Why large companies acquire small companies

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Large companies don’t acquire small companies for their financials.

Revenue multiples, profit multiples, premium over the previous financing — these are metrics used by sellers to help determine a minimum acceptable price. That’s the price that “pays for” enough foreseeable upside that it’s not worth rolling the dice against future troubles or the unlikelihood of an exit.

Large acquirers don’t care about small-company financials because mathematically those won’t affect the growth or value of the acquirer.  A company with $100m/yr in revenue growing 30% annually won’t go through the effort, risk, and distraction of buying a company with $1m/yr in revenue growing 100% annually, because that’s only a piddly 1% or maybe as much as 2% of additional growth.

Rather, buyer behavior is rooted in their strategy — a combination of product thesis, their theory of their market’s evolution, how they need to position for customers and against competitors, their long-term brand development, geographic expansion plans, and so on.

From this foundation, they’re constantly asking: “How can we execute our existing strategy, better?”

In terms of acquisition, they ask more specifically: “How can we trade balance sheet assets (cash, equity) in exchange for executing our strategy better?”

 

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The reason they want to trade balance-sheet assets for strategy-execution, is that (healthy, growing) software companies are valued on their P&L, i.e. the size and growth of income and earnings. They’re not valued based on how much money they have in the bank nor on how much debt they carry. So this trade is almost always a smart one.

But what does it mean to execute a strategy “better?” Let’s take three specific questions, all of which elucidate what “better” means:

“How can we de-risk the unknowns?”
“How can we accelerate the plan?”
“How can we become #1 or #2 in a new market?”

As a concrete example, suppose the product strategy included creating a new, complementary product that can be up-sold to existing customers, and that is unique in their existing market. One option is to build the new product in-house; this could take two years and millions of dollars.

(Startups shouldn’t act smug about this. Even for startups, it takes years for a new product to become good enough to demand many millions of dollars in revenue.)

Another option is to buy a startup that already built a decent product, which might take 6 months to integrate, accelerating the overall execution of the strategy by 18 months. Even if this costs more than 2 years of in-house assembly, it’s still worth it, due to accelerating revenue growth due to up-sales and market-differentiation.

This acquirer doesn’t care about the financials of the startup. The startup might have earned $1m/year on by clawing its way to (say) 1,000 customers, but if the acquirer has 100,000 customers, 10% of whom will buy this product, that’s $10m of revenue in the first year, even before including the value of market differentiation. It’s worth even more in the second year, in which their “do it yourself” plan would still not yet be kicking in.  So this acquisition is worth more than $20m in revenue, which at the average revenue-multiple for public tech companies, yields $100m in market value.

Let’s look at a real-world example, to see how this plays out even if the acquired company has zero revenue.

Pundits couldn’t agree how to analyze the sale of Instagram to Facebook. It was said that Facebook drastically overpaid (a billion dollars for a company with fanatical users but zero revenue) but also that that Instagram was stupid to sell so early (because after more “inevitable” growth it would be worth much more, and would “inevitably” be bought or go public at that larger valuation).

Zoom out to see the strategic decision. Facebook asserted publicly that their future was in mobile. Facebook mobile usage was already clearly eclipsing desktop, and the dominance of mobile in developing countries makes this trend permanent. Yet mobile advertising revenues were paltry. So the shift to mobile meant Facebook’s business model was breaking. This had to be remedied.

The least risky option was to buy mobile products that had already achieved scale within striking distance of Facebook itself (e.g. hundreds of millions of customers) and still growing fast. Instagram and WhatsApp were bought for a total of twenty billion dollars; they famously attempted to also buy Snapchat on equally generous terms.

It worked. The mobile trend has continued as predicted, Facebook mobile advertising effectiveness has been fixed, and growth continues on all fronts.

With a current market cap north of $400B, with 20% profit margins and high growth (given their size), paying $1B for Instagram or even $19B for WhatsApp looks brilliant in hindsight, even though neither company had a business plan. And of course, those same smug pundits now say Zuck was not only a genius for making the acquisitions, but also that he’s a genius for doing it without informing his board.

For a more recent example of the same, consider Atlassian’s acquisition of Trello, in which Atlassian revealed their “audacious goal: get 100 million monthly active users. To get there, Atlassian has to go beyond its traditional market of developer teams and branch out into other verticals.” Trello was already dominating other verticals in the space of kanban-style workflows, so this acquisition inserts Atlassian into those verticals immediately and with zero risk. All for the low-low price of $425 million, for a product which Atlassian itself recently admitted would bring in only $4 million in revenue this year.

Now let’s consider becoming #1 or #2 in a market.

In many markets, the top one or two competitors own the majority of the market, with share declining steeply from there. It’s often the case that the top one or two are larger than every other competitor combined, like Amazon Cloud compared to all others, or how McDonald’s has 20x the revenue of Burger King.

Acquirers know this, and they know it’s almost unheard-of for even a strong competitor to overtake the strongest brand. For example, the top two colas by sales are Coke and Diet Coke even though Pepsi has been fighting the “Coke Wars” since the 1980s.

Besides the general principle of wanting to enter a market as a major player, a large company is only interested in new products if they can deliver a material amount of new revenue, which means at least $100m/yr for a mid-sized company, or $1B/yr for a large company. In no case does it mean $10m/yr or less. Remember this is revenue, not valuation.

Because the top one or two competitors tend to dominate, acquiring the third-place position will probably not generate enough revenue to be interesting. History teaches us that the attitude of “we’ll kick-start growth with our brand, investment, marketing, sales” doesn’t pay off against entrenched incumbents. So, buying third-place is not a good choice.

The previous examples also exhibit this rule. Trello was #1 in kanban-style workflows, Instagram was #1 in social photo sharing, and WhatsApp was #1 in modern consumer chat.

Therefore, large companies either pay dearly to acquire the company who is already at the top of their market, or pay parsimoniously to add something to their existing product-line that will let them grow along their preexisting strategic path, incrementally improving their position in their existing market.

So, for small business owners hoping to sell some day:

You’re not wrong to worry about your growth and margins and multiples. That’s the floor of the negotiation. But if you’re angling for a sale, the solution won’t be found in your own financials. Rather, the single best question to ask is:

For what company would we be a “strategic acquisition?” Defined as: de-risking or accelerating the existing strategy of the acquirer.

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  • Jeffrey Fry

    I could not agree MORE!! It is all about how the “bigger” fish will benefit not so much fiscally, but strategically.

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  • Luca Fracassi

    Really well written post Jason, thanks

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