The article is contributed by Anand Bhushan, Chief Executive Officer, Educrack.
Instagram, the photo-sharing app was acquired by Facebook for $1 billion with only 13 team members at that time. Everyone thought and said that it was insanely overvalued at the time, but now I wonder if anyone would dare oppose the fact that it might be one of the greatest acquisitions of all time. There has been a multitude of successful acquisitions of startups, even so, there are some considerations that must be understood and kept in your deliberations as boundary conditions, before acquiring a startup.
The most important question to be answered is why acquire? Why not create from scratch on your own?
Factors to Look Into for Acquiring Startup
Cost to Develop Service
The first issue that needs to be looked into is, what would it would cost to develop the service, in terms of cost, human resources and also in terms of the time that would be required to develop it. For example, if it is going to take 6 months to develop the service then there would be no revenue during this period. That is also a cost; opportunity cost-are you willing to live with this and have built it in your costing? The acquisition will work only if there is a substantial saving of time or money or both.
The next thing to be examined is whether, by startup acquisition, revenue realisation is going to start immediately or how much time would be required to spruce up after the acquisition for revenues to start. It makes little sense to acquire a startup if the gestation period is too long. The interest costs associated with the gestation period can eat into the profitability of the venture. In the edtech sector, we have observed that if half of the course is ready to be delivered, the course can be launched and the revenue realisation can start immediately. However, one needs to be extra cautious to ensure that the promises made to the student are fulfilled.
Another aspect that needs to be examined is the reputation of the startup. Though there may not be many who are using the service at that time, it is important to take into consideration the views of the people, though a small number, who have used the service. In today’s world where almost, everyone is connected digitally, negative feedback spreads through social media rapidly but positive feedback rarely does so at the same speed, hence checking on the current user experience is important.
Startup Work Culture
It is a universally acknowledged fact that organisations have their own distinct culture and work environment which initiates and flows from the leaders and employees of that organisation. If a startup has been successful in creating a service and making it marketable, it is the result of the initiative and hard work of the people associated with the company. This is an important fact to be recognised. To ensure continuity of success, it is imperative that the existing employees do not act hostile towards the new owners and vice versa. Some systems indeed would need to be put in place to scale up the startup, which may be resisted by the old employees, especially if communication clarity is missing. Therefore, this has to be done smoothly by taking them into confidence. High-handedness will not work. After all, a system is only as good as the people associated with the system.
Nowadays, in the rush for getting higher valuations, profitability has taken a back seat. While valuation might be important in getting an investment, for the investor profitability should always be higher on the agenda. For this, due diligence needs to be done on both the sector in which the startup is operating and the startup itself.
Pricing of Services Offered
Today, it has been observed that many startups provide certain services free of cost, or at an enormous discount so that the number of users of the service increase. This increases the valuation of the startup. However, it dents their profitability. The due diligence process should examine whether customers would be willing to pay a higher price for the services. Are the services of such a quality that the users would pay more? That is the crucial question. It may happen that the quality of the services is so low that people will use it only if it’s free. That finding would be discouraging. “Present value of future cash inflows” is fine. But there should be a clearly established path to profitability and this should be achieved within a strict time frame.
Product Life Cycle
From a macro-economic perspective, the Product Life Cycle also needs to be looked at. Suppose, it is going to take three years for the startup to break even. Is the service being offered by the startup going to be relevant and innovative till that time?
The last checkpoint where it makes sense to acquire one is if it matches the area of existing work. This means, the startup itself is not in that good a state but you believe that with your existing system and resources either you can make the startup profitable or with the tools and resources of the startup, you can make your existing problems go away. In both cases, if you have done good market research and the odds are in your favour. Chances are that you might end up getting the acquisition at a fair amount and make it the best of both worlds. Synergies are important. Remember, proper research and analysis are the keys.
The only thing one can say about an acquisition making sense is that- “It depends”. Depends on how much time the startup has spent in the market, depends on what problems they are having, depends on your capability of solving those problems and also depends on the resources you have to make it work or use the startup’s resources to make something of your own known to the world. The thing is, if this all makes sense, then “Go for it”.