Billion-Dollar M&A Club Admission Guidelines

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Editor’s note: Glenn Solomon is a Partner with GGV Capital. Some of his recent investments include Pandora, Successfactors, Nimble Storage, Isilon, Domo, Square, Zendesk, Quinstreet and AlienVault. His personal blog,goinglongblog.com, focuses on growth-stage entrepreneurs who are thinking big. Follow him on Twitter @glennsolomon.

Average valuations for venture-backed M&A deals typically come in a pretty tight range.  According to the National Venture Capital Association (NVCA), in 2013 there were 377 total M&A exits of venture-backed companies with mean pricing of $161 million. This compares with total deal count of 499 and 488 and mean pricing of $143 million and $173 million in 2011 and 2012, respectively.

Every once in a while, however, a $1 billion or even multi-billion M&A deal for a venture-backed, relatively young company pops up, such as the recent Nest/Google announcement. These deals defy conventional valuation logic since the acquired companies are early in their revenue curve or sometimes even pre-revenue. Where do these billion-dollar deals come from and what factors are involved in their creation? Below I’ve identified three primary drivers that motivate acquirers.

Billion-Dollar M&A Drivers

Rocket Ship Riding. Sometimes a target achieves such incredibly fast early growth that acquirers become enamored with the potential for the future. Particularly in the consumer Internet context, these companies are often pre-revenue, with growth coming in other key metrics. Facebook’s $1 billion acquisition of Instagram is a good example. Facebook clearly saw Instagram’s growth as both a threat to its own popularity and an opportunity to continue to expand engagement among its core constituents. Price didn’t matter as much as this future potential. Google’s near $1 billion acquisition of Waze was similarly driven by the traffic app’s growing popularity and Google’s recognition that it could integrate Waze functionality into Google Maps, further enhancing its own product line.

Fear of Losing Out. In addition to perceived potential, fear is also a very powerful motivator.  Acquisition prices can be driven up to billion dollar levels when an acquirer develops the fear, real or not, that they might lose an opportunity, either to a competitor or to the target itself gaining enough traction that it will remain independent and become a threat to the acquirer over time.

When DoubleClick was acquired by Google for $3.1 billion, Microsoft was widely rumored to be aggressively pursuing the deal, as well. No matter that DoubleClick had been acquired by private equity firms Hellman & Friedman and JMI Equity for approximately a third of that price just a few years earlier. The perception that the inventory DoubleClick controlled was extremely strategic gained footing in Google’s board room, similar to Microsoft, which led to the outsized outcome.

When VMWare acquired early-stage Nicira for $1.3 billion, VMWare execs saw this as a move to protect their core server virtualization franchise and extend into network virtualization, as well. When looked at from this vantage point, the price makes more sense.

Lottery Pick on Draft Day. Innovation is rarely a core competency at large tech companies.  In fact, executional excellence, at which large tech companies usually excel, often runs counter to the culture of risk taking required to spawn new, disruptive initiatives. Execs at large tech companies know this and it can be very frustrating. This can motivate the desire to bring in a team of people who are perceived to have skills and abilities to drive innovation that otherwise won’t occur. With this logic, acquisition price becomes a minor issue.

Google’s recent $3.2 billion Nest acquisition must have been driven, at least in part, by Google’s desire to bring in a talented consumer hardware team, headed by Tony Fadell, that can innovate in the connected home area. This is a market Google has identified as important, but without a tiger team like the one from Nest, Google execs recognize they will likely never get from here to there.

Consideration and Considerations

Although entrepreneurs who end up selling for $1 billion or more rarely begin their journeys thinking they sell their companies, there are several issues that should be considered carefully if this becomes an option.

Cash vs Stock. With growing piles of cash on the balance sheets of many large tech companies, the ability to pay cash for some or all of the purchase price in a billion-dollar M&A is more common these days. Cash obviously removes any uncertainty with respect to the ultimate price. Stock prices can plummet, adding possible risk to a stock deal for entrepreneurs, their employees and investors. Especially if you’re being acquired as a lottery pick, expect acquirers to want you and your key team to stay for many years. The purchase price will highly incentivize you to stay, including stock vesting. Each entrepreneur has a very unique and personal situation and needs to weigh the pros and cons carefully.

Certainty of Closure. When an acquirer floats a very large acquisition price, the risk of the deal not going through to completion increases.  Recognize that someone at your potential acquirer is probably staking her or his career on the decision to pay up to acquire your company.  Its human nature to get cold feet.  Pay close attention to who the acquirer is – what’s their reputation is for going through with acquisitions?  what’s the status of the company right now?  how powerful is the board and/or CEO and are they behind the deal?  It’s not atypical for a target to go with a lower price from an acquirer who has a higher perceived certainty of closure versus other higher offers from riskier would-be acquirers.

Fit and Alignment. For entrepreneurs, there’s no rule that you must accept an acquisition price once it hits a certain level. Many potential acquisitions don’t consummate because the perceived cultural fit and/or alignment on the future vision doesn’t completely align.  Most entrepreneurs with whom I’ve spoken who have sold their companies (whether at billion dollar levels or lower) regret the decision later due to poor fit with the acquirer.  It’s critical to get this right.

For many entrepreneurs, their own indomitable will doesn’t waver, even in the face of a billion-dollar M&A offer, and it’s go long and go big or bust.  For example, Snapchat appears to be on this path, at least for now.  For some others, the appeal of taking a billion dollar offer is high enough to veer off the independent path.  Instagram went this route.  There isn’t a right answer.  But, recognizing the motivation of would-be suitors – be it rocket ship, fear of losing out, all-star draft picks, or some combination of the above – can help navigate the waters.