Beware of Premature Merge Elation

Posted on Aug 3, 2010 | 41 comments


There is a telltale sign of an inexperienced startup entrepreneur.  They get premature merge elation.  You know, they get so excited about doing deals all the time instead of doing the hard work of figuring out their businesses.  I understand this.  I was a premature merge elater once.  Here’s what I learned:

1. As a startup you shouldn’t focus on buying other companies until you’ve figured out your own business
A close friend of mine in LA who is 3 years into his startup called me about 2.5 years ago and told me, “I just got offered the chance to buy this company because the founder doesn’t want to continue.  It has awesome features that my main competitor doesn’t have.  I can save tons of development time and I think I can buy it for all equity.  How much dilution should I take for it?”  My friend’s company was pre-revenue.

Me: “Zero dilution.  Pass.  Focus on your customers and don’t obsess about deals or keeping up with your competitors releases.”

I’m doing due diligence on a company of another entrepreneur in LA whose company was apparently doing very well.  He had bought two companies and was eyeing a third.  He had an ad-supported business doing about 1.5 million uniques.  500k had come through the last acquisition.  He has raised (and spent) a ton o’ VC money.

My recommendation to our lead partner looking at the deal, “Pass.  He’s talented.  I’d like to work with him some day.  That day’s not now.  He hasn’t figured out his core business and he’s spending all of his time looking at ‘deals’ – that’s always a bad sign.  He’ll learn the hard way and when we work with him he’ll be more focused.”

Two CEO’s come into my office (this sounds like the start of a joke).  They want to merge with other and want to know if I’d fund the combined entity.

Me: Gag.

I lived through the era of companies doing premature mergers.  It meant that the management teams hadn’t figured out a product / market fit for their own businesses.  It’s far easier (and sexier) to spend your time working on deals – the chase, the negotiation, the secret dinners, the combination of assets, the PRESS STORY! – than it is to tweak features, A/B test products, crank out the next release, improve marketing copy, fly across the country to get a biz dev deal done or just pound the streets selling product.

That’s why immature teams spend so much time on mergers.  Been there, done that, made the mistake.  Please don’t relearn my lesson.  Focus on improving your core business first.  If you can’t just get it to work then one day you can focus on selling your assets.  A merger is not the panacea.

2. There is no such thing a “merger of equals”
For some reason the industry of bankers who try to buy or sell businesses work in what is called the “M&A (mergers & acquisitions) Industry.”  I’ve never understood this.  There’s really no such thing as a merger – only acquisitions.  I know, I know … technically they can be structured as mergers.  But 90+% of all deals involve one company taking over the other.

Yes, they have grandiose statements to make them sound like mergers.  Sometimes this involves co-CEO’s.  Often senior people from one company are given senior titles at the other.  They always have big lovey-dovey press releases.  They often involve big hugs on stage.  But to be clear the overwhelming majority of deals involve one company driving the cultural integration, establishment of uniform processes, hiring / firing decisions, etc.

This is a good thing.  When there is a merger without a dominant buyer you have indecision and malaise.

3. Merging two weak companies is, well, weak
Another common scenario with inexperienced teams is when two struggling companies come together to create a stronger team.

We had a joke about this when I lived in England.  We said it was like two people who couldn’t swim across the English Channel (21 miles) putting their arms around each other and trying to swim across together.

The only thing worse than your early-stage company buying another early stage company is you trying to pull off a merger of equals.  Trust me – if you haven’t figured out your sh*t – neither have they.

4. Don’t trade your cat for somebody else’s dog
I was recently at the Greycroft Summit in East Hampton.  During the weekend Alan Patricoff, the famed investor & founder of Greycroft said, “don’t trade your cat for somebody else’s dog” when talking about merging early stage companies.

I think we had slightly different definitions of this saying but since he coined the term I have to credit him.  We both meant mostly the same thing.  My version is, “you have a company with private stock.  Somebody else is trying to convince you to sell to them in exchange for all stock.  Assume they are not a hugely successful and growing company like Twitter, Facebook or Zynga.  They’re a bit like you but slightly bigger and better funded.  Don’t trade your company (cat) for their stock (dog).”

Why?  Look, the chances of your making money out of your own startup are small.  Most likely you’ll fail – most companies do.  If you’re in the minority that succeed it’s possible that even when you sell you’ve raised too much money and taken too much dilution and your exit price isn’t high enough to warrant a big return for yourself.

BUT … it’s your company.  You’re in control.  Want to sell early?  Your choice (obviously if you get investor consent).  Want to double down and GO BIG?  Your choice.  Want to cut prices and go for market share?  Choice, choice, choice.

The moment you sell, somebody else controls the exit timing, exit price, capital raising, etc.  And your outcomes are tied to their moves and their stock.  If they raise a bunch of capital little ole you isn’t going to be around to have your option pool topped up.

I know you think that you haven’t figured it all out and they seemed so polished.  I promise they’re not.  Remember that all companies sound great from their press coverage. If they’re early stage like you, they’re likely just dogs.

If you feel that you won’t be successful on your own I’d far rather:
– sell early and take real cash off of the table, even at a lower price than you had hoped for; or
– bring in management who can take your company to the next level and you stay on the board with some control

Neither of these outcomes is perfect.  But IMO they are better than trading your cat for somebody else’s dog.

5. Deals are mostly for deal junkies
Deals are mostly done by deal junkies.  You can tell who they are because when you want to talk about their business they’re always telling you about the three companies they’re trying to buy.

I confess to being a recovering deal junkie.  I learned much about how to make post merger (acquisition!) integration work but the data says they still fail 70% of the time.  And I’m convinced another 20% are liars.

6. Don’t do deals just because your VCs or board tell you to
VCs and boards are the worst at this. We can’t help it – deals are in our blood.  But once somebody (even a recovering consultant or banker) has been through a post-merger integration and has had to deal with the mess that comes afterward they realize that it is more prudent to focus on your own business.

Still, I often hear about boards pushing teams into mergers.  If it is right to buy a company you should consider it.  But not just because your board eggs you on.  Don’t assume they always have more wisdom than you on this front.

7. There are some times when buying a company (or assets) makes sense – there are especially good opportunities when tides turn quickly
I’m not saying there are never reasons to buy another company for cash and/or equity.  It is preferable when you are in the dominant position so you can control the post-merger integration strategy. It is preferable when the other company clearly realizes this.  It is best not to buy your competitors – they’ll always want an unreasonable price and think of the sale as failure.  It is therefore often hard to culturally integrate them.

There is often a period of extremely good opportunities just after a big market correction.  Many investors and management teams panic and get stranded without cash.  Prices suddenly become attractive and sellers less cocky.

8. Eight, eight I forget what eight was for, but

9. If you are going to start acquiring companies make sure you build a core competency for it
As I said there are times in your company’s evolution when buying other companies (or preferably their assets) makes sense.  This is when you have already figured out your core business and you’re bolting on related companies in which you can use your company to scale that asset more effectively.

A classic case of a company killing it doing this is AdKnowledge.  But they’re big and they have very experienced operators like Brett Brewer running things.

To make acquisitions work you need to know things like:

– how to structure deals
– how to incentivize management teams to stay / deliver value
– how to integrate technology, systems, people and culture
– how to avoid your team vs. theirs
– how to cut redundant costs
– etc.

So if you’re early stage and a first time entrepreneur and you’re bragging about all of the M&A deals you’re working on, just remember that some of us know that you’re secretly a premature merge elater.

  • http://twitter.com/IvanGaviria Ivan

    Mark,

    I like the metaphor about swimming the channel. My two favorites for private/private mergers over the years are “tying two stones together and seeing if they will float” and “seeing if two drunks can hold each other up.”

    One of the saddest parts of a really crappy private/private merger is the rearranging of the deck chairs on the Titanic element of watching two syndicates fighting over how to smoosh their cap tables and rights packages together (my B is worth more than your C, our side's investors need to control the Board, blah blah blah) while the cash quickly runs down…

    In my experience, it's a must that there be a clear “buyer” and a clear “target” so that brute force provides the mechanism for cutting through the b.s. The fabled “merger of equals” among private, venture backed companies is a really hard trick to pull off.

    The point 9 that I'll add to your list is that I think most corp dev folk will point to integration as the key to a successful acquisition at any stage, and it's just really hard for private companies to excel at integration. They just don't have the resources or the experience the way some of the big public companies do on this point. On the culture side too, the issues are complex. Not to say there aren't issues with entrepreneurs having to be convinced to work for BigCo but at least that issue is fairly binary and well understood.

    Thanks for the great post.

  • Al

    Great article – but I have to say I love your choice of images. Seems like you put a lot of thought into picking them :)

    Al

  • http://erica.biz ericabiz

    When I was running my hosting company, another hosting company approached us. The owner wanted to sell (quietly). They were in the same datacenter and we'd competed in the past. I signed the NDA and we looked at the numbers.

    We looked at the numbers again because we were sure we were seeing them wrong the first time. Then we confirmed everything with the owner.

    The company was bleeding red ink. They were losing thousands of dollars a month. Turns out the owner had a well-paying day job and had poured his whole savings account into it.

    He only wanted 5 figures for the company. I was the one who had to break the news: His company wasn't worth anything. In fact, it would be a net negative for us to buy him.

    He sold to another company. Ironically, I later sold my company to that same company. I think he got his 5 figures. But I got 7 figures for mine.

    :)

    -Erica

  • http://berislavlopac.tumblr.com BerislavLopac

    So basically, the entrepreneur thinking about selling his company for equity is really in a situation similar to an angel investor: he should sell only if he is a) absolutely certain that the acquirer has a strong chance of success (the team, the product etc), b) he can afford to lose his investment (his original company in this case) and c) he makes sure he is kept in the game so he can have some effect, at least in his area of expertise.

  • jpmarcum

    Enjoyed the Femmes reference – nice touch.

    Speaking of references I would add to your English Channel metaphor another specific to large, failing companies: hitching the Titanic to the Lusitania.

  • http://hdemott.wordpress.com Harry DeMott

    Enjoyed the Violent Femmes reference.

    Couldn't agree more. Small companies usually have a strong culture internally – so merging two of them together is fraught with personal risks for everyone involved. Since start-ups are so completely people dependent – anything that rocks the boat is sure to rock the boat.

  • vsagarv

    Mark, what seems to be common sense makes that much more sense when you quoting from your experience :) There is also this breed of psuedo-entrepreneurs who start prematurely thinking of 'getting acquired' before they figure out whether they are really worthy of any attention at all (from customers / potential acquirers / …). Kind of perfect match for the 'deal makers'.

  • Yavonditte

    As an angel investor in 7 different companies I can't tell you how many come to me with very early ideas of being acquired, which is kind of the opposite problem you describe here. But it's also a serious problem. My advice is always the same: build a good business and eventually something good will happen. It's a very tough hurdle for first-timers to get over.

  • http://twitter.com/vsagarv Vijaya Sagar

    Mark, what seems to be common sense makes that much more sense when you quote from your experience :)

    You should also do a post on this curious breed of entrepreneurs who focus on 'getting acquired' instead of figuring out whether they are really worthy of any attention at all (from customers / potential acquirers / …). Kind of perfect match for those 'deal makers'.

  • http://twitter.com/vsagarv Vijaya Sagar

    Ouch! a repeat post. My bad. Was briefly logged into a rarely used Disqus a/c. Thanks.

  • http://throughput.us/ consultski

    The exception to rule #1 would be when you need a talent you cannot hire. Think how Cisco Systems acquires often for talent first, technology (or market share) second.

  • bethtemple4u

    Another fantastic post and great list for every start-up … the best being the year-round advice of: “Remember that all companies sound great from their press coverage.” (to which also applies to your own firm when it is in the press)

  • http://bothsidesofthetable.com msuster

    Thanks, Ivan. Seems we're in 100% agreement. Yes, it's true that small private companies often lack the resources for PMI. At my first company by the time we were 120 people I'd say we weren't too bad at it ;-)

  • http://bothsidesofthetable.com msuster

    I do work hard to get the image right. In this case it was my wife's idea!

  • http://bothsidesofthetable.com msuster

    Great story. BTW, to be clear … if a competitor wants to sell and is willing to open up the books – I'd always be willing to look! It's amazing how much you learn that way. Thanks for adding your story.

  • http://bothsidesofthetable.com msuster

    Yup.

  • http://bothsidesofthetable.com msuster

    Ha – been wanting to sneak in that Violent Femmes reference for a while ;-) Memories of college …

  • http://bothsidesofthetable.com msuster

    For sure. That's why if you do it one company has to be dominant and establish strong ownership of culture, strategy and process going forward.

  • http://bothsidesofthetable.com msuster

    Yes, too many entrepereneurs look to be acquired too early.

  • http://bothsidesofthetable.com msuster

    I agree. They see so many other people selling that first timers get excited prematurely.

  • http://bothsidesofthetable.com msuster

    Cisco are the masters at this and as a mature company they should be. It's early-stage startups that should not be doing this. As an early stage business you should almost never acquire a company for it's talent – it's a horribly inefficient use of resources. I wouldn't never say “never” – it obviously is situation dependent.

  • http://bothsidesofthetable.com msuster

    For sure. If you haven't read the post it might be fun to click on the link since I have an entire post (filled with stories) about that topic. Thank you for the feedback.

  • bethtemple4u

    Did read and found this to be the most profound in that list: “Let your compass be based on your customers” (when will that be on a launch t-shirt?!) Post on!

  • http://www.nosnivelling.com daveschappell

    love the violent femmes link… oh, and nice post/reminder as well…

  • http://throughput.us/ consultski

    Definitely “situational” and a rare one-time occurrence for a startup. But an exception to rule #1. It is not about efficient “use of resources” it is about appreciating as the late Colonel John Boyd (of Boyd OODA Loop fame) said, “People, ideas, and then hardware. In that order!”

  • http://twitter.com/IBAssociate Entreprenuer TechIB

    As an Investment Banker, I've never understood this either –

    “For some reason the industry of bankers who try to buy or sell businesses work in what is called the “M&A (mergers & acquisitions) Industry.””

    - I've never “participated” in a merger, yet even when we call on potential buyers 10x the size of our client, we always say “Company x is exploring merger & acquisition opportunities” – it bugs the shit out of me – why can't we just say “We're thinking about selling, how do you feel about buying”? The unnecessary posturing never “adds value”…argh…I digress, much better lessons in your post.

  • philsugar

    Count me in as another person that doesn't like the word merger. You are either a seller or a buyer.

    I have learned the hard way (through expensive experience) that you can't merge equals and trade private stock for private stock for your exact reasons. Massive internal fighting happens versus getting stuff done when there isn't somebody “on top and in control”. Cap tables and preferences are complicated enough, when you try to put two together you don't double the problem you quadruple it.

  • Gary Bahadur

    Mark
    Another very good post. But I wonder about the two weak companies joing to form just a bigger weak company. I can see the logic there but I think there is value in eliminating waste from two companies and taking advantage of what size may offer. Quantatity has a quality of its own as they say. Two weak companies my not be equally weak in the same aspects, maybe the value lies in combining what may be good in each and getting rid of the garbage.

    Regards

    Gary Bahadur
    (small company but not weak :)

  • http://www.victusspiritus.com/ Mark Essel

    This post triggered an image of the formation of titanium alloys.

    If a merge is going to work there has to be titanium.

  • http://bothsidesofthetable.com msuster

    Yes, but not people at any cost. Hire the best. If you're acquiring the best at an early stage there is something wrong.

  • http://bothsidesofthetable.com msuster

    10, 10, 10, 10 EVERYTHING, EVERYTHING, EVERYTHING, EVERYTHING

  • http://bothsidesofthetable.com msuster

    Ha. Funny. But that's better than, “we're exploring strategic options” which is what most people say!

  • http://bothsidesofthetable.com msuster

    Yeah, but the problem is that weak companies are weak for a reason – normally either bad management or bad product / market fit. In either case, adding a merger just distracts them from the most important task at hand.

  • http://twitter.com/davidcottrell davidcottrell

    Speaking of the “compass be based on your customers” point. Back in that post in August of 2009 Mark said “Google announced Google Wave and people are worried about the impact on your business? Don’t…” pretty fitting given the Google Wave press today… http://bit.ly/9lhAsG

    I'm sure even now the wave crash can be viewed as a prelude to something much bigger. Even so, great point, focus.

  • http://throughput.us/ consultski

    Exactly! There is always “something wrong” in a startup… not going fast enough (or going too fast, etc.). It is like Guy Kawasaki says, “Everything is impossible, right up to the point when an entrepreneur does it for the very first time.”

  • Ryan Petersen

    Good points Mark, but what about if you are looking to acquire a company to get a license required by the government?

    I run a customs brokerage business, http://www.customshq.com, in a heavily regulated industry. Part of the reason there hasn't been much innovation in the transportation and logistics space is the piles and piles of red tape required to enter as a newcomer.

    If you want to get an NVOCC license (required if you want to be a middleman in the freight industry who issues his own bills of lading), you must have worked at another NVOCC for at least 3 years. The law doesn't say in what capacity or what you must have learned, merely that you must have worked there. What entrepreneur is going to go work in that industry for three years? Most would rather just build the next twitter app / check-in aggregator. Seriously, that is some medieval guilds, master and apprenticeship bullshit that the rest of the US Economy did away with years ago.

    As a customs broker (a license that took years to get in its own right), I would love to enter the NVOCC business. I'm not going to spend 3 years working for somebody else in the industry though. I'm either going to hire somebody whose done their apprenticeship time or acquire a business that holds the license I need.

    So I think there's still some room for startups to acquire existing companies under the right circumstances. Especially if they're planning to retool a stale business, as Fred Wilson wrote about yesterday.

  • claude

    you can all just kiss off into the air

  • http://twitter.com/IBAssociate Entreprenuer TechIB

    Oh yeah, that's my other favorite – btw, what Company isn't “exploring strategic options” ….ever?

  • jamespatterson2

    Interestingly, I had a conversation with a business friend who is starting a business remotely related to mine (call it 2-3 rings away) about merging. I take initial conversations like this with a grain of salt. But what came out of it is that he got into a bad business model and was looking for a way out. With their company's current model, they had a base but no revenue and couldn't get to the next level. The assumption of “we're just like each other” is usually wrong, and the CEO, who should know better, gets caught up in the “change” argument (much like a marriage where the spouse believe the other will change over time).

    I lived through the Sprint-Nextel marriage debacle, largely as an observer. I also lived through the Sprint-Centel merger which will go down as one of the most value-generating mergers of the last 50 years.

    Bottom line: Don't let sales guys lead merger discussions. It's likely to result in value desctuction.

  • http://www.hadleypartners.com/InReelTime/ Meganlisa

    Coming at it from the investment banking point of view (paid to facilitate M&A transactions) I mostly agree with your comments above. I hear the same lack of focus….all these deals companies want to do when it sounds like they are trying to buy a business model, customers or all of those core competencies they should be building organically.
    But…and you do state this…there are times when acquisitions make sense. To add a more comprehensive experience/product for clients/customers, if a competitor with real value stumbles, to get a geographic presence quickly when doing so matters – and you mention some other good reasons above.
    And, anyone pursuing an acquisition strategy should have the funding and management team to handle the results.

  • Shan

    What if the merger is between two startups with expertise in two areas? We are in talks with a startup who are stronger in the marketing side while our company is stronger in the technical end. Wouldn't it be a good idea if we can work out a deal amongst ourselves?