Seth Levine's VC Adventure

A different take on the Google/YouTube deal

My partner Chris sent the following around.  Its a more lighthearted way of looking at the Google/YouTube deal...

YouTube is currently "delivering" 100,000,000 videos/day.  I'm by no means a prolific consumer of YouTube content, but I'm going to guess that the average length of a YouTube video is about 1.5 minutes.

 

That translates into 150,000,000 minutes wasted (or 2,500,000 hours) wasted each and every day watching YouTube videos (it would be interesting to know how many uniques that translates into).

 

Assuming a 40 hour work week and 50 work weeks per year (2,000 work hours/yr/person), that means that there are 1,250 "man-years" wasted watching YouTube videos--that's each and every day.  And people say that technology hasn't boosted productivity...

 

I didn't venture past Econ 1, so there may be more accurate ways to quantify the lost productivity, but for simplicity's sake, let's use US GDP, which was $41,800 per capita in 2005.  I'm sure that YouTube's viewership is a global one, but I'm also reasonably confident that the majority of viewers are from the US and those that aren't from the US are much more likely to be from other industrialized nations with per capital GDPs that are similar to the US.

 

That means that YouTube viewership alone is reducing productivity by over $52 million per day or $19 billion per year.

I guess that makes Google's purchase price seem like a bargain--after all, how else could you spend $1.6b and cause $19b in lost productivity annually?

The missing step

This post is part of my ongoing series about mergers and acquisitions. You can take a look at the rest of my m&a posts here.

So – you have a term sheet/letter of intent/memorandum of understanding fresh off your e-mail from the other party (this could for be an acquisition, partnership,  join venture, financing, etc.). Now what? If you follow standard operating procedure you’ll call your lawyer, mark up the draft and send some kind of response back to the other side. Sounds logical, but you’re missing a key step.

I wrote a post a few months back about the importance of listening when you are around the negotiating table.  The same is true before you even get to that step, however. Perhaps the most important step in any transaction is calling up the party you are dealing with and asking them to walk you through their term sheet. You’ll be tempted to start negotiating on this call, but don’t. Just listen to what they have to say. Sure they may position a little bit or try to get you to agree to certain terms (don’t do that, by the way – tell them you’re just here to listen so you fully understand the deal they are offering), but you’ll get lots of great information about what’s important to them and what is less important. Perhaps they’ll even give on some terms (a very common occurrence).

You will almost always be in a better position after this call to formulate your negotiating strategy. Remember – all information is power in a negotiation. And knowing where you are starting from serves as the framework for the entire process.

M&A - Do your research

I’ve had an ongoing series running on my blog dealing with various topics related to mergers and acquisitions (link to the full series here). As part of that group of posts, Daniel Benel wrote a guest column from his perspective as an m&a professional at Verint. Yesterday he dropped me the following note:

I was in a negotiation last week where the bankers on the other side had googled me and found my blog posting on your site and then started complaining that I NEVER believe projections! I thought it was pretty funny -- not sure if it helped or hurt.

While it’s amusing that this happened it brings up a good point about preparing for any negotiation (or fundraising pitch or customer meeting, etc.) which is that you should take a little time to figure out who it is you are meeting with. Sounds obvious, but sometimes the obvious advice is the best advice (plus I’d say that this level of preparedness is the exception rather than the norm in my experience).

Most people won’t go out on a blind date without Googling their prospective dinner partner. Don’t walk into a meeting – particularly one as important as a negotiating session to buy or sell a business – without doing some prep work. Figure out what they like; what they’ve written about; what books they are reading; what articles have been written about them; where they went to school; who they know that you know; etc. Then use this information wisely to make a better connection with the people you are dealing with. A little upfront work can lead to large dividends around the negotiating table.

When should you sell your business?

Last week’s news that CA purchased Wily Technologies for $375m reminded me of a working theory that I’ve had for a while (which generally seems to be supported by market experience over time), which is that there are generally two time frames in a company’s life where it can extract the most value from being acquired. Below is my version of the ‘exit value curve’ for a software/technology business where the x-axis is time and the y-axis is value:

The drop in value should probably be a lot sharper after the initial euphoria phase (but this image took me long enough to produce and I didn't want to redraw it), but the basic idea is that companies are generally most valuable to a potential acquirer right as the technology is proven and then again as the company reaches scale (certainly most valuable releative to the money and time invested).

The 'technology proof' phase is the time after a company has built an inital product and installed it in a handful of key accounts but before the company has started dreaming of its billion dollar IPO; realized how difficult it is to sell to non-early adopters; taken more venture money and therefore raised the bar on their exit; hit a zero bookings quarter; shut their doors; etc. There’s a range here that depends on the company, the time its taken to get to this stage and the money that’s gone into the business but generally I’m describing businesses that have real bookings, but less than around $5m in revenue. The poster child in the last few years for a company being purchased in this stage was Appilog who was bought by Mercury for $49m, but more recent deals that fall into this category include a bunch of Web 2.0 companies bought by GYMAAAE (link from Brad) such as Truveo (by AOL) and del.icio.us (by Yahoo!).

Then comes what Gartner would call the trough of disillusionment but what entrepreneurs would more likely call the long hard slog (this is the part of the graph that is circled). Plenty of businesses don’t even get to this phase and a lot who do find it an extremely hard place to be. This is the ‘prove it’ stage of the business - where you need to figure out how to scale every aspect of your company – starting with sales but including product delivery and development as well as support, marketing, etc. You’ve also probably taken a bunch more money (possibly an 'expansion round' but just as likely through an 'inside financing').  Your value in this stage probably goes down – certainly on a relative metric basis, but probably on an absolute basis as well. You’re trying to build a real business now and you’ve moved past the technology experiment stage and the euphoria of your initial PO’s and handful of first customers. You work hard to grow your business and have success at it, but scaling sales is harder than you thought and that great channel partner that really had promise didn’t pay off exactly as you’d hoped. If you’ve taken more money (say your Series C) you’ll find it harder to exit in this stage at a valuation that is attractive to both your investors and your team and instead may have to opt for seeing the business through to the next phase (or if you are forced to sell you will do so for a modest multiple of invested capital).

If you execute well and stick with it, however, you may just emerge – as Wily did – on the other side of this slog. While running your business doesn’t exactly get easy, you now have real critical mass and market validation/adoption. Your revenues are well into the double digits and you’re probably cash flow positive even as you re-invest in your business to keep your growth up. The Wily deal is a good example of the kind of value that can be created for a business that reaches this stage of its growth. Teams and investors that stick with it are generally rewarded in this phase of their development with solid investment returns.

Obviously there are plenty of variations to the story this graph shows, and different markets reward technological promise vs. customers in different ways. Along the same lines, different individuals, investors and management teams have varying views on what constitutes a good early exit or even a good later-stage exit and success will depend on a number of factors including a team’s ability to execute and the financing strategy employed to fund that execution.

I'll write more on how this dynamic affects financing strategy in general and VC investing specifically in the next few days.

As always, your feedback is encouraged.

(thanks to Ross for the assist with Illustrator on the graph)

M&A Part IV - Timing

When I worked at Morgan Stanley in the mid 90’s we used to have a joke about the relationship between VP hours and analyst hours. The ratio of these hours was in the neighborhood of 7 to 1, so when your VP asked you to do an analysis or create something for a pitch book and said something like “ok – I know its 10pm, but this should only take you about an hour” you knew that you’d working until about 5am, give or take. I’ve found this relationship to be true of many lawyers as well (as in “I’ll get you this document in a few hours,” which typically translates to “I’ll get you this document at 11:59pm tonight”).

I have the same problem on sell side M&A deals, which is to say that I’m always forgetting that they take longer than I expect them to. Mostly I forget that while I can control my side of a deal (at least to some extent), I can’t control the other side of a deal. Particularly when I’m working on selling a business, I tend to be more motivated to move quickly than the buyer (who obviously wants to do careful due diligence, may have other deals they are working on, etc.). While one still needs to push so a deal doesn’t drag on forever, I’d probably stress myself out if I remembered that deals always take longer than when I map them out in my head (ALWAYS) and that each deal has a different flow (most of which have some variation of a sine curve in terms of activity level, but each of which has both a different amplitude and frequency) and that sometimes one needs to just go with the flow rather than swim up stream.

I’ll put up a post in the next few weeks about things that you actually can do to keep a deal moving (starting with understanding what things you control and what things you don’t and spending your time working on the former rather than pounding your head against the wall on the latter), but I’m living through it right now and don’t have the stomach for much more on this topic at the moment . . .

See the other posts in my M&A series here.

Changing styles . . .

Brent wrote in recently to remind me that I wrote in M&A Part I – Lines in the Sand that I’d talk a bit about changes in my negotiating style over time. I actually interested to hear if other people have had similar experiences, because what I’m about to describe both seems like a natural progression and might also be termed ‘growing up’.

I had an odd introduction to more formalized negotiation a few months into my first corporate job after leaving Wall Street. The company I worked for decided to embark on a few acquisitions and I was assigned to work on these with my boss who was the head of the business development group. Eventually we settled on our first deal and, after negotiating the purchase price, my boss turned to me and said something to the effect of “go get it done.” Disappointed that I didn’t get to participate in what I thought was the real action I accepted my role as the grunt on the deal and started work on processing the deal. Much to my surprise at the time it turned out that negotiating the price was about 5% of the actual deal and there were lots of other terms to be worked out. I had the great fortune of working with an outstanding lawyer (who I’ve since done several dozen deals with over the years) who took sympathy on this (at the time) 23 year old who knew nothing of either negotiation or m&a deals.

My initial negotiation style arose out of these circumstances and was at the same time defensive (I didn’t want to admit when I didn’t understand something – which happened pretty often – and I understood nothing of the nuance of the terms I was negotiating) and brash (I didn’t fully understand the give and take nature of negotiation and thought I needed to ‘win’ on everything).

I learned quickly (and in a few cases embarrassingly) that this style wasn’t going to get many deals done, but in thinking back on this period of my life realize that I maintained a somewhat brash style to negotiating deals (both m&a and business development) for quite a while (my original boss was promoted and I ended up working for someone who was more involved in the day-to-day details of the deals we were doing but who was also very harsh in his personality and negotiating style, which I think I picked up to some extent).

This style didn’t fit me very well, however, and by the time I was running an m&a group in the late 90’s and, importantly, operating in a much more competitive m&a environment, I had softened my approach quite a bit. Realizing as well that I possessed much more knowledge about the terms that I was debating with business owners whose companies I was purchasing (I’d learned a few things over about 20 deals at that point) and that the perspective they were getting from their lawyers was not always particularly balanced I also discovered the benefit of both negotiating for a ‘fair’ deal and taking the time to both fully explain my position on an item and to listen carefully to theirs (in my earlier days I would sometimes say things like “I can’t do that, because I just can’t” and in some cases draw a line just because I felt like seeing if I could get a term to swing my way; these days I’ll almost always provide my rationale and generally only pick a handful of terms that I really, truly care about to discuss).

I still modulate my style some, depending on the type of deal that I’m working on (m&a exit vs. m&a where we’re still investors vs. financing, etc) and also in response to the person I’m negotiating with but I generally find a congenial approach to both lead to best results (including a higher probability of getting deals done) and causes less stress and brain damage (which is important to me; life is too short to have a heart attack over a deal term).

I actually find it pretty amusing to think back on how little I knew when I started doing this . . . which is a good reminder of how I’ll probably feel when I look back on today 10 years from now . . .

M&A - A Corporate Development Perspective

I recently asked my friend Daniel Benel if he’d consider contributing to my M&A series. Daniel was a banker with Lehman Brothers (in NY and Tel Aviv) and is now a corporate development exec at Verint Systems (NASDAQ: VRNT). Despite having never bought one of my companies, he’s a great guy with a smart corporate development mind (rim shot). I thought he could add a corporate development perspective to the series. I’ll make sure he gets copies of any comments that get sent back, or feel free to reach him at the hyperlink attached to his name above.

______________

Below are three topics on my mind related to acquisitions from a corporate development perspective (perhaps the beginning of a series):

The Hockey Stick Projections – Hockey Stick Financial Projections did not die with the bubble’s burst. Perhaps they were put away in the back of the garage for a while alongside other unloved sporting equipment like that confusing lawn bowling set or the ambitious NordicTrack. Unfortunately, some mischievous banker found the darn things, had them shined up and sent out to technology companies near and far.

It is more likely than not nowadays, when I receive a book from a banker selling a technology company, that the financial projections show jaw-dropping out-year growth. The most noted reason for the turbocharged numbers: The Market. The Market is hitting a “sweet spot,” or the company is in a sweet spot and the market is about to develop a sweet tooth. These saccharine solution sellers expect, of course, to be valued off of forward numbers.

My common response to wild growth projections is to advise the company not to sell. If management of a selling company believes that they can accelerate growth dramatically over the next 12 months, why don’t they prove the business plan and come back to the merger market with a significantly higher value? At this point in a discussion some sellers choose to revise their outlook. Other sellers claim that the projections are based on “what the company can do on a pro forma basis,” that is, when combined with “your more significant resources.” (I’ll discuss that in the “We Don’t Pay for Synergies” section.)

Companies whose sales are truly going to accelerate dramatically, and are selling for a defendable reason, need to back up projections early on with a real sales pipeline/backlog (not a Frost & Sullivan report). Sharing pipeline/backlog data will immediately trigger competitive concerns in the mind of the seller, which is fair and will be discussed further in the “Overboard Competitive Concerns” section.

We Don’t Pay For Synergies – Often stated as an acquisition truism, but not always true. In general, it is synergy that motivates an acquirer’s interest in a given target to begin with and not something for which a buyer is willing to pay extra. Synergy is a value that the transaction itself generates and is not produced by a company on a standalone basis. Depending on the transaction, each side may lay philosophical claim to a greater share of this value, but this debate will not affect the standalone valuation an enterprise can demand and is usually a losing negotiation point anyway. That being said, the more synergy a given business combination offers to a buyer, the more that acquirer is able to pay for a business. While an acquirer may not admit to paying for synergies, in a competitive acquisition process, the acquirer with the most significant synergies (all things being equal) could write the bigger check. Sellers should negotiate accordingly with this knowledge in hand.

Overboard Competitive Concerns – Acquisitions often occur between competitors. This is natural, particularly in early stage markets that are in a consolidation phase. It is important to recognize that the time it takes to sell a company is correlated to the speed of information sharing. I am not referring in this case to the relationship-building phase that can take months or years, but rather to the moment in a transaction when there is a meeting of the minds between seller and buyer and perhaps a non-binding Memorandum of Understanding (or other term of art) in place. At this precarious juncture, just when you are tempted to think that some of the hard work has been done and you can put your Blackberry down for the night, sellers can become frozen with fear that all of their competitive secrets will be stolen during the diligence process and somehow abused. Sometimes this happens when they receive a buyer’s diligence request list and it is longer than the federal budget.

Sellers must recognize early on that they will have to accept the risk of sharing sensitive competitive information with potential acquirers in order to get a deal done. Some data, though, may be deemed so sensitive that particular workarounds need be put in place in order to make diligence acceptable for both sides. Sometimes a two-stage approach to diligence (deferring highly sensitive material to when the deal feels more certain) can resolve concerns. In this case, it is important to first determine how critical a particular piece of sensitive data is to the buyer’s diligence process. It may be, for example, that the seller believes his source code is something that can’t be revealed to a buyer early in diligence and he therefore stymies a process, when in reality the acquirer might be far more interested upfront in a customer list than in source code (and would be willing to delay source code review to just before signing).

Sometimes competitive concerns kill a transaction, or at least slow it down to a degree that momentum is lost, which is a topic to be discussed in a subsequent post entitled: “Don’t Lose Momentum.”

Your Exit

Here’s an interesting stat from a M&A update I received in my inbox a few days ago:

Since 2000, the ratio of technology companies sold vs. going public is 10:1 (1,300 m&a deals vs just 125 IPOs). 

The moral of the story – be realistic.  If you run a software company you are WAY more likely to sell your business than to go public.  Time to start planning . . . now.

M&A Part III - Getting Bought vs. Selling

Perhaps I’m stating the obvious, but one thing that I’ve noticed over the years (and have talked about extensively, particularly with Brad who very much shares this view) is that it’s much easier to have a company get bought than it is to sell a company. 

Getting bought means that someone comes to you.  Selling means you go to them.  The former results in a more motivated buyer, an easier (and faster) process for rounding up competitive bids and a higher price.  The latter is a pain in the ass, tends to result in fewer options and generally a lower purchase price. When you are getting bought, you by definition have other options (since you don’t necessarily need to sell); when you are selling you are signaling to the market that you’ve made up your mind (whether you’re “exploring your strategic options” or more directly “have decided to sell the business to take advantage of . . . “). 

So position yourself to be bought rather than to sell. Yes, sometimes this isn’t possible (otherwise all of our businesses would get bought), but I think companies think too late in the game about their exit and as a result end up as sellers.  An ongoing conversation at companies should be the list of possible buyers and the right ways to get close to them.  Striking “strategic deals” or OEM relationships should be at the top of the list (we’ve had several very nice ‘getting bought’ experiences with significant OEM partners – they understand the business and the fit and can more easily take advantage of owning the company/technology). If those aren’t options, still work at getting into a conversation (competitive or otherwise) with people that might be buyers of your business. 

The right time to do this is when you don’t need an exit.  The wrong time is when you’re got 6 months of cash left and need an out.

See my other posts from this series:

M&A Part I -  Lines in the sand
M&A Part II - A few thoughts on negotiating skills

Making your threats real

I wrote a post about a month ago in my M&A series about drawing lines in the sand (see the original post here).  In it I argued that people negotiating m&a deals are too quick to dig in and make statements that they can’t/don’t intend to back up. 

I was reading Ben’s blog today – his latest post references a HBS article on a similar subject that is worth a read.  Here’s the quote that Ben pulled from the article that pretty much sums up its contents.  When you look at the article pay attention to their point # 5 – it’s exactly what I was talking about in my earlier post.

"In the classic game of Chicken, two drivers on a crash course speed toward each other. The rules are simple: Whoever swerves first and avoids collision loses, and whoever is brave enough to stay the course wins. Of course, when both drivers stay the course, they collide and die. Clearly, this is not a game for the faint-hearted. But bravado alone doesn't guarantee a win. Your opponent has to believe that you're gutsy enough to stay the course, or he may do the same until the very end. How do you win at Chicken? One approach would be to talk tough beforehand. You might behave irrationally to suggest that you wouldn't swerve even to save your life. Once the game begins, however, your threat simply may not be credible.

Now consider this strategy: Once the cars are headed directly toward each other, you unscrew your steering wheel and throw it out the window, making sure that your opponent sees you do it. Foolish? So it would seem, but your threat is now entirely credible. You can't change course even if you wanted to. It's up to your opponent to decide whether to lose the game or die. The odds are in your favor."