Start from the end - potential for exit drives VC funding
To Warren Buffett, "favorite holding period is forever." He only buys something that he would be "perfectly happy to hold if the market shut down for 10 years." The VC world, whom entrepreneurs resort to, for funding, thinks very differently. As several VCs have expressed in different ways, "We invest to exit, not to stay put." With a typical investment horizon of 5 years, VCs plan their exit before they get in. People who are starting up, because of their huge passion for an idea or to make something really big, probably ignore this fundamental philosophical difference when they go to raise funds. Most of the recent success stories hailed by the VC world have the entrepreneurs out of their business (e.g., Tutorvista, marketRx), or left with a small minority stake (e.g. RedBus). Yet, if you do a poll among aspiring entrepreneurs, on what their stake will be in the company 10 years after inception, I doubt that even a fraction will say zero.The irony is tough to miss. VCs look for really passionate doers, and entrepreneurs look for long-term investment partners. Both having different objectives ultimately. While exit is an afterthought (at best) for most entrepreneurs, it is the thing that VCs constantly strive for. Naturally, this leads to dissonance in several forms. Issues such as extent of dilution, professionalizing management, composition of Board become the bone of contention later.
Prevailing themes, e.g. e-commerce, market place etc., attract a lot of aspiring entrepreneurs. While some are able to get early encouragement in terms of funding, others complain that their billion-dollar idea is not understood well enough. As entrepreneurs look to raise money, it is very important to put on a client-hat and appreciate the drivers of common investment themes. Ultimately, investors have clients to cater to: clients who would buy into their portfolio. The themes are driven by the needs of their clients. Since every VC has a different set of clients with varying needs, the themes vary by VC and change over time. Let's take a look at some of typical target clients of VCs.
- Stock market via IPO: The much talked about but equally rare. Less dilution, good valuation, fragmented buyers, ample liquidity – all these make the stock market the ideal exit. However, the market looks for strong track record of profits along with high growth – the minimum to list in India is 3 years of continuous profits. Given the typical investment horizon for a VC is 5 years, this is not a real option for them. Unless they invest in late stage ventures, it is pretty much ruled out.
- Strategic buyers: The more prevalent option. As per a study by KPMG, in 2012, for every IPO exit by PE there were about 10 strategic sale. The ratio would be further skewed for VCs. Strategic buyers are looking to either access a new geography or product enhancement or new technology, or expand book. They either look for majority stake or complete buyout. Ultimately they would dissolve the identity of the target company and merge into its own. For instance, Pearson started with a minority stake of 17% in TutorVista. Over next 2 years increased it to 80% and finally acquired the whole firm. Similarly if you see other major exits of 2012, CSC bought 50% stake in Applabs from Westbridge, Serco bought 66% stake in Intelent from Blackstone. The focus of valuation is on the strategic asset within the venture rather than the profitability. A PE multiple has less importance. The targets are valued on opportunity cost to build something similar green-field or destructive value if the target goes into competition's fold.
- Secondary sale to another financial investor: The most prevalent one. As per the same KPMG study, more than half of PE exits in 2012 were secondary sale (to other financial investors or open market sales). It is like passing the baton, where the ultimate destination is one of the above 2 exits. The preferred (though not the only) way is to pass the target to a large sector-focused fund. Given their easy access to Strategic buyers and ability to invest much more, they will nurture the firm better. Especially for early stage investments this makes for an ideal exit.
Now, I am not an investor but if I were one, I would certainly view my potential investments through the above lens. If my mandate is to ultimately sell in 5 years, I need to think about a buyer first. I will dump a pitch from an early stage real estate builder with a proven business model with strong cash flows, if I don’t believe I can sell it at 10x valuation to one of the large builders or take it to an IPO in five years or sell it to a fund. If there is a precedence it only makes the case stronger.
Let us put the above in perspective and assess some frequently given advice to start-ups on fund raising. Exit might not be the sole reason for the specific advice, but nevertheless it helps answer several anomalies. Several times you would look at a deal and say their valuation is better than ours though our model is similar albeit in a different industry. Or a firm who is yet to get a customer has raised money whereas you were denied for being early stage despite you already generating profits.
- Early stage investment entails high risk, hence be liberal with dilution: Of course there is a high risk element, however you are probably also seen as a buyout candidate; thus the need for higher stake. VCs are essentially betting on your idea and the probability that it would be of importance to a large company. If they cannot offer a majority stake, the strategic would not be interested. Instead if you are actually promising strong cash flows in year 6, thus an IPO at a later date, then slog out a little more. It is unlikely that investors would buy the idea of strong cash flows without some evidence of it over a couple of years.
- Create a strong Board and professionalize management: The push is much higher where promoter is left with a minority stake and the venture is at advanced stages. Investors could have been nurturing the company for a sellout. With the promoter gone, the company should not become headless. Hence it is critical that the dependence on the promoter is limited and he/she is seen much like any other professional CEO. The acquired entity may or may not have a role for the promoter (ironic, huh?).
- A strong technology platform helps in faster scalability: Absolutely, but there are several examples of high scale despite being less tech. It is also a fact that in Q2 2013, 6 out of 7 strategic exits have been of VC-backed IT firms. Large IT companies are acquisitive in nature. VCs know that they have a proven appetite for acquisition. IT companies have increasingly acquired new platform / technology rather than building it in-house. Naturally, VCs want to buy what they can sell.
- Focus on growth over profitability: Especially for early stage firms where investors are looking to prepare it again for a sellout. The moot point to buyer is that this target will help you accelerate growth. If the target itself cannot grow rapidly at a small scale, it cannot deliver meaningful growth for a much larger enterprise.
I must say with a big caveat that much of the above depends on the constraints that investor is operating in. If you have a successful entrepreneur investing his own money, or the LPs of a fund have the objective to build strong businesses for the long haul rather than a 5-year investment payback mindset, their flexibility and perspective towards building a business will vary. They are looking for a different outcome.
Both entrepreneurs and VCs do not talk about exit that often. However, it is a responsibility on both ends. Just for their own long term good. Entrepreneurs needs to appreciate the need and ways of VCs, who are ultimately in for commercial gain. At the same time, VCs need to talk a lot more about their preferred ways of exit.
The message remains - you have to start with the end in mind.
About the guest author
Abhishek is co-founder of securenow.in. The company works with investors and entrepreneurs to mitigate their business risks through insurance. Before he setup SecureNow, he was part of McKinsey's Health-care and Insurance practice, where they served large Insurance companies to solve product, marketing and operations issues.