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.

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