The New Road to Riches

Originally Published on October 1, 2004 in Business 2.0

The turning point on Iain Lamb’s unlikely road to riches may have come at that depressing moment when he was forced to part with his car. It was 2002, and Lamb and Ethan Diamond, two in the vast migratory herd of coders who’d made their way to Silicon Valley during the tech boom, were desperately struggling to ride out the bust. The high school pals from Colorado had jumped from a dying dotcom, where they had grown deathly bored by the company’s main business, designing spreadsheets. So they set about trying to create something that did interest them: a new Web-based e-mail service that would look and feel like a mainstay desktop program such as Microsoft Outlook Express. They didn’t really think it could lead to much; they just wanted to make their e-mail work better. “We didn’t see it as a great business idea at all,” Diamond recalls.

But that began to change when, after months of hard-core coding, they came up with a Web-based app that not only mimicked Outlook but in some ways improved upon it. Friends, mostly coders, raved about it. Eventually, popular blogger Dave Winer put up a link to the program on his website. Within hours the app got so many hits that the battered PC that Diamond and Lamb were using as a server crashed. “We realized this could be a real business,” says Diamond, who’s now 33. They formed a company and called it Oddpost.

There was one rather large problem. They were flat broke. Lamb sold his 1997 Saturn—”a bummer because it showed just how close to utter ruin we’d gotten,” says Lamb, 33. But that kept him afloat while Oddpost’s app picked up more and more users, exclusively through word of mouth. Another ex-dotcommer, sales whiz Toni Schneider, 33, joined the company as CEO. Eventually database giant Oracle licensed the software, and in July the big payday came: Yahoo bought Oddpost, by then grown to a whopping 11 employees, for $29 million. That’s almost $2 million for each of the roughly 15 months Oddpost existed as a real company. Oddpost’s total investment capital—from Diamond, Lamb, Schneider, and others—was just over $2 million.

Oddpost’s story features many of the standard plot devices of tech startup triumph: the clever spotting of an overlooked opportunity, the crashing server—the server always crashes—the plucky victory in the end. But the company also represents an entirely new force, one that’s reshaping the global technology world and redirecting the pathway to startup success. Oddpost is part of an emerging breed of here-today, bought-tomorrow startups that are sprouting with minimal funding, flowering briefly, and being gobbled up by far bigger companies. In many instances, these built-to-flip outfits forgo—or sometimes can’t get—money from venture capitalists. They instead create shoestring operations focused on the rapid development of narrow technologies to plug gaps in existing product lines or add useful features to existing products. Then they look to a deep-pocketed patron to scoop them up.

The phenomenon has gone largely unnoticed because most of the deals are too small to make news. But the trend is accelerating. By the end of September, there will have been more than 5,300 tech acquisitions in 2004, based on research from Mergerstat. The average reported selling price was $12 million; in two-thirds of the transactions, the prices were so small that buyers didn’t disclose them. At this point in 2003, also a big year for small deals, there had been 4,500 tech acquisitions, averaging $12.5 million. Microsoft alone has bought 46 companies in the past four years; factor out the $100 million-plus deals, and most of Microsoft’s acquisitions average a few million dollars. Oracle has been buying up small companies at the rate of about one per quarter, even as it pursues its $7.7 billion bid for PeopleSoft. Google has bought six small companies in the past 18 months. Hewlett-Packard, IBM, Intel, Symantec, Germany’s SAP—indeed, all of tech’s power elite—have made stepped-up acquisitions of small fry an integral part of their strategies.

What’s behind the spree? It’s driven by powerful postboom dynamics in the tech industry. For starters, Google’s recent public offering notwithstanding, the IPO market remains largely moribund and isn’t likely to be an express elevator to glory for entrepreneurs and investors anytime soon. That means that a buyout by a larger company is now the surest route to a sizable payday—and a steady job—for entrepreneurs. Another factor: Commoditization has made the cost of many basic technology components, from superfast chips to heavy-duty storage systems, so cheap that it’s easier than ever for a bare-bones operation to build new products. The emergence of Linux and standard programming languages like Java also has made it easier to write software that can be easily woven into existing applications.

More important, however, are the evolving positions of larger companies. In many cases they have emerged from the tech collapse more dominant than ever. The firestorm of the bust cleared out weaker competitors and underscored to technology buyers the virtue of teaming up with established players that can take the heat of tough times. Today it’s harder than ever for upstart companies to crack some of the most lucrative tech markets. Equally important, large companies increasingly recognize that, with stock options no longer the lure they once were, the most cost-effective way to bring in new talent and to fund R&D is simply to buy up innovators and their ideas. “Big companies stink at innovation, and they know it,” says Vivek Mehra, general partner at venture fund August Capital in Menlo Park, Calif. “There are a lot of chances for startups to fill the niches and holes in big companies’ product lines.”

The big-buying-small movement is in some ways a return to the tech industry’s traditional patterns. For most of its history, tech has been dominated by a handful of giants—from HP and IBM to Intel and Microsoft—that have constantly bought up talent and technologies. New members of the elite, such as Yahoo and eBay, emerged during the boom. That all these power players are feverishly acquiring now presents massive new opportunities for entrepreneurs who can spot things the heavyweights need, develop them rapidly, and be willing to sell out quickly. “‘The art of the deal,'” says Silicon Valley venture capitalist Bill Burnham, “has become ‘the art of the flip.'”

The shifting terrain has suddenly vaulted people like Henri Isenberg into some of the most influential positions in tech. Never heard of him? He’s an ace coder, one of the authors of Symantec’s mainstay antivirus and security programs such as Norton Utilities and Disk Doctor. That software made Symantec the security-software industry leader; it had revenue last year of $2 billion. But Isenberg’s role today is far more crucial to the company’s success: He is Symantec’s chief dealhunter.

The 38-year-old Isenberg and his 11-person team are charged with scouring the tech world to identify hot acquisition targets—before competitors spot them. He and his group have been sifting through nearly 100 deal proposals a month, and they’ve seen some doozies. Isenberg recalls one startup that claimed to have created the ultimate security system. “They had a very slick video that showed a network cable with a tiny box and advised, ‘When an intruder attacks your computer, simply flick the switch and shut the network down,'” he recounts, chuckling at the memory.

Most of what Isenberg does is no laughing matter, however. Symantec increasingly depends on his acquisitions to keep the right products with the top features in the hands of the company’s 700-member sales force, and to fuel the 14 percent annual revenue growth that Wall Street has come to expect. “Our focus is to acquire companies that help us enter new markets,” Isenberg says. “It’s absolutely crucial for us.”

That’s why Symantec has for the past year been making an acquisition every two months, usually of startups barely out of the garage stage. In July, for instance, it bought TurnTide, an antispam company, for $28 million. TurnTide, founded by David Brussin and Lucinda Duncalfe Holt, also featured some of the usual suspects of startup woe: Servers crashed. It had no meaningful revenue. It had only a handful of customers. But among the latter were some of Symantec’s own network geeks. “Our people knew the product worked,” Isenberg says. He swooped in just as venture capitalists began to circle around TurnTide. Brussin and Duncalfe Holt liked the idea of ready cash and an alliance with an entrenched industry heavyweight with a powerful brand and an established distribution channel. “Symantec could really give us a platform and sell this product,” says Duncalfe Holt. Most of the TurnTide team now works for Symantec—indeed, Isenberg says Symantec typically retains about 65 percent of the employees of companies it buys—and TurnTide’s technology will be part of Symantec’s standard security software package.

Brussin, 29, stayed with Symantec. But Duncalfe Holt, 41, moved on. She could afford to. The $28 million that Symantec paid works out to a 36-fold return on their startup’s total investment capital of about $775,000. TurnTide was less than six months old when it was sold.

Eric Hahn didn’t do as well with his most recent startup, but he’s not complaining. Hahn, a 44-year-old Silicon Valley serial entrepreneur, had sold his software company to Netscape in 1995 for $100 million. He had no urgent need to start another company. But he could see that the conditions for a quick-strike startup like some of his past ventures were better than ever. And he had found another startup niche to target.

One day in November 2002, Hahn booted up his e-mail and was confronted by the usual 200 to 300 new messages. For months he’d been stewing about having to claw through thickets of junk e-mails to find important messages. “I was having an e-mail crisis in my life,” he recalls. He figured plenty of other people were too.

Like any good engineer, Hahn set about trying to code his way out of the mess. He still had a day job running his own investment firm, but he spent a couple of hours every evening hacking together a tiny search engine that would sort through the e-mail stored in his Microsoft Outlook program. In May 2003 he posted an early version of his software on the Web. Soon thousands of people were downloading it and using it to make their e-mail more manageable. One was said to be Microsoft chairman Bill Gates himself. “We could tell that a lot of people in large companies were using the product,” Hahn says.

That product became a company, Lookout Software. Hahn funded it himself, investing less than $1 million. Microsoft bought Lookout in June for a rumored $10 million and plans to build the technology into its Outlook e-mail program and its MSN search engine. Hahn says there are countless opportunities to come up with similar small-scale, highly targeted technologies—what he calls “nano-type projects.” “E-mail, instant messaging, voice over Internet—there’s just a zillion things that can be created to improve that stuff,” he says.

For Microsoft, the Lookout deal was only one of dozens it has done of late to supplement products and add brainpower. Although Hahn wasn’t interested in working at Microsoft, one of his key Lookout engineers went to work for MSN, and many founders and engineers from recent Microsoft acquisitions have joined the company. That’s a big part of the plan, says John Connors, Microsoft’s chief financial officer. “The overwhelming majority of the deals we’ve done are to buy intellectual property or people,” he says. “We’ll continue to be an active acquirer—mostly of smaller companies.”

No one has mastered the tactic of buying growth as fully as Cisco Systems, which over the years has acquired scores of companies. But even Cisco has modified its approach in response to the new tech landscape. Historically, Cisco has bought fairly large companies with well-developed technologies, marketing departments, sales staffs—essentially fully formed businesses. That has enabled it to instantaneously invade new markets. But now Cisco has begun to fish aggressively for acquisitions in the shallows, where it rarely used to troll. Ned Hooper, the company’s No. 2 business development exec, says Cisco increasingly looks to small, early-stage startups that have come up with a feature or add-on for its existing products. Often the search is triggered by customers’ demands for a certain feature or upgrade. “It’s faster to go out and buy these technologies,” Hooper says. “Customers won’t wait for a new feature.”

For instance, in response to customers’ ceaseless clamoring for easier remote access to their corporate networks, Cisco scouts tracked down an obscure little outfit called Twingo. Engineers Reza Malekzadeh and Gregorie Gentil founded the startup 20 months ago with less than $100,000 of their own money. They bought used hardware on Craigslist, hired a few part-time coders, and within 12 months had come up with Twingo Secure Desktop, an ingenious technology that allows road warriors to securely connect to their office computers from any Web browser. Some VCs expressed interest in the company, but Malekzadeh says Twingo realized that what it had created was “more a feature for a product than a company.” When Cisco dangled a $5.5 million cash offer, Twingo bit. “It’s not such a bad thing to just be an addition to an existing product,” Malekzadeh says. “It’s OK not to go public.”

The acquisition frenzy isn’t limited to the big buying the small. Sometimes it’s the small buying the smaller. Jimmy Giliberti, a former IBM engineer, and two friends started FingerTwitch in Giliberti’s San Francisco basement with less than $100,000. Their big idea was to create software that would make it easy to run a videogame on many different types of cell phones. (Big handset makers like Motorola, Nokia, and Samsung use proprietary operating systems, so game developers have to create different versions for the various phones.) Giliberti ran a lean operation—no office, a tiny group of contract coders who worked from their apartments or from San Francisco cafes, minimal salaries. About the only overhead was the phones Giliberti bought to experiment with. He carried dozens of them in a black duffel bag that he passed along to his coders. “It looked pretty suspicious,” he says. “I was making phone drops and worrying about getting busted.” Within 15 months, FingerTwitch had a growing roster of customers. It also had a new owner: privately held MForma, a fast-growing mobile games publisher in Bellevue, Wash., with deep pockets; it has $63 million in venture funding. FingerTwitch had begun to attract VC interest. But Giliberti says he preferred the more certain payday from an established company and believes that the mobile gaming business will ultimately be dominated by large publishers like MForma. Besides, who needs VCs these days? “In this climate, you can start a company with $50,000,” he says. “One or two people can create a nice little business.” MForma won’t say how much it paid for FingerTwitch, but the figure is believed to be several million dollars.

Kevin Merritt, meanwhile, quit his job as a tech guru for a Citigroup unit last year after it became clear to him that corporate reform laws like the Sarbanes-Oxley act would require companies to store e-mail messages for decades. He founded MessageRite, an e-mail archiving company, in Southern California, using his savings as seed money. For 12 months he took no salary. But by early this year, the company had lined up about 40 customers. Still, Merritt feared that without a larger distribution channel, MessageRite would stall out. In April he ran into Steve Jillings, CEO of FrontBridge Technologies, an e-mail management software startup in Marina del Rey, Calif., with about $40 million in sales. Jillings coveted MessageRite; he figured he could develop similar technology himself, but it would take at least two years. Merritt, meanwhile, was running up against the “hard reality of trying to raise venture capital in 2004, especially if you’re a first-time entrepreneur.”

In August, with his wife about to go into labor with their first child, Merritt sold to FrontBridge for $15 million. Now that he’s working for FrontBridge, “my commute time’s gone from seven minutes to 55,” he says. “But, hey, I can’t complain.”

How long will the conditions behind the build-to-flip phenomenon last? They show no signs of abating; indeed, the buying binge may only intensify. Commoditization will relentlessly drive down component costs and make it ever cheaper and easier for entrepreneurs to build new technologies. A more forgiving IPO market could slow the trend, but even Google found the public offering waters rough, and many startup executives harbor no illusions about IPO bonanzas.

Moreover, the tech markets with many of the choicest opportunities for filling niches—wireless, network storage, security, communications—are growing wildly and will only churn up more demand from established players looking to buy features or technologies. (See “Golden Opportunities,” page 86.) Mike Butler, CEO of Seattle-based Cascadia Capital, an investment bank that specializes in small-scale tech acquisitions, expects the action to stay hot. “Our business is up 250 percent from last year, and we expect to repeat that growth next year,” he says.

That’s good news for those who wouldn’t mind a tasty little score like the one Oddpost’s partners rang up. Oddpost founders Lamb and Diamond and CEO Schneider are now comfortably ensconced in upper-level jobs at Yahoo and are worth several million bucks each. They’ve come a long way since the days when they were stashing their server in a friend’s basement and watching it crash because a housemate knocked the plug out while vacuuming. Yahoo servers rarely crash. And Yahoo sees Oddpost as a vital part of the company’s effort to develop a premium Web-based e-mail service that people will pay for—crucial as Yahoo goes up against Google and other rivals. “Oddpost would’ve never made it if we’d tried the old route of going for the rocket-ride IPO,” Lamb says. “I couldn’t be happier about the way it played out.”

One of the first things Lamb did when Oddpost’s deal closed was to buy himself a new car, a nifty little Honda Civic hybrid. He’s not going to be forced to sell that one anytime soon.