Note: This article is the seventh in an ongoing series on Exits. To learn more about how to plan for exits and maximize returns, download our free eBook today Angel Exits: Perspectives and Techniques for Maximizing Investment Returns or purchase our books at Amazon.com.
Not every startup needs to raise $100 Million to scale their business and get to an exit. In today’s world, Unicorns are raising in chunks of $100 Million+ with valuations in excess of a billion dollars. And if you have nearly unlimited capital, a lot of problems seem surmountable. So more often the thinking is to go big or go home. Unfortunately, this approach only works for a small percentage of startup companies targeting absolutely massive markets. Most startups don’t have that kind of market potential and should therefore raise significantly smaller amounts of equity capital and grow the business through a combination of customer revenue, some bank debt and prudent spending. Try explaining that to a gung-ho CEO!
As angel investors with finite capital to invest and no limited partners to report to, we have multiple options with the types of companies we invest in. Understanding what those options are and how to best deploy capital for those options is an important skill for angel investors to master. Through his investing at Launchpad and on his own, Ham participated in the funding of over 100 companies. He’s seen it all, from the startup that raised less than a $1 Million to the startup that raised over $100 Million. From these experiences, he learned many lessons on how to finance growth-based technology businesses.
Q: Ham, when you make an investment in an early stage company, do you have a sense for how much capital the business should raise over time?
To answer this question I start by digging into the company’s target market. I ask questions along the lines of “how big could this market become?” or if it is an established market, “have there been any recent IPOs or acquisitions in this market?” And, if so, “what are the valuations for those exits?” Understanding the potential size of an exit for a successful startup is critical in building a financing and exit plan that works for both the entrepreneur and the investor. And, hopefully, the company will successfully execute on this plan, otherwise your investment results won’t match your original expectations!
Q: Will you provide us with some examples that explain how to structure a startup company’s financing plan?
Sure, let’s begin with a relatively capital efficient software business. And let’s make a few assumptions: 1) at the time of your initial investment the company bootstrapped its way to shipping product and a small amount of initial revenue, and 2) the product provides real value to an already existing market that is dominated by 3 or 4 large software companies. Based on these assumptions, and historical norms, the most likely successful outcome for our company is an acquisition in a 5 year timeframe with a target exit price in the $20M to $40M range.
Now, let’s overlay some investor math to see whether you can achieve your investment objectives as an angel investor. Given the risk, time and effort, you need to believe that a 10X return is possible for all your investments. We need to make one more assumption before we can complete this exercise. To make the math easier let’s generously assume that after all the rounds of financing the investors own 50% of the company. Based on our target acquisition price $20M to $40M, the investors end up with return capital somewhere between $10M and $20M. For the investors to achieve a 10X return, the total amount of equity capital raised needs to be in the $1M to $2M range. That’s not a lot, but in our very simple example that’s what it needs to be! And that is assuming investors hold 50% - they might end up with less.
It’s not too hard to put together a spreadsheet to model the financing and exit plan for a company. I encourage all investors to take the time to understand this math and make sure the CEO does as well!
My first example was pretty basic, but with good financial discipline and some significant customer revenue, great CEOs can achieve those results. But what about a more complex example? Our second example is in a technology company that’s an early entrant in a brand new market. Let’s make the following assumptions: 1) at the time of your initial investment the company built a prototype using non-dilutive financing from government grants, and 2) they’ve built a product that addresses the needs of a potentially very large market.
Based on these assumptions, we tend to see two different exit paths. The first path is a relatively capital efficient path that results in the company being acquired in a few years as big companies start to realize the potential size of the new market and choose to make strategic acquisitions to establish a market presence. These early exits can range all over the place, but are typically at the $20M to $100M scale. Performing similar math to our first example, the investors can expect a 10X or greater return if the company raises between $1M and $5M.
But what if the company decides to turn down those lucrative early offers and tries to go big? What happens then? Well, first off, the company will need to raise a significant amount of capital in order to build a much bigger company. In scenarios like this, it’s not unusual for companies to raise $10M to $50M, or more. Now, in addition to the much-extended time scale, the exit math becomes more complicated. That spreadsheet I described above has a few more rows and columns! A typical scenario results in the early investors having their ownership position reduced to around 10% for the $2M they invested in the early rounds. For the angels to achieve that 10X return, the company has to be acquired for more than $200M. Large exits at that size do happen, but the odds of success for the investors are much, much less. And, don’t forget the impact that this will have on your IRR. That 10X return is now extended out by 5 or more years. Your exit multiple might be the same in both cases, but your IRR has dropped significantly!
Q: How do you decide if you should change from a lightly financed company (e.g. less than $5M) to a heavily financed company (e.g. more than $10M)?
There are three key areas that I evaluate when trying to decide which path to take:
For Market Size, I ask the following questions: Is the market this company can address bigger than I thought it was going to be? Has the company found new, big opportunities? Would the new capital generate a better risk and time adjusted return than selling now?
For Competition, I ask: Is competition starting to eat at the business? Can the company protect its advantage, its pricing and its margins?
And finally for Management Team, I ask: Are the CEO and the management team good enough to execute on a much bigger plan? Do I have faith in them?
Q: But being lightly financed is not easy either. What issues do you see when a company is undercapitalized for the opportunity?
Undercapitalized companies face many challenges when battling in a competitive market. With limited resources, almost every department in the company is underfunded. That leads to the following critical issues:
Sales: Even though the company achieved product/market fit, and there is plenty of opportunity, and there is a growing pipeline of business, the company regularly misses sales forecasts. So what’s the cause? Is it a lousy sales team? Maybe… but, in many cases it’s due to a cautious sales hiring plan. With limited financial resources companies don’t have the infrastructure to hire and train enough productive sales people.
Engineering: Most startups focus their early investment dollars on product development in order to reach product/market fit. Once they get there, they reallocate some of their financial resources to sales and marketing. The result is that their early competitive lead on product functionality starts to diminish. Technology companies need to maintain a rapid pace of product development for an indefinite period of time.
Marketing: It’s not unusual for a startup to be the first entrant in a new market. One of the biggest challenges in this situation is building market awareness around this new market. This requires significant and sustained marketing by the company with limited visible results in the early days. Maintaining this marketing spend is hard to justify with tight financial budgets.
Q: Just looking at the capital requirements for a company, under what circumstances would you decide to not invest?
Based on my answer to the first question, you can probably guess that I won’t invest in a company if I can’t model out a 10X return for my investment. Typically, this happens when a company is going after a small market and they need a fair amount of capital before they can succeed. I see this happen a lot with medical device companies. The cost of product development and regulatory approval is expensive in the healthcare industry. If the resulting market opportunity is small, the investor math doesn’t work.
A second scenario where I am reluctant to invest relates to any very capital-intensive business. If I know up front that the company will need more than $10M to achieve an exit, the hurdle I must jump before I invest is much higher. I spend more time during due diligence trying to understand the exit math and find answers to the following questions:
What will they pay for this type of company?
What are the characteristics of recent exits in this market?
Can this CEO deliver?
Given the difficulty in answering these questions with an early stage startup, it’s pretty rare for me to invest in a capital intensive company.
Want to learn more about how to plan for exits and maximize returns? Download our free eBook today Angel Exits: Perspectives and Techniques for Maximizing Investment Returns or purchase our books at Amazon.com.