The Epic Exit: Why mobile startups are acquired

March 25, 2014, 8:39 PM UTC

FORTUNE — Last month, Facebook set the tech world ablaze with its $19 billion acquisition of messaging service WhatsApp, which is expected to reach 1 billion users in the next couple of years. Given the impressive numbers and reach, it’s no surprise the company was acquired. The news received extensive media attention not only because of the scale of the deal, but also because acquisitions of mobile startups are relatively rare; the vast majority toil in relative obscurity. Which raises the question: Why do a few mobile startups, such as WhatsApp, achieve incredible outcomes while the majority fail?

To shed some light, let’s first take a stroll through the Apple (AAPL) App store as a proxy for competition in the mobile sector. It’s hard to imagine that when the App store launched in July 2008 there were less than 1,000 apps available for download. Late last year, the figure surpassed 1 million … and growing. The level of competition for a new entrant is downright frightening. This partially explains why the majority of mobile startups fail, but it does not explain why the fortunate few succeed.

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Before we discuss other blockbuster deals, such as Facebook’s $1 billion Instagram acquisition or its $3 billion offer for Snapchat, let’s start smaller. After all, exiting a mobile startup for any meaningful amount is a big win, given the thousands of apps entering the fray every year. Take Yahoo’s 2012 acquisition of Stamped, an app that allowed users to track and share restaurants, books, and other things they liked with friends. After the acquisition, Yahoo (YHOO) shut down the app, and employees joined Yahoo’s New York office, implying that Stamped was acquired purely for its talent.

This further confirms that recruiting a solid engineering team is a key first step to creating potential acquisition value. In fact, most mobile deals are “acqui-hires,” where the buyer hires the startup’s employees and incents them to stay with the buyer by granting them stock, which typically vests over three to four years. This type of deal usually gets done for under $10 million. Technology giants like Google or Yahoo use acqui-hires to grab talent that would otherwise be difficult to attract, since hiring experienced iOS or Android developers can be next to impossible in hot markets like the Bay Area or New York City. Acquirers even talk in terms of “dollars per engineer” and “dollars per employee” as valuation metrics.

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But a few million dollars is a far cry from the billion-dollar valuations necessary to acquire the world’s most dominant mobile platforms. So then, how can a founder increase the value of her startup? The natural next step after hiring the right talent is to build solid technology. Investing in a clean, scalable codebase that can easily be integrated into a buyer’s technology stack can reap huge rewards.

Take for instance Yahoo’s acquisition last year of Summly, a mobile news aggregation app founded by 17-year-old British entrepreneur Nick D’Aloisio. Yahoo paid roughly $30 million, a steep price if it only sought to acquire the startup’s small team. However, shortly after shutting down Summly as a stand-alone app, Yahoo incorporated the acquired technology into its own flagship mobile app; the transaction was driven by the relevance and quality of the technology that Summly had created.

Talent and technology are critical factors in any mobile deal, but a great product can also deliver significant acquisition value. While dozens of apps fought to become the “Instagram for video,” three notable mobile startups not only achieved significant exits, but also had their products live on after acquisition. Twitter (TWTR) was so impressed with the Vine beta product that it bought the startup for $30 million even before it launched and launched Vine itself. Today, Vine has over 40 million users. Socialcam, another video-sharing app, was sold to Autodesk in 2012 for $60 million. Qwiki, an app that automatically creates brief movies from a user’s iPhone media, was acquired by Yahoo for $50 million last year. As indicated by the exit values, these mobile startups were rewarded for creating products that buyers wanted to keep alive and grow.

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While the right team, solid technology, and a great product can make a mobile startup very valuable, a strong user base takes it to the next level. Of course, very few startups attract a user base large enough to give the big boys a run for their money.

When Facebook (FB) announced the acquisition of Instagram for $1 billion in April 2012, the mainstream media seemed incredulous that a company with only 13 employees could be acquired for such a sum. Of course, the company had much more than just a strong team — it had a young, active, and growing user base of 30 million people. With the added bonus for Facebook of eliminating a competitor shortly before its IPO, Instagram pulled off an epic exit. With the benefit of hindsight, it appears that Facebook got a pretty good deal. Today, Instagram has an estimated 180 million monthly active users and is one of the dominant mobile photo and video-sharing platforms on the planet.

Revenue generation potential also helps a mobile startup achieve a substantial exit, although whether it actually generates revenue may not impact valuation. Late last year, Facebook bid $3 billion for Snapchat, the popular messaging app that enables users to share self-destructing photos and videos. Snapchat has a large, young, predominantly female, engaged, and growing user base but currently no revenue. That said, it appears the revenue potential of the company drove the sizeable valuation. Facebook is a public company that needs to demonstrate mobile revenue growth to increase its stock price, and Snapchat has a highly attractive and growing user base. Facebook has also proven it can generate significant revenue from mobile, recording $1.2 billion of mobile advertising revenues in the fourth quarter of 2013.

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Presumably, an acquisition of Snapchat would be at least as successful as Instagram, which Facebook successfully monetized to the tune of $240 million to $485 million in projected revenue, according to Goldman Sachs. With this context, it’s not surprising that Facebook believed acquiring Snapchat for $3 billion would be accretive. The rejection of the offer, however, clearly means that the founders of Snapchat believe it is worth even more.

When a founder contemplates positioning her mobile startup for a potential sale, it is critical to understand why an acquirer might purchase the company. Would the most likely buyers monetize a strong user base, for example, or would they be more focused on building a strong team? Or both? To optimize the chances of success, founders should focus on building the best company possible at each stage, whether the startup is just starting to build its team or it has progressed to the point of developing a sales strategy.WhatsApp famously spent $0 on marketing to potential users, believing instead that a well-engineered product markets itself. When a startup builds a solid foundation at each stage, it is not only more likely to fulfill its mission, but also more likely to pull off an epic exit.

Navin Thukkaram is a technology investor and former chief operating officer of Qwiki, which was acquired by Yahoo in 2013. Follow him