Uthishtan Ranjan, a B2B software investor, published an interesting post on merging two SaaS businesses through an equity swap. It made me reflect and expand on the example. Before reading on, it’s helpful to read Uthishtan’s post first. TLDR; here is the premise of his merger case:
[…] you are a $20m ARR business growing 40% a year and believe your business is worth around 7x ARR ($140m). You have the opportunity acquire a $10m ARR business, growing 5% a year for 3x ARR ($30m).
Theoretically, if you pay 3x ARR for the $10m ARR business and its now valued at 7x ARR ($70m) because its part of your group, you have made $40m.
However, your blended growth has fallen from 40% (standalone) to 28% (blended) which will have a valuation impact on your group. As a result, your valuation multiple falls from 7x to 5x, meaning your new group is worth 5 x (20+10)= $150m.
So, what is the net result?
You have paid $30m for this acquisition but your group is now only worth $10m more. 𝗦𝗼 𝘆𝗼𝘂 𝗵𝗮𝘃𝗲 𝗺𝗮𝗱𝗲 𝗮 𝗹𝗼𝘀𝘀 𝗼𝗳 $𝟮𝟬𝗺 𝗳𝗿𝗼𝗺 𝘁𝗵𝗶𝘀 𝗮𝗰𝗾𝘂𝗶𝘀𝗶𝘁𝗶𝗼𝗻.
Moreover, Uthishtan cautions that mergers are potential management distractions that weigh more than attractive acquisition multiples and need compelling synergy drivers to be accretive.
We must examine the pros and cons before walking away from this equity swap merger opportunity.
Firstly, a theoretical observation. Given the acquirer’s valuation of 7x ARR, an equity swap ‘paper’ loss is already baked into the combined ARR, which is 5.7x ARR at the 3x ARR purchase value. If the combined market valuation is 5x ARR, then a fair purchase multiple would be 1x ARR.
Secondly, looking deeper at the practical reasons for going ahead with an equity swap acquisition, I took the liberty to expand on Uthishtan’s example because there are always challenges for good VC-backed companies to raise a new round, and there need to be more exits to unlock value from the ‘just-surviving-not-able-to-raise-a-new-round’ VC-backed companies.
So, here it goes.
If you are growing a $20m ARR business 40% annually with a cash-burn efficiency ratio of 1x and we assume you have 12 months runway left, you have a cash balance of $8m.
There may be a good reason to suffer a paper equity swap loss by acquiring a slow-growing peer. Let’s consider two cases: a wrong and a (potentially) good.
1. A wrong acquisition. You overpay for a company with little to no chance of raising new growth capital on a standalone basis with a 5% annual ARR growth and no reasonable path to cash flow breakeven. In this case, paying 3x ARR to acquire a $10m ARR growing 5% annually needs further detailing. Due to the slower growth, let’s assume a cash balance of $0.5m is sufficient to keep the company going for 12 months. What did you get, assuming no cost synergies to the combined business? A ‘paper’ equity dilution loss and a weakened position of 28% combined ARR growth when you jointly need to raise capital 12 months from now. As pointed out by Uthishtan, there is no acceptable equity swap ratio without merger synergies and only potential management distractions.
2. A (potentially) good acquisition. You are ready to suffer an equity swap ‘paper’ loss to extend your cash runway. How could this play out? Let’s assume the 3x ARR acquisition multiple is justified, as it should be, by the target’s cash balance, potential cash generation, and combined cost savings. In this case, as an assumption, our slow-growing target has a cash balance of $2m, can generate an operating cash flow of 10% (approx $1m annually), and net combined synergies can contribute another 2.5% to the operating cash flow (approx. $0.75m annualized). What do you then get? A ‘paper’ equity dilution loss with an extended cash runway to 17 months and 19 months, without and with net cost synergies, respectively.
Going further into the details, paying 3x for an ARR of $10m with a $1m EBITDA means paying 30x EBITDA. Few informed sellers would expect that kind of premium for a company growing 5% annually. Even paying 1x ARR implies an EBITDA multiple of 10x.
The more significant takeaway is that private market investments are illiquid and squarely remain so until they are monetized through an exit, whether through an IPO or an M&A trade sale. Successful M&As require two happy sides: seller and buyer. Paying 1x ARR, in this case, should be value-neutral and provide the combined entity with future flexibility and upside to raise capital as a step towards an IPO or reign in spending for a larger trade sale.
Let’s imagine you and the rest of the board and shareholders – with some help from an advisor – convinces the seller to accept your equity – with all the risk that implies – to combine for a slower-growing future for an exchange ratio at 1x ARR. You’ll now be in the market 19 months from now to raise with a combined ARR of $44.7m at the 5x ARR for a post-money of $223.6m; instead of on a standalone basis 12 months from now with an ARR of $28m at the 7x ARR for a post-money of $196.0m. Given your relative equity share of 92.5% and 100%, respectively, at a 15% dilution to pre-money equity, you created a future merger ‘paper’ profit of $9.2m, unlike the $20m ‘paper’ loss indicated on the date of the transaction as a result of overpaying and not looking into a combined future operation.
The above are just some of the complexities of an M&A opportunity evaluation and the first step toward a successful M&A transaction. Please reach out if you want more information or need assistance with your M&A projects.
First published on LinkedIn