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Thinking outside the box – M&A for start-ups

Mergers & Acquisitions for start-ups – "Only for grown-ups" or the logical next step?

It may sound contradictive for the founders of a young, innovative start-up to be thinking about merging with a competitor (mergers) or even acquiring a competitor if they have sufficient capital (acquisition). After all, such actions bring start-ups together with big companies much sooner, companies that might even want to "swallow" their smaller competitors. But is that really the case?

After some time (often a number of years), many founders reach a point where the time that they spend dealing with certain issues, which they really don’t want to have to deal with or cannot do so in any detail, has become disproportionately high. Topics such as HR or compliance require ever greater attention with increased employee numbers and growing professionalism. The same is true for the planning and design of sales campaigns and for company accounting, which can no longer just be dealt with in passing at the end of the year. However, it is often not yet worth employing staff specifically to deal with these complex issues.

If there are also few prospects for growth, e.g. because the market for your products seems saturated or there are few new ideas, there can be no harm in broadening your focus to look at issues other than the development of your own company.


It is normal to keep an eye on your nearest competitors and in doing so you might discover that other start-ups or even established, medium-sized companies face very similar problems. You might even have the opportunity to discuss such issues, such as through special workshops for entrepreneurs or small and medium-sized companies, or through an incubator or a university.

If you can find a like-minded partner, there are significant opportunities for both: utilise synergies!

Identify and Utilise Synergies

What this will actually look like depends on the specific case. If a start-up has developed a system, for example, which simplifies the distribution and exchange of pharmaceutical products within and between hospitals, there are numerous possible synergies, for example from a merger with another start-up that:

  • has developed a similar system for doctor’s surgeries or pharmacies; this will significantly expand the market and provide new interfaces for exchanging the product;
  • has developed a system, which is very similar on the whole; exchanging ideas can improve the system; in addition, it reduces the competition they face from one another;
  • sells a similar system in a different country; both companies could extend their target markets;
  • has developed a new type of system which significantly speeds up delivery and thus distribution or makes it particularly economical and/or environmentally-friendly.

Opportunities

Some of the resulting opportunities are clear. In addition to synergy effects, the opportunities include the injection of new ideas and people, or the merger of know-how. At the same time, expenditure for human resources, accounting and sales and marketing can be reduced when the new, co-developed entity is big and professional enough in its operations to employ specialists for each of these areas. Where there are already such personnel, there is potential for cost savings; the same is true for office rent, warehousing, etc.

Risks

You should also not lose sight of the risks. On the one hand, as with all decisions of such scope, there is significant economic risk for all parties involved. On the other hand, there can also be disadvantages to synergy effects. For example, your own start-up may no longer have the opportunity to expand into another country on its own, if the new merged entity or partner is already represented in that Country.

It can be problematic on a personal level, too. This depends on how professional the relevant actors are. If the founders of two merging companies and both intend to implement their own ideas, they will have to be ready to compromise again and again. In some cases, this can go beyond just being exhausting. It can lead to a permanently negative atmosphere in the new company and even the breakdown of joint efforts. This happens particularly when the merger is between "equals", and less frequently in the case of an extremely costly acquisition of another company.

An example: Modomoto and Outfittery

Despite the risks, if you decide to merge with another company – whatever the form – the potential can be unexpected. A good example of this is the recent merger of well-known start-ups Modomoto and Outfittery at the end of 2019. Both companies sought to significantly increase their turnover, yet their cost savings have almost doubled.

Financing

At an early stage, a close eye must be kept on any financing for this process. This is normal in the case of an "acquisition" of a competitor. However, it can also play an important role even in the case of a (pure) merger. The costs of advisors, registration changes, the drop in daily business while the transaction is prepared, etc. often cannot be borne by equity alone. In such cases, a bank or investor will be needed for financing. They will make a detailed assessment of the economic position of both companies, though there are no fixed rules as to which standards should be used to assess the value of a competitor, making it difficult for newcomers to penetrate this process. One simple yet imprecise method is the projection of the turnover of a company for a number of years.

In any case, the parties must set a purchase price, which will be used as a basis for determining the shares of the founders in the subsequent company. Often, it will be necessary to already pay out one of the founders at this stage, if the founder wishes to be released from the project.

In order to ensure the successful execution of the transaction - one of the cornerstones for success – some important aspects must be observed:

  • Do your due diligence: make a detailed legal and financial assessment of the other company, in order to be able to judge all the risks posed.
  • At an early stage, consider what type of "merger" you want and can achieve – merger, joint venture, acquisition of the smaller competitor.
  • Bring legal and tax advisors on board in good time.
  • Possibly involve an M&A expert, who would assist with the search for and analysis of a suitable competitor and provide support during the whole process.
  • Despite a high level of professionalism, the whole process can still take many months, during which time the daily business often takes a back seat.
  • Strategically plan the timing of the merger. If it is too early in your company’s own development, your risk stalling the regular business, which can impede the merger. Leave it too late, and it threatens to cause the company’s whole development to stagnate.

To return to our original question: A merger of competitors is not always a "logical next step". However, it is even less true to say that it is "only for grown-ups". Simply, M&A offers both enormous potential for development for a start-up as well as risks that should not be underestimated – just like the establishment of a start-up itself.

Dr Gesine von der Groeben
(Lawyer)

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Dr. Gesine von der Groeben T   +49 69 756095-408 E   Gesine.vonderGroeben@bblaw.com