Companies are being acquired at earlier and earlier stages – often just 2 or 3 years from startup. Why is this happening now? A large part of the answer is that this is another natural consequence of the internet – part of the development of our economy and the evolution of our species.
There are some excellent early exit stories in BC. Early exits helped make my early-stage venture capital fund a success. Early exits also boosted the returns in my new angel fund and provided our early investors a 100% return of their capital in just over two years. Research on venture capital returns from research at the University of British Columbia (UBC) shows we are very good at early exits and it makes BC a great place to do startups and invest early.
Yet, when I first blogged about how early exits were good for BC’s entrepreneurs, angel investors and economy, most of the comments to my post were negative. There are surprisingly few hits on the keywords “early exit” – more common are keywords ‘built to flip’. Writing associated with those keywords is also predominately negative.
What’s going on here? Objective research clearly shows that early exits are a good thing – a very good thing.
In my opinion, it’s just a byproduct of progress. Most people don’t like change – don’t adapt well to change. In my grandfather’s time, people resisted air travel. Some politicians are still trying to hold back international trade and globalization.
The most significant change in mankind’s history isn’t air travel or atomic power – it’s the internet. Today, at the beginning of the Web 2.0 era, our species is starting to actually experience the network effect. Everybody is connected to everyone – globally. The majority of mankind’s knowledge has been indexed and is available instantly to everyone regardless of where they are and how much money they have.
The most dramatic effect of the internet is that everything is happening faster – internet acceleration.
Companies are being built faster
In my first startup we built hardware – equipment that bolted into racks. We beat our Fortune 500 competitors because we were really good at rapid product development. We could conceive of a new product line, do the R&D and introduced it to the market in only 3 or 4 quarters. It took our competition two or three years.
My contemporaries who were building enterprise software companies were also trying to get their product development lifecycles down – from years to quarters. (It still takes Microsoft about five years to fully (?) develop a new product.)
Today, at the beginning of the 21st century, entrepreneurs are having fun with “weekenders”. There are a variety of forms and websites but they are all about getting a group of entrepreneurs together to conceive a new startup. They think up a new company concept, build the product, launch it, market it and watch the first customers use the product – all in one weekend. It’s true – new rapid development software technologies allow talented developers to do ‘mashups’ where they can build entirely new web apps in only part of a weekend. Blogs, Google, Facebook and the rest of the web allows them to launch, market and make the first sales all in that first weekend. By Monday, they can have an idea of whether the new company is a success.
The internet has compressed what used to take two years, or two quarters, into two days – a couple hundred times faster.
Investors’ time horizons are also shorter
In the 20th century, the average person planned for retirement by contributing to their company’s pension plan. It was also common to think of life insurance as an investment. If people had additional investable capital, they probably had an account with a stock broker. People couldn’t do anything with their pension plans or life insurance policies for three to four decades. With a human broker, every time you picked up your phone (they had cords back then), you paid the broker about 3% of the value of the transaction. If your investment was completed they would mail you the details. People didn’t make investment decisions very often.
Companies, even startups, were usually funded by venture capital funds and institutions. These institutions were the pension funds and life insurance companies that had everyone’s retirement money. The people who managed that money were very patient – they were happy with ten year horizons.
People aren’t putting their money in pension funds and life insurance anymore. Institutions, especially in Canada, have eliminated their in-house venture capital teams and dramatically reduced their investments in venture capital funds. Most of the new money going into venture capital funds in Canada now comes from individual investors.
Nobody I know even has a company pension plan, but everyone has at least one ‘$9.95 per trade’ internet brokerage account. Everyone is making investment decisions much faster and expecting returns in far shorter time frames. We check the value of our portfolios hourly instead of at quarterly meetings with our financial advisors.
The internet has dramatically shortened investors’ time horizons and preference for liquidity.
Most of the hundreds of millions of dollars I have helped to raise so far in my career have either gone into angel investments or tech venture capital funds with at least five year hold periods. I’ve probably been face to face with a thousand investors who are making a decision about an investment. Every investor, whether it’s an angel or big fund manager, is more and more reluctant to make an investment with a long hold period (the time from investment to when you can get your money back).
In the public markets, the regulators used to impose a one year hold on most new financings to encourage investment and reduce speculation. Today, investors just won’t buy one year hold stock – modern exchanges now have four month hold periods. Brokers will tell you it’s getting more and more difficult to sell a four month hold period.
Imagine how a typical investment pitch to angels conveys the hold period. These days, when most entrepreneurs pitch their investment opportunities, they don’t talk much about IPOs. Instead, they usually say they plan follow their angel financing with a venture capital series-A round and then hope to be acquired. Here’s what the angel investor is thinking: “Oh, great. These guys want me to invest now. Then, in two or three years, they are going to let VCs into the company. The VCs will determine when and how the company gets sold. VCs usually hold their series-A investments for around seven years. So, if I am lucky I might get my money back in ten years. I think I’ll pass.”
It’s hard to be specific how the internet has changed investors’ appetites for long hold periods, but my observation is that investors are five to ten times more resistant to long holds today as compared to a decade ago.
Entrepreneurs and employees – the most important change
The most important internet acceleration is what’s happening to entrepreneurs and employees.
In the middle of the 20th century, people often worked for the same company for decades. In the mid-1980s when I researched vesting for my first startup, the typical vesting period was ten years.
A decade later, when I was a CEO in Silicon Valley, the longest vesting period that anyone would sign up for was three years. Today, most people appreciate that even with a three year vesting period, the psychological, or effective, vesting period is only about two thirds of that.
This means that founders and directors should start worrying that their employees are recruitable in about two years (assuming three year vesting). And most companies can’t just go out and hire new employees because they have already allocated all of the founders’ shares. Even if you have an option plan, the attractiveness of options has plummeted over the past five years (the subject for an upcoming article).
If the company isn’t looking at an imminent liquidity event or if the vesting hasn’t been properly structured, or if the shares have all been allocated from the founders trust, the company’s only alternative is to pay employees with more and more cash to recruit and retain. This is usually not a viable option for a company that’s just a couple of years old. Even if the money was available, it would be very detrimental to the alignment.
Over the past decade or so, I believe the internet has compressed founders and employees’ timelines by a factor of three to five times. The net effect is that these days, many companies that are four or five years from startup are starting to feel “old”. The best and brightest have moved on, the equity is all allocated, people rarely work on the weekends anymore and the share price is increasingly more and more slowly.
In the previous century, it might have taken ten or twenty years to grow a company to a point where it made sense to take it public or sell it. In my first startup we built a family of seven high tech companies. We didn’t sell the first one for eleven years and back then that didn’t seem unusual. The internet has changed everything.
Today, whether you look at it from the company development timeline, investors’ hold period or entrepreneurs’ personal timelines, internet acceleration means that most founders and boards only have a few years to build a company and sell it. The good news is that with good planning and execution that’s all the time it takes to do a good early exit.
Entrepreneurs today have an unprecedented opportunity to start and exit startups faster than ever before. It’s just progress – and another step in mankind’s development brought on by the internet. Instead of worrying about it, I believe the goal should be to focus on ways to design and execute even better early exits.
Postscript: and it’s just going to get faster
Internet acceleration is far from complete. I recently spoke with a university Dean of Engineering. He was deeply concerned that his late teen, early twenties, students did not have the patience to read even a few chapters of a book or sit through a fifty minute lecture. He said his faculty had no idea how to educate people with such incredibly short attention spans. I really depressed him by describing what was coming next.
Anyone with a teenager has seen how that generation uses instant messaging, SMS, twitter, micro-blogging and Facebook to conduct tens of simultaneous micro-conversations while at the same time professing to do their homework. They make fun of us because we still use email as our primary communications channel.
These kids have a tenth the attention span that I do but ten times the ability to multi-task. The teenagers of today will be the new class of entrepreneurs in just a few years and the most important investors in just few decades.
They’ll probably define an early exit as selling the company before the end of the weekender.