Don’t Ride It Over the Top Nyenrode Business Universiteit, Amsterdam

This was a presentation to a hundred Dutch investors and CEO’s at the Nyenrode Business Universiteit just outside of Amsterdam. In this video I describe the critical importance of exit timing and the dramatic effect it can have on investor returns and the lives of entrepreneurs.

This talk included:

  • How the internet has accelerated everything and shortened company lifecycles
  • Entrepreneurs now have “Weekenders” where they build entire companies in a weekend
  • Ideally, a company would start the exit process 12 months before the peak in value
  • There are logical reasons why, if a company misses the ideal time to exit,
  • There’s a significant probability it won’t just exit for less, but will never exit at all
  • Some of the reasons this happens much more often than people realize include:
  • Over-investment by VCs, Competition, Negative momentum and Waves of Consolidation
  • Like many parts of life, and business, “timing is everything” with exits
  • Timing our exits better can significantly improve angel investor portfolio returns
  • And for entrepreneurs can literally change their lives

Got a Patent? Sell the Company! Element8 Angel Conference, Seattle

This is an excerpt from a talk I gave at the Element8 angels workshop in Seattle: Investing a World With Few Exits.

Some of the key points from my talk:

  • I believe only 25% of all companies that could have been sold actually end up successfully exiting
  • If a company misses the ideal time to exit, then the most likely result is that it will fail completely
  • I’ve identified five failure mechanisms
  • This talk describes the failure mode driven by intellectual property infringement
  • Patents have become a much more valuable tool for entrepreneurs and angels
  • Patents are a “Double Edged Sword” and create serious risks for smaller companies
  • Many big companies take the attitude that they will just use the IP and let the lawyers figure it out later
  • Defending your patent could cost $10 million and take ten years
  • Big companies know that many times a small company can’t even afford to start the suit, so they will win by default
  • If you have a good patent, the only reasonable strategy is to sell the company as soon as possible after the patent is granted
  • Or when you have disclosed the technology – whichever is sooner
  • The risks of not selling early just aren’t a good business, or investment, decision

Improving Returns for Angels and Entrepreneurs – Element8 Angels, Seattle

This video is a talk I gave at the Element8 angels workshop in Seattle: Investing a World With Few Exits.

Some of the key points from my talk:

  • I believe only 25% of all companies that could have been sold actually end up successfully exiting
  • If a company misses the ideal time to exit, then the most likely result is that it will fail completely
  • After seeing this happen over and over again I started to recognize a few patterns
  • I’ve identified five categories of these failure mechanisms:
  • Over-investment by VCs
  • Competition
  • Intellectual property infringement
  • Negative momentum
  • Waves of Consolidation
  • This talk describes in detail the failure mechanism due to patent infringement
  • In my opinion, if you have a good patent,the only reasonable strategy is to sell the company
  • As soon as possible after the patent is granted,
  • Or when you have disclosed the technology – whichever is sooner
  • If you are a small company, the risks of owning a good patent are not a reasonable business, or investing, decision

The Exit Process and Timeline

This video from the Exit Strategies workshop describes the exit process and timeline.

Highlights of The Exit Process and Timeline:

  • For many exits, the biggest question isn’t “How Much Can We Get?”
  • Instead “It’s How Soon Can We Exit?”
  • The short answer is 6 to 18 months
  • From the time you engage an M&A Advisor, until the cash is in the bank
  • But it can take longer if the company isn’t ready
  • Be very wary of M&A firms that promise something faster
  • Part 1 – Before Talking to Buyers – 1 to 5 months
  • Part 2 – Building the Sales Funnel 2 to 6 months
  • Part 3 – The Bidding Process – 1 to 3 months
  • Part 4 – Negotiating and Closing – 1 to 3 months
  • When to tell the team
  • CEO Deal Fatigue – a very real danger
  • References on the Exit Timeline

Exit Timing – Exits are Happening Earlier – Part 3

How Exits Have Changed in 2012 –
Presented at the National Angel Capital Association Summit –
March 8, 2012 in Austin, Texas –

Highlights of Part 3:

  • Story of a Vancouver company that was acquired before it’s first year end
  • A possible new record – the company acquired by AOL just four days after its product launched
  • Ideal exit timing for your company and why most entrepreneurs “Ride it over the top”
  • The financial loss is not the worst – it’s the part of your life you can never get back
  • Why companies that miss the optimum time often end up never exiting
  • Exit threats from competition, over-investment by VCs and negative momentum

This is the Powerpoint for “How Exits Have Changed in 2012“.

The video for part 4 of How Exits Have Changed is here.

Waves of Consolidation – The CEO’s Most Important Job – Part 4

This video explains why I believe that not missing the “Wave of Consolidation” may the successful CEO’s most important job.

How Exits Have Changed in 2012 –
Presented at the National Angel Capital Association Summit –
March 8, 2012 in Austin, Texas –

Highlights of Part 4:

  • The most devastating reason that companies fail to exit
  • A relatively new phenomena driven by the amount of cash available, number of buyers and the internet
  • The buyers are smart too and how they start the beginnings of the wave
  • When you can see the wave, it’s almost always too late
  • What happens after the wave – killing the small companies
  • My saddest job – explaining why an unsolicited offer is almost never good news
  • How we can all be better angel investors – support the ACA and ARI

This is the Powerpoint for “How Exits Have Changed in 2012“.

The video for part 1 of How Exits Have Changed is here.

Timing Your Exit – Don’t Ride It Over the Top

Most entrepreneurs wait too long to start thinking about their exit.

They usually sell their companies for much less than they could have. The valuation curve, and return to shareholders, usually ends up looking something like this.

Don't Ride it Over the Top

That’s exactly what I did in my first company. (It was the first time I lost several million dollars, and the first of many similarly expensive – and valuable – lessons about exits.)

Most of the technology companies I’ve known well exited too late. Yes, most. “Riding it over the top” is by far the most common exit scenario.

The fundamental cause is  simply our fundamental human natures.

The goal of this article is to help you time your exits better.

How Long Does It Take to Sell a Company?

Depending on who you ask, and whether they are trying to sell you something, you will get different answers on how long it takes to sell a company.

The time to exit depends a lot on the company – primarily on how long it will take to get the company into a saleable state, and then how much time the senior team has available to work with the M&A advisor.

A good rule of thumb is that it will take 6 to 18 months from making the decision to completing the sale. That means to execute the best exit, the decision to sell has to be made 6 to 18 months before the peak in the selling price.

Selling Price Depends on Internal and External Factors

Selling an entire company is similar to selling shares in the public markets – how much you can get depends on how the company is doing, but also on how the overall market is behaving. For many stocks, the overall market is a bigger factor than how the company is actually doing at any point in time.

This ‘external effect’ is even more pronounced when an entire company is being sold because the market for companies is much less ‘efficient.’  The term inefficient includes a lot of aspects, but the important effect here is price. This post describes market inefficiency and how you can use it to your advantage when selling a business.

At the end of 2008, near the bottom of the most recent debt bubble collapse, the overall stock market had dropped about 50%. If there was a similar index for the value of entire companies being sold, I am sure it would have gone down much farther than that, and stayed near the lows much longer. This is, in part, because the market for entire companies is much less ‘efficient’ and therefore more susceptible to changes in sentiment and liquidity.

The Macroscopic Economy Affects Every Exit

The overall economy is often the most significant timing factor in an exit. This means you’ll also need to consider what may be happening in the global economy 6 to 18 months into the future.

My first exit was sub-optimum because I hadn’t seen the previous debt bubble forming back in 1990. If I was paying attention, I might have noticed that most of my cable TV company customers were using a new financial instrument called ‘junk bonds’ and that S&L’s were financing too many real estate projects. Heck, I didn’t even know what an S&L was – let alone a junk bond.

We are all familiar with the effects of the macro economy. In the M&A business, the future condition of the ‘micro’ market  is almost as important.

The Micro Market for Your Company

The state of the micro-market you will sell the company into is the second biggest factor in choosing the optimum time to exit. Markets for companies are notoriously inefficient, and the valuations for a given type of company can easily vary plus or minus fifty percent in a year depending on perception and supply and demand.

If a space becomes ‘hot’ valuations can be several times higher than just a year earlier. These micro market conditions can often affect price more than the fundamentals of the company.

The micro market is often easier to predict than the macro economy. For example, I recently met with two bright, local entrepreneurs who are building a company in an exciting niche market riding on a long term trend. These two young founders chose their space well and were already global leaders in their niche. They had prototypes in the market and a respectable global mind share.

Their niche was heating up quickly – unfortunately for them. In the previous six months, I’d read several articles in finance blogs or newsletters about yet another company that had just been financed in their specific vertical. Most of the financings I read about were for $5 to 20 million. This local company has been built on something around $1 million.

This is a scenario I’ve seen about a hundred times before: too much money flushing into a space the VCs think will be hot. Too many companies being founded with exactly the same business plan.

These entrepreneurs were too young to attract the amount of capital they’d need to compete in this new environment. They had only two strategic options – an early exit or hiring a ‘name CEO’ who just might be able to raise a big enough round in time. I recommended an exit because I knew the money flowing in to their space would also increase valuations – possibly by 2 to 5x over normal ranges.

You can probably guess the young entrepreneurs wanted to wait a ‘little longer.’

Most CEOs don’t have time to keep up with the macroscopic economy, or the micro markets for selling their type of companies. They need advisors who have the time to stay current on the big picture and help them incorporate these market effects into their exit strategy.

Under Appreciation of Exits as a Strategy

Selling the business is an under appreciated business, and life, strategy. CEOs make important strategic decisions every day – often subconsciously. Most CEOs have never executed one exit and only a very few have done two. This inherent lack of familiarity results in exits being a very underused strategic alternative.

Most CEOs miss their optimum exit window simply because they haven’t been thinking about their exit and haven’t built alignment on an exit strategy. (I wrote about exit strategies in the previous edition of the Acetech Newsletter.)

Selling the company is also a life strategy. During my two decades in YPO, I got to know many successful CEOs. I watched many of them sell their companies. The exits were always a milestone in their lives and in every case I’ve been close to, the exit was a very positive event. And it was not just the successful exits that were positive life events – even the exits that might not have been considered a success by some of the investors were always positive events for the founders and CEOs.

I have come to believe that founders, executives and investors would all make more money, and have more fun, if we understood exits better and utilized exits more often as a business strategy.

And Largely Human Nature

I don’t want to be too hard on the young entrepreneurs I wrote about earlier. They were mostly victims of human nature.

They just couldn’t think about selling because they were having too much fun. They were leaders in their market and big companies were enquiring about huge orders. They knew their revenues were getting ready to grow – and possibly explode.

Unfortunately, they couldn’t appreciate that it was also the absolute best time to sell their company. In fact, they should have started the exit process 6 to 12 months earlier.

Human nature also affects the buyers. They will always pay the most when everything is going perfectly and the future looks even brighter. The buyers’’ human nature also means that a skilled M&A advisor can usually sell for a lot more based on the ‘promise’ rather than the ‘reality.’

Human nature also works against the entrepreneurs on the downside. The reason human nature ends up costing most entrepreneurs, and their investors, a lot of money is because most of the time CEOs and boards wait until it’s pretty clear that the company’s value has peaked before starting the exit process. By the time the buyers get to the serious price negotiations, it’s also clear to them that the company’s best days are behind it. And another 6 to 18 months has passed, which has usually allowed the trend to extend even further. The result usually ends up looking something like the graphic above.

When you do an Internal Rate of Return (IRR) calculation for an investor, the difference can be dramatic. Using the hypothetical example from the graphic above, an exit in 3 years at a 5x return works out to an IRR of 124%. If the company waits until the peak, then starts the process, and ends up selling for 2x at year 6, the IRR is only 15%.

With exits, like many things in business and life, timing can be (almost) everything.

Video of “How Not to Sell a Business – Don’t Blow the Biggest Deal of Your Life”

If you’d like to hear more about everything I did wrong during my first exit, and avoid some of my expensive lessons, this is a video  of a talk I gave the to the Vancouver  Entrepreneurs Organization titled: “Don’t Blow the Biggest Deal of Your Life“.

How VCs Block Exits

Most entrepreneurs don’t even know that a VC is likely to block an  exit when they accept the VC’s money. I didn’t when I started out —and neither did my friend who I describe in “Why VCs Block Good Exits“.

In my first company it wasn’t until the final extraordinary general meeting, when the shareholders were voting to approve the exit transaction, that I actually realized how aggressively a VC will try to block an exit.

VCs design their investment agreements to give them the power to block exits.  VCs worry that after they invest, the entrepreneurs will want to sell the company for something that might give the entrepreneurs a 100x return and the angels a 10x return but only a 3x return for the VCs. This concern was one of the reasons that VCs wouldn’t invest in Brightside.

My previous post, at the link above, has more on why VCs block good exits.

The Legal Mechanisms

VCs usually build in more than one way to block exits:

  1. The most effective way VCs block exits is with the terms in their preferred shares. Like my younger self, most first-time entrepreneurs have no idea how multiple share classes really work. For example, when I was starting out, I did not understand that different classes of shares each have to vote separately to approve important transactions. Usually, the VCs are the only ones with the pref shares, so they effectively have a built-in veto.
  2. VCs can also effectively block exits by dominating the boards of the companies in which they invest. This is usually a contractual commitment of their investment.
  3. They will also have terms and conditions in their investment agreements that allow them to make the decisions about when a company can exit.

Even the Y Combinator Docs Provide an Exit Veto

Paul Graham and Y Combinator are making enormous contributions to the evolution of entrepreneurship and early stage investing. Y Combinator invests very small amounts of money into early stage companies through an innovative, modern incubator model.

I admire Paul Graham for posting their term sheets and financing agreements. Even these simple agreements for very small, first financings contain absolute veto powers on exits:

“So long as any of the Preferred is outstanding,  consent of the holders of at least 50% of the Preferred will be required for  any action that: … or (iii) approves any merger, sale of assets or other  corporate reorganization or acquisition.”

I am not saying this is wrong. In an earlier post on Preferred vs Common Shares I point out that in some situations preferred shares are necessary to be fair to the investors. Even where there is a board in place, there may still be situations where it makes sense for the investors to have veto power on exits. There is, however, no way to solve the fundamental conflict of interest when holders of preferred shares sit on boards. Nor is there a way to repair the fundamental lack of alignment between common and preferred shareholders.

My point is that every entrepreneur and board must fully understand how their exit options will be impacted before accepting any pref share investment.

A Chilling Perspective from a Law Professor

For a fascinating, and chilling, perspective on how venture capitalists view entrepreneurs and exits, read this paper “Control and Exit in Venture Capital Relationships” by Gordon Smith of the University of Wisconsin Law School.

Smith has obviously spent a lot of time working with VCs. Some of his language provides an invaluable perspective into how VCs control  exits:

“In most venture capital contracts, veto rights are designated as “protective provisions”. They are also referred to by lawyers as negative covenants. For present purposes, the most important veto rights are those that prevent the company from forcing an exit decision…

Even if entrepreneurs value control highly, they cannot demand its retention at the time that they are seeking venture financing.

…this paper describes a relationship in which a combination of staged financing, board control, and contractual protections ensures that venture capitalists are able to pursue the most desirable exit options.

In these early stages of the relationship, the outside directors would usually be selected by consensus, as conflicts between the venture capitalists and entrepreneurs have not yet (fully) surfaced.

First, they use negative contractual covenants (often called protective provisions) to limit the ability of the entrepreneur to act opportunistically. These covenants typically prohibit the portfolio company from engaging in fundamental transactions (e.g., mergers) without prior approval of the venture investors, thus cutting off the means by which common stockholders have traditionally taken advantage of preferred stock.

In the early stages of the investment, therefore, venture capitalists are less concerned about initiating exit than they are about protecting against forced exit. As the business matures, new conflicts begin to play a more prominent role.

The tricky part of venture capital contracting stems from the need to make mid-stream adjustments which position the company for one exit strategy or another. The potential for conflict between the venture capitalist and the entrepreneur is most visible at these moments, and the key feature of the relationship is control.

Preferred stock has fallen out of favor with most investors, but venture capitalists rely almost exclusively on convertible preferred stock. Bratton attempts to explain why. Like A&B, Bratton relies on the notion of control. Where venture capitalists have full control – holding a majority of the votes in a corporation and electing a majority of the board of directors – the venture capitalist may block any potential opportunistic actions by the entrepreneur. On the other hand, where venture capitalists do not control the voting shares or the board of directors and rely exclusively on contractual covenants and other provisions for protection, room for entrepreneurial opportunism exists.”

This paper is not easy to read, but I highly recommend it for anyone considering a preferred share investment.

Exit Timeline with Venture Capital Investors

My previous post showed how  the math behind venture capital funds determined venture capital exit times.  The post included a simple model to show what the median exit times really meant to entrepreneurs and angel investors.

That model illustrated how the decision to accept equity from venture capital investors statistically extends the time to  exit for the angels by a decade or more.

The graph below illustrates that  happens to the time to exit, and probability of exiting, without and with venture capital investors. This graphic shows this from an angel investor’s perspective. The times are even longer for the entrepreneurs and friends and family investors.

The model, and the graphic below, illustrate a typical startup where if the board decided to exit before accepting VC investment, it might have been sold around year six – four years after the angels invested. But when venture capital investors are added to the corporate DNA, the time to exit extends to somewhere around year sixteen, twelve years after the angels invested.

Exits with Venture Capital Investors

There isn’t any actual  data on this yet, but the  implications are clear. If a company accepts financing from  venture capital investors,  the minimum exit valuation per share has to be 10-30 time more than the price the VCs paid. The venture capital investors will almost certainly block any attempt to sell a successful company that does not meet their minimum required returns.

Holding out for a very high value exit  will dramatically reduce the chances of success and  statistically extend the exit time for the angels and entrepreneurs by over a decade.

This is a main element in my new book: “Early Exits – Exit Strategies for Entrepreneurs and Angel Investors – But Maybe Not VCs“.

Google Wants Even Earlier Exits than in “Early Exits”

The main thesis of my book Early Exits is that entrepreneurs and angel investors would make more money, and have more fun, if they built companies around a strategy of early exits.

In “Early Exits” show that most M&A transactions are under $30 million. More recently, I have been saying that  the median price might be as low as $15 million.

Part of my message to entrepreneurs is that they don’t need to build companies to be profitable before they can execute very good M&A exits. This is a main theme in why I think this period will come to be called a Golden Era for tech entrepreneurs.

The fundamental driver behind this trend is that big companies have learned that M&A is the best way for them to grow.

But even I was surprised to learn just how early Google wants to do acquisitions.

Charles Rim, is one of the five most senior M&A professionals at Google worldwide. He did an interview for Corum’s online “M&A Class.” I am grateful to Corum for organizing this event and for posting the archive. (The Corum archive does not seem to be available any longer, so I’ve re-posted below. There’s also a transcript here.)

A few  of the fascinating points from the  interview are:

“90% plus of our  transactions are small transactions.  So  that would be less than 20 people, less than $20 million and that is truly the sweet  spot

“we do prefer companies that are pre-revenue

“technical staff, engineering, a strong engineering team, these are the  things that we think are very important to the future success of Google and  important for us to use acquisitions in that manner.”

This provides some excellent insight into how a very large company like Google thinks about acquisitions. This is a good confirmation of the trend toward early exits, but it goes even further than I did in my book.

Google actually prefers companies that are pre-revenue. In other words, Google doesn’t want to buy the business, they want to buy the team. The people. The entrepreneurial ingredient  that they know they need to keep their company growing and healthy.

You’ve heard it from one of the guys who really knows –  you can sell a tech company today long before it’s profitable, even before it has revenue. And if it was up to Google, it would be the latter.

Exit Execution – Part 3-2

Early Exits Workshop – Part 3-2

Sponsored by the Angel Capital Education Foundation and the Angel Capital Association
…presented at the Angel Capital Association National Summit, San Francisco May 5, 2010

Highlights of Exit Execution – Part 3-2

  • The exit timeline – why the first question is often “How long will it take?” The honest answer to how long it usually takes
  • Timing is important, when to tell the team, things to do before contacting the first buyer
  • Building the sales funnel, the auction and bidding process, negotiating and closing

Part 3-3 of the Early Exits Workshop is online here.

The Exits Workshop Videos are also available on YouTube.

It’s a Good Time to Sell a Tech Business

This is a very good time to sell your technology business – so good you might want to accelerate your exit strategy.

There is an  interesting article in the April 7, 2008 issue of Business Week titled “Ravenous for Small Tech”. The article reports that while the change in value of mergers and acquisitions in ‘all sectors’ is down 51% in 2008, compared to last year, the value of ‘high technology’ M&A is actually up 132%.

In a May 2008 article in Mergers & Acquisitions, Tom Stein said: “2007 will be hailed as the biggest year for acquisitions of venture-backed technology since the dot.com days.”

Why is this happening now and how should this affect your exit strategy?

Big companies are using company acquisition to grow

The main reason the M&A market is so active is company acquisitions are now the best way for large companies to grow. This is summed up nicely in a quote from Vivek Mehra, general partner at the venture capital fund August Capital in Silicon Valley: “Big companies stink at innovation, and they know it.”

Acquiring works so well that many big companies are now spending more on company acquisitions than R&D. Take Microsoft for example, according to Tom Stein: “Microsoft is seeking 20 companies, worth $50 million to $1 billion, and will spend more on acquisitions in fiscal 2008 than on R&D for the first time in its history.”

Cisco also prefers to “buy rather than build.” They have acquired 125 companies since 1993.

These big companies have large internal divisions completely devoted to buying companies.

It’s also a great time to  sell a business because large companies are sitting on loads of cash. So much it’s actually a problem for company management because shareholders want them to either invest the capital to create growth or distribute it to the shareholders as dividends. Distributing cash is considered an admission of defeat for tech company management because it shows they don’t have any ideas on how to invest cash to increase shareholder value.

Big companies are also trying desperately to re-energize the entrepreneurial cultures that got them started in the first place. This is described well in a December 2005, Business 2.0 article: “The Flickrization of Yahoo!” The story describes how Bradley Horowitz, the head of Yahoo’s developer network, decided to offer Flickr’s founders $30 million for their startup. Horowitz invited Butterfield and Fake to Silicon Valley in late 2004. They had lunch in the Yahoo cafeteria and immediately hit it off. “I met Stewart and Caterina and fell in love,” Horowitz recalls. “It was beyond Flickr. I saw them as kindred spirits, entrepreneurs who could infect Yahoo with that small-company focus.”

Examples of  tech company sales

Last summer, a partner and I completed a very successful sale of one of our portfolio companies, Parasun. Working on that company sale left no doubt in my mind that the market is hot. The bidding was very active and we wound up selling the company for about 50% more than the founders and board had set as the exit strategy goal less than two years earlier.

Another great company sale example is the acquisition of Hostopia on June 19, 2008. This Toronto based web hosting company was trading around $5.00 per share just prior to the acquisition announcement at $10.55 per share – double what it was trading for. Some other  examples of public company exits with 50% price increases are on this page.

This just might be the best time to sell your business

Nobody can predict the future. This may be near the peak of the tech M&A market, or it might be a trend that will last several more years. If you have been thinking about selling your business, now looks like a very good time.