Palm Drive Capital Managing Partner Seamon Chan explains why Investors want a clear exit strategy from Founders whom are considering raising funds via the venture capital route.
By Seamon Chan
Imagine you are a first-time founder at the beginning of your startup’s journey. You are looking into financing and have come upon venture capital as a solution. You may be wondering about funding rounds, growth strategies or market sizes. Or you are nervous about that upcoming pitch in front of an investor.
The last thing you are likely to think about is how it is all going to end.
However, if you are going down the route of fundraising from a VC, then understanding the perspective of an investor will increase the probability of securing the financing you need to grow your company.
It is important to note that not every business is suited to raise VC money. That is particularly true if your business is more cash flow driven and less likely to achieve exponential growth. If this is the case, then there are several other financing options besides venture funds, such as; commercial loans, a good choice for cash flow-driven companies with founders that want to hold on to their shares; crowdfunding, a crowdsourcing alternative where you raise small amounts of money from a large number of people; or bootstrapping, where you build a company from the ground up with personal savings, little outside finance sources, and a lot of hard work!
If you are a company with product/market fit and exponential growth potential with the desire to work with institutional investors, then VC funding is most likely the path for you. Trying to raise funding from VCs can be nerve-wracking, and one of the most crucial parts that is often overlooked and disregarded is planning an exit strategy for your startup. With this guide, we will walk you through the ins and outs of exit strategies, the options available to you and what you can expect.
Before you start
It is crucial that you spend time putting in the research and drawing together a cohesive set of exit plans. While this may not be at the forefront of your mind when it comes to building or scaling your product, it is the salient point for investors and should therefore be part of the pitch.
Even if you plan to exit through an IPO or M&A, without a comprehensive exit plan in place, venture capital firms will be less interested without a clear exit path.
After years of working in venture capital and speaking to thousands of startup founders, it is clear that one pitfall that founders fall into is idealism. Many founders want VC investors for the long-term and think that an exit is not necessary. But let’s be frank, this is not the case. If the goal is to get longer-term investors, then getting financing from wealthy investors and family offices would be a better bet.
Unlike longer-term investors, VC investors are looking for financial returns within a limited time period – typically within 5-8 years as most funds have a lifespan of 10 years. In a VC’s eyes, startups with no clear exit plan will most likely either become a slow-growing private business that may be difficult to exit the VC’s shares, or will never reach the targeted return goal of the investors. The risk/reward does not make sense for investors, particularly as they themselves are held accountable by their LPs, family offices and investors and thus have to generate a considerable return on investment.
Understanding the exit event
The main way investors get paid back is through an exit event, therefore it is important to note that equity investments are not the same as loans – there is no loan payback period or interest payments. Equity is stock, and a private company stock has no market value until the company goes public, is sold, or is merged with another company.
As the company continues to grow into a larger company, it is fairly common for founders to then want to exit their business and bring on more professional managers. If this is the case, the best two potential options are going public or being acquired.
In many cases, the right exit event can further grow your business by leveraging additional capital and resources of a potential acquirer. Done correctly, combining the right companies may provide the injection of resources needed to continue solving the problem that you have set out to address.
Explore your options
With multiple exit options to choose from, it can be overwhelming, particularly at the start. Thus, is it important that you consider each exit option equally. There are three common avenues that you can take with your startup: mergers and acquisitions (M&A), initial public offering (IPO), and private offering (Secondary exits).
Often perceived as a win-win event, an M&A is the combination of two businesses. Through an M&A your startup is bought or merged with a larger business, or perhaps even a competitor, allowing both you and the investors to cash out as you sell your startup. This enables the resulting entity to have larger growth opportunities, gain complementary skills, and get access to more customers.
Once the default strategy, and frequently viewed as a form of public success, an IPO is a process through which a private company sells its shares to the public in order to raise public capital.
An IPO is the goal of many entrepreneurs, but due to concerns about high liability, demanding shareholders and high costs, only 16% of venture-backed startups recently used this approach.
Lastly, private offerings, or otherwise known as secondary exits, are essentially funding from later-stage investors to help founders and investors cash out. Just 19.2% of VC-backed companies (primarily technology companies) were exited through a private buyout between 2000 and 2019, leaving the buyer with the challenge of taking the business to the next level.
Every VC and every startup is different, and an exit strategy will always depend highly on the situation. Identify and build relationships within the universe of acquirers early; speak to them, learn from them and make sure you understand and can explain their acquisition rationale.
Research industry comparables, as well as the estimated exit metrics, valuations and returns for the VC investors. Absorb everything you have learned, prepare an exit plan for your startup, and mention the exit strategy during your pitch to VC investors. While the exit shouldn’t be the focus at this stage, VC investors will appreciate the thoughtfulness of a startup with an exit strategy.
(Ed. Featured image by Photographer Dids.)