The Value Circles of a Start-up
Over the years, working with start-ups and investors (as well as starting a few and selling one) taught me how to understand the value of the special breed of companies called “start-ups”. Today, after giving my pitch to a friend (Noam Bernstein) he mentioned I should write a Medium post about it, so I guess that’s what I’m doing now.
Start-ups are very different than normal companies in many ways. You can define them in many different ways and they probably all make sense, just as modeling a photon can be done by a wave function and a particle model at the same time. But the core essence of the Venture Capital business model relies on creating massive amounts of value, sometimes very quickly.
To understand why start-ups can get acquired so fast and for such large amounts of money, it is necessary to understand all components that make up the value of a start-up company, with a strong emphasis on the last value circle — the Strategic Value a start-up company can give its acquirer. However — the Venture Capital industry does not rely solely on exiting companies to other companies, especially in the larger, later round investment stages, where start-up companies are directed to mature into normal companies.
Every start-up always starts out as a team. The team itself, as a whole, is worth more, sometimes much more, than its team members alone. You can think of it as an engine — torn apart it can’t do much, but assembled together, it can exert a lot of force. A team is a construct which has proven to be able to work together and to deliver value, in a specific area of expertise. For example, a company which developed a game can always be repurposed to build other games, but a random bunch of developers can’t necessarily do that, because it is missing all the different components, as well as the right manager.
A lot of the acquisitions that happen (and usually are considered a failure from an investor’s perspective) are valued mostly on the team — at around $1-$2 million USD per developer, and a lot of times get paid in options or RSUs as opposed to cash, so that the developers will stay in the company. A lot of times, this type of acquisition is referred to as an “acquihire” (e.g. an acquisition which is actually a consolidated hiring effort).
Companies are tempted to do these types of acquisitions simply because they have the proof that teams work well together, and that the fact that they have attempted their shot at building a start-up also means they’re probably very talented and ambitious, so the companies will hire them for a premium. Not only that, but it’s also an easier path to justify higher salaries where the limitation of salaries can sometimes be dictated by the organization compared to hiring people in the standard route.
If the team has managed to build useful technology during its attempt to build a start-up, it is worth a lot — at least the time it took to develop it times the number of developers it took to develop, times their salary. Keep in mind that technology by itself is worthless, as engineers always have to maintain any piece of code or other types of technology, for it to actually function in the real world. In many cases, when the team receives a large amount of compensation, it is also due to the fact that the acquiring company wants the same developers which build the technology to stay for a few years and integrate it in the acquiring company.
Technology cannot live without the team when looking at the value of the company — for this specific reason, and this is why technology encapsulates the value of the team, as it is part of it. At least, at the point of acquisition, that is.
So, why do companies acquire technology?
Successful companies manage to utilize their technology to build a thriving business. The business component is made up of all of the signed partnerships, paying customers, business agreements, etc. and a lot of times is considered to be less significant when valuing early-stage companies because it takes time to build a business. For later-stage companies, the business can be significant and is usually valued with some sort of typical multiplier that is common for that type of company, just like any business.
However — a start-up making even a small amount of revenue for an early-stage company is an extremely good sign. It usually means it is up to something new which can quickly scale in sales. It’s also well known that the chances of multiplying your revenues as a start-up company after reaching $1M USD to, say, $2M USD in annual revenue are much much higher than the chances of getting from zero revenue to $1M USD in annual revenue. (Peter Thiel said it first).
The business of a start-up most of the times relies on the technology which was developed, which in turn, relies on the team to function. Buying the business (the signed contracts and partnerships, and the code) is never enough if the business needs to continue to function until fully integrated into the acquiring company — which is why in such cases, the employees can receive even more compensation to stay.
Last but not least — and the most critical component of fast-growing companies is the strategic value of a start-up company to a potential acquirer. Let’s take an example — let’s say that a company has developed amazing technology to migrate your servers into the cloud. The company can either go and sell their product, one customer at a time, or they can get acquired, and use the thousands of already existing customers of the acquirer who are looking for the solution you’ve developed and are ready and willing to pay for it. Not only that, what the buying company really wants is to block the company not to merge with other competing companies (e.g. Amazon won’t want Microsoft to buy the cloud migration company because it will give Microsoft a relative advantage over Amazon).
The strategic value relies on the technology and the team, and sometimes also on the business agreements which were signed as part of building the company.
When looking at fast-growing start-ups who also sell fast (e.g. 3–5 years) and for a lot of money, you will always notice that there was always a non-trivial strategic value for the acquiring company, much greater than the potential future revenues of the product line that company has developed. It’s usually hard to explain how companies who almost never get to $10M annual run rate can be worth $300M or more, just by looking at their P&L — and this is the reason.
A lot of times acquiring companies will talk about the strategic value the acquisition brings to the acquirer for marketing purposes, but they will never bother mentioning that some (if not most) of the money used to acquire the company was invested to get the company “out of the market”. A classic example would be Waze — which was never critically strategic for Google as much as it is critical to acquire them so that Apple won’t have such a great product. Same goes for WhatsApp and Instagram, which were acquired mostly to avoid competition from another social network, and to ensure dominance by Facebook of the social network world.
The interesting part about building start-ups is that there are really two ways of building “successful” start-ups: one way is to build a thriving business, which usually takes a really long time, and the other is selling your company to another company for a disproportional amount of money compared to the amount of money the company makes from its business. The acquiring company will either make your product and technology a thriving business using their assets, or perhaps buy you just to take your company “off the shelf” so that others won’t have it. In some cases, the reason that companies will buy you for such a disproportional amount of money is simply to mitigate existential risk, either from you or their competition.
If and when you decide to build a start-up company, it is very important to create a “hedge” in the form of formalizing your potential strategic value to other companies and directing your tech and product there as well. As most companies will not reach an IPO stage (just because it’s very hard), it is always important to think about how your companies can create even more value to larger companies which dominate the space your company operates in — in the common case which you won’t be able to reach enough customers to become a sustainable long-running company.
It’s also very beneficial to build meaningful, defensible and repurposable technology, so you can navigate the rough waters of a start-up — and eventually be able to provide value in the form of a business for you or your acquirer.
And, last but not least, invest in your team the most, because, without them, everything you have built will fall apart.