The Art of Exit

In the startup business, it goes without saying that a key milestone, if not the end goal, is for investors, founders and management to achieve an exit. An exit, hopefully a fruitful one, places a stamp of success for the entrepreneur and the investors. It creates a launch pad for both towards the next big thing, whether it’s the next venture for the entrepreneur, or a brand creation opportunity for investor, whose name might then be synonymous with companies in that particular domain. He/she might then have the title of king/queen of SaaS, IOT, VR or something else. For some it’s an ego trip and have their name in the Midas list of most successful VCs. For others, it’s the pure joy of helping a company make it through the proverbial ups and downs to eventual success. Needless to say, Exits are important and for some, an end all, be all. More often than not, for companies fortunate enough to get to a fruitful exit, especially in case of an IPO, it’s simply another milestone in the long journey from a startup to a multi-billion dollar enterprise. Obviously, if it’s an M&A scenario, the exit might itself be a culmination of years of hard work, with both investors and entrepreneurs moving on to their next opportunity.

It is also true that the startup landscape is littered with a high mortality rate. Much more often than not, companies go to a zero or near zero, given the sheer high-risk nature of startups. In other cases, while there may technically be an exit, it’s a fire sale or an aqui-hire being positioned as an M&A to provide slightly better outward facing optics to the less-than-fruitful outcome. It’s very rare to have a fantastic exit where everyone does extremely well financially.

What I want to really talk about here is the fairly common situation where a company grows and often struggles through multiple rounds of financing with several investors, all with different timelines in terms of their respective exit horizon. I term that timeline as “womb to tombstone”, typically implying the duration from inception or seeding of a startup to the tombstone which is not meant to imply death, but rather a trinket that bankers and VCs like to prominently display in their offices upon a successful exit event which returns a meaningful investment multiple and IRR. That “womb to tombstone” defines the reputational index in the VC and startup industries. Did the investment do well? How well? (in terms of both cash on cash multiples and IRR’s, with different firms placing varying emphasis on both metrics), and what was the hit rate (what % of investments were successful).

Now let’s talk about the challenge, one of many, that an entrepreneur and/or a CEO of a private company faces. Imagine the following scenario. You are company ABC, founded in 2008. Now nine years later, you have raised four rounds of financing from six different investors, but you are still 4-5 years away from an ideal exit (M&A). The oft-mentioned mantra in exit realm is “companies should be bought, not sold”. Implication being that if the company is doing well, the prospective buyers will come knocking. At that point the company has all the leverage, because it’s not in the market to be sold and the buying entity(ies) will get into a bidding war. Going back to company ABC…imagine if you are a seed/Series A investor, you are already 9 years into the investment. A typical fund has a 10-year life cycle (with potentially some extension), but VCs really try to get the capital back and portfolio closure by the 10th anniversary of a given fund’s vintage of formation date. Series B investor might be 6-7 year into their investment. But the most recent series D investors have an additional 4-5 years until they would/might want an exit. The entrepreneur/CEO has a real dilemma. Not only does he/she have a company to run, scale, worry about financial health of the company, strategic forks on the road, continuously changing competitive landscape etc etc, but she/he has a challenge managing the internal dynamics among and between investors, each of whom will have different timelines and exit thresholds. The entrepreneur ends up getting different signals and pressures from different investors at different times leading to a constant dose of hypertension medication to maintain his/her sanity.

My strong recommendation to entrepreneurs is to understand the above situation whole-heartedly up front, and have a clear conversation with all investors along the way, especially around funding events. Because, more often than not, companies don’t have a Facebook or Snap-like run in a few years to a point where everyone does extremely well. Even in the upside scenario, it’s usually a 8-12 year slog to even have a shot at a reasonable exit. So, how does one manage this tension and make sure that there is alignment on the Board and among various groups that works in the company’s favor, rather than create constant tension and friction. That, by the way, is not only draining on the entrepreneurs and management, but work against the overall well-being and potential positive outcome of the company (which then leads to further tension and a vicious downward spiral)

In my humble opinion, the right thing for the entrepreneur to do is two-fold: 1) to keep in mind the exit timelines for the earlier investors. That is something they (the investors) would have communicated when making their initial investment. And while, investors are usually understanding of the fact that companies almost never deliver on their 1,2 or 5 year plans, they are responsible to their partnerships and LPs, and therefore have to try to return capital to their investors within a reasonable timeline. 2) to be very mindful of the fact that the early investors came in when the company had very little, if anything, in terms of traction and she/he should do right by them. Often, the late stage investors might encourage or incent entrepreneurs to work within the new investors’ timeline (a new trigger, often with new incentives/stock options tied toward a 4-5 year exit horizon), much to the frustration of the early investors. But the late stage investors usually have leverage, with deeper pockets (when the earlier investors are often tapped out). The entrepreneur has to walk a tight rope between authentically appreciating the risk the early stage investors took, with the much needed growth capital that the new investors bring to the table. In an ideal situation, company continues to hit its milestones, attracting value-additive capital at increasing valuations, within a timeline that works for everyone. That scenario however is in the realm of miraculous, and therefore, highly unusual.

Add to the above, an environment like the one that exists in India, with a dearth of public exits, and you create a real quandary. The solution to the above dilemma is secondaries. It’s really the only mechanism whereby the company does not have to exit outright pre-maturely, but still be able to create an exit mechanism for earlier investors who have reached the end of their fund life cycle. This can happen through either a straight secondary, similar to what DFJ or Canaan embarked on in India (selling entire portfolios), or by a company raising capital through a combination of primary and secondary capital infusion. In that scenario, typically a private equity investor comes in with a large capital infusion, which is used, in part, to buy out existing investors (either partially or fully) and provide primary capital to the company. If done right, this can create a real win-win situation for older investors, new investors and the company. The old investors get a needed exit; the company gets needed primary capital and the new investor usually gets decent ownership at a blended average cost which is lower than the preferred price of the most recent financing round. As an example, company ABC raises $50M, split $25M each between primary and secondary. The primary capital comes at a $250M post money valuation, but the secondary capital is at a $200M post money. The primary capital buys 10% of the company, but the secondary chunk buys 12.5% of the company for a total of 22.5% (rather than 20%, which would have been the case if the new investor had invested the entire $50M as a primary). Obviously, there are some caveats to a deal like the one above. The fact that the company has $25M less primary capital may have an impact on the business growth. Additionally, the portion that was bought through a cheaper secondary may have lower liquidation preference (which is one of the reasons the existing investors were willing to sell at a discount. But the primary reason for taking a discount is liquidity).

Exit creation is an art. I would encourage all entrepreneurs to think about the exit horizon and scenario when creating a business plan. And truly think about the process and challenges which I have tried to highlight. It’s very easy in a powerpoint to indicate that “we will exit through M&A or IPO” in x-y years. Everyone knows that plans almost never work out, but the key is to set appropriate expectations, with periodic re-forecasts and as deep an understanding as possible with existing investors around their exit timelines and thresholds. Last thing that an entrepreneur wants is investors pushing for an exit when the entrepreneur knows in his/her heart that the company is significantly more valuable 2-3 years downstream. Having said that, entrepreneurs are optimistic by nature and the hockey stick uptick is just around the corner…always. But at some point, it might be pragmatic to draw a line in the sand alongside your investors and say, that “if we don’t achieve certain business or financing milestones within a certain time period, then we will hire a banker to find a home for the company and employees”. That is a perfectly appropriate action to take, rather than be hard headed (which both entrepreneurs and investors tend to be sometimes), due to ego or other reasons and continue to “bang the company’s head against the wall”.

Often entrepreneurs fall in the trap of “second guessing” and the “only if I had…” thought processes. My advice usually is “when in doubt, follow the data”. Do the needed analysis (market, industry, competitive, technical, financial…) to determine what the likelihood of success (however you define it) is within a certain timeline (usually 6-12 months). If you are not able to hit those milestones or come close to hitting them, then perhaps the market is telling you something and you, as the entrepreneur/ceo have to internalize and digest that feedback and brainstorm next steps with your Board, keeping in mind the fiduciary responsibility to the shareholders.

Bottom line: Exits are clearly important, but there is an art to their creation and execution. Managing expectations and pro-actively delivering on the exit promise to investors is one of the most challenging but most important measuring sticks for an entrepreneur. You cannot let down the early investors who bet on you when you had nothing. Nor can you create an unnatural short term outright M&A, much to the dismay of your late stage investors. Sooner you start understanding this common, yet un-discussed phenomenon, better off you will be as and when the time comes for tough conversations with your investors. With all that said, now go build the next $1B startup! Good luck!