The big obsession yesterday was with why Google spent $3.2 billion on startup Nest Labs. But lost in the shuffle of the breathtaking price and lots of questionable speculation about whether this is relevant to Apple was exactly what motivated the company to take the deal. Nest CEO Tony Fadell had the right soundbite: “ Google made a very strong pitch for how we could have all the resources of a large company while retaining the independence of a next-generation Nest,” he told Fortune. In reality, there’s more to it than that.
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1) It’s always about the money
Fadell and co-founder Matt Rogers started the company in 2010 after leaving Aple. While there is talk Fadell was forced out, Rogers left on his own, walking away from a big gain in Apple stock. Nest has since raised more than $100 million. But if the scuttlebutt is to be believed, the earliest investors are walking away with only about 20% of the take. Add in the investment Nest received from Google and others and the founders and employees apparently still own the bulk of the company. For Fadell and Rogers, this means a payday in the upper hundreds of millions.
2) Nest is not a social network
With the Snapchat team turning down $3 billion from Facebook recently, though, and Nest certainly able to raise more money, why sell now? The answer has to do with the nature of companies making hardware. While Snapchat currently has no revenue, the potential of it scaling to Facebook-like user numbers gives investors the ability to believe the sky is the limit. Further, Snapchat is inherently viral, becoming exponentially more valuable as it grows.
Nest’s connected thermostats are not an inherently viral product. I can tell you how much I like mine, but you buying one doesn’t change my experience one bit. Further, while there might someday be functionality to compete with your neighbors to save energy, the last thing most of us want is any kind of intrusion into our home from strangers. Concerns about how Google might gain access to Nest’s data are already all over the internet. (Nest says not to worry.)
3) Nest’s business is growing, but not exploding
So that leaves Nest ultimately with the valuation of a company that sells stuff. And Wall Street has never treated sellers of stuff with the kind of nosebleed valuations it gives pure software ventures. Nest says they’ve sold somewhere around 1 million thermostats, telling Forbes recently the product is in almost 1% of U.S. households. While that sounds impressive, it means the total is almost certainly below 1.3 million overall (U.S. Census Bureau data suggests an even lower number).
In January, Nest was allegedly moving 40,000-50,000 thermostats per month, according to GigaOm. The hope was to reach a rate of 85,000 units monthly by summer’s end. Presumably, the cold winter should have continued the growth curve. Add that all up, though, and you find yourself realizing Nest is not moving 100,000 thermostats every 30 days at this point. If it were, the installed base would be higher because 2013 would have represented nearly 1 million sales, assuming linear growth.
With the new Protect smoke detector line, the overall revenue picture for Nest is doubtless stronger than whatever thermostat sales might be. But the market for that product is almost certainly smaller given the high price to outfit homes with multiple $129 detectors and the fact they are effectively disposable after 7 years. (At our household, it would cost nearly $800 to replace our existing detectors with Protects, which seems hard to justify given the smoke alarm is a product you hope never to use.)
Right now, then, the company’s revenues are likely on the order of $200-300 million. That puts the purchase price in the vicinity of ten times revenues. While Nest is doubtless outgrowing most makers of “hardware,” its worth noting that multiples of 2-4 times sales are more common in hardware than anything approaching 10x. That means Nest got tomorrow’s price for the company today.
4) Google can do things Nest simply couldn’t
Fadell says Nest will run independently within Google, somewhere between Motorola — which acts a separate, owned company — and YouTube, which has its own offices but is very much a Google product. What he didn’t say was what his job would be. If Google really bought Nest to own lots of data about energy use, to track you in your home, or to help build the smart grid, it doesn’t need to make a profit selling thermostats. In fact, Nest itself has been trialing a program with utilities where it gets paid to manage thermostats — $30-50 per user per year. The company gets the ability to turn down the heat or cooling in empty homes, saving utilities and consumers money in times of high power demand.
Nest the independent company would have likely been able to go public as soon as this year. But it would have likely done so with a story about the strong gross margins behind its hardware as well as the burgeoning services business. Google has now freed the company to ignore those margins and break even — at least in theory. One way we’ll learn quickly if this is part of the plan is through price changes. The acquisition won’t close for a few months, but if the Nest thermostat suddenly falls to $149 from $249, you’ll know that’s where Google and Nest are headed. (Precise build cost info on the Nest isn’t public, but looking at the internals, it doesn’t seem like it’s much above $100.)
5) Dreams do come true
So imagine Google making Fadell and Rogers wealthy beyond their imagination, freeing them from having to run a public company, and in the process bringing the dream closer to reality faster than Nest could have hoped to. Selling the hardware on a breakeven model, like Google’s Nexus tablets, will lead to many more buyers. While a $149 thermostat is still expensive compared with the cheapest model at Home Depot, the $100 difference will likely double sales on its own. Perhaps if those smoke alarms were only $69 each they’d already be all over my home (and yours).
Now, you get more users more quickly with Google’s deep pockets at your disposal. You can always be working on the next piece of the puzzle (better light switches? a sprinkler controller that isn’t dreadful?), perhaps even two at the same time. Fadell talked to The Verge back in 2011: ”The problem with Silicon Valley is that you all want to impress your friends — you want to make the next thing and revolutionize it. But you have to make a strong business,” he said. “We want to make multiple products that all relate together, so that the business is there to continually drive innovation.” Inside of Google, it can do the revolutionizing without building the strong standalone business. Google’s product is information, everything else it offers is about making that more accessible.
While the Motorola deal has yet to prove itself a winner, Google is already the greatest acquirer in the history of Silicon Valley (YouTube, Android, Applied Semantics and DoubleClick). Maybe not much comes of Nest. Perhaps it takes 10 years to realize it. Either way, Fadell gets all the resources he needs to try to build the connected home. He’s no longer his own boss; but he arguably has more freedom than he did yesterday.