Part 3: An exit happens when you work every day towards achieving goals
Updated: Feb 17, 2020
Getting the funding plan in order.
Have a funding plan.
I wish more tech entrepreneurs had a broader understanding of how funding can work. There are literally trillions of dollars of investable capital just in the US, and very little of it flows through a VC. Think of funding sources as different wrenches in a capitalization strategy toolbox. Each wrench has a different job depending on what you’re trying to do. Funding sources need to be matched to what stage the business is currently in and what it will end up looking like near, mid, and long-term.
Let’s cover some funding basics. First, it is important to understand what type of outcome you think your company will have as that has a big influence on what type of funding you’ll need. VC’s and PE (private equity) firms raise funds from other investors, and those funds have a time period attached to them, usually 10 years.
This means the firms the VC invested in are expected to exit (pay back the VC) or die within the life of the VCs fund. VCs are in it for the home run and are looking for a ten-fold return. So, at a minimum, if they invest $10 million, they’re looking for a $100 million return. This doesn’t happen very often and the time period for when it does these days is long - around 96 months. This means you need to be early in the life of the fund to give your company the most runway. It also means VC’s are very selective in their investments. It isn’t a snub; it means they are looking for a very narrow opportunity and a firm’s partner may only fund one or two deals a year.
You will need to plan on lots and lots of pitch meetings. Lots of meetings. Jeff Bezos had to go on 60 meetings to land his first investment for Amazon and, realistically, that’s not that many. Here’s a simple way to manage this, so you don’t find yourself hoeing the proverbial endless row: set a timeline up for pitching, somewhere between 2-3 months. Get all of the presentation materials, executive summary and investor materials done prior, along with a list of all the investors that you think fit the thesis for your company. Then, do nothing but raise money during the timeframe you’ve set aside.
Fundraising is not a distraction; it’s a full-time job. A CEO may run point on this process with one or two other team members, but ultimately, investors are investing in the business and management team, so everyone should be ready to be involved in the process. Yes, some things will get dropped and no doubt they’ll be a few emergencies you need to deal with. But having a fixed timeline will give you some finality to what can be a pretty arduous process. It also gives you the ability to tell a potential investor what their effective timeline is, so they don’t string you along.
Drive through the Midwest, and you'll see loads of businesses that someone spent 40 years building, very few of which utilized VC funding. Again, there are many other funding sources. This could be anything from an NHI grant, an SBA (Small Business Administration) loan, bank loans, angel financing, incubators such as Pioneer Square Labs, strategic investors or even NRE (non-recurring engineering) funds. Angels usually invest $25,000-$100,000 and are common investors early on. However, if you’re going to take angel money, it is important to limit the number of angels as a large number of small investors, many of whom are typically not professional investors, can be difficult to manage.
Strategic investors are usually in some way related to what you’re building, and thus they have a vested interest beyond just a return on their investment. NRE money, while usually a smaller amount, can sometimes substitute for angel investment.
Critically, NRE doesn’t involve selling any equity and is recognized as revenue! In the strategic and NRE cases, you are getting both an investment and a customer or partner, so you’re getting a ‘twofer.’ Strategic and NRE money is also a positive signal to other potential investors that you’ve got something good happening. Note also that investments aren’t always cash, some large firms offer office space, compute resources, headhunting, and other in-kind investments.
In general, regardless of the investor type or stage the company is at, I’m a big believer in creating a narrative that mitigates investor risk or ‘derisking’ the investment. If you can get a working product out the door that’s already generating revenues before taking a penny, for example, you’ve mitigated investor risk. If you can get to cash flow breakeven with a working product and you’re growing sales month over month you’ve significantly mitigated risk. When you mitigate investor risk, it lowers the cost of the money you’re raising, both in terms of the effort and what you have to give up in equity itself.
Lastly, once you embark on fundraising, start the investor meetings with the investors you have the least interest in and work your way up to the ones you think are ideal. The reason to do this is that while you can practice your pitch, it isn’t the same as actual pitching. You’ll need to give the pitch over and over again before you really get it nailed, so it is better to start with the prospects you view as the least likely to invest and work towards best so that you really have the pitch down before you see the potential investors that you think are right for your company.
Create a cogent elevator pitch.
As trivial and inconsequential as this may seem I have come to view this as a foundational aspect of any successful company. Simply put, if you can’t clearly explain what your company is doing in one or two short sentences, then you will have a very difficult time getting internal alignment and executing, let alone getting investors and customers on board. It is important to understand that an elevator pitch should never explain how you’re doing something, only what you’re doing. When I ran Abacast we came up with a simple elevator pitch: “Abacast enables radio stations to stream and monetize their broadcast.” This covered the two primary things we did: streaming the broadcast and providing the monetization tools. There were many, many complex pieces of engineering behind how we did all this but none of that was part of the elevator pitch.
A great way to test your elevator pitch is to explain what your company does to the most non-technical person you know. If they understand it, then chances are you’ve got a really good elevator pitch.
Create compelling investor materials.
This may seem obvious, but it is hard to do. You need 4 things: (1) an executive summary, (2) a PowerPoint overview, (3) a proforma, and (4) a term sheet. Let me cover what each one of these should look like.
The executive summary should be a written description of what the company does, what market it is serving, and who is on the team. Ideally, it’s one page.
This PowerPoint is aimed at investors. It is not a product deck. The flow is generally high-level market information, challenges facing the market, your solution, competition, intellectual property, traction, description of the raise, use of proceeds, revenue projections, and projections for a huge win. At most, it is 15 slides. There is a strong temptation to cram a lot of words into the slides, which is a giant mistake. You want the absolute minimum number of words possible to accurately tee up your story for your verbal presentation. It takes discipline and effort to reduce the number of words you need to the bare minimum.
There are a lot of pitches you can see as examples on SlideShare, which is a great resource. The ultimate example of this is perhaps Steve Job’s presentations which frequently only had one or two words per slide. Your deck should be constructed as talking points for your presentation and discussion. If you find yourself reading from the deck, you have too many words on the slide.
Some potential investors will require that you send them the deck in advance and you want to try to avoid this at all costs. No PowerPoint can substitute for who you are, your story, and your passion.
What about the numbers? Well, as in the case with all of the documents, if the company is very early, it is at best an assumption to say where you are going to be in three years. That’s what some people will want to see though. Why? Because, as in the case with all of the documents in this section, it shows that you’ve got some sort of logic, reasoning, and research behind them; that you did your homework. Most investors recognize that these numbers will be wrong. That said, no institutional investor is going to invest in a guess that someone slapped together.
A good proforma is best put together by a CFO level person that is familiar with startup and early-stage financing. All it takes is one number out of place for your credibility to be shot down. Find a rent-a-CFO if need be to help with this, one who’s familiar with the financial structuring of technology companies. Many CFOs that do this work attend tech events, and usually, you can find someone through these events or from other startups. Again, like lawyers, you need someone whose particular skill set, and experience is in startups.
Once you’ve determined what the offering/ask is going to be, have your lawyer prepare a term sheet before you pitch to anyone. You want to have a completed term sheet that your board has signed off on when you go pitch so potential investors can see the terms and, most importantly, so you can close the financing. If you’re going to be cashflow negative, figure out your breakeven point and then add six months, you’ll need the buffer. It takes time and energy to raise money, and it can be unpredictable. (Raising money in 2008 was tough. Who planned for that?)
I’ve listened to a lot of pitches, and it is simply amazing to me the number of people who won’t actually ask for the money. There’s no beating around the bush; you need to ask directly and unequivocally for their investment! Your investment materials don’t close the deal, you do. Something along the lines of “our investment round ends on xx/xx/xxxx, and we already have commitments for xxx. It would be great if you could join in the round. How much are you comfortable committing to at this time?” Yes, that direct.
One last thing about raising money: you might have to say NO to a potential investor. As hard as it can be to raise money, and as good as that “yes” feels, if the terms aren’t right, then you shouldn’t take the money. This means, crucially, that you need to have a walk-away position established before you start fundraising and the understanding that your pitch is a bidirectional negotiation. Once you sell equity, you can’t un-sell it, and there are many cases of regret in this area.
Determining how and when to exit can be complex.
Things are going well; your company is growing; how do you know when to exit? What if the company isn’t doing well or it is static in its growth? What is the process? This is a large topic, so I won’t cover it in detail here. Having said that, there are a few things to consider.
It is important, before I go further, to discuss companies that are stalled, or “tree top” companies. This means they are off the ground but are having difficulty gaining momentum and are frequently in cash flow trouble and thus “crashing into the tops of trees.” Exits for companies like this can be problematic because effectively the company is distressed. Often, it is dead with no path forward, but the investors and people running the company are too close to it and don’t realize this.
Companies in this state have 3 options: (1) run it as is with little to no hope of and exit, ever; (2) fire sale it for whatever they can get, accepting the fact that any exit is better than what most companies return; or (3) rejigger the company, reposition it, reload, relaunch, and bring in outsiders who can help with this. The reality is that the people on the board and running the company if it has flatlined, have probably already done the best that they can do, and a new perspective is needed. People that are experts at this can help turn the company around; albeit it is difficult to do this. Perhaps the best example of this is Apple. It was all but dead after Steve Jobs left, the stock was under $10, and there was talk of Sony buying the company. Obviously, after Steve came back, they had arguably the best business comeback ever. It almost always takes fresh eyes to do this.
What type of investors do you have? Institutional investors always say they are patient. Sort of. At some point, their funds will require an exit or a write-down. Angels are often your oldest investors but have the least ability to push for an exit. Banks will require payback on a schedule. How long have your investors been invested in the company? Everyone who invested, no matter who they are, eventually wants a return. Part of the job of the CEO and executive team is to determine and forecast this path and present this information to key investors. Effectively and consistently communicating with investors and setting expectations is part of the job and will make things easier for you in the long run.
What gets calculated when you do this, essentially, is the Time Value of Money. In other words, how much additional potential return is in the company if investors stay the course vs. cashing out now? The additional consideration is how much additional risk is involved?
Ultimately these are the two key questions to ask. PointCast was an awesome product with a lot of momentum and almost no revenue. News Corp. made a huge offer of $450M. The PointCast board and team got greedy and assumed that if they were getting an offer for $450M on almost no revenue, that they should hold out for even more money. The problem was that while PointCast was a really cool product, it quickly was being replaced by destination websites such as Yahoo.com that combined not only targeted news but email and other services such as instant messaging. News Corp. balked, pulled their offer, and with no other suitors, PointCast’s value plummeted. The other side of that is a friend of mine who sold his company for $156 million on no revenue. The difference? My friend’s product was a complex biomedical product and method that was in no risk whatsoever of being encroached by other technologies, and further, it created a clearly articulated massive value-add for the acquirer. The acquirer’s initial offer was just $11 million, but my friend understood the true value of what he had created, and he held out for his company’s real value. This is part instinctive reasoning, part market knowledge, and part math. In each case, you will need to work with your board to determine the right course of action.
To conclude, as a very, very broad formula some of the specific questions to consider are as follows:
· Is the market expanding or shrinking? Being #1 in a shrinking market is not the place to be.
· Is your company leading the market sector or at least in 2nd place? As Jack Welch used to say when he ran GE, either be first, second, or get out.
· Do you need to raise additional, significant capital to grow the business?
· How much money has been invested relative to the overall value of the market? I was involved in a company that had raised $45 million in a roughly $100 million market, and they had a 50% market share. There’s no way, with those factors, to drive a high multiple exit, regardless of how unique the technology may be.
· How unique is the company’s technology? I’m not talking about patents, which may or may not be valuable, but, rather, is the technology leading the market and ahead of other offerings, especially larger competitors’ offerings?
· How defensible is the company’s technology and at what cost?
· What is it going to cost, in terms of ownership and terms, to raise more capital?
Remember that raise capital is selling your company, just not all of it.
In my experience, after answering the above questions, you’ll have a sense of the direction to take. As a way to test the market, put together the same materials that you’d use to raise capital and do a short road show, both with potential capital investors and with strategic investors to gauge a response towards investment, not selling. The response from the market will help validate your position and plan.
In most cases, getting to a CAGR of 100% and realizing revenues of $1 million per month make any sort of exit much more feasible. Below that, if you’re thinking of exiting, you’re probably looking at an aqui-hire (the acquirer essentially buys the team/talent) or a technology acquisition. That can still be a good outcome, but the highest value exits are generally going to come when the company is meeting or exceeding the CAGR and revenue metrics as stated above.
Finally, actually selling the company is a big, big commitment, an “all-in” affair. There are many ways to exit, but here are three common ones:
1. Asset sale. In an asset sale the acquired company technically still exits, but all of the assets are transferred to the acquirer. This is a fairly quick process as the acquirer isn’t assuming any of the liabilities. The downside is that the company that’s being acquired will perceive the purchase as revenue that will likely be taxable and those taxes will be taken as corporate taxes prior to distribution to shareholders. Basically, this amounts to double taxation because the employees and investors will bear their personal tax. This is mitigated by the company’s debt but rarely do small to midsize companies have enough debt to offset the full purchase price.
2. Stock merger. This form of acquisition and involves merging the acquired and acquiring firms and the firm being acquired ceases to exist. This is a much more intensive process involving due-diligence and can take months to complete. Often, if the opportunity is large enough, investment bankers will be hired, for a fee of the deal, to help drive the process. The reason it is more intensive and expensive is that the acquiring firm is acquiring all of the acquired firm’s debts and liabilities, which is potential exposure for them. There may be hold backs, earn outs and other terms that are insisted upon in order to help protect the acquirer.
3. Public sale. Going public on a stock exchange used to be the holy grail of exits. For a number of reasons, such as significantly increased regulations and associated costs from Sarbanes Oxley, the need to prepare detailed quarterly reports, and the need for constant messaging to the market, far fewer firms chose this route today. Generally speaking, this is a route for companies that are already well established with significant revenues and profits. In fact today, there are around 3500 publicly listed companies in the US, which is down from 7500 just 20 years ago. If you choose to go public, you’ll need to hire an investment bank to help drive the offering which will be shopped to various brokerages and funds around the country. You’ll also need to do a lengthy road show to present to potential investors directly. Last, going public isn’t a complete exit, but rather is intended to enable early investors to become liquid, and for the company to raise additional funds for growth by selling shares to new investors.
So, you’ve checked all the boxes; you’ve got the right team, you’ve built a meaningful and timely product, you buttoned everything up legally, you’re starting to generate real revenues, and you just nailed down your funding. Now what?
Now you need to run the business, and that’s something that is, importantly, different from starting the business. There are a few general points worth considering. I think it is valuable in the same way I described a funding process, to break the growth of the business into milestones and hopefully, at the successful conclusion of each segment, the management team takes some time to not only evaluate each aspect of the company’s performance to plan but also their own capabilities relative to the company’s current stage. Very few people can grow a company from zero to tens of thousands of employees. Those are different skillsets.
Again, it is vitally important for each person to understand their limitations. Of course, you want to grow the business as quickly as possible, but there still has to be some level of control, process, and sanity to it. There are companies that have actually gone out of business or faced large layoffs from growing too fast. That’s why it is important to have the fundamentals down first. They are harder to fold in later as it becomes more of a cultural shift. Lastly, if you have shareholders, you have to think about an exit. Shareholders are there to make money, and they need to know that you’re thinking of how this is going to happen.
Run and grow the company, and evaluate and analyze everything on a regular basis. If you do this and you can weather the inevitable storms, then you’ve got a really solid chance of making it.