Three types of acquisitions

There are three types of technology acquisitions:

– Talent. When the acquirer just wants the team (generally just engineers and sometimes designers). As a rule of thumb, these acquisitions are priced at approximately $1M/engineer.

– Tech: When the acquirer wants the technology along with the team. Generally the prices for these acquisitions are significantly higher than talent acquisitions. Sometimes they are even in the hundreds of millions of dollars for fairly small teams (e.g. Siri). The calculation the acquirer uses to price tech acquisitions is usually “buy vs build”. An important component in this calculation is not just the actual cost to build the technology but the opportunity cost of the time it would take them to do so.

– Business: When the company is either bought on a financial basis (the acquisition is “accretive”) or bought based on non-financial but highly defensible assets (Google buying YouTube which had minimal revenue at the time but a huge network of producers and consumers of video).

As large companies mature they move from doing just talent acquisitions to doing talent and tech acquisitions to eventually doing all three types of acquisitions. Usually it takes a startup beating the large company in an important area for the large company to realize the necessity of business acquisitions. For example, Google seemed to dramatically change its attitude when YouTube crushed Google Video. Eventually every large company has a moment like this.

Technology and job creation

In response to my recent post “Making industries ‘garage ready’ for startups“, venture capitalist Jordan Elpern-Waxman made an interesting comment:

If I understand correctly, “garage-ready” essentially means separating design from manufacturing, i.e. “creativity-intensive” processes from capital-intensive ones. This may be an inevitable result of industry maturation and specialization, but there is a downside to it, at least for the so called “developed” nations. The result of differential costs for commodity labor, the fungibility and liquidity of capital, and the ease of transmitting both human and machine-readable information across arbitrary distances, means that capital-intensive processes – i.e. making things – migrate to locations with lower total cost of operations (which, Germany excepted, tend to be locations with lower labor costs). Another way of saying this is that nothing is fabless; the foundry is merely outsourced and moved to a cheaper location. This reality is great for the creative class and for the lower cost locations, but it’s less happy for the residents of the higher class locations that are not so lucky to be part of the creative class.

I’m not ready to draw the conclusion that this is the cause of the economic inequality in the US and malaise across Europe and Japan, but there definitely appears to be some correlation. Again, I don’t know if these results of the “garagification” of an industry can be reversed or mitigated in the name of societal stability, but if anyone can find a way to do it it would be the creative class. Unfortunately, because techies and entrepreneurs are solidly part of the creative class and perhaps even *the* primary beneficiaries of the separation of design and manufacturing, we generally avoid acknowledging or discussing the negative aspects of this trend.

Note that I said “reversed or mitigated.” Trying to reverse or stop these trends is probably a quixotic goal, but perhaps mitigation is in fact possible. For example, is it possible to create a country in which the entire labor force is “creative”? I myself have trouble seeing how such a possibility could be made real, but I’d like to see more intellectuals and entrepreneurs spend some brainpower on the question.

It is true that new technologies often lead, in the short term, to lower wages and fewer jobs. Craigslist, for example, has about 30 employees yet, by replacing the classified ad industry, eliminated many thousands of jobs (local newspaper reporters, classified ad salespeople, etc). The same could be said for almost every popular website.

On the flip side, new technologies have driven down prices (Walmart and Amazon), led to massive increases in information productivity (Google and Wikipedia), and created new income sources (eBay and Craigslist). Greater productivity and lower prices at least partly compensate for part-time jobs and lower wages.

Jordan is right that these are questions we – the technology community – should spend more time discussing.

Always have 18 months of cash in the bank

I was once told by an experienced entrepreneur (I can’t remember who) to always have at least 18 months of cash in the bank. The logic behind this is: 1) as a rule of thumb it takes 3 months to raise money, 2) building/marketing/selling technology always takes longer than you think.  Subtracting 3 months for fundraising and 3 months for things taking longer than expected, this gives you 12 months to execute your plan. (Also you never want to raise money “with your back against the wall” – when you are near the end of your runway.)

More adventurous entrepreneurs might argue 18 months is too conservative. It’s true that following the 18 month rule can be extra dilutive. At SiteAdvisor, we raised our Series A about three months before we were acquired. So we gave up equity for cash that we never spent. But in retrospect, given what we knew at the time, I think it was the right decision.

The question of when to raise money is one of the few times that entrepreneurs and early-stage investors have somewhat divergent economic interests. If you control a large investment fund, you always have the option to extend a company’s runway. The entrepreneur doesn’t have this option. I’ve even heard some entrepreneurs whisper about Machiavellian VCs who deliberately try to get you to the end of your runway so they can negotiate harder. I think this is a bit of a conspiracy theory. Almost all VCs I know care primarily about the success of their companies and not about extracting every last point of equity.

Best practices for raising a VC round

Having raised a number of VC rounds personally and observed many more as an investor or friend, I’ve come to think there are a set of dominant best practices that entrepreneurs should follow.

1. Valuation: Come up with what minimum valuation you’d be happy with but never share that number with any investor.  If the number is too low, you’ve set a low ceiling. If your number is too high, you scare people off. Just like on eBay, you only get to your desired price by starting lower and getting a competitive process going. When people ask about price, simply tell them your last round post-money valuation and talk about the progress you’ve made since then.

2. Never tell VCs the names of other VCs that are interested.  Reasons: 1) if you are overplaying your hand that could send a negative signal.  Most VCs know each other and talk all the time. 2) it is possible they’ll get together and offer a two-handed deal in which case you have less competition.

3. I think the optimal number of VCs to talk to seriously is about 5.  That is usually enough to get a sense of market but not so much that you get overwhelmed.  You should pick these VCs carefully – this is where trusted, experienced advisors are critical.

4. If there is a VC you really like, have a “buy it now price” and if they hit that valuation (and other terms are clean) do the deal.  Otherwise, say you’d like to “run a process” and include them in it.

5. Try to set timelines that are definite enough that investors feel some pressure to move but not so definite that you look dumb if you don’t have a term sheet by then.  (Investors have an incentive to wait – “to flip another card over” as they say – whereas entrepreneurs want to get the financing over with asap). Depending on where you are in the process, say things like “we’d like to wrap this up in the next few weeks.”

6. Once you start pitching, the clock starts ticking on your deal looking “tired.”  I’d say from your first VC meeting you have about a month before this risk kicks in.  You could have a great company but if investors get a sense that other investors have passed, they assume something is wrong with your company and/or they can wait around and invest later at their leisure.

7. The earlier stage your company is the more you should weight quality of investors vs valuation.  For a Series A, you are truly partnering with the VCs.  You should consider taking a lower valuation from a top tier firm over a non top tier firm (but probably any discount over 20% is too much). If you are doing a post-profitable “momentum round” I’d just optimize for valuation and deal terms.

8. Term sheets:  talk about terms in detail over the phone.  Only accept a term sheet once you have decided that if it matches what was described you are prepared to sign it.  After sending a term sheet VCs get worried you’ll shop it and usually want it signed in 24 hours.

9. Get to know the VCs.  Talk to their other portfolio companies, read their blogs, call references, etc.  You will be in business with this person for (hopefully) a long time.

10. Timing.  While it’s ideal to raise money once you hit the milestones you set out initially, you also need to be opportunistic.  Right now, for example, seems to be a really good time to raise a VC round.  You could make a ton of progress over the next 6 months but the market could tank and end up in a worse place than you would be today.

Financing risk

Startups that raise seed funding face the risk of not being able to raise additional money. This is what is sometimes known as “financing risk.”

If you are a company that just raising seed funding, financing risk should be top of mind.  Here are some tips for mitigating it:

Start by thinking about the next round of financing and work backwards.  What milestones do you have to hit to get VC funded at an upround?  If you are a consumer internet company, the milestone probably involves getting a certain number of users.  If you are building hardcore tech, it probably means building a working prototype.  Basically you want to take the main risks that exist at the seed stage and eliminate as many as you can. A good way to discover what milestones you need to hit is to talk to as many VCs as possible. Experienced seed investors can also advise you on this.

Raise enough seed money. How much money will it take to hit those milestones?  A good rule of thumb is 18 months – 3 months to get going, 12 months to execute, 3 more months to raise VC.  But it really depends on the specifics of the milestones, your operational plan, etc. which is why you need to figure those out first.

Preserve cash.  Pay only subsistance wages but be generous with equity for great people (this also provides a screen for hiring people with the right startup mindset).  Keep legal fees low (try to keep incorporation and financing costs to $10K or lower – this is one reason I prefer convertible notes).  Act like a scrappy startup.

A rule of thumb is a successful Series A is one that is led by quality VCs with a pre-money at least 2x the post-money of the seed round.