Start-Up M&A

I was recently interviewed for a small business publication about mergers and acquisitions for start-ups, and whether the tough economy makes it a good time to make an acquisition.

While I think there are advantages to doing M&A in a weak economy, the lack of capital available probably offsets the advantage. And while it motivates some businesses to sell - it is often the businesses you didnt want to buy in the first place. Of course, there will occasionally be some opportunistic moves a business can make to scoop up a competitor that would not exist but for the pressure of a smaller pie to divide. I think this is what the reporter was hoping I would say when he asked me about our recent acquisition of Ronning Lipset Radio. In fact, this was not the case in this situation, and I would argue that the deal we did with RLR is probably the only kind of M&A activitity a start-up should engage in.

Here's why. The reality is that completing an acquisition is a ton of work and the amount of work involved often has little to do with the size of the transaction. Smaller companies often have founders that are emotionally attached to the business that is often absent with professional managers at larger companies. Also, diligence is harder to complete with smaller businesses who often do not report finances in as great detail as larger companies who use professional auditors and have financial controls and policies in effect. Public companies (in theory, at least) are transparent and have disclosed not just their financials, but all known risks of their business, as well as thier outlook for the future. And there are criminal penalties if these were intentionally misleading or not disclosed. Smaller businesses are not regulated, so the overly optimistic forecast probably has a greater shot of rearing its ugly head, so the diligence process must be even more rigorous in these transactions.

Furthermore, start-ups and small businesses rarely have dedicated corporate development teams, so the bulk of the work to close these deals either falls on the CEO/Founders and/or their legal and accounting firms. Both aren't ideal since the time and effort to close the deal means people are doing that instead of growing the core business. And legal expenses add up very quickly, adding to the price of the deal. And since the time and effort to close these small deals are often similar to larger deals (we joked that our last deal took longer to close than Wachovia/Wells Fargo), the expenses of these transactions relative to the cost of the overall deal can be very high.

So when does it make sense to do a deal like this? Rarely. But there are times when the deal makes so much sense, you need to do it. Here are my criteria:

1. Must bolt on: When I was 17 year old car enthusiast, I was always looking for things that would make my 280Z faster. But I didnt have the expertise to weld or do anything electronically. I needed something that would work out of the box and merely bolt onto the existing hardware. Start-ups rarely have time for a lengthy integration before synergies are realized. And while it may make sense for management to spend a good chunk of time closing the deal, the distraction of putting pieces together that do not easily fit is probably a time suck that smaller organizations can't afford.

2. Good Chemistry: When you have a large organizations coming together, everyone talks about the "culture" of the orgs, and how they will mesh. In smaller companies, it is not the culture of the company, but chemistry of the people on the team that will be working together that matters. The bottom line is that if you don't like the people on the new team, the business will not combine well. There needs to be trust and respect between the teams and the individuals that will be working together so they will be able to work through the inevitable hiccups that occur when putting two businesses together. A sales culture and a tech culture can come together nicely if there is good chemistry between the individuals. A law school professor I had years ago always said people don't sue people they like. They also don't quit their jobs when they work with people they like. Two good reasons to make sure there is good chemestry.

3. Buy>Build: Quite simply, the cost of the acquisition should be cheaper than building the business yourself. This, of course, is not an easy calculation. We can all figure out the cost of hiring a team and/or developing a technology and then add in the opportunity cost of not having this team/technology in the market during the development period. But you also need to factor in the talent of the team you are hiring and whether it is possible to replicate things like expertise, relationships and credibility, and how much this is worth. And finally, you need to factor in the execution risk of being able to replicate the business. If the business you are acquiring is the undisputed leader in their space and few others have been able to replicate their success despite attempts to do so, there is clearly a lot of value to assign to this.

4. Necessity: Is this a business your company needs to succeed. This can't be a "wouldn't it be cool if we bought x" moment that drives the decision. You need to decide that your business must either build or buy, and doing neither is not an option. If being in this business is not the first item in your strategic plan, don't bother.

5. The Reese's effect: With a peanut butter cup, we all know that the chocolate and peanut butter on their own are tasty, but together it is greater than the sum of its parts. This applies to M&A as well. Merely bolting on a business is often appealing to add revenue, but if it doesn't have significant synergies, you will not get any additional value from it. It makes sense to get the perspective of professional investors when considering these types of transactions. Ideally, the cost of the deal should be paid for by the synergies of the business. By this I mean you should be able to raise $ for the combined business at a valuation that is equal to the pre-merger valuation of the acquirer plus 2X the value of the acquired company. If you can achieve this, or something close to it, it's a good deal.

If you can hit on all 5 of these points, go for it. If not, you should reconsider whether it is worth the effort. And this applies in good and bad economies.