The wrong answer to the exit strategy question

One of my favorite stories about companies pitching the 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.

How an angel investment works

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, which generally requires a “liquidity event” or a sale.

So, all the investors care about are quick growth and a quick exit, usually within five years.

To add a level of complexity, they are also looking for a substantial return, 30 times their investment or more.

As unreasonable as this sounds it is because early-stage investing is so risky that even just considering those companies with the potential to generate a 30 times return, most will fail.

Investors need a company to generate a substantial return to compensate for losses elsewhere.

When we ask how we make money, that is code for what is your exit strategy.

When investors ask how they will make money, they want to see that you understand this challenge and are thinking about preparing your company for the sale.

Regarding the investment decision, the market for the company itself is more important than demand for the product.   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 may sound worse, but at least failure has an end.  A lifestyle business continues along, earning just enough to keep itself in business, maybe with some moderate growth but with no big future.

And no return.

Entrepreneurs don’t think this way

Entrepreneurs have different incentives, which can create a problem.

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.

They are focused on operating and delivering results, not getting out of the business.

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, right from the beginning. Build the company for the sale.

Something else to consider: there is an added benefit here for everybody.  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 makes the business salable but also strengthens it in general – making your venture more profitable.

A bad exit strategy

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

However, though everyone wants an IPO, only |a vanishingly small fraction of startups realizes that milestone.  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 does, but it isn’t a strategy.

What a good exit strategy looks like

Instead, look for a logical industry acquirer of the business. 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.

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

In contrast, to the “ask your accountants” pitch from the beginning of this post, others have done this well.

One company identified major food companies with publicly stated strategies of acquiring startups that made products in the same category as the presenter.  They showed that similar startups had found acquirers willing to pay significant premiums and demonstrated a pattern of acquisitions.  This made their pitch very attractive.

Five elements of the exit strategy

The details of an exit strategy always depend on the situation, but a good exit strategy 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.

The more precisely 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.

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.

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