As we’ve noted many times before, venture capitalists never make an investment without a vision of how to exit that investment. We are not buy and hold investors. Our hit-driven business model requires a liquidity event so that we can return capital to our investors, our limited partners. For VCs, success is one-dimensional. A VC is, after all, a capitalist, and as such has a legal obligation (fiduciary duty) to return capital to investors. There is only one definition of success for VCs: high financial returns.
There is a replicable pattern in the growth of a venture-backed company on its way to a successful exit. It is characterized by several rounds of VC financing (Series A, Series B, etc.) separated by periods during which the startup team is deploying the capital in an effort to hit milestones.
The Exit Strategy for a VC investment in a startup includes a prediction of what may happen at the end (what kind of exit, an estimation of valuation at exit, etc.). However, just as importantly, it includes a path to that end, driven by a series of value-creating milestones. The size each round (Series A, Series B…) is not arbitrary. It should be the amount of cash needed to reach the next big milestone.
Beach House Exit Strategy Example
Back to our earlier example in which we inherit a beach house. Let’s assume it is a fixer-upper and is worth a million dollars in its current condition. The best strategy to reach positive cash flow quickly would be a quick sale. Put it on the market at a reduced price and get cash fast. Perhaps we could get $800,000 in that scenario.
Or we could take the time to go through the normal home selling process with a real estate agent. That could take a few months and cost a 3-6% commission, but perhaps we’d get the full million dollars or even more. However, it is not guaranteed. It would be a higher return with a longer period and some uncertainty. Which is a better strategy?
Lastly, looking at other properties in the neighborhood, we think our house could be worth $1.5 million if we make some improvements. We estimate it would cost $100,000 and take another five months. Now we have a third option for exiting this investment. Which “exit strategy” is best? It depends.
In the above example, we have all our wealth tied up in an illiquid asset, and three different exit strategies have been proposed. The one we choose will depend on a number of factors: our appetite for uncertainty, our access to cash, our willingness to oversee a project, our interest in making more money, our need for immediate cash, etc. You might break the variables down like this:
Table: Comparing exit strategies for inherited beach house
|1. Quick Sale||$0||0-1 month||$800K||~10%|
|2. Regular Sale||$0||2-3 months||$1M – 6%||~20%|
|3. Fixer Upper||$100K||5-8 months||$1.5M||~30%|
My guess is that most of us would likely put the house on the market, wait the few extra months and be very happy with the million dollars. But if our sole goal was to maximize financial return, we’d find a way to raise the $100K so that we could get the extra $500,000. There are not many opportunities out there to earn half a million dollars on a $100,000 investment in five months. Think of the things you could accomplish with an extra $400,000 lying around!
VCs similarly need to exit startups (illiquid) so that we can return a liquid asset (cash or public stock) to our LPs. As we’ve discussed in Part I, the exit can come in the form of an acquisition by another company, or via an initial public offering, or IPO, in which shares of stock are sold on a public market. The IPO is much more challenging and rare than an exit by acquisition. Going public is only a viable option to the few startups who can reach huge revenues (usually north of $100M) with significant predictability. Public markets are driven by expectations, and startups are ill advised to go the IPO route unless we are very confident of the growth trajectory.
Much more common and nuanced is to pursue acquisition as an exit. When going this route, VCs and founders will identify potential acquirers early in the process to form relationships that may ultimately culminate in acquisition. An ideal exit strategy should include the following:
- Model the startup venture to be a good candidate for acquisition based on recent M&A activity: What companies are actively acquiring other companies? What strategy do they appear to be following? What metrics are they using for success? What valuations are in the market?
- Establish and achieve milestones that create the most value (and lead to highest price) for potential acquirers. Is the acquirer interested in customers, talent, technology and/or revenue?
- Begin relationships early with potential acquirers, perhaps by bringing them on as early strategic partners or strategic investors.
One key lesson here is that these strategies are not necessarily in concert with achieving maximum profits. Perhaps the most common example in this arena is the customer base as the most important asset and driver of exit valuation. Examples include unicorns exits by Instagram (acquired for $1B by Facebook), YouTube (acquired by Google for $1.65B) and Myspace (acquired by News Corp for $580M).
Now let’s take a look at the theory behind the math…
Also covered in this chapter:
- Return Analysis
- Total Investment
- Proceeds from Exit
- Exit Valuation
- Comps, Multiples and DCF