[I wrote a draft of this post nearly two years ago as part of my Starting Findory series, but did not publish it at the time; it seemed inappropriate given my position at Microsoft and the economic downturn. Recently, Google and Microsoft both announced ( ) that they intend to make 12-15 acquisitions a year, which makes this much more timely.]
At various points when I was running Findory, I approached or was approached by other firms about acquisition. For the most part, these talks went well, but, as with many experiences at Findory, my initial expectations proved naive. It gave me much to contemplate, both for what startups should think about when entering these talks and changes bigger companies might consider in how they do acquisitions.
For a startup, acquisition talks can be a major distraction. It is time away from building features for customers. It creates legal bills that increase burn rate. It distracts the startup with nervous flutters over uncertainty over the future, potential distant payouts, and the complexity of a move.
Acquisition talks also can be dangerous for a startup. Some companies might start due diligence, extract all the information they can, then decided to try to build themselves.
There is some disagreement on this last point. For example, Y-Combinator's Paul Graham wrote, "What protects little companies from being copied by bigger competitors is ... the thousand little things the big company will get wrong if they try." Paul is claiming that big companies have such poor ability to execute that the danger of telling them everything is low.
However, big companies systematically underestimate the risk of failure and cost of increased time to market. For internal teams, which often already are jealous of the supposedly greener grass of the startup life, the perceived fun of trying to build it themselves means they are unreasonably likely to try to do so. Paul is right that a big company likely will get it wrong when they try, but they also are likely to try, which means the startup got nothing from their talks but a distraction.
There are other things to watch out for in acquisition talks. At big companies, acquisitions of small startups often are channeled into the same slow, bureaucratic process as an acquisition of a 300-person company. Individual incentives at large firms often reward lack of failure more than success, creating a bias toward doing nothing over doing something. In fact, acquiring companies usually feel little sense of urgency until an executive is spooked by an immediate competitive threat, at which point they panic like a wounded beast, suddenly motivated by fear.
Looking back, my biggest surprise was that companies show much less interest than I expected in seeking out very small, early-stage companies to acquire.
As Paul Graham argued in his essay, "Hiring is obsolete", for the cost of what looks like a large starting bonus, the companies get experience, passion, and proven ability to deliver. By acquiring early, there is only talent and technology. There is no overhead, no markups for financiers, and no investment in building a brand.
Moreover, as the business literature shows, it is the small acquisitions that usually bring value to a company and the large acquisitions that destroy value. On average, companies should prefer doing 100 $2-5M acquisitions over one large $200-500M one, but business development groups at large companies are not set up that way.
There is a missed opportunity here. Bigger companies could treat startups like external R&D, letting those that fail fail at no cost, scooping up the talent that demonstrates ingenuity, passion, and ability to execute. It would be a different way of doing acquisitions, one that looks more like hiring than a merging of equals, but also one that is likely to yield much better results.
For more on that, see also Paul Graham's essay, "The Future of Web Startups", especially his third point under the header "New Attitudes to Acquisition".