The two sides of startup M&A: How to capture the good and mitigate the bad

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This piece was originally published on my Forbes column here.

Startup M&A and roll-ups are predicted to rise in fintech and this already seems to be manifesting. Yet, recent events like Thrasio’s impending bankruptcy offer a cautionary tale.

The opportunities, pitfalls and risks of technology M&A are real. When does it make sense to execute M&A as a technology startup? And how can you avoid the most common pitfalls? We dive into both.

M&A Rationale: Before You Start, Make Sure The Whole Is Greater Than The Parts

As Simon from Marqeta told me: “I always say that M&A is a tactic and not a strategy. For Marqeta we have a north star we’re building towards and if acquiring a company can get us there faster we would look at it. Smart, well-built and well-run modern technology that can be additive to a greater mission will always be in demand.”

This is critical.

Startups must ask themselves the hard questions around the rationale for M&A.

Does M&A Expand Product Offering To Existing Customers?

In other words, does M&A allow increased cross-sell of new products to expand the relationship with the customer. In unit economics terms, this means average order value per customer (AOV) or lifetime value (LTV) expands, with a stable CAC.

As Ross Buhrdorf, the CEO of ZenBusiness and Founding CTO of Homeaway told me, “both at HomeAway and now at Zenbusiness we see roll-ups as an opportunity to accelerate growth via added distribution be it known brands in a market or organic SEO position.” (Disclosure: I was previously an investor in ZenBusiness at my previous firm).

Does M&A Expand Reach Beyond Existing Customers?

Certain acquisitions allow companies to better serve existing or new customers with the current product range in a more enduring way. This has an impact on customer acquisition cost (potentially lowering it) or market size (potentially expanding the reach of customers). Square’s purchase of Afterpay is an example.

For example, an acquisition of a similar business in a different geography or customer segment.

Does M&A Build A Moat?

M&A can help increase a company’s moat or defensive positions.

Certain deals must be owned for fear of others owning it. Arguably one of the reasons Visa had offered so much for Plaid was because it would be too painful for a competitor to own it.

Many M&A deals increase internal capabilities (e.g. the topic du jour: artificial intelligence, and the acquihires taking place) to better serve customers - and make it harder for others to steal them.

Constellation BrandsSTZ -1.9% has been built on an M&A strategy. As the Economist recently wrote: “Whether by fluke or design, Constellation’s dealmaking success is based on principles that look strikingly similar to those of the world’s heavyweight acquirer, Berkshire HathawayBRK.B -0.5%...[Constellation Brands] seeks out businesses with a lasting competitive edge. In Constellation’s universe, such a ‘moat’ is enjoyed by software firms that specialise in building digital wares for unsexy industries from car dealerships and builders to spas.” Constellation’s market value grew 250% in 5 years, reaching $50b.

So You Want To Execute M&A. What Should You Keep In Mind?

A Fair Price Is Critical

Price determines the value created vs. the value paid.

Some roll-ups are built on a thesis of multiples expansion (by growing the size of the business, the roll-up will be valued at a premium). Getting entry price right is critical.

M&As are often based on the promise of “synergies” - operational efficiencies derived from combination.

But remember, both of these can be uncertain: multiples change, and synergies often take longer to materialize, if they do at all. The transaction price should reflect this uncertainty.

Incentives Matter

The deal needs to work for everyone. For sellers, cash is often what sellers are looking for. But buyers may want to keep the sellers around. They may also want to mitigate adverse selection (is the asset as good as the sellers claim).

That’s why incentives matter. One solution is to structure a portion of the buyout as equity to keep sellers engaged.

Earnouts can also be powerful tools to bridge valuation expectations between sellers who think the company is worth more than buyers. For instance, if sellers believe certain future pipeline deals will materialize and should be compensated, an earnout can solve this divide.

Create A Margin Of Safety

Price and deal structure are drivers of success. But risk is real and should be recognized. For example, one of Thrasio’s pain points was its floating rate debt, whose cost exploded in a rising interest rate environment.

Build in a margin of safety so even if everything doesn’t go just perfectly, everyone still wins.

Create the playbook

Buying a company one-off can be hard, particularly if it is large. If you want to do a roll-up, you need to create a playbook.

This means a structured way to map the ecosystem, prioritize targets, run diligence and execute deals. As Ross emphasized to me: “It is critical that you have a well established playbook at every stage of an acquisition, from research to the final stages of technology and brand integration.”

That’s often the easier part. The harder part is garnishing value on what you’ve built. Some have argued Thrasio was strong at the former, but the latter was a challenge on a platform dominated by Amazon. Making sure inventory was stocked at scale while forecasting demand in a dynamic environment is no simple matter.