Make a right, down to the stairs and exit…
The past decade has shown us that you can’t have a single plan in life. Whether you’re a university student or an employee, having a “Plan B” has become a must-have. Similar applies to startup founders, who undertake huge personal risks as a means to bring about innovation in the economy. Such endeavors are also filled with uncertainty and various business risks, which is one of the reasons why most startups end up failing within five years time. Achieving P/M fit, being able to scale up, growing the startup and exiting afterwards can be seen as a successful journey for most. However, exiting the startup earlier doesn’t mean it has failed. Founders have various reasons for exiting, and in this article we will be looking closer at what early exits are and how startup founders can go about them. We will also shed some light on what our approach at N3F Ventures is when assisting founders in exiting their startup and discuss a decision-making process towards an early exit.
So what is an Early Exit?
The sale of a startup’s shares or assets through a standard M&A transaction is usually called an exit in venture capital. While there are many types of exit strategies, including a trade sale, management buyout (MBO), asset liquidation, leveraged buyout (LBO) and IPO/STO, these exits typically occur at an advanced stage of the startup’s lifecycle.
Specifically, we can distinguish between seed stage, growth stage and maturity stage, with M&A transactions usually occurring after the growth stage. However, things don’t always work out as planned and startup founders can find themselves in situations where they need to exit their startup and/or discontinue operations either due to the startup’s failure or personal reasons for example. As such, an early exit is an exit that occurs early in the startup’s lifecycle, where the venture (or its assets) are typically acquired by a buyer. In these cases, we can distinguish between early exit strategies such as a MBO as well as an acquihire, a trade sale and an asset liquidation. What early-stage startups usually sell are their assets such as the IP developed (e.g. patents, website, mobile app, proprietary algorithms etc.), tangible inventory of products produced, brand value (incl. community developed), established partnerships and client base as well as the skill base of all employees working at the startup at the time of the transaction. Nonetheless, early exits are usually not deemed as being a founder’s preference or a portfolio strategy by a vc. The reason is obvious – any founder or investor that embarks on a startup journey has their eyes set on the long-term.
It’s situations where further growth seems impossible to achieve, or the founder is met with personal problems or lacks motivation to continue the venture, that can lead the startup to an early exit. As such, early exits can be a good way for founders to get a return on their sweat equity and for (Angel) investors to recoup their investment back (or at least a part of it). Moreover, an acquisition by a larger company is a good way for said company to build a new innovative product quickly with less risk. Startups usually do better at innovation as opposed to large corporates, hence acquiring startups early-on and scale them up is an ideal strategy many firms implement. Furthermore, the early exit M&A market is a relatively volatile market, due to innovation trends from larger companies, economic changes and increased startup activity. Acquisitions at the early-stages are happening more often than ten years ago, which is a clear sign of demand for new innovative startups across several sectors (e.g. fintech, insurtech, SaaS etc.). In a nutshell, an early exit, if executed properly, can be a good way to benefit various stakeholders involved.
How Can a Founder Execute an Early Exit?
As with any other M&A transaction, executing an exit in the early-stages will require a substantial time commitment. Not only would the founder need to prepare the documents required, but the main work will consist of finding potential buyers, having meetings, doing due diligence and closing a deal. If day-to-day management of the startup is not an issue, then it can be a viable option to take on all this work internally. However, it’s usually best to team up with others that can provide professional support in this specific area as this can improve the odds of success for an exit. We suggest founders to check with their immediate network of mentors, advisors, investors, accountants and legal counsels as a first step as these may be able to support directly or point you in the right direction.
Early Exits vs Business Continuation
In reaching a decision, a founder along with her co-founders typically weigh various pros and cons of doing an early exit. In essence, the matter becomes a question of continuing the business (by raising funding needed, hire new staff, pivot etc.) or selling now and exiting in the short-term. In both scenarios the founder loses some control over her startup depending on the type of investor sought (e.g. venture capital). However, with an early exit all shareholders can liquidate their stake immediately while a startup that seeks further vc funding will need to grow the venture further before being able to exit successfully at a much later stage. In such a journey, they may also not be the (only) director in charge of things as some investors or board members may opt for a more experienced C-suite to take the business from its growth phase to maturity. However, the main aspect to consider is whether the startup will continue to exist, be it under a different brand, with a new management team or if it will cease its operations entirely. Founders exiting early might not want the venture to cease its operations, which makes it important for them to find the right buyer or investor. So how can founders reach a decision? At N3F we find it useful for founders to consider the following set of questions along with their co-founders:
-Do we want to continue the startup with our own resources?
-Do we have the know-how, skills and required support to grow the startup further?
-Do we have the motivation to grow the startup further, taking into consideration the time investment required?
-Do we have other startup projects we are keen to work on? Do we see other opportunities that we might be missing out on?
-What is the likelihood of attracting new investors to our startup in the short-term?
-What is the likelihood of finding a buyer for our startup in the short-term?
-Would we be ok with the startup ceasing its operations tomorrow?
-What does our team, advisors and investors think of selling as opposed to continuing the venture?
These are but a handful of questions that startup founders can ask themselves to reach a conclusion. If an early exit is deemed as the best option, we usually suggest founders to work with an advisor or investor that can support with the execution of the early exit. At N3F we have our own particular approach towards early exits that we discuss in the following paragraph.
Our Approach to Early Exits
We believe that founders take on a lot of risks and face multiple challenges in their journey as an entrepreneur. As such, they should be properly rewarded if their startup becomes a success or if they exit the business and sell it. In terms of early exits, our approach starts by (1) determining the motivation to sell by the founder. Without a strong motivation it is easy to discontinue the execution of an early exit if a new big client is closed or if a new investor shows up, which usually are reasons for continuing with the business. This is especially true if the founder is motivated to continue at the outset but is unable to do so do to a lack of funding, sales or other aspects that may change in the short-term.
Once the founder’s motivation is determined and there is a clear consensus on the way forward, we (2) discuss the exit options for the startup and reach an agreement with the founder. There’s a difference in a trade sale, an asset liquidation and an acquihire for example, which has a big impact on how we execute the exit. This also requires internal team discussions and determining what to sell in order to get potential buyers interested in the opportunity. Hence, knowing how the startup will exit is paramount before moving on to the preparation phase where (3) an initial valuation is determined and all respective documents are drafted and made ready for executing the exit. These documents, include (but are not limited to) a bespoke pitch deck, a memorandum and a DDQ prepared in advance for prospective buyers. The purpose of these, similar to fundraising documents, is to inform buyers of the opportunity and help them in making a decision. Describing the opportunity accurately and informing potential buyers of the technology, market, trends, competition etc. is key for garnering interest. Once these are in place, we typically (4) look into proposing prospective buyers to the founder and do the outreach to get the first meetings going. As with any M&A transaction, (5) conducting further due diligence during in the process and (6) transitioning the startup post-deal are aspects that we also support founders with.
Closing Remarks
When embarking on their startup journey, founders typically imagine themselves being committed for the long haul. However, the path of entrepreneurship is a roller-coaster ride with many unknowns. Exiting at the early-stages is certainly not a strategy or goal of any founder or investor at the outset but it can be a great way for various stakeholders to win. The founder, her investors, the buyer and the market being catered to all can benefit from an early exit. The founder receives a good reward for all her hard work and hours put into the startup, investors get a return or at least a portion of their investment back (au lieu of losing the investment entirely), a buyer acquires a new innovative product which it can fund, scale up and grow into a successful product line and customers who benefit from the startup’s product can continue to purchase it whilst receiving new and improved features etc. Founders seeking to execute such a transaction ought to seek support from their immediate network of advisors and investors or externally. At N3F, we focus on understanding the motivation of founders, determining the potential value of the startup to a buyer and putting together a realistic case for an early startup exit.
If you want to learn more about our approach, need an opinion or are interested in an early exit for your startup, feel free to reach out to us via pitch@n3fventures.com.
All images in this article were sourced from Unsplash unless otherwise stated. This is an excerpt of a medium article. To stay in touch and receive our blog updates, please follow us on twitter.