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.

Ten million users is the new one million users

Entrepreneurs and investors have been enamored with consumer internet startups for the last few years. But there are signs this is ending.

Some observations:

– Thousands of early-stage consumer web/mobile companies were started and funded in last 24 months.

– There are only a few dozen VCs who actively write consumer Series A checks, and those VCs will only do a few deals a year.

– Facebook’s market cap is about half of what most tech investors expected before the IPO.

– A few breakout early-stage consumer hits (Instagram, Pinterest) have reached tens of millions of users in record time.

– Internet users have tens of thousands of services/apps to choose from but limited time and attention.

Some consequences:

– For consumer startups with non-transactional models (ad-based or unknown business models), you need something closer to 10 million users versus 1 million users to get Series A funded.

– For consumer startups with transactional models, e.g. e-commerce, the number of users required is often far lower because revenue is the more important metric. Hence, many early-stage consumer startups are switching to transactional models.

– It’s becoming increasingly common for early-stage consumer startups to do bridge financings (raising more money from past investors, usually on terms similar to the prior round) instead of Series As.

– VCs are increasingly focusing on B2B for early-stage investments.

– There will be a lot more consumer talent acquisitions.

Some advice:

– If you are thinking of starting a non-transactional consumer startup, be aware that you are entering what is perhaps the most competitive sector in tech in the last decade.

– If you can raise more money, do it. (Especially pre-launch: remember, there’s nothing like numbers to screw up a good story).

– Be prepared for lower valuations for non-transactional early-stage consumer startups (breakout later-stage companies, on the other hand, will likely continue to command high valuations).