When XSeed Capital engages initial discussions with a startup, the conversations usually surround traditional topics: what is the size of the market opportunity, how good is the current product/market fit, what skills does the team have or want to add, etc. However, as talks continue over subsequent weeks, almost always a series of questions is floated by the entrepreneurs asking how XSeed looks at liquidity events: How big of an exit do we expect? What if the management team wants to sell and the investors do not? What if the company can be flipped in 18 months – would we be supportive?
The answers to these types of issues have not changed since I began working in the technology business over 25 years ago — the logic remains the same either for a startup executive or for a VC today as it did when Silicon Valley was first emerging. What I would posit is that the “right” answer to these questions is best discerned by looking through a series of filters that can be used to analyze a potential liquidity event and how various parties might view the opportunity.
1. What Does Management Want?
Investors and entrepreneurs have a symbiotic relationship – usually, each group needs the other to achieve each parties’ goals. However, even if an investor has deep operating experience, he or she recognizes that the venture capitalist is not going to step in and run a company — management runs the firm. Once an individual becomes an investor, he has stepped into the role of “coach” and away from being a “player.” Further, if a company is performing well, investors do not want to replace a well-functioning management team. Thus, the desires of management have a huge impact on any liquidity opportunity. Key factors for management deciding about an opportunity will often include the amount of the company which management owns, as well as the personal financial situation of the management team. An acquisition where an individual can pocket $3M could be a huge, life-changing event for someone with children and a “Bay Area mortgage.” It is usually very difficult for investors to force a management team to do something that ultimately the company’s leadership does not want to do.
2. If The Investors Are Institutional, Do They Need An Exit?
Venture funds have life spans, and general partners are expected to return capital within a period of time from the start of the fund (usually 10+ years). As such, VCs may have business exigencies that influence their desire to have a company public or to be acquired. In addition, if a fund is in need of a solid return in order to raise its next fund, this can also influence the wishes of the investors and the pressure they might put on a management team.
Furthermore, the size of a fund can also shape how investors will look at a particular exit. If an angel investor turns $100K into $400K, that is a great return. However, if a fund is $500M or more in size, an exit needs to be very large in order to move the needle for that fund to deliver the types of returns that the VCs limited partners are expecting. Therefore, the attitudes of the investors will depend on the type of investor they are and the surrounding data of how their broader portfolio is performing.
3. In A Perfect World, An IPO Is Just A Step In The Journey
If a company is delivering the financial metrics required to go public (strong growth, profits or a believable story to profitability, etc.), an IPO can not only deliver liquidity to employees and investors, but perhaps more importantly, it provides cash for business investment. Additionally, if a company’s stock appreciates after an IPO, the equity becomes a new currency that can be used for acquisitions. Also worth considering is that an extra lump of cash in the bank and a rising stock price can provide competitive advantage between a company and its competitors for recruiting, signaling strength to potential customers, etc. Thus, an IPO can be a strong advantage for future company growth and the ability to become a leader in a market segment.
4. Who Is The Natural Owner Of The Asset?
In one of the classes I taught at Stanford last Fall, Life Technologies executive Mark Gardner discussed the idea of who is the “natural owner” of a business asset. When his firm is looking at an acquisition, they like to analyze which firm is the one that most naturally can take advantage of a product line or customer base, and which company can get the most economic value of managing the asset. One could argue that this was the logical conclusion to Google’s acquisition of Waze — while other companies were reportedly trying to buy the hot Israeli startup, the logical mating of Waze’s traffic capabilities with Google Maps’ broad geographic reach was the best and most likely pairing for that company. Even though the company was doing well independently, the offer that Google made was the right offer, by the right company, at the right time. Management and investors should consider this notion of the “Natural Owner” of an asset to either consider or reject acquisition opportunities that arise.
5. Companies Are Bought, Not Sold
Firms are at their most valuable point when the acquirer believes that they are the Natural Owner of a business asset. It may sound pedantic, but a company deciding that it wants a liquidity event usually only has a good outcome if there is a party on the other side of the table that wants to control that entity. The best and largest acquisitions only occur when a buyer willingly believes that taking on the extra dilution of ownership will yield long-term results for its shareholders. Artificially driving a liquidity event when there is no highly interested buyer generally yields unsatisfactory results no matter what the seller might want.
While we as VCs are often asked how we look at exit scenarios, there is no simple answer as to when a company is ready to go public or be acquired. The filters above, however, can be useful tools in thinking through how to process the situation if an opportunity presents itself.