The economic logic behind tech and talent acquisitions

There’s been a lot of speculation lately about why big companies spend millions of dollars acquiring startups for their technology or talent. The answer lies in the economic logic that big companies use to make major project decisions.

Here is a really simplified example. Suppose you are a large company generating $1B in revenue, and you have a market cap of $5B. You want to build an important new product that your CTO estimates will increase your revenue 10%. At a 5-1 price-to-revenue ratio, a 10% boost in revenue means a $500M boost in market cap. So you are willing to spend something less than $500M to have that product.

You have two options: build or buy. Build means 1) recruiting a team and 2) building the product. There is a risk you’ll have significant delays or outright failure at either stage. You therefore need to estimate the cost of delay (delaying the 10% increase in revenue) and failure. Acquiring a relevant team takes away the recruiting risk. Acquiring a startup with the product (and team) takes away both stages of risk. Generally, if you assume 0% chance of failure or delay, building internally will be cheaper. But in real life the likelihood of delay or failure is much higher.

Suppose you could build the product for $50M with a 50% chance of significant delays or failure. Then the upper bound of what you’d rationally pay to acquire would be $100M. That doesn’t mean you have to pay $100M. If there are multiple startups with sufficient product/talent you might be able to get a bargain. It all comes down to supply (number of relevant startups) and demand (number of interested acquirers).

Every big company does calculations like these (albeit much more sophisticated ones). This is a part of what M&A/Corp Dev groups do. If you want to sell your company – or simply understand acquisitions you read about in the press – it is important to understand how they think about these calculations.

http://www.engag.io/Abdallah Abdallah Al-Hakim

Nice analysis Chris. So, does this mean that the big company would insist or anticipate that the talent will stay with the acquired company? And who would be key personnel that would be needed to stay the most?

http://www.cdixon.org/ chris dixon

Smart acquirers do careful analysis of incentives etc to make sure this happens. Normally there are named “key people” in the acquisition documents who have extra lock ups.
Anonymous

Chris, same question, if a company is hiring for “talent” how long are the contracts for the talent or the earn outs usually to make sure they retain what they are buying?

http://www.cdixon.org/ chris dixon

It varies a lot, but I’d say mean is 1.5-2 years (normal tech product cycle plus some buffer).

http://andrewbryk.tumblr.com/ Andrew Bryk

Great post. What are your thoughts on the difficulties the startup and the large company face after they perform an acqui-hire? It seems some startups have a tough time getting accustomed and finding the right fit in a larger company, similar to what occured with Dennis Crowley at Dodgeball. I assume that this risk is incorporated into the equation when they are deciding if they would like to do it but we seem to hear many stories where the fit just isn’t right.

http://www.cdixon.org/ chris dixon

Yeah, as I mentioned I am grossly oversimplifying. There are lots of others pros/cons of acquiring. Cons include “integration risk” that you mention. I think most acquirers assume this exists but is lower than hiring/building risk.

http://redesignmobile.com Rocky Agrawal

That makes total sense in the historical case where these decisions were being made.

But for many “products” that are being bought these days, the product is tossed aside and the teams are put to work on things that have nothing to do with the original product.

The calculation needs to also include the risk that the team will bolt. Although many companies claim they have an entrepreneurial culture, a lot of the folks who seek out startups can’t stand the culture of many large companies or for whatever reason wouldn’t be successful in one.

You can address some of this risk with earnouts and retention bonuses, but if the team had a reasonably successful sale, they might not be motivated by that.

http://www.cdixon.org/ chris dixon

If the products are tossed aside, I’d consider that a talent acquisition. Buying for hardcore tech is a common case where product isn’t tossed aside but needs to be integrated. Those acquisitions were the norm 10 years ago but less common now.

Smart acquirers are very good at setting up packages where people stay. Whether they are productive within a large company is a totally different and harder question.

Anonymous

In the bigger company world, it’s sometimes thrown out that 9 out of 10 mergers fail to achieve their objectives, often due to integration issues, CEOs attempting to empire-build, etc.

Any sense of how this compares in the world of tech startup acquisitions?

http://www.cdixon.org/ chris dixon

Very hard to say, but I think the success rate is higher. I think Google claims to track it and says 60% of acquisitions are successful. Also, the distribution of outcomes is skewed. One great acquisition (e.g. Youtube) might pay for 9 bad ones.

Anonymous

Interesting stat about Google and great point about YouTube.

Their acquisition dynamic may be closer to venture capital, while big company corporate development may be closer to PE.

http://twitter.com/mattstraz Matt Straz

There’s far more upside if the acquisition is handled well.

- Leadership: It’s nice in theory to say you can just hire some engineers but in reality you need leaders. Great founders seem to have an innate ability to attract talent and build great teams. If the acquirer is struggling, it’s even more important.

- Culture: Some organizations (media companies, etc.) don’t have much of an engineering culture. Buying startups can help jumpstart the creation of one.

- Market: There’s a huge difference between building a product vs. buying one where even just an initial market has been created. Sometimes its just that last 5% of a product that makes product/market fit really work.

- Brand: When AOL bought the company I co-founded they also got a brand that was well liked by agencies and publishers. 2 years later the brand still exists because presumably because it helps them sell more of their main product (media advertising).

And of course, from a financial perspective, there’s a big difference between CAPEX and OPEX.

2X could be very conservative if things really work out for the acquirer.

http://www.cdixon.org/ chris dixon

Agree completely. I was thinking of including some of these but thought my post might get too long & complicated.

http://twitter.com/goldberg_dan Dan Goldberg

I’m on board with 95% of this post and comment thread. I guess where I lose the plot is on acqui-hires that are either (a) so early stage that there really isn’t any product or IP yet–just a couple of founders and maybe a noteholder or seed investor(s), or (b) a company going down the tubes and the acqui-hire is basically just a fire sale by the company.

Chris and Matt, neither of your last sales were these scenarios–your companies had real products and IP (not to mention brands/goodwill) sought after by the acquirers, and they both were fairly high-profile acquisitions touted highly by the acquirers (at least based on the press I saw around both deals). Plus, the companies were large enough that poaching so many employees would be hard and would probably get the acquirer in trouble from a non-compete perspective.

But, both in scenario (a) and (b) above, those aren’t really concerns. In (a) it’s just a tiny team, and in (b) the target doesn’t really have the wherewithal to make a stink about non-competes. I guess if they really do value the IP in scenario (b), but I’ve not seen that too much.

I guess my bottom line is that we’ve done a ton of both types of deals in the last 18-months and I’ve never quite figured out the logic from the acquirer’s point of view. Perhaps keeping on good terms with VCs (in the case of scenario (b)) is part of it, so those VCs will look fondly upon the acquirer when they come calling about a more successful company in their portfolio.

http://www.cdixon.org/ chris dixon

I’ve never heard a big company M&A person say anything to suggest they care about VCs. In fact, quite the opposite. If loyalty/reputation is a factor, it is usually the loyalty of the entrepreneurs to their investors who had faith in them.

Some big companies do try to simply hire and not acquihire. Sometimes it works and sometimes it doesn’t. It’s a very competitive market for very good teams.

http://twitter.com/VilliSpeaks Villi Iltchev

Chris – I think in theory what you are saying above is sound. However, I think it is probably right in the long-term. In the short-term, the buyer has only pain and no gain. When you buy one of these small startups, you inherit the cost of the team and you usually do not add anything to the top line. In fact, the more-exciting and faster-growing the company, the less profitable it probably is. So, it puts a lot of strain on your resources and nobody rewards you in the short-term. Every time you do one of these deals, you are in essence taking resources from another group within your company.

Thus, I really don’t think in the way you described above. My calculus is different.

I do want to distinguish between deals involving a young startup, with a good product that you care to retain vs. no-IP talent buys. This is about the former.

Building a product from scratch is really, really hard (as you know much better than me).

- You need to find top talent internally, move them from whatever else they are doing (hard to do), and put them on the new project. The forces of Innovators Dilemma are in full force here.

- Even if you could pull that off, this team typically does not know much about the new market/product you want to build, or even have the passion for it.

- It will take you 1-2 years to get something to the market that is maybe on par with where the competing startup is today. By then, competitors will be far ahead and probably the market would have moved away from your initial target as well. You may have a product that is on par in 3-4 years, if you are lucky.

- If you have to hire from scratch to build this team, it will take you 6-12 months to assemble the right team.

- The execution risk, competitive risk, and market risk of the internal build option is often times unbearable. Usually this is not a price a strategic is able to afford.

So, in thinking build vs. buy, I often times go through this exercise and ask lots of question to get a good sense of the cost, time, and likelihood of success if we build. Do we even have the vision, expertise, and technical wherewithal to pull it off. As you know, time to market is so critical and if you get too far behind, you can’t recover no matter how much resources you throw at it.

Of course, I try to size the market, build models, etc. But at the end of the day, what a buyer is willing to pay is really driven by how critical is success for this product initiative and the scarcity of the alternatives, including the internal build option.

http://www.cdixon.org/ chris dixon

Thanks Villi. Great points. One thought re your specific situation: salesforce acquisitions seem to be more “forward thinking” (VC like) lately than most big companies. Instead of buying something to bolt on to increase revenue (e.g. Cisco buying new infrastructure pump through their sales channels) you are buying stuff to expand your cloud portfolio. I wonder how much this difference informs your views. (I don’t expect you answer this btw).

I agree about all your points about trying to build internally. My experience is that it is very hard, in startups and in big companies. It is worth it to pay up a bit for someone who has already de-risked product development. I suspect that overall the VC’s lose on this game and the big companies win. E.g in anti-spam back in 2003 there were dozens of companies funded by VCs. The VCs lost money overall. Big companies picked up the winners (Brightmail, Postini, Ironport) and paid a premium but overall got a bargain vs doing R&D from scratch.

Teeter

Chris, I’ve always been curious why companies “acqui-hire” for talent and discontinue their products. If talent is what they want from the startup, it seems more cost effective to entice key employees to switch jobs by offering them better salaries, bonuses or something else. What am I missing?

http://www.cdixon.org/ chris dixon

I suppose in a world where there was only one company trying to hire great tech teams that might work. I’ve seen companies try to do that and they almost never get the people because someone else offers to acquire the whole team. Besides hiring competition, by the time the company actually folds most of the team has dissolved and gone to different places.

http://twitter.com/VilliSpeaks Villi Iltchev

In addition, these companies have intense loyalty and a sense of obligation to their investors. They will do anything to take care of their investors. An acquihire allows them to create some value so the investors can get something back. This is really the primary reason these deals get done, despite the pundits claiming that angels and VCs hate them, which is BS.

http://www.cdixon.org/ chris dixon

Obviously VCs/angels prefer some money over no money. But there is definitely a sense that with acquihires the investors can end up spending disproportionate amounts of time for a return that has a negligible effect on the portfolio. I’ve also seen cases where companies sold for low prices when they didn’t have to. I think this is what people mean when they say investors don’t like acquihires.

Teeter

I’m a little confused as to which VC/investor you guys are referring to here. Let me be more explicit.

There is the big company A (Google, Facebook, etc) buying a small company B. Acqui-hires make sense if the product that company B makes hasn’t gained enough traction in the market but has a talented group of people. Investors, employees, founders of company B could be happy with an acqui-hire as an exit strategy. But from company A’s viewpoint, why not simply entice key employees of company B to leave instead of buying company B as a whole, which includes paying for a product or intellectual property that company A is going to throw away anyway?

http://www.cdixon.org/ chris dixon

Big companies can and do try that. I saw that happen recently but then another big company offered to acqui-hire the team. So the company that tried to hire them lost the talent. It is incredibly competitive for great talent.

Other considerations: the founders usually want to get some money back to investors, so try for acqui-hires over outright hiring.

also, if a big company met under the auspices of acquisition, it is often considered unethical to then try to hire the employees. I’ve seen big companies suggest the hiring strategy but then it gets shot down by a senior person on ethical grounds. (If the company dissolved and then they made job offers, that wouldn’t be an issue).

Finally, companies that actually fail usually lose people at different times to different places. It is very hard to get the whole team together again.

Teeter

That’s interesting insight about the ethics of acquisitions. Thanks.

http://veespo.com David Semeria

You’re assuming acqui-hires relate only to the team. But if you buy the whole company you also get the IP in addition to the people who built and know how to run it.

http://twitter.com/mktgwithmeaning Bob Gilbreath

The other huge, oft-ignored difference is that internal investment is a hit to the income statement, while an acquisition is a use of available cash from the balance sheet.

Companies are under enormous pressure to minimize operating costs and head-count, but it’s relatively “free” to use cash.

http://www.cdixon.org/ chris dixon

Yeah, agreed. Opex vs capex. Academics say it is impossible because of efficient markets but anyone who has been through it knows that is false. Relatedly, people who think acquisitions are related to tax optimization (cap gains vs ordinary income) are very misguided. I’ve never heard tax optimization mentioned in the many conversations I’ve had on these topics.

http://www.facebook.com/profile.php?id=502477211 Stephen Balaban

Another intrinsic feature of buying a company is that the market has already vetted the team and specific implementation for you. Imagine being able to build N teams for free, see which are the most fit, cull the herd and repeat. With the market conducting search over the problem space, the company can (for a premium) reap the cream of the crop.

http://www.cdixon.org/ chris dixon

Yes, thanks, well put.

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