Monday, July 25, 2016

It’s M&A Time! (IPOs Return In 2018)

The first half of 2016 saw an initial set of acquisitions that will only accelerate in the next 12-18 months. From now through the end of 2017, we will see an increased wave of large M&A sweeping through the technology industry. This will be following in late 2017 through 2018 with a wave of IPOs.

The driver for the 2016-2017 M&A cycle is a few fold:

1.  Valuations have been coming down, and raising money has gotten harder.
Companies can no longer rely on new investors coming in with ever-larger amounts of capital and ever higher valuations. With 6-12 months of cash left, and the inability to raise an up round, companies will exit.

Founders realize a $100M exit is a big deal and a $1 billion exit is a huge deal. With an ever-inflating valuation it is easy to think that the company and team is unstoppable and that a $10 billion valuation is the new normal. Expectations are getting re-set as people realize it takes many years and a lot of luck to reach a sustainable valuation in the hundreds of millions or low billions of dollars.

Many founders will be tempted to exit when faced with a tougher fundraising environment or down round. People forget that even great companies like Facebook ended up doing down rounds at some point (Facebook did one with DST right after their $15 billion valuation with Microsoft). I know a number of companies who are not closing financings due to ego around valuation. Unfortunately this only causes risk to the company and may not end well.

2. Big non-tech companies are realizing that they need to buy technology driven companies, or companies using new distribution platforms (like Dollar Shave Club).
The acquisition of Cruise by GM shows how a set of traditional companies are seeing their business change dramatically due to the latest waves of mobile, cloud, and machine learning. Examples include BlackRock's acquisition of FutureAdvisor, and Visa buying TrialPay. Similarly, new ways of distributing product via online platforms is continuing to change how commerce works, leading to the Dollar Shave Club buy by Unilever. Between these two trends, companies in the automotive, food, healthcare, and other segments are realizing they need to participate in the latest technological innovations. This will drive a new set of acquisitions in the next year and a half.

3. Large, old-school technology companies want to participate in the latest wave of technology.
The recent purchase of LinkedIn by Microsoft demonstrates the value of the latest wave of social products to large incumbents like Microsoft. Similarly, older enterprise companies will want to participate in the massive shift to the cloud and SaaS, as well as the rise of AI/machine learning technologies. This will lead to a flurry of deals in the next year as Microsoft, IBM, Oracle, HP, Salesforce, and others will want to accelerate their businesses or shift more to the cloud. Similarly, Google, Apple, Baidu, Facebook, Tencent, Alibaba, Softbank, Samsung, and others will be battling across mobile, cloud, commerce, ads, consumer and other major platform wars leading to additional major acquisitions. 

Small Acquisitions in 2016-2017

In 2016-2017, we will also see a shift in both who the most active acquirers are, as well as the acceleration of machine learning / AI as a major talent acquisition category.  

1. The companies doing acquihires / small M&A will shift.
In recent years, Twitter, Facebook, and Yahoo! had been amongst the most acquisitive buyers of teams, the mantle has been passed as these companies matured. Uber, Lyft, Dropbox, Pinterest, and AirBnB are all likely to become more acquisitive[1]. As markets cap rise and companies grow their engineering and design teams rapidly, the use of M&A as a recruiting function tends to scale. Given that funding is becoming ever harder to obtain, now is a good time for breakout companies to double down on M&A. If your breakout company does not have an M&A person, you should hire one.

Depending on how it strategy evolves under new leadership, Microsoft is one to watch in terms of M&A volume and directions.

2. AI & machine learning M&A will accelerate.
During the social era when smart phones were still a new phenomenon, a company could get acquired by Twitter or Facebook solely for having e.g. strong mobile talent. The next 18 months will be the best time to have a machine learning / AI company from an M&A perspective as both new breakout companies (Uber, Pinterest) as well as older incumbents (Apple, Google, Facebook) will continue to buy great machine learning and data centric talent. Large non-tech companies will also buy more machine learning talent to augment their engineering or commerce divisions. I would not be surprised if companies like WalMart of Visa go in this direction.This machine learning shift is ongoing and fundamental.

If you want to build a startup for a fast small flip, machine learning targetted to a specific vertical is your best bet over the next 2 years.

2018 As The Year of IPO

As major M&A unfolds in 2016 and 2017, we will finally start to see major IPOs occur for technology companies in (perhaps) late 2017 and (for sure) in 2018. Big breakouts like Uber have both near exhausted many private sources of capital, but will also see increasing demands to provide liquidity to investors and employees. Additionally, they will realize the additional benefits of liquidity for M&A, equity & debt raises, and hiring.  An interesting side effect of these IPOs will be the creation of new classes of angels and entrepreneurs due to more people having liquid cash. 2018 and 2019 will be interesting years indeed.

[1] I am making this prediction with no inside knowledge. Rather, once you hit a certain market cap and growth rate as a company, you tend to buy more stuff.

End of Cycle?
Waiting Too Long To Go Public
What Is Your Startup Acquisition Really Worth?
5 Reasons To Sell Your Startup
M&A Ladder
How To Sell Secondary Stock
The Road to $5 Billion

Wednesday, July 6, 2016

End of Cycle?

One sign that technology markets often exhibit at the tail end of a cycle is a fast diversification of the types of startups getting funded. For example, following the core internet boom of the late 90s (Google, Yahoo!, eBay, PayPal), in early 2000 and 2001 there was a sudden diversification and investment into P2P and mobile (before mobile was ready) and then in 2002-2003 people started looking at CleanTech, Nanotech etc - industries that obviously all eventually failed from an entrepreneurial and investment return perspective.

It turned out the real wave was just around the corner with the rise of social products (LinkedIn, Facebook, Twitter, Instagram, Whatsapp, Pinterest) and consumer enabled marketplaces (aka sharing economy - e.g. AirBnB, Uber, Lyft). The heavy investments in cleantech and other areas was a sign that one economic cycle had ended and there was a gap in identifying the next one.

Similarly, today we are seeing a shift to a boom in the variety and type of companies being funded as tech investors pursue other areas that I would characterize as "software aware" versus "software driven"[0]. There are two ways to interpret this trend[1]:
1. There are lots of industries suddenly available for transformation.
While I think the range of markets about to be transformed by software is large, the interpretation of what is truly a tech business is being misapplied. Software, the Internet, and AI are transforming a variety of industries on an ongoing basis and I am a huge fan of software is eating the world pmarca statement. However, people are starting to apply software valuations to low gross margin, physical good businesses that are not software businesses. In other words, lots of tech investors are now investing in areas they do not understand, at valuation multiples that do not make sense for these alternate businesses. This is similar to the 2001-2003 bad period of cleantech and nanotech.

2. We are at the end of an economic cycle for tech, and tech investors are desperate for the next new thing.
It is always hard to call the end of an economic or innovation cycle[2]. Technology-driven shifts will continue to be incredibly resilient and transformative. However, the rate of creation of truly fundamental massive businesses accelerated for a few years, and may decelerate for a few years before the next wave hits. During this period of deceleration, entrepreneurs and investors will go into a search pattern to try to find the next wave.

The reasons people shift startup founding and investing patterns at the end of the cycle include:

Everyone is searching for the next thing.
The period of 2004 to the 20-teens will be viewed as the era of network driven business, developer & B2B SaaS infrastructure, and the lean startup. This rich vein of innovation is not over, but appears to be slowing. As this happens, entrepreneurs and VCs go into search mode, trying to seek out other markets that have not been mined as deeply. This explosion in startup investment diversity by technology investors in my opinion is a sign of weakness versus strength in the entrepreneurial ecosystem. Tech investors are investing in food, hardware, traditional biotech, oil and gas, and other industries they know nothing about. Is this a sign of software transforming these areas, or unstated (and perhaps, not even self-aware) desperation?

Investors have fewer great organic opportunities and shift from reactive to thesis driven. Further, past success investing in one area gives false confidence to invest in unrelated areas.
Investors tend to get confident about success irrespective of whether the success was deserved or merely being at the right place at the right time. If you are an investor in great companies like Uber or AirBnB you may start to believe you are smarter then you are about non-tech driven areas and begin to invest more broadly than you should.

The warning sign is often when a large portion of venture firms shift from entrepreneur-driven to thesis-driven. There are a handful of venture firms that are always thesis-driven, for example Union Square investing in network driven businesses. However, most venture firms are admittedly reactive - they do not have a specific theme they are driving themselves, but rather respond to where the best entrepreneurs are creating the most high growth, high margin, companies fastest.

When lots of VC firms shift into a thesis driven mode, it is usually a sign that organic entrepreneurial activity is no longer sufficient to drive that firms investments. As a result, lots of capital gets invested in areas that do not merit the investment, there is a flurry of activity that looks important (Cleantech), but ultimately this activity does not yield great returns. Typically these areas are ones where the investors lack real expertise.

People move from bits to atoms without realizing the change in underlying fundamentals.
Many tech investors are shifting from investing in bits-driven business (software) into atoms driven businesses (anything you need to manufacture). I know tech investors now looking heavily at food, traditional biotech, hardware, pre-fabricated housing, and numerous other areas. These businesses all have fundamentally different development and ship cycles, distribution models, and margin structures than software. However, investors are applying tech multiples expectations to these radically different types of businesses. This is unlikely to end well.

I think it is important on an ongoing basis to ask "how important is software to this business" and "why now?". Software is truly eating the world, but you need what is fundamentally a software business in these traditional industries to make a real difference. Too many people are saying "oh this biotech is using algorithms so it is a tech company" even though it is really still a drug company with all the standard drug business timelines and fundamentals. They are merely using software for one part of their approach, but it is not a software driven business.

Another way to put it - is software truly transformative/the basis for competition for the startup? If so, you may end up with a tech model of innovation and disruption which is great. If you are merely using software but the business fundamentals have not shifted - than the startup is probably not that differentiated and will not merit tech multiples. A software-enabled, network connected, crowd funded, smart toaster is, when all is said and done, still just a toaster.

There are still lots of strong opportunities today. 

I am a huge optimist about the future of technology and its ability to transform large markets. There is still a lot of transformation happening in the world due to software driven businesses. Self driving vehicles, AI, the ongoing FinTech transformation, and digital health are all examples of rich entrepreneurial veins. Similarly, there are still a few great network driven businesses to be founded and funded. However, we are seeing an explosion in a lot of other businesses areas concurrently with tech VCs investing in areas they know nothing about. I believe this to be a sign that we are entering a period where everyone is looking for the next truly deep vein to explore. It may already be here - just as social products co-existing with cleantech and nanotech - but my sense is the tech community is in a period of searching for the next big thing.

[0] By "software aware" I mean some software is used by the startup. However, the true basis for value for the startup has little to do with software despite claims by the founders. At least one prominent food tech company is like this. E.g. a food company masquerading as a tech company.
[1] Obviously there are many more ways to interpret this. But here are the two that stand out most to me.
[2] Maybe calling the end of a cycle is overly dramatic. Rather, we are likely to see a slow down in the rate at which huge companies in one market segment are funded and a gap in activity as the next trend is identified and accelerated.