"What's your exit strategy?" The logic behind the question
In our crusade to pick apart the VC mindset, it seems appropriate to address early on, in our opinion, one of the biggest causes of startup-VC grievances: the exit strategy.
First up, let there be no doubt about it, VCs need an exit to make money. And that exit needs to be within 6-10 years, so we can provide returns to our LPs and pay our mortgages.
However in each investment VCs are looking for a company whose exit will return the entire fund. For a detailed explanation read our article on how VCs make money, but the short of it is that our business model and investment ethos has to be centred around sizeable exits. So here's the paradox: we need an exit, but that exit needs to be big, and big exits don't happen over night, so we also need our founders to be in it for the long run and motivated to build lasting enterprise value.
To put it in perspective, according to a report by CB Insights there were 3,400 technology exits in 2015. 54% were for less than $50m, 38% between $50m and $500m, and 7.8% greater than $500m (3% of which were greater than $1b).
Here's a table of all VC backed exits in 2015 ≥ $500m, the year the company was founded and the type of exit.
Those companies that exited in 2015 were founded between 1995 and 2010, with a mode founding year of 2000 and an average age of 12 years. The youngest companies were 6 years old.
What does this mean?
It means that when sizing up a prospective investment, we need to be confident that the founder isn't looking to exit the company too soon and thus most likely below the required value the VC needs. A < 5 year exit strategy raises a couple of red flags. Perhaps the founder just wants to make some 'quick' cash; or perhaps they've built a fantastic product, that's easily monetizable but when it comes down to it there's no real desire to build a long-lasting business, rather to sell the product. For us, this means the founder has built a tool not a business.
The other thing we must be confident about is that the founder is looking for an exit in the first place. It is not uncommon for a founder to be motivated to build a long-lasting and highly profitable business, but with the intention of paying herself annual dividends rather than exiting. This is what is known as a lifestyle business.
So that hopefully explains the exit strategy question. As an early-stage VC (later stage VCs may be more expectant of a clear exit strategy) we expect the founder to be fully concentrated on building her business, not deciding how best to get out, so being taken through a well planned acquisition strategy in year 3 raises some concerns. At the same time however we want to be sure that our interests are aligned, namely that at some stage there will be an exit.
Lesson to take away
If we could sum up in one sentence the attitude we're looking for, it would be the founder who is focusing on building an exit-able business, not on how they are going to exit.
One final point to consider is that the founder who deeply understands their market and competitors, who knows their business inside out, their value proposition and their strategic positioning, will have a confident understanding of what exits are possible. This is the type of founder we seek.