Early exits (without VC funding)

The National Angel Capital Organization had their annual summit last week in Toronto. The summit is a gathering of angel investors and angel group managers from across Canada to discuss best practices and current trends in angel investing. Two main themes in this year’s conference were co-investment and early exits. I’ll cover co-investment in another post. In this post I’ll talk about early exits as presented in talks by Dave McClure and Basil Peters.

The basic premise that both Dave and Basil spoke about was that for certain types of businesses, you no longer need (or want) to get traditional venture capital investment. For many software and Internet start-ups, you can get a product to market with minimal capital. This makes it possible for a company to realize an exit and provide payback to investors in a few years. This can start a cycle of wealth creation that will fund future companies/start-ups and contribute to a strong start-up ecosystem.

The following factors contribute to an environment that is supportive of early exits:

  1. Entrepreneurs in the Internet/software space can productize their ideas with minimal capital (i.e. several hundred thousand dollars) thanks to advances in development tools, cloud based computing, etc.
  2. Friends, family, founders and angel investor rounds can provide the necessary capital to get a company from start-up to market (i.e. Maple Leaf Angels typically does deals in the $200k-$400k range).
  3. Established companies in this space (i.e. Google, Yahoo, Microsoft, IBM, Oracle, etc) are very acquisitive. Innovation is harder to realize in a large corporation than a start-up. As such, large companies look to start-ups to prove out a new idea/technology and then acquire the start-up. Large companies are good at taking this start-up and applying their sales, marketing, operational expertise and growing it into a several hundred million dollar operating unit. In other words, large companies use M&A as a form of R&D investment to help find the products that will help fuel their top line revenue growth.

The model above works when M&A exits are in the sub $50 million dollar range because:

  1. Typical valuations for a first round of angel investment are in the $1m to $3m range. As such, a strong return can be realized assuming there are no more or only a couple of subsequent financing rounds with minimal dilution.
  2. Smaller value acquisitions are more frequent, easier for the acquiring company to do, and there are more acquiring companies that can be in the market for acquisitions. Large acquisitions in the hundreds of millions or billions of dollars may get the press, but they are infrequent and require higher levels of due diligence/approval by the acquiring corporation.
  3. Given this math, you can see how angels can realize exits of 3x-10x based on a sub $50 million dollar acquisition at an early stage in the company’s life.

Injecting Venture capital investment into this scenario is not conducive to early exits because:

  1. VC investments at the series A round are several million dollars in size and have post money valuations in the low 8 figure range.
  2. A VC fund of several hundred million dollars needs to have series A winners be 10x+ to meet their overall fund return objective of 20% per annum.
  3. Given this math, a return based on a sub $50m acquisition will not be enough. VCs need to have the company hold out to grow in its life to support a > $100m acquisition (or IPO) which as was stated does not happen as frequently and will take more time. Basil Peter’s states that an angel only backed venture will be likely to exit in 2-5 years whereas a VC backed venture will take 10-12 years.

So what does this all mean? Since most of the readership of this blog is in the software/web space, there is no better time to be an entrepreneur in this space to have the framework in place to start, build, fund, and exit a successful venture.

Even in the US, where you can argue it is easier for start-ups to get Venture Capital funding, angel investors fund more than 27 times more start-ups than VCs. As Basil’s blog states, it is erroneous for entrepreneurs to think VCs are the main source of funding. Successful companies can be started and profitably exited with just friends, family and angel rounds. Understanding your strategy for funding and exiting should be a key part of your business plan as angels are becoming more and more sophisticated and increasingly want earlier exits of their investments. Understanding the investment return expectations of any investor (be it angels or VCs) is critically important as it has a strong bearing size of exit they will be willing to accept and what this means in terms of timeframe to exit.

craig at mapleleafangels.com

Weekend Reading

Compared to others

“With the proper level of ambition, talent, and opportunity, even a small, islolated company can turn the world into its market” – Michael Cusumano, Dealing with the Venture Capital Crisis

I’m reading Michael Cusumano’s Dealing with the Venture Capital Crisis in the October 2009 issue of Communications of the ACM, I’m struck by the idea that our geographical proximity to the US, advanced economy, good universities and strong intellectual property rights might be the spawning ground for new ventures, sources of wealth, social welfare and employment. The article proposed 4 markets that meet these requirements including:

  • Israel
    Estimated 2009 Population: 7.4 million
    2008 Venture: 483 investments totaling US$2.08B, $780M from local VCs (Cdn$2.54B/Cdn$904.84M)  (IVA
    Investment-to-GDP: 0.0125/0.0045
  • Finland
    Estimated 2009 Population: 5.3 million
    2008 Venture: 406 investments totaling 360M euros (Cdn$620.55M) (FVCA)
    Investment-to-GDP: 0.0032
  • Ireland
    Estimated 2009 Population: 4.9 million
    2008 Venture: 160 investments totaling 243M euros (Cdn$418.87M) (IVCA)
    Investment-to-GDP: 0.0022
  • New Zealand
    Estimated 2009 Population: 4.3 million
    2008 Venture: 52 investments totaling NZ$66.1M (Cdn$46.81M) (NZVCA)
    Investment-to-GDP: 0.0004

Well these are great numbers, how does this compare to Canada?

  • Canada
    Estimated 2009 Population: 33.8 million
    2008 Venture: 371 investments totaling Cdn$1.3B (CVCA)
    Investment-to-GDP: 0.001

When compared to the US and Israel, Canada looks like a poor third cousin. What is the appropriate measure here? Investment as a percentage of GDP? Well we fall somewhere between New Zealand and Ireland. Maybe things aren’t as bad as we’d like to think. We have more venture money than New Zealand. We’re closer to a larger market. Maybe we should start to look at the positive factors and exploit the constraints to build opportunities.

  • Advanced economies
  • Sophisticated customers
  • Good universities
  • Strong intellectual property rights
  • Favorable tax laws
  • Vibrant entrepreneurial cultures

What’s an entrepreneur to do?

In my opinion, there are only 2 items on the above list that are directly impacted and influenced by entrepreneurs: Sophisticated customers; and Vibrant entrepreneurial cultures. Sure, the net result of a more positive entrepreneurial environment is a advanced economy that produces good universities. We can lobby politicians for strong intellectual property rights (and consumer freedoms) and favorable tax laws. But there are advocacy groups like the National Angel Capital Organization and the Canadian Venture Capital Association that more directly benefit and are better funded to act on the behalf of entrepreneurial financing. This is not some that necessarily deserve any additional attention than you currently dedicate to the political process. I’m arguing the entrepreneurs should build companies and leave this to the pundits, advocates, policy wonks and politicians.

Sophisticated customers

For entrepreneurs,we need to work on helping develop sophisticated customers. Often these customers are located near where the entrepreneur is building their product or service offering. However, this is not a requirement. Entrepreneur should look for sophisticated customers around the globe. Including customers in your product design and development process is key to creating products that meet customer needs and to develop more sophisticated customers. Steve Blank and Eric Reis have proposed the Customer Development Manifesto and Lean Startup as ways for founders to engage customers in the earliest work. All startups should read these posts.

Vibrant entrepreneurial cultures

Isn’t this what we’re trying to do? Read our thoughts on:

Part of the reason that we are luck enough to have Dave McClure in Toronto (and he had a great time). First Round Capital had office hours with Chris Fralic and Phin Barnes. We continue to see folks from Atlas Ventures, General Catalyst, and Microsoft (Don Dodge presented at StartupEmpire and will be presenting at CIX). This is a result of your participation. Canadian cities have a lot of buzz and attention based on the things that are going on.

It’s cumulative!

It is the force of a thousands of butterflies flapping their wings. All of the blogging, twittering, attending conferences, showing up to events, participating online. It’s about the DemoCamps, Launch Parties, StartupDrinks, Social Media Breakfasts, Third Tuesdays, Founders & Funders, NEWTECH, SproutUps, Meshes, and everything else.  It is a cumulative effect. It doesn’t take a lot of extra effort, but it adds up to the rest of the world paying attention to the noise.

We have great spokespersons like Saul Colt, Mathew Ingram, Mike Lee, Michael McDerment, Leila Boujnane, Brian Sharwood, Sarah Prevette, Pema Hagen, Bryan Watson, Anand Agarawala and others running around the world telling their stories of being a startup and the reasons they are doing it in Toronto. In Vancouver there’s Robert Scales, Kris Krug, Boris Mann, BootupLabs, Boris Wertz, Andre Charland, amd others. In Montreal it’s Austin Hill, Heri Rakotomalala, John Stokes, George Favvas, Ben Yoskovitz, Fred Ngo, Pinny Gniwisch, Ray Luk and others. Let’s not forget Social Media Breakfast, StartupOttawa, Scott Lake, Allan Isfan, Jacqui Murphy, and everyone that I’ve missed (it’s on purpose, because I don’t like you any more and I hate your startups).

But it is up to us to make noise. It’s up to us to build successful companies. It’s up to us to make Canada a better place for startups. No one is going to walk in and make it easier. We all have to participate and build a vibrant entrepreneurial culture. We need to talk about entrepreneurship as a career path. We need to talk to politicians about policy decisions.

So the first rule of being an entrepreneur is to reach out. Invite a friend. Make a connection. Tell a customer. Most of all, do the things that make the ecosystem better for you.