8. Exit Strategy

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

Exit Strategy Investment Time Proceeds Uncertainty
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

9. Return Analysis

VC Math 101

The two most fundamental terms in a venture capital term sheet are the pre-money valuation and the investment size. Adding those two gives you the post-money valuation:

For example, VCs have offered to invest $4M on a $6M pre-money, sometimes called a “4 on 6” deal, though it is becoming more common to hear this as a “4 on 10 post,” as the post-money would then be $10M.

The next level of this algebra is used to determine the ownership structure, and needs to become second nature to a VC. Pre-money divided by post gives you founders’ percent ownership. The investment divided by post gives you the VCs’ stake.

       

In our 4 on 6 example, we end up with:

       

 

Another quick example, let’s say a VC firm is investing $2M in a startup with a pre-money valuation of $3M (or 2 on 3). The post-money valuation is $5M and the VC owns 40%, the founders 60%.

 

$2M Investment + $3M Pre-Money = $5M Post-Money
 

 

VC Ownership =

$2M Investment
______________

$5M Post-Money

= 40%

 

VCs quickly learn to do this algebra in their head. Knowing the key deal terms, like “1 on 2″ or “5 on 5,” VCs will immediately know that their ownership would be 33% or 50%, respectively. See the table for a cheat sheet of percent ownership for various deal terms.

Shark Math

I want to take a quick aside to address what I call Shark Math. Due to the popularity of ABC’s show Shark Tank, many people think that equity deals should be offered as “_% of the company for $__.”

As we’ve already discussed, this is not how VCs offer deals because it implies that a percentage of a pre-existing company is being sold (p. 57). With VC investing, a new class of preferred stock is being created and new shares are being sold. Nonetheless, the algebra is the same. Money comes into the startup, and the investors now own a percentage of the company.

If a deal is offered as _% of the company for sale for $__, we can solve for the valuation:

VC Ownership =

Investment
____________

Post-Money

Post-Money = Investment
_______________VC Ownership

 

For example, let’s look at a deal where 25% of the company is being offered for a $100,000 investment. Plug that into our deal algebra:

 

25% VC Ownership

 

= $100,000 Investment
________________Post-Money

 

Post-Money

 

 

=

$100,000
___________25%
Post-Money = $400,000

 

If you are a regular viewer of Shark Tank, you have heard sharks say something like, “Do you realize you are valuing your company at $400,000.” This is actually a manipulation (or a mistake). Take a moment and see if you can catch what the Sharks are trying to do in the above example by claiming the founders are pricing their startup at $400,000.

What is the mistake? (answer below)

Also covered in this chapter in the book:

  • Breaking it Down
  • Seed Round
  • Series A
  • Series B
  • Series C
  • Fund Fit Alert!
  • To the Exit
  • Back to the Forest: Rules of Thumb
  • Adding the Option Pool

 

The founders are actually pricing their startup at $300,000 prior to receiving the investment. The $400,000 valuation derived in the formula above is post-money. That valuation includes the investment, which the startup has not yet received. The current valuation should be pre-money, and should be $300,000. The valuation will increase to $400,000 after the cash is received.

In manipulating the math, the Sharks are employing a negotiation technique to make the valuation seem higher. Coming up with a valuation, also known as “pricing the deal,” is often the stickiest part of the negotiation. I believe that is why I’m hearing more VCs talk about 4 on 10 post deals, when they used to all say 4 on 6 ($4M investment on a $6M pre-money).

The use of post-money vs. pre-money as the valuation can make a big difference in perception if the investment is for a large percentage of the company. If you take a traditional 2 on 2 deal: a $2M investment on a $2M pre-money valuation, and reframe it as a 2 on 4 post—wow, we just doubled the value of the company!

More VC Math – Breaking Down a Deal

Return Analysis Worksheet

I recommend you watch the VCIC training videos first.

Disclaimer: this is not written in stone. VCs are notoriously individualistic. There is no agreed upon “VC Method” despite some teachings that claim otherwise. If your team understands the thinking behind the advice below, and you can explain your thinking to the judges, you will have a successful partner meeting. If you fill in the blanks but are not really sure of what it all means, and then tell the judges you used some form or standard VCIC methodology, you will have an uncomfortable Q&A with judges.

To download a printable version, go to bit.ly/vcic-return-analysis.



HOW TO HANDLE SEED ROUNDS

There are two different types of seed deals to consider:

Seed Round is Significantly Lower than Anticipated Series A (less than 1/5):

  • Think of the seed deal as the chance to get in the deal early but use the projected Series A to calculate potential return.
  • E.g., $100k seed with an expected $2M Series A. You may negotiate the seed at a $1M pre-money, resulting in lower than 10% ownership. But the Series A is projected to be a 2 on 4, at which time you will get 33%. Base your return analysis on the Series A.
  • You could even offer a SAFE, but you still must project potential return based on the anticipated future Series A.
  • Point is, you don’t care (much) about the valuation of this round…you’re focused on the A.

Seed Round is Close to the Size of the Series A (within 4X):

  • Use the seed round to establish your percent ownership and reserve 3X of the seed round to maintain pro rata.
  • E.g., $1M seed with an expected $3M Series A. For the seed round, negotiate approximately the percentage ownership you’ll need at exit, say $1M on a $4M pre, or 20%. Reserve another $3M, total investment is $4M (which is appropriate for a fund size in the $50-80M range).

 

For more, order Venture Capital Strategy on Amazon.

 

 

More VC Math

Breaking down a deal.

The book gives a case in which a VC firm is considering an investment in a startup, which is pitching for a $100,000 seed deal.

As we’ve said many times already, when VCs first look at a startup, we are thinking holistically about the entire life of the investment, not just the Series A. We will map out in our heads a best guess as to every round of investment on the way to exit.

For this case, while the startup is pitching a $100k seed round, the VCs are thinking about the A, B and C rounds, and are (internally) guessing that it may look like this:

  • Seed round: $100K investment on a $1M pre-money valuation
  • Series A: $1M on $2M
  • Series B: $5M on $10M
  • Series C: $20M on $40M
  • Exit: $200M

Of course, this is all an educated guess, but this type of educated guessing is a key component of thinking like a VC. In this scenario, we start with a $100,000 seed round, followed by a Series A, B and C. Each follow-on round dilutes the ownership of earlier shareholders. In this case, each follow-on round happens to be diluting by 33% (1 on 2, 5 on 10 and 20 on 40). There is no magic to the 33%; it’s mostly just coincidence. If we anticipated hitting a huge milestone, for example, there would likely be a bigger jump in valuation between rounds.

I’ll walk you through the math later, but for now, take a look at the effects of dilution:

Every round projected is an up round, or course, as we are forecasting success. The seed investment of $100,000 on a $1M pre-money yields a post-money of $1.1M. The Series A has a pre-money of $2M. This implies that milestones must have been hit, as the value has increased approximately 1.8X.

The seed investors’ $100,000 investment is now worth $180,000 (on paper), and the $1M worth of stock owned by the founders, as determined by the seed round pre-money valuation, is now worth $1.8M. The image to the left shows the pre-money breakdown; the $1M investment is not in there yet. (Series A is a 1 on 2 round.)

Similarly, between the A and B rounds, we are projecting a healthy up round, going from a Series A post-money of $3M to a Series B pre-money of $10M, or a 3.3X increase. Finally, from Series B to Series C we see another increase of 2.7X, from a post of $15M to a pre of $40M.

With the $200M exit projected in this case, the splitting of proceeds is represented in this pie chart.

The seed investors and founders, while suffering dilution, benefit from all of the up rounds. Multiply them all (1.8 x 3.3 x 2.7 x 3.3) and you get just over 54X on the way to a $200M exit. Series A enjoys three bumps, 3.3 x 2.7 x 3.3, or 30X. Series B has two jumps, 2.7 x 3.3, or 9X.

You can see why a firm would want to participate in the early rounds, with 30-55X returns for the seed and Series A. However, very little capital was put to work. If VCIC. II only participated in the seed and A rounds, they would not have returned even half of their $75M fund. Total proceeds for seed and A are $5.4M + $30M = $35.4M.

After the Series A, VCIC Ventures owned 39% (6% from the seed and 33% for Series A). If they were able to maintain pro rata through the B and C rounds, holding at 39% at exit, they would indeed return the fund with this investment: 39% of $200M = $78M.

We will now dive into the weeds of the math so that you can understand how all of this works. The algebra gets pretty complicated, and we’ll use a cap table to keep up with all the moving parts. However, I’ll will attempt to keep it all in perspective so that we don’t fall too deep into a spreadsheet!

Seed Round

In the seed round, this particular startup had very low capital needs ($100,000) to hit the next milestones. Some VC firms would not bother with an early stage investment like this. They would “pass” and ask the startup to come back when they were ready for their first institutional round.

However, VCIC Ventures’ strategy is to find early stage deals like this. The purpose of the seed investment is to get an early seat at the table for the Series A, as the returns from seed investing will not likely move the needle on the fund (see the previous section: total returns on the seed investment were $5.4M).

For the seed round, VCIC Ventures invested $100,000 on a $1M pre-money valuation, resulting in a 9% ownership stake.

VC % ownership = investment/post

$100,000/$1,100,000 = 9%

On a cap table, the seed round would look like this:

You can view and create a copy of this capitalization table in Google Sheets by clicking here. The chart above is a tab called “Seed Round.”

 

For more, order Venture Capital Strategy on Amazon.

 

 

VC Razor Checklist

Below is a screenshot of the VC Razor Checklist, which you can view and copy here: http://bit.ly/vc-razor-checklist.

Not every startup will need every box checked, but this should give you a good roadmap to be sure you’ve covered all your bases. The hard work is still up to you to determine which areas (boxes) are the ones on which you need to focus for a given startup. The book VC Strategy has an explanation of each checkbox.

Click to make a copy in Google Docs