by Elad Gil
What is the set of metrics I can use to set a purchase price?
M&A: Convincing someone (and their major investors) to sell
There are two sorts of founders: those that want or need to sell and those that don’t. In general, founders sell either due to fear and exhaustion (because they are tired, have run out of money, or are about to get crushed by a competitor) or conversely due to ambition and excitement (because they are excited about the impact they and their team will have, or about the financial payday).
Convincing people to sell: Team and product buys
For team and product buys, you need to convince both the entrepreneurs and the investors73 that selling to your company is a good idea. There is a different strategy to getting each on board.
Convincing entrepreneurs. If a founder is burned out or running out of money, not much convincing is needed—they will even try to sell you on the sale. If the entrepreneur does not need to sell, your main levers are:
Compensation. There are different “levels” of wealth in people’s minds. They might include, for example, the ability to pay off school debt, the ability to buy a house, and the ability to never work again. In general, founders will react differently to $1 million in stock (“Wow, that’s a lot of money! I can work for your company for a few years and then try again at a startup”), $5 million (“I can afford real estate in the Bay Area and not worry as much in life!”), and $10 million (“I probably do not need to work ever again”).
Depending on the entrepreneur, her financial status to date, and her personal history, different levels of wealth may be sufficient to convince some founders to sell irrespective of other factors. In general, stock and even cash payments will vest over one to four years, and in some cases stock the entrepreneur already earned will be re-vested.
Impact. What impact will the founders and their company or product have on your product and direction? Since you are starting to buy other companies, you are probably reaching millions or even hundreds of millions of people with your product. Can their product or vision overlap with yours so that they can influence the lives of millions of people?
Role. What role can you offer the founders and/or CEO? Will they have a larger team or even more influence than they did at their startup?
Threats. While I am not a big fan of this approach, some companies are famous for threatening startups they want to buy. They may file a lawsuit claiming IP infringement, or mention casually that they plan to enter the market, so the two companies may as well join forces. In most cases these are idle threats.
“One of the biggest causes of early exits are founders’ spouses, who are typically less risk-seeking.”
—Elad Gil
Convincing investors. In a team or product buy, you will also need to convince investors to allow the sale to go through (assuming they can block it). Most investors want to see at least a 3X return on their investments on average. Of course, that means they need to do better than 3X on the “winners” to offset companies that shut down or return nothing to the investors. If your offer returns less than 3X their investment, investors may fight against the acquisition.
Things to mention to investors:
“You are trading low-appreciation stock for high-appreciation stock.” The basic argument is that the company you are buying is not on a high-growth or breakout trajectory—but your company is. By selling now, the company you acquire (assuming you are using stock to do so) will have a multiple on this outcome, as your own stock should appreciate dramatically. In contrast, even if the startup doubles in value over the same time period, selling to you is a much better return. For example, my startup Mixer Labs sold to Twitter in 2009, when Twitter was worth about $1 billion. This means we’ve seen at least a 10X return, on top of what we were acquired for, since that time.
“We plan to buy someone in this market. If it is not this company, it will be someone else.” This means the door may close on the opportunity for the company to exit to you in the future. It’s now or never.
“Our relationships are important to us, and you are in our ecosystem.” You see certain VCs involved in exits to the same set of companies over and over (e.g., Google, Facebook, Twitter, etc.). These VCs will want to maintain a good relationship with your company so that if they need to help sell one of their portfolio companies, they will have a direct line of access to your corporate development team. This is another way of saying that Silicon Valley is a long game, not a short one.
Convincing founders to sell: Strategic buys
Assets that are truly strategic and breaking out themselves are much harder to acquire. This means longer-term relationship building will make a big difference in the likelihood that you will be able to purchase the next hot company in your market.
Once your company hits a certain scale, you should start meeting with the CEOs of companies you may want to buy every quarter or two. This relationship-building may eventually pay off in a competitive strategic situation. Mark Zuckerberg at Facebook was notoriously focused on building relationships with the founders of WhatsApp and Instagram, leading to pole position for them to acquire both companies over time.
When convincing people to sell a strategic asset, there tend to be a few large levers:
Autonomy. Many founders started companies so that they could drive things themselves. They do not want a lot of overhead and bureaucracy. A promise that you will leave them alone to run their company, while providing financial and Sales, General & Administrative (SG&A) resources to help support scaling, can be attractive to founders. For example, Android and YouTube both ran autonomously, with their own hiring processes and criteria, for years post-Google purchase. In parallel, Google supported these acquisitions financially, and provided headcount and resources for the messy business areas (operations, sales, etc.) that product-centric founders often don’t want to deal with.
Support. Some founders just don’t want to do the extra work of building a stand-alone public company. They want to focus on product and design, not building out a sales team. Or they hate sitting in meetings to discuss employee ladders and accounting. Pitching autonomy plus the support to focus on the stuff they care about can convince founders to join you.
Impact and role. In some cases an incoming founder will be given a larger role than she had in her own stand-alone company. You often see startup founders take on broader divisions of the acquiring company or key strategic roles. For example, John Hanke from Keyhole (which developed the software behind Google Earth) ended up running all of Google Maps.
Competitive dynamic and/or fear. YouTube exited to Google in part due to the threat of lawsuits from the media industry. Some founders/CEOs can be convinced that they are about to get crushed by third-party forces, lawsuits, or other external threats.
Money. Financial outcome can cut both ways—i.e., if a company is going to do well no matter what, founders may think a certain amount of money is a high enough baseline and not be tempted by the immediate exit. However, in some cases you can convince a founder that the safe road is to sell now and never have to worry again. One of the biggest causes of early exits are founders’ spouses, who are typically less risk-seeking. Often they push for the safe exit so that they and their children are set for life.
M&A: Negotiate the acquisition
Negotiate the sale: team or product buy
All negotiations are about relative leverage (or the perception of leverage). In order to understand more about the company you plan to acquire, you should ask about cash position/burn rate, cap table, team size, product growth rates, and other factors. This will allow you to determine how desperate the founders are to exit.
Some additional rules of thumb:
1. If a company closed a funding round in the preceding 3–6 months, you usually need to pay at least a 50% premium on the valuation. In some cases their investors will try to push for a 2–3X valuation bump. However, if the overall market has shifted dramatically, the founders are desperate to ex
it, or the company has poor future prospects, you could trade at the last-round valuation or a discount.
2. The typical value per engineer, product manager, or designer is between $1 million and $3 million per person. Business, operations, or community managers tend to have low-to-negative value for a team buy (since in some cases they will not be part of the acquisition and you will need to pay severance). For special or outsized talent this may go as high as $5 million. Note this money is often spread across the cap table (mainly investors and founders) and retention.
3. Get a range of valuations to offer from your CEO or board, and then anchor as low as you reasonably can. A board typically approves an “up to” price for an acquisition, with an agreed-upon likely range (e.g., $15 million up to $20 million). If the situation is not super competitive, the deal team may anchor on the lower side (e.g., $12 million) to provide some room to move. If the situation is competitive, the deal team is more likely to open with an aggressive offer (e.g., $18 million).
4. Many corporate development teams quote total deal value in their opening bids without mentioning what part goes to the cap table (i.e., preferred and common stock) versus retention. This can materially impact value to founders, investors, and employees. Bids usually also ignore cash on hand.
As an example, say you offer a $10 million purchase price to a six-person team with $1 million still in the bank. Since you are buying the company, you also get their cash, making the real purchase price $9 million. (Some people even use part of the company’s cash to pay bonuses to the team in a manner that does not impact the acquirer’s cash holdings.)
In reality this offer may mean $6 million to the cap table and $3 million in retention. So, if a founder owns 20% of the company at this stage, she will receive $1.2 million, not the $2 million she likely expected when you quoted a $10 million offer. The remaining $3 million may include additional retention for the founder, but is likely to also be split among the other five employees (i.e., $500,000 in four years of retention each, including the founder).
In many cases, once an entrepreneur decides to exit and is excited by an initial offer, she will not walk away once she fully understands the nuances of the deal. At that point, she has already seen the light at the end of the tunnel (“I don’t need to wake up in a cold sweat in the middle of the night anymore!”) and has mentally spent the money (“I can finally pay off my credit cards and buy a condo!”). This is why entrepreneurs should always talk to a small subset of their investors or advisors when they receive an acquisition offer. They need experienced people, who have seen this happen a bunch of times, to help them avoid the common traps laid by savvy corporate development people.
In general, it is important that the person negotiating the deal with the founder not be the same person that the founder will eventually report to or work with day-to-day. There are often bad feelings between a deal person and at least some of the entrepreneurs who get acquired. Letting go of your startup baby is hard to do, and negotiations can be tough on first-time entrepreneurs.
“Entrepreneurs should always talk to a small subset of their investors or advisors when they receive an acquisition offer.”
—Elad Gil
Negotiate the sale: Strategic asset
When buying a strategic asset some key principles are:
1. Buying strategic assets is also a sale by your company. Facebook’s ability to buy Whatsapp and Instagram was a reflection of the relationship Zuckerberg had built with each founder in advance. Over time he sold the other CEOs on the benefits of joining Facebook and built a trusted relationship. Effectively, Zucerkberg sold Facebook to Whatsapp rather than the other way around.
2. The CEO needs to get involved. As CEO, you will need to be part of the relationship building leading up to the acquisition, and some aspects of the actual deal itself. If your counter party CEO feels they have a relationship to you, they will trust you with their, and their company’s, future. It will be easier to negotiate and close the deal.
3. Move quickly. Especially if there are multiple parties bidding on the asset, moving quickly to a conclusion may benefit you enormously by creating time pressure or a sense of inevitability that you are the right choice. It will also show professionalism and a lack of dickering on minor items. Google famously bought YouTube in less than a week for $1.6 billion.
* * *
72 Note that in some cases companies may pay an enormous price per engineer for key talent areas. For example, Google paid large sums for deep learning teams in 2015, and before that for “social” experts during the Google+ heyday/fiasco.
73 Some investors (especially large VCs) may have the ability to block any acquisitions of the company. This means you will need to convince them to go with your offer. Some investors may behave poorly when you are getting acquired. One of my investors at Mixer Labs, while we were being acquired by Twitter, was an enormous pain in the butt and kept trying to negotiate more deal value for himself.
SCALING RESPONSIBLY, FOR YOUR USERS AND THE WORLD
An interview with
Hemant Taneja
Hemant Taneja founded the Silicon Valley operations for General Catalyst in 2011 and made a series of successful investments, including Snap, Stripe, Gusto, Color, Grammarly, and Livongo. He also cofounded Advanced Energy Economy, a nationwide nonprofit for advanced energy, and serves as a board member for Khan Academy. Hemant has five degrees from MIT.
Hemant has become an outspoken advocate for responsible innovation, calling on fellow tech leaders to embrace their influence and wield it responsibly. He published a book called UNSCALED, which describes the 30-year secular shift in society where we are rewriting all major parts of the economy.
I sat down with him to hear his thoughts on where we are in Silicon Valley’s evolution, how startups can position themselves to scale successfully, and why a winner-take-all mindset is often counterproductive. Along the way, he also shared how founders can embed social responsibility in their processes from day one.
Elad Gil:
One of the points you made is that we’re in the midst of a large, secular shift around organizing content, community, and commerce online. I’d love to get your view on what’s happening.
Hemant Taneja:
The big shift that we’re in the midst of is around scale. For 100 years we used scale as a metric of success. We scaled core services like healthcare, education and finance so everyone in America could have baseline access. And this was a net positive for a long time. Childbirth became safer, we got really good at dealing with trauma injuries and infectious diseases. Through scale, more kids were educated and more people had access to financial services. We created a vibrant middle class with economies of scale in the past century. China moved over 300m people into middle class within two decades using the same principles of scaling.
But today, I am convinced that scale has run its course.
Let’s take healthcare for example. In the old days, healthcare was only available to the affluent members of society. They used to have a family doctor who came to their home, knew them intimately, and took care of their health with great empathy. In order to bring basic healthcare to everyone, we started building hospitals across the country. We figured out how to control infant mortality rates, infectious diseases, and trauma, among other things. Today, if you visit a hospital, you barely get a few minutes with a physician, they barely know anything about you, and they are busy typing notes into their electronic medical records (EMRs) instead of making eye contact. This experience is a far cry from the experience a family doctor provided.
We could go similarly go through education, finance, energy, and other core sectors.
We’ve literally taken every one of these important services in society and scaled them to the breaking point. The banks have failed small businesses and large segments of consumers. The health care system is bankrupting us. We are not preparing our kids for the twenty-first century. The power sector has contributed significantly t
o climate change.
Fortunately, over the last twenty, twenty-five years, we have been engaged in this secular shift to organize content, community, and commerce online. It has given us, for the first time, an opportunity to rethink how we provide these basic services that are fundamental to our society.
It has also brought the role of technology and technology entrepreneurs front and center. We’re in the hot seat. We’re building modern education, modern health care, modern financial services. When I think about my own work over the last decade, I’ve been drawn to founders who are trying to take advantage of this secular shift and taking on these extraordinarily large markets.
Elad: I’d love to hear your perspective on first principles around focus on customers versus focus on regulators. As companies are scaling in these big, regulated markets—health care, education, finance, etc.—how should that focus shift?
Hemant: Take health care. I recently convened a working group of healthcare executives, who lead the most forward-thinking health systems in their use of technology. The conversation focused on use of software standards to interoperate with EMRs for improving healthcare quality and costs. And they were going on about standards and the various issues of EMR for four hours. I was shocked that their dialogue didn’t include any focus on either the patient or the physician at all.
In my closing remarks, I said that to them at the end of the dinner. “Gosh, if you think that by thinking so incrementally you’re going to go impact healthcare quality and costs, it’s never going to happen.”
One of the companies I helped create, Livongo, is an example of rethinking healthcare for consumers with chronic diseases from first principles. Today, a majority of the more than 30 million consumers who have type 2 diabetes check their blood sugar regularly and visit their primary care physician or endocrinologist a few times a year. In between those visits, their health deteriorates and they have seizures and development of co-morbidities. Most solutions, including use of software, in a traditional sense has been to get consumers to follow this regimen of engaging with their health. Silicon Valley created dozens of diabetes management apps for consumers to capture data around blood glucose and nutrition more efficiently. Meanwhile, the prevalence of the disease and cost of delivering care keeps rising.
