The image of a successful startup exit might be ringing the bell at the stock exchange. But the most common route to exit is still an acquisition: in 2022, 10 times as many US startups were acquired than went public.
As with any deal, the acquirer — which could be another startup — is going to do extensive due diligence.
JP Morgan’s botched acquisition of US fintech Frank is a recent reminder of just how high the stakes can be when a target company isn’t what it seems. So how can companies looking to acquire startups avoid catastrophe with good due diligence? And what sort of scrutiny should startups be prepared to face from an acquirer?
Buy-side due diligence, defined
The information-gathering process done by a company looking to acquire another is called buy-side due diligence.
What this looks like in practice can vary widely, depending on the nature of an acquisition and a company's reason for doing it.
Many parallels can be drawn between the buy-side due diligence process for startups and buying a house. A homebuyer will often commission a surveyor to identify issues with a building and then make a decision about moving forward with a purchase, renegotiating the price or taking out indemnities to insure against losses, and a startup may work with multiple third parties to go through very similar processes.
But before all this can be done, companies need to figure out why they’d be doing M&A in the first place.
First, interrogate your own strategy
Startup advisers say that even though there may be cheaper deals to be had right now, caution should be applied to growth through acquisitions.
“I think the most important thing is understanding why you're doing M&A,” says Lisa Chang, corporate M&A partner at Linklaters.
“When companies have a good strategic rationale as to what they’re trying to achieve as a result of an acquisition, it then drives a lot of how they approach the transaction. Having that clear defines what you do in terms of due diligence.”
Goals may include:
- Access to a particular technology or IP that another startup has which could help the acquirer accelerate the growth of one of their own products.
- Access to new products that another startup has already built.
- Access to new markets. Chang says she sees this particularly in regulated sectors (like many areas of fintech), where it may be quicker for a startup to acquire a target company that already boasts the relevant licence in a new market than try to apply for a licence itself.
- Access to people and talent.
One good tactic for figuring this part out is looking at historical acquisitions made by famous tech companies that went wrong, says Alvise Fasolo, corporate development manager at secondhand clothes marketplace Vinted, which has acquired four startups in the last four years.
“A common feature that we often found is that those acquisitions didn’t make immediate sense from a strategic perspective. Their rationale was not clear, nor intuitive,” he says. “If this ‘makes sense’ factor is missing, we often won’t proceed further.”
Are you actually a seller?
For some companies, this introspective due diligence may reveal that in fact, they’re a seller, not a buyer.
“In the current climate, every company should be asking themselves the existential question: are we a consolidator or do we get consolidated?” says Aman Behzad, managing partner at advisory firm Royal Park Partners.
This decision will be influenced by the risk appetite of a startup’s shareholder base — what kind of investors they are and how long ago they invested.
In well-resourced scaleups, M&A-related processes are often led by the company C-suite or in-house corporate development teams. But often, earlier-stage and smaller companies may hire specialist startup advisory firms to help them figure this out.
And in all cases, once a startup has figured out its M&A strategy, it’s time to hire external help.
Consultants, lawyers and bankers are all needed for different bits of due diligence, but their involvement will depend on the objective behind the transaction, the type of transaction and the size of the transaction.
Second, begin market mapping and high-level due diligence
Once a startup has decided it wants to buy another, it will start market mapping for potential targets.
Again, depending on its internal resources, a startup’s own in-house M&A or corporate development team may do this itself, or it may hire specialist advisors.
Then it’s time to work out the type of due diligence that's relevant for that acquisition. There are four types, and often deals will combine several:
- Commercial due diligence
- Legal due diligence
- Tax and financial due diligence
- Product due diligence
The type and extent of investigation depends on factors such as company size and stage, geography, type of business and regulatory requirements.
For example, in the case of a low-value acquisition for a specific product or tech, full financial due diligence may not be necessary.
For Vinted, which is 15 years old and boasts a $4.1bn valuation, a specialist in-house M&A team handles a lot of the process. Fasolo says it usually splits the process as follows:
- “For tax and legal DD, we often seek specialised support from local advisors. Tech is an important component as well and we run a product DD via advisors where applicable.”
- “For commercial and integration DD, we tend to do it in-house (unless restricted by regulatory aspects). We believe that the buyer is best placed to assess the business model of the company, and whether the acquisition makes sense strategically.”
Alternatively, a less well-resourced startup may go to an advisor like Royal Park Partners’ Behzad to get the initial discussion with another company going.
“Usually, this involves setting up a CEO-to-CEO chat, or one shareholder from each startup has a chat with us to get the lay of the land,” says Behzad. “Then we agree some kind of high-level information sharing, which focuses on key diligence items to educate each party on each other’s company in a short period of time.”
The rule of thumb is to focus on obtaining details from the last two years. Behzad says initial high-level due diligence should include:
- Two years of financial statements
- 24 months of management accounts
- Information on a startup’s top 10 customers and how their revenues have evolved over the last two years
- Complete customer lists (can be anonymised)
For product and tech acquisitions
In the case of some smaller acquisitions for product and tech, that may suffice on the finance side of things. So then it’s time to instruct lawyers to check that the target’s product is legally compliant.
Lawyers will check:
- Who owns the IP rights for the product or tech
- How is the IP protected
- Is the product compliant with licensing regulations
- Is the product compliant with any other data or digital regulations
- Will it be compliant with any new regulations coming down the line
For fire sales
Unfortunately in capital-poor funding climates like the current one, not all acquisitions are between two healthy startups. Analysts predict that a large proportion of the next year’s consolidation will be so-called fire sales, when a startup is sold at a very low price to avoid bankruptcy.
In these instances, the acquiring company already knows its target is heavily loss-making. So once it’s got hold of a properly attributed set of financials, it should focus on understanding profitability per customer.
“Here, you should diligence the revenue sources quite extensively,” Behzad says. “So focusing on the key customers and cashflow; making sure you've got a good grasp of what the payments terms were for these key customers; how often they paid and whether they paid; and how long they’ve had their customer contracts.”
For larger acquisitions
The larger and more complex the deal and its financing, the more due diligence is required.
In some of the biggest and most complicated cases, startups must hire a proper financial diligence provider, which tends to be one of the big four auditors (Deloitte, EY, KPMG and PwC).
They will be appointed to put together a proper FDD (financial due diligence) report. This may range from what’s dubbed a “red flag” report, which is typically around 20 pages and can take around four weeks to compile, to a full financial documents exercise amounting to 250+ pages, which can take six to eight weeks.
Universal legal due diligence
Once a startup has decided it wants to go ahead with a deal, there are a few last bits of legal due diligence that it must instruct lawyers to do. These include:
- What contracts does the target company have and do they need to be terminated?
- What are the termination rights when the company changes control?
- Has the target company got any ongoing claims in court against it?
- Who will own the shares of the target company?
- What are the employee returns from the deal?
- Do you want to keep the employees or terminate their employment?
If and when startup M&A dealmaking reaches its peak in the next 12 months, lawyers say startups shouldn’t lose sight of that first step — their introspective due diligence — or skim over details to snap up a good deal.
“There’s always that pressure between getting the deal done quickly and ticking all the right boxes,” says Chang. “But being clear at the outset and then asking the right questions is the most important thing.
“Proper due diligence is not something you can rush.”