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.

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