How to turn $5m into $100m in 18 months

Here's a view into the bizarre economics of mergers & acquisitions.

Suppose you're a startup with $5 million funding and a couple of dozen clever engineers.  You set your engineers loose on creating a killer 1.0 product, which takes them a year and a half or so.  Now a fast-growing Hot Public Company decides they really want a product like this, and they are doing a build vs. buy analysis.  What's it worth to them to avoid having to build the product themselves?


They do have to consider time to market, and maybe you've filed a patent or two, and perhaps your engineers are so clever that the Hot Public Company wouldn't do as good a job.  But let's leave all that aside for a moment and just focus on the cost side of build vs. buy.  Even if they know how to build what you've built, it can be cheaper from their point of view to pay you $100 million than to do the same R&D work you've already done.

The reason has to do with how the stock market values public companies.  There is a fundamental error in the way stock market investors price stocks, and it's one that entrepreneurs and venture capitalists can (and do) exploit.

It works like this.  Your R&D is undoubtedly more efficient than Hot's - your engineers work longer hours, for less cash compensation, and they have fewer meetings to attend.  So let's say the thing you built in 18 months for $5 million would take them 24 months and $10 million to duplicate.  Then on a pure cost basis, they should buy your company if they can get it for less than $10 million, and they should build themselves if acquiring costs more than $10 million.  Shouldn't they?

Often, no.  The way Hot will analyze it is this: taking on an additional project that costs $10m over two years means $5m/year of additional R&D expense.  That reduces operating profit by $5m/year and after-tax profit by (say) $4m/year, depending on how arcane Hot's offshore tax structures are.  If Hot is trading at a P/E ratio of 25 times earnings, then reducing after-tax profit by $4m/year will cause the stock to trade down and will knock off $100 million of Hot's market capitalization.

The public market systematically overvalues profit fluctuations -- buy-side analysts observe small changes in the first derivative (profit growth) or even second derivative (acceleration of profit growth) and extrapolate.  The market also systematically undervalues cash on the balance sheet (as well as one-time charges).  So in terms of market capitalization - which after all is what the company is meant to optimize - spending $100m of balance sheet cash to save a few $m of P&L impact can look attractive.

Another factor is often at play too - the hubris of Hot's product managers, who believe that everything in their current roadmap is going to generate huge return, so of course nothing could be canceled or deferred to make room to develop technology like yours within the current R&D budget.  (Or maybe hubris is the wrong word; it may be just the unpredictability of the market.  A product manager says, I don't know which of these features is the one that matters, but we can't afford to be wrong, so we have to do them all.)

There are a few catches, as you'd expect with any 20x return out there available to be arbitraged.  Some of these are:

• You take the risk.  If your product doesn't work, it's $5m down the tubes and you get nothing.  (That cuts both ways though.  If the engineering is risky, then from Hot's point of view they might take the $100m market cap hit and still not succeed.  So that would push their perceived value up even higher than $100m in the event that you do get it to work.)
• What you've built is probably not exactly what they want; whereas (in their mind at least) the build option would have been exactly on target.  So take some discount for that.
• The value to Hot will be very sensitive to the P&L impact in the period after the acquisition.  This math works best when you are within striking distance of breakeven (which will be helped by Hot eliminating some of your SG&A expense, so your revenue may only have to cover R&D).
• If you sell to a company with a lower P/E multiple, their build vs buy equation is affected accordingly.
• This analysis only shows the "value price" to Hot, which is the price they should be willing to pay in the absence of competition.  If there is another startup with the same technology as yours, then the market clears at the "competitive price," meaning it's governed by whichever of the startups blinks first.

Still, even allowing for these factors, it's a pretty sweet deal from the seller's side.  If you've ever wondered how once in a while a young company with fairly modest sunk R&D can sell for an astronomical price, this balance-sheet vs. operating arbitrage is part of the answer.

Of course, it does eventually come home to roost, in two ways.  When Hot pays you $100m, they put a goodwill entry for most of that amount on their balance sheet.  The first true-up happens if the acquisition of your company doesn't go according to plan.  Then at some point in future Hot will take a one-time charge to reduce the goodwill amount.  But remember, the market undervalues one-time charges; so even when the deal doesn't work out, they may be able to escape unscathed.  The second true-up happens when Hot becomes Cold.  Then hindsight condemns all the acquisition overpayments and goodwill writedowns.  You will want to have sold your Hot stock before then, natch.