We know 2023 was not a great year for M&A activity, but seed- and early-stage startups fared much better than their later-stage counterparts. A recent PitchBook article addresses this, highlighting data that shows young startups were much more likely to be the targets of acquisitions last year, a trend that looks to continue into 2024.

The PitchBook NVCA Venture Monitor data shows 151 seed-stage startups were acquired in 2023, and while that might be the lowest number since 2017, it is still much higher than the number of later-stage targets that hit a ten-year low. So why has there been a shift in targets?

PitchBook points out that several factors motivate early-stage companies to sell early. For example, founders still retain much control and ownership at the very early stages. Therefore, a sale at that early stage provides them with a much more significant percentage of the sale proceeds than they would likely receive if they sold later after several rounds of financings.

There is also the issue of fundraising in the current economic climate. While conditions are improving, we have seen a slowdown in funding at all stages for some time now, with investors being highly selective with where they are putting their money. If a company is cash-strapped, a sale is a desirable option to avoid shuttering altogether or securing investments with less than favorable terms.

Selling early makes sense when founders do not have another option, which seems to be a place many startups have found themselves in over the past year. An article in Fortune last year signals that mergers and acquisitions could be poised to “explode” this year, with nearly 1,200 companies expected to run out of money. So many founders are likely still looking for an off-ramp this year as funding remains in short supply.

There are certainly some benefits for founders who choose this path, as they can avoid the multiple funding rounds ahead of them and exit with a bigger check. However, this might not be so attractive to investors who would certainly prefer a later-stage sale when their return on investment will be greater.

There are also other issues to consider, such as limited negotiating power – with buyers having more control over terms at this stage. Because these early-stage startups have an incomplete proof of concept and less of a track record of success, they do not have the leverage to negotiate favorable terms such as earn-outs or performance-based incentives. Founders are also walking away without realizing the full growth potential of their company and the higher valuation that comes with it.

We are seeing venture capital backers of early-stage companies encouraging struggling parts of their portfolio to reinforce their chances by combining in mini-acquihires. We are seeing later-stage private companies offering common stock to buy seed-stage companies to acquire unique groups of engineers and technology.

What happens to the target’s existing SAFEs, convertible notes, and options? Who gets the residual cash? What happens to the customer agreements, inbound and outbound licenses, and tax liabilities? The decision to sell – and how – at any time – involves a great deal of consideration and a thorough examination of the risks and rewards and the motivating factors for founders and their investors. While selling early might seem like the only option, as startups face many roadblocks, working with counsel and advisors to consider all options and outcomes is critical to ensure the most favorable outcome for all involved.