Perspectives on entrepreneurship, startups and venture capital from K9 Ventures.

4 Rules of M&A for Startup Founders

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The following post was written by @TomioGeron for ExitRound based on an interview with me and was published on the ExitRound blog on January 9th, 2014. It is being reproduced in its entirety here with permission from the author…

Manu KumarManu Kumar, founder of seed stage venture firm K9 Ventures, focuses on investments that have a hard science or new technology focus. He knows about acquisitions, having invested in BackType, which was acquired by Twitter;, which was bought by PayPal; Torbit, which was acquired by WalMartLabs; and IndexTank and CardMunch, which were both bought by LinkedIn. Previously, he founded SneakerLabs, which was acquired in 2000 for more than $100 million, then he founded iMeet, which was merged then acquired in 2002.

In this piece Kumar, who is often actively involved in M&A negotiations for his startups, talks about how to build a startup for the long-term while also preparing for an exit; what information is important for startups to keep private from acquirers; and why he often meets with and negotiates with buyers on behalf of his startups.

What are your rules for startups when it comes to mergers and acquisitions?

1. Build A Real Company

When I was doing my first startup, my rule number one for M&A: Companies do not get sold, they get bought. It’s probably the single most important thing. It’s very difficult to take a company, dress it up and go sell it. Any good acquisition happens because buyers come looking to find the company being acquired.

2. Prepare For An Exit–Just In Case

The second thing is: it’s important to make sure the M&A process is not a one-time thing or an isolated incident. It’s something you have to be thinking about and working towards for the life of the company. For example, with CardMunch (which I invested in and which was acquired by LinkedIn). They pitched an idea (to me as an investor) that they wanted to work on. But I didn’t like the idea but I said, “Let me pitch you on another idea.” (It became an app to digitally capture business cards and integrate with your address book). I said to them, these are companies that could be interested to buy you: LinkedIn or Salesforce. So at the point of inception we’d already identified who could be potential M&A targets.

So you have a balancing act: on point 1, you’re building strictly to be a standalone company, not to sell, but at the same time, on point 2, you’re keeping those top acquirers in mind early on?

Right, you’re not building the company with the intention of selling it. If you do that that’s setting it up for failure. You have to build a company as if it’s ascendant and a self-sustaining company. But at the same time you can do things to attract potential suitors. That’s how CardMunch played out.

I get pretty deeply involved in product and talking about potential acquirers. But I don’t get involved in making a company attractive for an acquisition. It’s truly about: what do I need to do to build a product people love and are willing to pay for? If you achieve that, the rest will sort itself out. If I’m trying to build a product or company for an acquisition it rarely works. I haven’t ever seen that.

3. Manage Your Emotions

For founders, very often the startup is their baby. When you’re talking about selling their baby or someone comes along who wants to buy it, they tend to get very emotionally involved. That can often blow up a deal. It’s important to realize folks on the acquiring side in corporate development, they’re normal human beings. They want to be treated with respect. If you treat them with respect, only then will they treat you with respect.

Negotiating any deal is always an emotional roller-coaster. When founders get emotionally involved they tend to view the other party as an adversary. That’s not conducive to getting a deal done. After all it is supposed to be an acquisition — where the both sides have to work together once the deal is done. It’s important for founders to realize that both parties are generally trying to protect their own interests. So when a founder is upset by a certain ask from an acquirer, I generally recommend that they try and get to the reason/motivation for that ask. Quite often there are multiple ways of addressing the concerns at hand.

Another rule for M&A: you want to drive a very straightforward and honest conversation. If someone’s not meeting the terms, it’s nothing personal; you don’t have to take offense. You always have the option to walk away.

4. Be Ready To Walk Away

The last rule is you always have to be willing to walk away from a deal. You can never enter into a M&A situation without alternatives. Otherwise you have no leverage. The single strongest alternative to an acquisition is, “I don’t need to do a deal. I can continue doing what I’m doing and do it alone.”

For many tech companies in Silicon Valley, corp dev is like musical chairs. You look at who is working in corp dev, typically it’s the same people moving from one company to another. The Silicon Valley process for M&A becomes fairly streamlined. Almost all the big companies go through a similar process. That’s not the case outside the valley.

You said you want to keep potential acquirers in mind early on. How does a startup go about doing that and building those relationships?

Most  potential acquirers follow startups and it’s important to stay in touch with them. You want to have them know what you’re doing and have those channels open. This should be well before the startups get to any acquisition stage.

It’s better if investors are doing this. The founders shouldn’t be doing this. I’m doing this for my companies. I make a concerted effort to connect with corporate development executives at all the major tech companies. I make an effort to say, “I want to come and meet you and get to know you and tell you all about my portfolio.”

So you’re meeting the potential buyers, not the startups?

Yes, it can’t be founders doing that because they would feel like they’re trying to sell the company. For me I’m building relationships, essentially educating potential buyers. If buyers are out there choosing companies to acquire, I’d much rather have them choose a company I’m invested in. In this phase I don’t take it to the level of the acquirers meeting the startups. They know them and what do if they want to meet them.

How’s the acquisition market now?

It was a strong market a couple years ago: in 2009, 2010 and parts of 2011. Especially in the acquihire market, it was strong and healthy. These days (acquihires) often don’t end in any good returns for investors. If investors get their money back they’re lucky.

In 2009-10 a lot of angels had the mindset that, if a company doesn’t work it’ll get acquired by Google and we’ll still make money. That’s largely gone away. That reflects more of today’s mindset of: if you’re investing in a company you must truly invest in a company, not thinking that “oh yeah (if they fail), they’ll get acquired anyway.”

My pet peeve is when companies, many of them are sold in fire sales, that get reported as “they got acquired.” But nobody knows, only insiders know, whether it’s a good deal or not. There’s a very strong desire in the Valley to make everything look like a success even if it wasn’t. If they have the opportunity to get acquired for close to nothing, get a job and spin it as if they got acquired, most people will probably take it.

But can’t these smaller acquisitions still be meaningful for founders? 

Yes. But also I got into the venture business with the intention of doing it for the next 30 years. I’m not doing it for one or two deals. For a first time founder (with a smaller exit) this is a life-changing event for them. You want them to take that deal. For me, this guy or gal will probably start another company in the future. I’ll hopefully invest in that company. They’re not going to do just one company. If they have a life-changing event, I get to invest in the next company.

Is there any conflict of interest with you as an investor negotiating a deal since you may want certain things that founders don’t?

At the size I’m playing at, you can look at it as: I want to be fair. I do not want to take advantage of anybody and I don’t want to be taken advantage of. If somebody tries to screw me over they’ll see the worst side possible. But I also play fair.

Is the potential for conflict less with you than with a larger venture firm since as a smaller fund you are more likely to benefit from smaller exits?

That’s my understanding with founders. There will be things where investors’ interests and founders’ interests may diverge. That’s something to have an open and honest conversation about and reach a conclusion together about what to say to potential acquirers. You present a unified front. It doesn’t always happen and it can end up hurting both sides if you don’t have that united front.

What’s your role in these acquisition talks?

The role I take in these deals ends up being very different from most investors’ roles would be. I negotiated the sale of my first company (SneakerLabs) in 2000. At that time I learned first hand what M&A was like. Since then I’ve been involved in probably 6 or 7 deals. I tend to get pretty involved in M&A deals. The reason is founders are at a disadvantage when negotiating a deal.

That’s because they have to go work there after a deal (and it can be uncomfortable). It’s a lot easier for me as an investor to step in and negotiate the deal. If there’s anyone ruffling feathers, I’m the one doing it because I’m not the one they have work with. On a couple occasions I heard feedback that the level I was involved was unusual.

Is the strategy for startups to find multiple buyers?

You’re always going to do that. The timing of something like that needs be well orchestrated. You cannot get an offer then say, I’ll go down the line to company B, C, and D. The timing’s not going to work out. All these deals have a life of their own. It takes time for people to become familiar with the company or team and determine that they want to make an offer.

From that point of view it’s similar to the way venture capital fundraising works. Even if you’re fundraising, you want to make sure all offers drop on the same day to make it happen. Likewise with M&A you want to make sure all offers drop on the same day.

You have to know the potential buyers already. It’s a relationship thing. If you don’t know the acquirer at all you can’t start a relationship at that point. It’s too late.

What about your startup’s cap table?

Don’t share your cap table (with a buyer) until you actually have a signed term sheet. It’s a fairly standard move on the part of corp dev guys to say, “Send us your cap table.” As an investor my advice is: absolutely do not send the cap table. Once they have the cap table, they can reverse engineer things. At that point they’re not valuing you for what you’re worth. They can use a divide-and-conquer approach. They can split founders and investors. Essentially they can minimize the amount they pay as opposed to paying for the company as a whole.

What if the potential buyer says they really want it?

Tell them, “We want you to value this company for what it’s worth to you.” They don’t need to know what the cap table looks like to make an offer. I typically don’t even tell the buyer how much capital the company has raised.

How does the cap table affect the price?

Do you want to do cost-based pricing or value based pricing? The only reason you need the cap table is if you’re doing cost-based pricing. As a seller I want to do value-based pricing. In other words: the actual value of the company, not the lowest possible cost based on how much the company has raised.

What do buyers like startups to do during an acquisition process?

Have all your corporate documents in order. That’s just general corporate hygiene. Is the accounting done every month and are the books closed? A balance sheet, P&L: can you produce that, or will it take three weeks to get your books in order? Make sure all your documents are ready to go. If you’re trying to get multiple buyers interested, you want to make sure you have all your homework done and can move at the speed that others are moving at.

What do startups want from potential buyers in the M&A process?

On the startup side, the most important thing is making sure the person you’re dealing with (at the buying company) is empowered to actually do the deal. That’s very often an issue. Corp dev folks (at large companies) typically have certain parameters within which they can work (price, etc.). These individuals have to be empowered to negotiate the deal. It’s painful if you’re dealing with someone who’s not empowered and has to constantly things run up the flag pole (to superiors).

There’s often serendipity when it comes to M&A deals. The way the CardMunch deal came around was that I happened to go to an event and met one of the cofounders of Linkedin. I talked to him and told him about CardMunch. A few weeks later the CardMunch founders met other LinkedIn folks. They ended up talking. Then I met Ellen Levy from Stanford (where I did my Ph.D.), and she’s from LinkedIn. She called me and said are you involved with CardMunch?

These are the casual interactions — one or two minute conversations — that eventually may bubble into M&A discussions. Those kinds of conversations only happen when you’re local.  You can’t have them when you’re sitting in different geographies. That’s one of the strong reasons why I only invest in companies here (in Silicon Valley) — because that serendipity only exists when you play in that ecosystem.

Have you ever been burned in an acquisition process?

With one of the companies I was helping, they signed a term sheet with an east coast company and had already agreed to everything. The day before we expected to receive final documents the buyer came back and reneged on the offer. It was crazy. When we received the draft version of the documents the payment section was missing. How can you send us draft documents and the thing we care about most–when and how much we’re getting paid–that section is missing? That was a signal there was something wrong.