There continues to be a lot of discussion in venture capital and entrepreneurial circles alike about the onslaught of early acquisitions being made by the folks at Yahoo, Google, InterActiveCorp and increasingly Fox Interactive Media. The question I am often asked goes something like, "isn't this really bad news for venture capital?" After all, if all the "good companies" are bought up before they have the chance to raise venture money, how will we VCs make any money?
Early acquisitions are nothing new. While it feels like they are occurring at perhaps a faster pace for the time being, it has always been the case that the "good companies" attract lots of attention quickly and end up with early acquisition offers. Sometimes entrepreneurs accept those early buyout offers. And sometimes they don't. But when the do it is by no means an indictment of the venture capital industry. It is simply a decision made by an entrepreneur at that particular point in time that the risks associated with continuing to build enterprise value in the future are outweighed by the certainty of a particular price paid today. To my mind, these acquisition offers are just like the new TV game show Deal or No Deal.
For those of you who haven't seen Deal or No Deal, it is one of the more brain dead game shows created. At the beginning of the game, a contestant stands in front of 26 models holding briefcases in their hands. Each briefcase contains a particular dollar amount, ranging from one cent to one million dollars. The contestant picks a briefcase but does not get to look at the dollar value in that case. She then proceeds to pick a half dozen briefcases, the dollar values of which are revealed. As each case is picked, its dollar value is removed from the board of potential winnings. Once the first six cases have been chosen, a fictitious "Banker" is asked what price he will pay in exchange for the case held by the contestant (this is perhaps the most glamourous job ever held by a statistician -- for insight into the Banker's psyche, you can visit his ridiculous Bankers Blog). In theory, the Banker knows no more about the contents of the contestant's briefcase than does the contestant herself. If the six cases eliminated were all low numbers, the Banker will offer a number in the tens of thousands of dollars. If the cases revealed high numbers, however, thus indicating a higher likelihood that the contestant holds a low dollar value in her chosen briefcase, the Banker will offer a buyout of mere thousands. The contestant then has to choose to take the offer based upon the information available or risk potential losses while turning over some more cards. The case picking and Banker offers continues until the contestant either takes an offer from the Banker or has chosen all of the cases and gets to reveal what is in the briefcase she originally picked.
Entrepreneurs who receive acquisition offers early in the lifetime of their companies are essentially faced with the same conundrum as that posed in Deal or No Deal. Relatively little information has been revealed about the long term value of the company, yet the entrepreneur must decide whether or not to take the offer and, in essence, stop playing the game. As can be seen from the game show itself, in many instances taking the deal early on is a good idea because as each new briefcase is opened, the perceived value of the case being held by the contestant goes down, as do the buyout offers from the Banker. However, in many other instances, as time goes on and risk is removed (all the low numbered briefcases are picked), the buyout offers from the Banker increase to substantial dollar values.
Some recent acquisitions and acquisition offers reveal the parallels to Deal or No Deal. Companies like Flickr, Delicious, Bloglines, Writely, etc. had early success and were offered solid amounts of money to sell very early on. Little had been revealed about their long term value but the early indications were excellent (the first briefcases picked were low numbers) and therefore Yahoo/IAC/Google were willing to pay millions of dollars to buy them early. On the flip side, Friendster had similar early indications of high long term value and accordingly Google made an offer to buy the company based upon those early indications. In that instance, however, the company decided to open a few more briefcases, and, unfortunately, each new briefcase revealed negative news about the long term value of the business (in other words, the briefcases all held high numbers). As a result, the offers from Bankers to buy the Friendster business have fallen precipitously. Another twist on the same theme is the Facebook story. Early indications on the Facebook were excellent and the management decided to pass on the first set of acquisition offers. Yet, as the Facebook continues to open briefcases, they keep finding nothing but good news. Thus, if the rumors are true, with each additional piece of good news, the Bankers have offered larger and larger numbers to buy out the company. The folks at the Facebook, however, continue to refuse buyout offers and play on. With any luck, their value will continue to go up until such time as they choose to sell or take the company all the way (I suppose, to kill an already wounded analogy, sticking with the original briefcase you chose and discovering it holds a million dollars is the equivalent of a startup going public).
I don't for a second want to suggest that the long term success of companies is purely a question of chance. Nor do I want to suggest that the key to financial success in a startup is only about selling at the right time. Unlike the contestants on Deal or No Deal, entrepreneurs have a lot of influence over what dollar values are revealed in the cases they choose to open. Successful entrepreneurs systematically eliminate risk while building increased value in their companies. While some factors are outside an entrepreneurs control (e.g. market adoption), many of the risks are influenced by the smart choices made by entrepreneurs along the way.
Ultimately there will come a point in time when each entrepreneur will have to ask him or herself, "deal or no deal?" That some entrepreneurs will choose "deal" early in their company's life cycle is not an indictment of the venture capital industry, it is merely an indication that the Yahoo and Google Bankers are making offers some entrepreneurs cannot refuse. That's good news for entrepreuners. And as companies mature and additional briefcases are opened, in many instances the Bankers' offers continue to grow. And that will prove to be good news for VCs as well. I just pray that Toby Coppel isn't replaced by Howie Mandel any time soon.
An interesting corollary of these relatively small and relatively quick acquisitions that I've seen is VCs trying to include terms that specifically discourage it. The comment I've heard repeatedly is "oh, well this would be a great deal for Google/Yahoo/Whoever to buy for $Xm but where would that leave us?" It actually creates a tension point around a venture investment because the Flickr/Writely/etc. deals get a lot of press and attention don't really move the needle for VCs in terms of return. No problem if you haven't taken the VC money. But if you do take VC $$$ or are thinking about it, it's an issue . . .
Posted by: Jason M. Lemkin | 03/20/2006 at 10:48 AM
As you mention, there has been a lot of discussion recently about the "threat" to venture capital firms posed by the latest trend of large companies buying early-stage start-ups.
The argument is that: (1) the comparatively low cost of starting Web 2.0 companies coupled with (2) the relatively early-stage at which companies like Google and Yahoo are willing to buy, threatens to disrupt the traditional venture capital model.
In my opinion, both arguments are flawed.
The first argument, which essentially says that Web 2.0 start-ups won't work with venture capital firms because they don't need the money, ignores the fact that capital is just one of about a dozen reasons why a start-up chooses to work with a venture capital firm.
So, even if a start-up does not need the money, they may still want to work with a venture capital firm in order to get assistance with recruiting, customer introductions, etc.
The second argument, that the traditional VC model is obsolete due to the fact that venture capitalists are being squeezed out of some Web 2.0 investments by large acquirers is, in some ways, even more ridiculous.
First, as you correctly imply, the flow of mergers and acquisitions is cyclical.
Google and Yahoo may be swallowing lots of smaller companies now, but what about a year from now?
If the pace slows, you are going to see a lot of companies requiring the assistance of venture capitalists, particularly since most of these Web 2.0 companies are not really stand-alone businesses.
There was a great quote from Brad Schell, the founder of @Last Software, which was acquired by Google last week, which said, ""3D for Everyone" is becoming a reality; we're bringing the '3D' part; Google's contributing the 'Everyone.'"
Whether you are talking about 3D, tagging, maps, or another technology, most of these Web 2.0 start-ups can eek out a subsistence level existence on their own but they only begin to take on real value when integrated into a larger company.
Finally, assuming that everything the critics say is true and that venture capitalists are not needed in a Web 2.0 world, big deal!
Though they may currently be in vogue, Web 2.0 companies comprise just one small part of a much larger universe of potential venture capital investments.
There are, and will always be, many other promising areas to invest in, clean energy and synthetic biology being the most recent additions.
Posted by: Simon Olson | 03/20/2006 at 12:35 PM
As you mention, there has been a lot of discussion recently about the "threat" to venture capital firms posed by the latest trend of large companies buying early-stage start-ups.
The argument is that: (1) the comparatively low cost of starting Web 2.0 companies coupled with (2) the relatively early-stage at which companies like Google and Yahoo are willing to buy, threatens to disrupt the traditional venture capital model.
In my opinion, both arguments are flawed.
The first argument, which essentially says that Web 2.0 start-ups won't work with venture capital firms because they don't need the money, ignores the fact that capital is just one of about a dozen reasons why a start-up chooses to work with a venture capital firm.
So, even if a start-up does not need the money, they may still want to work with a venture capital firm in order to get assistance with recruiting, customer introductions, etc.
The second argument, that the traditional VC model is obsolete due to the fact that venture capitalists are being squeezed out of some Web 2.0 investments by large acquirers is, in some ways, even more ridiculous.
First, as you correctly imply, the flow of mergers and acquisitions is cyclical.
Google and Yahoo may be swallowing lots of smaller companies now, but what about a year from now?
If the pace slows, you are going to see a lot of companies requiring the assistance of venture capitalists, particularly since most of these Web 2.0 companies are not really stand-alone businesses.
There was a great quote from Brad Schell, the founder of @Last Software, which was acquired by Google last week, which said, ""3D for Everyone" is becoming a reality; we're bringing the '3D' part; Google's contributing the 'Everyone.'"
Whether you are talking about 3D, tagging, maps, or another technology, most of these Web 2.0 start-ups can eek out a subsistence level existence on their own but they only begin to take on real value when integrated into a larger company.
Finally, assuming that everything the critics say is true and that venture capitalists are not needed in a Web 2.0 world, big deal!
Though they may currently be in vogue, Web 2.0 companies comprise just one small part of a much larger universe of potential venture capital investments.
There are, and will always be, many other promising areas to invest in, clean energy and synthetic biology being the most recent additions.
Posted by: Simon Olson | 03/20/2006 at 12:39 PM
Mistah Hornik -
great piece & interesting reading... but i think the analogy with 'deal or no deal' is a bit off, for at least 2 reasons:
1) the example 'deal or no deal' appears to have a fixed price, whereas most acquisitions have at least some upside / earnout potential based on post-acquisition performance (could be individual and/or company based). options on upside performance would likely reduce some of the fear of a big 'missed opportunity' that might come from selling at too low a value.
2) in the 'deal or no deal' scenario, there isn't really any structure that mirrors previous startup valuation / investment structure, and/or the investor's IRR targets or expectations. i mention this because whether or not a venture investor has been involved in a startup may limit the exit options / set a higher bar for sale.
while no analogy is ever perfect, your example appears to state the acquisition scenario as a bit more random & apparently negative than might really be the case.
in reality, i think the VC investor perspective / belief is that maximal returns are best achieved when portfolio companies swing for the fences. however, that strategy only works well for the VC, their LPs, and for the folks employed by the 1 of 10 companies that hit it big in the VC's portfolio... on the other hand, the asset allocation benefits of an "only swing to hit home runs" strategy don't work so well for people at the remaining 9 of 10 companies that don't hit it out of the park.
whether or not playing "small ball" (aka, taking an early acquisition offer) benefits the entrepreneur better than "home run hitting" may be up for discussion, but i don't believe it's quite the equivalent of the random value you are associating with a TV game show.
my .02,
- dave mcclure
(note: the opinions expressed are my own, and do not necessarily reflect the perspective of my employer... who most certainly *is* VC-funded ;)
Posted by: Dave | 03/20/2006 at 09:58 PM
My point wasn't to suggest for a second that valuation is random. Nor to suggest that taking an early deal is a bad decision because of all the missed opportunity. I was simply suggesting that at any given point in time when an offer is made to buy your company there is a limited set of data that a company needs to assess to determine if now is the time to sell. There will never be perfect data. So a company needs to assess what they know and what they don't know and decide Deal or No Deal.
While it is true that some acquisitions include earn outs that could potentially increase the upside, as a general matter those earn outs take two forms. They are either earn outs that are designed to be assuredly met and therefor are the equivalent of deferred revenue. And there are those earn outs that will likely never be met, and they are frankly in there just to make entrepreneurs and VCs feel better about the lower price they are actually agreeing to. Because so much of what happens in a company once it is acquired is determined by the the acquiring company (marketing budgets, placement, support, hiring, etc.), it is hard to assure that the "necessary" resources are afforded a startup once it has been bought to meet many earn out criteria. So I personally assess the realistic likelihood of achieving an earn out and factor that into the offered price when considering acquisition offers.
As for the "swing for the fences" attitude of VCs, it is certainly the case that a $30M acquisition can been a fantastic outcome for an entrepreneur while not a particularly exciting outcome for a venture capital firm. That is why I don't think all companies should be venture funded. When I fund companies, I don't perceive it as hitting for the fences. I fund companies because I believe that if they hit solid singles in the business that they are pursuing that there will be a huge market and the outcome will be large. Before any entrepreneurs and I decide to work together, everyone is very clear about the economics of taking venture capital. Which is not to say that we never accept early acquisition offers. But I perceive the companies that I fund to have very big upside at the time I fund them, so the key question with any early acquisition offer is whether it is large enough given my perception of the big upside discounted by the risk of executing on the business. In some instances, the price is big enough or there is new information since the company was funded to suggest that an early exit makes sense. All you can do is look at the briefcases you've opened, consider what may be in the briefcases that are still closed, assess the likely outcomes at hand and decide Deal or No Deal.
Posted by: David Hornik | 03/21/2006 at 06:11 AM
David: This is a great post and certainly an apt comparison for our times. Interestingly, the "Hornik TV Game Show Test" also works for entrepreneurial ages of the not-too-distant past. "Who Wants to Be a Millionaire" conjures up memories of lots of companies calling their VCs during the internet rage for another lifeline -- and sadly, "Survivor" sums up the whole post-boom period! Fortunately, I'm far too young to make judgments about the "Gong Show" or "25,000 Pyramid". However, when it's all said and done -- I think that the only rule for when to sell a company must be that venerable-standard, "The Price is Right".
Posted by: CliffBoro | 03/21/2006 at 04:42 PM
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Posted by: john | 03/24/2006 at 02:45 AM
I reckon this early acquisition phenomenon is more than a temporal fluke but a reasonable trend- a modern form of "going public". Particularly in the class of firms and technologies dubbed ad-hocly as "Web 2.0." With development costs lower, a widespread awareness of the value of openness and the big gorillas in the room, a larger proportion of firms would seem to not be able to scale to traditional VC-level exits. In the basest of terms, there is frenetic competition.
I am excited to see a few new "angel" funds. Personally, I think larger VC funds, and even big corporate players, should consider entering the angel stage via new partnerships and even membership agreements. There are a few too many big piles of money chasing the few ideas that truly have massive upside. And perhaps too few smaller piles of money, particularly outside Silicon Valley, chasing smaller but fast-growing and feasible ideas.
In line with the ecosystem perspective folks like David H promote, we need to be aware of the necessity to fund ideas and teams as early as possible in order to boost the vitality of the overall ecology. Too many ideas either cannot be pursued, or are pursued after very aggregious angel terms (e.g., first rounds that take 50%). That's not good for the environment.
Posted by: joystick | 03/28/2006 at 06:09 AM
I reckon this early acquisition phenomenon is more than a temporal fluke but a reasonable trend- a modern form of "going public". Particularly in the class of firms and technologies dubbed ad-hocly as "Web 2.0." With development costs lower, a widespread awareness of the value of openness and the big gorillas in the room, a larger proportion of firms would seem to not be able to scale to traditional VC-level exits. In the basest of terms, there is frenetic competition.
I am excited to see a few new "angel" funds. Personally, I think larger VC funds, and even big corporate players, should consider entering the angel stage via new partnerships and even membership agreements. There are a few too many big piles of money chasing the few ideas that truly have massive upside. And perhaps too few smaller piles of money, particularly outside Silicon Valley, chasing smaller but fast-growing and feasible ideas.
In line with the ecosystem perspective folks like David H promote, we need to be aware of the necessity to fund ideas and teams as early as possible in order to boost the vitality of the overall ecology. Too many ideas either cannot be pursued, or are pursued after very aggregious angel terms (e.g., first rounds that take 50%). That's not good for the environment.
Posted by: joystick | 03/28/2006 at 06:10 AM