Most entrepreneurs struggle with defining their exit strategy and presenting a clear one in their pitch.  The reason seems to sit in the difference between how entrepreneurs and investors view a business.

The exit strategy is your plan for creating such a great business that another business is excited about acquiring it at a huge premium.  You should identify a few potential target acquirers and a rock star exit strategy will show investors how you are positioning yourself for the sale. 

In this post, I’ll give you a view on how investors view a business and a guide to creating an exit strategy that investors can buy.

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.  This is where the disconnect lies, entrepreneurs want cash flow, investors want exits.

In this post I explain how an angel investment works, it is important to know this before you get started.  Then I discuss the challenge that entrepreneurs face meeting these needs and explain the exit strategy.  I go through an example “bad” exit strategy an example “good” exit strategy and end with five elements of an exit strategy.

 

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, which generally requires a “liquidity event” or a sale.  Early investors earn a return only when they sell their equity.  

Investors, therefore, are interested in fast growth and a quick sale.  They are actually LESS concerned about the company’s customers and whether they buy.  They are more concerned about whether there is a customer for the company: they want to know that you are creating something so interesting that some other, larger, company, will buy.

And, to make this all more exciting, investors want to see a big 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.

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)

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 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 company, and scale that way.  They pay dividends to all investors.

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

 

But to raise money entrepreneurs must show that they can address the needs of the investor

To raise money you must meet the needs of the investor and show that you have a good, well thought through exit strategy.

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.

 

Exit Strategy example: the exit strategy to avoid, IPO

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 realize 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.

Another example of a bad exit strategy is a vague reference to an industry.  We see this all the time: “insurance companies will be excited to acquire us.”  This may be true but it isn’t specific enough and doesn’t explain why.

 

Exit Strategy examples: 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 that 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.  We were very excited about this company.
  • a software company shoed how their solution solved a problem for consumers but ALSO a major software company. They showed us how that company had been acquiring and created a convincing argument 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 overdone 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 will:

  • Identify who will acquire your startup company. This should be as specific as possible, the more detail, the better.  The best exit strategy starts with a clear potential acquirer.
  • 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 – this shows that you are planning your startup’s exit.
  • 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 exiting your startup, specify 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 your startup exit strategy the easier investors can estimate their returns and invest.

Always remember that as a startup 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 acquirer buys the equity of a company.  The acquirer 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.

IPO vs acquisition which is the best exit strategy

Acquisition is always a better strategy than IP and here is why: IPO is unrealistic.  The fact is that very few companies ever go from startup on paper to IPO.  This is one of those homerun scenarios that everybody dreams of but most realize it is completely unrealistic.  If your exit strategy is IPO then you haven’t thought through your exit strategy.  Figure out who will acquire you.

How to choose an exit strategy

Your company solves a problem for a customer.  But it also either solves a problem for another company or creates a problem for another company.  If you are disrupting a market the leader may acquire you in order to protect your market.  Do you have an amazing search engine technology?  If you start making a dent in the search market, Google will acquire you.  Many companies, like Pepsi for example, acquire companies that fit in their portfolio.  If Pepsi is moving into healthy snack foods, they would rather acquire a solution than develop one. So think about the problem you solve or create for another company.  The more specific you can be the better.

What is a good exit strategy for investors

Investors want a clear, specific, well-defined exit strategy.  I have seen companies explain to us why they believe that an executive team is searching for a company just like theirs.  That is great.  Try to get examples of past acquisitions and the multiples paid so that you can tell us how much you think you will be able to sell yourself for.  If you can say: we think company y will acquire us for x when we meet these three milestones, here is why and this is what we are doing to make sure they know about us, we will be very impressed.

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