus internal resources—and giving you a decent infusion of cash (or a potentially valuable equity stake). Nothing complicated about that.

More often, a divestiture is an unpleasant event. Either a merger or acquisition didn't work out or a business-line you have invested considerable time and resources into isn't performing. In other words: you failed. Not comprehensively, not terminally. You failed. Admit it. Suck it up. Move on. Don't and you will slow your business down.

Startups have limited resources and an underperforming unit is a drag on those resources. It's not paying its way, forcing your profitable businesses to fund its existence. Sell it. Stop diverting resources from successful business units to prop up a dud. Use those resources to fuel real growth.

There are external benefits to divestiture as well. It's hard to position a company that's doing a dozen things at once. Recruits, potential investors and industry analysts like the clarity that comes from focus. It makes it easier to hire talent, communicate your message and raise money. As your CMO will be happy to remind you, customers like it, too.

Executing a divestiture is the flip side of acquiring a company, of course, and it's no simpler. You need to first find the right buyer or sets of buyers and negotiate a deal. If the division you're selling is big enough and the range of buyers is wide enough, you might want to use a banker to help. You will have to deal with the receiving end of the “stock, cash or earn-out” question. I learned one really important lesson from our divestiture of Authentic Response, a market research business that we started trying to sell in 2007: the more you can do the hard work ahead of time of untangling the line you're selling from the rest of your business, the better. Otherwise, no buyer will believe your pro-forma financials and they won't necessarily want a long-term operating agreement between your two companies.

ODDS AND ENDS

In either kind of transaction, both parties should have fantastic lawyers—and they should agree in advance on how to use them. With any deal this complex, their tendency will be to run amok and do too much, slowing the process down to a crawl. The best thing you can do is have a detailed term sheet for the lawyers to work from.

Due diligence is also something that requires a level of agreement up front to set expectations properly. How deep will you go? How buttoned up do you expect things to be? If you're acquiring a small company, the resources that you're likely to put on a deal will be much greater than that of your target. You need to make sure you get what you need, while respecting that you might have a CEO on the other side of the table fulfilling every diligence request on his or her own.

INTEGRATION (AND SEPARATION)

No chapter on M&A would be complete without talking a little bit about the human side of buying companies and selling a division. This can be one of the most difficult and disruptive elements of a deal.

If you're acquiring another company, the first people-oriented thing to do is due diligence on the culture of the company you're acquiring. Ignore this at your own peril! Companies that have sick cultures—or cultures that are just radically different from your own—may be incredibly hard to integrate. Even if you love the company's products or technology, make sure you will be able to port the people to your company's operating system or at least acknowledge that if you can't, you will either have to run the business very separately or risk losing most of the people in the business.

Ahead of closing, spend as much time as you can with the other management team to work through the majority of the transitional and postclosing issues: how to work with the new team members and what the shared priorities and goals are. Not only is this helpful in terms of giving you a better sense of how—and whether or not—things will work out culturally but you start building new muscles early on. You also start on the process of integrating the two businesses, which can be a significant undertaking. We have always done merger integration as a joint project, with a leader from our company and a leader on the other side and a massively public project plan that covers every last detail.

There are different models for how radical and forceful you should be about integrating an acquired company. The answer is “it depends,” meaning specifically that it depends whether the two businesses are going to be closely integrated or not, especially from a customer-facing perspective. At a minimum, we have always insisted that acquired company employees become full-fledged members of our team, with all the same benefits, policies and information flow as everyone else in the organization. In some cases, we have eliminated the acquired company brand, email addresses and offices; in other cases, we have kept those things. The trick to getting this balance right is to discuss it openly—if you have an unmovable position, state it up front so everyone understands it. If you are open to discussion about specifics, then have the discussion and recognize that you need to engage in some give and take. You never know—a company you acquire may have some way of doing something that's better than your company, so you can do some level of backwards integration as well!

As a private company, we have always been very transparent with our employees about when we're considering an acquisition and we continue to keep employees posted about deals in progress. This is somewhat risky and you may run into a situation where the target company doesn't want you to do so (that's data as well on that company's culture) but we have always found that it maximizes excitement and buy-in internally.

If you're selling a division of your company, the issues are parallel but less significant. You want to do some financial diligence on the buyer if they're paying you in illiquid stock. If you have people leaving your organization to go to the buyer, you want to make sure they're going to a good place or at least recognize that they're not and figure out how you want to make them whole via some kind of retention bonus. You will want to do as much work as possible to disentangle the operations of the departing business unit—things like accounting, systems and Salesforce.com or other CRM implementations are all hurdles that can be very messy to separate. This is all a cost of the divestiture; you need to view it as such and surely that's how the buyer will view it. The level of transparency you bring to employees around a divestiture is probably more akin to selling your company than buying a company. It's much trickier and you have to navigate the process carefully. Even highly transparent organizations can founder when employees are uncertain of their future, especially when their future becomes untethered from yours. We were up front with the team at Authentic Response when we started that sale process and we instituted retention bonuses to make sure we kept people engaged. I think we made the right call on it but it was really difficult to get through. That said, it would have been unthinkable for us to just sell off the business and spring it on employees as a fait accompli.