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Private Equity

PE buyers eye cash-constrained startups for add-ons

PE-backed portfolio companies are acting on the opportunity to capitalize on the slumping valuations of venture-backed companies and pursue add-ons at cheaper prices than they could find two years ago.

More PE firms are examining the opportunity to snap up cheap add-ons for their portfolio companies as the dry spell in venture funding has left many startups hungry for cash.

Industry participants say they are seeing PE-backed platform companies bargain-hunting for startups that are experiencing tight liquidity. The target businesses are unable to rely on existing venture backers, who are unwilling to inject new capital to save them, and some have defaulted on their debt obligations.

With these target companies in a tight spot, and bankruptcy not typically viewed as a viable option, buyers are able to negotiate big valuation cuts.

Also drawing private equity buyers are the startup’s products or blue-chip customers that could enhance those of a portfolio company, said Jeffrey Bede, who heads the growth capital business at ORIX USA that lends to growth- and late-stage businesses.

Buying on the cheap

Private equity firms do not typically acquire companies before they reach profitability as it is difficult to apply the LBO model to a business that doesn’t generate cash flow. However, when the market chilled, some startups started to tighten their belts, cut expenses and generate cash, and private equity is now taking a closer look at those.

PE buyers chasing startups now are very price sensitive, demanding relatively low multiples.

“You are seeing material discounts, and it depends on how distressed the situation is,” Bede said.

This means buyers may offer 1x or 2x revenue multiples in today’s market to purchase venture-backed companies that are under stress or distress, rather than the 3x to 5x multiples that these kinds of businesses could fetch in normal times, he said.

The startups being acquired are not necessarily in trouble. Some just need recapitalization and operational support, said Kyle Brown, president and chief investment officer at venture lender Trinity Capital.

Brown said he has started to see a trend of PE-backed consolidations that involve startups in need of liquidity being picked up for roll-ups, a strategy of consolidating multiple businesses into a sprawling enterprise.

He mentioned that buyers could find attractive targets in the enterprise SaaS sector.

“Those long-term contracts create real long-term value, and multiples are trading significantly lower than they were a couple of years ago,” he said. “Valuations were 15x to 20x of annual recurring revenue, and now it’s back down to 5x to 7x. That’s an entry point for an investor.”

The biotech and pharma sectors, where startup valuations hit a trough last year, are also going to garner great interest from acquirers, Brown added.

Short on funding options

Startups don’t typically file for bankruptcy to restructure their debts, as they don’t have substantial tangible assets to reorganize.

“The big reason is that venture-backed companies are generally losing money,” said David Spreng, the chairman and CEO of Runway Growth Capital. “So not only do you have to fund all of the bankruptcy expenses, but you also have to fund the operation of the company. And unless you really know what you’re doing, it’s pretty hard to judge which company’s going to make it and which one isn’t.”

Taking longer to close

Despite the opportunity to buy companies at lower valuations, acquisitions of troubled startups are taking longer to close, with some taking twice as long to purchase as a performing company.

Some acquirers are drawing out processes to see how far down they can go in price, according to Bede. These transactions also tend to require more intensive due diligence, as buyers are being cautious.

In addition, some of the deals involve extensive negotiations around onerous earn-out terms, which also makes these deals take longer to complete, said Michael Fieweger, a deal attorney at Baker & McKenzie.

Dealmakers can bridge valuation gaps in this uncertain market with earn-outs, which are tools to offer the seller one sum today with the promise of additional compensation upon meeting certain performance targets in the future—typically after a period of one to three years.

“The use of earn-outs leads to heavy negotiation over control of the acquired company during the earn-out period and the appropriate metrics to measure the company’s performance,” Fieweger said.

Featured image by Flashpop/Getty Images

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