Five Years Too Late

March 31, 2009

If You Build It…

Filed under: venture capital — Tags: , , , , , , , — fiveyearstoolate @ 10:38 am

Stuart Ellman

Stuart Ellman

Eric Wiesen

Eric Wiesen

“Should I build my company to be a profitable, standalone business or should I be aiming to fit into the long-term plans of my likely acquirers to facilitate an M&A exit?”

This is a question that entrepreneurs ask themselves every day. If you asked a hundred venture capitalists this question, I suspect the overwhelming majority of us would give you the canonical answer – build for long-term profitability and a standalone business, because the tides of M&A can come and go. In the previous era, many VCs liked to see every investment as an IPO candidate. And that made sense in an era when a pre-revenue web company burning cash could actually go public. But in today’s market, when even nine-figure companies with positive EBITDA can’t go public, it is worth asking this question again.

The argument for the traditional answer is simple and compelling – when you go to start your company, you don’t know what Google or Cisco or Dell will be buying in 3-5 years when you achieve sufficient scale to be interesting to them. As a result, if you build toward M&A, you’re likely to build toward whatever they’re buying when you start, and that will likely change significantly over the build period of your company.

There is also a huge issue of stage and valuation. Acquisitions tend to happen in two lumps. First is the “cheaper and quicker” route. This means that Dell can buy something for $10 to $25mm because it is cheaper and quicker than building it themselves. The second is “they already have scale” route. Obviously, a company like Dell can pay a great deal more for a company that sufficient scale that cannot be reliably replicated simply by recreating the technology. A good example of that would be the acquisition of Pure Digital Technologies (creator of the Flip video camera) by Cisco. Could Cisco build its own version? Sure. But they paid almost $600mm because Flip already had brand and scale . (BTW, kudos to Jonathan Kaplan, CEO of Pure Digital and a former RRE CEO). If you are selling in the “cheaper and quicker” category, it better be at a single-digit valuation. Nothing past a Series A.

The emerging counterargument is that the IT landscape has so significantly consolidated that the it’s become easier to project the tectonic movements of the “continental” companies like Microsoft, Google, Cisco and Dell. But is this true? Can you forecast what these companies are going to do? We sold MessageOne to Dell because it wanted to make a big move in hosted services. Could we have forecasted this in 2001 when we funded the company? Again to the Pure Digital example, how could you have guessed that Cisco would be going after the consumer market in 2002 when Jonathan was raising his first round.

We think this question is being answered in real-time. The standard advice to build for the long term is still good advice, but if all the exits are going to be via M&A for the foreseeable future, we’ll be thinking pretty hard here at RRE about what the big guys are really looking for. We still want to fund great entrepreneurs solving big problems in growing markets. But we also want to know what acquirers are looking for. Time to get smart in this area.

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