Instagram. It’s understandably on everybody’s mind these days. Clichés abound about, “You know what would be cool? …”
I’ll write soon on my views of why I believe Instagram took off as a social network and what I think comes next. Instagram happens to be one of the few social networks I regularly use along with Twitter. I use it much more frequently than I’ve ever used Facebook and have done so since inception.
Still, there will be a “next.” I’m just back from Spring Break with the kids so I chose not to weigh in during the fracas. I will weigh in with some thoughts soon.
What I want to talk about today is one of the insider baseball discussions of our industry this past week: The odd fact of the $500 million financing round completed just before the company sold for a B. This head scratch was best captured by Alexia Tsotsis in her post on TechCrunch.
Was this a good thing?
Did raising money at a $500 million valuation help secure the $1 billion deal? And what can we – as the entrepreneurial community learn from that?
99.9999% of you won’t be contemplating raising capital at $500 million any time soon or selling for a billion. But a healthy percentage of successful startups have potential buyers “showing interest.” And because most startups have 12-18 months’ cash-on-hand at any point in time (usually less that 1 year, actually), the age old neurosis of whether to fund raise now or “wait and see what buyers might propose” comes up.
I’ve lived this personally. It sucks.
My friend Christine Herron of Intel Capital weighed in on the issue
“it’s smart to use an impending investment valuation to drive a higher acquisition valuation”
I would like to amend her statement slightly to read, “it’s smart to use an impending investment valuation to drive an higher acquisition.”
Emphasis placed on both “impending” and removal of “higher.” In this week’s discussion with entrepreneurs I think the word impending wasn’t used often enough.
Christin goes on
“If the company was able to use the Sequoia deal to drive its Facebook acquisition value higher, then in theory the founding team’s smaller share of a larger $ pie is greater than the larger share of a smaller $ pie. A nice play if you can make it.”
A nice play if you can make it. True.
Let me be clear – you cannot. You are not Instagram.
Let me explain
“Impending” valuation
Let’s say your company is currently valued at $15 million. You’ve found yourself in a super hot category and – let’s face it – it’s still a very frothy venture capital funding market so you may have loads of VCs chasing you. You think you are now ready for your $20 million round. In a perfect world you’d like to hit your always-dreamed-of valuation of $100 million pre. In the “worst case” you’d settle for a cool $80 million pre.
But you’ve had tons of inbound interest from potential acquirers. You don’t know what they’d be willing to pay but they’ve been courting you. But they are SO FREAKING SLOW. Maybe you should just close your VC round? They seem to move a bit faster. And maybe that would force the big buyer to finally get off their butts.
And, hey, maybe you could just “Pull an Instagram.” You know, close your $100 million round so buyers will come in at $200 million.
Let me remind readers as I outlined in this post, there are VERY FEW M&A transactions for early-stage startup companies above $100 million. Many – MOST – are done in the $10-30 million range. Closing a VC round might just be the right move for you. But if you raise the money at the big price (or any price) please go in with the expectation that you are going to build a large, long-term business. Not as an enticement to get a buyer to pay up after the deal.
Think about it. You are either bought for stock or for equity. Let’s say you target LinkedIn to buy you. They’re worth $11 billion as of today. So $200 million would represent 2% of the entire company’s value. Is your crappy little 12-person company really worth they and their shareholders diluting by 2% given more than a decade they’ve put in building one of the Internet’s most solid business social networks? You better be a very clear improvement to their bottom line to pull this off.
Oh, I know – we’ll just ask them for cash!
Doh. Just checked their balance sheet. They have $339 million in cash on their balance sheet. Your $200 million “small acquisition” is a cool 60% of all of their cash. Uh… yeah.
And most likely your potential buyer is some other company with a much lower valuation, much less secure position in the future and probably less cash on hand.
Which is why the mega valuations you read about are almost always by companies with enormous valuations and/or cash on hand: Google, Microsoft, Cisco, etc.
And stating the obvious – Facebook’s valuation is estimated at $100 billion.
Hang on, Mark. You just said, “nobody would take 1-2% dilution.” No, I said you’d have to be really freaking awesome for them to do so. I believe Instagram was. Is. And represents great defensive value for Facebook as Chris Dixon aptly pointed out on Twitter
“Giving up 1% of your market cap to take out biggest threat is a savvy move.”
So my point. Raising a large round at whatever price will almost certainly take many potential buyers off the table. At least for a couple of years until you’ve grown into your new valuation / made enough revenue / captured enough customers / etc. to justify a “strategic” price.
Strategic must be a hugely defensive move or a move that the management team of the buyer believes could drive a huge increase in future revenue to more than cover the costs of having acquired your company.
If you ARE thinking about the possibility of selling – the most important word Christine used (which I fear was lost on the entrepreneurs with whom I spoke recently) was “impending.”
Getting a term sheet on the table is the second most sure way to get a potential acquirer to move faster. The first being a competitive acquisition offer from a fierce competitor. But that’s another story.
A buyer who has been thinking about acquiring your company will suddenly realize that within 30-60 days the potential purchase price for your company will go up significantly and if they want to take a look they had better do it sooner rather than later. I see this all the time.
Are You Screwing These VCs?
Unsurprisingly I recommend transparency with your incoming VCs. I would simply tell them,
“We are deeply committed to building a long-term, valuable business. We wanted you to know that we have, as you would imagine, have inbound interest in acquiring our company. We would like the opportunity to carry on these discussion for 30 days. I doubt we would consummate a deal. But I owe it to my existing investors and co-founders to listen.
In the event that they do purchase us now I would obviously pay all of your legal costs associated with this transaction.
And I want you to know that if we do complete the funding as we intend to – we’re not looking back. We’re not going to keep up the M&A discussions at a small mark-up to your round. We plan to double-down and build the huge company we know we can.”
What about “Higher” – Why Did you Strike That Out?
Well, of course you should use your “impending” valuation to get as high of a price as you can. But often times M&A is a yes or a no. And using the term sheet to get to a “yes” is a huge first step. The justification for the purchase price of the acquirer will likely not be determined by the price the VC was willing to pay.
Appendix
When I write quick posts and don’t have much edit time I feel I am often misunderstood or misquoted. So I want to be clear on a few points
- I am not saying all companies should be for sale. If you’re passionate, are enjoying what you’re doing, believe it can be much bigger – stay heads down. That’s obviously what we’re all shooting for
- I am not saying you should artificially talk to VCs and to game them to get your M&A deals done. That’s bad behavior. You should talk to VCs if you think you will – or might – genuinely raise money. Most startups are always less than 12 months from their next funding round so you are likely always in need of more money to grow. And so this situation of having VCs and acquirers present is a common one.
- If you think you might be acquired by a company – do your homework. Some tech professionals are helplessly naive about financial transactions. They never stop to think, “what is the market cap of my acquirer, how much cash do they have, what would their investors think about dilution, etc.” In most cases the numbers in your head are fantasy land.
- We read, discuss, envy, model behavior after the 0.1% of deals that are enormous outcomes like Instagram. I am a HUGE fan of what they’ve built. If one day that’s you – congratulations. But since it’s not what normally happens I encourage all other companies to do the harder work of finding out what happens in the 99.9% case, which is what is often never written in the annals of the tech news media. But mad knowledge exists inside of every founder who has sold a business. I promise you the answers won’t be anything like what you’d imagine.
- Yes, there must be terrible typos in this post. I’ll fix them all later. Don’t be annoyed. It’s a day with my family at Griffith Observatory today – or – fixing typos. So …
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