Buyers are ‘window shopping’ for startups, but few are willing to spend big

Acquisitions of VC-backed companies may have hit a decade low in Q1, but the number of conversations between potential buyers and sellers is far from that nadir.

“There is a lot of window shopping,” said Sheila Patel, vice chair and general partner at VC firm B Capital Group.

For now, startups don’t feel an immediate pressure to sell, and buyers—whether larger startups, publicly traded companies or private equity investors—are holding out for lower prices. But dealmakers and investors agree that by the end of this year or early next year, M&A activity will increase significantly.

They say that the timing comes down to simple math. The runways of many early and mid-stage startups are expected to expire in the next six to nine months.

“If companies can’t raise money, where are they going to go?” said Navin Chaddha, a managing director at Mayfield. “I see a lot of consolidation.”

But investors and M&A advisors are urging companies to try to get ahead of the forecasted acquisition stampede.

“There are a lot more conversations now than there were in the boom times,” said an M&A advisor who works exclusively with portfolio companies of a major VC firm. That’s because capital was easy to raise until last year, and most founders had their eyes on an IPO. “Back then, we tried hard to get them to think about M&A because valuations were high, but that message rarely landed.”

While a relatively significant number of term sheets are being issued nowadays, transactions rarely close, he said.

I asked several dealmakers why what seems to be widespread flirting is leading to few marriages. There are several types of M&A deals, and each type tends to fail for its specific reasons.

Startup-to-startup acquisitions

Larger startups are looking to buy smaller companies with complementary products. These acquisitions aim to create a bigger platform and grow revenue by cross-selling to each other’s customer bases. Combining these companies could create a business large enough to be an IPO candidate.

There are many such discussions across the VC ecosystem now.

“These are great conversations, but these deals are not closing at the rate we thought they would be,” said the M&A advisor. Most of these transactions are a strong strategic fit, but agreeing on a valuation is a big hurdle.

While some VC-backed companies may be able to raise capital or venture debt for the purpose of acquiring other startups, most such buyers are very protective of their balance sheets and offer to pay with their stock instead.

The buyer and the seller need to figure out how much they are worth relative to each other, and neither party is willing to accept that their valuations have dropped since their last rounds of financing.

Since many sellers still have runway left, they have been walking away from these deals. They hope that they may succeed with raising another round, but if that fails, they will consider their M&A options again.

Sale to a publicly traded company

The largest strategic buyers are always on the lookout for right opportunities, said Karan Kapoor, managing director and co-head of tech investment banking at Kroll. But companies that went public more recently have a lower acquisition appetite than before because their valuations are down significantly, he added.

“A lot of things need to align” for these acquirers, according to the M&A advisor, who works only with VC-backed companies. He said that strategics would only buy a startup that offers a product they absolutely “must have,” and it should be straightforward to integrate the target into the parent business.

But more importantly, public investors are assigning a higher valuation to profitable companies. Therefore acquirers don’t want to buy startups that are more than a year or two away from breaking even.

While prices for VC-backed companies have been dropping steadily since last year, large strategic acquirers are not jumping at the opportunity to pick up startups at lower prices. A recent survey of CEOs from The Conference Board found that executives expect the economy to deteriorate further by the end of the year. Such sentiment may be a reason to wait for valuations to drop even lower.

Overall, strategic acquirers are also generally willing to pay less than other VC-backed companies.

Sale to private equity

While a sale to a private equity firm is seldom a great financial outcome for VCs, dealmakers expect a surge in these transactions in the next 12 months. Even if a company previously valued at $1 billion sells for as little as $150 million to a PE firm, earlier stage investors could make a big chunk of their money back. While later-stage backers are less likely to recover invested capital, they may still be happy to return some cash to their limited partners.

“There will be many such deals coming to market in the second half of the year,” Kapoor said.

But dealmakers warn that it may be best not to wait too long to put their startup on the block. They say that there will eventually be a deluge of VC-backed companies for sale, which means private equity investors can afford to be picky.

Featured image by Joey Schaffer/PitchBook News