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 produc 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 her 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)