Three generations of businessmen - Things to know before buying a start-up

Mergers and acquisitions notoriously fail to deliver the expected returns in more than 50% of cases. In situations where the acquisition is of a start-up company, the failure rate is even higher. Here are three questions for which any CEO should ensure to have a satisfying answer before closing the deal.

What questions a CEO should ask himself when buying a start-up?

1. Why is the start-up being sold?

There is no doubt that the company for sale is being presented with exciting growth figures and enticing EBITDA projections. The current owners want to relax and enjoy their new wealth (if they are the founders) or have reached their investment horizon (if they are business angels or funds). But is this their real reason for selling now?

In any acquisition, there is obviously a strong information asymmetry, in favour of the seller. And any astute seller will want to sell at the moment where he can maximise the valuation of his company, which is at the point in time where he can anticipate issues that are not yet visible to outsiders and so benefit most of the asymmetry of information.

In the context of start-ups, problems of scalability are quite typical. This is mainly, but not only, an IT problem. The reason is that the company has started very small and has then grown very rapidly. So, for example, an algorithm that is one of the start-up’s essential assets, may have been conceived to deal with a few thousand calculations per second, which may have seemed more than sufficient when the start-up had the ambition to grow to about 1 million customers. But at the time of the sale, this algorithm may be reaching its maximum capacity and redeveloping it may mean extra costs and delays that the buyer is not taking into account.

Thus the due diligence process when acquiring a start-up must include a particular attention to the potential issues that may arise from further growth, in terms of IT systems, in terms of processes, in terms of supplier capabilities …

2. Is the business plan really as good as it seems?

The acquisition of a start-up is generally motivated by the high growth rate. But a high growth rate does not last forever. So it is essential that the CEO develops his own view of what the actual sustainable growth rate is and how hard the landing will be.

This seems obvious, but it is extremely difficult, because often the start-up company will be active in a niche, a segment of the market different of the one where the buyer is operating. And so there is a real effort required of analysing this niche, understanding its full potential in terms of size and value, understanding the competition, … Doing this requires a level of focus on the acquisition which a CEO cannot always afford as he is running his own company. So he needs to assign that task to a fully dedicated person (internal or external).

3. How to integrate the new business?

The integration has many aspects, of course, but the main risk is a clash of civilisations. The corporate culture of a start-up and that of a mature business are worlds apart. The start-up favours personal initiative, whereas the mature business favours processes. Decisions are much slower in mature businesses. Leaders are closer to their staff and more accessible in start-ups.

But it goes beyond corporate culture. The difference may also be in the salary packages (stock options are more likely to appear in the package of a start-up employee), for example.

The natural evolution is that the buyer gradually imposes its organisation and culture onto the start-up. The consequence is that staff (mainly the best) gets alienated and leaves the company, taking with them part of the knowledge and experience for which the buyer paid.

So there must be a transition phase, during which the “start-up culture” is preserved but the knowledge is being transferred to staff that is most likely to accept the new culture.

Conclusion

These questions ought to be raised in any acquisition, of course, but they are even more critical in the context of a start-up acquisition because of the characteristics of a young and fast-growing company. Answer them properly (and act accordingly) and your acquisition will contribute to improve the awful 50% failure ratio.