M&A Fundamentals

Posted on by Fred Wilson & Jason Li


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.


From the comments

JLM added:

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.

andyswan replied:

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.”

And Aaron Klein replied to that:

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…

And JLM weighed in again:

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.


This article was originally written by Fred Wilson on December 6, 2010 here.