The article below is from my other site Two Letter Worlds.
About a month ago Chris Dixon posted about the economic logic behind tech and talent acquisitions, or more commonly known as “acquihires” these days. In the post he gave a pretty clear example as to why firms would do this, that makes perfect sense.
Suppose you are a large company generating $1B in revenue, and you have a market cap of $5B. You want to build an important new product that your CTO estimates will increase your revenue 10%. At a 5-1 price-to-revenue ratio, a 10% boost in revenue means a $500M boost in market cap. So you are willing to spend something less than $500M to have that product.
Suppose you could build the product for $50M with a 50% chance of significant delays or failure. Then the upper bound of what you’d rationally pay to acquire would be $100M. That doesn’t mean you have to pay $100M.
Before Chris’ post I had always wondered about the legitimacy in these acquihires, but after doing some additional reading it speaks volumes to the level which tech companies will add what I call “risk-free add-ons.”
Risk-free add-ons are ones that come from integrating an already established product into your own. Although they aren’t truly “risk-free” as you run into over-complicating your product, integration issues, as well as personnel issues, they are devoid of any build-risk, or issues that can arise while trying to build this feature or product on your own.
In private equity I have seen the willingness to pay 10x more for something that is already built to enhance a portfolio company, even if it hasn’t had success (think software without users/a client base) versus developing it from scratch. In big companies like Facebook or Google there are already so many moving parts that mitigating this kind of risk is one of the most important variables to them. When you have the best developers in the world, you still can run into unexpected issues that can derail a project, business segment, or even company.