Big Startup acquires Niche Software, Part 1

In this example, a VC-backed startup (let’s call them “Big Startup”) wanted to acquire a much smaller business which operated a niche software product which was useful to Big Startup’s customers. Let’s call the smaller business “Niche Software”.

The owner of Niche Software knew that his product was potentially extremely valuable to Big Startup and could quickly propel Big Startup to even greater heights. But Niche Software was only really valuable to that particular company, few other companies would value it so highly.

So, how should Niche Software structure a deal which gets Niche Software some of the upside which Big Startup might enjoy, but without asking for a ludicrously high price? Big Startup recognises that this deal could be enormously useful for them, but they also understand it might not work out.

Obviously some kind of earn-out is needed here, but earn-out based on what metric?

Finding a useful metric is quite tricky in these circumstances. Big Startup wanted to give Niche Software to their customers for free, so you can’t use revenue as a measure of success. Nor even users, because they might get a lot of users theoretically using the software, but not exactly as they intended, or not with the results they hoped for.

Here’s what Niche Software proposed to Big Startup: Big Startup paid £1m for 51% of Niche Software, giving them immediate control but not complete ownership. They could buy the remaining 49% at any time, priced at £1m * x, where x is the increase in Big Startup’s own valuation.

So, if Big Startup raises another chunk of VC money, a year down the road, at 5x their last valuation, then they pay 5x £1m for the remainder of Niche Software. The rationale being that if Niche Software has contributed to Big Startup’s continued success, helping them grow five times as valuable, then Niche Software itself is at least five times as valuable.

If the plan doesn’t work out, and Niche Software turns out to be less useful to Big Startup than they hoped, then Big Startup just never exercises their option.

Of course, Big Startup has 51% control from the outset, so they could choose not to exercise the option even if Niche Software is very valuable to them. But Niche Software is confident this won’t happen: there are some things you can’t do without 100% control, and if Niche Software has become a crucial part of Big Startup, Niche Software is reasonably confident that Big Startup will want to acquire the rest of the shares to keep everything clean and tidy.

Next instalment: how it actually panned out