The other day I was talking to a good friend of mine who is on the executive team at a startup in the ad technology space. We were talking about strategy -- and in the midst of the conversation, I suggested that since the company hadn't taken any money yet, it should strongly consider selling at its early "life stage" for $10-20 million now. He gasped and told me, "Are you kidding me? I'd put our valuation at between $100-200 million."
I stopped talking for a minute, and then said, "I'm not sure how you could possibly have the revenue to justify that." This is, after all, an early stage startup that only has been in business for a year or two, and I'm fairly familiar with the company and its customers; I know it's not doing more than $2-3 million of annual revenue right now.
And he said, "In (insert niche here) nobody is bought on a multiple of revenue -- it's always based on strategic value."
To which I replied, "That might be true of funding -- of course VCs and increasingly PE firms are betting on the long-term value of disruptive technologies. But for an acquisition, at least for a rational one, nobody is bought without some discussion of 'comps' for similar companies and revenue, and some 'reasonable' multiple is definitely a factor."
My friend rattled off several examples of companies that have been acquired (for what I see as irrational amounts of money) lately and some of his beliefs on their revenue pictures -- and we picked over the specifics of the acquisitions. And that's when I started to get worried.
This conversation has been rattling around in my head for days now, and I have to say I'm concerned about the market. I see this space as primed for consolidation. The Luma Partners display ecosystem slide is a perfect example of much that is wrong in our space:
As dollars move between advertisers and publishers, the folks sitting in the middle are trying to find a way to strip off some money as it passes through the ecosystem. The only way they're going to be able to strip some pennies off of the dollars as they flow through is if they provide some value back to the ecosystem. The problem is both the number of companies in this space and the exuberance of those companies for how they believe they'll participate. Many are not realistic on what they should be paid.
There's opportunity in this space; don't get me wrong. I wouldn't be invested so heavily in online advertising if I didn't believe that there is a strong opportunity for me and my company. But let's all be very clear about what that opportunity really looks like. The greater the provided value, the more money that the company in the middle can take away. So is the value a moderate improvement in efficiency -- or a substantial change in value? How significant is the change? At the end of the day, the market will bear only so much being stripped away, so only those companies that have disruptive technologies are going to be able to extract significant amounts of money.
It might be useful to look at what percentage of spend various vendors are able to extract today. Let's start with agencies, which are often the target of technology companies trying to find a place to disrupt the market through disintermediation. But that's crap. First of all, the agency lives in the power position in the ecosystem. And despite the kvetching of the technically minded who don't "get" what agencies do (nor even the difference between a creative and media agency), agencies provide a lot of value to the advertiser (their customers). Agencies are not easily disintermediated -- nobody has been able to disintermediate them so far.
Most startups vastly inflate the amount agencies get paid -- typically the number that is thrown out is somewhere between 15 and 20 percent of spend, which would be freakin' awesome if it were true. But those kinds of percentages went out of style in the ad space along with well-tailored suits, smoking a lot of cigarettes, and drinking whiskey and water like it's going out of style. Most big agencies no longer negotiate their contracts with the marketing team as an advertiser; they negotiate with procurement offices and negotiate for fixed margins -- very low margins, in many cases. They'd be psyched to claim 15 percent of spend. They'd be excited about 10 percent of spend -- even 5 percent, in some cases, would be cause for ecstatic celebration.
OK, so agencies are not where the money pools. What about tech startups? The reality is that technology vendors take small percentages of the dollars out of the flow and make it up on margin and volume.
Ad serving is a great example of this. A third-party (buy side) ad server is typically getting between $0.07 and $0.15 CPM for its service. That is really not a huge amount of money. It typically comes in at less than 5 percent of spend -- and at volume, and depending on price, it frequently is down below 1 percent.
In traditional media, typical vendors are well below 1 percent of spend as the money travels through their systems. But ad serving is commoditized, you might say (and I'd argue that before too long, most technologies are commoditized). Look at DSPs, which have been the much-laureled darlings of advertising technology for the last three years. There's very little differentiation here. They've all commoditized out to varying degrees, competing only on price or service, or minor feature differences, rather than by disrupting each other. (And for the record, there's nothing wrong with this -- which is sort of my entire point.)
"But the DSPs are the future," you might say. "They're the ones who are bringing automation and efficiency to this space; they're the future of advertising! Damn it!"
Well -- yes and no. DSPs are playing in an emerging media -- the real-time inventory market. In emerging media, the top-line media spend CPMs are generally higher. (Let's not have any illusions here -- it's a product of supply and demand in which the amount of available inventory is low and the demand is high.)
In emerging spaces, the technology vendors typically take much bigger pieces of the pie. For example, look at ad serving back in 1998 -- CPMs were closer to a dollar. Look at rich media vendors, which could easily pull close to $2 out of the ecosystem back in the early days. But the core CPMs of the media in an emerging market are higher. Look at mobile: In 2004, the average mobile CPM was between $60 and $80, and is now below $5 (depending on who you talk to). And when the CPMs are high, and the market is still figuring itself out, vendors can take a big piece of the pie. Even in paid search, which hasn't seen the bottom drop out of CPMs (for very strong economically provable reasons), the percentage of sustainable media spend by vendors hasn't been very high. The simple truth is that mature media markets are only willing to allow very small amounts of money to leach away between buyer and seller for "table stakes" technologies.
Does this mean that the online advertising space is not as "hot" as investors have believed for the last decade? I think this space is incredibly hot -- and that there's a huge amount of value to be created and we're only at the beginning of it. But let's be clear. Let's look each other in the eye and not pretend that the dynamics of an emerging market are sustainable over the long term.
There are only two tricks to play out here: You either need to be the Donovan Data Systems of your market (i.e., you are indispensible, are taking a reasonable percentage of spend as the dollars flow through you, and you're the stand-out leader in your space). Or you need to be the company that redefines the market completely (i.e., you will use technology to fundamentally change the way the market operates). And if technology is at the center of that disruption and technology is the driver of that fundamental change, then suddenly the rules are different.
What bothers me about the space we're in right now is not only that it's getting really crowded, but also that most of the parties playing in the middle are not adding the value that a full corporate entity needs to be adding in order to both create and extract the value needed. Most of these startups are really more of a feature rather than a whole business. But if they're just a feature, what do they plug into?
The problem is that consolidation is not easy. It actually sucks majorly -- for everyone involved. I speak from experience; I was on the deal teams for of a bunch of companies we acquired when I was at Microsoft. I was involved in the projects to consolidate those acquisitions, and I'm friends with a bunch of folks who were in similar roles at Google, AOL, Amazon, Yahoo, etc. And it's just never easy. The buyer has this nasty problem of a new and generally incompatible technology, plus a completely different culture -- both of which are super hard to converge successfully.
And what about when you're getting bought? It only works out well for those who are fairly mercenary -- the ones who ran after the idea because they wanted to exit well, and who were determined to exit well, and were plenty happy to exit as early as they could. But what about for those who are in love with their own startups, who see them as children? Great entrepreneurs I've met look upon an acquisition as an opportunity to get their struggling products the visibility and distribution might that they deserve. And it's called an exit for a reason. When your company is acquired, it ceases to exist. It's no longer your company; it belongs to someone else, who is very likely going to screw it up and kill it.
The trick for having a successful startup in this space and a successful exit (not only for the cash value, but to have your beloved business count for something going forward) is for folks to be realistic about both the value they bring to the table and the way they can be leveraged. And let's not forget that in order to really be valuable when you are acquired, your technology has to somehow rationally live in the context of the acquiring party's landscape -- both technically and culturally.
Exit earlier rather than later if you can -- while you still own a good chunk of the company. As a founder, would you rather have 30 percent of $20 million, or 5 percent of $80 million? I'll give you some advice -- earlier is better. Exit before you have to scale the thing up -- before you have to invest in customer support or in operations, before hosting everything in the cloud stops scaling for you cost effectively and you have to invest seriously in capital expenses and need to raise a lot more money.
And please -- build your technology in as abstracted and "ingestible" a way as possible. Please -- I'm begging you!
But I digress. The reality is that there are a lot of companies that are stuck. They've taken a lot of money, but they aren't the leader of their space or disrupting their space significantly. And most of them have become targets for new companies coming in and running after them -- and either exactly copying them (further commoditizing them) or disrupting them.
It's these second-generation companies that are the ones to watch. They're typically bootstrapped and generally doing more interesting things than their established competitors. And they're the ones who are most ripe for consolidation because they can afford to exit for much less money since they haven't taken as much from investors.
The only question is this: What happens when they get acquired? And what happens to the middle of the market -- those that have raised $15-40 million and that have stalled on growth and suddenly face a plethora of competitors? They had better find a way to get profitable real fast.