Even as investors began retreating from tech deals in early 2022, the majority of European startups have managed to cling on by making cuts and redrawing their business plans. But there is only so far a bumper 2021-era raise can go.
As startups run out of runway towards the end of 2023, the looming period of consolidation could finally be upon us.
“It’s in Q4 that the dams will break,” one investment banker tells Sifted.
For distressed startups, this could mean fire sales. But for those more successful firms, M&A could be an option.
Not only is M&A the only way to return money to investors with the IPO window firmly shut, but CEOs may see it as the only way to guarantee their own survival chances.
The only people M&A may not be attractive for is VCs, says Joel Van Arsdale, founder of fintech advisory firm Flagship Advisory, who may get less return than they were hoping for. Startups across Europe have plummeted in value compared to the price tags their investors assigned them in the bull market: the average late-stage startup, for example, was worth 77% less in Q1 this year than in Q1 2022.
In order to squeeze as much value as possible from an M&A exit, startups may be looking at bringing on M&A advisors, says Jennifer Chimanga, partner at Clifford Chance.
“There’s a much heavier reliance on external advisers in sell-side M&A for startups, because they tend not to have any in-house support, unless they’re huge,” she says.
“If you go to any bank today, they have an entire M&A team, but if you’re a startup, you have to build that team from the outside.”
What does a sell-side M&A advisor look like in startup land?
The size and circumstances of a transaction determine how many different advisors a startup will need to get involved.
The general rule of thumb is that the bigger a deal, the more professional advisers you need.
- Big investment banks like JP Morgan and Goldman Sachs
- Smaller investment banks that specialise in certain sectors, for example, fintech-focused firm FT partners
- Boutique advisory firms, like Royal Park Partners and Flagship Advisory Partners
- In-house M&A advisers at VC firms
- M&A lawyers, who will advise on sell-side due diligence and deal documentation
What do M&A advisors do?
Preparing a startup for sale is a bit like selling a house. First, you need to figure out what kind of advisor you need (in terms of size, as above) and then wait for the pitches to come in.
During this process, a startup will share financials and the advisors pitching for the gig will do a number of things:
- Assess the company’s financial forecasts
- Evaluate the sector and its potential clientele
- Decide whether it is a good time to sell
- Assess potential buyers — for example, could private equity firms be interested? Are there potential strategic acquirers?
- Value the company based on this data
- Pitch for why they’re the best advisor for the sale
Getting the books in order
Once a startup picks an advisor, it’s time to get a financial history in order and build a defensible business forecast, an all-costed financial model of revenues in the coming years.
Then they’ll also help sort out its organisational design and product roadmap.
“We make sure that when they go to sell, they’re properly packaged,” says Van Arsdale.
“A lot of these startups are run in an ad hoc manner, where there may be three or four people running the whole company, so when they go to sell, they want to appear more as a grown up than as an adolescent.”
Producing a “teaser” and “data room”
An advisor will usually help put together a “teaser”, a one- or two-page mini presentation on the company that reveals a few key metrics that potential buyers would be interested in, without mentioning its name.
The advisor shares this with, say, 100 potential buyers and asks them to sign an NDA if they want to know more.
Perhaps 20 buyers might sign the NDA, and the advisor then opens up a “data room”, which gives them access to financial models and company information they’ve helped the startup prepare.
Vendor due diligence
At this point, a startup may enlist additional advisors to compile further vendor due diligence, perhaps alongside an additional investment bank to prepare an extra independent report that assesses the state of the company and its position in the market.
Advisors say the smaller the company looking to sell is, the less they will tend to do this extra vendor due diligence.
When it comes to legal advisory on sell-side M&A, a startup has to be smart about when they get lawyers involved — because they can be very expensive, says Chimanga.
Often a startup can have preliminary conversations with a lawyer for a steer on the key issues that buyers will be concerned about before they start charging, but the clock generally starts ticking when the data room is prepared.
“Law firms have developed toolkits to help startups prepare the data room according to the full requests for information they’ll get from buyers,” she says.
The lawyers, M&A advisory firms and company management will work closely together at this stage.
Lawyers are particularly relevant for the NDAs that are handed out at this stage.
“While this stage isn’t heavy on legal negotiation, it’s extremely important to get the right NDA guidance,” Chimanga says.
“A lot of tech IP sits in people’s heads. If you’re suddenly sharing everything with another company and telling them how wonderful your tech stack is, if you don’t have a robust NDA, you shouldn’t be having those conversations.”
Then lawyers will play a central role in the vendor due diligence documents that determine the price at which the startup is sold, and also in the closing negotiations of the transaction.
Why do you need them?
To drive up hype and price
M&A advisors can provide access to a network they wouldn’t otherwise have access to.
“They’re seeing so many transactions in the market and they’re in contact with private equity firms and strategic acquirers all the time, so they know which buyers will be interested in you and how much buyers will be offering,” says Lawrence Kilian, corporate development principal at Speedinvest.
Once they’ve tapped this network, they then help give structure to the selling process, and tend to enforce a pretty strict timeline on prospective buyers to drive up competition and therefore price.
“An advisor may let quite a few buyers in the data room to look at a company’s materials, but they’ll then run a strict process giving them, say, a week to review the materials, and two weeks after that to place a bid on the company — all the while telling them there are several other companies looking at the startup right now.”
Once the deadline has passed, the advisor will choose the highest bidders, and allow these companies to have conversations with management and do their further vendor due diligence, perhaps requesting more information in the data room.
After another two or three weeks, they will then allow the prospective buyers to put in a final binding offer. They’ll speak to the bidders about the price others are offering and how much they’d need to increase their bid to be more considered.
“Driving this competitive tension ultimately leads to a lot of value creation for the seller so that they can get the best price possible,” Killian adds.
Advisors will also know the sweet spot for how many prospective buyers to go out to in the first place.
“The downside of a really broad auction is that it can be distracting to the company,” Van Arsdale from Flagship says.
“So if you have private equity owners and their five-year investment end is on the horizon, you’ll be focused on getting the best price so may need to run a large auction process, but for many other startups, they’ll be better suited for a smaller set of potential strategic buyers.”
“In this case, we’ll run a much tighter process to make sure we land on the right competitive price.”
To give buyers reassurance
Where buyers may not be too familiar with a startup or the market, they will likely be familiar with the advisory firms working on a deal.
“[It gives] the process a kind of formality and also adds a shine to the asset,” Van Arsdale says.
To avoid liability risks years down the line
Legal advice is essential when it comes to the documentation when a startup is closing a deal — without it, a startup founder may find themselves with a hefty bill years down the line.
“If the buyer finds a problem within the diligence, they’ll either want to reduce the price — which often the seller is unwilling to do — or more likely get some more protection in the documentation,” says Chimanga from Clifford Chance.
“So what you often end up finding in the offer documents is that X risk has been identified, and if it materialises at some point in the future, we want it to be compensated like X.”
This could produce real liability issues for the selling company years after the acquisition is complete — so getting a lawyer to negotiate limitations to these warranties is critical at this stage.
How much do M&A advisors cost?
It all depends on the size of the company, the likelihood of a successful deal and the type of advisor a startup has brought on board.
“Success fees”, where advisors receive money if they sell the business, can range from anywhere between 1% to 5% of the selling price.
But 5% is “unusually high”, Van Arsdale says. Typically, fees are between 1% and 3%.
The general rule of thumb here is that the smaller the selling startup, the higher the percentage success fee an advisor will charge.
For a unicorn selling at £1bn plus, the fee will be at the lower end, perhaps even less than 1%. But for most startup deals in the hundreds of millions, the fee will be between 1.5% and 3%.
Some advisors will charge a monthly retainer fee — for example, $100k a month — as a way of locking in some return on the time they’re investing in the deal.
“The retainer is really there to hedge an unsuccessful outcome,” Van Arsdale says.
While the large investment banks working on deals at the top of the market will mostly work without a retainer, advisors working on small deals at the bottom of the market are most likely to ask for one as part of their terms, due to the higher probability of these being unsuccessful.
Startups should be wary of this, Killian says.
“If you’re running the process on a success fee, it means that if you take this on, you’re confident you’re going to sell the business — that’s the only way you make a return.”
“But if you’re on a retainer, there’s much less incentive and it shows less confidence — if it doesn’t work out, you’ve made some money wasting your time.
Lastly, perhaps the most relevant factor in the current market is that most of the companies looking to sell in the next few months will be strapped for cash — so paying on exit means they’ll have the necessary liquidity.