Validating the acquisition strategy

When it rains, it pours.

The same can be said of the recent successes of venture capital firm Draper Fisher Jurvetson, which funded two free email companies, Four11 and Hotmail, that recently were acquired by notable tech companies.

Within three months, the VC firm watched the two start-ups become acquisition candidates for search company Yahoo (YHOO) and software giant Microsoft (MSFT), respectively.

Industry watchers say that it is more than a mere coincidence that the firm has had two successes in selling the similar companies within such a short period of time. Moreover, the recent deals are likely to spur interest in sending start-ups off on the acquisition path, rather than into the public realm with an initial public offering, especially given that the IPO market for high-tech companies slowed in the past year over the previous two.

Yahoo bought Four11 in October for $92 million in stock, and Microsoft bought Hotmail last week in a stock deal that has been estimated in the hundreds of million of dollars, according to industry sources.

Robert Sullivan, CEO of investment marketing firm Makenna, Delaney & Sullivan, said it is not unusual for VC firms to invest in a handful of companies within the same market and then shop them around simultaneously. As for knocking out two acquisition deals virtually back-to-back, he said it was simply the luck of the draw.

Timothy Draper, managing director at Draper Fisher, agreed.

"I am lucky as can be. I would have liked to [have seen] them go public. I didn't want to sell [Hotmail], so the price kept going up," Draper said. "Both were situations in which both of these companies were going to be successful anyway. People paid a premium to buy it out of the market, and in some ways it was great because it paid more than the market would have paid right now."

Draper added that he lost one of his favorite companies with Hotmail and one of his favorite management teams with Four11.

A typical return for a venture capital firm has been between 30 percent and 40 percent annually from companies either launching an IPO or landing an acquisition deal, said Kirk Walden, a national director at Price Waterhouse, which tracks venture capital firms.

Walden estimated that Draper Fisher probably made a 60 percent to 80 percent return on its investment in Hotmail.

Walden said the last time a venture capital firm had such a profitable run was when Sevin Rosen was the investor in both Compaq (CPQ), which went public, and Lotus, which was acquired by IBM (IBM).

"It is very unusual that [Draper's deals] are that close together. There is some luck involved, but it goes beyond that. They have made some really good bets. This just shows that a company need not go public for it to pay off handsomely for the VC firm," Walden said. "Hotmail is a validation of the acquisition strategy."

The success of Draper Fisher's deals demonstrates that VC firms can take on more risk and relieve some of the risk of start-ups at the same time.

Knowing that a company has the option of being sold makes it easier for VCs to invest in businesses that have a standalone product. Otherwise, those companies would have a hard time convincing Wall Street that their one-trick pony is viable, Walden said. When companies are small and carry a single product line, they incur a lot more risk standing alone than if they were, for example, to become a small part of Microsoft.

The acquisition route also reduces the risk of going public and being scrutinized under the microscope.

"Once you are public, you have to deal with people like Bill Lerach.... Why would you want to be exposed to that kind of stuff?" asked Mike Hall, a partner at Venture Law Group, a law firm that represents Yahoo and that once represented Hotmail. Lerach is an attorney renowned for filing shareholder lawsuits.

But Draper does not agree that these deals validate an acquisition strategy. "If you go for an acquisition strategy, you'll never be acquired," he said. "You should always be thinking long term. If you think short term, you make the wrong, shortsighted decisions."

Other venture capitalists concurred.

Mark Gorenberg, a partner at the venture capital firm Hummer Winblad, said there could be some harm in aiming for an acquisition rather than taking the traditional route of aiming for a public offering.

"Entrepreneurs need to stay the course. They need to have the passion for business rather than the passion to make a quick buck," he said, adding that start-ups and investors must not look at an acquisition strategy as a license to have a short-term view because a company may forget to build the business when it is focused on the shortsighted goal of being sold.

The fact that some firms have had successful acquisitions should not change the fundamental motivation for investing--to build a strong company that can obtain real market real estate and go public eventually if it so chooses. It all comes down to generating a company that has a choice, Gorenberg said.

Venture capital firms receive about 100 to 300 business plans a month from start-ups looking for seed money. The recent deals with the email companies likely will boost interest in similar businesses, at least until the next big thing comes along.

"Venture capital is a close-knit industry. Firms are always looking at what other VCs are doing and we will likely see a surge in those types of deals for a while," Sullivan said. He said the same thing happened not too long ago with companies that manufactured Web servers.

The most notable thing about Draper Fisher's recent run is that it illustrates that there are two basic ways to gain liquidity. An IPO has been the traditional way, however, the acquisition way has become more and more favorable over the past five years. That can partially be attributed to fast product cycles and the fact that some companies see buying their way in as the best way to gain access into new markets.

The latter is the kind of deal that both Hotmail and Four11 got, Draper said. He added, however, that if you have a successful company, it is going to be successful and you don't need an acquisition to squelch that growth.

It is also beneficial to have a venture capital firm backing whatever path a company takes. In both types of deals, the offers made at least doubled the entrepreneur's original offering price, Draper said. He noted, however, that the VC does add an element of risk to the acquisition because, "if we are holding out, there is the big opportunity [the potential buyer] could walk away."