5 reasons a startup might snap up its neighbor

One by-product of falling startup valuations and the current squeeze on investment will be an increase in startup-to-startup acquisitions

Global venture investing fell by 30 percent or more from Q2 to Q3 this year. There is still a lot of investment firepower around – much more than in 2020 – but it is being more carefully targeted.

In these tougher times, startups need to consider all the options as valuations flatten, cash tightens, and customers cut back in the face of a looming global recession exacerbated by Russia’s assault on Ukraine.

One element of the startup toolkit is often overlooked: merging with – or acquiring – another startup.

When you start thinking about what to do with your company with regard to an exit, the first thought is to consider which large corporation you can pitch to, hoping they will save you before the clock runs out. M&A is usually considered as the preferred path to an exit, a happy ending for founders and investors, if the price is right, as a large multinational snaps up a startup, delivering multiples on capital all round.

The problem is that large multinationals are deliberate and often slow to the uptake, unable to finalize crucial decisions within the timeframe relevant to a startup burning through its last cash resources.

But there is another type of M&A that companies should keep ready in their toolkit for use at times like this, where two small companies merge without the involvement of a major partner.  This may sound counter-intuitive when belts are being tightened. While everyone looks for efficiencies in scale in an acquisition by reducing duplication in effort and function, sometimes acquisitions can actually require more cash, increasing headcount and burn at a time when all eyes should be focused on extending runway in a tight market.

But startups need to do more than merely survive until a bigger player comes by to pluck them. Startups looking for long-term success must think strategically and aspire to become multinational companies themselves. They could be acquired or go public, but a third way of expanding quickly into new territories is through acquiring other startup companies in the same sector.

I predict that one by-product of falling startup valuations and the current squeeze on investment will be an increase in startup-to-startup acquisitions. Down rounds mean that some startups will present bargains for acquirers as well as for investors. Companies that are not successful in raising money will need to seek an alternative exit or disappear. Usually, that alternative will be with a corporate partner. While large corporations deliberate, there will be an increasing number of other, better-funded startups that will see benefits in snapping up smaller companies that, in turn, can help everyone to succeed.

“Amid a venture funding decline and dearth of IPO activity, startups have found a new way to occupy their time: buying other startups,” Rebecca Szkutak noted in TechCrunch in June. While such deals have occurred for many years, Szkutak observes that “until the last few years, these transactions were mainly large and infrequent. Now, they are getting smaller and more frequent.”

There are five benefits in startup-to-startup deals:

1. Product extension

Large partners and customers are increasingly looking for a comprehensive business solution and are less inclined to work with companies that essentially offer only a single feature or two. Companies must offer an entire platform and not a single product. One of your smaller rivals may have an offering that neatly complements yours, enabling the joint result to be a more attractive and complete product solution.

2. Accessing complementary technology

R&D is slow and expensive. Why spend years and hard-won cash developing proprietary technology when the platform you need is up for grabs?

3. Adding talent

In a tight labor market, where job seekers are in great demand, why spend time and management resources on headhunting and hiring when you can acquire an entire company with an experienced, disciplined team? Aquihires have actually become strategic.

4. Distribution and customers

A company that offers complementary or even rival technology will have its own customers and distribution network. Embracing them all not only enhances your offering overnight, it also gives you access to additional markets and customers with established loyalties.

5. Deepening the bench

Startups can flourish or fail due to the depth of the VC advisory and investment team and dry powder behind the company. Merging and strengthening the mentors and supporters of two different startups can help build the critical mass required to survive and prosper.

This is not just a theory.

In 2003, Michael Eisenberg, my then partner at Israel Seed Partners, was the architect of a highly successful merger between Dealtime and Epinions. The merged company, Shopping.com, went public in an IPO backed by Goldman Sachs that raised $124 million on the first day of trading in October 2004. It was acquired by eBay for $634 million less than a year later, in August 2005.

Recently, we have seen an emerging pattern of startup-to-startup mergers in the OurCrowd portfolio.

In June, 2019, data.world acquired Capsenta, adding its virtualization and modeling technologies to data.world’s huge data catalog. In May, 2022, Arcadia acquired Urjanet, folding the resources of the largest utility data provider into Arc, Arcadia’s industry-leading data and API platform, to create a universal software layer for the zero-carbon economy.

Through 2020 and 2021, CropX, a farm management and crop-sensing startup in the OurCrowd portfolio, acquired Dacom Farm Intelligence, CropMetrics and Regen, vastly extending its product offering, customer base, headcount and geographical reach.

“It is very difficult to design a solution to a specific problem a producer faces, test and refine it, and gain market confidence in a short period of time. Our M&A strategy enables us to shortcut this challenge significantly,” John Vikupitz, President of CropX, told AgFunder News. “We believe we’ve been successful for a couple of reasons: a shared vision about the future with the acquired firms’ founders, and an opportunity to be part of a bigger global organization focused on delivering exceptional products to producers.”

In October 2022, Phantom Auto, which allows customers to operate forklifts, warehouse trucks and delivery robots remotely, acquired Sweden’s Voysys AB, a leader in ultra-low latency video streaming.

“With the Phantom and Voysys’ technologies now combined, the resulting product has increased functionality in the most extreme and volatile network conditions,” Elliot Katz, Phantom Auto Co-founder and Chief Business Officer, told Ed Garsten in Forbes. “This will prove helpful as our technology scales to more warehouses and distribution centers, which sometimes have sub-optimal connectivity.”

To illustrate just how effective the integration of Voysys’ software might be, Phantom Auto accompanied the acquisition announcement with a video of a remote-operated race car driving without mishap at 120 MPH.

“Joining forces with Voysys, and integrating their IP into our technology stack, strengthens our core technology for our customers,” Phantom Auto Co-founder and CEO Shai Magzimof told Autofutures.

M&A should not be approached lightly. Most M&As actually fail. Companies should carefully consider the downside. Management and teams can be very hard to integrate. Mergers can distract the focus of the leadership from the main business of the company. They can exacerbate cash problems unless at least one of the companies involved is already producing a steady revenue stream. The process usually dilutes everybody’s shareholding. But it can unlock real value.

There is a myopia about the potential that leads to many people not even considering this path. Dozens of such transactions have happened here in Israel over the past couple of years. I predict there will be more. I expect there to be more consolidation among young companies as a by-product of the tech re-alignment we are currently witnessing. Investors and venture capitalists should be ready to alert their portfolio companies to relevant opportunities.

Mergers need to be handled with care and skill, but they need to be part of the toolkit of entrepreneurs, VCs and investors as they look for strategic alternatives for their companies in the current climate.

Startups should continue to talk to major corporations about potential exit strategies. But there could be another startup next door or in a similar sector across the world that might be the perfect partner to chart a course through choppy financial waters.

About ‘Investors on the Frontlines’

I’m the CEO and Founder of OurCrowd, the global equity investment platform that gives individual accredited investors access to pre-IPO startup deals alongside top-tier VCs. If you are an investor, private family office or financial advisor, subscribe here for my biweekly commentary or follow me on Twitter. I welcome your comments in the response section below.