For every headline you see about a tech company being acquired for some huge multiple of revenue or profit there are literally hundreds of other acquisition approaches that either ended in nothing or a much less desirable outcome for the company being acquired. I’m going to attempt to describe some basic M&A do’s and dont’s through the lens of two stories and the associated lessons learned. This first story has a sad ending for the selling company but don’t worry, Part 2 of this series has a happy ending (you can read it here). Both stories draw from actual acquisitions I have been involved in, either on the buyer or seller side of the table. But since I have been involved in 10 such deals to date and many dozens of exploratory acquisition approaches, I have incorporated elements from multiple engagements to better help demonstrate the lessons learned.
Now for the story.
For this story, Shockwave Innovations (aka – Shockwave) will be the acquirer and Acme Inc. will be the target for acquisition (the seller).
Acme was one of three hot companies in a niche sub-segment of a fairly big software industry. The sub-segment wasn’t very large but was growing quite fast and becoming increasingly interesting to the large incumbents in the “parent” industry. In fact, Acme was only at about $5M in annual revenue. They were still losing money, had a couple of million dollars in debt, and had raised more than $12 million in venture capital to get to that point.
The first chess piece moved into place when their chief competitor and the biggest of the three companies was acquired for a huge multiple of their revenue.
Side Note: Using a multiple of revenue to determine the acquirer’s offer is quite common for acquisitions of early stage companies and you’ll hear it all the time when talking to M&A brokers, investment bankers or corporate development executives at large companies. While a respectable acquisition multiple (of revenue) for an early stage software company might be in the 4-6X range, Acme’s competitor was acquired for something like 15X and it got a lot of attention within the industry.
With one hot company already acquired, the scarcity factor caused a flurry of activity. This is not unusual in innovative or disruptive markets and resembles sort of a “musical chairs” game in which there are more potential acquirers interested in the technology or disruptive market sub-sector than there are interesting companies to acquire. In fact, because of scarcity risk, the highest acquisition multiples often go to the second or third company to be acquired after one of these shakeups starts to happen. But in this case, the first deal done was at a very high multiple.
First Offer
Sure enough, after a couple of months Acme was approached for acquisition by another big player for $30M. Even though a 6X multiple is often welcomed with open arms, in this case the offer was quickly rejected by Acme as being way too low. Acme pointed to the 15X multiple the other company got and said it would take a number in the $50M range to get a deal done. The 10X multiple was much higher than the acquirer was willing to pay and the two companies failed to reach agreement on a price. So they parted ways only to have the big player later acquire smaller vendor #3 for something like $20M.
At this point, two of the three hot companies have been gobbled up inside big software companies and Acme is alone with some much smaller and newer players in their segment of the industry. That might sound like good news for Acme because of the scarcity value but there are also fewer big companies left that might want what Acme has and those big companies have already heard stories from investment bankers that Acme turned down an attractive offer.
Second Offer
After a couple of months, Acme is again approached for acquisition by a big player but this time the price tag is only $15M. Acme reluctantly agrees to sign a Letter of Intent (LOI) at that price and the due diligence process begins.
Side Note: Agreeing on an acquisition price and signing an LOI is far from a guarantee of getting a deal done. I don’t know what the industry odds are for getting a deal closed once an LOI is signed but can tell you that plenty of deals bust during due diligence, which is when the acquirer gets to crawl through just about every aspect of the selling company’s business. (See related article titled “Revealing Company Info Before Getting an Acquisition LOI“)
After a couple of weeks of due diligence, the acquirer backs out and the rumor amongst investment bankers and brokers is that Acme had some issues related to their use of open source software and maybe some other things.
Shockwave’s Turn
Shockwave was in the same big industry but in a different sub-segment and definitely not yet a big company. Adding the Acme product to Shockwave’s portfolio would be well received by Shockwave’s customers and Shockwave had even debated building a competitive product to Acme. So Shockwave decided to entertain an acquisition approach as long as the price was “cheap”. Shockwave didn’t have the large bank account of the other acquirers and decided to see if Acme could be convinced to accept an offer at a 1X multiple – that’s right, $5M. Guess what, it worked. Acme and their investors were frustrated from the previous encounters and saw that the remaining small companies in their sub-segment would either be acquired or likely not survive. Remember that two of the industry giants had already acquired competitive technology.
I’ve already mentioned that getting a signed acquisition LOI is far from getting a deal done. In actuality, it also puts the acquiree (the seller) in a very risky position. With no guarantee of a deal getting closed, they must still run the company but at the same time they are under huge inspection by an acquirer, which is very distracting. And if the general employee population finds out what is going on, the distraction is multiplied exponentially.
Due diligence by Shockwave revealed two key issues:
- Customer Contracts – Acme had contracts with a few large enterprise customers that included terms that Shockwave could not live with. These customers represented something like 50% of Acme’s annual revenue. But Shockwave concluded that if the acquisition ultimately closed, these customers would need to be informed that their software license agreement needed to be terminated and replaced with a new one. That put 50% of Acme’s revenue at big risk.
- Open Source Software – Acme’s software development team had not done a good job of documenting their use of open source software. Additionally, there were some cases in which enhancements were made but not properly contributed back to the open source community like the license called for. The effort to fix these issues was determined to be substantial. I dive into this whole topic much more in an article titled “Misuse of Open Source Software Can Kill Your Acquisition“.
Shockwave ultimately backed out of the deal and the Acme technology was put on the shelf without a financial return to their employees or investors. Nobody will ever know what would have happened if they had agreed to the original $30M offer. Maybe that acquirer would have walked away because of the same issues.
Lessons to Be Learned
- Be careful what you agree to in contracts – This isn’t just for customer purchase contracts or license agreements, as in the Acme example. It also pertains to partnership agreements or any form of legal agreement in which the other party could ask for specific rights if your company is acquired. The way these terms are worded in legal agreements can be confusing and not easily identifiable, so make sure to involve your attorney so you can at least understand what you are agreeing to and how things could play out in the future based on different scenarios. Especially be on the lookout for phrases like “source code escrow”, “right of first approval (or refusal)”, and “change of control”. Andreessen Horowitz wrote a fabulous article describing 16 potentially risky sales contract clauses to scrutinize and you can find it here.
- A “fair” acquisition multiple is only what someone else is willing to pay for your company – Don’t get overly distracted with M&A market averages or other recent M&A transactions. Every deal is different and your company is different.
- Understand your company’s use of open source software – The legal landscape in this area is changing regularly. Until there is a generally agreed set of case law to define what is OK and what isn’t as it pertains to incorporation of open source software, at least make sure to have your software development team fully document its use. This includes the licensing method (ie – GPL, Mozilla, Apache, etc) and any modifications made and whether those were contributed back to the community (if required by the license). Do periodic code scans to audit your use of open source and adopt an open source use policy for your developers and contractors.
- Investment bankers have loose lips – If you are considering selling your company and decide to meet with investment bankers to explore possibilities, just realize that while many of them can fully be trusted for confidentiality, others will try to gain credibility with their larger clients by revealing that your company is available for acquisition.