Early Departures

Contrary to common belief, venture capital investment reduces your chance of a successful founder exit. Planning the exit from your company should begin at the entrance.

Businesses pay their owners in two ways: present income and asset appreciation. By developing a growing profitable business, entrepreneurs and their investors receive the dual benefits of current profits from operations as well as increases in enterprise value.

Realizing enterprise value is the true benefit of being a founder. Of course, realizing that value requires a successful exit, and it seems logical to expect that securing capital from a venture capital firm (a “VC”) would facilitate higher growth, leading to a more lucrative exit.

Well, not so fast.

According to “Early Exits” by Basil Peters (MeteorBytes, March 2009), having VC investors actually decreases the likelihood of a successful exit by a factor two or three. Also, earlier exits are more favorable to founders and early-stage investors than later exits—even when the later exit is for more money.

This makes sense when you take into account some key factors. First, for venture capital funds to be successful, they have to invest in large chunks. They don’t have the manpower or funding to permit small investments, especially since the time to make and manage an investment is not proportional to the amount invested.

When I first got into this work, the magic number at which an entrepreneur should look for VC investors was about $5 million. But VC funds have increased dramatically. So, my anecdotal experience suggests that the minimum has tripled to about $15 million. Peters believes the average VC investment is $25 million.

Because they take a portfolio approach to investing, VCs expect only one home run in 10 investments. To achieve required return on investment objectives, VCs must achieve multiples of 20 to 30 times their funding of the home run investments over a five- to seven-year period. This means VCs investing $15 million must anticipate an exit event where their portion of the exit proceeds is between $300 million and $450 million. A lower multiple usually puts the investment in the loss column.

So, rather than accept the loss, the VC will prevent the exit and see what comes along, even where the exit would be a win for the entrepreneur and the other investors (family, friends and angels). Even though they’re usually minority investors, VCs can kill the deal through the investor rights or shareholder agreements that were signed when the investment was made.

A VC will typically have only a minority interest in the company. Therefore, to achieve the required return on investment in this scenario, the transaction value would be about $1 billion or more. Since the initial public offering (IPO) market has been very limited over the past nine years, a successful exit means acquisition of the company. There just aren’t many prospective buyers for billion-dollar transactions, and only a limited number of companies are sold annually at those amounts.

Enhancing this situation are fundamental changes occurring in the large-company ecosphere. Many large companies have embarked on a strategy of acquiring technology companies as a sort of outsourced research and development process. For financial reporting and as a result of internal capabilities, buying new technologies is easier and has a higher success rate than developing them internally. Large companies are, therefore, buying “small” technology-related companies. These types of purchases are typically $50 million or less.

Finally, it’s easier (and faster) for a founder to grow a company to $20 million in sales than from $20 million to $250 million. And the skill set required to go from $20 million to $250 million is much different from the one needed to found the company. Thus, the likelihood of the founders’ getting to $20 million in sales is greater, and they are more likely to be successful and do it again (i.e., become serial entrepreneurs).

While well thought out, Peters’ theory is applicable only to companies, such as Web and mobile application developers, that don’t require substantial infrastructure or capital expenditures. These types of ventures can use infrastructure on an as-needed basis (typically, on-demand software) without having to buy or build their own systems. As a result, no big investments are required for equipment or IT infrastructure. Where big investment is required, a number of the reasons for and benefits of an early exit are no longer applicable.

Understanding the benefits of an early exit is crucial for every entrepreneur.  Because a successful exit is built on a series of strategic decisions, starting from the company founding, the exit should, from the start, be considered part of the process of growing the company. When founders properly plan their exit in advance, they will significantly increase return to themselves and to investors alike.

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Ed Alexander is founder of the Entrepreneurship Law Firm, PL, in Orlando and author of the book “10 Common and Costly Business Killing Legal Mistakes and How to Avoid Them.” He works regularly with the University of Central Florida's Business Incubation Program, among other regional business clients.

Tags: Entrepreneurship, Finance