Sometimes an investment makes more sense than M&A

Scott Lenet headshotBy Scott Lenet
President
Touchdown Ventures

I’ve personally participated in the creation of more than a dozen corporate venture capital (CVC) programs. In most of the examples I’ve seen, these efforts are championed by corporate development professionals who understand the need to bring external innovation inside the corporation. That typically means that experienced M&A executives are expanding their purview to include minority investments.

As a result, it’s natural to view investing and acquisitions as part of a continuum that ranges from partial control to full control. I believe there’s some validity to this thinking.

On the other hand, venture capital investing is very different from M&A. The sourcing and diligence activities vary, transaction terms are deceptively different, and the post-deal management of an investment departs meaningfully from what happens following an acquisition. In many ways, minority investing can be more difficult than M&A due to the lack of control — and it’s rare to execute these programs successfully without developing skills that are specific to venture capital.

Perhaps because of this, many new corporate venture programs struggle. The control of M&A is the comfort zone for corporations, and acquisitions may seem like a good analogy for investing. Both activities include buying ownership in an external company; but there are important differences in how to execute and manage minority investments compared to control investments.

One of the best questions I’ve heard from senior executives attempting to understand the difference between M&A and venture capital investments is whether it wouldn’t be simpler just to acquire startups, and skip the messy investment venture capital process.

While this may sound tempting, my experience is that corporations need to develop the distinct skill set of making minority investments in startups, for three main reasons:

  1. The corporation isn’t ready: in the case of smaller startups, it’s often unclear whether it is worth it for the corporation to own the startup
  2. The startup isn’t ready: entrepreneurs and their other investors want to make enough money for all the effort to have been worthwhile
  3. Neither party is ready: the startup is too fragile and the entrepreneur must build the business until it’s truly ready to scale

1. The corporation isn’t ready because it’s too early to tell whether a full acquisition makes sense
While it’s generally understood that venture capital is a hits-driven business, where 10–30% of the deals can make up for losses in the rest of the portfolio, M&A is supposed to work every time, in theory. It’s painful to lay off employees, publicly admit failure, and write off assets following acquisitions that are typically well-publicized.

Making an acquisition is a big commitment. Venture capital deals are simply lower stakes, and not just for the reasons above, which largely focus on morale and the potential for embarrassment, but also because they are less expensive. On average, a venture capital investment costs about one-tenth of the price of an acquisition, and it can make sense to defer that full commitment until it’s clearly worthwhile. According to Pitchbook, the median venture capital investment was $2.0 million in 2019 and $2.9 million in 2020. This compares to median M&A price tags of $27.5 million in 2019 and $27.1 million in 2020. This means a single M&A typically cost 13.8x that of a venture investment in 2019, and 9.3x in 2020.

While not every corporate venture capital investment would make sense as a potential future acquisition, in many cases it could be desirable for both sides as a way to deepen the relationship. While M&A and investments can each be considered like a marriage, an acquisition might be more like marriage and moving in with your in-laws, too. It’s a good idea to be really sure.

If it isn’t clear that it’s worth it for the corporation to own the startup, a minority venture capital investment can be like buying an option instead.

2. The startup isn’t ready because selling early leaves too much money on the table

I’ve found that one of the greatest sources of confusion at large corporations is how venture capitalists value startups. M&A professionals are accustomed to objective metrics based on relatively predictable indicators like revenue, EBITDA, and cash flow. These metrics are used to determine whether an acquisition will be accretive.

But early stage startups can’t be valued on these metrics, especially when there is frequently no revenue, or if that revenue is unpredictable. This means that the corporation can’t justify paying much to buy the entire startup. The math is different for venture investors, because VCs need the company to be worth more in the future, but rarely expect that the path will be predictable. When an entrepreneur shows us a business plan, we typically heavily discount the projections.

But this is actually a bigger problem for the entrepreneur than for the corporation. After all, the corporation can just offer to buy the startup for a lower amount, right? Well, the entrepreneur and her investors want to maximize value. A startup requires a lot of blood, sweat, and tears, and most entrepreneurs I’ve met are ambitious and would rather work harder for a bigger payday. In my experience, they are usually not ready to give up their independent ability to chart their own course to success, and that “outsider” view of the world is key to startup founder psychology.

Hunter Walk describes this in his article Why There’s No Such Thing as a ‘Startup Within a Big Company’ about Noam Bardin’s experience growing Waze following Google’s acquisition of the Israeli startup:

“There’s various leash lengths to your freedom, but you’re no longer a startup. You get a bunch of things in return and, for many people, it can be a wonderful outcome, but you’re no longer a startup.”

3. Neither party is ready because startups need to be far enough along for corporations to take over when the founder leaves

This might be the most important reason of all.

Here’s how Noam Bardin of Waze describes what happened in his own article, Why Did I Leave Google, or Why Did I Stay So Long:

“Working as an independent start-up is fundamentally different from a corporation and it is much more nuanced and deep than I had understood. I am proud of what we achieved within Google — when we started talking to Google, we had 10M MAUs vs 140M MAUs when I left. We went from 2.5B monthly driven Km’s to over 36B.”

Staying for 7 years is phenomenal success following corporate M&A with a startup. My experience is that the average startup founder stays for only two years following an acquisition, and Bardin lasted 3.5x longer than average. Legendary investor Fred Wilson describes the post-acquisition tenure of his founders similarly:

“I can’t think of a founder or key early employee of one of our portfolio companies that has stayed at a buyer for more than three years. Most are gone after two years and some leave well before that.”

But what’s most telling here is not just what Waze accomplished following its sale to Google or even how long Bardin stayed, but the scale of the business prior to being bought. Waze was already at 10 million monthly active users driving 2.5 billion kilometers. The business had already achieved scale and had developed something that was ready for expansion. At this point, Bardin was not figuring out what product to make or how to get consumers to engage. Waze had built a loyal following with very clear usage patterns. The challenge at that point was to grow the business following the blueprint that Bardin and his team had already proven.

This is exactly where big companies should excel. It is far easier to take an existing, proven product, and pump it through established distribution channels, than to develop something new. It’s what controversial investor Peter Thiel explains in his book Zero to One and what makes startups special and fragile at the same time: in many cases, it may be more difficult to go from “zero to one” by finding that product-market fit than from “one to one hundred” by expanding a fully articulated business model.

Imagine instead if Google had acquired Waze when it had only 10,000 users, and if Bardin had left after the typical two years. Google probably would not have been ready or capable to take over the business. As Walk put it:

“I love that Bardin took this challenge and stayed well beyond when he needed to in order to set up a management team who could carry the product forward, as a business unit.”

More than anything, this could explain a key decision point in the timing of whether M&A makes sense between a corporation and a startup, and when a minority investment could be a better near-term form of engagement.

In summary, here’s how to think about whether it’s too early for M&A:

  • Corporations shouldn’t buy startups if they are unsure it will work out and that there’s a good chance the M&A price will be written off
  • Startups shouldn’t sell to corporations if key stakeholders still feel the drive to be independent and will have regrets over not maximizing value
  • Neither party should want to combine if the startup hasn’t proven enough of its model to survive in the hands of the acquirer once the founder leaves

If you are an executive at a corporation exploring venture capital, or a startup entrepreneur attempting to work with a large corporation, these distinctions may help you navigate whether M&A or an investment is the best form of transaction for everyone concerned.

Scott Lenet is President of Touchdown Ventures, a Registered Investment Adviser that provides “Venture Capital as a Service” to help corporations launch and manage their investment programs.