In most cases early stage investors whether Angel Investors, seed Investors or early stage venture capitalists invest not in a company’s cash flow, but in the potential for an exit.  We buy equity in an entity that has an idea and lots of upside.  We care about the exit because that is the point at which we make money.

The exit strategy is very simply a startup’s plan to sell itself.  The ideal exit strategy identifies potential buyers of the company, estimates the price they will pay, and explains why they will acquire. The startup management team should provide as much evidence as they can to support their assumptions and show how they will make the company an attractive acqusition target.  

One of my favorite stories about companies pitching the Westchester Angels is about a company with a good idea that eliminated themselves with one phrase.    When we asked how the investors would make money, the CEO suggested we ask our financial advisors.

For the future benefit of all who may stumble upon this article: that is the wrong answer.

Investors know how they will make their money: through exits.

We want to know if YOU know how we make money and whether you have a plan.

Start by understanding how angel investing works and why we care about exits

Early stage investors acquire a minority share of the company and rely on the entrepreneurs to deliver growth and entice more investors.  Early investors earn a return only when they sell their equity, that is why they are so focused on the exit.

They want to see that you can find a buyer so that they can make some money out of the deal.

We KNOW that you don’t know how you are exiting, but we want you to be thinking about it and ideally have a plan to exit within the next five years.

And not just any buyer: they are also looking for a substantial return, 30 times their investment or more.

This may sound absurd, but investors are trying to manage a return out of risky investments. Even just considering those companies with the potential to generate a 30 times return, over 50% fail and  only a handful actually return more than the orginal investment.

So, when we ask how we make money, that is code for what is your exit strategy (and how much will your company sell for)

This is one reason why focusing so intently on the product that you are selling can be a mistake.

Investors want to understand the market for the company (understand who will acquire the company at exit) even more so than the market for the product the company makes.

The worst possible outcome for an angel investor is when a portfolio company languishes in “lifestyle business” territory – the business operates and stays afloat but is not interesting enough for an exit.

Complete failure sounds worse, but at least failure has an end.

A lifestyle business bumps along forever.  It earns just enough to keep itself in business, maybe with some moderate growth but with no big future.

And no return.

Entrepreneurs often don’t think in terms of an exit

Here is the challenge: entrepreneurs have different incentives.

Most entrepreneurs are concerned about earning enough money to survive.  Good ones are laser-focused on connecting products and customers and filling a need in the market. They are building and growing and making things work.

Not every startup needs to raise money from angels or venture capitalists.  Bootstrapping is a viable alternative and growth isn’t always important.

These companies establish a business model, reinvest profits into the ocmpany and scale that way.  They pay dividends to all investors.

The problem is: this isn’t enough for early stage investors.

So, entrepreneurs must show that they know where the exit is

If you are happy with a lifestyle business, that is fine.  It can deliver a good living.  However, if you want to raise money think about the exit strategy, right from the beginning.

Build the company for the exit.

Something else to consider: there is an added benefit for everybody in planning for the exit. If you focus on building a business for eventual sale, you will be forced to professionalize it and define clear processes and develop your intellectual property.

This not only makes the business salable but also strengthens it in general – making your venture more profitable whether you eventually sell or not.

A bad exit strategy: the IPO.

A small step up from no exit strategy is those who “plan” for an initial public offering.  Everybody would love an IPO, that is the best way to turn privately held shares into a marketable asset.

The idea is that a company is mature enough and has raised everything they can from venture capitalists and private equity. This initial public offering can raise billions and be a large payout to all investors.

This is a great story.  There is only one problem: only a vanishingly small fraction of startups actually get to an initial public offering.

The IPO is the Everest of business growth.  Many companies start out aiming for the IPO summit, but very few will ever make it.  It might happen, and everybody would be happy if it did, but it isn’t a strategy.

Stating that the IPO is your strategy is lazy and uninspiring.

What a good exit strategy looks like

The best exit strategy is to entice another company in the same industry to acquire.  Large companies acquire small companies… your startup is a small company, find a logical larger company to acquire.

These are companies who are already in the space and for whom your solution is either a threat or an extension of their product line. Here are some startup exit strategy examples:

  • a snack food company explain to us how this would fit well into Pepsi Co’s portfolio. They also showed some backups.
  • a software company whoed how their solution solved a problme for consumers but ALSO a major software company. They showed us how that company had been acquiring and created a convincing arguement for themselves.
  • a few companies told us how they created disruptive problems for insurgent companies and how these companies would eventually be forced to acquire.
  • and dozens are creating solutions for google and Facebook… that one is a little over done actually – something less competitive is more attractive.

Investors will also love some evidence showing a rate of return or how much similar exits have generated.

Five elements of the exit strategy

The details of an exit strategy always depend on the situation, but a good exit strategy generally will:

  • Identify who will acquire the company. This should be as specific as possible, the more detail, the better.
  • Explain why they would be compelled to acquire. The new product may be a threat or a complement to your target acquirer’s current offering.
  • Give an idea for the price the acquirer may be willing to pay. The price will usually be a multiple of earnings.  By showing the growth in earnings and applying a multiple, investors can calculate their expected returns.
  • Provide a timeline for the exit, explaining when it may happen.
  • Show a strategy to deliver the exit. This should explain how the entrepreneur is marketing not just to customers but also to future acquirers, making them aware of the startup’s existence.

And then you can say: or we may IPO.

The clearer and more convincingly you present this exit strategy the easier investors can estimate their returns and invest.

Always remember that you are not presenting your cool groundbreaking product – you are offering an investment opportunity in the form of a company.  That investment only yields a return when it sells, no matter how attractive the product may be.

But please, the one mistake entrepreneurs should never make is to tell investors to consult their financial advisors to understand how they make money.  That will definitely inspire investors to keep their checkbooks shut tightly.

The “exit” is the transaction in which an acquierer buys the equity of a company.  The acquierer buys out all of the previous investors and they finally realize a gain on their investment.  An IPO is a great example of an exit: shares are listed on a public market and all previous investors have the opportunity to sell.  But this is unusual: most exists are to strategic investors, large companies who acquire the startup for strategic reasons.

 

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