A conversation on venture exits

A recent entrepreneur was kind enough to share notes and learnings on an interesting topic for startups — a buyout / an exit.

1. Build your data room from day one. Start even before you incorporate! Here is a possible list of things you personally as founder should ensure you have updated every month. Once your team gets used to updating this like a well oiled machine — keep reducing the time period and freshness.
2. What investors look at and buyers look at — are two very different things.
3. Team team team. Not just assembling a team before a fund raise — but who believed in your vision early and was part of the execution. You hear this over and over, but will never focus on this enough. Team. Even if you have 10x execution capabilities with your team. With no folks with prior experience or reputed experience — it will be tough for a buyer to perceive value. This is a harsh unfair reality. It’s a chicken and egg if you can’t afford a team. Half your hires may fail. Each founder has to bring under them a capable experienced team who have been at the company for a few years understand everything inside out and who will be considered — a valuable bunch of folks to have onboard. At every level down the hierarchy. Also solo founders — you just shot yourself in the foot.
4. Investors essentially are valuing a startup at how much was invested, due to the way liquidation preferences are setup. So a company valued $1B who raised only $100M and sells for anything north of $200M odd is still not a complete loss at 1.2x. It may appear that a unicorn was sold for $400M but it is a 2x return for investors. You are worth your last investment. So if credit karma was worth $3.5B in the last round — when it was sold for $7B — it may appear as 2x return — but the comparison is more $300M invested to the $4–$5B or more likely to be returned to investors. 10–12x for just the last investor. Angels would make probably 5x times every round they were diluted, but I digress.
5. The last (most recent) investor has an upper hand over other investors as the company progresses. Never sign anything more than a 1x liquidation preference in your SHA/SSA. The worst terms of every round get carried over to every next round. If you never had tranches — you may never have tranches. Good for you. If you have always had even in 1 — you will always have later as well. If KMP shares get clawed back to 0 at Series A — that shows precedence for repeating that in later rounds as well. Also pick your battles in the SHA/SSA drafts btw. Everyone is a capitalist/self-motivated, but pick the ones you need to loose, for the ones you want to win. More on this in 24.
6. With all due respect — Buyers do not buy the company for the investors. They are buying for the business or tech or assets or team or ideally a combination of the four.
7. The cap table is finally relevant to figure how investors will split their share. Buyers think only binary — team vs rest. Maybe founders as a big chunk within the team pie as well. The more the team owns the better the deal because they don’t want to be paying off investors who will have no role going forward. Let’s call this the tax. That said total investment into the company is looked at. And once the buyer values your company, at that point they are dealing with paying investors only because the overhead is worth it. Eg I want to buy an orange. Tax on the orange is 18% vs 80%. Two very different reactions. While easier said than done — are you are building an orange so good that 30–50% tax is also worth it? You know best. If this math is not agreeable with the buyer — again you will end up ‘here’s the price for the orange and here is the max I can pay as tax’. #dilemma No matter how good a business you are, how profitable you are, what your top line is. If the team is diluted down to 10% — you are in big trouble. Would anyone buy an orange for 1/- and pay 9/- tax. This is where liquidation preference, comes in. You are your last valuation round. Buyers will begin there as a starting point. Also put yourself in a buyers shoes. You don’t have to look for M&A only because you are running out of time/money. Most SHA’s force a drag/exit on 5 years. But do the tax math every few quarters.
8. While investors can intro, investor led M&A is a myth. People will stay value the biz, team, assets, tech and figure if the tax is worth it. This is because there are capitalists on the both sides of the table.
9. Buyers from certain parts of the world or certain kind of buyers — like to assess you based on your IP, agreements, business processes a lot more. Take it seriously.
10. There will always some areas that the company is good at and some areas of concern. While this is only natural — and a function of deciding to dedicate time to fix and prioritise — buyers may or may not see it that way. Sometimes investors also think unit economics are written in stone.
11. Clearly explain levers, that can go both up and down. Shows that you understand the variables, and that you are and can be deliberate to change something from A to B by changing these x,y,z variables. Definitely have this ready for unit economics, revenue top line, bottom line, for market, for CAC, for LTV. Assume conversion drops, assume churn. See what is working.
12. Buyers will oversee gaps that they themselves are good at. Because they know they can solve it. But maybe worried if they are unsure if you or they can solve some gap.
13. A corollary. Buyers will see value in areas that they themselves have gaps or want to improve that the company has shown evidence of solving. This is only natural.
14. A small market can be dangerous. If it’s a small market and you’re already 10% — then is the TAM 10x of where you are today large enough? If it’s a small market and you’re not yet 10% — why aren’t you yet ? it’s a small market anyway. Moreover, think of the buyer’s fund raising post acquiring you. Could there be one slide showing a gazillion dollar market, and your company as a vehicle to get there? Can you see them scream “Here is the traction and early evidence. And here is where we can get, and hence why we are acquiring now”. Also- team, team, team.
15. Before approaching a company — look at the last investment raised. 4x that is pretty much the valuation. Now look at that sky high valuation you want. Do you think someone will part way with double digit of their equity based on a cold email / rubbing shoulders with you at conferences ? They may consider if team, team, team or inside info of genuinely great tech/team/business/x. The buyer may btw, try to offer a share swap but say your $xM is worth only N% because in the next round just rounder the corner we will be valued 2x. It’s rare to find an entrepreneur who will do pro-rata valuation or even share the math. If they screw you — you will get to know soon enough. Also while doing a shareswap — it’s not a bad deal for angels/investors to get onboard a company that is going to double in the next few months. Value shouldn’t matter for investors as much as increase in value consistently over time.
16. 1–2% is a good ballpark number IMO any entrepreneur would be comfortable with an acquisition opportunity that was nowhere in the picture yesterday, and is suddenly presented today. Post due-diligence done and time for ponying up for a startup — if this company was of interest you would have known about it. Hence the reason to network, and reach out to potential buyers early and often. Allow the buyer the privilege of coming up with the idea of acquiring you and seeing the synergy without you spelling it out. But if you just show up and it’s a Buyer you are just meeting, it’s possibly a 1–2% deal so you may as well prioritize companies 100x your size. Which based on liquidation pref / valuation — means — at least 25x your investment.
17. Suggest a variation of cash and stock split that will help do the deal. At this point the intent is there. Everyone has their own limits and opinions on using cash vs not. Again, If the tax is too high — new structures will emerge. Eg paying lesser but as per the cap table and maybe esops and payouts and retention bonuses to the team.
18. Team location. Your buyer may want your team to relocate. If several do not want to — the structure of the deal may suddenly change. Now I understand why investors want the startup to be in certain cities. It eliminates this friction point later on. If your buyer can evaluate your satellite office — good for you and definitely convenient for the team.
19. If possible do esop allocation or sharing the wealth, as early as possible. 10% even before your first institutional investment is worth it. A good board will support this.
20. Set aside double digit % of your founders stake towards esop pool, with a clause to return back to you if un-used at your exit event. Even 20–30% if you have to. You will save expensive dilution later, and there is enough room to hire. And if you don’t use it completely, the remaining should come back to the founders in the same proportion it was given.
21. No one likes to be rushed, but some sort of urgency is nice to have — but finally a question of who has more leverage. Whether this is situation based or perhaps demand or momentum or some other reason. Give them the opportunity to reach consensus and a room full of nods. Much like the fund-raise — do the M&A dance well before you run out of money, so that you get market feedback and have time to tweak based on feedback perhaps. It will be a learning experience.
22. Don’t take a banker to meetings. This is a founder job. Get to know the team buying you. Get the bankers to arrange meetings and support behind the scenes.
23. A company is perceived as a magnification of the founders.
    2 engineer founders = oh, all tech.
    2 sales founders = oh, company isn’t tech focussed.
    A good balance is key not just for M&A but for running your company and distributing load well. Unless you want to get bought for those patents, or those BD deals. Know your strengths and the perception.
24. There are hundreds of ways a board/buyer/seller/anyone/timing can screw with you when things don’t go well and they want to. SSA/SHA are 40 pages for a reason. But that said — there are hundreds of ways a board/buyer /seller/anyone/timing can tweak things in your favour if things are going well. All is forgiven and forgotten when things end well.
25. Play the long game. Don’t burn bridges. Everyone is a capitalist. Use every stint as a stepping stone and learning experience. Also — team, team, team.

Hope you find this as useful as I will!