No One Can Sell Your Cash Well

What I’m about to describe is difficult for some people to understand. Recently, I completely failed to convey this concept to an experienced professional accountant.

The fact is, nobody can sell your cash well.

What I mean is this: if you’re thinking about selling your company, I feel strongly that it’s desirable to strip out the cash that’s not absolutely necessary before starting the exit valuation negotiation with prospective buyers.

Even better, the company should have just the right amount of debt, probably in the form of a bank operating loan, to smooth out the peaks and valleys in working capital.

While I can’t prove this mathematically, I feel strongly enough to recommend that owners strip out the cash before the exit, even if it means incurring some tax.

The simple reason is that buyers will pay less than a dollar for a dollar’s worth of cash. (This made no sense at all to the professional accountant that I tried to explain this to recently.)

It may help to imagine two scenarios, where companies with exactly the same income statements have balance sheets which differ by $1 million in excess cash. If you offered each of these companies to 100 buyers, the average price for the company with the cash would be less than $1 million more than the company without the cash.

This is the result of the imperfect science of company valuation plus the peculiarities of human psychology.

Valuation based on multiples

Almost everyone will think, at least in part, of company valuation based on revenue or profitability multiples. Buyers are used to thinking that certain types of businesses are worth four to six times EBITDA. Or that certain types of companies that are growing at 50 to 100% per year are worth three to four times revenue. These multiples evolve from comparative valuations.

When people use multiples for valuation, they often switch back and forth between the current year and the next projected year. Depending on the company growth rate, that can result in a very big difference in the valuation, which illustrates how imprecise valuation calculations are.

In my direct experience, almost nobody will take into consideration the additional value of having cash on the balance sheet when doing a valuation based on comparative multiples.

Cash makes the price higher

Having excess cash compared to working capital requirements makes a company more expensive. Sellers will expect to get the same multiple described above, plus a fair value for their cash. From the buyer’s perspective, they are being asked to pay what they think is a fair price plus an additional amount. (At this point the professional accountant thought I had lost my mind.)

But the reason this is an impediment is that the people who buy companies have to go through an internal consensus building process to get to an approval. Some of the people they need to ‘bring onside’ will not take the time to appreciate that there is excess cash on the balance sheet. I know this seems difficult to believe, and you’d expect that even people in a large company would care about whether there was an extra million dollars or not, but on average they care less than the actual value of the cash.

The higher the total price, regardless of how much cash is on the balance sheet, the more difficult it is to get the valuation approved. This difficulty creates a suppressive effect on the total valuation (i.e. the value of the business + the cash).

Most buyers have too much cash

It’s a fascinating and difficult-to-appreciate psychological fact that most buyers have so much cash that it’s a problem. For them, having cash come along with an acquisition really isn’t any advantage. Cash is the least of their concerns.

Working capital efficiency

Perhaps the most logical reason that nobody can get full price for excess cash is that buyers will assume that the previous shareholders left that cash in the company because it’s required to operate the business. What this means is that the buyers will discount the value of the cash because they consider it necessary to generate profit. In their minds they’re paying for the stream of future profits, and they don’t really spend a lot of time thinking about what assets are required to generate those returns.

The more working capital that’s required, the more they’re going to reduce the value of the business. In other words, the most valuable company is one that can generate a given profitability on the smallest amount of working capital. In other words, that company is a more efficient generator of profits – and is therefore more valuable.

Closing working capital

An experienced M&A Advisor will always negotiate the amount of working capital at closing. This is one of several dozen tactics to maximize the value received by the sellers. It can also be a powerful tool in increasing the probability of closing.

The optimum amount of working capital at closing is usually zero, or perhaps a modest amount such as $250,000 or $500,000.

The idea situation when the transaction closes is not to have any significant amount of working capital above that specified at closing. The reason is that if the company has excess working capital, it will require another cheque to be issued by the buyer several months after closing. This is always problematic because in the post-closing transition it will take the buyers a number of months to stabilize their accounting systems.

Every time we’ve had to help buyers and sellers through a post-closing working capital adjustment it’s been arduous. The need to re-engage also occurs at a time when the buyer and seller are both looking forward to not working on the transaction, but instead working on the newly acquired business or their recently expanded investment portfolio.

Summary

Nobody can say how much any of these factors affects any individual’s perception of value. But there’s no question in my mind that, taken together, the important conclusion to be drawn is that the value of excess cash in a company is worth more to the seller than to the buyer.

For these reasons, it’s usually worth the time at the early stages of the exit process to investigate the options for stripping out the cash and possibly even putting in place enough debt to provide the optimum amount of working capital.

Gold, Silver and Bronze M&A Services

I recently had a fascinating conversation about fees with another M&A professional. We have never worked in the same geographic region, and had no hesitation about openly discussing our firm’s fee structures.

His firm is considerably larger than mine. They employ dozens of professionals, associates and support people.

We agreed pretty quickly on what reasonable fee ranges are for the kind of work that he and his team do. Their fees are very similar to the fees my firm offers in our region.

Working with Clients Who Want to Negotiate Fees

I asked how his firm handles prospective clients who want to negotiate lower fees. His reply surprised me. He explained that they have three tiers of service, gold, silver and bronze.

His firm developed this three tier system after working on some engagements for months, and ultimately losing them to other firms in their area who offered M&A services at lower fees.

He went on to describe their fees for each tier:

– bronze level fees are about half of their gold service fees, and

– silver fees are midway between gold and bronze

The Difference between Gold, Silver and Bronze M&A Advisory Services

Fascinated, I asked what the difference was when clients selected gold, silver or bronze. He explained that there are really two factors that changed depending on the fee scale:

– the quality of the team

– how much effort they invest before giving up on a transaction

My friend said that when a customer agrees to their initial fee offer (the gold level service) they work with the “A team.” My friend is the head of the A team in this firm. Over the years he’d handpicked the very best to work with him on his transactions.

The B team are people in his firm who just don’t have the experience, or just aren’t good enough to be on the A team.

The C team are seconded from a sister firm that works as business brokers.

He explained there’s also a difference in how many hours his firm invests in a silver or bronze transaction. We both agreed that some transactions end up taking two or three times the hours anticipated, and that the right thing to do in each case is to continue until the company is sold. He was quite open about admitting that the commitment level is significantly less with the silver or bronze services. If a transaction doesn’t close after the first round of outbound communications, the firm  decides to move on to the next transaction (hoping it will be one of the easy ones).

Why His Firm Offers Three Levels of M&A Services

Personally, my friend has no interest in working on silver or bronze level exit transactions. He’s earned a reputation for being one of the best in the M&A Advisory industry. He prides himself on his exceptionally high success rate (completing 75% of the exits he starts).

But as a partner, he’s pleased his firm offers three qualities of service because:

– after investing time getting to know a company they don’t like losing the business to a firm offering a less expensive service, and

– it gives his firm an opportunity to train new hires and keep their B team players working (he candidly admitted that even in his firm not everyone is an A team player).

The Difference to the Client – Price and Probability of Success

I asked about the difference for their clients between gold, silver and bronze services. He said they discuss that question often inside their firm. They want to be sure that their silver and bronze level services are competitive with other firms offering similar fees in their market. He was very clear that the important differences for the clients are:

– the probability the transaction will actually complete, and

– the price the company sells for.

Intrigued, I asked if he had a gut feeling for how different the prices and probabilities are for their three levels of service. He admitted that it was very hard to be specific, because even a firm like his doesn’t have enough data to provide certainty about statistics.

His opinion was that the difference in the price received by the shareholders might be as much as plus or minus one-third.

He added that the differences in the probability of success are much larger.

As we finished up our conversation, I asked if his firm ever discussed their three tiered pricing structure and service levels with prospective clients. He looked a little surprised and said, “Of course not.” He then asked me to promise I’d never attribute our conversation to him.

I admire the strategy my friend’s firm has developed. They have done what most successful companies do – responded to market demand for different products. They are large enough to be able to offer a client everything from economy to top tier M&A advisory services. It all depends on what the client really wants.

Thinking about our conversation afterwards, I decided it all comes down to how important a particular exit transaction is to the shareholders. I supposed if the company is a small investment in a larger fund, a bronze or silver level service might seem to be a reasonable choice. But if it was a company that I’d invested years building, I can’t imagine wanting anything less than the gold level service.

M&A Advisors Should be Local to Reduce Failures

When CEOs and boards begin to look for an M&A Advisor, they often start in one of the big financial centers like New York or Boston. For most transactions under $100 million, I believe an M&A Advisor more than a couple of hours away by car is usually a bad choice.

One of the dirty secrets in the M&A Advisory business is large number of M&A Advisory engagements that fail to result in a successful transaction. It’s impossible to find statistics on this. Every M&A Advisory firm keeps their failure rate a closely guarded secret – many probably don’t even calculate their failure rates.

For over a couple of decades now, I have been asking every CEO, board member and investor I know to share their M&A successes and failures. My twenty years in YPO also provided a broad perspective on M&A transactions, both successes and failures.

Most Planned M&A Transactions Fail (under $100 million)

I used to think that at least half of M&A transactions failed. As I learned more, I realized that the percentage of times a planned exit fails to result in the company being sold is closer to 75%.

Failure Increases with Distant M&A Advisers

After hearing first hand about the success or failure of over a hundred transactions, I realized there were several patterns. One is that the M&A transaction failure rate increases as the distance between the company and the M&A Advisor increases.Distance to the M&A Advisor (in miles)
The reason the success rate decreases with distance is that the relationship between an M&A Advisor and a company, CEO, board, their accountants and their lawyers is intimate and intense. Even the smartest M&A Advisor needs a considerable amount of time to really understand the value drivers in a company, its strategic value and who the best potential buyers are.  Much of this work has to be done face to face at the company.

The middle part of an M&A Advisor’s job can be done remotely – the prospecting, qualifying and sales funnel building. But in the latter stages of the M&A process, during the auction, negotiation and closing, the M&A Advisor will be working close to full time to help the CEO and board close the transaction. Most of this work also has to be done in the same city as the company. This is partly because the selling company’s lawyers and accountants are usually in the same city as the company.

Another reality of M&A transactions is that inevitably, ‘stuff happens’. In some of the transactions I’ve been involved with, the deal looked like it was dead several times. These ‘near death experiences’ require immediate action to resuscitate. It might require reconsidering the entire transaction strategy, working through an unexpected snag in the agreement and/or working through the business – and psychological – implications of whatever deal factor that’s changed. This type of work is almost always unexpected, and requires face to face action on short notice. That’s just less likely to happen if the M&A Advisor has to factor in travel and hotels. Failing to resolve even one of these potentially fatal challenges  usually means the transaction is dead.

The really good M&A Advisors factor this in and will plan to spend up to half of their time in the same city as the company during the first third of the process and be ready to spend most of their time in the same city during the last third.

There are M&A Advisors who claim they can do most of the work remotely –  with only weekly visits to the company. Those are the ones that CEOs and boards should be wary of. Even in today’s hyper connected world, you cannot do a really good job as an M&A Advisor without a great deal of face time.

From the observations I’ve made, I believe the failure rate doubles with distant M&A Advisors. In other words, a hypothetical company using a remote M&A Advisor might have a failure rate of 50%, but with a local advisor the failure rate might only be 25%. For another company, the failure rates might only be 40% and 20% respectively.

Please keep in mind that these are very approximate percentages based on observations. There simply are no databases of exit transactions and M&A Advisor distance that could be used to precisely quantify this effect.

Distance Matters Less When Transactions are over $100 million

From what I’ve seen, this effect is significantly reduced when transactions are over $100 million. When an M&A Advisory firm is working on a transaction over $100 million, the fees are usually a few million. There are also often two, or three, senior individuals involved with deals over $100 million.

When the fees are in the multi-million dollar range, the M&A Advisors can afford to fly to the company almost every week and spend most of their time in hotels for many months. It’s also easier on their lives if they can split this between two or three senior people.

But this just doesn’t happen when the fees are below a million dollars. For sub-million dollar fee transactions, there is almost always only one senior person on each transaction. The economics, and human costs, just can’t justify more people, or the travel required, on smaller deals.

The A-Team Usually Works on the Largest Transactions

Another dirty secret, or obvious reality, depending on your perspective is that the best people in each firm will be working on the most valuable engagements. It’s also well known that the people the client meets during the sales process are often not the ones that will be doing the work after an engagement is signed. Similarly, many firms will put their B team, or even their trainees, on the assignments that are farthest from their office.

Reputation is also More Heavily Weighted Locally

This is where another dirty secret of the M&A Advisor business comes into play. Professional M&A Advisors know that every deal doesn’t end up closing. They build their business models, and manage their sales funnels and calendars, based on their knowledge that somewhere between a third, and two thirds, of the deals they sign up to do will probably fail. These M&A Advisors will still do OK on the deals that fail because their direct costs will be covered by the work fee.

Part of optimizing their business is knowing when to stop working with a company because the probabilities of success are too low. This is usually 6 to 9 months after they sign the M&A engagement.  At that point, if the transaction looks like it’s not going to close soon, many M&A Advisors will reduce the amount of time they spend on the company. Instead they’ll devote their time to other companies with new work fees and higher probabilities of success.

This is Especially Likely When the First LOI Doesn’t Close

In every M&A transaction, the company has to select a single prospective buyer when it’s time to accept an offer and sign an LOI (letter of intent). At that point, they have to contact the other interested parties on the short list and tell them they cannot continue discussions with them.

From the time the LOI is signed to closing is often around three months. If the deal falls apart after a month or two, the other prospective buyers have usually moved on to other opportunities and it’s usually quite difficult to get them back to the table.

When this happens, the M&A Advisor has to go back and rebuild the entire sales funnel. This is when I’ve seen many M&A Advisors throw in the towel – especially when they’re busy.

The challenge in rebuilding the funnel is that the M&A Advisor will have already contacted most of the best prospects. If they have to go back to the same buyers, the perception will be that they did not succeed the first time. This makes it much more difficult to build momentum on the second pass. It’s also psychologically much more difficult for the M&A Advisor. So they’ll be inclined to move on to a ‘fresh’ deal and blame the failure on the company, valuation expectations or a ‘difficult’ CEO or board.

It’s Much Easier to Give Up on a Remote Company

It is just easier for an M&A Advisor to give up on a company that is further from their office. When M&A transactions fail, quite a few people will hear about it. But those people are usually geographically close to the company. The negative impact to the M&A Advisor’s reputation will be similarly localized.

If the M&A Advisor is geographically close to the company, they will be much more likely to persevere to protect their reputation.

This is another factor that is much less important for transactions over $100 million. With these  larger opportunities, local effectively translates to most of the country.

For Under $100 Million You Really Should Chose a Local M&A Advisor

Many CEOs and boards engage remote M&A Advisors because they think that somebody from New York or Boston must be better than someone who lives within driving distance. Or they believe that domain expertise is an important selection criterion (more on that myth in a future post). In my experience, the perceived benefits are mostly psychological – it’s like that old adage about a consultant just being a regular guy a long way from home.

The difference in a simple consulting job might not be significant, but when it’s your company being sold, and it’s under $100 million in value, I believe you really should chose an M&A Advisor close to home.

How Not to Sell a Business

This is the first time I’ve described all of the things we did wrong the first time I tried to sell a business. It’s also the story of the first time I lost several million dollars.

How Not to Sell a Business – Don’t Blow The Biggest Deal of Your Life

This is a talk I gave to the Vancouver Chapter of the Entrepreneurs Organization (EO) on February 19, 2009. It is consistently the most viewed video on my blog.

In this talk, I compare my first experience selling a business to a more recent one where everything was perfectly planned and executed.

PowerPoint PDF here

Highlights of Part 1:

How Not to Sell a Business Part 1

  • This is the first time I’ve described all of the things we did wrong the first time I sold a business. It’s also the story of the first time I lost several million dollars.
  • During this presentation, I compare my first business sale to a more recent one where everything was perfectly planned and executed.
  • My story begins with the launch of my first company, Nexus Engineering, while I was still in university.

Highlights of Part 2:

How Not to Sell a Business Part 2

  • I wish we had done a secondary sale before we sold the business.
  • I confess that we had never discussed our exit strategy.
  • We start to learn about exit strategies at the worst possible time.
  • We make the classic error of having the CEO sell the business.
  • I learn that every business sale needs multiple bidders.
  • What happened because we hadn’t checked the alignment on our exit strategy.

Highlights of Part 3:

How Not to Sell a Business Part 3

  • Painful lessons about how nasty take-over battles can get when you sell a business.
  • I was a rookie and ended up playing defense all the way through.
  • We finally get the business sold, but my regret was that we ‘rode it over the top’.
  • It took me another ten years to understand all the things we did wrong.
  • The truth is… we were lucky. To this day, I wish we’d had a good exit strategy and checked the alignment before we started to sell the business.

Highlights of Part 4:

How Not to Sell a Business Part 4

  • This is the story of the Parasun business sale – where we did everything perfectly.
  • We developed alignment on a simple exit strategy at an offsite planning retreat.
  • At Parasun, we successfully executed two secondary sales before we sold the business.
  • We sell the business right on schedule, but the price was 48% higher than the target.
  • A comparison on the Nexus and Parasun exits – what to do and what not to do selling your business.

Many of these lessons are described in my new book on selling businesses for entrepreneurs and angel investors – www.Early-Exits.com.

If you enjoyed this video, you might also like this one on Exit Strategies or this series on Maximizing Value in Business Sales.

Only 25% of Saleable Companies Exit

I’m convinced that only about 25% of the businesses that could be sold actually end up successfully exiting.

Yes. I believe that about three out of four times when a company could have been successfully sold, a sale did not end up happening – ever. And most of the time, it was avoidable.

The Frustrating Lack of Data on Exits

One of the most frustrating aspects of researching exits is the lack of data on transactions under $50 million, which are about three quarters of all exits.  I have spoken with most of the organizations that manage databases that include information on entrepreneurial companies, early stage investments and exits, and I am certain the data does not exist.

There are now a few groups who are just starting to accumulate some of this data, but we’re at least a decade or two away from having a sample large enough to be useful in developing best practices on exits.

This lack of valid data means that while something may be true, and even fairly obvious, most of the time we just can’t prove it.  For now, the best we can do is develop best practices based on empirical observations.

This article is about one of these truths. Based on my observations and hundreds of conversations with entrepreneurs, investors and M&A professionals, I have no doubt that what I have written here is true, but I wish we had the hard data to prove it.

My Observations on Exits

Since the early ‘80s, all I have done is start, grow, finance and sell technology companies.  I have invested in about fifty companies, sold several dozen and had a front row seat to watch more than a hundred grow from their early stages to their eventual conclusion.  I believe I’ve developed a pretty good understanding of which companies were saleable and when.

I Believe Only 25% of Saleable Companies Actually Exit

I’m convinced that only about 25% of the businesses that could be sold actually end up successfully exiting.

Yes. I believe that about three out of four times when a company could have been successfully sold, a sale did not end up happening – ever. To be clear, I am not including unsuccessful exits – for example, where the company has not succeeded and another entity acquires the assets for a low value. What I am writing about here are ‘successful’ exits where the investors end up with a smile on their face.

It is also possible that a single company will end up creating more than one saleable business. The best example is our recent understanding of how many startups pivot. Often pivots are the result of failing to exit the prior business when there was an opportunity. It’s not uncommon for persistent management teams to build two, or three, saleable businesses in one company before they actual exit.

Of course, I’m not saying this happens exactly 25% of the time.  We just don’t have the data to be anywhere near that accurate.  But I’m certain it’s less than half the time, and I’m pretty sure it’s less than a third of the time.

What gets me excited is imagining how much wealth could be created if we could improve our best practices to increase this percentage of saleable companies to even 50%. That would double investor returns and create twice as many wealthy founders and entrepreneurs.

Increasing the rate of successful exits to half would also create a lot more economic activity. Investors would invest more capital, more entrepreneurs would create startups, and more successful early stage companies would be scaled up by cash-rich corporations and private equity funds, all of which would create more economic growth and good quality jobs.

Why Do Only 25% Exit Successfully?

Why do so few companies that could be sold actually exit successfully?

Like many parts of business, or life, there is no single, simple explanation.  Each case includes a different combination of factors which combine to end up in either a successful exit or not. Following are some of the main reasons companies end up failing to successfully exit.

1.    The Exit Team Failed to Execute

In a depressing number of cases, the board of a company will decide that they would like to exit but the team they assemble will fail to execute.  I believe there are two primary reasons this happens:

– The company wasn’t actually saleable (at that time), or

– The team that was assembled didn’t have the skills and experience to successfully execute the exit.

I used to think that when a board decided to assemble a team and execute an exit, they were successful about half of the time.  More recently, though, as I have observed more attempted exits and spoken to at least a hundred more M&A professionals, I have revised my estimate, and I now believe attempted exits under $50 million only succeed about 25% of the time.

This summer, I spoke at the national AM&AA conference in Chicago, and another speaker there said that she thought the percentage of time companies successfully executed their exit was only 5 to 7%. Here statement was based on the often referenced study from the US Department of Commerce that reported only 20% of the businesses that are for sale will successfully transfer hands to another owner.

2.    Boards Don’t Realize the Company is Saleable

I’m surprised to see how often an entire board will fail to realize that a company is approaching, or has even passed, a saleable stage of development. I think there are two reasons why boards miss this so often:

– Experienced directors are very difficult to recruit and retain today. Very few boards have even one member who has been closely involved with more than a few exits.

–  Many of ‘the rules’ about M&A exits have changed dramatically in the last ten years. Very few entrepreneurs, directors or investors appreciate how much this part of the economy has changed. Experiences from a decade ago can often lead to entirely wrong conclusions.

These factors often lead boards to develop strategies to:

–  delay starting the exit process,
–  accept additional financing because they believe the company needs to scale before exiting, or
–  accept licensing or partnership offers because they feel like a bird in the hand.

In a short while, I will be sharing some very valuable information about the Pacinian exit.  This was a good example of where directors and stakeholders had a variety of mutually exclusive opinions about the best strategy for the company.

3.    The Board was Waiting for an Unsolicited Offer

This is one of the exit failures I really hate to see. Surprisingly, boards believe the right exit strategy is simply to wait for an unsolicited offer.  This almost certainly ensures an exit valuation significantly below market. But worse, this strategy also dramatically reduces the probability that the exit will actually complete.

As I have said many times before, I think it’s almost always bad news for shareholders when a company receives an unsolicited offer. Yes, just receiving the offer is usually bad news.

4.    Riding it Over the Top

“Riding it over the top” is an increasingly common way to fail to exit. I don’t’ want to be too hard on the decision makers in these companies. This is a relatively new factor in our economy, And the importance of not riding it over the top has increased significantly in the last few years.  Here’s my guide on how to ensure you don’t ride it over the top.

This talk also describes why exit timing is so critical and why missing the optimum time to exit doesn’t just mean exiting later and probably for less money. It very often means not exiting at all.

How to Improve Your Probabilities of a Successful Exit

What can your company do to improve the probabilities of a successful exit?

There are quite a few elements to a complete answer, but I think the two most important are:

–    Education – Read all the good information you can find, and talk to as many knowledgeable people as you can get in front of. If you have the opportunity, attend some of the new workshops on exit strategies. (Here is a link to an excellent exits workshop coming soon.)

–    An exit strategy – I strongly believe every company should have an exit strategy. This one best practice alone will dramatically increase your probabilities of a successful exit.

Please post a comment below if you disagree with my 25% estimate of if you have suggestions on other ways entrepreneurs and boards can improve this percentage. Thanks.

The Psychology of Exits

When a saleable company fails to sell, it’s often the seller’s psychology that kills the transaction. Most of the time, the seller doesn’t even know that they were the reason their company failed to sell. This talk describes the seller psychologies that can kill exits.

The Psychology of Exits
Presented at the Alliance of Merger and Acquisition Advisors Summer Conference
July 10, 2012 in Chicago

Highlights:

  • What percentage of M&A transactions close after an M&A Advisor has been engaged?
  • According to a speaker from a large multi-national M&A Advisory firm, only 8% end up closing
  • Why do ‘saleable’ businesses fail to sell?
  • Is the fault most often with the Buyers? Or the Sellers? Or the M&A Advisors?
  • Two reasons the Sellers are the most likely cause of an M&A failure:
    1. The business becomes un-saleable
    2. The Seller’s psychology – including some of these common psychological pitfalls:
  • Unrealistic value expectations
  • “It Feels Like I am Selling my Child”
  • “My Business is Me”
  • “I am Still Having Fun”
  • Fear and Greed
  • “I am the Smartest Guy in the Room”
  • Approach Avoidance
  • Cloaked Decision Makers

This is the Powerpoint for The Psychology of Exits.

The Psychology of Exits – AM&AA Summer Conference 2012 from AM&AA on Vimeo.

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“.