For the past few weeks, I’ve been telling readers about the exciting opportunities that have recently opened up for regular, average investors to own a stake in some of the most innovative companies in the world before they issue shares on the major exchanges.

And while an initial public offering (IPO) is the Holy Grail for early-stage investors, often fetching multiples of many times your investment and higher, acquisitions are by far the most common exit. In my years of experience of being involved in the pre-IPO world, investor exits by acquisition make up about two-thirds of exits.

That makes the ability to analyze what makes a good acquisition target critical to your success as an early-stage investor.

This isn’t an aptitude you’re born with, but it’s a skill you can learn. It’s a technique I’ve picked up in almost ten years working with venture capital firms and angel investors to find the best new startups.

Being able to spot a likely acquisition target involves a little corporate strategy, some financial accounting and an understanding of industry-specific supply and demand. Among the many reasons a startup might be acquired, these five stand out as the most common.

#1: Consolidation And Removing Excess Capacity From An Industry
Fast-growing industries attract new entrants. As the industry matures and growth slows, supply from too many new companies begins to exceed demand and profits shrink. It doesn’t benefit any singular company just to shut down and leave the market but there is an opportunity in acquisitions to combine companies and then shut down underperforming assets. The combined company realizes economies of scale and industry-wide capacity is reduced.

What to watch for in startups: Startups that can demonstrate fast sales growth in industries where established companies demonstrate slower growth may become targets. The startup doesn’t even necessarily need to be profitable if its customers or growth can be added into the buyer’s larger business.

#2: Market Access And New Products
New products and market access are two of the most frequent reasons for startup acquisitions. A startup develops an innovative product that grabs market share or creates a new niche within an existing market. A buyer can gain access to the startup’s customers and add a new product to its portfolio through the acquisition.

#-ad_banner-#Larger buyers can also typically take advantage of existing marketing and sales networks to increase sales and reduce expenses, earning more profit than was possible at the smaller startup.

What to watch for in startups: Watch for startups with unique, innovative products or those with specific demographic or geographic customer bases. It costs a lot of money to acquire a new customer, and it’s often less costly for a large company to gain new customers or markets through an acquisition.

#3: Acquiring Talent Or Patents
Startups often have valuable patents or assets that can be attractive to larger companies. It may be far cheaper for a buyer to acquire the startup than to develop its own competing product or to risk a lawsuit for patent infringement.

The “acqui-hire” is also a popular strategy for startup buyers, especially in the technology space where computer engineers can be worth their weight in gold. The buyer is not necessarily acquiring the startup for its assets or business but to fold its founders and other key employees into the team.

What to watch for in startups: Look for startups with multiple patents on their business or R&D spending that has produced results with a new product. Potential buyers are typically companies whose products complement those of the startup.

Watch for key employees, usually founders with a significant share of the company, for acqui-hire targets. However, serial entrepreneurs are not generally good acqui-hire targets because they are likely to leave the buyer soon after an acquisition.

#4: Business Development
Business development acquisitions often happen when an established company wants to move into a related industry or market. For this reason, judging startups on the potential for a business development acquisition is difficult because it usually depends on an acquirer with an eye on the industry. Google does this extremely well, investing in startups or simply acquiring them at the outset to develop the company before anyone else sees the potential.

What to watch for in startups: One of Google’s key questions when it decides to buy another company is what co-founder Larry Page calls the “Toothbrush Test,” or does the target company produce something that is used at least once or twice a day. Look for companies with a clear product vision, a product with a unique solution, or products that are used every day or have broad usage across a huge demographic.

#5: Underutilized Assets And Improving Target Company Performance
Without access to the capital market through shares, funding for startups is limited. But a larger company can buy the under-leveraged startup and fold its cash flows into the buyer’s capital structure.

The strategy works especially well if the two company’s cash flows are not perfectly correlated, if they do not rise and fall closely because of similar products. Combining the two companies then means less variation in cash flow and likely a higher rating on any debt issued, which would lead to more affordable rates.

Increased debt capacity was used as a rationale for the $104 billion merger of beer makers SABMiller and AB InBev earlier this year. By taking on the smaller company’s debt at the lower rate, the combined firm was able to lower total interest payments by tens of millions.

What to watch for in startups: Being able to use this increased debt capacity isn’t usually a primary reason to acquire a pre-IPO company, but it may be a factor. Watch for startups that have built stable sales and cash flows through years of development and that may not have put much debt on the balance sheet.

This Is Just One Piece Of The Lucrative Pre-IPO Puzzle…
Stick with watching for the potential of an acquisition based on these five factors and you will dramatically improve the odds of a pre-IPO company in your portfolio being acquired for a high premium. This is the same advice I offer to subscribers of my premium newsletter, Pre-IPO Millionaire.

I pull no punches interviewing management, evaluating the market and finding the deals with the highest potential every month. Never have regular investors had access to these kinds of investments and this level of professional analysis…Until now. It’s like having a venture capital firm working for you!

Pre-IPO Millionaire is your first look at some of the hottest companies before they issue shares on the public markets. We bring you the best equity crowdfunding deals so you can invest before the company goes public. To get my full analysis of the most promising acquisition targets and pre-IPO companies on the rise today, click here.