So you want to buy a startup?

So you want to buy a startup?

Startups are so cool right? People want to work for them, buy from them, hang out with them, associate with them. And people want to buy them… and it makes sense right? …..Right?

Well it depends. Buying a business is a serious thing. Deploying your own capital, or shareholder capital, or using third party debt to buy a business is a serious thing. You’ve got to be sure that you know what you’re doing, that the ROI is right, the fit is right, the strategy works, the vision is bang on. You’d think that would be the case right? I mean, it makes sense….

Except when it doesn’t. I have a good friend who got to work for a startup in Australia. His experience provides the background to this story, and it’s a sad tale. What’s strange is, the tale is not unique. I’ve heard similar tales told around the traps from brokers, investment managers, merchant bankers, VC crews — same story, different names.

So my friend was working for a startup. Like many startups that are two years in, it was bleeding cash. Haemorrhaging cash. They had high growth, the revenue line was impressively steep but their business model was chewing cash and their high volume low margin play wasn’t helping. They’d burned through their seed round and their series A and were desperately trying to secure a solid series B. They spoke to everybody in this town, and I mean everybody. It was looking grim. Experienced investors could see the business model was going to take years to generate a return, and the cash requirements until that time would be steep. In the end, most doors were closed. Cash was so tight they had only a couple of months left before the doors had to shut. They were desperate times…

Until along came a couple of Directors of a small cap public company listed on the ASX (Australian Stock Exchange). They were customers of the startup, they used the App the startup ran and they loved it. I mean they really loved it. Their own company had come off the boil in growth terms and they were looking for an acquisition to excite their shareholders, to excite the market and to make their company cool. You see, for this ASX listed company, in the eyes of these two Directors, their own core business was boring. It wasn’t sexy. It didn’t excite investors, didn’t attract institutional investors and didn’t get written up in the financial press. But a startup they thought would change everything.

The Board was split 2 for and 2 against. They engaged a top accounting firm to perform a due diligence and their report said don’t do it. They were warned the business model was flawed, that the cash burn would be significant and ongoing, that the founders had to be replaced, that the break even point was years into the future on the rosiest of (unrealistic) projections and that the startup didn’t align with their core business. It was damning. But the 2 directors who were so keen would not be deterred and ignored the report. They wanted to own a startup because the magical fairy dust that made it cool would make them cool too. So the Chairman used his casting vote to break the tie and the decision to buy the startup was made.

When the contracts were signed and the deal finally done the startup was on its knees and on life support. They barely survived. But when the dust had settled, the founders remained. They were never removed as was recommended. In fact, through the deal they retained control of the company. For a price in the millions of dollars only 30% of the company was secured from them. A convertible note for more than three times the purchase price was also issued, but the options to convert the loan into shares were never taken up. Control of the startup remained with the founders and they burned through the many millions of dollars of other peoples money in just 18 months.

Now, that might not have been a bad thing. Except after 18 months, the startup had nothing more to show for itself. They had spun their wheels faster, revved the engine louder and worked with better, fancier brands but in the end had achieved little in terms of the metrics that mattered.

The fortunes of their ASX parent had soured over the same time. Their share price fell some 358%. Their core business was decimated by changing market forces and their share price by December 2016 was only around 30% of what it had been at its height over the previous 18 months. But the 2 Directors who were such fans of the startup would not be deterred. They doubled down. They poured even more money into the startup and finally bought out the founders to secure 98% of it. Now things would be different they said, without actually doing anything differently and they expected different results from what had come before. To make matters worse, the startup had run out of cash again.

Over the next year the ASX listed owners of the startup would see their share price fall further to be two thirds it’s December 2016 close, to be only 11% of it’s previous high. Unable to properly fund the startup, they cut costs and they raised prices trying to fix a business model that was flawed to begin with, killing growth and sending the startup into a virtual death spiral of plunging customer usage, where revenue fell off a cliff and NPS scores of +44% and 5 star app reviews were obliterated. Both demand and supply sides of the startup contracted sharply compounding all problems. Heads rolled, staff exited and the death spiral continued.

In the end, after only three years of “ownership” the ASX company sold out of the startup. When they exited, the startup was performing at roughly the same levels as it had after only 6 months in operation, yet ironically with less cash at its disposal. After burning many millions of shareholder funds, the ASX company realised an ROI on their investment of -96.25% and their share price recently bottomed out at 2.3% of its high point value in 2015.

So what happened to the startup that my friend worked at? It’s now in new and private hands. Time will tell to see if it turns around, but he tells me the new owners have a plan and they are executing on it so we’ll have to see whether things are looking up from where they’ve been, or whether the new owners will repeat the mistakes of the past. But hey, even if they do, they’re still going to be pretty cool right, because they bought a startup and startups are cool.

So you want to buy a startup?

Research & References of So you want to buy a startup?|A&C Accounting And Tax Services

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