When an investor invests in an early-stage company, they may already be considering the various exit pathways that a startup could pursue. Some may consider an initial public offering (IPO) to be the ultimate goal, but what happens if the more common outcome occurs where a startup is acquired before an IPO? In this blog, learn more about what an acquisition before an IPO means for early-stage investors.

Acquisition Before IPO

While an acquisition and an IPO are both exit events for a startup, each has its own benefits, limitations, and impacts for investors.

IPO

An IPO occurs when a private company offers its shares to the public for the first time, listing them on a stock exchange like Nasdaq or NYSE. This process allows the company to raise significant capital from public investors and also holds the potential to provide liquidity to early-stage investors and employees. For many investors, an IPO is considered to be a more favorable exit event in the expectation it could lead to better results but that is not always true.

Acquisition

On the other hand, an acquisition occurs when another company purchases the startup. This can happen at any stage of the company’s lifecycle, from early-stage to when a company may also be considering an IPO. Acquisitions are often driven by strategic goals, such as acquiring new technology, entering new markets, or eliminating competition.

Understanding the Acquisition Process

For early-stage investors, an acquisition can be a positive outcome, but it can be important to understand how the process works and what it means for your investment. Here’s a breakdown of some of the key steps involved:

• Negotiation and Due Diligence: The acquiring company will conduct thorough due diligence to assess the startup’s financial health, intellectual property, customer base, and other assets. During this phase, the terms of the acquisition, including the purchase price and structure of the deal, are negotiated.
• Approval by Shareholders: In many cases, the acquisition must be approved by the company’s owners or shareholders. As an investor, you may have the opportunity to vote on the deal, depending on the terms of your investment and the company’s bylaws.
• Closing the Deal: Once the acquisition is approved, the deal is finalized, and the acquiring company takes ownership of the startup. This is when shareholders receive their potential payout or new shares in the acquiring company, depending on the structure of the deal.

How Acquisitions Affect Early-Stage Investors

When a company you’ve invested in is acquired, the impact on your investment depends on several factors, including the terms of the acquisition, your position as a shareholder, and the structure of the deal. Here’s what you need to know:

1. Payout Structure

The payout structure of an acquisition determines how much money you’ll receive and when, if a payout happens. There are two primary types of acquisition deals:

• Cash Acquisition: In this scenario, the acquiring company pays cash to purchase the startup. As a shareholder, you could receive a portion of the proceeds based on your ownership stake. The amount you receive will depend on the purchase price and the order in which shareholders are paid.
• Stock Acquisition: Instead of cash, the acquiring company may offer its own stock as payment. In this case, you may receive shares in the acquiring company, which you can hold or sell depending if there is liquidity available for the new shares and your investment strategy.

2. Liquidation Preferences

One of the factors influencing your payout in an acquisition is liquidation preference. Liquidation preferences determine the order in which shareholders are paid during an exit event, such as an acquisition. Here’s how it this process may work:

• Preferred Shareholders: Early-stage investors, such as venture capital firms and angel investors, often hold preferred shares. These shares come with liquidation preferences, meaning preferred shareholders are paid before common shareholders (usually founders and employees). The amount paid to preferred shareholders is often a multiple of their initial investment (e.g., 1x or 2x).
• Common Shareholders: Once preferred shareholders have been paid, any remaining proceeds are distributed to common shareholders. If the acquisition price is not high enough to cover the liquidation preferences, common shareholders may receive little or nothing.

As an early-stage investor, it can be important to understand the liquidation preferences associated with your investment. If you hold common shares, your payout could be significantly reduced if the acquisition price is low.

3. Earnouts and Contingent Payments

In some cases, the acquiring company may structure the deal to include earnouts or contingent payments. These are additional payments made to shareholders if the acquired company meets certain performance targets after the acquisition. Earnouts can be a way to bridge the gap between the seller’s and buyer’s valuation expectations, but they also can introduce uncertainty for investors.

4. Tax Implications

An acquisition can have tax implications for investors. If you receive cash or stock as part of the deal, you may be subject to a taxable event, for example capital gains on any profits . The tax rate will depend on how long you’ve held your investment and your overall tax situation. It’s a good idea to consult with a tax professional to understand the specific implications for your investment.

What Happens to Your Shares?

When a company is acquired, your shares are typically converted into cash, stock in the acquiring company, or a combination of both. Here’s what you can expect:

• Cash-Only Deals: If the acquisition is a cash-only deal, your shares will be bought out, and you’ll no longer have any ownership stake in the company. You’ll receive a potential payout based on the terms of the deal and your position as a shareholder.
• Stock-Only Deals: In a stock-only deal, your shares in the startup could be exchanged for shares in the acquiring company. The number of shares you receive will depend on the exchange ratio specified in the deal.
• Mixed Deals: Some acquisitions involve a combination of cash and stock. In this case, you could receive both a cash payout and shares in the acquiring company.

Benefits and Limitations of Acquisitions

An acquisition can be a positive outcome for investors, but it’s not without its challenges. Here’s a look at the potential benefits and drawbacks:

Benefits

• Liquidity: An acquisition could provide liquidity for your investment, allowing you to realize returns without waiting for an IPO.
• Availability: Acquisitions occur more often than IPOs, which can be delayed or canceled due to market conditions.
• Potential for Returns: If the acquisition price is higher than what you paid for your investment, you have the potential to earn a return on your investment.

Limitations

• Lower Payouts: In some cases, an acquisition may result in lower payouts compared to an IPO, especially if liquidation preferences reduce the amount available to common shareholders.
• Loss of Control: Once the company is acquired, a previous owner typically no longer has a say in its operations or future direction.
• Tax Implications: As mentioned earlier, an acquisition can trigger a taxable event,.

Key Considerations

It’s important to note that an acquisition or an IPO are not the only two outcomes for a startup. A startup could choose to stay private while also maintaining strong standing in the private market and not seek out acquisition opportunities, negating either result. The other main outcome for a startup is unfortunately failure. All investments are risky, and the private market is especially risky with its high failure rate, illiquidity, and uncertainty. While exit opportunities like acquisitions or IPOs are not guaranteed, each can provide unique opportunitites for investors.

If a company you’ve invested in on MicroVentures is acquired, you will be notified of the transaction and outcome. Please reach out to our investor support team at +1 (800) 283-9903 if you have any questions about an investment you made on MicroVentures.

Are you ready to invest in startups? Sign up for a MicroVentures account start investing!

Want to learn more about investing in startups? Check out the following MicroVentures blogs to learn more:

• Common Pitfalls: Mistakes in Venture Capital Investing
• Investment Asset Classes
• High or Low? Find Your Risk Tolerance
• Navigating the Risks: Why Startups Fail

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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.