Answer by Kevin Iudicello, Tech M&A, Former Entrepreneur, on Quora

I see this all the time in M&A, and it is indeed baffling. It's because of an irrational optimism that is a product of three things:

  1. All entrepreneurs play against/ignore odds--if they weren't optimistic, they wouldn't start a business.
  2. "Board Bubble"--Board meetings and updates about the company are necessarily upward/positive biased. The CEO wants the board off their back, and the board, even if they don't want to further support the company will say they do because a disenchanted CEO is not good for the investment no matter what the circumstance ... so everyone sits around and talks about how tremendous everything is ... how much the company is worth despite its 'minor' problems and how unique things are when no one looks around hard at competition.
  3. This one is the most prevalent. In the valley/in tech--there's this psychological drift for valuations. Everyone ... management teams, investors, press, loves to talk about the wins. If you had a good deal, you talk about that one ... the high valuations are the stories that make it into the press. NO ONE talks about the 10 other companies in the portfolio that they shut down without a return. The venture model is hit 2 miss 5-8 ... over all you can still make good returns with this. No one talks about the 5-8. The 2 are all over the press. Point is, in general, good news spreads, and even companies executing horribly compare themselves to the 2. In general ... valuations/expectations/psychology drifts until you hit the reality of a deal (unless you are performing like those 2 ... then good times)...

Answer by Jason M. Lemkin, Co-founder/CEO EchoSign, acq'd by Adobe. Co-founded NanoGram Devices, acq'd by Greatbatch. VP @ NeoPhotonics, NYSE IPO. Sr. Dir @ BabyCenter, on Quora

First, at a high level, I think Kevin Iudicello nailed all the factors: ignoring odds, board bubble, valuation drift.

But I that's really the How. I don't think that explains the Why?

The Why? I think is "simple" BATNA analysis (Best Alternative to Negotiated Agreement), maybe done right, maybe done wrong.

If you get an offer for $x00m to acquire your company, and you've raised say $0Xm in less or capital (great return for VCs too) ... and you turn it down ... what you are really saying is you are Pretty Darn Sure you have a Better Alternative.

And at that point, the Better Alternative is likely a $2 billion market cap IPO, because there are just so many other folks who are going to pay $x00m for anything--often zero others.

Thinking of a few recent case studies:

  1. Groupon turns down $6b from Google, partially cashes out the founders and early investors, goes IPO instead, worth $5b today. So far, looks like the wrong bet financially. But we shall see.
  2. Facebook turns down $1b from Yahoo! at pre-revenue stage, after seriously considering it. BATNA again, IPO in the end. Played out right.
  3. Box turns down Citrix at $600m, raises round at $1.2b, on way to $2b IPO. So far, so good. Looks like this one will play out the right way too. Although you could almost argue otherwise for the founders, given dilution, time value of money, etc. if Box doesn't end up growing to $5b .
  4. DropBox turns down Apple at $600m(?), later raises round at $4b and then $10b. So far, so good, we shall see at the IPO.
  5. Yelp walks away from $500m deal with Google in '09, goes IPO, worth $1.4 billion today a year ago and $3.5 billion today. That was the right call in the end.
  6. Oracle's (I presume) $500m-ish offer for Eloqua, turned down, Eloqua IPO's, sells to Oracle within 1 year for almost $1b. See my analysis here: BATNA, And Oracle's $811m Purchase of Eloqua.

Let me also point out one key fact: these companies, with the exception of Facebook at the time, were all large enough and established enough by this point to Clearly See The Future. They could see the growth compounding, the revenues compounding, etc. Which isn't to say there isn't risk. It's just when you can see a much bigger future rather clearly--it's easier to turn a big offer down.

Of course there are many other counter. Just illustrating the 'Why?'

I agree there is excessive optimism, Board Bubbles (not their money), and valuation drift at play. But I think the real issue in all deals passed up is the Board sees their BATNA as better than the offer, "simple" as that. And once the $$$ get large, the BATNA is usually an IPO.

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Published on: Apr 24, 2015