Note: This article is the eighth 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.
It all comes down to making money… Early exits are an important part of the financial reward needed to turn a very risky portfolio of angel investments into an asset that provides an excellent risk/reward profile for you, the investor. Not all companies are primed for an early acquisition, so it’s important to understand before you invest whether your are jumping into a situation that is conducive to an early exit.
Let’s take a look at some of the key characteristics that make a company a viable candidate for an early acquisition. And, we should spend some time thinking about situations where we might not want to pull the trigger so early and be willing to sell before the company matures.
Q: Christopher, what are some of the characteristics that make a company attractive for buyers to consider an early exit?
Strategic buyers are often tempted to grab a hot company early, before they raise a ton of money from VCs or achieve a ton of success and become so expensive that the deal is really risky. There are a number of things that can attract a buyer in this context. For example they are drawn to startups which have:
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A hot new product that nicely complements a fast growing, large company’s product line;
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A disruptive product that has the potential to damage a larger company’s market position;
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A new product that fills an emerging and growing gap in a big company’s product line;
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A new product with strategic patents that a buyer cannot risk having fall into a competitor’s hands;
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A new technology or business model that is so innovative and trendy that the opportunity to get the team and the goodwill around the brand is irresistible;
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A new product that is clearly constrained by lack of sales and that would be instantly accretive and profitable in the hands of a larger and more capable sales force;
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A really capable team who can bring new DNA into the buyer’s organization and run the acquired business or even grow to become future leaders in the combined entity.
Q: What are some of the advantages of an early exit for angel investors?
Unlike VCs, who operate on fixed fund cycles and must distribute capital to limited partners (LPs) when it is returned to the VC, angels are essentially two-legged evergreen funds. As soon as they get money back, they can turn it right around and re-invest it. The faster that happens, the more they can recycle it in a given period of time and the more shots they have at increasing their returns. It also allows them to manage risk. If an angel gets a 3X on an original investment, they can take that original single investment and put it across three different investments which can allow them to hedge risks (three relatively safe follow-ons in other successful portfolio companies) or chase returns (three new aggressively risky moonshots) or anything in between.
Since angels don’t answer to LPs chasing specific levels of performance, don’t have massive funds to return, and are not obligated to return capital when it comes in, they can use the liquidity from the trailing edge of their portfolio to fund investments in the leading edge. Early exits are the grease that keeps that wheel turning!
Q: How about some disadvantages? Why wouldn’t I want all my exits to be quick?
Fruit can taste much better if it is allowed to fully ripen on the vine. The strategic position, and therefore the value, of a company may be increasing at an exponential rate, so it could be much more lucrative to wait, even just a bit longer. For example, new industries can take time to develop and reveal their true scale. Or the macroeconomic cycle may be in the early stage of expansion. Consider Instagram: Facebook paying $1B for a 13 person company with no business model or revenue seemed absolutely insane ... until Facebook paid $19B for Whatsapp just 22 months later.
Of course, all these factors work in reverse - competitive positions can weaken overnight, industries can go out of fashion quickly, macroeconomic conditions can change without warning. Trying to optimize the timing of acquisitions is very difficult - what looks like genius in retrospect is often more accurately characterized as luck. This is why most companies facing a legitimate buyer making a fair offer are inclined to sell. There is always the possibility you could get more later, but you could be waiting a long time - possibly forever.
Q: What effect does an early exit have on the Internal Rate of Return (IRR) for the investor?
The worst thing you can do is pass up a good offer only to be forced to take a weaker offer later on. Public company M&A proxies are full of these types of tales of woe - companies who pass up offers only to deeply regret it later. A recent example of this kind of over-optimization is Good Technologies. They were on a path for an IPO, but they didn’t like the price because it was so much less than they thought they should get, so they sought a buyer. According to their disclosure documents, they next turned down a buyer offering over $800M because it was so much less than they would yield in even a mediocre IPO. So they waited, but things continued to deteriorate. In the end they were forced to take an offer of about $425M.
Because IRR takes into account the effect of time on your return, it brutally illustrates the pain of waiting for a lesser deal. For example, take the hypothetical where a company passes up a deal offering a 5X at year three because it is an “insult” compared to what they think the company is really worth, and then are forced by circumstance to wait three years and settle for a 2X out of desperation. In this example, the comparison of IRRs really drives home the folly of their ways: what could have been an IRR in excess of 120% becomes an IRR of 15%.
Q: If a company in my portfolio raises financing from a VC, how will that change the timing on an exit?
The more money you take from investors, the greater the exit valuation has to be to pay them off. Consider this simple math: if you take just $1M from an investor expecting a 10X, and you give them half your company for the money (which is generous - you’d almost certainly give less), you need a $20M exit to “pay” that investor back. Using that same math, if you take $100M, you’d need a $2B exit.
If the typical range for M&A valuations is 3-5X revenue (or maybe 6-8x for recurring SaaS revenue), how much revenue do you need to have to support a $2B acquisition? $300-500M in revenue. How long does it take to grow a company with that kind of revenue? A lot longer than it takes to grow a company with $3-5M in revenue, which is what it would take using the same multiples to deliver a 10X on the company with $1M in equity investment.
This is an extremely crude example, but it illustrates a point that many investors intuitively understand: with investing, there is a tension between period, potential and probability. A thinly capitalized company looking to exit early may not have huge potential, but it has a greater probability of happening, and a much shorter period. In contrast, taking huge money from a VC definitely increases the potential (i.e. size) of the exit, but it also decreases the probability (since big exits are very rare) and definitely increases the period. Perhaps this is why there is an old saying with angels: “whenever I made big money there was a VC involved, and whenever I lost big money there was a VC involved.”
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.
