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In this installment of the series I want to focus on exit strategies. The first and most important thing to realize is that the expectations and, indeed, objectives of investors are necessarily different from those of the management team. The investor’s time horizon extends, by definition, only so far as a liquidity event that will allow them to recover their capital and realize a substantial profit from having taken the risk of investment. The management team needs to take a much longer view. They should be interested in building the company, and their wealth, far beyond that point.
One red flag is when the founders seem to have the same expectations as they do. This sometimes happens when investors fund companies headed by one of their ‘stale CEOs’. Many funds maintain close relationships with founders that they know and trust. Often, and sometime in concert with one of these CEOs, they will come up with an idea for a company. In these situations, the CEO tends to have the same exit expectations as the investors. The result is that there is no truly long-term vision for the company. Its culture becomes purely instrumental and self-serving. Personal greed, rather than effectively servicing the needs of the customers, dominates that culture.
Every definition of ‘investment grade’ must include a description of possible exits by the investor. It is important to realize that it is the investors’ definition of ‘exit’ that is the issue when talking to them. Although investors may pay token attention to management’s long-term prospects, they have a far different set of expectations when it comes to exit strategies.
- Investor Perspective: The investor perspective is driven by their approach to providing funding. They are approaching their participation in the company as an investment. This is a critical point. Investors are not treating the company as an investment; they are focused on their ownership in the company. Their analysis and expectations are driven by a calculation that begins with the investment and ends with its repayment with profit. Once their investment and profit have been recovered, the company will be a fading and hopefully fond memory. They will seek other opportunities for investing their funds. Investors are generally invested for short and medium periods. They always want to see the back door or doors as they enter the front.
- Entrepreneurs Perspective: Entrepreneurs, on the other hand, need to see their company as a long-term commitment; an investment of their time, resources and energy. Investors will respond negatively if the founders clearly intend to exit at the same time as they do. They are looking for a team that is making a long-term commitment to the company and value proposition. Good entrepreneurs value the welfare of their company over their own welfare. Founders who adopt the investors’ approach to exit strategies are not going to meet that standard.
- Future Funding Needs: Most investors know that they will probably not be providing all of the funding that a company will need during its growth. They will structure their agreements to take into consideration the possibility of follow-on funding. They will also pay particular attention to the fate of earlier investors. One extreme variation of this second consideration is called the cram down. If investors are providing second or third round money, they will want to see most of their funds used to grow the company. They will also want to get as large an interest in the company as possible. Earlier-stage investors will want to see part of that new funding go to paying them back for their investment. Teams need to realize that this tension is unavoidable and to work with all parties to reach an agreement that will receive broad support and advance the interests of the company.
- Downside Exits: Few people go into business to fail. But the hard fact is that only one in ten companies makes it to their fifth anniversary. That means that in nine out of ten times investors have to face the challenges of a downside exit. In business, as in life, breaking up is hard to do. Most of the time the investment agreement will guide the process. In the absence of such an agreement, things can get both chaotic and very messy. It is in the interest of all parties to have worked out the details of what will happen if the company fails to get the traction necessary to flourish.
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