MENLO PARK, CA - November 26, 2018 - Many venture-backed startups reach an inflection point in their lives at which growth at any cost ceases to be palatable to their existing syndicate of investors. As a result, all too often startups are forced to take aggressive cost-cutting measures in an unnatural pivot toward profitability, which only exacerbates the problem and frequently creates a challenging work environment. For the lucky few, a more conservative financial plan with achievable unit economics can lead to a new syndicate of investors placing a risk adjusted bet on the longer-term success of the business. In the absence of a new check, however, and often as a last resort, a startup quietly pursues a soft landing within another company, and very little value is ever realized from the original investment.
Historically, Private-to-Private (P2P) M&A between mature venture-backed companies (typically series C-D) has not often been pursued as a strategy to unlock embedded value. The top reasons include: (a) fear of dilution and uncertainty of liquidity; (b) fear of losing control; (c) fear of execution risk; and (d) strong Not Invented Here (NIH) bias by technical founders and engineers. While many of these fears and concerns are legitimate, there are many positive collateral factors which should be considered much earlier in a company’s lifecycle and well before its syndicate of investors issues a breakeven ultimatum.
Here are three key value drivers to keep in mind when considering P2P M&A as an alternative (or in parallel) to a standalone financial plan to profitability:
Customer Acquisition Costs: In an environment where private companies continue to trade at significant premiums to public market comparables and spend astounding amounts of money in sales and marketing, acquiring customers through P2P M&A is an increasingly cost-effective alternative. Furthermore, hiring and training armies of unproven sales reps takes longer and provides no guarantee of successful quota attainment. Relinquishing control and accepting near term dilution can therefore enhance the growth profile of the combined business while simultaneously de-risking the financial model through greater operating leverage.
Speed of Innovation: Engineering organizations with mature tracking capabilities can usually quantify the amount of time their R&D teams spend “running the engine” while working through legacy technical debt instead of innovating on new product initiatives. Inevitably, as most startups grow larger, an increased amount of time is spent in maintenance mode or chasing feature parity with competitors. Less time is allocated to innovation and product differentiation. Unfortunately, adding an incremental engineer here and there doesn’t typically reverse this trend. Similar to acquiring customers in P2P M&A, acquiring adjacent innovative products can accelerate roadmap time to market and provide further operating leverage for sales teams to bundle and upsell to existing and new accounts. Furthermore, fighting strong NIH bias frequently leads to healthy debates about best practices and inevitably serves as a catalyst to re-evaluate development in more cost-effective regions and/or potential opportunities to outsource.
Economies of Scale: Without question, this is the most frequently used value optimization tool and is generally part of most Private Equity playbooks for tuck-in or transformative acquisitions. Obvious synergies exist in overlapping general and administrative functions as well as marketing and sales organizations, particularly if the buyer persona between merging entities is the same (e.g. both companies sell in to the Chief Security Officer or Chief Marketing Officer). Aside from organizational efficiencies, scaling opportunities also frequently exist in cross selling initiatives. One key benefit for companies that are still early in their channel adoption model is to leverage established channels (e.g. existing MSPs, VARs, etc.) of companies with stronger channel pull through to immediately accelerate path to market.
While these three value drivers are not unique and do not represent a comprehensive list, it’s important to highlight that a startup’s ability to unlock value from them is highly dependent upon timing and strategic positioning. The sooner these types of dialogues occur in a startup’s lifecycle, the more likely value will accrete to existing stakeholders. Given a Venture Capitalist’s general proclivity toward less hands-on operating models, adopting a more pragmatic approach toward scaling a business oftentimes requires a different kind of financial partner.
Despite renewed optimism that 2018 and 2019 should be a great year to raise Venture Capital, later stage companies with historically high cash burn metrics are still likely to have considerable difficulty raising additional equity. At HighBar Partners, we endeavor to help mature private companies unlock embedded value in strong engineering driven technology organizations with a creative and collaborative view toward inorganic growth rather than the single threaded nature of venture capital investing.
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Brian Peters is a Managing Director of HighBar Partners, a private investment firm focused on enterprise and infrastructure software companies undergoing change or transition. HighBar provides patient, long-term capital and resources to fund growth and assist management teams with financial, strategic and operational execution.