Imagine that you are approached by literally thousands of folks every year. Nearly everyone you will meet would love to take your money, is particularly nice and says you’re a great guy and the right partner for their company.
If you are not careful, you will start believing it. You will get used to entrepreneurs reaching out to you – not you to them; they will come to your office – you wont bother taking the first meeting at their place; they play to your timeline, to your terms. And from all those people you meet you will invest in the ones you think are the best. And because in venture capital it can take many years before you realise you may not be very good at your job, you will go on like this for years and years. “We have such good proprietary deal-flow”, “we see nearly every deal on the market – they come to us” is what you will think and say.
What is actually happening is that you are engaging and getting feedback from the wrong side of the market. You have become an adverse selection investor. It’s a common VC movie that does not end well.
A clear observation of mine is that – as a rule of thumb with exceptions – the best investments are usually the hardest. You have to fight to get in; fight hard to convince the entrepreneur you are the best partner. You’ll get a few knocks, it’s humbling.
But it’s good for you, keeps you on your toes. Don’t need funding right now? – how about we take out those seed investors in an attractive secondary and put in a little fresh money on top at a much higher valuation to make this work? Being creative, finding ways of having the best companies and entrepreneurs accept your money – not finding the easiest (laziest) way of investing money in whoever walks in your door.
The best deals are when VCs are pitching founders.
For some folks this is an observation from the church of the bleeding obvious. And they are right. But I still see it every day. That is why I am very happy to observe increased competition in the European VC market. It is good for everyone.
Our best product driven companies have a pretty inclusive decision-making style. This means that every team member can contribute to key product decisions and their opinions and thoughts are taken seriously.
Sometimes this can go a little too far though and all of a sudden the product roadmap becomes more or less subject to a democratic process. Mostly inform of an unofficial committee of the most vocal team members – sometimes correlated with their seniority / experience, often not.
Then it’s important to remember that startups aren’t democracies and that a camel is horse designed by a committee.
One of the true gifts from the internet to entrepreneurship has been the volume and accessibility of information on how to build and run a company. Thank you internet for helping to democratize and liberate entrepreneurship like that.
Most good entrepreneurs will suck up information like a sponge, digest it and apply key learnings to their companies if and when they think it makes sense.
Here’s what doesn’t work so well: a CEO (usually young & at a small startup) reads a blog post in the morning and changes the company’s product, strategy and / or operations later that day based on that blog post. Same CEO, same procedure next week. After a while your team may get the impression that you have no idea what you are doing.
They may be right.
Recently one of our teams walked us through how they had significantly improved their conversion rate in their email marketing channel. They used a simple but highly effective user incentive trigger to make more people click on the sig-up link. This was great. But of course we then started discussing how this could potentially be masking other things we may not be doing so well – the messaging, mechanics, distribution strategy, etc. The only way to find out is of course to alternate and compare.
There are lots of great email marketing frameworks, but we ended up with this very simple one. We basically split up email marketing in to the following elements:
- Messaging: this is basically the text, your claims, your promises, your language, etc
- Mechanics & design: these are things like whether the sign-up button is red or green, it’s plain text or html, you use screenshot A or B
- Incentives: these are things like “first 100 sign-ups will get x”, “only 200 beta slots available”, etc.
- Distribution: this is for example when you (what time and day) send an email out (it can matter a lot), do you send to groups of people with the same company email address at the same time or staggered, etc.
You then narrow down each element to say five alternatives. And you go through a few (sensible) combinations of the alternatives:
Until you have your winning combination of the right messaging, mechanics / design, incentives and distribution strategy.
Benedikt Lehnert is the chief designer officer at 6Wunderkinder. He wanted to create a guide to typography for his team. So he built typogui.de and it is now one of the most popular typography guides on the web. Benedikt has a whole portfolio of these things, including various apps he has built over the past few years.
Cat is the lead designer at EyeEm. However she’s also building Liberio, which is getting rave reviews from e-book publishers that have been lucky to get beta access. Who knows where it can go from there & I am rooting for her.
My point is that the best designers are easy to spot. They aren’t happy with just working on one thing. They are also not happy at just making things look pretty. They are only happy when they can actually building things; many things. The best designers roam free.
“We only invest in real technology.”
I am hearing this more and more among VCs recently. I dislike it a lot. I dislike it because it falls short of the reality we live in, ignores huge opportunities (through false assumptions) and has an arrogant / elitist undertone. It implies that, somehow, if your company does not have a strong technical / engineering aspect (“real technology”) you are somehow a less worthy startup or entrepreneur.
This is of course nonsense.
The way we view the world is that there are 3 engineering challenges:
- Technical engineering: you are solving a technical problem
- Social engineering: you are introducing a new social / human behaviour or making it easier / better to act in a social way
- Economic engineering: you are introducing a new economic behaviour or making it easier / better to perform economic transactions
This is very simplified but you get the picture. All 3 can individually or combined create extremely valuable companies.
That’s why I don’t care if you are a “real” technology company or not.
More often than not the reaction to a large company buying a comparatively small startup for a few hundred million or even a few billion is “nuts”, “bubblicious”, etc. In some cases this may be true and history sure is littered with poor acquisitions.
It is also full of great acquisitions that were called crazy at the time.
The problem is that we (e.g. wider public, journalists, the tech community and anyone not part of the deal) are largely working of a fraction of the information required to determine the “true value” of the startup company (let’s call it StartCo) to its acquirer (let’s call it LargeCo). The two key pieces missing to outsiders are usually the financial projections of StartCo for the next years and the synergies (both cost savings and additional revenues) LargeCo thinks it can achieve by acquiring StartCo.
Let’s say we know a lot more than the public usually would:
- StartCo’s 2014 revenues are expected to be $10m
- the discounted value of an independent StartCo’s future cash-flows is $100m
- StartCo’s stock-exchange traded peer group has an average 2014 revenue multiple of 5x (enterprise value divided by 2014 estimated revenues)
LargeCo just announced they are acquiring StartCo for $200m. You can add a few 0’s here and there for more fun – the same math applies.
Limited information usually leads to two mostly knee-jerk reactions that go something like this:
- “StartCo’s peer group is valued at 5x revenues and LargeCo bought StartCo for 20x! Nuts!”
- “Even if you factor in future cash-flows and the high growth of StartCo, StartCo is still only worth 10x revenues at most – and LargeCo bought them for 20x! Bubblicious!”
Yet 20x revenues could be just the right valuation of StartCo for LargeCo. In fact it could be a complete steal for LargeCo. Why?
1) Growth Premium
The first one is easy and independent of LargeCo acquiring the company: growth. It explains why startups can be acquired (or listed for that matter) at much higher multiples than a more established lower growth peer group of companies.
Having more growth means you should be valued at a higher multiple than your lower growth peers. The reason is that today’s valuation needs to – in relative terms – reflect a much higher cash flow going forward vs. the cash flow today.
So let’s look at how StartCo’s revenue profile compares to its more established, lower growth peers:
So you can easily see that StartCo is in a growth league of it’s own (145% compounded annual growth rate – “CAGR” – from 2014 to 2016) compared to it’s more established peers (17% average CAGR over the same time). I am assuming here that cash flows are growing at an equal rate because they ultimately determine value. In fact StartCos cash flow growth is likely to be even higher, coming from negative, to low % positive to (better than) industry standard. But to keep it very simple I’ll stick with revenue multiples.
Ok so now let’s look at how StartCo’s peers are valued on the stock exchange and what their implied EV (Enterprise Value) / revenue multiple is. I have also added the acquisition price LargeCo is paying for StartCo so we can get its implied EV / revenue multiples too.
So StartCo’s peer group trades at 3.3x – 9.0x 2014 revenues with an average of 6.2x. So looking at 2014 revenue multiples the acquisition price LargeCo paid for StartCo sure looks a bit crazy (20x vs. an average of 6.2x). But it doesn’t look so crazy when you look at 2015 (6.7x vs. 5.2x) and based on 2016 multiples the acquisition is a complete steal (3.3x vs. 4.7x)!
Remember – the 2014 revenue multiple of StartCo is very high because it reflects extraordinary growth; the revenue (and cash flows) will ‘catch-up’ with the valuation and it is not unusual that the implied 2016 revenue multiple is even lower than the peer group, probably due to the relative higher risk, still lower profitability, etc.
The picture becomes even clearer if you map the revenue multiples and growth rates on to a chart.
You can see that revenue multiple and growth rates are correlated within the listed peer group:
… and if you add in StartCo’s data points (top right) you can pretty much see it’s actually below the likely correlation line.
Key takeaway: extraordinarily higher growth warrants extraordinarily higher revenue multiples.
But wait – didn’t we say that all future cash flows of StartCo are worth $100m; so clearly $200m is still way overpaid – even if growth warrants a higher multiple to StartCo’s peers?
No – because we haven’t factored in…
2) Synergies LargeCo can achieve
This is harder and relies heavily on assumptions made by LargeCo – i.e. on how beneficial LargeCo thinks the acquisition of StartCo will be, beyond the actual value of StartCo’s future stand-alone cash flows.
LargeCo isn’t just buying StartCo and planning to keep it as it is. It plans to aggressively push StartCo’s products through its own sales channels, it plans to bundle StartCo’s products with its own improving conversion and churn, it wants StartCo to be the nucleus for an entire new product strategy, etc.
Let’s say LargeCo’s management team has carefully analysed the potential synergies and presents the following to the board (list of synergies with corresponding value of future cash-flows of these synergies for LargeCo):
So StartCo is actually worth $300m to LargeCo. Now of course if LargeCo paid $300m it would not create any value for its own shareholders.
But the management team and it’s board decide that it’s worth paying $200m for StartCo. This will create $100m in value for LargeCo’s shareholders – while paying 2x the value of StartCo’s future stand alone cash-flows and over 3x the peer group’s average revenue multiple.
Nuts? Bubblicious? Maybe, maybe not – time will tell for LargeCo. That’s why I’m careful with knee-jerk reactions to startup acquisition prices.