Startup Acquisitions Are About More Than Money
European Straits #69
Dear all,
Let me share a secret with you: finance is one of the topics that interests people the least. I know that because whenever I dedicate an issue of this newsletter to financial matters, most people neither share it nor click on the links. Most don’t even open it, making my finance pieces consistently the least read.
I do still believe, however, that discussing finance is critically important. One reason is that finance in general and the financial services industry in particular have a tremendous effect on the economy and our daily life. The other reason is that mastering finance is absolutely needed to succeed in the current transition to the Entrepreneurial Age.
We at The Family are currently reflecting on a very important financial topic: startup acquisitions—why they matter and how we as a firm could contribute to making the field better in Europe.
For one, startup acquisitions is a critical input in building a thriving entrepreneurial ecosystem. Not all startups will become the next Facebook or the next Amazon. But not every startup should be doomed to fail if it doesn’t become the next tech giant. There’s a middle ground, a significant part of which is being acquired by a larger company.
Startup acquisitions are especially important for venture capitalists. As remarked by William H. Janeway in his landmark book Doing Capitalism in the Innovation Economy (whose 2nd edition will be released...tomorrow), the health of the venture capital industry is highly correlated to that of the IPO market. But the next best contribution in supporting venture capital is when there are a lot of well-priced startup acquisitions by larger companies. These generate above average ROIC and make it possible for VC firms to schmooze their LPs and raise more capital to invest in the next generation of startups.
Acquiring startups also matters for larger tech companies, and indeed incumbents as a whole. It’s the way for them to snatch up key value held in startups: the technical talent, the sense of urgency, the radical model of execution, the intimate knowledge of the market, and the sustained growth that is so critical for surviving in the evermore competitive Entrepreneurial Age.
During most of the 1980s and ‘90s, acquiring smaller companies was the cornerstone of big corporations’ efforts at innovation. At the time, corporate executives had decided that innovating on their own was not particularly important, since if things really changed they could simply acquire a target that would put them in position on new markets.
A symbol of that era is the legendary former boss of General Electric, Jack Welch. Although he was himself a technology innovator while climbing up the corporate ladder within GE, as CEO Jack Welch became well known for betting everything on operational effectiveness and maximizing shareholder value. If innovation was needed, he often explained, GE would spot it in other firms and proceed with an acquisition. He essentially got rid of the principle of innovating within the organization (the corporate research lab) and placed all his cards on early acquisitions.
Alas this approach has become impossible in the current Entrepreneurial Age, since a key feature of tech startups is increasing returns to scale, and it makes it very difficult to spot radical innovation from the outside. There are two phases in the life of a startup: the first is before what we call product/market fit, when the startup isn’t much to look at, seeming to be very similar to thousands of other startups. Good luck acquiring one of them at that stage, when success is virtually impossible to predict from the outside.
Then the startup reaches product/market fit, which triggers increasing returns to scale and leads the startup to a phase of exponential growth. And at that point, it’s also impossible to acquire the said startup, for three reasons:
Because the entrepreneur is focused on growth, and growth usually attracts a lot of external funding, they’re not really interested in being acquired. If they are, it’s a bad signal because it reveals a worrying lack of ambition.
Even if the entrepreneur was willing to discuss an acquisition, it would be very difficult to reach an understanding on the price. The acquirer, as an incumbent, is valued based on discounted cash flow; the target, because it’s a startup, is valued based on increasing returns to scale. It’s very difficult to reconcile the two frameworks when it comes to setting the price.
Finally, even if the acquirer manages to convince the target and an understanding on the price is reached, it will be very difficult to integrate the target within the purchasing organization, because the differences in culture / values / strategy make it impossible to make the most of the targeted startup.
Thus as part of transforming traditional companies into tech companies, the entire discipline of M&A must be reinvented, too. Large companies must embrace a new approach and put acquisitions into the broader perspective of their strategic repositioning in the Entrepreneurial Age. They also must master a new set of tools, as the right way to acquire a startup follows these three steps:
It’s a negotiation between chief executives, not between bankers.
Due diligence must be swift to account for the fast pace of market changes.
The price should be calculated within the new paradigm (increasing returns to scale), not the old (discounted cash flows).
Here are a few articles to go further on M&A in the Entrepreneurial Age:
Why So Many Startups Are Being Acqui-Hired (Jay Yarow, August 2012)
Corporate acquisitions of startups usually fail. Here’s why (Steve Blank, April 2014)
No need for banks in an era of intellectual capital (Felix Salmon, August 2014)
Fear of Failure and Lack of Speed In a Large Corporation (Steve Blank, March 2015)
So Many M&A Deals Fail Because Companies Overlook This Simple Strategy (Alan Lewis & Dan McKone, May 2016)
The Berkshire Hathaway of the Internet (Andrew Wilkinson, March 2017)
Google doesn’t necessarily need innovation (Steve Yegge, January 2018)
There’s No Good Alternative to Investing in R&D (Anne Marie Knott, April 2018)
Warm regards (from London, UK),
Nicolas
(By the way, if you are in Paris on May 24, come join us for a fireside chat with Bill Janeway at The Family at 6:30pm. All details HERE.)