September 8, 2021

Growth: Buy or Build

Growth: Buy or Build

Growth through acquisition(s) has long been the refrain of mature companies and private equity, but it is a relatively recent trend in mid-stage startups and venture capital. Is it a good idea?

The basic tenets of traditional growth through acquisition are (A) synergies through spreading fixed costs over a larger revenue base, (B) cross-selling and integrating products for the same customers to upsell and (C) valuation multiple expansion through efficiencies and overall increased asset size. At the extreme, acquisition can also create such a large market share for the combined entity that the resultant achieves some monopolistic pricing and buying power (if the DOJ turns its eye).

Since operating margins aren’t a major focus of startups before maturity, finding cost synergies is not a compelling reason for acquisition in the startup world. Cross-selling and multiple expansion can be, however. There is also a third factor, which I think explains the recent rash of growth-through-acquisitions we’ve seen: the balance between capital and labor availability. Let’s look at all three.

1. Cross-selling and product integration:

The basic idea is that software markets tend to move in repeating innovation cycles from point solutions to platforms. You have one part, I have the other; or you have most of a platform, I have an additional piece. Let’s combine forces and then increase revenue by integrating products and cross-selling to each other’s customers. We rarely see this approach as a merger of equals. It is usually Big buying Small — say a $40M ARR company buying a $4M company with the hopes of quickly upselling an additional $10M of cross-product within a year.

2. Valuation multiple expansion:

Small slow growing assets (that are often burning capital) trade for smaller multiples; larger faster growing ones trade for higher multiples. If Big buys Small, then maybe Small suddenly assumes Big’s valuation.

Putting these together with some math:

Let’s say Big is worth $400M, or 10x revenue with a nice growth clip. Small is worth $24M, or 6x, with stalled growth and limited prospects to raise capital. If the strategy is successful, the company pays $24M now to get something worth $(4M+10M) in revenue x 10 = $140M in a year. If the upsell strategy doesn’t work, it’s still worth $40M with multiple expansion alone.

In most cases, CEOs who want to acquire a target hard-sell the $10M revenue upside vision to their board but yield a relatively small part of it. So without that, is a $40M prize on a $24M investment worth it?

Well, when capital is scarce, probably not. How much could a $24M investment buy you in organic growth and valuation instead? The best SaaS companies add $1 in revenue for $1 spent. If $1 in revenue is worth $10 in valuation, that $24M investment could be worth $240M, well more than $140M? Most SaaS companies with access to capital can at least achieve an efficiency of 50%. That means burning $24M and adding $12M to get a $120M increase in valuation, while still avoiding all the risks and challenges associated with acquisitions (see below). This is why acquisition growth strategies used to be less common in startups and venture; reasons (1) and (2) - even together - are often inferior to solid organic growth.

But enter (3)...

3. Balance of capital and labor:

In the past three years, it feels like capital is twice as easy to raise and labor is twice as hard to raise. I say “feel” because the quant arguments for that are imperfect. Valuations and round sizes are surely up 2x at Series A and later, but the unemployment rate is not down 50%. Either way, it seems that the bottleneck to growth for many companies is labor - not capital. In this state of the world, the math above starts to favor acquisition because you actually can’t hire the people you need to deploy $24M to create $12-24M worth of revenue.

So should you go buy a bunch of smaller startups?

While attractive in certain circumstances, acquisition strategies are not without risk. First, finding and diligencing targets requires a lot of time, usually of the CEO who has to vet serious targets for product compatibility and talent…as well as having to sell the target on being acquired. Distracted CEOs are a classic unintended consequence of an acquisition strategy, often at the cost of a slowing core business.

For the math to work you also have to really believe in both the multiple discount and cross-sell upside. In a world of excess capital with others executing acquisition strategies in competition with you, it is shocking how quickly a mediocre asset can start looking good to multiple buyers. When that happens, the multiple spread disappears, but you often don’t find out until you’ve already done a lot of work and lose the bid.

Likewise, the cross-sell upside is completely dependent on a successful integration - of people, product and customers. We have all used software from rolled up companies where the product experience feels like an unseemly one-man-band with vestigial branding and incompatible logins. If that’s the outcome, kiss the cross-sell upside goodbye.

Happy hunting!

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