Month: October 2007

It seems that everyday there is a new annoucement of a tiny startup being bought by a large company.  Two days ago it was Jaiku being bought by Google and this morning CBS announced that it is buying Dotspotter, a 10 month old gossip blog.  Put yourself in these entrepreneurs’ shoes – you launch a great product or service today, usage is growing, revenue is nil or minimal, and cocktail party chatter and buzz are at its highest.  You then have the opportunity to sell today at a pretty good number but you forego your chance of building that huge business.  What do you do and how should you think about it?  As i started thinking deeper about this question, I was reminded of the old Gartner Hype Cycle chart.  If we use this as a backdrop, perhaps I could show a framework from which to think about this important decison.

According to Gartner, "A Hype Cycle is a graphical representation of the maturity, adoption and business application of specific technologies."  Similarly, I have graphically represented the choices an entrepreneur has to make in the continuing saga of build or flip.  Let’s call this the "BeyondVC Startup Cycle." According to Gartner, there are 5 phases in a Hype Cycle (my comments in parentheses): Technology Trigger (product launch), Peak of Inflated Expectations (height of buzz), Trough of Disillusionment (this is harder than I thought), Slope of Enlightenment (the broad market is finally ready), and Plateau of Productivity (better have my next product ready).  I believe the descriptions speak for themselves as what usually happens with the adoption of new technology is that the hype builds quickly but it actually takes a lot longer to reach critical mass.  Similarly, one can superimpose a startup lifecycle on the graph.  If you look at the build or flip question in this context, it is obvious that an easier, less risky choice to make is best done at the Peak of Inflated Expectations or height of the cocktail circuit chatter.  Usually at this point in time, an entrepreneur can maximize short-term value as acquirers will buy more on vision and technology than on business fundamentals.  If you decide to build for the long haul and go for the home run, it will take you a fair amount of effort and time to create the same value that acquirers will pay today at the buzz cycle as they will expect more mature companies to have more established products or services and more milestones hit.  Companies that sell at the early stages should understand that while they may forego going big, if they do not sell today for strategic value then they would have to live up to their hype and be bought in the future for real revenue. In other words, as companies mature the valuation of a startup turns from pure strategic value to one where it is based more on actual revenue multiples and market comparable data.   

At this inflection point, an entrepreneur needs to think about whether they want to and can build for the long haul (taking into account the risk and time to do so) or sell today (net present value of your potential expected outcomes in the future). This is the point where you have built a nice service or product, gotten a number of users, but have not really monetized it or created a scalable business model that can drive profits.  Can you really build a company or is this just a feature for a bigger player?  If you choose to go for it and raise VC funding, you have to really believe that the capital you raise will help you create a much larger pie in the end.  Do you want a larger percentage of a smaller pie or a smaller percentage of a much larger one?  Once you take in the money, it requires a ton of hard work to build a team, continue to innovate, and refine your business model.  There are no guarantees and given the amount of time and energy you expend you could just as easily go out of business after 5 years of effort.  One other factor for entrepreneurs to look at is the opportunity cost or the time you spend on one venture. 

Since I never like to make decisions in a vacuum, if I had an offer, I would test the market to get a read from VCs to see what their interest level is in funding my business and also poke around and speak to a couple of other strategics to see if I could extract more value.  In the end, these valuable data points will help you make a more confident decision – if no VCs bite, then it is an easy decision for you.  If some VCs have an interest, try to understand how much capital and at what price they would be willing to invest.  If you really believe in your business then you should either take the money from the VC or get a significant premium from the strategic investor to sell today versus building your business for the longer term. 

At the end of the day, it comes down to two things.  First, what is your appetite for calculated risk – in finance there is a direct correlation to risk and reward.  If you want the big payday, you are not going to get it investing in risk-free bonds.  Secondly, it comes down to your passion.  Building a company is about more than just the money as money can be fleeting – remember the bubble, it sent a lot of carpetbaggers home.  The ones who have made the big payday have focused on a broader and bigger goal, building an insanely great product or service for their customers and keeping them incredibly happy. As you do the right thing for your customers, you will do right for your investors, your employees, and ultimately yourself.

I am sure you remember the ebay-Skype deal where ebay coughed up $2.6b upfront for Skype and offered an earnout of up to another $1.7b for hitting performance numbers.  Besides the value of the deal, what struck me most was that 40% of the total potential deal size was based on performance-based milestones.  Fast forward 2 years later and in the day of reckoning it seems that eBay is only going to pay $530mm of the $1.7bb earnout (see Eric Savitz from Barrons post and press release).  I am not going to comment here on whether or not the Skype deal was a complete failure for eBay, but rather I thought I would more importantly share my thoughts on earnouts in M&A transactions.

Quite simply, be wary of performance based earnouts unless you get significant value upfront.  Many times an acquiring company may say that they can’t pay higher than a certain value for your business but if you perform they can pay alot more.  In other words, they want you to put your skin on the line and also incent you to stick around.  That is fine as long as you get more than enough upfront for your business so that any dollar from earnouts is just pure upside.  If you feel that you are not selling for enough and that too much is tied in the earnout, then trust your gut and either rework the deal or walk away. 

Earnouts in theory sound great – the better you perform the more you get.  However in practice it doesn’t always work out well.  First, earnouts could potentially put the acquiring and target company at odds by creating potential perverse incentives for the acquiring company.  Hmm, the company I just bought is doing great but I don’t really want them to hit it out of the park just yet so I may delay giving them their marketing dollars?  You can obviously think of a bunch more examples on this front.  More importantly, though, I feel that unlike a startup, you have relatively little control of your own destiny.  In any M&A with performance numbers, the acquiring company will say it is offering all of these resources and distribution and therefore the revenue, profit, and customer targets should be quite high yet attainable.  In a startup, if you fail it is your fault.  As part of an operating business or larger entity that isn’t always the case as you are most likely dependent on the acquiring company for resources, distribution, and cash to grow and deliver on your promises.  Big companies move slow and you are more likely to not get the support you need in a timely manner meaning that realizing your earnout becomes a very tough proposition.  Even thinking about the ebay-Skype saga, I can remember reading the countless news items and stories about how the 2 cultures clashed, how ebay did not understand the Skype business, and the management changes and reorgs that took place.  All that being said, I am sure the investors are bummed about leaving another $1.2b on the table in earnouts but at the same time they are still ecstatic about the initial $2.6b they received upfront.