Stanford BUS 73 — Exit Strategies: Maximizing the Value of Your Company
June 18th - July 19th, Live Online Class
by Paul V. Weinstein
As published in Harvard Business Review
Microsoft’s $7.5 billion acquisition of GitHub is a perfect illustration of how value is ascribed differently in Silicon Valley than in the rest of the world. GitHub was acquired for close to 30x annual recurring revenue (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 why the difference? 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. It’s about the 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 the company does (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, how much it costs to provide the 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 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 five people and no revenue can sell for a billion dollars, while a company with 500 people and $100 million in revenue can sell for a fraction of that amount. Although the most well-known Silicon Valley success stories, such as Apple, Facebook, and Google, are hugely profitable examples of financial value, the vast majority of startup success stories are not about building a company capable of an IPO and continued growth as a public company (an extraordinarily difficult feat); they’re about building something of value for someone else.
In other words, Microsoft is not paying $7.5 billion for GitHub for its ability to make money (its financial value). It’s paying for the access it gets to the legions of developers who use GitHub’s code repository products on a daily basis (the company’s strategic value) — so they can be guided into the Microsoft developer environment, where the real money is made.
Let’s look at a couple of well-known examples of strategic value. In 2006 Google acquired YouTube for an eye-popping (for the time) figure of $1.6 billion. YouTube’s business was wildly unprofitable, and the liability issues it faced for illegally posted videos seemed virtually limitless. Why take on this crazy business, much less pay a huge premium to do so? It wasn’t because of YouTube’s ability to make money in the future. It’s still unclear, 10 years later, whether YouTube is profitable. It was because YouTube had immense strategic value to Google (in this case, the ability to block a competitor from encroaching on its very profitable search business). Google’s acquisition of YouTube — again, 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’ billion-dollar acquisition of MySQL (where I was an executive at the time) in 2007. 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 its overall business model (its financial value) was speculative at best — and yet the company had multiple suitors willing to pay large sums to acquire it.
MySQL’s value was strategic, not financial. To the Oracles, IBMs, and Microsofts, its strategic value was related to protecting their 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 even the most important. Sun at the time was in serious trouble, as its expensive hardware was quickly becoming undermined by much less expensive commodity Linux servers. Sun needed an answer to this threat, and it needed one fast. For Sun, acquiring MySQL would allow it 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’s acquiring Sun six months later).
While Microsoft’s 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 high-tech startups. Namely, 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.