The Blitzhire Acquisition

Over the last couple of years, we have seen a series of acquisitions that have adopted a new and novel structure (I will call it Blitzhire). Windsurf, Character.AI, Inflection, ScaleAI, and Adept are all examples of very exciting AI startups that have forgone the traditional M&A process and adopted a new structure that basically transfers the employees and perhaps the IP to the buyer. But these deals are not what we traditionally refer to as acquihires where the buyer only acquires the team and the remaining startup is shut down. With this new structure, the acquired company survives which is required to facilitate the acquisition.

I admit that this method of acquiring a company is very strange and cumbersome. The opaque nature of these deals makes it easy to assume that there are good actors, bad actors, traitors, and victims. But this is not the case most of the time and this structure is simply a vehicle to achieve everybody’s objectives and facilitate the transaction. I will try to explain the drivers behind Blitzhires and the mechanics in non-technical terms. It is important to emphasize that I am not a lawyer or an M&A practitioner.

What drives Blitzhires

Traditional M&A is usually facilitated through either acquiring the equity of the target or acquiring the assets. When you acquire the equity of a target, the consideration goes from the buyer to the shareholders (and employees) and the acquiror becomes the new owner of the company. The legal entity of the target may or may not survive, but the acquired startup and its employees become part of the acquiror’s group. The alternative structure which is usually driven by liability or tax considerations is to acquire of the assets (IP) of the company and hire the employees. In an asset sale, the consideration flows from the acquiror into the legal entity of the target. The proceeds are distributed to the shareholders after taxes are paid, and the company is subsequently liquidated and shut down.

Regardless of the structure, regulators want to keep a close eye on corporate acquisitions to ensure that consumers are protected. In 1976, Congress passed the Hart-Scott-Rodino Antitrust Act (HSR) which mandates pre -merger notification to the FTC and DOJ before completing an acquisition and establishes a waiting period and extensive investigation process, which often can be longer than a year. Today, any acquisition larger than $126 million must go through a review and potentially an extensive investigation process. The FTC process is slow, unpredictable, and highly politicized which adds risk to any deal. Many observers are rightfully frustrated with the politization of antitrust policy and enforcement. I tend to be a strong proponent of strong antitrust policy, but I also find myself frequently frustrated by the process and politics involved.

In today’s age of AI where everything is moving at an incredibly fast pace, the idea of acquiring a company and going through a prolonged review process is completely unrealistic and unfathomable for both acquirers and startups. If you take Windsurf as an example, Google acquiring the company and having to wait for 12+ months to take over the IP and employees is certainly a dealbreaker. It is completely unrealistic given the intense competition in the market. Even if Google had absolute certainty that the acquisition would clear the HSR process, the delay would render this acquisition impractical and uneconomic. A year in the world of AI is eternity. Speed is everything and speed is the driver for this new Blitzhire structure. It circumvents the HSR review process, allows the acquiror to take over the key employees and IP of the startup, and have the employees with a badge in their office the next day.

How does the Blitzhire structure work

While there is huge variability in how this structure is accomplished, it is important to think of it in simple terms. It is an acquisition. It is an acquisition designed for speed and to circumvent the HSR process. And when you think of it simply as an acquisition, the acquiror needs to offer consideration that is acceptable to the management team (founders), their investors, and very importantly the remaining employees who stay behind. The rest of it is a puzzle, figuring out how to facilitate the flow of cash to each constituent to gain their support for the acquisition. The objective of the structure is to facilitate the acquisition of the target employees and IP but accomplish that in a way that creates a defensible case that the target startup will survive as a viable entity. If you do this in a way that makes the startup fall apart shortly after the acquisition, obviously it was intended to be an acquisition designed to avoid HSR review and you can bet every regulator will be all over it and investigate it.

The mechanics of how this works are as follows. The acquiror will negotiate a non-exclusive license agreement with the startup for their IP. The license agreement for IP is the mechanism to provide consideration to the target startup, whether the acquiror intends to use the IP or not. The money flows from the acquiror into the legal entity of the target. It is important to highlight that the license must be non-exclusive to make this pass the smell test with regulators. The acquiror must establish a fact pattern that the target has a viable business and a plan after the transaction, and it is not a sham to avoid regulatory scrutiny. On a funny side note, this is why you don’t see any law firm taking credit, bragging, or publicly talking about how this is accomplished.

Now that the acquiror has figured out how to transfer the consideration into the startup which has multiple uses (I will get to that in a bit), the acquiror needs to find a way to incentivize the founders and employees they want to hire. This is another puzzle, where you start from what would have happened had you just acquired the company and what every person would have received. The acquiror will extend offer letters to each founder and employee that provides consideration, compensation, and retention incentives for them to go through the transaction. I suspect there is huge variability in how this is accomplished across deals. But it is probably fair to assume that the team will make the same or more over time as they would have in a traditional acquisition. Usually, the founders and team will relinquish their ownership in the startup in their agreement, which will affect the cap table of the startup left behind and how the proceeds from the license agreement will be distributed to the shareholders and remaining employees.

Now that you have secured the support of the investors (via the license agreement) and the acquired team (via their employment agreements), the acquiror must secure the support of the remaining employees with the help of the investors. Remember, everybody is aligned that the target needs to appear as a viable business for this structure to avoid regulatory scrutiny. If the remaining employees walk and the target startup falls apart shortly after the acquisition, there is clear evidence that all of this was a sham. The acquiror needs a new management team (remaining employees) to take over the company and continue to operate it. Thus, enough cash will have to be left in the target startup to execute on their plan. And you have to guarantee the employees a certain level of compensation if they agree to do their best to operate the business and stay with the target startup for a negotiated time. This basically means that a portion of the consideration will also be set aside to incentivize and reward the remaining employees to stick around.

So far, the acquiror has achieved the support of the investors, dealt with the founders and acquired team, and received the support of the remaining employees. Once the consideration lands in the bank account of the target startup, there are four uses for the cash. First, Uncle Sam needs to take his cut. The target will have to set aside a portion of the proceeds to pay the income tax resulting from the license of the IP. This is a HUGE inefficiency in this structure. There are ways to minimize the income tax, but you can’t avoid it. Second, a portion of the proceeds go to the investors. That is accomplished either through a dividend and a share repurchase. The mechanism here is highly technical with lots of legal and tax considerations that are beyond the scope of this post or my understanding. If this is done through a share repurchase, the investors will be bought back, and the startup will become employee owned. Important to note here that share repurchases do not qualify for QSBS. If a dividend, the investors will remain on the cap table. It is important to note that the startup may actually have a viable business after the Blitzhire and may continue to raise additional capital in the future. I believe Inflection is a good example. But, otherwise the startup will continue to operate for a period of time (2 years) and it will be shut down.

The third use of cash is the operating cash that needs to be set aside for the startup to continue to execute on its plan. You have to set aside reasonable capital to credibly demonstrate that the startup can continue as a viable entity. Finally, you need to set aside the cash agreed upon and necessary to compensate and retain the remaining employees for sticking around and running the business.

In summary, Blitzhires are another form of an acquisition and should be evaluated through that lens. Certainly, not everybody may be thrilled of the outcome. Certainly, employees left behind may feel betrayed and unappreciated. Certainly, investors may feel founders may have broken a social contract. But, for a Blitzhire to work, usually everybody needs to work together and align. The driver behind these deals is speed. Maybe concerns over regulatory scrutiny are part of it, but more importantly speed. Not going through the HSR process at all may be worth the enormous complexity and inefficiency of foregoing a traditional acquisition path. Finally, the structure is incredibly inefficient and it just tells you how far acquirors are willing to go in order to achieve their strategic objectives. The structure results in double taxation, which is a huge leakage in value. The acquired startup pays corporate income tax and the investors pay taxes on the distribution of the proceeds, whether via a share repurchase or dividend. The structure is also grossly inefficient in that you need to create a credible case that it is in fact not an acquisition, which prevents the acquiror from acquiring all of the employees of the target.

There is a lot to be improved about our antitrust process, but I am afraid in a dynamic market like AI where everything moves at the speed of light, any process and delay is unacceptable. Thus, acquirors will continue to utilize this grossly inefficient and suboptimal structure in order to maximize the speed of achieving the desired outcome. And finally, none of these deals are outside the reach of the regulators and you can bet they will be investigating them. Don’t be surprised if we see regulators challenge one of these transactions in the future.