VC Funding Spelled Backwards
So there’s been a lot of talk about the Xobni/Microsoft rumors floating around. I thought I’d weigh in on it a bit because a lot of people apparently don’t understand the interplay between venture funding and acquisitions.
First, I should mention that I’m not privy to any information you guys aren’t. I do know the Xobni founders (Brezina was the first person I met when I went to the Y Combinator interview) but I don’t know any more about the situation than I’ve read on TechCrunch. It’s not really my business anyway, and I just want to be clear that anything I write here is my own speculation and should be taken as such.
One thing all of the big blogs covering the situation don’t mention is that the founders may not have had the ability to sell to Microsoft at the rumored $20 million. They took a VC round a year or so ago and raised $4.25m. I have no idea how much equity they gave up in the process, but suppose it was 50% of the company, which would be a large amount but a reasonable guess given how young Xobni was at the time.
That gives them a post-money valuation of $8.5m, which means that $20 million would be under a 2.5x return for the VCs. A VC accepting such a small ROI is uncommon. I suppose they might do it if they thought, for some reason, that it was the best result they could hope for. But the funding round was only a year ago, and barring something catastrophic, VCs generally don’t accept much below a 5x return. They usually swing for the fences. That’s their job.
(Also note that if Xobni gave up less equity, that makes the multiple even lower. At 25%, that makes it barely more than 1x. It seems almost impossible they gave up much more than 50% as well. VCs have found, over the years, that they do better when they leave the founders feeling that they still own enough of the company to make it interesting. Buying 90% of a company doesn’t benefit you at all if the people running it no longer care what happens.)
For all anyone can tell, things are going well for Xobni. TechCrunch says they’re at 50,000 beta testers, and that’s pretty solid. They’re hiring, and just got their first outside CEO. Once again, I don’t know exactly what’s going on there, but it seems safe to say there has been no catastrophe. If I were their VC, I’d be holding out for a bigger payday than 2x as well, at least judging from the information I have.
Some people have said something to the effect of “surely the VCs don’t have control of the board and couldn’t veto an acquisition if the founders wanted to go forward with it.” That’s clearly wrong. Almost every Series investment creates preferred shares, which gives the investors some protections, the most basic of which being that the founders cannot sell or merge the company without approval from both a majority of the preferred shares and of the overall ones. This is absolutely necessary from their perspective. Otherwise an unscrupulous founder might turn around and sell the company (which now has a $4m balance sheet) to his wife for $1.
So again, I don’t know anything specific about their terms, but I’d bet my house that the VCs could nix the deal. And they probably would for $20 million. I would if I were them.
I also hear “what if the VCs think Microsoft will just include Xobni-like functionality in the next Outlook?” I’m pretty sure this occurred to Vinod Khosla when he funded them, and the founders when they started the company. Anyone whose business is a plug-in is cognizant of that possibility. Luckily, a big corporation trying to clone your product suffers from a Zeno’s Paradox of sorts. By the time they catch up to where you were when they started copying, you’ve advanced even further. And so on and so on ad infinitum.
But unlike the real Zeno’s Paradox, the laws of calculus don’t favor the megacorporation. The laws of bureaucracy imply that they’ll always be behind. In programming, throwing more money and more developers at a problem doesn’t mean you’ll proceed at a faster pace. But having to get every detail signed by four layers of management ensures you’ll move at a slower one.
Which doesn’t mean that Microsoft isn’t a threat. But it’s one the investors knew about going in and accounted for, so them suddenly sniffing around doesn’t change much. It only validates their initial judgment, which was, when they put over $4m into Xobni, that the company had a future, and would be worth 5x (which I’d guess to be $40m or above) or more at some point in the not too distant future.
Everything I’ve just said is pretty much common knowledge. It’s neat to see it in action though. You hear a lot about the tradeoffs of VC funding versus angels. Most people in the industry know that taking that big check from the VC means more outside interference and drastically reduced exit opportunity. But it also means getting more money, and all of the perks that go along with that, while giving up the same amount of equity you might to an angel to get ΒΌ as much cash.
So in the end it all comes down to what you want out of it. If you’re swinging for the fences, which apparently the Xobnis are, take the big check and try for the grand slam. (Sorry for the baseball analogies, I run a fantasy sports site. What do you expect?) This makes extra sense if you’re a Marc Andreessen or Peter Thiel type and you’re already set. Or if you just have the attitude that if you fail, you’ll just shrug it off and try again until you don’t. But if you’re just a young guy trying to bank a couple million fast, go with angels.
Had Xobni taken $1 million instead of 4, they’d all be buying beach houses right now. On the other hand, Microsoft might come back and offer the $40 or $50 million it would take to make the VCs agree (I think it would be a good idea for them to do so) and they’ll be buying beach house and Bentleys. Or nobody might buy them for awhile and they might get bigger and bigger, and it’ll be private jets. At this stage, who knows?
I have to say, I also wouldn’t be surprised if Fred Wilson is correct and becoming another cog in Microsoft’s giant wheel isn’t particularly appealing to the founders. Part of the reason anyone starts their own business is that the thought of someone telling them what to do keeps them awake at night. I once had a nightmare that I was middle management. I’d rather starve, and I’m not the only one.
Which is not to say that I would be totally opposed to being acquired, even by Microsoft. But I’d only do so if either I was guaranteed a large degree of autonomy, or I had fast enough vesting that if I quit after 6 months, I’m still happy with the money I got.
