Non-Tech Firms Changing Startup Business Models

A few days ago Hunter Walk (quickly becoming one of my favorite VC blogs to read) posted a blog on the new reality that is non-tech firms being more frequent acquirers of startups than tech companies.

Yesterday, CB Insights did the same putting the spotlight on several of the companies that exited to traditional companies with the graph below to highlight the change over the last few years.

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As a result of more traditional firms getting into the M&A fray, I believe 2017 is the year we’ll see more startups try to build more sustainable, or close to profitable businesses. Sure, there will still be a few outliers like Jet and Cruise who were likely not operating even close to profitability but Dollar Shave Club appears to have been on its way before being acquired.

There are a few reasons for my thinking:

  1. Over the last year or so, growth rounds (B and beyond) have required tougher metrics for funding and good valuation meaning that companies need to have some optionality in the event they cannot raise capital at the valuation they want or because of internal growth metrics.  This squeeze will put the focus on sustainable business models.
  2. Traditional companies like businesses with economics that make sense when synergies and adjusted revenue are applied.  Hunter’s post had amazing insights on the different levels of acquisition but my particular favorites were levels 3 and 4. Non-tech companies are looking to prevent themselves from the same fate as their peers in retail since Amazon arrived on the scene, which gives reasoning behind level 4.  But I would argue that most of the M&A activity will occur in level 3 where startups with decent unit economics have the chance to provide a real product line or new acquisition channel to a non-tech company where the economics get better with synergy from a bigger firm.

An example of this thinking is Seventh Generation v. The Honest Company.  Two very similar companies but with different business models.  Seventh Generation, while older built itself like a real business, gained profitability after year 10 and took $100M in funding along the way.  Unilever acquired SG for 600-700M in 2016.

The Honest Company, by contrast, has taken the “growth” approach raising $228M in 5 years, has 3X more staff, and the same level of sales.  Fortune highlighted the comparison in December and reports that The Honest Company is restructuring to build higher margins after being snubbed in acquisition talks by Unilever before the SG transaction.

Though the exit horizon for SG was much too long for VC,  the business model contrast with Honest highlights an important point.  In some industries, especially those that non-tech firms are interested in, margins and sustainability matter greatly.

One particular industry that I believe will see this happen is FinTech, banks are slowly being disintermediated from their consumers and Bitcoin is picking up a lot of steam as of late.   As a result, we’ll see more formal institutions create partnerships and acquire FinTech companies focusing on security and payments, digital currency, and customer engagement.

Earnest, SoFi and Student Loan Genius, all of whom are re-thinking the way lending, credit and payments work, are prime examples of acquisition targets for banks that want to engage young, educated consumers who are likely to use their other products like home loans, credit cards, and investment vehicles.  These startups represent a chance to acquire new customers while pre-empting an existential threat on the chance that new loan processes leak into traditional bank products such as mortgages.

With all of the capital raised in 2016 and prices coming back into alignment, it is almost certain we will see increased M&A activity in 2017.  The most interesting question will be if these acquisitions accelerate the pivot of startups building for sustainability instead of growth.

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