In a recent speaking event at WeWork in downtown Durham, and then again at an NC IDEA Summer Series event a few weeks ago, two different entrepreneurs asked me a similar question, “What does a good exit look like from a VC’s perspective?” I responded with my always correct, but never very enlightening answer: “It depends.”
The questions VC’s ask ourselves before we ever make an investment might be, “Can this investment return half or all of our fund? Are there dozens of obvious acquirers that can write $100M+ checks? Does this industry typically support 6-10x-revenue-multiple acquisitions?” But, years into a company’s life those questions may evolve into, “Can we get a portion of our investment back? Will anyone buy this company? How quickly can an acquirer complete this transaction?” You see how quickly the definition of a “good exit” at any given moment can change.
If the classification of a “good” or even “acceptable” exit can change that rapidly in an investor’s mind, what must be going through an entrepreneur’s mind? After all, an investor has likely diversified risk across 15-20 companies and can pick and choose where to “swing for the fences” or where to “soft land” a company, but entrepreneurs have all their eggs in one basket.
In a monthly meeting of local angel groups and seed stage funds earlier this month we discussed the topic of getting more successful exits in the Triangle, even if they were smaller and didn’t draw Red-Hat-like headlines. We discussed whether we, as investors, are doing enough to get our heads out of the continuous cycle of “sales, raise capital, repeat”; and whether we’re doing enough to encourage evolving exit strategies and open communication between founders and investors. Here are some suggestions that we have tried to implement at Cofounders Capital:
- Before taking an investment, understand your investors’ goals — Return expectations vary widely between entrepreneurs and investors, between angel investors and VC’s, between different VC firms, and even between two different funds in a fund family. Take Cofounders Capital’s Fund I, a $12M fund, vs. Cofounders Capital Fund II, a $31M fund. A $3M return for CFC in Fund I returns 25% of our fund, and eight of those gives us a nice 2x overall! Apply that same math to Fund II and the $3M “win” returns less than 10% of our fund, and eight of those doesn’t even get us back to even. Scenarios will change after an investment is made, but before you take capital, make sure that you are both signed up for the time, effort, and exit size that you will each deem as a “win.”
- Openly discuss how return expectations are evolving — For entrepreneurs, personal or professional situations can change. New, well-funded competitors can enter the market or established ones can pivot to a new market. Pro-forma assumptions can be wrong for better or worse. Similarly, for investors, circumstances change. Angels’ liquidity needs may have altered or a VC may have had a different big win in the portfolio. Often, I feel that there is hesitancy to discuss an acquisition path or amount if it has changed from the one in the original pitch deck. But it is the job of the Board and the entrepreneur to adapt to changing data and situations. Make it a regular part of conversation with investors and your Board to discuss exit pursuits. You may disagree on what the target should be, but you will engage in healthy (hopefully) dialogue and you may even be on the same page!
- Inform your Board (and/or major investors) of all acquisition discussions, or partnerships that could turn into acquisitions –— We often test founders as part of our diligence, and ask them “what would you do if you were offered $10M for the company in six months?” Considering that Cofounders is a seed stage fund you may think that the obvious right answer would be to take the money and run! But, the correct answer from an investor perspective is always “It depends. I’d talk to my investors and get their input.” Your investors and your Board can only help weigh in on the exit strategy if they know the alternatives. Even if it is a low offer, discuss it. It provides an alternative and creates a floor you can negotiate against. Any offer you receive is a good excuse to re-open that dialogue around acquisition with your investors and/or Board.
Because of large funds being raised in Silicon Valley and Boston, I believe that startups often pitch the $100M+ sale/IPO exit-or-bust mentality to investors, which is generally a fine starting point in those regions. In 2018, average VC fund sizes were north of $82M and there were 16 first-time funds that closed between $100M-$500M. Those funds need those huge exits to make investors their desired returns.
But here, in the Triangle, we have smaller funds and an active angel community, which provide us with a little more flexibility on what a “good exit” can be. So, entrepreneurs, as your business model evolves through the years, has your exit strategy changed? What would your investors say about that? It would be good for both of you to talk about it.