Pando

M&Apalooza: 2017 will be a year of put up or shut up in Silicon Valley

By Sarah Lacy , written on January 6, 2017

From The Money Desk

It’s the first week of January and everyone not on a plane to CES (that’s us!) is making predictions (that’s also us!)

There are debates over quite a few, like just how good this year may be for IPOs. While Fred Wilson and Kevin Kelleher have argued it will, other journalists are rightfully wary of a lot of people saying the same thing last year.

The biggest reason those folks were wrong after the hellscape of January public markets eased up? Private capital and mega rounds didn’t stop, they slowed for a lot of companies, but they didn’t stop. Everyone predicted the tourists would go, and force cash burning companies to go public. And a lot of hedge funds and mutual funds did. But foreign capital and corporate VC didn’t. There was no forcing function and the markets were lousy a large part of the year.

I’m on the side of thinking we’ll see a lot of IPOs this year: Both due to the Snapchat school of reactionary thinking to the Google and Facebook generation and the Pinterest and Dropbox reality that they’ve simply waited too long and everyone needs some shot at liquidity at some point, no matter what their last private valuation was.

But the one trend it seems everyone can agree on is that we’re in for a banner year of acquisitions. The evidence: A shit load of money is potentially coming back in repatriations and -- the narrative du jour!-- the iPhone has allowed so many Valley unicorns to disrupt the real world that those old economy companies are gonna start swallowing them up.

As VC Hunter Walk noted on his blog earlier this week when the Wall Street Journal and the New York Times have the same trend piece, someone powerful and influential certainly wants us all to believe this is true.

The New York Times was particularly excited saying “the technology deal-making club has had its doors blown wide open.” Wow! M&A as produced by Michael Bay!

The evidence are a handful of examples from last year: GM’s purchase of Cruise for north of $1 billion; Wal-Mart’s purchase of Jet.com for $3 billion, Unilever’s purchase of Dollar Shave Club for $1 billion. A “burst” of activity, says the Journal.

Or three exceptions. Memo to unicorns: These are the exceptions, you are the rule.

If you are in the food or dinner space, if you are most subscription or vertically integrated ecommerce companies, if you do most things in the real world once someone pushes a button and your name isn’t Uber or Airbnb, you are likely not going to get bought in this price range.

Press reports have speculated that even Lyft and Postmates-- two of the better companies of the non-Uber/non-Airbnb gang-- floated the option of acquiring them and were underwhelmed by the responses. Rumors were also floated that Unilever could be looking at Honest, which excited everyone because-- hey!-- they just bought Dollar Shave Club! It didn’t happen.

Because the Valley is a game where 95% of the returns come from 5% of the companies, decisions are based on hedging if that one company could be in that 5%. That’s why VCs pay the valuation prices they pay: It’s worth the gamble if just one of those companies is the next Facebook or Google. That’s why companies like Facebook and Google have made the gambles they’ve made: It’s worth it if they avoid the younger version of themselves coming after them.

That isn’t bad portfolio math or risk mitigation. It’s only dangerous when you start to think that the exception is the rule. And unfortunately, that’s what the last few years of unicorns and mega-rounds have bred. Whether you believe it’s a rash of M&As or IPOs: This year is shaping up to be a year of put up or shut up in Silicon Valley.

We saw the same faulty extrapolation in 2014 when Facebook bought WhatsApp for a then $19 billion, which wound up being even higher due to the stock’s subsequent climb. That acquisition set a new bar for what an early company could sell for. Before that $1 billion for Instagram seemed crazy. This had a big psychological impact on the venture community, as Dennis Keohane wrote for Pando in July of 2015 in a piece called “The WhatsApp Moment”:

In the perpetual penis measuring contest that has become venture-backed valuations and exits, WhatsApp is the king shit -- which is kind of funny because WhatsApp wasn’t an Uber-like darling of the venture world. It only raised a little more than $58 million in three rounds, which is nothing compared to what companies that have a fraction of WhatsApp’s eventual value have raised. And the messaging app can’t even compare on a business strategy level. That’s because it had the audacity to charge users for a valuable service and therefore didn’t need $1 billion in venture capital….

...There are two numbers that matter: The amount going in (and yes, the price paid) and how much comes out. WhatsApp was a magical outlier on both.

According to a CB Insights report on the 2014 exit activity of privately-backed companies, the WhatsApp deal and the IPO of the Chinese company JD.com made the exit dollar amounts for the first half of the year three times greater than the exit numbers in the second half. By CB Insights account, the current $22 billion value of the WhatsApp=Facebook deal is more than four times greater than the next closest 2014 exit, which was Lending Club’s IPO.

Although WhatsApp isn't the sole reason for the current frothy state of the venture market, what the acquisition did was reset the dollar amount of what's considered a “big purchase” for an up-and-coming Internet company by a massive corporate giant threatened by it. It used to be closer to $1 billion: Whether that was the $1 billion Yahoo tried to buy Facebook for once upon a time, the $1.6 billion Google paid for YouTube, or the $1 billion Facebook paid for Instagram. The two latter deals were seen as culturally-transformative moves for the companies. Imagine a world where Twitter bought Instagram and Facebook didn’t. And WhatsApp was worth a staggering 19 Instagrams.

The deal changed the way VCs thought about exits, not too differently from how Netscape’s IPO changed what 18-month-old Internet companies could be worth to investors....We didn’t see a flood of WhatsApp-sized deals come next. But this is an industry where the top-end economics are delivered by outliers, so likewise they can’t be dismissed.

But the sheer size of the deal has had a distorting effect on the whole market, trickling all the way down to the early stage funding climate; not in terms of actual returns, mind you, but in terms of optics and perception, and how VCs are starting to structure their funds to take advantage of the next “outlier.”

It seems that Facebook’s acquisition of WhatsApp has affected the venture-backed technology market in three ways: exit psychology, the velocity of deal flow, and valuations.

You see some similar math going on in the Journal’s story when it boasts that non-tech companies spent nearly $10 billion on startups last year “nearly double the amount last year and the highest total in at least five years” it says. That’s true but just like the WhatsApp purchase, that was greatly skewed by a few deals. Jet, Dollar Shave Club, and Cruise make up half the total, or the total increase in activity.

(The New York Times puts the non-tech buying tech company figure at a dramatically higher $125 billion, presumably, because it included tech companies beyond the scope of venture-backed startups.)

I buy that there will be more frequent deals, but they are likely to look more like the one in the Journal’s lead: When Ford bought Chariot for $46 million. The logic of tech’s disruption into old economies worrying the giants makes sense. They won’t be able to build this stuff in house, and hundreds of companies will be looking for buyers outside the traditional tech buyers. It’s just that a lot of the unicorn price points won’t make sense for companies outside of tech, no matter how many tech blogs they read. Old economy companies last year were said to be worried they’d end up another TimeWarner/AOL cautionary tale. Dozens of disparate industries don’t move in lockstep. Surely many still do.

The rise in corporate venture capital is likely some sort of indication of old economy interest in startups. We’ll likely see a few stunning deals, and a lot of the other kinds Walk describes in his post: Product buys, distribution buys, talent buys.

But it’s worth remembering: WalMart bought Jet.com, because it was worth less than 2% its market cap to throw potentially the only hail mary it had to try and compete with Amazon. This says absolutely nothing about your startup’s prospects.

For what it’s worth, while the fashionable story line is that old economy companies are going to be doing all the buying, I wouldn’t count out big tech players making a few major purchases. Sure, they were quiet last year. But that’s all the more reason a few mega deals could be on the horizon.  

For one thing, I agree with Fred Wilson that some SAAS consolidation is coming, and Lyft is certainly a valuable asset worth a few billion that is probably more valuable in the hands of someone else.

There’s another factor that could make tech purchases likely in 2017: Beyond repatriation, beyond the idea the fact that a handful of global tech companies have more cash than they know what to do with, beyond everyone fighting to get into everyone’s market, the attitude towards M&A has changed in recent years.

For many years, the conventional wisdom was that most M&A failed. But look at the giants. YouTube and Android are two of the best acquisitions in tech history. Facebook vaulted over the desktop-to-mobile and social-to-messaging inflection points largely because of the gambles on Instagram and Whatsapp. Oculus was likely worth the $2 billion flier. Amazon hasn’t had these kinds of transformative deals, but it does have a good track record of keeping its deals separate, and keeping its promises to acquired entrepreneurs.

As much as the dot com reaction soured the view of taking a company public, the 2005 era until now has done a good job of convincing entrepreneurs and big companies that M&As may not be quite as bad as we thought.

Perhaps these are also the exceptions. But at least mega tech companies understand the Silicon Valley startup math.