Reverse Acquisitions: A New Playbook for Big Tech in the M&A Game

Last Friday, Character.AI informed its approximately 130 employees that Google will acquire the company for a reported $2.5 billion through a strategy known as a “Reverse Acquisition.” Unlike traditional mergers, reverse acquisitions focus on hiring AI or software engineering teams from startups and licensing their core technologies instead of purchasing the entire company. These deals usually close more quickly and with fewer complications.

Unlike traditional acquisitions, where the entire company is purchased, reverse acquisitions involve hiring key personnel and securing licenses for technology, effectively absorbing the startup's innovation while maintaining the larger entity's structure. 

For insights into the accounting of reverse acquisitions, you can find a valuable resource here: PWC.

The Character.AI acquisition is notable because, unlike an “acquihire”, the company was not in distress, and the financial consideration was substantial enough to potentially warrant antitrust scrutiny. However, the deal was structured to avoid such regulatory filings. 

In contrast, an acquihire occurs when a company acquires another—typically a struggling startup—mainly to hire its engineers rather than obtain its products or assets. Acquihires have been a common practice in the tech industry for many years. The financial exit payment in such deals is usually low, with minimal emphasis on strategic value. The acquiring company focuses on gaining the talent and skills of the employees to strengthen its team or fill specific roles. 

The primary aim of reverse acquisitions is to bypass regulatory challenges. In some instances, they serve as a tactic to lower the premium for strategic acquisitions and in some cases shortchange investors. The founders of Character.AI, who were formerly with Google, sold the company to Google. The acquisition price is said to be a licensing fee for Character.AI's technology and involves retaining key personnel. 

In case you aren’t familiar with the practice, the recent Google deal is not the only example of these playing out in the market.

In a recent $650 million deal, according to Microsoft, it will pay $620 million to Inflection AI to license, use its AI models and retain key personnel. The remaining $30 million will be paid to give up any legal rights the company may hold related to the mass hiring. (Microsoft press release here.)

Investors in Adept, an AI startup that lost key employees to Amazon in June, will be reimbursed despite no change in ownership. Adept retains a third of its workforce and will receive $25 million. Investors like Greylock and General Catalyst, who invested $414 million, will mostly recover their funds. Founded by researchers from OpenAI and Google, the startup was recently valued at $1 billion.

What Does It Mean in the Scheme of Things?

This approach to M&A allows big tech firms to integrate cutting-edge technologies and talent without the complexities and scrutiny of a complete takeover, facilitating quicker integration and continued innovation within their existing frameworks. 

By using reverse acquisitions, tech giants manage to evade the intense scrutiny typically associated with major mergers—particularly from the U.S. FTC and SEC—making it a strategic move in a highly competitive technology market.

Google's acquisition of Character.AI, Microsoft's deal with Inflection AI, and Amazon's partnership with Adept demonstrate how these acquisitions allow tech giants to benefit from startup agility while leveraging corporate resources.

Why It Matters

While the practice seems to benefit the market’s 800 lb gorillas, reverse acquisitions and acqui-hires generally present several downsides for founders and investors, including:

1. Lower Financial Returns: The financial compensation in a reverse acquisition or acqui-hire is often lower than in a full acquisition or IPO. This can limit the potential financial gain for founders who might have expected a higher valuation for their startup. Investors may receive lower returns on their investment compared to a traditional acquisition or public offering. Additionally, the deal might not cover the initial investment or expected returns, particularly if the startup was initially valued higher.

2. Loss of Autonomy: For founders, joining a larger company may mean losing control over the strategic direction and culture of the team and technology they likely sacrificed many aspects of their lives to build. They may have to adapt to the parent company's priorities, processes, and culture, which can be a significant shift from the startup environment.

3. Limited Role in the Acquiring Company: Founders may be given roles that do not fully leverage their skills or vision. They will likely not have the influence they had as leaders of their own company, potentially leading to dissatisfaction or a lack of engagement. Startup employees integrated into the larger company might face changes in job roles, expectations, or a decrease in their previous level of responsibility.

4. Impact on Equity: In a reverse acquisition or acqui-hire, equity compensation in the form of stock options or shares might be offered, but the value can be significantly less than anticipated. The terms might not be as favorable as in a traditional acquisition.

5. Reputation and Future Opportunities: A reverse acquisition or acqui-hire can sometimes be perceived as a less successful exit, which might impact the founder's reputation or credibility in the startup ecosystem. This could affect future fundraising or entrepreneurial endeavors.

6. Dilution of Vision and Innovation: The larger company’s strategic goals might overshadow the original vision of the startup. Innovation could be deprioritized if it doesn't align with the parent company's core business objectives, potentially stifling creativity and growth.

7. Regulatory and Legal Challenges: While reverse acquisitions and acqui-hires aim to avoid regulatory issues associated with traditional M&A, they may still face scrutiny regarding antitrust concerns, especially if the startup holds significant market potential or proprietary technology.

The Wall Street Journal reports (here) that the Federal Trade Commission is probing both Amazon’s deal with Adept and Microsoft’s with Inflection to see whether either buyer structured the arrangement to avoid government approval.

The shift towards reverse acquisitions in Silicon Valley represents a change in tech industry exit strategies. This approach can help revitalize tech mergers and acquisitions by providing financial stability and access to resources but it also comes with the downside of lower financial returns and reduced autonomy, often leading to the loss of a startup's unique culture and vision.

Time will tell if this new shift is a fad or here to stay, but in the meantime founders and tech behemoths alike have a new tool to utilize in their growth and exit strategies.

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