The last thing we want as Angel investors is reluctance on the part of the Founder and/or the management team to pursue an exit, and yet we seem to put little effort into ensuring we all want the same outcome. Too many Angels focus on the near term issues without appreciating that even these decisions need to be seen in the context of the exit. Far too many Angels shy away from confronting the management team about exit preparation, seeing this as a confrontation issue rather than a collaborative activity. It’s time to put the exit front and center and ensure there is an alignment of interests in a good exit.

We all have our own mental models for how we deal with issues in growing and developing a business, but very few of us have the experience of multiple exits to guide us through an exit planning session. Unfortunately, we’re trapped by an old valuation paradigm which places a value on a venture based on its achieved and near term inherent profitability and thus inhibits our thinking about how to get the best exit value. Apart from the fact that this is fundamentally wrong, it leaves our focus on growing revenue and profit rather than identifying the best buyers and packaging the business to give us the best exit value.

Without a framework to guide the discussion and to undertake the exit planning, we’re left with a set of ad hoc experiences and half truths. Furthermore, you can’t rely on the investment bankers to give you the best advice. They’re often in for the quick transaction and fast buck.

We have a number of issues to deal with in planning an exit; due diligence, change of ownership, selecting the best buyers and ensuring we get the best price. Each of these activities will require careful planning, often changes in the business structure and activities, and a project plan with assigned tasks, timescales and costs to ensure we get the outcome we seek. Basically, a good exit does not happen by accident, it needs careful planning and an allocation of resources. Furthermore, you can’t depend on circumstances becoming favorable just around the time you wish to exit. You need to manage and create your own circumstances to give you the best outcome.

We often forget that our highest value comes when the buyer clearly sees they can exploit the acquisition for significant gain. It is what the buyer anticipates they can do with the business which will ultimately determine the exit value. We need to construct a business at the point of sale where we reduce risks to the buyer as well as improve their probability of success on post acquisition performance. It would be naïve of us to expect we can develop the best post-acquisition results without the active cooperation of our management team. Not only do we need them in the planning and construction of the business at point of sale, but we may well need them to be part of the post acquisition business which produces the results.
Our task as an Angel is to gain the active cooperation of the Founder and the management team in planning the sale and the post-acquisition potential. We want them to be active and enthusiastic participants in the process, and we should ensure that it is worth their while to do so. The alignment we seek is to have the management team as committed to the exit process as we are.  They need to see that their best personal outcome is achieved when a great exit is achieved for the Angels.

I’ve spent many years developing and documenting the exit process for high growth potential startups. This is set out in the free ebook ‘Ultimate Exits’. With this book comes a workbook ‘Ultimate Exits Workbook’, which you can use to develop an exit strategy with your management team. This workbook deals with the alignment of interests, due diligence preparation, identifying the potential buyers and preparing the business for the best post-acquisition performance. I encourage you to use this process to ensure exit preparation is at the top of your list for your investee reviews.

Historically our angel investment criteria have always focused on the ability of a management team to prove they can deliver on a high growth business concept. Our return on investment has been tied to the entrepreneur’s ability to produce the revenue and profit growth needed to create enterprise value. Our exit has always been seen as some multiple of the net profit which the venture can generate, whether this be immediate past or near future, captured in an IPO or trade sale – but always through the efforts of the venture itself.

What we have failed to do is to see two different paths to value creation, one from high growth potential itself and the other through the execution of that potential. In fact, we would have walked away from many deals where the product or service itself was capable of generating high growth but the entrepreneurial team was judged inadequate to execute on the potential. Without the team, there will be no proof of concept, therefore no value creation and thus no chance of a good exit.

However, high growth potential itself has value in its own right separate from high growth execution. Basically, we just need to go find someone else who can execute on the potential. In the case of most high growth potential products and services, this would be a strategic trade sale. We should position these ventures for a trade sale to a large corporation which had the capacity and capability to readily exploit the underlying asset or capability and thus execute on the potential. To prepare the venture for this type of exit might be as simple as sorting out the IP. In other cases, we would have to establish some reference sites and collect some market data. What we don’t have to do is grow a reasonable size enterprise. Rather than walk away from the venture investment, we should see it as a chance for the entrepreneur and the investors to capture value through an early strategic trade sale.

An entrepreneurial team capable of high growth execution is rare. All too often we have undertaken an investment based on high growth potential hoping the team will be able to learn quickly and, with our knowledge and support, overcome any deficiencies in their experience. Our track record of failures would suggest that this model is somewhat suboptimal. We end up with most ventures either failing or delivering small returns. It is only the exceptional ones which result in the 10+ multiple of capital injected.

The other problem we face is that high growth execution, by its very nature, often requires additional rounds of funding. This usually dilutes the original investment, often at lower valuations, but also puts the venture at risk through funding delays or inability to raise additional funds.

We should, in the future, embark on a two pronged approach to investment. Of course, we still want to focus on high growth potential. However, instead of excluding those where the entrepreneurial team is less able to execute, we should fast track those to a strategic exit which can usually be readily achieved by putting a deal team around the venture and limiting the funding to exit activities. Those few ventures which are capable of high growth execution can then be treated very differently and a full growth plan developed with an IPO or longer term trade sale as the exit.

The advantage of this approach is that we will end up funding more ventures with many of them being smaller investments with low execution risk and short exit horizons. Our success rate on high growth execution ventures will improve as we limit investment to those which have both high growth potential and the ability to execute on that potential.

I’ll admit to having a bias towards exits and focus my review of a potential investment on the exit potential.  I do sometimes get impatient when the investment proposal has little or no information on the exit path. Even where an exit strategy is proposed, the descriptions demonstrate either limited information about what it will take to structure the exit or look like a last minute addition to the plan to ensure that that box is ticked.

Without exception, the normal business plan is built on a revenue and growth model where the substantive part of the plan deals with how the venture will develop market traction, acquire and support a growing customer base, develop strategic partnerships and so on. However, such a model drives you either towards an IPO, a very high hurdle which very few will make, or a financial exit (an EBIT multiple) which has relatively high risk, long timescales and, on average, a low ROI.

What I look for is high growth potential which will support a strategic value exit. These only occur in a small percentage of ventures but they stand out because they have a unique set of attributes. They have a product or service which satisfies a high compelling need, focus on very well identified and reachable but large niche market, demonstrate good scalability and have a strong competitive advantage when fully deployed by a large corporation. However, when I see the strategic exit possibility, it is rare that the entrepreneur or their board members/advisers have even considered the possibility.

Most founders and entrepreneurs have limited knowledge of strategic exits and very few know how to construct a robust strategic exit strategy. What this means is that while you see the possibility, you are confronted with a lengthy conventional growth business plan which usually requires a significant investment to develop it into a solid business suitable for a financial exit. While the conventional plan may be interesting, the strategic exit path will normally generate a significantly higher ROI, has considerably shorter investment timescales and usually a much reduced investment requirement.

Now comes the hard part – how do you shift the focus of the entrepreneur the highly detailed plan for growing their baby to constructing an entirely different plan where the strategic exit may occur in months but usually less than 2 years. The focus will switch from building out the business to building strategic value. If the buyer has the distribution channel, organization and funds to fully exploit the strategic asset or capability, they may not need your sales force, customers, distribution channel or management. Your resources will focus instead on creating additional IP and scalability, making contact with potential buyers and building the deal team.

In my experience few Angels have been down this path because few have experience of putting together a strategic exit as part of the investment evaluation. The ones who have this experience have mixed opinions on how to move the entrepreneur from a financial exit to a strategic exit. Some prefer to allow the entrepreneur to present their business proposition and then, through discussion, shift their focus to a strategic exit. Others prefer to have the entrepreneur understand and evaluate the possibility of  a strategic exit before the first presentation.

My preference is to allow the entrepreneur to consider the possibility before the first presentation so they are more open to a major change in direction. I achieve this by sending them a link to the ebook Raising Angel & Venture Capital Finance.

I ask them to read the book and revise their proposition in light of the exit possibilities. Since the ebook covers both financial and strategic exits, this gives them the opportunity to consider both exit paths. It has the additional advantage of showing them that the investment decision will depend on the exit strategy. Those who then take the strategic exit path are much more open to major shift in focus. The higher exit values in strategic exits also makes the discussion of valuation easier as there is potentially much more harvest money to spread around.

What we do know is that the focus on exit informs the business development strategy. If we work back from the exit, we can establish a very specific set of actions and milestones to be achieved to correctly position the business for the identified buyers. Funding can then be directed towards specific activities to ensure investment funds are only used for exit critical expenditures.

An informed entrepreneur who understands the nature of Angel investment and the critical part which the exit plays in the process is much easier to work with. With strategic exits this is critical to ensure that entrepreneurs and the investors are aligned on strategy, the use of the funds and timescales.

Anyone interested in learning more about strategic value investment and strategic exits should read the ebook Invest to Exit also available free.

Over the last few years I’ve written extensively on strategic exits and encouraged Angel investors to concentrate their investments where a strategic exit is highly likely.  I have focused on strategic value investments as I have found convincing evidence to show that these have higher ROI, shorter investment periods and lower execution risks. I have observed that more Angels are now discussing strategic exits, but find that there’s some confusion as to exactly what is a strategic exit.

I don’t believe there’s any confusion that a strategic exit does not occur where a single individual buys a business to manage it themselves. There are no benefits which accrue to the buyer beyond the boundary of the firm. Any return the buyer receives on their investment must come from the revenues and profits generated by the assets and capabilities of the acquired business. However, we would anticipate that a smart buyer would bring additional knowledge, funding, networks and experience to the business thus improving the return on the investment. In fact, knowing they could generate higher profits from the business through their own contribution, they may be prepared to bid higher for the right to acquire it. This is clearly a financial acquisition rather than a strategic acquisition. Therefore, the sale is a financial exit.
On the other hand, a business which is bought solely for its IP by a corporation and which has no revenue history or sales capability and will never be managed as a stand alone entity is a strategic acquisition. The buyer anticipates bringing the acquired IP into their own organization and leveraging their extensive capabilities, funding and distribution channels to generate new revenue. This would be strategic sale.

It is the direction of the benefit that determines what type of sale occurs. If the benefits of the acquisition are to be generated from within the acquired firm, even if the buyer puts additional resources into it, this is a financial sale. So even if the buyer provides trademarks, IP, new processes, new management, additional funding or excess demand to improve the performance of the acquired firm, it still remains a financial acquisition. The return on their investment is received solely through the performance of the acquired firm.

We might also argue that costs which are outsourced to the buyer, such as head office and services costs, do make a difference to the profitability of the acquired firm but this hardly makes it strategic. The acquired business still operates substantially as a stand alone entity from a product/market interface and the ROI must be generated through its revenue stream.

Moving to a different scenario, I would classify any acquisition as generating strategic value for the buyer if the buyer’s revenue, separate from that generated by the acquisition itself, was either protected (threat mitigation) or enhanced (opportunity exploitation) by the acquisition. Any situation where assets or capabilities are passed to the buyer to exploit within the buyer’s organization and which changes the buyer’s future prospects should be considered as a strategic value acquisition.

There are situations where the acquired business continues in operation, improved or not, with assets and capabilities passed back to the buyer’s organization. This would still be a strategic acquisition as additional benefits are being derived by the buyer beyond those which can be generated within the acquired firm.

This classification is critical for preparing a business for sale. A business which achieves its highest value on sale through its own revenue and profit potential needs to be structured for a financial sale. The bulk of the sale preparation effort needs to be put into revenue and profit growth, risk reduction and identifying growth potential which the buyer can execute on within the business. Any marginal strategic value or buyer synergies enhances the potential sale price but the major thrust of the sale preparation strategy remains with revenue and profit growth.

Alternatively, a business which achieves its highest value on sale by providing a large corporation with a means of mitigating a significant revenue threat or exploiting a major revenue opportunity through the transfer of acquired assets or capabilities, should be prepared for a strategic sale. The value of the strategic acquisition to the buyer is mostly determined by the size of the threat or opportunity within the buyer’s organization and not by the revenue and profit generating power of the acquired firm. In this case, the existing or even potential revenue and profit/loss of the acquired firm may be entirely irrelevant in determining what the business is worth to the buyer. You would prepare a strategic sale by concentrating resources on ensuring that your strategic assets and capabilities are structured so that the buyer can rapidly exploit them within their own organization.

We should not confuse the source and size of the value generated with the price paid to the sellers. The sale price achieved often has much more to do with positioning, preparation, negotiation and competitive tension in the deal. Any high growth potential firm suited to a financial sale, if handled effectively, can easily achieve 3 to 5 times a conventional (EBIT multiple) sale value. On the other hand, a venture suited to a strategic sale can often achieve a sale price equal to 20 to 100 times their net asset or revenue values.

A premium on sale to a corporation may be due to the inherent potential in the acquired business rather than synergistic or strategic benefits accruing to the buyer. Just because a corporation buys a business at a premium over the industry norm EBIT multiple does not make it a strategic acquisition. Rather it is only where additional benefits are achieved outside the boundaries of the acquired firm which determines it is a strategic acquisition and thus a strategic exit for the sellers.

I recently reviewed a set of investment ready criteria published by a respected Angel Group (not the Pasadena Angels). All the usual factors were there–what problem was being sold, the extent of competitive advantage, the experience of the management team, size of market, etc.  You could quickly infer from the questions that the objective was to find a high growth potential venture to invest in. No doubt the intention was to fund the company,  establish a market position, grow market share and then somehow harvest the venture. What I found remarkable was that the question of possible exit path wasn’t on the list.

Perhaps I shouldn’t be that surprised.  I recall conducting a study 5 years ago when I and a colleague reviewed several hundred VC websites to ascertain the extent to which exit strategies were discussed or requested in investment proposals. Even then I was surprised to discover that over half the sites had no mention of exits and not one had an explanation of the various forms of exit and an indication of what information the VC firm would like to see on the proposed exit strategy. Five years on and I had hoped that we would have gained a much better appreciation of the importance of the exit to the investment evaluation.  It seems I was wrong.

What I find distressing is that we still seem to be locked into a business concept from the 70’s and 80’s where the dominant VC model was to grow a business to a point where it could be taken to an IPO.  In those days the pent up demand for hardware and software meant that any reasonable product could fuel significant growth so an IPO was a real possibility.  Then along came the internet boom followed by the biotech boom and that simply reinforced the conventional wisdom. However, it is very clear now that the days of easy IPOs are gone and so is the conventional VC model.

In the present environment our liquidity options now are very limited, basically the best and most likely path is a trade sale.  If that is the case, then why are we still fixated on building out the business. Surely the question we need to ask is – what form of trade sale is the best harvest option for this venture?  Only then can we deal with the other criteria. Is it not the case that the exit method drives the development of the business?

Before we get tied up in legal and financial due diligence we should be working out the exit. We should be ascertaining how the venture will create value and what type of acquirer wants what they have?  Since there is a fundamental difference between a trade sale based on inherent revenue and profit generation from one based on exploiting an underlying patent or other form of IP, these are critical to an evaluation of whether the venture can be prepared for sale.

Asking about market share, distribution channels, management experience, R&D pipeline and so on, before ascertaining the exit path is clearly asking the wrong questions.

If you want to get into a heated argument, put a dozen CEOs in a room and ask them if they should tell their employees that they’re preparing to sell their company. What you’ll find is that they quickly polarize into those who would tell their staff and those who would not. Each group will advance very strong arguments for their case but few will have thought through the longer term implications of their position on the sale value of their business.

Those who argue for not telling employees will argue that the possibility of a sale will create stress and uncertainly among employees resulting in a drop in productivity, a loss of key employees who decide to leave rather than face an uncertain future and the possibility of the news reaching competitors who will use the information to undermine the business. Those who argue for informing employees believe that the information will leak anyway and that it’s better to inform employees rather than let them imagine worse case scenarios.

When I’ve spoken with entrepreneurs who have sold businesses, I’ve been very interested to find out what they did pre-sale and what they would do differently if they had to do it again. In almost every situation where the information was kept from employees, the entrepreneurs regretted the decision. Employees who had worked diligently for the business felt betrayed for being left out of a critical decision which would materially effect their future. In some cases this had the result of undermining the sale process or in key employees leaving the business prior to the sale. Few entrepreneurs who told their employees had adverse outcomes.

My personal view is that the preparation process itself requires active support of key managers and employees. They are required to create the right foundation within the business so that the sale price can be optimized and they are most often needed to remain with the business so that the buyer is able to best operate the business after the sale. Basically you need your best people to support the process before and after the sale. So involving them in the sale process and providing incentives for them to assist you to prepare the business for sale and for being prepared to leave the business if required, or transition with the business if needed, is an essential part of selling a business. Key employees can be rewarded by being given shares, options or bonuses to assist in the preparation process. Those being made redundant can be compensated for their efforts up to the date of sale while those who are needed by the buyer can be given a bonus after some set period after the sale for staying with the buyer to assist the transition.

While competition is always an issue, businesses which are always open to the right offer can simply portray that position. That is, they are willing to sell out to a buyer who can best develop the business. This allows the current owner to position a future sale positively to customers and staff.

Over the course of this week I’ve come across some great articles and blog posts that should be required reading for any entrepreneur looking for funding—including those that have done it before. Starting with The Entrepreneurs Report from the law firm Wilson Sonsini Goodrich & Rosati (WSGR) there are two articles from outside contributors on Perfecting Your Pitch and How Do I Get Meetings with Investors. For the first piece you can pretty much substitute ‘Angel’ for ‘VC’ and it’s right on the money with respect to the Pasadena Angels. One word of caution, however, when reading the WSGR report, try not to dwell on the VC financing trends. The good news in all this is that although Angel and VC financings are down, there are still good companies getting funded as we speak.

A couple of other good posts/videos that I’d highly recommend are Tony Tjan’s the Great Entrepreneur’s Secret and 10 Things to Know Before You Pitch a VC for Money by David Rose which do a good job of covering the intangibles we look for in entrepreneurs and pitches.

By now everyone has seen the infamous Sequoia presentation, R.I.P. Good Times. From what I can tell traveling around the US and overseas, it looks like these slides have circulated faster than the Paris Hilton video (sorry, no link on this last one–you’ll have to find it yourself). If you’ve already seen the presentation, there’s a good post worth checking out from Silicon Alley Insider that provides a few more details on what was discussed at the all-hands Sequoia meeting.

There’s also a good post from last week by Jason Calcanis of Mahalo, What to do if your Startup is About to Fail. Although it’s vintage tell-it-like-it-is Calcanis and a little disparaging of investors (VCs), it provides some further thoughts and granularity for dealing with the current tough times.  Although Jason’s been in the news this week for not fully vetting a prospective employee and accidentally hiring a felon, don’t discount the worthiness of his advice. Even though we may not agree with his explanation and apology for this recent mis-step, I can vouch for the quality of his advice having been on the other side of the table in a number of startups.

Most founders and CEOs leave preparing their businesses for sale far too late to do any serious changes. Generally they decide that they wish to sell out and it becomes an imperative that they do it as quick as possible. If you think about this a little, you can readily understand why selling quickly is foremost in their minds. For many years they’ve been working diligently in the business and their efforts has been focused on the future of the business, now, all of a sudden, their focus is on life after the business and their willingness to put the same energy into the business reduces – thus the quicker the sale the better.

Suddenly faced with the prospect of selling, they quickly realize that they really should have spent some time increasing the profits so that the valuation on sale would be higher. This is almost certainly based on their expectation that their business will be sold for some multiple of earnings and that the earnings number will be, most likely, the most recent full year result or some variation on it. With this in mind, they quickly try to find ways of reducing costs as increasing revenues rapidly is generally not possible. As they search around for costs to reduce they imagine that they can take some infrastructure costs out of the business which won’t have an immediate effect on revenue generation. This often leads to cutting back on advertising, marketing expenses, research and development, delaying equipment replacement, deferring maintenance of plant and so on. This window dressing takes costs out of the business and immediately improves the bottom line. They now feel ready to put the business on the market and feel confident that the increased profits will gain them an extra kick up in the valuation.

This could not be further from the truth. In fact, what they are doing is rolling the dice on whether a smart or a dumb buyer comes through the door. If they are really unlucky, only the smart ones will be interested. However, smart buyers know these tricks as well and they will diligently go about looking for such adjustments. Smart buyers are looking for sustainable profits. As soon as they see window dressing cost cutting they will simply add back the expenses to get a better view of the long term profitability. However, they will also probably increase their assessment of the risk in the business predicting that they may not have found everything and that the business may need additional investment or time to bring it up to the estimated profits. The increase in risk reduces the earnings multiple thus further reducing the value of the business. The window dressing which the seller had undertaken to improve valuation has now reduced the valuation below that which the seller could have achieved before the cost cutting occurred.

If you want to protect the value of your business at the time of sale, make sure the buyer only sees changes in the business which improve the long term profit potential.

I’m often asked ‘When should I sell my business?”.  Usually they want me to give them some highly professional, probably, theoretically reason based on the state of the share market and their industry. Almost as if I could predict what the Federal Reserve Bank is likely to do in two years time. While I’m sure there are advisors out there who would be willing to speculate on such an alignment of stars and planets, I have come to the conclusion that selling a business has more to do with the interests and motivations of the entrepreneur than the state of the business.

Assuming that the business is making a profit and growing and has reasonable potential, when should you sell? One would hope that the value in the business is growing with increased profits, however, value in a business need not be based on profits. For example, when you sell based on strategic value, the value is determined by what a large corporation can extract from your underlying assets and capabilities rather than on your current or potential profits. Thus your current revenue, profits, staff numbers and customer base may be irrelevant in terms of extracting the premium price. In fact, value may be lost by getting bigger or delaying the sale.

On the other hand, a conventional business does generate value through increased profits, but the right buyer who can exploit the business much better than the current owners may be willing to pay well beyond conventional revenue or EBIT multiple to have that opportunity. It might be better to sell now to someone who can better exploit it than you.

Also clearly the future cannot always be predicted with any accuracy. Look at the likes of Enron, Arthur Anderson and so on. Who would have predicted their demise?

Instead focus on your own motivations and potential. Is this the right business for you or should you put your effort into a different business?  Could someone else take your business to a new level thus providing a better workplace for your employees?  Do you have passion for a different type of business? Are you physically and mentally able to continue with the business or would you be better off getting out of this one and reshaping your life?

Ask the personal questions first. What do you want to do with your life and is the business giving you what you want? Would you enjoy life better if you took the money and did something else?  Where is your passion and your interest and are you following that in your business?

Business for entrepreneurs is their life. Find a business which you have a passion for and then spend your time there – don’t waste your life and your passion where you don’t have fun.