Planning Your Exit

This is one post/chapter in a serialized book called Startup 101. For the introduction and table of contents, please click here.

If you have raised money from investors, you will need to sell the company at some point for them to get a financial return. It’s simple: if you don’t want to sell your company, then don’t raise external equity capital; if you want to maintain control indefinitely, then opt to incur debt instead (and meet your debt covenants). You may find an unusual breed of equity investor who is looking for long-term dividends. But the normal deal with venture investors is to sell the company within approximately five years so that they can get a capital gain.

Four Tips to Get a Sky-High Valuation

Ever hear about those deals that have sky-high valuations at exit? How do they do that? Here are the four things you need to do:

1. Create competition for a critical scarce asset. The best exits come when two Goliaths fight in a market and you have that one critical strategic thing (customers, users, technology, whatever) that makes the difference. Two Goliaths are sufficient as long as they really hate each other and the market is big and the winner is undecided. Having a scarce asset means that you have already beaten the other early-stage ventures: you are the declared winner of the new kids in town.
2. Make sure time is on your side. If you are burning cash and your current investors are less than supportive, even the hottest negotiator will fail to get a great exit deal. You need positive cash flow from operations. That will put time on your side. If the markets crash or your sector falls out of fashion or the offers you get are not good enough, you can just hold on until the right deal comes along.
3. Enable potential buyers to get to know you over time. Deals don’t get made overnight. The final haggling happens quickly but usually after a long courtship. And during most of the courtship, neither party explicitly talks about acquisition (yes, it is like dating). Instead you do some business together, discuss synergy and partnerships, etc. This gives the buyer’s negotiator the support for the deal they need to justify a big valuation. A lot of the managers there should be saying “We need these guys.”
4. Exit early in your hockey-stick-like growth. If you are saying, “We’ll grow fast when X happens,” you’re leaving room for skepticism. If X is expected to come from the buyer, then your negotiating position is weak. Your metric for growth could be used as a proxy for revenue if you’re in the late stage of a bull market (i.e. a bubble). But in a normal market, real revenue and even profit growth determine valuation. The good thing about selling in a down market is that expectations are lower. When flat is the new 30% growth, you will get a big premium if your growth is 50%. Why not exit later? Three reasons:
• Markets can change and growth can slow,
• Investors want their return sooner than later,
• Buyers of early-stage ventures buy more on future expectations than past results.

What If Those Four Pieces Are Missing

If you have all those pieces in place, you will have built the perfect venture, and any competent investment banker will be able to get you a great deal.

What if only some of these pieces are in place? The result depends on how many pieces are missing. Most exits can be put into one of the following categories:

1. Liquidation, which is opposite to the sky-high deal (described above) on the spectrum. Your goal here is simply to pay off creditors. Investors and the management team lose everything.
2. Investors get their money back (through Liquidation Preference), and the founders (management team) get nothing. The consolation for the founders is that their reputations remain intact.
3. A reasonable return for all, which happens when you have perhaps only two out of the four pieces in place.
4. Sky high, when all four pieces are in place.

The One Piece You MUST Have in Place

You must have either positive cash flow or so much cash in the bank that even the most skeptical analyst believes your runway is long enough for you to lift off.

If you have neither, you had better be a superb poker player and lucky. Yes, both!

Three Things to Prepare Early

1. Eliminate any due diligence show-stoppers. You don’t want something that you could have easily fixed early on killing the deal at the 11th hour. That something could be a litigation-related issue, the poor reputation of a team member, a corporate structure that doesn’t sit well with the buyers, anything. A good investment banker or deal specialist can help with this.
2. Get to know some investment bankers. Get to know the ones in your market early on; you can decide on one when you are closer to exiting. Investment bankers do the same thing themselves; expect a lengthy but low-maintenance courtship. You can get some free advice and good lunches, and you will be able to make a better call on whom to choose when the time comes.
3. Do some real work with potential acquirers. See point #3 in the first section above: allow potential buyers to get to know you over time.

Timing

Venture investors usually like a return within five years because this is how they plan their funds, but the range is usually more like two to seven years, and some go way beyond that. Essentially, holding on longer is much better if you can reasonably expect your venture and/or the market to improve.

Don’t set an exit date. Your venture’s momentum will determine the timing.