How to acquire a funded startup

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September 06, 2021

by a searcher from Washington University in St. Louis in Claymont, DE 19703, USA

Hi,
We have a proposal to acquire a startup that has been funded substantially (Till Series A) but has not been significantly profitable.
The startup is an excellent fit for our long term goals. and would boost its and our capabilities. Hence the owner is willing to sell the company.

Any ideas on how to evaluate and acquire this startup? Cashflow based finance is ruled out.

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Reply by a searcher
from Stanford University in San Francisco, CA, USA
Venture financing can get complicated due to the presence of multiple parties with potentially different terms per shareholder. It's critical that you understand who you are negotiating with, what the liquidation waterfall looks like, and what are the motivations of the critical party. When you say "owner", are you referring to the founder? The majority shareholder? A consortium of aligned investors who hold majority rights? The board chair?

The founder may wish to sell and move on, but depending on how much of the company he or she has given away, in addition to voting and shareholder rights as dictated by the company's COI, may not be able to make this decision. Assuming the founder can make this decision, given shareholder rights, the series A preference stack, hurdle rates, senior debt, how much will the founder net out if you pay $15M or $25M... enough to move the needle? (caution that you will be negotiating against ownership bias here) Even if the founder has sufficient voting rights to exercise a change of control, the founder may seek a strategic option instead of selling altogether, as doing so at such an early stage may strike a black mark on his/her ability to raise venture funding again in the future (depending on the founder's relationship with investors). If it's the board or lead investor that wishes to sell, then critical to understand this same exit waterfall... how much would these shareholders make on their Series A investment? If these are savvy venture investors, even getting back 3x on a series A investment may not be enough to entice them to get out if there is a possibility that they could still make 100x in a few years, unless they are fatigued / lost faith in the founder / long in the tooth between fund cycles. They may be willing to get out for a discount if the rest of their portfolio has performed (i.e. motivated to get their time back), or they may wish to carry their shares into a strategic merger (i.e. motivated to find new leadership).

Net - you really need to understand the cap table and perspective of the key stakeholders.
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Reply by a searcher
from The University of Texas at Austin in Austin, TX, USA
I have invested in and founded a few VC backed startups, been in corporate M&A etc. and am speaking from my own experience. As you may be aware for traditional VC backed SW companies, the valuations are based mostly on potential earlier in the cycle (upto Series A) and a multiple of any creative formula involving ARR, Net Dollar Retention (churn), growth rates in late stage/growth rounds. A good yardstick for you since the alternative for that company is to raise a Series-B is to look at those criteria. For Series-B, you are already assuming the core team, core product and a repeatable sales/customer success motion is in place, and all you need to do is to step on the gas (sales/Marketing/partnerships) etc.

That said, in your case, usually VC backed Series-A milestone needs aren't that sophisticated (1M ARR+, repeatable sales process, customers live/using the platform etc.) So, since you know your business/space and how this contributes to your future, you should value this startup mainly based on opportunity cost (effort involved for you to build what they have, the time it takes to get there etc., captive/marquee clients you are acquiring from them, talent quality etc for redeployment in strategic areas etc - this is how large companies do it.

This may not be a specific answer you are looking for but if I can help in private, please DM me, happy to.
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