Tying Two Rocks Together: Why Venture-backed Startups Should Exercise Caution When Considering Acquisitions
- Between 70% and 90% of acquisitions fail—placing a significant burden on the acquiring firm.
- Acquiring another venture-backed startup at an early stage can aggravate cash flow issues, leading to a reduced cash runway and financial instability.
- The distraction caused by an acquisition can be detrimental to a startup’s core business.
The conventional wisdom is that a particularly good time for venture-backed startups to acquire other startups is during an economic downturn, such as the one we are currently experiencing. And with the failure of Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank still looming large in our rearview mirrors, more than a few startups are battered and looking for a lifeline—in the form of cash—to shore up their bottom lines and help weather the storm.
I’m here to tell you that, in this case, the conventional wisdom is wrong.
As a venture investor who has navigated both the highs and lows of the startup ecosystem, I have seen many venture-backed startups succumb to the temptation of acquiring other startups, particularly during market downturns. While it might seem like a smart move to consolidate and strengthen a company’s position during a downcycle, the reality is often far more complicated, and the outcome much less certain.
The analogy that tying two rocks together does not make them float holds true here. Venture-backed startups should be cautious when considering acquisitions, particularly if they are not yet at scale or cash flow breakeven. Here’s why:
The High Failure Rate of Acquisitions
According to recent studies, between 70% and 90% of acquisitions fail—placing a significant burden on the acquiring firm. While large, habitual acquirers have the ability to absorb these failures—the occasional big wins make up for the many losses—venture-backed startups often lack the resources and experience to weather such failures, leading to devastating consequences for their businesses.
The Cash Flow Conundrum
Acquiring another venture-backed startup at an early stage can aggravate cash flow issues, leading to a reduced cash runway and financial instability. This can be fatal in a tough fundraising environment, as startups struggle to secure additional funding to support their operations. A study by Startup Genome found that 74% of high-growth startups fail due to premature scaling, which often leads to burning through cash faster than the business can support. This is especially true when both companies are still in the growth phase and have not yet reached a stable and scalable business model.
Valuing startups accurately is notoriously difficult, and venture investors on one or both sides may be quite unreasonable. Overpaying for an acquisition target can result in substantial financial strain on the acquirer while underestimating the target’s value can lead to lost opportunities.
Integration Challenges and Loss of Focus
The distraction caused by an acquisition can be detrimental to a startup’s core business. Time and resources that could have been spent on refining the product, enhancing customer relationships, or expanding the team are instead diverted to managing the newly acquired company. Successful post-merger integration declines when the acquiring companies lack expertise in mergers and acquisitions and when there is limited human resource capacity. These factors are often the case for startups, which are already stretched thin as they scale.
Cultural Clashes and Employee Attrition
Early-stage startups often have distinct cultures that may clash, leading to employee dissatisfaction and attrition. According to a KPMG report, one of the main reasons acquisitions fail (KPMG put the failure rate at 83%) is because of cultural differences. The loss of key talent and the disruption of a harmonious work environment can severely impact a startup’s ability to execute its vision and maintain momentum.
Conclusion: Go for Organic Growth During the Current Down Cycle
In a down cycle, the smart move for stronger, well-funded startups is to resist the temptation to acquire distressed venture-backed companies and instead focus on growing organically. This means achieving scale and reaching cash flow breakeven before considering the acquisition of distressed companies.
By focusing on organic growth, startups can maintain control over their operations, preserve their culture, and increase the likelihood of long-term success. Startups should leverage the current economic climate to strengthen their core businesses and emerge as industry leaders, better prepared to make strategic acquisitions in the future when they have achieved scale and financial stability.
As the old adage goes, “If you want to go fast, go alone; if you want to go far, go together.” In the world of venture-backed startups, going far often means growing organically and cautiously, considering acquisitions only when the time is right.