Friday, December 14, 2007

When Bad Acquisitions Happen to Good Startups

Hard to believe it’s almost Christmas, but I know I’m looking forward to the break. A woman jostled me on the street the other day and I called her names I would ordinarily only use if I was talking about her behind her back.

Name-calling is the least of the problems startups can face if they don’t do some due diligence of their own on potential acquirers. Many founders feel they know their buyer well enough after the rigors of integration planning. But integration due diligence is all about rainbows and unicorns and how well you’ll all dance in the land of happily-ever-after-closing. It doesn’t help assess the risks associated with the payment terms offered by the buyer. Is an earn-out acceptable? Should future payments be placed in escrowed accounts by the buyer? Should the startup insist that it receive a security interest over its assets, in case there are payment disputes down the road?

Consider these true stories:

1. Startup A (not its real name) is sold to a competitor, who agrees to pay the purchase price as certain "earn-out" targets are met by the startup (now a division of the purchaser). When the first target is achieved, instead of making the agreed-to payment, the buyer admits that all profits generated by the division were used to pay off other company loans, and that there is no cash on hand.

2. Startup B is bought by a venture-backed business for a combination of cash and shares. Its shareholders believe that the combined firepower of the two startups, together with the backing of this VC, will make the shares they receive more profitable than an all-cash purchase price today. Turns out, the VC is having its own issues and is struggling with its current LPs/struggling to raise its next fund. Since it holds shares and secured convertible debentures, the VC decides to shutter the business and sell of the technology. As a secured creditor, it takes all of the proceeds from sale, leaving the shareholders with nothing.

Lawyers reading this will tell you that these kinds of risks can be mitigated against in a number of ways – restrictive covenants, secured interests, putting funds in escrow for example. But startups need to consider these possibilities at the letter of intent stage, and factor them into the deal. Post merger and technical integration, it’s very hard to undo a bad deal, and take your technology and go home.

If you'll excuse me, I have to go to a high-end electronics store and jostle other wives out of the way while I look for a piece of equipment which, far as I can tell, does nothing but look flat and have a wood-grain finish on its casement. (Open letter to trademark goddess Jessica Stone Levy: who let some boys name their company "Nad Electronics"? And then compounded the problem by adding the tag line "Powered by Passion"? I'd like to send him/her a note)