Exit

Ah, the exit. Such a terrible word for such an important part of the process. Exit refers to the opportunity for investors to exit the investment, but VCs would be well-served to figure out a better way to communicate this to founders. It doesn’t seem like such a fun date if one partner is always looking at the exit, right?

But VCs must exit. It is a simple fact of life, built into the structure of the investment vehicle, and founders must understand the deal they are seeking when they solicit venture capital. VCs are but a cog in this entire machine, taking cash from LPs, delivering it to startups, and ultimately returning more cash to the LPs.

Another word for exit is a liquidity event, referring to the conversion from an illiquid asset (equity in a startup) into a liquid asset (cash), required by our LPs. Ultimately, for VCs this means our investments must be sold, and there are effectively only two options for a successful exit:

1. Be acquired by another company for cash and/or publicly traded stock that can easily be traded for into cash; or
2. Go public via IPO, initial public offering, thus turning illiquid private stock into a publicly traded stock.

Acquisitions

Companies merge and acquire one another all the time. This is known as the M&A market (mergers and acquisitions). Business schools have classes devoted to M&A, and many business school graduates go into M&A careers. It is a popular field for students interested in venture capital, as there are some similarities. Both fields involve complex transactions that include valuing companies and negotiating equity deals. There are similarities in the rhythms of doing deals, and some people self-identify as deal junkies.

Sidebar about VC vs. M&A

In addition to the transactional nature of both jobs, they also both deal with organizations going through disruptive changes, relying on human beings to thrive in chaos. VC-backed startups are growing incredibly fast, often doubling their workforce every few months. Integrating all the new people hired and evolving the company culture are competencies that VCs often bring to the table.

M&A professionals similarly must ensure that the cultures of the two merging companies can integrate. However, there is often a dramatically different atmosphere. Whereas startups are challenged by fast growth and hiring, M&A is often saddled with cost cutting and layoffs as two organizations come together.

While M&A professionals and VCs might both be deal junkies who rely on human capital, there are differences that create a gulf between the two, even though those differences may seem academically minor. Perhaps it can be summed up as mindset. VCs consider themselves value creators. Their holy grail is making something out of nothing.

This contrasts with something that many business school students learn about and hold in high esteem: arbitrage. Arbitrage is a situation in which you almost simultaneously buy something and then resell it at a higher price in a different market. To many business students, arbitrage is as kind of a holy grail. However, I never hear VCs talk about arbitrage. In the VC world, the focus is on value creation, not finding a lucky loophole.

Another key difference is structure. Both thrive in disruption, but the VC world is fraught with ambiguities. M&A professionals have the luxury of things that already exist! Their spreadsheets, for example, have real numbers in them, not just projections. The people who work at the merging companies are real people already in place, not imagined new hires, and they already have real customers paying certain prices for existing products.

VCs build companies from scratch, from a few founders and no customers to a few hundred employees and millions of customers. There is a lot more uncertainty where VCs thrive, as well as much higher highs and lower lows, in terms of business outcomes.

Back to Acquisitions

Historically, exit via acquisition is the more common but less unicorn-like route. It is the faster, cheaper option versus going public. In being bought, a startup must give up the bigger vision of growing into its own large, public company. That said, acquisitions don’t have to be small. There are some acquirers out there big enough to buy unicorns.

When VCs first begin considering a Series A investment in a startup, we are already doing mental calculations on that startup’s attractiveness to potential acquirers. Each buyer has its own set of needs. Perhaps they are trying to break into a new market or looking for a rebranding opportunity. Buyers may want to add new products to offer to their current customer base or find new customers for their current product base.

VCs will have some ideas about potential acquirers from day one. They may even begin checking in with acquirers as part of the due diligence process for the Series A. This is the VC equivalent to being Lean: test the MVP (minimum viable product) with customers.

If an acquisition is considered the likely exit, the VCs will want to groom the startup while courting potential acquirers. The goal is to make the startup the most valuable asset it could possibly be for the most likely acquirer, resulting in the highest purchase price (and highest return for the VCs).

This can, of course, be a source of conflict between VCs and founders, who will have their own vision for the company. VCs may begin imposing strategic direction toward becoming the perfect acquisition target while founders are focused on creating the most sustainable company.

IPO

An IPO, initial public offering, as an exit strategy provides the largest return potential for the rare startup that has the potential to mature into an industry leader, generating steadily growing revenues north of $50-100M a year. An IPO is not a good choice if future earnings are unpredictable. Public markets reward predictability.

This makes sense if you think about the nature of these liquid assets. Lots of people are buying and selling shares of public stocks all the time, just as you and I buy groceries regularly. Imagine how confusing it would be if the price of groceries was highly volatile. How would we budget for that? There is value in predictability, which means we should not be seeking an IPO as an exit strategy unless we are confident that we can reach a stable stage, no easy feat for a startup.

An IPO, as its name describes, is offering new shares to the public. If this sounds familiar, it should. An IPO is another round of equity financing much like any Series A, B or C that preceded it: new shares are issued at a certain price. Those shares will dilute current shareholders, but the overall valuation of the startup will grow by the amount raised by the offering.

However, there is one big difference: the new shares are being offered to the public, and all of the fancy preferred shares that VCs received will be converted to common stock. After an IPO, we end up with one large pool of common stock.

After an IPO, there is now a public market for the company’s stock, and the share price can fluctuate minute by minute. There is now a specific value at any given moment for the VCs’ investment. The stock is liquid.

However, VCs cannot sell right away. There is usually a lock-up period ranging from 90 to 180 days post-IPO during which the VCs cannot sell our shares. This is to prevent a steep decline in stock price if a large number of the shares were dumped on the market at once.

The VCs will usually be divesting as quickly as we can, as our business model is not in holding public stock. We’ll want to get liquidity as quickly as possible, thereby creating a higher IRR (internal rate of return) for our LPs.

Return the Fund

Whichever exit strategy we pursue, we have the same goal in this hit-driven business. Just as record labels need multi-platinum records to drive their business model, we need startups that can return the fund. In other words, upon exit, there is a possibility that the proceeds from this one investment (startup) will be equal to or larger than the entire fund size.

For example, let’s say we raised a micro-fund of $50M. As an early stage investor, we may own something like 20% of a startup upon exit. To return the fund on this investment, owning 20% at exit, the valuation would need to be $250M ($50M/20%=$250M).

If we were in the same situation, owning 20% of a startup, and our fund size were a mega-fund of $500M, we’d need an exit valuation at $2.5B to return the fund.

Another way of stating the rule of thumb that we want the potential to return the fund with each investment is to be looking for a 10-20X return potential. Since VC funds routinely have portfolios of 15-25 startups, the 10-20X goal gets you to nearly the same place as returning the fund.

For example, let’s look at a $100M VC Fund. From the top, if we are not recycling fees, we can take out 10 years of 2% management fees, leaving $80M to invest. If we are planning a portfolio of 15’ish startups, that would imply an average around $5M in each startup ($80M/16). At that rate, one of them would have to hit 16X to return the fund.

Backwards VC Math (again)

For VCs, the exit strategy comes first. Learning to think like a VC includes having a vision of the endgame, even in this startup world of ambiguities. VCs may not know exactly which acquirer or when the IPO might be held, but we will be aiming for a vision for success, which we define as a successful exit.

The math of VC funding, whether it is a Series A or Series F, is dictated by the end game. As VCs, we start by making a rough estimation of an exit valuation. Based on our experience as VCs, we try to guess what this startup may be able to get upon exit. We then estimate what percentage of the startup our firm will need to own to return the fund.

For example, let’s imagine we’re looking at a very exciting startup that we think could be a unicorn, with an exit valuation of $1B. How much of the equity we need to own at exit depends on our fund size, as our default goal is usually to return the fund. If we have a $200M fund, we need to own 20% so that our proceeds would be $200M from the $1B exit.

Note that returning the fund is not necessarily always the goal. For example, our firm may be in a more conservative region, such as the southeastern U.S., characterized by fewer home runs and more doubles and triples. Another reason we might relax on the 10-20X rule of thumb, we might perceive lower risk with a certain startup and be willing to accept lower returns.

If we had the $100M fund from the top of the previous page, we’d need to own 10% of a unicorn $1B exit to return the fund. As noted, we’d have about $5M per startup.

With those parameters in mind, we might offer a Series A term sheet with a $1.5M investment on a $6M pre-money, reserving $4.5M for follow-on rounds. After that A round, we’d have 20% ownership, quite a bit of wiggle room for dilution in future rounds.

In the last chapter we discussed the factors that determine the investment size and the valuation. Intuitively, the investment size should be dictated by the needs of the startup. How much cash will it take to hit milestones and get to an exit? And the valuation, shouldn’t that be dictated by how much a startup is really worth?

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