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.

Notes on the acquisition process

Ten years ago, startup financing was an insider’s game. Since then, the topic has been widely discussed on blogs, to the great benefit of entrepreneurs. Comparatively little, however, has been written about the important transaction at the other end many startups’ life, acquisitions. Here are some things I’ve learned about the acquisition process over the years.

– There is an old saying that startups are bought not sold. Clearly it is better to be in high demand and have inbound interest. But for product and tech acquisitions especially, it is often about getting the attention of the right people at the acquirer. Sometimes the right person is corp dev, other times product or business unit leads, and other times C-level management.

– Don’t use a banker unless your company is late stage and you are selling based on a multiple of profits or revenues. I’ve seen many acquisitions bungled by bankers who were either too aggressive on terms or upset the relationship between the startup and acquirer.

– Research the potential acquirer before the first meeting. Try to understand management’s priorities, especially as they relate to your company.  Talk to people who work in the same sector. Talk to industry analysts, investors, etc. If an acquirer is public, Wall Street analyst reports can be helpful.

– Develop relationships with key people – corp dev, management, product and business unit leads. The earlier the better.

– Don’t try to be cute. Leaking rumors to the press, creating a false sense of competition, etc. is generally a bad idea. Besides being ethically questionable, it can create ill will.

– What you tell employees is particularly tricky. Being open with employees can lead to press leaks and can annoy acquirers. Moreover, some public companies insist that you don’t talk to employees until the deal is closed or almost closed. Employees usually get a sense that something is going on and this can put you in the awkward situation of being forced to lie to them. I don’t know of a good solution to this problem.

– Understand the process and what each milestone along the way means. As with financings, acquisitions take a long time and involve lots of meetings and difficult decisions. Inexperienced entrepreneurs tend to get overly excited about a few good meetings.

– Strike while the iron is hot. Just as with financings, you need to be opportunistic. Waiting 6 months to hit another milestone might improve your fundamentals, but the acquirer’s interest might wane.

– There are two schools of thought on price negotiation: anchor early or wait until you’ve gotten strong interest. Obviously having multiple interested parties makes finding a fair price a lot easier.

– Deal structure: the cap table is an agreement between you and the shareholders that says, in effect: “If we sell the company, this is how we pay out founders, employees, and investors.” Acquirers have gotten increasingly aggressive about rewriting cap tables to 1) hold back key employee payouts for retention purposes, and 2) give a greater share of proceeds to employees/founders.  Some even go so far as to try to cut side deals with key employees to entice them to abandon the other employees and investors. In terms of ethics and reputations, it is important to be fair to all parties involved: the acquirer, founders, employees, and investors.

– Research the reputation of the acquirer, especially how they have behave between LOI and closing (good people to talk to: investors, other acquired startups, startup lawfirms). This is when acquirers have all the leverage and can mistreat you. Some acquirers treat LOIs the way VCs treat term sheets, as a contract they’ll honor unless they discover egregious issues like material misrepresentations. Others treat them as an opportunity to get free market intelligence.

– Certain terms beyond price can be deal killers. The most prominent one lately is “IP indemnification.” This is a complicated issue, but in short, as a response to patent trolls going after IP escrows, acquirers have been trying to get clawbacks from investors in case of IP claims. This term is a non-starter to institutional investors (and most individual investors). You need to understand all the potential deal-killer terms and hire an experienced startup law firm to help you.

– Ignore the cynical blog chatter about “acqui-hires” (or, as they used to be called, “talent acquisitions”). Only people who have been through the process understand that sometimes these outcomes are good for everyone involved (including users when the alternative is shutting down).

Finally, acquisitions should be thought of as partnerships that will last long after the deal closes. Besides the commitments you make as part of the deal, your professional reputation will be closely tied to the fate of the acquisition. This is one more reason why you should only raise money if you are prepared for a long-term commitment.

 

The time to eat the hors d’oeuvres is when they’re being passed

The efficient market hypothesis is a widely taught financial theory that states, roughly, that under certain generally-held conditions, asset prices are an accurate reflection of the information available at the time. The arguments underlying it are mathematically elegant and have been widely popularized. Its hardcore proponents argue that financial bubbles do not (indeed cannot) exist and that government intervention in financial markets is unnecessary. While efficient market theory is dominant in academic circles, it is very hard to find active participants in financial markets who believe in it. In financial markets – like most complex human systems – the closer you get, the more nuance you discover.

Venture capital markets are perhaps the most inefficient of mainstream financial markets. Complicating factors include: heavy reliance on comparables for valuations, desire of VCs to be associated with “hot” companies, tendency to overreact to macro changes, illiquidity of startup financings, illiquidity of financings for VCs themselves, perverse financial incentives of VCs, inability to short stocks, extreme uncertainty of startup financial projections, vagaries of the M&A market, dependency on moods of downstream investors, concentration of capital among a small group of VCs, the difficulty of developing accurate financial models, rapid shifts of supply and demand across sectors and stages, and non-uniform distribution of accurate market data.

The title of this post is an old venture capital adage (via Bill Gurley) that reflects a hard-earned truth about financing and M&A markets. For social consumer startups, the hors d’oeurves were being passed in the build up to the Facebook IPO. They are being passed now for B2B and e-commerce companies. In the M&A markets, the most extreme example is probably in adtech, where there were waves of acquisitions in ad exchanges (DoubleClick, RightMedia, Avenue A), then mobile ads (AdMob, Quattro), and then social advertising (Buddy Media, Wildfire). If you didn’t sell during these M&A waves, you’re suddenly stuck with lots of powerful competitors and few potential acquirers/partners.

It is common to hear entrepreneurs say things like “I am waiting 6 months to raise money/sell the company, when we’ve hit new milestones.” Of course milestones matter, and companies are ultimately valued based on fundamentals. But along the way you’ll likely need capital and sometimes need to exit, and for that you are dependent on highly inefficient markets.

The TripAdvisor IPO

Great startup story. Raised a total of $4.2m in venture capital, sold to IAC/Expedia for $210M, and had some interesting adventures and pivots along the way. They started out by trying to aggregate reviews from other websites and white label their product to Expedia and other large travel websites. TripAdvisor.com was just a showcase that accidentally became a destination site. As of today TripAdvisor is an independent public company, trading at a market cap of $3.5B.

Great for Boston. Fairly or not, Boston is often typecast as an infrastructure, B2B, hardware, and biotech town. Between Tripadvisor and Kayak, Boston now has at least two very important consumer internet companies.

Big win for the “golden age of SEO”.  By which I’m referring to roughly 2001-2008 when “demand” for content (people typing in search queries) far outpaced supply (good content). Companies like Yelp and TripAdvisor (along with Wikipedia, IMDB, etc) grew huge during this period, almost entirely through SEO. They did this by getting highly defensible flywheels spinning where more content meant more SEO which meant more users which meant more content. It is now far more difficult to grow a startup primarily through SEO. Almost all monetizable search categories have vast excesses of SEOd content. Moreover, Google is creating their own content (e.g. Google Places) which, at least at times, they have favored in their search results.

The user experience should improve. MG Siegler and others have criticized TripAdvisor for an excess of ads. I don’t disagree with MG, but I also think this is largely the result of the broken online ad attribution system that punishes intent generators and rewards intent harvestors. Travel reviews are for users at the beginning of the travel research process (which on average takes weeks), but all CPA and CPC ad programs pay only for the last click which usually means when users are purchasing tickets or making reservations. Hence review sites are forced to saturate their website real estate with purchasing widgets and display ads. Hopefully as online ad attribution improves this will no longer be necessary.

It’s weird how little coverage this IPO got and how the financial press missed the interesting stories. TripAdvisor ended the day at ~$3.5B in market cap, making it the second most valuable East Coast consumer internet company (after Priceline). Every story I saw focused on the share price drop over the day. The fact that the price dropped from its opening price simply means the bankers mispriced the stock and therefore insiders didn’t get the sweetheart deal they thought they were getting.

Update: I interviewed the CEO/founder of TripAdvisor on TechCrunch yesterday. Topics include the company’s origins, relationship with Google, SOPA, and advice to fledgling entrepreneurs.

Seth Godin on “organizational momentum” acquisitions

Seth Godin left an insightful comment on my post yesterday (“Three types of acquisitions“) describing a type of technology acquisition you might call an “organization momentum” acquisition:

I think the most common form of tech acquisition is a variant of the [business acquisition], in which the acquirer wants to inject forward motion into the organization. It’s far more difficult for a public company to rally around a launch into what might seem like a small sector… it just doesn’t seem worthy of the biggest brains and bravest folks, so it gets shunted aside.

On the other hand, once a smart tech company acquires a smaller company with momentum, it gives the company permission to drive, perfect, polish and grow that business. I’d argue that this what actually happened with YouTube.

The logic underlying organizational momentum acquisitions can be found in Clay Christensen’s disruptive technology theory. Smart CEOs of large companies realize how hard it is to shift internal momentum away from developing sustaining technologies. As a way to avoid this trap, Christensen recommends that large companies set up internal startups that are as organizationally separate as possible. But, as Seth points out, acquiring startups with momentum is another way to get the same result.