When the WSJ and the NYTimes write the same trend story you can assume it’s a narrative that is being pushed by people who want it to be true! And the narrative for 2017 is OLD ECONOMY COMPANIES WANT TO BUY YOUR STARTUP. So, is it true? Largely yes, but the pot of gold might be more modest than some of 2016’s notable transactions suggest (Jet, Cruise, Dollar Shave Club).
When Satya and I started Homebrew in 2013 one of our bets for the coming decades was that non-traditional acquirers would become more aggressive in their pursuit of technology startups. Satya likes to describe the trend as “outsourced R&D.” But we also knew that most Fortune 500 M&A transactions aren’t at unicorn levels (actually well sub-$250m), so we advise founders to not over-raise capital until they’re using it to fund profitable growth (or a clear path to profitability). This keeps them aligned with their investors since a $250m exit with modest venture financing raised can be wonderful for all parties, but the same transaction can look awful if your last round was $60m on $300m pre! It’s also a reason we’ve seen an increase in strategic corporate investors getting involved in our companies earlier and earlier.
We had our first taste of this trend playing out early in 2016 when GM acquired self-driving tech startup Cruise for north of $1b. Even though we were only supporting investors (aka small check) it was a great return multiple to our fund. It also helped us flesh out our hypotheses about how corporates would behave as the US left industrial capitalism behind and entered a new era of technology capitalism. With all due respect to Maslow, here’s our Hierarchy of Corporate M&A Needs
Lowest Level – Buying Talent
The Fortune 500 version of the “acquihire,” seeking to add technology talent to an existing team or give a VP the seeds to spin up a new effort. The total value of these deals might look higher than when a tech company makes an acquihire but the premium tends to go to retention rather than the cap table (especially since (a) the acquirer might not be seen as an ‘attractive’ place to work and (b) there’s assumption of less equity upside post-acquisition). Key words in any press release to look for are “XYZ product will be shut down so the team can concentrate on new projects, etc.”
Next Level – Buying Product
In these cases the startup has a nice polished product, potentially with some degree of product<>market fit, but usually growth has plateaued (or there’s some other internal/external factor that has made the company challenged to raise its next round of outside capital). Acquiring F500 company imagines incorporating this product into their existing channels, or even keeping the product and using it as the launching platform for their further digital initiatives (ie they’re essentially purchasing the company to control its roadmap).
These acquisitions will be richer than pure talent acquisitions but you’re still not going to get many huge checks, both because the startup typically has limited optionality and big companies only pay bigly for “transformative” deals or out of extreme fear. One note is that if this type of acquisition occurs early in a company’s lifecycle, they can work out VERY well for founders (usually followed by the investor community speculating that they “sold too early”). See Mint and Periscope as examples.
Next Level: Buying Customers/Revenue/Distribution
Oh yeah, this is where the acquisition premium starts to grow, although it’s industry dependent as some markets (and market caps) can support hefty acquisitions while others are more modest. Under Armour purchasing MyFitnessPal for $475m feels like a reasonable example. Here the acquisition becomes more metric-driven and the assumptions around growth and multiples drive the offer. There’s often “synergy” magically inserted if an acquirer is trying to make a deal work at a level above current metrics. For example, you would say “oh, sure this startup spends 5x LTV to acquire a new customer but once we plug them into our sales channel, it’ll drop to .25x LTV” 🙂
At this level, the acquired startup usually has some optionality – either they’re profitable or near profitability, growing fast enough to raise additional dollars, or still have capital in the bank from the last round. So typically an acquirer will need to pay for future growth in order to make playing it out less attractive. OR, the team and/or investors will be ready to take their money off the table. Maybe it’s been a long, hard slog to get here and people are tired. Or the lead VC needs some liquidity and there’s 20% of the cap table sitting in departed founders/execs who are badgering for a payout.
Highest Level: Buying Peace of Mind
Cruise was this. Jet was this. Dollar Shave Club (as best I can figure was .5 this and .5 the previous category). When the Cruise transaction went down, people were asking me how GM came up with the $1b+ figure. Although as small investors we weren’t privy to the specific conversations, here’s my interpretation:
“There’s no ‘bottom up’ way to get to the $1b+ figure. GM saw autonomy becoming an existential threat to its business over the next decade so they asked themselves, ‘What percentage of our market cap are we willing to spend in order to reduce the risk it [market cap] ultimately goes to zero?’ Turns out in their case it was 2-3%. And they got an amazing team in a space where there’s not that much talent available, and a leader who wants to help transform an iconic American company.”
That’s really it. Was Jet.com “worth” $3b? Likely not by any calculation of their metrics using traditional ecommerce multiples. Did Walmart want to spend 1.5% of their market cap making a last gasp effort to not be halved by Amazon over the next 10 years? Apparently so.
And rather than roll eyes at these large sums of money, I’m strongly in favor of high-fiving the acquiring CEO (and not just because they helped me return my fund). There are so many reasons for a current Fortune 500 CEO to *not* bet the farm and make a big tech acquisition. It could go wrong and they’ll look stupid. It could lower earnings because of continued investment and share dilution. Whatever market challenge they’ve uncovered likely won’t doom their company on their watch – heck, kick the can down the road to the next CEO!
Of course there are going to be some TERRIBLE acquisitions that later become writedowns or handicap the acquirer for years and years to come. But if you believe in the slow unavoidable decay of large, non-tech native companies (and I do), they’ll have to embrace this sort of change and very few can do it without a catalyzing event. Better that be a smart acquisition than a bankruptcy. The fact it’s become more palatable to Wall Street to make these tech investments (and of course they want their M&A transaction fees as well), arms the current CEOs with more dry powder than their predecessors had.
So yeah, 2017 will continue to be the “Year of the Non-Tech” acquirer, and potential tax repatriation of international profits will only increase the volume. If you’re a founder or investor, it’s worth making sure you’re realistic about the acquisition potential and rationale.