Recently, at an Exit Strategies Workshop in Victoria, someone asked me to compare the pros and cons of an early exit versus a traditional Venture Capital financing.
The scenario we used for our example was a successful startup company with a proven business that needed $10 million to $20 million to fund growth.
(In this article, I am being precise about the distinction between the business and the company.)
There are only two likely options for obtaining $10 million to $20 million of growth capital for the business:
1. a traditional VC financing, or
2. an early exit.
Either way the business gets the capital it needs – so what are the differences?
Either Way You Lose Control
It would be very unusual for a company to raise $10 million to $20 million from VCs and not lose effective control of the important decisions. Most entrepreneurs don’t appreciate how much control they’ve ceded to the VCs, because many of the control provisions in the investment agreement are not readily apparent.
Yes, with an early exit, the ultimate control is now in the hands of the acquiring company. But at least that’s clearly understood by everyone at the outset.
VCs usually fire the CEO
What surprised the audience at the workshop was that the chance of the CEO continuing to run the business is much lower with a VC financing. The data on this is sparse, but in VC circles it’s widely agreed that VCs replace the founding CEO about 75% of the time.
One data point on this comes from Thomas Hellman at UBC’s Sauder School of Business. His analysis shows that VCs replace the founding CEO faster than non-VC financed companies.
Compare this with an early exit; in this case, the acquiring company will usually want the CEO to continue to run the business for as long as possible.
An Exit Generates Cash Now – Not in a Decade
The second biggest difference is when shareholders will receive cash for their shares. In the case of an early exit, all of the share and option holders will usually receive cash, notes and/or shares from the buyer at, or shortly after, closing.
In the case of a VC financing, none of the shareholders are very likely to receive any cash for their stock until the VC exits.
The problem is that, on average, it takes about another decade for a liquidity event to occur after a traditional VC fund invests. (This is explained in my book “Early Exits“.)
And On Average a Lower Return
Even worse, for more than a decade, the net returns on traditional VC funds have been negative. Statistically, this means that when the shareholders eventually receive cash for their shares, it will, on average, be less per share than when the VC actually invested – likely a decade before.
This may not seem intuitive. But there is no question that for more than a decade VCs, on average, have lost money. If they bought shares in a company for $10, when they exit, the chances are they will realize something less than $10 per share.
Yes, some of that is due to fees, but that isn’t the main point here. Taking money from a traditional VC has meant, at least for the past decade, that the value of the company would decrease. (There has been much written about this and some of the good references are linked here).
These are probabilities and there will always be exceptions
Of course, there are counter examples. There have been many situations where VCs invested and the shareholders had exits at prices above when the VCs invested.
Please remember that this article is about probabilities.
The data we have leaves little doubt that, on average, choosing VC financing instead of an early exit will result in:
1. a higher probability of the current CEO not running the business for long,
2. about a decade-long delay in receiving cash for your shares, and
3. on average receiving less than you could have with an early exit today.
Anyone want to debate this?
I appreciate that this will seem controversial to many readers. Some VCs may disagree.
I don’t think I’m biased. I’ve started and run a VC fund and was very successful as a VC fund manager. Many of my good friends still call themselves Venture Capitalists.
I’d be pleased if this post generated comments on my blog or a real-time debate. That conversation will help entrepreneurs and other shareholders make better decisions about the growth capital options for their businesses.