Entrepreneurs: What's Your Exit Strategy? Here's a Suggested Answer.

In the old days of Silicon Valley, there were two possible ways for startups to "exit":  (1) an IPO and (2) and acquisition.  One used to hear investors ask the question to entrepreneurs: "what is your exit strategy?"  Back then, I always thought the question, while it made some sense, was silly and naive.

Why?  One couldn't (and still can't) really build a valuable startup in a way that maximized the chances of an IPO vs. an acquisition.  All one could, really and truly, do was to build a fast-growing, profitable company that delivered customer happiness.  If one did that, one would have a nice exit.

Things are different now.  Even without the impact of the recent Facebook IPO, there hasn't been a real IPO market for technology startups for years. [While this is orthogonal to the argument in this post, I believe that we will never have a robust IPO market until a number of deep changes are made in the regulatory structure governing IPO's and in the parts of the financial services industries that facilitate them.  I am exceedingly pessimistic that these will occur in my lifetime.]

What that, in reality, means is that almost 100% of the exits by technology startups will, for the forseeable future, occur via an acquisition.

Nevertheless, I still hear the question ("What's your exit strategy?") asked by potential investors of the companies with whom I work in my Sherpa capacity.  Although it needs to be asked in a different way, the question makes more sense now for investors, when there is essentially only one path to liquidity, than it did when there were two.   It makes more sense because it focuses on making sure that, before investing,  there are potential buyers for the Company -- because, for investors nowadays, that's the only way out.

Because the question is still so frequently asked by investors, here's a draft answer that entrepreneurs and their startups might think about using:

"Dear Investor,

Thanks for your question. 

At X Tronics, we view our job as building a fast-growing, profitable company that provides kick-ass user benefits.  If we can do that, then good things will happen in an exit.  Obviously, the IPO route is less probable (for any company) these days, so the (numerically) higher probability outcome for X Tronics is M&A.  If we eventually proceed down that path, we think there are a number of possible acquirers for X Tronics, such as _____, ______ and _______.  We closely track those companies and stay abreast of their market activities.  Through our advisors, we are developing relationships with them that, we think, will serve us well in demonstrating (at some point) how much value we could add to their businesses. 

That said, we don’t believe that “build to sell” is a business strategy that creates real shareholder value.  We think the only way to build real shareholder value is to focus on creating lots and lots of very happy customers.

So, bottom line, we are aware that an M&A exit is more likely than an IPO, just on the law of averages.  There are a number of large companies who would be interested in buying X Tronics if we can create a company with happy customers.  We are 100%, heads-down focused on that."

Comments

[twitter.com/direwolff]

Perhaps another approach would be for the entrepreneur to not take money from an investor with this question because it's clear that they don't understand the market they're getting themselves into. If the entrepreneur is just looking for "dumb money", then any answer will do so long as they say with conviction and believability ;)

[Allen Morgan]

Pierre,

Good comment. The key point I wanted to make is that the question is usually framed the wrong way, not that the question, rightly framed, is wrong. Aimed at the right issue (given that your only way "out" is through an acquisition, who are the logical buyers, and do you, either yourself or through your advisors (this is a lot of what I do in my "Sherpa" role), keep abreast of what the buyers are doing?), it's a question to which entrepreneurs should have a good answer.

That said, any investor who doesn't ask the question in some form, probably fits your description in your comment.

Thanks.

[LewisGersh]

Great post Allen. When I was an entrepreneur and raising dough, I always thought that question was silly at face value, but more about sizing up the entrepreneur and how big he/she was thinking. That in turn was codre for big funds to get comfort on how much capital they could potentially deploy into the deal since an IPO will usually allow for more capital and bigger exit value potential. If a founder said plan is to exit by sale, it inherently meant smaller potential capital to invest and terminal value. Just build BIG intrinsic value and all is good.

[Kellyrporter]

Well said, Allen. As an investment banker focused on software/internet M&A, I would underscore the importance of staying close to 5-10 likely acquirers and developing relationships there, in addition to laser focus on building the business and creating delighted customers. When it comes time to exit, I can assure you that those acquirer relationships prove extremely valuable. In my experience, most boards and CEOs give good lip service to the importance of developing those relationships, but relatively few prioritize enough that it happens in an effective way. Instead of "if we build it, they will come" the mantra should be more like: "as we build it, we need to tell them about it and stay close to them".

[Allen Morgan]

Lewis Gersh adds a good, additional bit of explanation. He's right: in the "old" days, for an entrepreneur to admit anything other than he wanted to IPO was code for "not a big enough dreamer".

Thx, Lewis. Good clarification.

[Allen Morgan]

Kelly Porter's comment is good advice for entrepreneurs and the boards of their startups.

Entrepreneurs, do yourselves a favor and heed this advice.

Thanks, Kelly.

[Holden]

@Lewis and @Allen, I thought this might be the first point for asking the question. Similar to many traditional interview questions, this is about seeing how the entrepreneur/interviewee thinks and problem solves. Sizing the market (IPO vs. M&A) is one thing, but even recognizing that a market exists for the company would be a big step for a tech entrepreneur who was centrally focused on the product / service / site. This tells the (potential) investor how much work the entrepreneur will require in terms of advising / babysitting. Are they aware of how business is done post dot com? Are they thinking globally?

Following via Google Reader now, thanks for the targeted, helpful blog!