Tuesday, December 8, 2015

Does Elon Musk + Peter Thiel = 3 or 1.5

I've written previously (here and here) about the issues with private companies merging in an acquihire or other downside scenario (i.e. one company running out of cash and another with cash but searching for a business model).  Often times those involve trading within a venture capital portfolio or between two venture firms portfolios.

But what about the case where both companies are well capitalized and doing well?  I think we will see more of these in 2016 and beyond as IPOs are still far and few between and unicorns struggle to justify their stratospheric valuations.

One of the first I was exposed to was the merger between Peter Thiel's Confinity/PayPal and Elon Musk's X.com.  Both companies were relatively well capitalized, building peer to peer payments businesses and spending a significant amount of their funding on customer acquisition.  According to David Sacks (PayPal's COO at the time), both companies were involved in a scorched Earth battle to acquire customers (upping referral bonuses to $20) that neither were likely to survive if they continued down that road and the merger solved this problem (although created others).

Obviously, Musk and Thiel both did fine off the eventual Paypal IPO (and even better subsequently with Facebook and Tesla).  Musk was the early winner taking the CEO role (for a brief period) in the merged company and the largest equity stake as well.  Not surprisingly, the merger was highly dilutive, particularly to Confinity/PayPal shareholders.  I was a Limited Partner in Angel Investors II (Ron Conway's angel fund) that was an investor in Confinity.  At the IPO, Musk held a 14.2% stake vs Thiel's 5.6% (Sequoia Capital had 10.7%).

For the LP's in Angel Investors II, the investment ended up returning around 7x (but only 1% of the fund), which was a very good return but not as high as it could've been, and clearly not enough to make a dent in many of the other 150+ companies (most that went out of business) in a portfolio that included candybarrel.com, eRugGallery, and dunk.net.  Luckily, Google was one of the 150 and did ultimately return the fund assuming the LP was smart enough to hold the stock after distribution.

I originally got to thinking about this when I received a 485 page information statement on a previously announced merger between Clean Power Finance and Kilowatt Financial.  I was a seed investor in Clean Power Finance (CPF), which subsequently raised $90M+ in venture funding and  over $1 billion in project and debt financing.  CPF's major venture backer is Kleiner Perkins, who coincidentally, is also the majority equity holder in Kilowatt.  Like CPF, Kilowatt also provides solar financing services to consumers.  It is obviously too early to know whether this will be a successful merger, but I generally prefer to roll the dice with the original horse I bet on.  You also have to wonder about the numerous conflicts of interests involved in a deal where one investor owns a significant stake in both parties.

Another seed investment where something similar happened was the 2010 iControl Networks merger with uControl (yeah not a lot of creativity in naming...).  Kleiner was also the lead venture investor in iControl, which had raised close to $50M in financing at the time (I previously wrote a post about iControl's financing history).  Both companies offered home security and automation services through partners.  iControl had make significant inroads in the security industry (partnering with ADT to deliver ADT Pulse) while uControl had more success with cable and broadband providers.  As an investor, I wasn't very excited at the time due to the dilution and challenges in integrating the two platforms.  Looking back five years later, it appears that the merger was a very expensive partner acquisition strategy for iControl.  By the way, this month is the 10-year anniversary of iControl's Series A financing and I haven't been able to get liquid on a single share.  Hope that changes in 2016...

What does this mean for entrepreneurs and investors?  Here are a few thoughts:

  • Expect more consolidation - While acquisitions of early stage companies often provide benefits to fill in product line, acquire a team, or enter a new market, later stage acquisitions are often a sign that one or both companies got stuck in the red zone and the hope that the combined effort can get the ball across the goal line.  
  • Many acquisition are a Zero Sum Game (or worse) - This holds true for many public company acquisitions as well.  Press Releases always tout the synergistic benefits of the combination, but in reality, rarely are both entities better off.  Typically one comes out better and often both end up in a worse position.
  • Resetting of Liquidity Clock - Similar to raising a large late stage private round, this also increases the combined enterprise value and limits potential exits to either an IPO or very large acquisition.  It takes time for the business to catch up to these market expectations and valuation.  Most never make it there.  I do wonder if we will being to see the rarely used redemption clauses triggered where early investors may be happy to take their money back plus accrued preferential return to close out a fund.
Back to that PayPal merger.  What would've actually happened if Confinity and X.com had continued to battle it out.  One thing I know is that the combined business turned out a lot better than Peter Thiel's original business plan for infrared beaming of electronic payments over Palm Pilots that I unfortunately passed on investing in 1999.  For those interested in an entertaining look back at Silicon Valley history, you can find that business plan here.