M&A Fundamentals

This is the first post on the "acquisition finance" series we started last week in MBA Mondays. I am going to try to lay out the basics of mergers and acquisitions in this post. Then we can move on to some details.

As the term M&A suggests, there are two types of deals, mergers and acquisitions. Acquisitions are way more common. It is when one company is taking control of the other. A merger is when two like sized businesses combine. An example of a merger is the AOL/Time Warner business combination ten years ago. I am not a fan of mergers. I believe it is way better when one company is taking control of the other. At least then you know who is in charge. Mergers are very complicated to pull off organizationally.

I have done a few mergers in the startup world. The best example is Return Path and Veripost which merged in 2002. The two companies started at about the same time, both got venture funding, and built almost identical businesses. They were beating each other up in the market and getting nowhere quickly. The management teams knew each other and the VCs (Brad Feld and yours truly) knew each other. We finally decided to put the two companies together in a merger. It worked because we decided that Matt Blumberg, Return Path's CEO, would run the combined companies and because Eric Kirby, Veripost's CEO, was fully supportive of that decision. Even so, it was not easy to execute.

Acquisitions are way more common and I believe way better. Most of the deals you can think of in startupland are acquisitions. A larger company is acquiring a smaller company and taking control of it.

The next distinction that matters a lot is how the consideration is paid. The most common forms of payment are cash and stock. In fact, you'll often hear corporate development people say "it's a stock deal" or "it's a cash deal." Companies can pay with other consideration as well. Debt is sometimes used as consideration, for example. But in startupland, you'll mostly see stock and cash.

Most people think cash is preferable. If you are selling your company, you want to know how much you are getting for it. And with cash, that is clear as crystal. With stock you are simply trading stock in your own company, which you control, for stock in someone else's company, which you don't control.

However, over the years in maybe a hundred deals now I have made more money in stock based deals with the acquirer's stock than I have lost in acquirer's stock. I don't know if that is just my good fortune or not. But I certainly have had the experience of taking stock in an acquisition and having that stock crumble and lose it all. So if you are doing a stock based deal, make sure you do your homework on the company and its stock.

The third and final distinction we will cover in this post is what the acquirer is purchasing. Typically the purchaser can either buy assets or buy the company (via its stock). If you are selling your company, you'll generally want to sell the entire company and thus all of its stock to the buyer. The buyer may not want to entire company and may suggest that it wants to do an "asset deal" which means it cherry picks what it wants and leaves you holding the bag on the unwanted assets and some or all of the liabilities.

For obvious reasons, fire sales are often done as asset deals. Healthy companies with bright futures are not often purchased in asset deals. They almost always sell the entire company in a stock deal. If you are selling your company you should try very hard to do a stock deal for the entire company.

That's it for this post. We've covered the three most important distinctions; merger or acquisition, paying with stock or cash, and buying assets or the entire business. We'll get into more detail on each of these issues and more in the coming weeks. 

#MBA Mondays

Comments (Archived):

  1. Emmanuel Bellity

    “The two companies started at about the same time, both got venture funding, and built almost identical businesses. They were beating each other up in the market and getting nowhere quickly. “Did this also apply to Flurry / Pinch Media merger ? Or was it different ?

    1. fredwilson

      That’s another great example of a merger in startuplandWe were the lead investor in Pinch and DFJ was the lead in Flurry. We putthem together with Simon, Flurry’s CEO, in chargeIt has worked out fabulously

  2. jpwoodland

    When you get to the topic of buying assets vs. stock I’m curious if you see a lot of 338 transactions which aim at achieving the best of both options.

    1. fredwilson

      I will need you to write that post. Not sure what a 338 transaction is

      1. jpwoodland

        I’m not an expert on it as I’ve only seen it once. The company I worked for used it in its acquisition of a small S-Corp. It’s more common with S-Corp’s or a subsidiary of another corporation, and I’m now realizing you’re more likely to be involved with freestanding LLCs or C-Corps so it may never be relevant for your portfolio companies.Nevertheless, here’s a link to a dated, albeit still relevant overview of the 338 and 338(h)(10) election.http://bit.ly/dQz2VP

        1. Zeke

          338(h)(10) is a federal tax election essentially to treat the stock sale as an asset sale, so the acquirer can take a step-up in basis on the underlying assets while the legal structure remains a stock deal. I wouldn’t say it’s the best of both worlds. It’s just something to consider if the seller insists on doing a stock deal but the buyer wants the tax treatment of an asset sale. The related provision for partnership taxation (including LLCs that are taxed as a partnership) is 754, similar but not the same.I’ve almost never seen a deal where either election was made, so I would be interested to hear if anyone else has. Usually I see language where the parties give a rep that they are not making that election.

  3. awaldstein

    Fred…Really clear, thanks.Cultural assimilation in these mergers is something that you should do a post on sometime. You’ve touched on stock incentives to keep executives, vesting on change of control in previous posts, but the cultural morphing or friction is hard to forecast and I bet you have some stories there.My own experiences being on both sides, is that its often challenging and leadership from both the acquired and the acquirer makes it work (when it does).

    1. fredwilson

      AbsolutelyAcquisitions work or fail quickly and its all about the way you do theintegrationI am not an in the trenches expert on integration. More of a Monday morningquarterback to be honest

    2. RichardF

      Like you Arnold I’ve seen this a few times. I think it’s really important that the senior management in the acquiring company/lead company in the merger (I don’t believe there is such a thing as a merger of equals) keep their staff on a short leash and welcome the new employees on board.I’ve seen some really arrogant behaviour by the staff of an acquiring company make the assumption that they are more important than those of the company being acquired.Which can be a bit of a schoolboy error because quite often the acquiring company is trying to hide it’s own shortfalls by buying another company with better technology and/or staff.

      1. awaldstein

        We, I bet, have stories to share.I’ve been on the acquiring side a bunch of times and always tried to focus on strong earn outs for the acquired company, incentives for the responsible acquires exec to drive resources and empowering smart folks to drive the integration in the trenches.Never easy…but it can work.

  4. ErikSchwartz

    As for cash or stock… It depends how you think the acquirer is doing and how it looks going forward.A little story. In late 1997 I was running entertainment for YHOO. I identified that we wanted to move into casual gaming. I found a little two person company that had built some games with potential. There was a great engineer and a huckster type business guy.We came to terms to buy the company for $1M. The huckster guy wanted cash, which we agreed too.The engineer became an employee and also got a nice option package (the huckster was not offered a position). Over the next 36 months the engineers options went up 30X in value. I don’t know the specific numbers but I bet he made 10X as much money on his options than he did on the acquisition.

    1. fredwilson

      the Yahoo stock we got for Yoyodyne went up 3x in the time we had to hold itturned a $30mm deal into a $120mm dealroughly same time period

      1. daryn

        I was part of a deal that closed 9/1/2001. We did all cash, at a discount from the stock offer, due to various issues, but between the company’s financials and the post-9/11 economy, it turned out to be a very smart choice.Acquirer’s stock was at 32 at closing, dropped to below 5 within the year, and stayed underwater for several years.

    2. BillSeitz

      Yep, and if the deal had been done 2 years later, the opposite would have happened.I think CharlesFerguson’s book about building Vermeer/FrontPage talked about a possible deal with AOL that fell through because he felt their stock was in bubble mode and doomed to go down, so he wanted the price adjusted accordingly. They didn’t see it that way. He was right. (And chose to get bought by MS instead.)

      1. ErikSchwartz

        Yup. That’s why it depends on what you think the prospects for the acquirer are. If you think they’re in a bubble, don’t take stock (unless you’re willing to collar it).

      2. JLM

        “Value saving” clause on any stock deal is imperative. This is pretty tame stuff. I have personally done this and it works.

  5. andyswan

    Asset sales vs stock deals often also comes down to the tax implications and corporate structures of the buyer and seller.For example, a seller may be willing to take a lower value on a stock deal than a cash deal if it is within 12 months of founding. If done properly, this can avoid it being considered a “sale”, and not trigger a short-term capital gains tax of 35%. Instead, the seller simply swaps into buyer stock, and the “sale” doesn’t occur until he sells his stock of the buying company.This is what we did with mytrade when we were bought in the 11th month. Took public stock instead and put off the “sale” until after the one year mark, when capital gains became “long term” and were 15% federal (still too high).Tougher to do with private stock, but still possible with the proper structuring and options attached.

    1. fredwilson

      yupi think i am going to have to talk a lot about tax considerations inthis series of posts

  6. William Mougayar

    A seasoned M&A professional once told me “Companies acquire the future, not the past”.As much as this post is about fundamentals and basic mechanics of a transaction, a key question is – “how do you land on the M&A radar?” I would be interested if you can share practical experiences on the prelude to M&A, and key things that a start-up can do that maximize their value (qualitative & quantitative).

    1. Matt A. Myers

      I imagine good accounting and documentation such as plans and even presentations would make a potential acquirer feel that it will be easy to integrate. Basically the same things investors would want from you. 🙂

    2. andyswan

      A few off top of head. I’m sure Fred has way more:1) Partner. Build a relationship that shows your company incentives are aligned with theirs, your team is competent and your value stack improves their value stack.2) Win. Start beating them at a slice of their business. Or, beat them to an emerging niche that they didn’t get in front of.3) Ask them. This is one where many startups fail. They expect to stand in the corner until Mr. Right comes and asks them to dance. It didn’t work at prom, and it won’t work here. Get out there.EDIT: 4) Don’t need them….right Groupon?

      1. awaldstein

        Good list but I wonder whether the actions to build a start-up to succeed on its own are different than building one to be bought.I’ve alway’s believed that the actions are the same…especially if you believe, as I do, Fred’s phrase “startups are bought, not sold”

        1. andyswan

          Absolutely agree with that phrase. As usual, I think the “or” is a false choice.Build your startup to succeed on its own, AND so that it can be bought.Structure properly. Make some noise. Get on the dance floor.You’re not going to get a partner, an investor or a buyer by putting your head down in the corner. They’re all varying degrees of the same thing.

          1. awaldstein


    3. fredwilson

      and startups are bought, not sold

      1. awaldstein

        “…startups are bought, not sold”A smart phrase about a basic truth.

        1. Bob Egan


      2. William Mougayar

        I’m with you there, and also believe in “don’t ask for something that ought to be offered.”But I was eluding to the proper market positioning that a start-up must do as a prelude to getting noticed.

      3. John Prendergast

        Fred, this comment is worthy of an entire post (or an entire book!). Far too many entrepreneurs believe that you can sell the business whenever you’d like. Its almost never true and its a belief that often sets you up to fail.

  7. Matt A. Myers

    Nice and simple with stories. Thanks for an easy read today. :)P.S. “The buyer may not want to entire company and may suggest” – s/to/the/

  8. JLM

    The essence of any capital transaction, including mergers and acquisitions, is due diligence.When merging it is essential to know what you are merging with and when acquiring it is imperative to know what you are really getting.Anybody in the M & A business on a professional basis should have a 15-page DD checklist which smokes out all of the horribles and squares all the corners. I cannot tell you the number of times I have been surprised to see how “seat of the pants” DD is conducted on big and important transactions.I honestly believe that if the AOL-Time Warner deal had been subjected to a serious DD effort, it would never have happened. Everybody just wanted to “do it” and the rest is history.

    1. fredwilson

      yup, deal heatvery dangerous stuff

    2. andyswan

      So true. Buyers are outsourcing their DD to the legal team.BUT….There’s an enormous difference between legal DD and business DD.Legal DD is making sure their IP is registered to them.Business DD is saying “let me talk to 100 random customers of yours.”

      1. Aaron Klein

        Talking to customers is great, but it’s also looking at what’s behind the numbers that make a deal pencil.I remember hearing that the average consumer did $139 of discretionary spending on entertainment, and AOL projected that the combined company could achieve 136% of that number.Why that didn’t set off alarm bells at Time Warner we will never know…

        1. JLM

          You refer to what I think is one of the most important aspects of any acquisition — the setting of the basic “go v no go” parameters and how the final acquisition financial model is going to be prepared.The most basic “go v no go” parameter is the hurdle rate or other financial return objective. This should never be compromised and should be set before anyone starts ciphering otherwise you decide to accept what is presented to justify the deal.Having done a great number of such transactions, I have defaulted to having the deal guys and the accountants work independently of each other to develop separate financial models.Both start with the seller’s numbers — if they exist.The deal guys use their perceived market views of the deal and make independent projections based upon their market perceptions — “we can do this better, cheaper, etc.”; and, the accountants start with the “proof of cash” approach wherein they look at and verify the actual historic financial performance of the enterprise deriving any trend line slopes, etc while dropping in “real world” — like our actual labor rates and costs of insurance, etc — numbers which we know to be accurate.This ends up with a couple sets of numbers which I initially look at separatetly and then show to each other for a bit of a roundtable discussion. Undoubtedly, we settle upon something in the middle or we don’t settle at all.I don’t feel any necessity to agree if both show us clearing the hurdle rate.We then take a look at actual performance 90, 180 days later and 12 months later. This is important as it recalibrates everybody’s view with a splash of reality.Done over time, it is very effective and objective.

    3. Fernando Gutierrez

      Corporate heroes are usually the deal makers. Very few people like or give credit to the guy who stops the deal during DD.The incentives of the people involved are not always aligned with the interest of the shareholders. Too much people win a lot if the deal is done, so too much deals are done.

    4. ShanaC

      More basic question -beyond usual numbers, are the differences in what one would look for depending on the kind of deal?

    5. Aaron Klein

      We do know that Time Warner did not do proper due diligence.But for all we know, the deal heat may have been *because* AOL did its due diligence. :)The AOL shareholders got the deal of a lifetime in that merger.

  9. baba12

    In the acquisitions that I have read about, it seems like it is more of a closed network of operators making deals. I assume a acquisition is much smoother when the key operatives i.e. lead VC’s have a personal relationship with each other i.e. play golf together, go sailing or have their kids goto the same private schools etc.I wonder if Mr.Wilson has a list of acquiree’s that acquired his portfolio companies for reasons that defy logic.Generally when do you wish to acquire a company it is one of several reasons but a lot of times these acquisitions seem to be made due to some relationships that are in place between certain parties in the management and boards of the two companies.There are many examples where the acquisition has not panned out well for the acquiree and Yahoo has a bunch of deals where they did not come out better than before the acquisition. Any thoughts on why such deals don’t awaken them to avoid deals that are not in the best interests of their shareholders, they tend to be best for a chosen few only.

  10. Andrew Watson

    “There’s no such thing as a merger.” That’s a statement I almost believe, and used to make when teaching the M&A session of a business school strategy course.I preceded it by asking the class what the difference is between M and A. We’d usually agree that a merger was a marriage of equals.Looking for examples of mergers, we’d talk about deals that were claimed as mergers. Chrysler-Benz, anyone? I remember an exchange student telling me that before long there would be one real HQ and one real CEO. I asked her about the location of that HQ and CEO, and she made it clear that the answer was obvious. (As, perhaps, is the answer to the question: what was the nationality of that student?)AOL-Time Warner is another interest case. It was always a takeover. (Extra credit question: difference between acquisition and takeover?) But who was taking over whom?

  11. ShanaC

    Can we do a post about reasoning behind purchases?My example in my head is the following- there are multiple analytics packages out there for twitter, why did twitter buy a particular one and not another.Or why did Charlie sell to Cobalt which was then sold to Sun -why not sell directly to Sun?How does a company choose a good match?

    1. Aaron Klein

      They like the technology better.They like the team better.They like the price better.One will sell and the other won’t.One has their office closer than another.Culture appears more in sync.Your question is spot-on. There are a million and one reasons though.

      1. ShanaC

        Yes, but knowing some of the whys of how people think this through is the way to understanding a good deal from a bad deal (i hope)

        1. Aaron Klein

          Absolutely agree.

  12. Moses

    Two more points worth remembering for sellers:1. If the buyer is a public company and you’re taking stock as a large portion of the consideration, HEDGE THE SHARES. I know a very smart founder who sold for stock, hedged, and then bought his old company back for $0.50 on the dollar when the buyer’s stock cratered. He’s a billionaire now.2. For smaller deals: Do not take unsecured loan notes as part of the consideration. I’ve seen someone sell his business / life’s work with notes making up a big portion of the consideration, only to see the buyer go under and be left with worthless paper.

    1. fredwilson

      both great advicei’ve done a lot of hedging of stock received in an acquisitionit is the only time i’ve ever done any hedging

  13. Steve Miller

    Fred, also interested in your perspective on using an investment banker to sell a portfolio company. . . . The company I worked for was recently acquired and our investors would not sell the company without hiring a banker given the divergent interests on the board.

    1. fredwilson

      i don’t feel the need to hire a bankerbut i’m not against it eitherit all depends on the circumstancesprobably worth a post in this series

  14. David Noël

    Maybe you’ll adress the topic of a transition phase after an M&A (would love to hear about it) so I’ll just leave this right here:Shai Agassi mentioned Five Frogs On A Log during one of his talks and I highly enjoyed reading this locomotive of a book. While it doesn’t necessarily have a start-up spin, it definitely was an insightful and straight-forward read.For reference, here’s Shai’s talk at Stanford’s ecorner (podcast version) in which he mentions the book at around minute 7:30 saying “Buy it just in case you have to do a merger”http://ecorner.stanford.edu…

    1. fredwilson

      i need to read that book too

  15. paramendra

    Asset deals are the worst kind, it seems.

    1. FlavioGomes

      Often but not always. Its great when you want to divest a segment of your business that doesn’t fit within a long term plan. Its generally easier to do and hence a shorter close period. Buyers like it cause they don’t carry excess liability. There are some downside tax issues but overall in some circumstances its a great way to focus and generate cash at the same time. I did it and it worked out great.

      1. paramendra

        Good to know you had a good experience.

  16. paramendra

    If this is going to be a boom decade, like I think it will, we will see many, many more mergers and acquisitions. We will see few IPOs comparatively, and that’s the way it should be. But that ratio is to state the obvious. My point: timely post.

  17. Jim Wang

    On the point of stock vs. cash as consideration, it’s important to note that as a VC you will want to run the numbers and determine the best option. As an entrepreneur making an exit, it’s often better to take the known “safer” exit of cash, especially if it’s your very first. You have more experience making the determination of whether stock >> cash, but most people don’t (and won’t have the opportunity to make too many exit decisions).

  18. fredwilson

    i think i may be calling you for a guest post on this stuffnothing like scars in the back to learn the hard lessons

  19. Dave Pinsen

    Your kingdom for some puts on Sun. Buying puts on Yahoo as a hedge after they bought his company was a brilliant move on Mark Cuban’s part.

  20. ShanaC

    Thank you