The Corrosive Downside of Acquihires

Posted on May 13, 2013 | 59 comments


For the past 5 years or so Google, Facebook and a handful of tech industry giants have been quietly buying scores of early-stage startups for their talent. And to keep up with the Jones’s it seems that Yahoo! has now employed the same strategy.

Screen Shot 2013-05-12 at 8.47.12 AMAnd who cares, right?

A couple of tech giants throw millions around in either cash (for which they have hoards) or part with some publicly traded stock. And a few teams of super talented, educated and bright entrepreneurs make a few mill. in their 20’s. What could be more capitalist than that?

It has even gone so far that we now have evocative headlines in the tech press such as “Buy or Die,” which is what got me thinking about this post.

We’ve been here before – trust me. Every era has its own amnesia for M&A gone wild.

In the end, it doesn’t really matter. It’s not some big tragedy on a grand scale. But the press (and I suspect many of the senior execs of these companies) don’t really explore the corrosive downside of these acquisition.

So I thought I would.

Buy. Or Die.

Really?

If I don’t commit to millions of dollars of acquisitions I will … die? I’m supposed to believe that my best innovation can only come from scores of startup founders who just made millions and have now become CVOs at my company? (Chief Vesting Officers)?

Meh.

The Aqui-hire Business

Many buying companies price these deals on the basis of $1 million per engineer on the team for an early-stage deal. And they might give a premium if the team has been around a longer period of time, has built some hard-to-build proprietary technology or has some customer traction.

Usually the location of the engineers matters great so having offshore engineering makes acquihires unlikely.

Let’s assume an early-stage company around for 2 years with limited traction. It is probably purchased in the $5 – 15 million range even if you see higher numbers in the press.

Almost certainly the startup would have raised some capital. Let’s assume $2 million in seed money.

If the money comes from professional investors it usually has a “liquidation preference” meaning that their money comes out before the founders or common stock. (If you don’t know venture economics – there is an overview here.)

While at initial glance this sounds unfair, when you think about it – it doesn’t. If you give $2 million for 20% of a company ($8 million pre + $2 million investment = $10 million post-money valuation) that has no product and no customers and it turns around 3 months later and sells for $5 million it would hardly be fair for investor to get $1 million back (20% of the proceeds). That’s why liquidation preferences exist – downside protection.

After the liquidation preference the founders (probably 1-3 people) are likely to get 90% of the remaining proceeds and the staff – those engineers that the acquiring company so desperately wants – would ordinarily receive a very small proportion.

I talked about the math of this in this post, “Is it Time to Learn or to Earn.”

Mark – doesn’t the acquiring company mostly care about the super innovative founders? Those 1-3 you’re talking about?

If they do then they’re naive. And most buyers aren’t. Most founders stick around for their lock-up period (1-2 years) before going on to found their next company.

Think about it – they were the ones most willing and most able to take risk in the first place. They founded their last company with no money in their pocket. Now they get to go out and try again with $2 million in their pockets plus the credibility of having just gotten a big W.

Most founders stay the least amount of time they can.

I know the buyers try the best to believe that [insert well known founder name here ... David Sacks, Max Levchin, Dennis Crowley, Keith Rabois] will stay and help lead their company in a totally new direction. But evidence suggests otherwise.

So the buying company usually wants to pay $0 for the company. And wants to structure a huge payout for the employees that will remain. That way investors (dead money for the buyer) and founders (flight risk) don’t get all the spoils while the faithful staff who will stick around get nothing.

And precisely because buyers usually prefer to have limited money go to investors – investors almost always have the ability to say “no” to transactions in the terms of their funding documents (aka “blocking rights”).

And that is the tension in the acquihire – what is the purchase price for the company, what is the “earn out” if the acquired company hits some performance targets and what is the amount of money set aside for staff retention? And will investors allow a deal to happen in the first place.

The numbers you see announced in the press for deals are hardly ever right.

OK, Mark. We get the mechanics. But what is so corrosive about this?

Why Acquihires Hurt the Acquiring Company

How about if we look at it from the “rest of company” perspective.

You have been at Google, Salesforce.com, Yahoo! for years. You have worked faithfully. Evenings. Weekends. Year in, year out. You have shipped to hard deadlines. You’ve done the death-march projects. In the trenches. You got the t-shirt. And maybe got called out for valor at a big company gathering. They gave you an extra 2 days of vacation for your hard work.

And that prick sitting in the desk next to you who joined only last week now has $1 million because he built some fancy newsreader that got a lot of press but is going to be shut down anyways.

What kind of message does that send to the party faithful who slave away loyally to hit targets for BigCo?

I’ll tell you what is says.

It says if you want to make “real” money  – quit.

Go do a startup. Get some famous angel or seed money. Get yourself in a big demo day competition. Woo the press. Hire legions of young, impressionable graduates from the top engineering universities. And then come back and sell me your company.

I know many rank-and-file employees. I’ve had the chats with them. You rarely meet people who don’t resent the scores of entitled acquihirees of their company.

Does Yahoo! et al really have to keep up with the Jones’s to build its future?

For the 200 new employees they’ll get through acquihires do they unleash 2,000 unhappy existing employees? Sure, most won’t quit. Because they know that it’s not a slam dunk to start a business and get acquired. But the most talented of those 2,000 will.

What if the $100 million you’re going to spend trying to win this alleged “war for talent” in stead went into big retention plans to keep your most talented employees.

You can’t “Roll Out the Red Carpet When Your Best Employees are on the Way Out the Door” as I wrote in this post. So why not announce big, hairy audacious goals on recruiting the best mobile talent with sign-on bonuses and retention plans? And reward your existing top 10% of employees handsomely.

I’ll bet the ROI would be higher than acquihires.

Acquihires and Venture Capital

I’m a VC. I know I’m supposed believe in acquihires to bury my investments that aren’t working.

I would never discourage any teams of people I’m working with against early acquisition if they felt it was in the company’s best interests.

But that’s not how you make money in the venture capital business. You make money by backing winners that build real businesses.

I look for entrepreneurs who set out on their journeys to do exactly that – build big businesses. Change industries. Not looking for quick flips.

And on many occasions I have passed on deals where it was clear that the founding team was over-optimizing the deal structure to focus on a quick exit.

When I have great teams with products that are taking longer to show traction than they or I would like I usually spend time trying to figure out how we can build a better business versus selling early.

I don’t blame entrepreneurs who go for an early exit when it comes up. To the contrary. On many occasions where I’ve met with teams of people in whom I’ve never invested I’ve encouraged exactly that – an early exit at a “small” price. Because if you’re business isn’t working or isn’t likely to work it’s obviously better than running into a brick wall or over-capitalizing yourself.

And of course many small acquisitions work for the buyers when there is a clear strategy for owning the asset or a clear alignment with the team you’re acquiring.

But as a repeatable strategy for large companies to try and compete with each other it still strikes me as a wasteful strategy. And few in the press are willing to call this out.

Sarah Lacy did. It’s why I love reading her writings – she’s one of the few remaining journalists in the tech sector (along with Kara Swisher and a few others) who have been around long enough to have earned their critical eyes or cynicism.

She wrote this excellent piece last year called, “The Acqui-hire Scourge: Whatever Happened to Failure in Silicon Valley

And I thought I’d finish on a quote from Sarah,

“Allowing entrepreneurs — and their investors — to save face by saying they were “acquired” instead of failing is nice, but it’s a bit like the pre-schools where everyone wins a trophy for showing up.”

Note: image from PandoDaily, clicking it will take you to the article in which I found it.

  • https://www.reesio.com/ entrepreneurSF

    I think acquihires suck as well and I would never want my startup to exit that way (even though I’ve never had an exit yet and I sure could use an extra $1M). I definitely want to build a $1B company that goes public (that being said, I’d be willing to listen to real acquisition conversations that weren’t acquihires).

    BUT (and this is a big but), the one party that I think acquihires actually do work best for IS the large company making the acquihire. I recently did a stint in a mid-level manager job at Intuit in between my last startup and my current one, and I can tell you that large companies don’t offer proper compensation packages for entrapreneurs to incentivize them to stay and build amazing products. For example (and I told Intuit this when I left), I would have been willing to take a 50% pay cut in my healthy salary if I could even just have a 5% stake in the new product that I was creating (5% is of course nothing for a typical startup co-founder). They wouldn’t have any of it. Little do they realize that entrepreneurs aren’t motivated by high salaries, but instead would prefer a solid stake in a business that they’re trying to grow. I know a few large companies are looking at this sort of comp style for top flight talent, but it’s rare.

    On the other side of it, you have the 9-5’ers at these big companies that just want to collect their nice paychecks, work on legacy products, and go home to their families at the end of the day. While there’s nothing wrong with that, no innovation is going to come from that approach.

    So you have the best entrepreneurs/intrapreneurs at the large companies not being properly compensated how they’re used to, you have the other group of employees that like how they’re being compensated but they don’t know how to innovate. So what are you left with? Acquihires.

    And this doesn’t even get into how large companies have problems promoting the best and the brightest vs. who has been there the longest, etc. etc. So until large companies know how to attract and retain top, entrepreneurial talent the organic way, they’ll constantly be left in the position of having to acquihire to build innovating products.

  • johnssokio

    than why write this post??

  • Brenton Thornicroft

    Acquihires seem to be a relatively new phenomenon. It makes me wonder… since there are incredibly smart, talented and experienced individuals running the companies doing the acquihires for the most part, do you think they aren’t actually running the numbers on potential ROI of the acquihire in fear of “missing out” on talent and losing it to competitors? I always like to think the big guns know what they’re doing and maybe know something we don’t that justifies it for them.

    Or do you think it’s because there’s not much data on the strategy since it’s relatively new behavior, so we’re still in the trial and error period of it?

  • http://www.5toolgroup.com/ Jay Oza

    Isn’t this how NFL kind of works?

  • http://ciurca.ro/ Vlad Ciurca

    From your example ($10 million valuation, with $2 million initial investment), if the company is sold for e.g. $20 million, how much money do the investors take back?

    Would it be $4 million or is there a certain formula on how you calculate this (depending on time, revenue and other indicators)?

    I really wanted to know this for a while :) Thank you!

  • C_LaFontaine

    Finally, a man after my own heart regarding this strategy. In today’s world of work, where 5 years is considered a long time for someone to stay with a company and 30 months is more the average, the acqui-hire strategy is a money losing proposition at best for the acquiring company.

    For example, let’s say you acquired some 17 year old’s company for say $30 million. He works for you for two years then, with his entrepreneurial spirit burning bright again, leaves to start another company. If you also paid him, say $200k a year while employed, you’ve now invested $15.2 million a year in him. The question becomes, did he actually return enough in revenue and/or value to cover a $15.2 million/annual investment?

    Secondly, I think there is a another side that gets overlooked often – that of compatibility. Entrepreneurs have a particular “fire in their belly”, one usually fueled by building good products as well as good companies. Once they are put into a corporate environment, they tend to be incompatible with those without such a fire.

    Take the example of Michael Jordan. A stellar basketball player, bar none, yet so-so when he tried baseball for a couple of years. Entrepreneurs, in this analogy, are in their element like he was in basketball when they have their own companies, yet become like he was in baseball when thrown into a corporate environment. In other words, their drive running their own companies is greatly diminished when they become another cog in the wheel of a corporation; further degrading the return on investment.

    In the end, I think the acqui-hire strategy works good for the entrepreneur and their investors and completely sucks for the acquiring company.

    Thank you Mark for writing this piece. I’m glad someone finally gave it some serious thought and analysis.

  • http://heathrost.com/ Heath Rost

    Subscribed to Mark’s blog after reading this. I love your honesty Mark. From your perspective as a VC an aqui-hire is great to bury your less successful investments–but at the same time thats not thinking with the end in mind is it? You want a larger piece of the pie and you’re encouraging others not to end the party at 9. Great article.

  • http://prometheefeu.wordpress.com/ PrometheeFeu

    I’ve wondered for a while if maybe there is an upside to all this though. I’ve thought for a while about how I would formulate an acquihire strategy. I would start a company with a bunch of really smart engineers and not even try to build a product. Instead, I would go off and try to solve a really cool really hard technical problem. This approach has I think many benefits:

    1) You get to show off to potential acquirers just how smart the founding team and employees are: Look, I just solved this really cool, really hard tech problem.

    2) You don’t have to pay as many business people if you don’t intent to market a product.

    3) You will have a super easy time recruiting. What recent Stanford grad doesn’t want to go work on something which is fun, exciting, new, challenging and without any of the pressures of trying to make it useful.

    Let’s say this gets pulled off. Well, the world is better off because there is a new cool technology which somebody some day will figure out how make useful. The acquiring company found a bunch of smart people to add to payroll. The founders and employees made a bunch of cash and worked on something really cool. But really, the cool part is the first one. If all you care about is showing off, that means you can do things which will really benefit humanity some day down the line and which nobody else would have ever built because it just doesn’t have a good ROI today.

  • http://twitter.com/andyidsinga andyidsinga

    re ‘It says if you want to make “real” money – quit.’

    this is soo true. ive argued with managers at bigco about acquire vs organic growth projects. acquire seems cheaper / easier than making hard decisions about freeing up resources from existing, underperforming projects.

    the worst part for engineers isnt the money issue though, its really “if you want to keep and improve your skills – quit”