There are two primary reasons why a startup is acquired: technology and/or revenue. For the buyer revenue means increased income, profitability, market share, and an improvement in other metrics. Buying revenue is easier to value and leverage over the long term.
Buying a startup for it's tech means a strategic hole is being filled. The startup has something the acquirer needs. That could be:
- Tech the buyer doesn't have
- Better tech than the buyer has
- A tighter, leaner, more efficient infrastructure
(There are plenty of other reasons why a buyer and seller come together: people, cachet, FOMO, and the list goes on. In my experience it's great tech and exciting revenue numbers that turn an initial call into a second meeting)
How do you value building vs buying
Anyone can build anything given enough time and resource. It's highly likely a buyer could replicate the technology behind the business they want to acquire. The challenge for the buyer is that means taking time, resource and money away from something else.
Maybe the buyer is in the ~99% of companies where tech projects over-promise and under-deliver. Maybe they're frustrated with their own development teams, and hate that their business success has been hindered in the past by the sheer effort needed to get a big project over the line. Maybe they see significant value in a three month acquisition and integration process versus a fifteen month development cycle. There's a lot of maybes, but they're hard maybes.
Acquisition processes are not emotionless, but the emotion is burried deeper. To give this context, if a buyer is looking to acquire a startup for their tech and the buyer has had a painful experience itterating on their own product that's a felt emotion that plays into the sales process. Pain comes from missing launch deadlines, undercutting revenue targets and sitting in a board meeting explaining why. Telling your board, "Yes we screwed up on that criticial new product, but here's why I want to go through the same process again" means 2 x pressure.
For larger buyers the opportunity cost of building versus buying is easier to codify. For mid-sized buyers it's codified and wrapped in the "what if's".
- What if the project is delayed? (Deep shame, missed targets)
- What if the new product under-performs versus the market? (Missed targets, further build costs)
- What if our other products stagnate? (Reduced market share, missed target)
- What if it's so difficult that we end up shelving the project (CXO jobs at risk)
How do you codify build vs buy?
Critical factors: How long will it take to build this tech and how many people will I need?
Other factors: Hiring costs, additional business overheads, management costs.
It's easy to calculate pure build costs to a ~90% accuracy ("How many people will I need?"). The numbers will vary significantly based on region and salaries, and this is important from a sellers perspective when you consider the location of potential acquirers. A buyer in the US will be paying 4x the developer salaries of a buyer in India.
It's difficult to calculate the build time to a high degree of accuracy. Deep planning will lead you to an answer, but it won't reveal the unknown-unknowns. If you've ever worked on a technology project that required more than two people for more than two months then you'll know that it's the unknowns that cause slippage. The unknowns can lead to minor timeline adjustments, major adjustments or project cancellation.
The difficulty around predicting build time won't stop a buyer from making an educated guess. If it's an estimated nine-month build they may push that to twelve. Add in recruitment and warming-up time and that's thirteen. Factor in holidays, a resignation and some sick-leave and that's more like fourteen. It's still just an educated guess. A smart buyer will know that.
So a simple codification of the build cost (using build time) is:
Months To Build X Monthly Team Cost X Safety Ratio
Where safety ratio is anywhere between 1.25 and 2.
The Opportunity Cost
- Opportunity Cost = What if we had it sooner, what if we didnt have to build it
- Generally the bigger the buyer, the great the opportunity cost.
- Good CXO's understand this intrinsicly.
What if the buyer had a market-leading new product or technology by the end of the next quarter, versus the middle of the next financial year? To a smaller startup the difference is minimal, to a larger organisation it can be game-changing. The difference between build and buy could be four quarters of revenue. When you have a hungry, efficient sales team and a large installed userbase that's a lot of opportunity. If the buyer is considering an exit in 2 - 3 years, or an IPO, then the acquisition could give them a boost. Equally if the buyer's board feels that the business is flagging, and metrics are starting to lag, a nice new product for the business to ingest and sell, could make everyone look good.
Turbo-charging an acquirers mid to long term strategy is a great outcome. On the flip side a buyer may look at a startup, look at their own long term strategy, then realise that the nuanced differences between the business, the products or the target market mean that an acquisition isn't right. The bigger the buyer, the more you have to be a perfect fit into their strategy.
As a seller, why is understanding build vs buy important
If you're selling a product or service to a potential client you're armed with answers to difficult questions. Talking the buyer around from a negative position is easier when you've worked out the angle. An example in one of my businesses was buyers used to say we were expensive versus our competitors (and we were). My rebuttal was always around: "We help you fix a critical part of your technology stack and we're the market leader. Let's go through the predicted revenue increases...".
It's the same in an acquisition process. Buyers will "lay their cards on the table" and tell you that they could build something similar to your startup. This may be true, or it could be bluster, but either way it needs to be shut down. "We're thinking of building this and we have a great tech team" is common in a startup sales process.
Arming yourself with knowledge of the buyer and being able to play-back the opportunity and build costs will help the buyer see the true opportunity. They may have missed something out of their calculations, or they may just feel that pang of fear that they have around technology projects. They'll also begrudgingly respect you for your intelligent thoughts.
At the start I mentioned that anyone could build anything given enough time and resource. You may be the market leader in your field, have Harvard and Cambridge grads on your team, have won every award going and be head and shoulders above the buyer when it comes to tech. There's a gentle, warm way to frame that and there's a douchebag way. Don't poke the c-suite by claiming that they'd never-ever get to 10% of what you have. They might just be stupid enough to try. Or they might buy your competitor.
