17 January 2011

Coming Soon: A Game Of Startup M&A Musical Chairs

Several weeks ago, I organized an event called StartupExits.com, where Naval Ravikant of Venturehacks gave an excellent keynote called, "The Rise of the Super Angels" (you can watch Naval's video here). Naval was discussing whether there was a new seed investment bubble forming, and one of his comments stuck with me me– namely, that while the number of seed investments has grown 20x, the number of acquisitions has barely risen. 

The implications of this are rather profound; essentially, it means we could soon see a serious glut of startups populated by impatient investors, founders, and equity-incentivized employees, but not enough buyers to make everyone happy. It’s a classic supply and demand imbalance, and my conclusion (also voiced by Naval) is that startup failure rates will rise. 

So, what are the takeaways for early stage startups? How should you prepare for a game of ‘M&A musical chairs’ to ensure you get a seat when the music stops? 

Ask yourself if you really need external funding-- or if you can get by without it. Any startup that takes outside capital is obligated to generate an exit for their investors either through an IPO (extremely long odds), or through an acquisition (very long odds). However, with the cloud, EC2, offshoring, viral social media marketing, etc., it has become ridiculously cheap to start a startup, particularly in the software / SaaS / Internet space (Guy Kawasaki famously started Truemors, which led to Alltop, for $13k). In addition, many startups are great at generating healthy cash for their founders, but will never be “M&A material.” In short, if you can bootstrap your way to cash flow positive, you can control your own destiny, and avoid any M&A shakeout altogether.

Start working on your exit strategy now. I genuinely believe that entrepreneurs should strive to build something great, and not ‘build to flip’. But successful exits do not just happen; they need to be part of a startup’s broader strategy and gameplan. Developing an exit strategy is worthy of its own blog post, but in brief an exit plan covers topics like: when to sell (ASAP, or let the chips ride?); minimum acceptable valuation (at what price would you sell your baby, and give up control?); type of acquirer (who is likely to buy you and why?); type of acquisition (are you ok with an earnout, and working for the acquirer for another 3 years?). A key exit strategy goal is to set and align expectations for the above between founders, investors, and employees; failure to do so now creates fertile ground for lawsuits down the road.

Build acquirer relationships early. This is an important one. Startup acquisitions can happen quite quickly– sometimes in as little as a few months– but in most of these cases, a relationship already existed long before acquisition talks heated up. This can take several forms; for example, Google often buys startups founded by ex-Googlers–they already know the folks they’re buying. Similarly, many large companies acquire startups with which they have an existing business development relationship. The key point is to get on the radar of potential acquirers early, and to stay on it; reach out to their business development, developer relations, or corporate development group and start exploring ways to work together.

Pivot faster and more frequently. I’ve worked with startups for more than a decade now-- through both Web 1.0 and 2.0 cycles--- and something I’ve noticed recently is that the speed of business model “pivoting” is accelerating. Entrepreneurs are getting better at experimenting with different business models, testing and measuring feverishly, and quickly scrapping things that don’t work until they lock on something that clicks with customers (which is usually the point at which acquirers and investors start to pay attention as well). The classic example is PayPal, which went through multiple, completely different business models before settling on one that was successful. In most cases I think this experimentation is a very healthy thing, and acquirers are often willing to pay a huge premium for startups that have successfully “figured out” their business model (cue Steve Blank here) and are now ready to scale rapidly.

Fail quickly. This might be somewhat controversial, but the moment it becomes apparent that your 'great idea' is actually just the 22nd Twitter desktop client or the 56th Groupon clone– and you do not have a clear, better idea for a pivot– I would argue that you should fold up shop quickly and return as much money as you can. This is advantageous for your investors– $0.40 on the dollar is better than $0– and it’s advantageous for you, allowing you to get back in the game with a fresh start (and fresh capitalization table) and try again. This does not mean you should give up easily-- very few things in life are as hard as getting a startup off the ground, and it takes a special level of persistence and faith. But all too often I've seen great entrepreneurial talent locked up in a startup that has no exit options and really isn't going anywhere, and it's a waste.
    That’s it for now. Let me know what other topics related to startup exits you’d like to see covered, and stay tuned for our next StartupExits.com event, tentatively scheduled for late Q1 or early Q2 of 2011. In the meantime, be sure to check out our "Exit Strategy Thought Piece" on Slideshare-- please 'like it', 'tweet it', 'friend it', whatever.

    11 January 2011

    Deals Gone WIld (aka "What Drives Massive Startup Valuations?")

    A few months ago, I wrote a blog post on startup valuation that presented a table of normal or “typical” price ranges for startups depending on the sector and stage of development, among other things. You can view that post (and the valuation table) here.

    But what about the outliers? What drives the sky-high valuations and manias we occasionally see around a deal? What about the deals we all envy and aspire to do?

    In short, what creates valuations such as the $2B for LinkedIn, $2.1B to $3.7B for Twitter, $5.5B for Zynga, $6.4B to $7.8B for Groupon, and last but not least, the $42 to $70B for Facebook? (estimated ranges, based on recent secondary market trading).

    While every deal is unique, here are three of the top startup valuation drivers of "deals gone wild": 

    Founders who have done it before (ideally at a name-brand company). The premise here is that a proven jockey will figure out the best way to win the race. And while history is generally a decent predictor of future results, other success-determining factors probably come into play too. For example, ex-founders of “hot” startups often find it easier to attract top talent (e.g, FourSquare, Square, and Quora), which in turn draws in more top talent. In addition, seasoned founders have presumably gained much of the scar tissue and lessons learned from navigating companies to a successful exit the first time around. 

    A leadership position in a winner-takes-all market. Some startup business models benefit from so-called “network effects,” which means that as the number of participants grows, the network becomes incrementally (or exponentially) more valuable to each new member. Social networks like Facebook and LinkedIn work this way, as do services like Groupon. The ultimate result is the creation of the Borg (for Star Trek fans) or a snowball rolling downhill (for non-Trekkies); in other words, an entity that sucks up all the customers in a market space as it gathers mass and momentum, and that produces a dominant new platform leader. In my view, this is the biggest driver of deals that go truly wild. 

    Profitability from Day One. Some startup business models are, quite literally, profitable almost from the get go. Assuming the startup has achieved some baseline level of engagement, stickiness, and (ideally) viral growth, the investment bells go off the moment that ARPU > CPU; or, in simpler terms, each new customer brings in more revenue than it costs to acquire them. At that point, it becomes less about the business, and more about the opportunity to arbitrage that delta through increased marketing spend. In such cases, funding is a no-brainer, and it simply becomes a function of figuring out how large the company can grow, and how quickly capital can be pumped into it. The virtual goods space with its almost zero creation and transaction costs, and the online gaming space in general (especially those that feature low cost-to-create casual games like Zynga) fit this model.

    Granted, there are typically many other factors at play when valuations skyrocket, such as general frothiness at the secondary markets, implied validation by a trusted party (such as the Goldman deal with Facebook), or a hot exit or IPO environment. But in my view, the three factors above are at the core of most hot deals, particularly in the Internet space.

    What am I missing? When you put on your CSI hat and analyze the scene, what other causes of 'deals gone wild' do you see? What do you think drives huge startup valuations?

    04 January 2011

    Your Financial Model Is A Work Of Fiction; Build It Anyway

    Startup Financials Series

    Startup financial models are a pain in the ass. They take a ton of time to build. They are complex and often messy. They are never truly “right.” And they are outdated almost the moment you finish them.

    Yet building a solid financial model is absolutely one of the best things you can do for your startup. Here’s why.

    Why Build A Model? 

    I've been building startup models and forecasts for over a decade now, and I've seen the entrepreneurs and founders that I work with gain a lot of value by going through the model-building process. Here are a few of the core benefits:

    Analytical Lens:  First off, building a model brings a much-needed analytical lens to your startup. It’s a great framework for thinking through your business in an objective, critical manner, and it forces you to construct numbers around each assumption you have about your business model. Consider the model a vehicle that captures all the drivers and levers of your business plan in a single, cohesive place, and explores how sensitive the business is to these levers.

    Operating Roadmap:  A model is, by its nature, a chronological way of laying out what you expect to happen and when—and what it will cost—in a very granular manner. As such, it becomes a roadmap for your business, and a great way to set milestones, track progress, and identify issues or problems as they arise. It’s also a great way to set goals with your team (e.g. monthly sales quotas per salesperson) and to manage expectations with the board, investors, and other stakeholders.

    Risk Assessment:  Identifying the key levers (and sensitivities) of the business helps illuminate the risk points of your startup— in particular, the magnitude of downside risk. For example, at most startups, expenses precede revenue. Matching cash outlays to a timeline helps us monitor our "burn rate" and remaining months of runway, and it helps us get a handle on how deep in the red we might get before hitting breakeven. (Notably, this can be very illuminating and even a little frightening—on more than one occasion, I’ve worked with founders who decided to pull the plug after building a model and uncovering the real economics of the business; this is healthy.)

    Scenario Exploration:  Models allow for multiple forms of really useful business model analysis. For example: what happens to our break-even point when we lower prices by 10%? Or, how much extra money will we need to raise if sales take a lot longer than we expect? Or, what do margins look like if we hire a direct sales team vs. recruiting a network of affiliates? When we isolate a key factor to analyze, we’ll often do a best case, base case, and worst case version of the model. Trying out various business model scenarios in a spreadsheet is far cheaper and easier than learning by trial and error.

    Pitch and Sales Tool:  Last but not least, models are a great way to bolster your pitch to investors, lenders or strategic partners. At its most basic, the model eloquently explains how much money you need, and how much you will make for the investor or partner. And in my opinion, it’s a perfect left-brain / right-brain combo when you can go in with an excitement-inducing pitch deck or demo (which sells your vision and appeals to the emotional side of the brain) as well as a solid model (which speaks to the logical, rational side of the brain). I’ve seen numerous situations where the model is the icing on the cake, the tool that ultimately helps seal the funding round or deal.

    That’s it for now; in my next installment of this Startup Financial Model series, I will cover several attributes that make a really excellent model. Let me know what you'd like to see addressed, or how you’ve used your models to solve business issues.

    In the meantime, here is a presentation we gave at Plug & Play Tech Center a couple years ago: Financial Modeling Tips for Startups Plug and Play Tech Center