Early Exits Reviews
Early Exits by Basil Peters
Richard Jackim (read at MidCap Advisors)
"I just finished reading Early Exits by Basil Peters. Peters is a fascinating entrepreneur. Beginning in school, he started and built a business up to a few hundred employees. He then sold it, took his cash, and invested in some start-ups. By his own admission he lost a lot of his capital, but he learned a great deal in the process. He used the capital he had left and the knowledge he gained and got involved in a hundred or so other companies –as an entrepreneur, angel investor and/or advisor. Thoughout his business career Mr. Peters has been an advocate of "early exits." The best way to give you an insight into Basil's approach is to quote an excerpt from a recent interview with Basil Peter by John Warrilow, author of "Built to Sell".
What exactly do you mean by an early exit?
There isn’t a precise definition. "Early exits" refers to a strong trend in the 21st century economy, driven by buyers who want to acquire companies in the $10 to 30 million [value] range. With "internet acceleration," entrepreneurs can often create values in that range just 2 or 3 years from startup. The combination of those values, and that timing, are what I think of as an early exit.
What are the telltale signs that a business (or entrepreneur) is ready for an early exit?
Exit timing is one of the things I wish I had done better in my first five or six exits. Now having watched about 100 exits reasonably closely, I am convinced that in the very large majority of situations, entrepreneurs wait too long to start working on their exit. They end up 'riding it over the top' and selling for much less than they could have. Or even worse, missing the optimum time often means the company never exits. This phenomenon has not been discussed very much and is something that I am working hard to illuminate for entrepreneurs and investors.
A lot of business owners are planning to wait until the market for privately held businesses recovers, banks are willing to lend more aggressively, and multiples start going up again. Is it worth waiting?
In my opinion, that time is now. Interest rates are lower than they have been in our lifetime, the private equity funds are back, and the corporate acquirers are very receptive. With everything going on in Europe, I wouldn't wait.
What if you have a really small business, maybe only $500,000 in revenue with some promising technology, should you still think about selling early?
I don't think of it as a question of selling "early" or not. I believe it's a matter of the best time to sell. Often the best time is well before the company is profitable or hits $1 million in revenue. Recently, Google said: "we prefer companies that are pre-revenue." How's that for early?
Can you explain the structure of the typical early exit? Are businesses owners walking away with a check or are they selling a part of their business to a private equity firm with hopes of taking a "second bite of the apple" in 3-5 years, or are you seeing a lot of earn-outs?
Most of the exits I see these days are all cash, or possibly cash with a portion of vendor financing. Buyers know that if they try to reduce risk with earn-out formulas or risky structures, the sellers will just go somewhere else. The problem for most buyers today is that they have too much cash. So if the transaction is fairly priced, the structures today tend to be cash, or 'near cash.'
Once a business owner makes the decision to sell, what are some of the mistakes you see them make in approaching a transaction?
The most common mistakes I see are:
- CEOs trying to do it themselves, and
- Selecting the wrong M&A advisor (i-banker)
Do you believe in running an auction for a company, or do you try to negotiate with one strategic at a time?
I believe multiple bidders are always desirable. In some cases, that’s not possible or isn’t what the sellers want to do. But in my opinion, it’s almost always a good strategy."
"So I just read an ebook titled Early Exits by Basil Peters. The book argues that VCs are spurring on companies to go for the "home runs" when it may not be in best interest of the entrepreneurs or angel investors. The book argues that companies should be wary of taking VC money as their business models are reliant to go for huge return exits versus going for "singles" or "doubles". These singles and doubles can offer very rewarding returns for their shareholders payed out much earlier and with greater probability.
To illustrate the point about the VC business model, he writes the following:
An Outline of the VC Math
Peter Rip of Leapfrog Ventures describes the math behind VC funds in a fascinating post titled 'Traditional Venture Capital Sure Seems Broken—It’s About Time.' This is a high level summary of how the math works for a VC fund.
In a typical VC portfolio, all the returns are from 20% of the investments. These are the two out of ten investments that are winners. A minimum respectable return for a VC fund is a 20% compound return. For a ten-year VC fund, the fund needs to pay investors 6x their investment to generate a 20% compound return. So those two winners each have to make a 30x return on average to provide investors with the 20% compound return—and that's just to generate a minimum respectable return.
This math is simplified but it's more than accurate enough to illustrate this important point. If you are not familiar with the math behind an investment portfolio, I hope you will spend a few minutes with a spreadsheet so you feel comfortable with these numbers.
Even more interesting is that a traditional venture fund is usually a limited partnership. This means that the fund managers only get to invest the money once. So if they make an investment and exit for a 3-4x return, they give the principal and gains back to their institutional investors. They don't get a chance to invest it again. From the VC partner’s perspective, this effectively guarantees they have failed.
This is probably a bit exaggerated. In speaking with some other friends that are either VCs or been VCs there are plenty of situations where they would be very content to take a 3 or 4x return. This is especially true if they are a later stage venture capital firm where that type of return would be considered a home run. However, for early stage VCs, I do believe that their model definitely has them put on rose colored glasses if they see that their portfolio company may be able to achieve that home run. This is because the personal risk/reward scenarios for the stakeholders involved.
Think about it this way, for a basic "single" or "double" exit, you can see entrepreneurs making single digit millions of dollars and angels would make anywhere between 3 to 5x from their original investment. Each of them would probably be pretty happy with that. As for the VCs personally (not the funds investor but them personally), it is a very different story. Let's say they put $3 million in and could exit with a 3x exit. That would mean that they had a $6 million gain ($9 million for original investment of $3 million). The VC would take 20% of the carry being about $1.2 million ($6 million x 20%). Split that among 5 general partners and that is less than $250k each. After tax, that is really not much at all for them personally. So if they have a chance to go for a home run which they could make millions or tens of million of dollars individually and all they had to risk is something like $125k after tax. I think they are more inclined to "go for it". This is the danger of taking VC money. The shareholders may not be aligned given the very different economic incentives. So bottomline, if you do take VC money, be ready to realign your personal incentives to more closely match theirs or set your terms so they don't get to completely control your destiny.
The Early Exit
Jay Turo (read at growthinkBlog)
"The next big technology investment idea is the "Early Exit." The best articulation of it comes from Basil Peters, a serial technology entrepreneur, co-Founder of Nexus Engineering, former Canada Entrepreneur of the Year, and Managing Partner at 3 venture capital funds – Fundamental Technologies I and II and the BC Advantage Funds. His blog is one of the best resources on technology investing out there.
Aptly to the point, Basil is the author of a great book – Early Exits: Exit Strategies for Entrepreneurs and Angel Investors. His core thesis is that successful private equity investing is now driven by quickly getting to the smaller investment exit.
Or, as he says it, "Today, the optimum financial strategy for most technology entrepreneurs is to raise money from angels and plan for an early exit to a large company in just a few years for under $30 million."
This is a realistically attainable for the individual investor. Here's why:
You, Mr. or Ms. Main Street Investor, are NOT getting a piece of the next big IPO: The 2 best known venture capital funds –Sequoia Capital and Kleiner Perkins - because of their reputations and massive bankrolls – will continue to get the lion’s share of the deals with rockstar IPO potential. Try these names on for size – Electronic Arts, Apple, Google, NVIDIA, Rackspace, Yahoo!, Paypal, Amazon.com, America Online, Intuit, Macromedia, Netscape, Sun Microsystems.
They were all Sequoia and/or Kleiner investments that became mega-successful IPOs. To give a feel for the power of their investment model, estimates are that Kleiner's investment in Amazon scored returns of 55,000%!
YOUR big problem – your friendly neighborhood stockbroker (if they exist anymore) isn't getting you in on any of these deals anytime soon. And if you don’t have a $100 million bankroll and the very right connections to become a Kleiner or Sequoia LP, you're not joining their club.
Hit'em Where They Ain't: The size of most modern venture capital funds has increased, with the average sized fund now having more than $160 million under management. As a result, the vast majority of professional investors simply ca'’t and won't invest in smaller deals. The new VC model has, for better or for worse, become "Go big or go home." As such, competition for smaller deals is much less and the deal pricing on them far more favorable.
Small Deals Rock: You don't need a lot of money anymore to build a technology startup – not with outsourcing, viral marketing, and the Software as a Service (SaaS) revolution. And if your business isn't cash flow positive REAL FAST, you probably don't have a very good business.
So the new technology investment model is to place small amounts (under $1 million) into companies that a) develop intellectual property and compete in markets with lots of active strategic acquirers (think Internet, software, biotechnology, digital media, and energy) and b) have management with the mindset and track records to ramp-up and exit FAST and at very attractive but not pie-in-the sky multiples.
Not a game that big private equity or venture capitalists are interested in playing because it is just too hard to put large amounts of money to work in such a fragmented marketplace.
But if done right, an EXTREMELY lucrative one for thoughtful entrepreneurs and the investors that back them."
Book Review: Early Exits: Exit Strategies for Entrepreneurs and Angel Investors
"As someone several years into a successful venture backed enterprise software startup, I find myself spending a lot of time looking at the green grass on the other side of the startup fence: angel funding and quick flips. People have mixed opinions on flipping, both the practicalities and the ethics of quickly flipping a company. Ethically, I tend to agree that “Flipping is Good“. But practically, there are a lot of moving parts in a company and lining them up for a quick windfall seems to require more than a bit of luck. It was in hopes of better understanding these practicalities that I read Basil Peters book Early Exits: Exit Strategies for Entrepreneurs and Angel Investors (But Maybe Not Venture Capitalists).
Many business books have only one good idea. This book has three, which is nice:
The business environment is in great shape for early exits – If you want to sell a company for $5-30 million, there are a lot of buyers, they have gotten easier to find, and the deals have gotten simpler. For many more businesses than in the past, an early exit is feasible.
Align your exit timeline with your investors to make an early exit possible – If you take traditional venture money, that is a commitment to swing for the fences. It can be very difficult to accept a $5-30 million exit after you have raised even seed money from a VC, because they are depending on your company to consume growth capital and deliver the kind of returns that their funds require.
Employ an outside party to manage the exit – The book really drove this point home, presumably because the author is making a career out of this role. It was an interesting perspective to me, not something I hear much about in the blogosphere, and something I’ll have to investigate further.
Unfortunately there were a few problems with the execution of the book:
Lack of rigor – Peters’s financial models are quite simple, and generally not backed up by broadly sourced data. The traditional-versus-early-exit model that makes the cover of the book and drives home the point about avoiding VC is purely hypothetical numbers, for example.
Canadian heavy - Writing about what you know is great, but more information about key geographies like the United States would have helped make the book more credible. There is plenty of research and statistics available, and the author only scratched the surface.
Simplistic Angels versus VCs viewpoint – There are a lot of opinions flying around about what makes someone a super-angel, or what makes a seed-stage VC firm. Suffice to say the book’s black and white distinction between angels and VCs is simplistic. I would have expected more reasoned discussion of investor types, given that investor alignment is a key point.
Insufficient detail – The later chapters in the book, notably around pricing, are insultingly light on detail. I realized that pricing is complicated and it’s best to work with a professional, but that’s no excuse for introducing net present value of cashflow and then leaving everything else as an exercise for a consult.
Too much of a commercial – I understand that the point of this book, and many others, is to promote the author’s services. However, there were too many pages dedicated to the need for such services, and too few to the nuts and bolts of what would be done or how value would be realized. That, in the end, is the real problem with this book. I was hoping the author would tell me more of what he knows, since I’ll probably never have the opportunity to hire him directly.
The author has a blog, and it remains somewhat unclear to me why he put the effort into a book rather than sticking with the blog format. Much of the information in this book is available on his blog and around the blogosphere. I had been hoping for more new work, or more depth. Unfortunately I did not find it.
If you’re considering starting a company with an eye to early exits, it’s easier to read this book than to track down 100 good blog posts on the topic. Unfortunately, you’re going to need the blog posts either way to fill in the gaps."
Vegas Valley Angels Advisor
"A colleague in Vancouver, Basil Peters, has written a book on Early Exits for angels. At the Angel Capital Association Summit in Atlanta, he used the data from the book to create a new 1/2-day workshop on the same topic. I have read the book and attended the workshop and find his to be a fresh new perspective on angel investing.
Basil’s premise is that the VC model is broken. There are larger and fewer firms resulting in much larger average investments by VCs. Most importantly (and something I had not considered before), because VCs are investing more money per deal (now nearly $25 million per deal in total), they must wait much longer for exits (now 12-15 years). Why? To get a reasonable return on $25 million, they need to build the value of the company to $500 million or more. Considering the market conditions for most of this decade, that takes a long time. What happens along the way? VCs often block exits that would be quite attractive to angels and entrepreneurs, choosing instead to wait for much larger exits (and increasing the risk of failure along the way).
Basil is suggesting that angels think very carefully before funding deals that will require more money than angels can provide in multiple rounds (say, an upper limit of $3-4 million). He warns that the consequence of investing in deals that will eventually require more than $5 million is a long time to exit and increased risk of failure.
Basil also points out that the sweet spot for M&A deals in now about $30 million. Most of M&A deals are being done in the $15 to $40 million range. Exits in this range are very interesting for angels and entrepreneurs – but not necessarily for VCs.
Basil concludes that we angels should focus more energy on "angel-only" deals requiring $500K to $3 million to get to point where the business model is proven and then begin to look for an attractive exit. Along the way, angels can help their portfolio companies get all the funding they need (in this range) and start early helping to tee the company up for exit."
"Back in January, I wrote about the oncoming era of the "small exit". I felt then (and still do) that the combination of capital efficiency, the bad fit between traditional VC and today’s young startups, the sheer number of startups vs. amount of available capital (especially here in Canada) all pointed towards small exits. Vancouver-based Basil Peters has written a book on this topic which I recently had the pleasure of reading.
His book Early Exits covers his considerable personal experience as a founder, VC and now angel investor. His thesis for the book is as follows:
“Today, the optimum financial strategy for most technology entrepreneurs is to raise money from angels and plan for an early exit to a large company in just a few years for under $30M.”
There are many reasons why this message likely resonates with today’s tech entrepreneurs:
- VC is getting harder to find. Funds are getting bigger and only want to do deals that require a lot of capital
- Its easier to generate “small” exits than big ones but small exits don’t interest VCs
- Putting a few million in your pocket as a founder can change your life
– As VC has gone through some challenges we are seeing more and more the impact and scope of angel investing
Basil lays out a compelling case for early exits. We all know that taking VC is no guarantee of success. In fact, Basil has shown that VC-backed companies have considerably longer time to exit and lower rates of success. There is no question, that his message is anti-VC. And since this comes from a former VC, we should take note.
Basil covers many important considerations for entrepreneurs and angels as they plan for their exits. Some highlights:
– Founder shares should vest over time with 1/2 vesting on exit (since up to 1/2 of the value creation comes here and all of it is realized here).
- Aligning on exit strategy can be the single biggest factor in determining whether founders actually realize the value in their shares.
I agree with both of these points, especially the latter. I have seen the complete paralysis and disfunction that comes from having stakeholders that are not aligned.
For someone who has spent the last 10 years raising VC, Basil’s book and message will not have me abandoning this market. The fact is: not all startups *should* raise VC. However, you don’t have to choose your path right away. You don’t have to decide between a big swing for the fences raise lots of $ strategy vs. an angel-fueled early exit play.
To me, the ideal strategy for most startups (especially in the web, where I spend most of my time) is to raise modest amounts, keep burn low, be positioned for the early exit, BUT if you feel you can and want to make a big play, then have the team, technology and traction that will enable you to fund it and go for it! In other words, have your cake and eat it too! This also enables you to go down the VC path should you choose to from a position of strength as you will have more of the elements that they look for in a deal. The best time to raise VC is when you don’t need it. So, building a business that does not depend on it can only help you if you decide to take VC down the road.
I definitely see the potential for early exits. This is in fact one of the big reasons why I scaled back from doing one startup at a time to taking on several: So that I could help finance, grow and sell startups that may never be big enough to need a full time in-house CFO. And will never be big enough to work with great M & A advisors that can increase their exit value.
If you have not done so already, I highly recommend you read Basil’s book."
"I came across the book Early Exits recently. It is definitely worth a read, especially for anyone having anything to do with EDA startups. An early exit is one after a relatively small number of years at a relatively small multiple to the original investment. As I discussed earlier, VCs don’t like this sort of deal in general. They need big returns on at least a few of their investments and they don’t care that much about the rest. Early exits don’t interest them.
There are a number of reasons that EDA startups are not getting funded by venture capitalists any more. The most obvious is that large EDA companies have stopped buying them at high valuations. This is for a mixture of reasons but one is that standalone tools are harder to ramp up profitably without tightly integrating them into the main body of pre-existing tools. For example, standalone statistical static timing is interesting, but much more important is integrating statistical static timing into the synthesis, place and route flow. Don’t just find the errors after the fact, stop them occurring in the first place.
But a second reason that EDA startups are unattractive is that they don’t require enough money. Venture funds are growing larger and it is a fact of life that being on the board of a company looking after a $3M investment is about the same amount of work as looking after an investment of $30M. If a fund is large, it can’t afford to dole it out $3M at a time; that requires too many investments. Instead, fewer but larger investments are required. This means that the size of investment is too large for an EDA company. Too large in two ways: too large since EDA tools don’t require that much capital to develop, and too large since the exit price required to make the investment successful is higher than is likely to happen.
I’ve been somewhat involved with several startups recently who are looking about how to raise a little money. Relatively small amounts are needed and venture capitalists are simply not the place to go looking. Individual investors (angels) and corporate investors (customers) are much more likely. New technology continues to be needed and this type of investor can live with the likely return on a successful company.
The new rules are raise only a tiny amount of money, run the company on a shoestring, validate the technology with some initial sales and exit earlier rather than later. If you wait, you will need more money to build a big channel, and any acquirer will have to tear it down anyway. EDA startups spend more money building sales channels than technology, and one thing Cadence and Synopsys don’t need more of is channel.
One thing that the book points out is something I’d not really thought about. The sales cycle for an EDA tool is about 9 months. What do you think the sales cycle for an EDA company is? More, a year or two from first contact to closed deal. If you are going for an early exit, the sales cycle for the company is about the same as the time you need to develop the product, so you need to start selling the company before you found it!"
Prof. Colin Mason (now with University of Glasgow)
Hunter Centre for Entrepreneurship
University of Strathclyde, Glasgow, Scotland.
"I have been involved in studying and observing the angel investment market for some 20 years. In recent years I have observed what I call the bifurcation of the venture capital market (bifurcation = to fork into two branches, for example, rivers) in which angels and venture capital funds are increasingly operating in separate markets. This bifurcation has been driven by two key developments. The first is the breakdown of the ‘relay race model’ of investing, described by Benjamin and Margulis in their book Finding Your Wings: How to Locate Private Investors to Fund Your Business (1996, Wiley) as follows: "angel investment runs the critical first leg of the race, passing the baton to [the] venture capital [fund] only after the company has begun to find its stride." Others have preferred a baseball metaphor, seeing angel investors as the farm team for venture capital funds – the major league investors. This development has largely arisen because VCs have raised their minimum investment threshold and reduced their commitment to making early stage investments.
The second development, which is partly related to the first, has been the emergence of angel groups. Individual angels have found it advantageous to work together, notably in terms of better deal flow, opportunities for diversification, superior evaluation and due diligence of investment opportunities. And by aggregating the investment capacity of individual high net worth individuals angel groups are able to make larger investments and follow-on investments to avoid dilution.
Basil Peters’ book Early Exits adds an important third strand to the bifurcation story. His argument is that it costs less to start a technology company so they can be financed by angels, and can achieve an exit within a few years of start-up so follow-on finance from VCs is not needed hence the initial angel investors are not at risk of being diluted. Peters develops this second point at length. Because VCs are investing more in each company this drives up the returns needed from successful investments to generate an acceptable return for the fund as a whole. The consequence is that VCs need to wait longer before they seek an exit, which adds to the risk and reduces the chance of success. One implication is that they may block an exit opportunity that generates an acceptable return for an angel as they strive for a ‘home run’. This behavior is likely to discourage angels from investing in companies that are likely to need a VC round of finance. A further implication for angel investors, which Peters discusses in the second part of the book, is the need to give much more emphasis to exit planning. This discussion complements the writings of Australian entrepreneur, academic and consultant, Tom McKaskill who has written extensively on ‘the art of the exit’ (www.tommckaskill.com).
Peters tells a coherent story. It resonates with what I read and hear from investors. It is consistent with other trends in the VC market. It should be essential reading not just for all angels but also those involved in policy and practice (e.g. university technology transfer offices, economic development officers).
But I do have one caveat. How widely applicable is Peters’ early exits thesis? How relevant is it beyond the Web 2.0 economy? Does it apply to life sciences or clean technology for example? And how relevant is it beyond Silicon Valley? A critical part of the process of early exits is the presence of large technology companies with ‘buy to build’ strategies which spend more on buying small innovative companies than on internal R&D. A cursory reading of the VC media identifies frequent reports of small companies being gobbled up by Microsoft, Cisco, Google, Yahoo! and the like all Silicon Valley-based. But geography matters! Will young technology companies located at distance from Silicon Valley appear on the radar screens of these large acquisitive businesses? If they are, will their location reduce their attractiveness as acquisition opportunities? And, if such companies are acquired, then what are the economic development implications? Will their IP and know-how simply be uprooted and transferred to Silicon Valley, leaving nothing behind in the locality, region and country in which they were spawned?"