The slowdown in funding is making it incredibly difficult for startups to raise money. As a result, more mergers and acquisitions (M&A) will take place in the near future. Many founders will look for an exit by looking for a buyer, as they may not have any other options to avoid going bankrupt. At the same time, lower valuations make M&A more appealing for financial and strategic investors who want to enhance their portfolio or grow their business without spending too much money.
Macros Point Towards More M&A in Tech
Many companies raised two to four years of runway in 2021. As their runway is coming to an end now, they find themselves in a very different market environment. Since the beginning of 2022, European tech companies in both public and private markets have experienced a loss of around 400 €B in value according to the recent State of European Tech Report by dealroom.co, based on data by S&P Global. This caused the total ecosystem value to drop from its 2021 peak of 3.1€T to 2.7 €T.
Unsurprisingly, in 2022 VC deal value YoY also dropped for the first time in the past decade according to data from PitchBook. European VC deal value decreased by 16% last year while fundraising stayed mostly on par with 2021 – suggesting VCs sit on a lot of dry powder for the time being. In fact, the European VC ecosystem is expected to have a record amount of 60 €B in dry powder in 2023.
Despite record volumes of dry powder, VCs are less willing to take risks. Instead of investing in new companies, they are providing bridge financing to their existing portfolio companies. This results in less funding being available in the market, especially for startups beyond their Series A stage. This funding decrease is particularly noticeable for companies that are not demonstrating strong commercial numbers and traction.
The reality of the new market environment is reflected in the study State of European Tech, in which 82% of founder respondents believe it is now harder to raise venture capital than it was 12 months ago. VCs share this impression, by stating that the change in the market environment has impacted fundraising dynamics for their portfolio companies. Overall, fundraising takes longer and there are more bridge or extension rounds as well as slower decisions by investors. In addition, exit processes are delayed and investors demand more extensive and deeper due diligence.
PE deal value remained rather resilient according to data from Pitchbook, although European PE exit value reaching a nine-year low in 2022 as is down approximately 13%. Megadeals also hit a nine-year low, but there were more smaller deals. For 2023, analysts expect the value of take-private deals to reach 30 €B, with fewer than 40 PE-backed public listings to take place.
Overall, European M&A remained quite robust: We saw a record number of 17,900 deals, a YoY increase of 11.7% from an already record-breaking year. Although the value of European M&A deals declined, this indicates that there were more deals with slightly lower values compared to 2021, as mentioned above.
As the conditions remain very much the same and for some tech companies even turning more dire, we expect to see even more M&A activity in 2023. At the same time, companies that are in a position to acquire other companies are taking advantage of lower valuations, which allows them to acquire high-quality technology, strategic partners, or talented people at a more reasonable price. Therefore, we predict that 2023 will be a year of tech startup M&A, potentially including Series A and even some seed companies.
Different Tech M&A Scenarios and How Tech DD Supports Them
First, there is the financial M&A scenario, in which a company is acquired by financial investors, particularly Private Equity players. The lower valuation in the market is a major driving force for financial investors to increase their funding and acquire companies at a reasonable price, thereby improving their risk-return profile. For them, it is critical to verify the product’s capability and evaluate any technical risk that may impact their growth plans. For this financial investors should rely on a deep tech due diligence.
Buy and Build
Then there are the buy-and-build cases. With the help of a Tech DD, these investors want to understand the integration capabilities of the company they plan to acquire. If the company is a platform, they want to understand if they can add other components to increase its capabilities. If it’s an add-on to a platform, they want to understand how the technology of the company they plan to acquire integrates with that platform and if the integration is feasible based on the PMI schedule and the potential technical outcome. Integration risk is usually highly underestimated by many Private Equity investors, as it can make or break platform acquisitions.
Strategic M&A is all about acquiring companies that align with the long-term goals and objectives of the buyer company. The focus lies with the potential of the company, such as the team, technology stack, or product. This can be seen in both scale-ups acquiring competitors and corporates acquiring startups.
The idea is to increase existing capabilities and leverage the strategic potential of the acquisition. Throughout the acquisition process, it’s important to evaluate the potential synergies and benefits by conducting a Tech DD. This includes things like product complementarities, technology integration, and market fit.
Product or Technology Acquisition
Product or technology acquisition is another type of strategic M&A. This happens when a buyer sees potential in the product or technology of another company and wants to add it to their existing product line. The aim is to enhance their offering and increase market share. Through a Tech DD, acquiring companies want to understand and evaluate the technical feasibility of the product or technology, understanding its limitations and future roadmap, and assessing the risk of integration with their existing systems and processes.
The technical team of the buyer company will typically be involved in evaluating it to ensure it’s a good fit. It’s crucial for the acquiring company to understand the technical capabilities of the individuals they plan to get on board to make sure the integration goes smoothly and meets their innovation goals. Evaluating the technology and product being developed by the target company can also help the buyer assess the potential future impact of these individuals. To make sure the integration is successful, it’s essential to get a clear understanding of the capabilities and skills of the individuals in the target company, as well as their track record of achieving their technical goals. The buyer also needs to consider how well they fit with their vision and objectives.
M&A for Integrity of the Tech Value Chain
It’s important to consider the health of the startups that play a vital role in your tech value chain. Without fully understanding the potential impact of a startup’s failure or disappearance, companies risk facing significant disruptions in their operations. For instance, many tech firms rely on startups for payment infrastructure, but often overlook the risk of a startup going bankrupt. In such cases, the impact on a company’s operations could be severe.
To avoid these risks, some companies choose to acquire critical startups and take control of their products. However, to do this successfully, companies need to carefully evaluate the technical risks and reliability of the product with help of a Tech DD, and then plan for a smooth transition to in-house operation. It’s also important to have a well-structured plan for post-merger integration (PMI), including retaining key team members and ensuring a seamless transition to the new operation.
AI Companies Pursuing M&A for Proprietary Data
Another scenario, that we will see much more in the tech scene, has to do with the recent rise of strong AI business cases. This M&A type can be considered a combination of both the strategic integration and the functional aspect of the tech value chain. Here, companies are acquiring other companies, even those from traditional industries, for their data.
In the AI industry, many companies are building their own machine learning models and intellectual property. The differentiating factor between these models is the data used for training. To enhance their models and achieve a competitive edge, many companies are seeking to acquire data providers or companies that have been collecting data for a while.
In this scenario, the main focus of the Tech DD would be to comprehend the data collection methods, validate the data’s continuous availability, and assess the diversity and integrity of the data set. In some traditional industries, the data’s labeling and diversity may not be ideal for machine learning, requiring substantial effort to clean and label the data. If the data set lacks diversity, the investment’s return will not be favorable. So, it’s crucial to evaluate the data collection process, its sustainability, and the diversity and quality of the data set.
Have Technical PMI on Your Radar
Currently, there is a lot of emphasis on cultural aspects and general PMI, but neglecting the technical PMI may lead to the failure of the acquisition. That’s why it is essential to execute the technical PMI correctly. This aspect is often underestimated, but it’s crucial to the success of the M&A case. If the integration of the technology stack is poorly planned or has incorrect goals, it can result in failure, dissatisfied customers, and negatively impact business performance. That’s why it’s essential to prioritize technical PMI during integration planning for tech companies.
Tough times will in part become a test of strategy for companies, and also of character for founders and tech leaders. During these periods of pain it is important to keep in mind that pain is temporary. Tech remains strong in Europe, despite the current setback. It will continue to be a massive wave of transformation, with many future opportunities yet to come. At the same time, tech companies need to face and adjust to the realities of the current market and find the best solution at hand. For financial and strategic investors, this can be a time of opportunity. But the technical risk of any M&A case should be effectively bridged with solid due diligence and the technical integration carefully planned and properly executed.