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An Early Exit is Better than a VC Financing

by Basil Peters on October 6, 2013 · 4 comments

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.

Summary

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.

{ 4 comments… read them below or add one }

Jade Bourelle October 7, 2013 at 11:42 am

This conversation entirely depends on the the quality of the company and it’s prospects. In general, companies that sell strategically have clear merit to the acquirers today. Companies that VC’s invest in may or may not have a future… VC’s quest to place funds push some pretty bad investments and as an average pull down the industries returns. I don’t see an apples to apples comparison from comparing VC portfolio averages to companies who exit early… missing also are the successful companies that don’t take either path. Overall, the quality of the company is missing in your debate. As is the quality of the CEO in regards to their ability to stay on.

Reply

Basil Peters December 11, 2013 at 2:15 pm

Jade,

I agree that each company is unique and CEO quality is always a significant factor. But, in this economy, most of the companies that are candidates for VC financing also have early exit opportunities. This is partly because any company that VCs will invest in, is also a candidate for corporate (i.e. strategic) investment. Today, the strategics have a very strong preference to acquire.

The only other probably path from that juncture is an IPO.

Theoretically, you could say that a company could be run to provide dividends to the shareholders, but I have only seen that be a good option in about 1 out of 1,000 startups.

Basil

Reply

Paul Slaby October 8, 2013 at 2:43 pm

Seems to me this analysis may be right for specific cases when:
- the business is, as you say, “proven”, i.e. stands on its own feet, cash positive, etc
- the company (founders) have the luxury of choosing their options
For sure this is a nice position to be in and given the specifics of the deal one could likely argue both ways and choose appropriately.
However in many cases, we do not have the luxury of choice, example: funding an expensive product development or turning a nascent growing business to a big success. Selling off (exit) prematurely could be as bad as loosing control through VC financing.

Reply

Basil Peters December 11, 2013 at 2:08 pm

Paul,

I agree that each company is unique and that circumstances may give some companies only one option.

But as an ex-VC, I do believe that an early exits is better than losing control in a VC financing. At least with the exit you have the cash (i.e. the capital gains). With the VC financing, you have some equity, but the probabilities are that your exit will be about a decade into the future. And statistically not at a higher price per share (on average, VC firms have not created gains over the past decade. That means they are selling for around the same price they are investing in. Of course, this is all still statistics and each company is unique.)

Basil

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