The Acqui-Fundraise Hybrid Round

In this blog post, I’d like to briefly cover an interesting deal structure that I’ve run across lately. I haven’t been investing long enough to know if this has been common in the past, but this proposed scenario has come across our desks twice in the last few months — so I thought it deserves some analysis and discussion.

I’ll call this an “acqui-fundraise hybrid round”. The mechanics are not complicated: A larger venture-backed tech company agrees to acquire a smaller venture-backed tech company contingent upon an additional cash investment from the smaller company’s investors into the larger company. Helpful (?) diagram below:

The circumstances are as follows: Both companies are cash-burning, and both have raised their most recent rounds at high valuations (in the bull market of ‘14-’15) with the expectation that they would continue to grow and be valued at a nice multiple in subsequent years. Due to the hard crashing of valuations in the first half of 2016 and recent VC retrenchment into proven winners, both companies are concerned about what their next round of funding will look like.

The smaller company’s (Company A) challenge is existential: Because the company has been a decent-to-good grower but not a runaway hit, it’s worried that it won’t be able to find anybody to fund the future burn of the business (let alone at an attractive valuation), and it faces hard decisions around whether to continue burning cash for growth or to cut to profitability yet abdicate a bigger market share opportunity. There may be acquisition offers, but they are often below the company’s existing preference stack, which means that all proceeds from the deal go to the investors.

The larger company’s (Company B) challenge is more optical: It still has willing funders, but not necessarily at the same valuation as the last round, despite the progress the team has made over the past year. The management is concerned that a down-round will make the company appear troubled. They have more time to figure things out, but they could really use some more cheap cash as a buffer to allow them to “grow into” their last round valuation. More topline revenue (since the company is big enough to be valued on a revenue or bookings multiple basis) wouldn’t hurt, either.

So what Company B proposes as a way to amelioriate both company’s problems (or more accurately: Company B’s problems and Company A’s investors’ problems) is to tie together an acquisition of Company A and an investment from Company A’s investors. Here’s that chart, with fake illustrative numbers this time:

Here’s how Company B benefits:

• They acquire various assets from Company A — the team, the revenue stream, the customer list, the product — without having to spend any cash (beyond whatever future cash it takes to run the acquired business if it remains unprofitable on a pro forma basis).
• They actually add cash to their balance sheet in the transaction, allowing them to forestall a larger fundraise — or perhaps take them all the way to profitability.
• They gain revenues from Company A that can be used to improve their valuation at the next round of funding.
• They avoid the appearance of a down round (for now).
• (By extension, Company B’s investors benefit from most of these as well.)

Here’s how Company A benefits:

• They find a home for the company and deliver returns to their shareholders. If the acquisition valuation is high enough, it clears the preference hurdle and puts capital (albeit tied up in another company’s stock) in founders’ and employees’ pockets.
• The company’s technology is more likely to live on in Company B, compared with the acqui-hire scenario where another acquirer buys the engineers and then shuts everything else down.
• Company A’s employees, or at least some of them, get jobs at Company B, and can potentially continue doing the same things they were before the sale.

And here’s how Company A’s investors benefit:

• Company A’s investors get a “2 for 1” on their investment in Company B. They package up their sunk costs in Company A plus X amount of cash, and get X+Y shares of stock in Company B. If Company B ends up doing well, then Company A’s investors end up doing very well because they effectively added leverage on top of their purchase of Company B shares (in the diagrammed example, they spent an incremental $25M in cash to buy $50M worth of stock).
• They get to list an exit on their portfolio page and add a new (potentially high-profile) logo.

Of course, for any acquisition to work there should be a business rationale for why Company B’s prospects are strategically enhanced with the addition of Company A’s assets. Exploiting these quote-unquote “synergies” is hugely important to prevent a failed acquisition (and we all know that the majority of acquisitions are deemed “failures” in hindsight). With that being said, one advantage of this sort of hybrid deal is that due its two-pronged nature, the bar for “sufficient” synergy is lowered somewhat. If Company B is excited enough about the new capital injection into its business, it can afford to be slightly less convinced about the applicability of Company A’s assets to its core business.

To analogize: Let’s say I approached you and offered to sell you my used Volkswagen for $10,000. You’d probably reply “Well, first I’d need to do some research on how much the car is actually worth, and then inspect it and get a vehicle history, and then haggle based on what I learned. But most importantly, I’d need to determine whether I actually need and/or want this car or not.” But if instead my offer was “Hey, I think your new startup is super promising, and I’m willing to angel invest $100,000 into it at a high valuation… but the only catch is, you have to buy my used Volkswagen for $10,000”, you might be more willing to omit the car-related research and haggling (knowing you can figure out what to do with the car later) in order to fast-track the angel investment you really want. Similarly, if Company B is angling for a stress-free funding round and knows they can get it by buying Company A’s assets with stock, they might opt to sign the deal quickly and keep Company A as an independent division mostly on autopilot until they figure out how to best exploit it at a later date.

(Another thing this illustrates is how varying the proportions between the price of Company A and the magnitude of new capital injected into Company B can vastly change how attractive the deal is to each side. When the Volkswagen proposal is coupled with a $100k angel investment, the buyer will probably take that VW for a test-ride and inspection before signing. When the angel investment is $1 million, the buyer would hardly care less if the car was manufactured by Hot Wheels.)

(8/31/16 edit: A helpful reader brought up the following point — Another benefit for Company B and its investors is that Company A’s investors will only participate if they believe that the A+B combined entity is a strategically sensible (and investment-worthy) business. In any normal cash-only transaction, Company A’s investors could care less about Company B’s fortunes after the deal is closed and thus might cheerlead a deal that doesn’t actually make sense for Company B. That’s less likely to happen here, which should put Company B at ease.)

Beyond Company B’s willingness to acquire the assets of Company A, the other key hurdle facing the dealmakers is How attractive is Company B’s stock to Company A’s investors? One way to approach this is for these investors to ask themselves: Would we want to invest in Company B completely independent of the transaction for Company A? If the answer is yes, then the deal gets done 100%. If the answer is no, then the question is: By how much does Company B fall short? Company A’s investors are getting something that they want — the sale of Company A — so how much of a squeeze are they willing to take on Company B’s shares to make that happen? This depends on lots of things: Company B’s valuation, the price for Company A, whether Company A’s proceeds pay out in common or preferred stock, how much new cash the investors need to pony up, how much cash the investors have available to spend, how sensitive Company B and its investors are to dilution, and so on. As with most deals, there are a lot of moving parts — which means plenty to negotiate.

As 2016 advances I suspect we’re going to be seeing a lot more of this sort of deal as cash-burning small companies approach the end of their runway and near-breakout larger companies search for the final missing pieces to earn escape velocity.

(Kudos to my man Christian from Comcast Ventures for reviewing an earlier draft of this post.)

Patrick invests in B2B software companies as part of Toba Capital.