Microsoft’s recent $7.5 billion mega acquisition of GitHub is a perfect illustration of how differently value is ascribed in Silicon Valley as opposed to the rest of the world. With a reported annual reoccurring revenue rate (ARR) of approximately $200 million, a net loss of $66 million and a series of sexual harassment scandals causing the founder/CEO to be forced out, GitHub was acquired for close to 30x ARR (an astronomical multiple). To put this in perspective, Microsoft acquired LinkedIn for $26 billion in 2016 (7.2x revenue) in what was considered one of the richest tech deals ever.
So what makes GitHub so different? The answer lies in untangling a pervasive misunderstanding of how Silicon Valley works and where these astronomical values come from.
In Silicon Valley there are basically two ways of creating shareholder value: financial and strategic. Financial value is the stuff of business school and stock markets. It's about multiples of revenue or earnings, sales growth, profit margins and management theory. Financial value is about a company’s ability to grow and prosper as an independent company.
When we talk about how the price of oil will affect Exxon’s stock price we intuit a direct connection between what they do (drill for oil), the price of oil and how those two things are related to the stock price. Similarly, if you run a local dry-cleaning business the value of that business is based on how many customers you have, how much they spend vs. how much it costs to provide that service and expectations of growth.
Strategic value, on the other hand has little to do with any of those things and almost everything to do with how a company’s product and/or market position help or hinder another company's (usually a bigger one's) ability to be successful. Strategic value is value that is realized not by a business’s ability to make money independently, but by its ability to generate (or in some cases protect) profit for someone else.
This distinction is at the heart of why a company with 5 people and no revenue can sell for a billion dollars while a company with 500 people and $100 million in revenue sells for a fraction of that amount. While the most well know Silicon Valley success stories like Apple, Facebook and Google are massively profitable examples of financial value, the vast majority of start up success stories are not about building a company capable of an IPO and continued growth as a public company (an extraordinarily difficult feat), but of building something of value for someone else.
In other words, Microsoft is paying $7.5 billion for GitHub not for its ability to make money (it’s financial value), but for the access it gets to the legions of developers that use their code repository products on a daily basis (GitHub’s strategic value) so that they can be guided into the Microsoft developer environment, where the real money is made.
Let’s look at a couple other well-known examples of strategic value. In 2006 Google acquired You Tube for an eye popping (for the time) figure of $1.6 billion. You Tube’s business was wildly unprofitable and the legal liability issues it faced for its users posting video illegally seemed virtually limitless. Why take on this crazy business much less pay a huge premium to do so? It wasn’t because of You Tube’s ability to make money in the future, it’s still unclear, 10 years later, whether You Tube is profitable. It was because You Tube’s strategic value to Google (in this case the ability to block a competitor from encroaching on its wildly profitable search business) was immense. Google’s acquisition of You Tube, a company that 10 years and billions of dollars of investment later still probably doesn’t make money, is now widely considered one of the best deals ever made.
Another example is Sun Microsystems acquisition of MySQL in 2007 (where I was an executive at the time). MySQL’s main product was a free, open-source database that was extremely easy to use and provided the back-end functionality for just about every website in existence. The company’s revenue was minimal and overall business model (its financial value) was speculative at best and yet the company had multiple suitors willing to pay large sums to acquire the company (MySQL was ultimately acquired by Sun for a billion dollars).
MySQL value was strategic, not financial. To the Oracle’s, IBM‘s and Microsoft’s its strategic value was related to protecting their very profitable database businesses from a free product that did 80% (and growing) of what their expensive solutions did. While this was a good example of strategic value, it turned out it wasn’t the highest. Sun Micro at the time was in serious trouble as it’s expensive hardware was quickly becoming undermined by much less expensive commodity Linux servers. Sun needed an answer to this threat and they needed it fast. For Sun, acquiring MySQL would allow them to build certain Sun specific advantages into the database that would make websites built on Sun/MySQL run 10 times faster than on competing solutions. With the very survival of Sun on the line this was very strategic indeed (and a major factor in Oracle acquiring Sun 6 months later).
While Microsoft acquisition of GitHub is major news it is just another in a long line of illustrations of a basic truth about the primary value of most successful of hi-tech start-ups. Namely, that building a self-sustaining business is the exception not the rule. Strategic, not financial, value is what drives most successful outcomes. If you reorient your thinking around this thesis, making sense of the crazy world of Silicon Valley will be much easier.
Published in the Harvard Business Review: https://hbr.org/2018/06/why-microsoft-is-willing-to-pay-so-much-for-github