AngelBlog by Basil Peters

Timing Your Exit - Don’t Ride It Over the Top

Mon, 13 Sep 2010 18:12:42 GMT

Most entrepreneurs wait too long to start thinking about their exit.

They usually sell their companies for much less than they could have. The valuation curve, and return to shareholders, usually ends up looking something like this.

That’s exactly what I did in my first company. (It was the first time I lost several million dollars, and the first of many similarly expensive - and valuable - lessons about exits.)

Most of the technology companies I’ve known well exited too late. Yes, most. "Riding it over the top" is by far the most common exit scenario.

The fundamental cause is simply our fundamental human natures.

The goal of this article is to help you time your exits better.

How Long Does It Take to Sell a Company?

Depending on who you ask, and whether they are trying to sell you something, you will get different answers on how long it takes to sell a company.

The time to exit depends a lot on the company - primarily on how long it will take to get the company into a saleable state, and then how much time the senior team has available to work with the M&A advisor.

A good rule of thumb is that it will take 6 to 18 months from making the decision to completing the sale. That means to execute the best exit, the decision to sell has to be made 6 to 18 months before the peak in the selling price.

Selling Price Depends on Internal and External Factors

Selling an entire company is similar to selling shares in the public markets - how much you can get depends on how the company is doing, but also on how the overall market is behaving. For many stocks, the overall market is a bigger factor than how the company is actually doing at any point in time.

This ‘external effect’ is even more pronounced when an entire company is being sold because the market for companies is much less ‘efficient.’ The term inefficient includes a lot of aspects, but the important effect here is price. This post describes market inefficiency and how you can use it to your advantage when selling a business.

At the end of 2008, near the bottom of the most recent debt bubble collapse, the overall stock market had dropped about 50%. If there was a similar index for the value of entire companies being sold, I am sure it would have gone down much farther than that, and stayed near the lows much longer. This is, in part, because the market for entire companies is much less ‘efficient’ and therefore more susceptible to changes in sentiment and liquidity.

The Macroscopic Economy Affects Every Exit

The overall economy is often the most significant timing factor in an exit. This means you’ll also need to consider what may be happening in the global economy 6 to 18 months into the future.

My first exit was sub-optimum because I hadn’t seen the previous debt bubble forming back in 1990. If I was paying attention, I might have noticed that most of my cable TV company customers were using a new financial instrument called ‘junk bonds’ and that S&L’s were financing too many real estate projects. Heck, I didn’t even know what an S&L was - let alone a junk bond.

We are all familiar with the effects of the macro economy. In the M&A business, the future condition of the 'micro' market is almost as important.

The Micro Market for Your Company

The state of the micro-market you will sell the company into is the second biggest factor in choosing the optimum time to exit. Markets for companies are notoriously inefficient, and the valuations for a given type of company can easily vary plus or minus fifty percent in a year depending on perception and supply and demand.

If a space becomes ‘hot’ valuations can be several times higher than just a year earlier. These micro market conditions can often affect price more than the fundamentals of the company.

The micro market is often easier to predict than the macro economy. For example, I recently met with two bright, local entrepreneurs who are building a company in an exciting niche market riding on a long term trend. These two young founders chose their space well and were already global leaders in their niche. They had prototypes in the market and a respectable global mind share.

Their niche was heating up quickly - unfortunately for them. In the previous six months, I’d read several articles in finance blogs or newsletters about yet another company that had just been financed in their specific vertical. Most of the financings I read about were for $5 to 20 million. This local company has been built on something around $1 million.

This is a scenario I’ve seen about a hundred times before: too much money flushing into a space the VCs think will be hot. Too many companies being founded with exactly the same business plan.

These entrepreneurs were too young to attract the amount of capital they’d need to compete in this new environment. They had only two strategic options - an early exit or hiring a ‘name CEO’ who just might be able to raise a big enough round in time. I recommended an exit because I knew the money flowing in to their space would also increase valuations - possibly by 2 to 5x over normal ranges.

You can probably guess the young entrepreneurs wanted to wait a ‘little longer.’

Most CEOs don’t have time to keep up with the macroscopic economy, or the micro markets for selling their type of companies. They need advisors who have the time to stay current on the big picture and help them incorporate these market effects into their exit strategy.

Under Appreciation of Exits as a Strategy

Selling the business is an under appreciated business, and life, strategy. CEOs make important strategic decisions every day - often subconsciously. Most CEOs have never executed one exit and only a very few have done two. This inherent lack of familiarity results in exits being a very underused strategic alternative.

Most CEOs miss their optimum exit window simply because they haven’t been thinking about their exit and haven’t built alignment on an exit strategy. (I wrote about exit strategies in the previous edition of the Acetech Newsletter.)

Selling the company is also a life strategy. During my two decades in YPO, I got to know many successful CEOs. I watched many of them sell their companies. The exits were always a milestone in their lives and in every case I’ve been close to, the exit was a very positive event. And it was not just the successful exits that were positive life events - even the exits that might not have been considered a success by some of the investors were always positive events for the founders and CEOs.

I have come to believe that founders, executives and investors would all make more money, and have more fun, if we understood exits better and utilized exits more often as a business strategy.

And Largely Human Nature

I don’t want to be too hard on the young entrepreneurs I wrote about earlier. They were mostly victims of human nature.

They just couldn’t think about selling because they were having too much fun. They were leaders in their market and big companies were enquiring about huge orders. They knew their revenues were getting ready to grow – and possibly explode.

Unfortunately, they couldn’t appreciate that it was also the absolute best time to sell their company. In fact, they should have started the exit process 6 to 12 months earlier.

Human nature also affects the buyers. They will always pay the most when everything is going perfectly and the future looks even brighter. The buyers’’ human nature also means that a skilled M&A advisor can usually sell for a lot more based on the ‘promise’ rather than the ‘reality.’

Human nature also works against the entrepreneurs on the downside. The reason human nature ends up costing most entrepreneurs, and their investors, a lot of money is because most of the time CEOs and boards wait until it’s pretty clear that the company’s value has peaked before starting the exit process. By the time the buyers get to the serious price negotiations, it’s also clear to them that the company’s best days are behind it. And another 6 to 18 months has passed, which has usually allowed the trend to extend even further. The result usually ends up looking something like the graphic above.

When you do an Internal Rate of Return (IRR) calculation for an investor, the difference can be dramatic. Using the hypothetical example from the graphic above, an exit in 3 years at a 5x return works out to an IRR of 124%. If the company waits until the peak, then starts the process, and ends up selling for 2x at year 6, the IRR is only 15%.

With exits, like many things in business and life, timing can be (almost) everything.

Video of "How Not to Sell a Business - Don't Blow the Biggest Deal of Your Life"

If you’d like to hear more about everything I did wrong during my first exit, and avoid some of my expensive lessons, this is a video of a talk I gave the to the Vancouver Entrepreneurs Organization titled: "Don’t Blow the Biggest Deal of Your Life".

Angel Investing in the 21st Century Video - Part 1-2

Mon, 13 Sep 2010 15:42:04 GMT

This is part 1-2 of the video series from my Early Exits workshop at Angel Capital Association National Summit, San Francisco May 5, 2010.

It was sponsored by the Angel Capital Education Foundation and the Angel Capital Association.

Highlights of Angel Investing in the 21st Century - Part 1-2:

What happens to angels and entrepreneurs when traditional VCs invest in our companies?
When VCs invest, on average it adds about a decade to the exit timeline - the math explains why
The best strategy is to have angel investors or traditional VCs - but not both - university research shows
When do traditional Venture Capital investors make sense for technology companies? A simple test for each company.

Part 1-2 of Early Exits Workshop - Angel Investing in the 21st Century is online here.

Angel Investing in the 21st Century Video - Part 1-1

Mon, 13 Sep 2010 00:26:58 GMT

This is part 1-1 of a video series from a workshop I presented at Angel Capital Association National Summit, San Francisco May 5, 2010.

It was sponsored by the Angel Capital Education Foundation and the Angel Capital Association.

Part 1 of the Early Exits Workshop is titled - Angel Investing in the 21st Century.

These are a few of the highlights of Part 1-1:

Outline of the Early Exits Workshop and how I got started on Early Exits
Successful investing requires two things - investing right and exiting well
Angels and entrepreneurs would have more fun, and make more money, if we focused more on our exits
Angel investing is still new - about where traditional Venture Capital investing was in the mid-1980s
The economy has changed and traditional Venture Capital isn't working for today's tech companies

Part 1-1 of Early Exits Workshop - Angel Investing in the 21st Century is online here.

Selling a Business - A Guide for Investors and Entrepreneurs

Sun, 12 Sep 2010 22:26:33 GMT

This video series is a practical guide on selling a business, the exit process, the exit team and how to sell for 50% more.

It's my keynote speech at the National Angel Capital Organization Summit on October 15, 2009.

Some of the topics include:

Successful investing requires two things - investing right and exiting well
Exiting well means selling a business at the right price but also in a reasonable amount of time
Why its important to engage professionals and why the CEO should not lead the exit
The exit is just another business process and why every company needs an exit strategy
Term sheets create exit alignment and vesting is the most important term
Who are the buyers for tech companies today?
Corporate buyers are often the fiercest competitors for traditional Venture Capital funds
Today, companies are often acquired just two or three years from start-up
The most important criteria for selecting the M&A Advisor and the M&A Advisors functions
M&A Advisor fees and why the M&A Advisor should be local
The benefits of doing a secondary sale before the exit
Things to do before contacting the first buyers - clean up the structure, employment agreements
Financial statements - review or audit, the financial model, tax considerations, the sales collateral
The sales funnel and ways to maximize the final selling price of the business
Structural value increase, illuminating strategic value, capitalizing on inefficient markets
Why you always need multiple bidders and the selling skill of the M&A Advisor
Reps and warranties, the closing process, it's recycling other resources on selling businesses

The video series on Selling a Business is online here.

Why Every Company Should Have an Exit Strategy

Mon, 11 Jan 2010 22:47:45 GMT

This is the first in a series of articles on how to design and execute an optimum exit for your company. Future installments will discuss: how exit strategy drives financing strategy, corporate DNA, who the buyers are, secondary sales, building an exit plan, the exit timeline and ways to maximize your exit value.

This article was written for the Acetech newsletter: CEO Snapshots.

Every company needs an exit strategy. Ideally, the exit strategy should be signed off by the founders before the first dollar of investment goes into the company. This is especially true today when early exits are such an attractive option for many technology companies.

These days, tech companies are often sold only two or three years after they’re founded. Flickr was a year and half old when it sold for $30 million. Club Penguin sold for $350 million when it was just two years old. YouTube sold for $1.6 billion when it was two years old.

Of course, in many cases it will take longer than two or three years to optimally exit. But this doesn’t reduce the need for an exit strategy and continuous work on the exit plan – right up until the day the company is sold.

It’s just another business process – the most lucrative one

Selling a company is just another business process. Designing and executing the exit well can easily make half again as much money as all the hard work that goes into every other business activity – so it is often the most lucrative of all business processes.

Every manager knows that large business goals need a strategy, plan and regular monitoring. The exit is no exception.

The entire purpose of the company

Looking at it in the simplest terms, or as an investor would, the company is simply a black box with the inputs being entrepreneurs’ effort and investors’ cash and the only output being the purchase price paid by the ultimate buyer.

Everything else that happens inside the black box is simply a component contributing to the single output – the successful exit. While this is no doubt an enormous simplification, it is clearly the most purpose of most companies with external investors.

Build It and They Will Come – Not

The classic joke for managers involved in product development is ‘build it and they will come’. In the 80s, there were several well-known management gurus who wrote books and made good livings on the lecture circuit advising entrepreneurs and managers to listen to their customers before starting to build new products or services. Today, almost everyone agrees that a strategy of ‘building it and they will come’ is laughably ill-advised.

Even so, many entrepreneurs still go happily along building companies hoping that one-day a ‘buyer will come’. It’s an equally bad idea. To succeed in any business process you have to start at the end – clearly articulate the desired outcome and then plan the intermediate steps needed to achieve the goal.

For most technology companies with external investors, the ultimate objective is to sell the company. To achieve that goal, the exit strategy should become part of the corporate DNA. The exit strategy should be clearly articulated, signed off and reviewed regularly. With a good exit strategy, and reasonable attention to the process, your company will exit earlier and for a better price.

The First Step – Your Exit Strategy Rev 1.0

An effective exit strategy can be pretty simple. Here’s a real life example from a company that I can talk about – Parasun Technologies which was in New Westminster. At the company’s second strategic planning retreat in September 2005, the board and management agreed that “Our Core Purpose” was to sell the company for more than $10 million by late 2006 or early 2007.

That’s all you really need: a target date and a price. Exit strategies can be more complicated, and might include statements on maximizing strategic value, target customers and even sales tactics. But the two essential elements are when and how much.

Parasun’s simple exit strategy worked perfectly. In February of 2007 the company agreed to be sold for $14.8 million. The transaction closed in May. The story of how the price grew from $10 to $14.8 million is the topic of a future article in this series.

Early Exits Selected as a "Best Books for Business Owners of 2009"

Mon, 11 Jan 2010 22:14:47 GMT

I'm very pleased to say that Inc. Magazine has selected my book, "Early Exits" as one of their "Best Books for Business Owners of 2009."

"Written by a seasoned early-stage investor, Early Exits is a must-read for any entrepreneur who has wrestled with the dilemma of taking outside funding. Peters makes the case that marching toward an exit is a good thing, and not nearly as impossible as it may seem. A surprising number of business owners are cashing out after only two-to-five years and for between $5 million and $30 million, he asserts—making this period, for all its turbulence, a golden era for entrepreneurs." Recommended by Bo Burlingham.

The Inc Magazine article is available here.

The list was also discussed on these blogs:

800CEORead Blog's Inc. Magazine’s Best Books for Business Owners

WorkingPoint Blog's Christmas Reading List for Entrepreneurs

Goolge Wants to do Even Earlier Exits than in "Early Exits"

Mon, 11 Jan 2010 17:58:42 GMT

The main thesis of my book Early Exits is that entrepreneurs and angel investors would make more money, and have more fun, if they built companies around a strategy of early exits.

In "Early Exits" I show that most M&A transactions are under $30 million. More recently, I have been saying that the median price might be as low as $15 million.

Part of my message to entrepreneurs is that they don't need to build companies to be profitable before they can execute very good M&A exits. This is a main theme in why I think this period will come to be called a Golden Era for tech entrepreneurs.

The fundamental driver behind this trend is that big companies have learned that M&A is the best way for them to grow.

But even I was surprised to learn just how early Google wants to do acquisitions.

Charles Rim, is one of the five most senior M&A professionals at Google worldwide. He did an interview for Corum's online "M&A Class." I am grateful to Corum for organizing this event and for posting the archive. (If you are interested, I've converted an excerpt to flash and posted it here. There is also a transcript here.)

A few of the fascinating points from the interview are:

"90% plus of our transactions are small transactions. So that would be less than 20 people, less than $20 million and that is truly the sweet spot"

"we do prefer companies that are pre-revenue"

"technical staff, engineering, a strong engineering team, these are the things that we think are very important to the future success of Google and important for us to use acquisitions in that manner."

This provides some excellent insight into how a very large company like Google thinks about acquisitions. This is a good confirmation of the trend toward early exits, but it goes even further than I did in my book.

Google actually prefers companies that are pre-revenue. In other words, Google doesn't want to buy the business, they want to buy the team. The people. The entrepreneurial ingredient that they know they need to keep their company growing and healthy.

You've heard it from one of the guys who really knows - you can sell a tech company today long before it's profitable, even before it has revenue. And if it was up to Google, it would be the latter.

Angel Term Sheet Evolution

Sun, 10 Jan 2010 17:02:52 GMT

This video is from a Bellingham Angel Group Education Breakfast on Angel investor term sheets. Dan Rosen, Chair of the Alliance of Angels in Seattle, and I talk about how term sheets for angel investors have evolved over the past few years.

Term sheets are an especially important topic right now as angel groups work to develop best practices on syndication (or co-investment.)

Dan introduces the Rosen Light Pref Angel Term Sheet as a model for future angel investments.

We discuss:

Preferred shares, exchangeable shares and common shares
Vesting, protective provisions, reporting obligations, governance terms
When common shares work and when they don't
Everything flows from the valuation - Excel is your friend
Participating prefs, protective provisions, being entrepreneur friendly
Drag alongs, anti-dilution, discounts and warrants
Board compensation, lead investors, working with entrepreneurs
Why all directors should make a meaningful investment, selecting good directors
Exit alignment, redemption rights, exit 'push' and 'pull', valuation
Balancing protective provisions and governance
Working with lawyers and negotiating with entrepreneurs
Why it's a good idea to negotiate the term sheet and valuation first
How lead investors help before and after the investment
Optimum financing strategies, valuation, capital efficiency
What Angels and VCs think of each other and how its changed recently
Is valuation a science or a black art

The full high definition video of this education event is online here (click on "Fullscreen Toggle" for best viewing.)

Fund Structures for Angel Funds and Early Stage/Seed Venture Funds

Mon, 21 Dec 2009 21:37:34 GMT

As the it becomes increasingly obvious that the traditional Venture Capital model is broken, and as more angels start funds, there is a growing interest in the best fund structure for new angel funds and similar early stage/seed funds.

This post describes what I believe is the optimum structure for today's early stage equity funds.

This is the link to the full post on AngelBlog

Exit Early - Exit Often Keynote Video

Wed, 14 Oct 2009 16:12:10 GMT

This is the high def video of my keynote at the Capital Connects! Southeastern Regional Angel Capital Association Meeting in Greensboro, North Carolina - October 1, 2009

Highlights of the ‘Exit Early - Exit Often' video:

Why I think this will be called a "golden era" for entrepreneurs and angel investors.
Successful investing requires two things: buying right and exiting well.
The median price for private company M&A transactions is under $20 million.
Today, the corporate buyers are competitors to the traditional Venture Capital funds.
Traditional Venture Capital could shrink to half, or even a quarter, of it’s current size.
92% of M&A exits don’t work for these traditional VC funds - but they all work well for Angels and entrepreneurs.
So Angels and Entrepreneurs have a choice - an exit in 3 to 5 years without VCs or 10 to 14 years with VC investment.
Angels alone are "as likely as the VC backed firms to have successful liquidity events".
Checklist to determine whether an individual company should be financed with Angels only or VCs.
It depends on how much money the company will need, how long before the exit and the likely exit value.
It’s possible to sell a company much earlier than most people believe - all you really need to do is prove the model.
Developing the optimum exit strategy is one of those things that requires experience. Angels, directors and coaches can help.

The video is online in 720p high def here.

Exit Strategies for Angel Investors Video

Tue, 13 Oct 2009 22:16:54 GMT

The Northwest Energy Angels invited me to Seattle to talk about exit strategies for Angel investors. The full video and Q&A from that talk is online in full 720p High Def.

Some of the highlights include:

Organized angel investing is still quite new - only ten or twelve years old.
Successful investing requires two things - buying right and exiting well.
The big ‘new story’ is the large number of small and medium size exits.
The ideal size for big companies to acquire is $10 to 30 million.
Companies are being acquired earlier and earlier - often just 2 years from startup.
Venture Capital in North America is in crisis - big funds aren’t working anymore.
Traditional Venture Capital funds have grown too large for today’s exits.
We now have a much better idea of the differences between traditional Venture Capitalists and Angel Investors.
The most important differences relate to the exit - the minimum investment size, minimum return required and acceptable time to exit.
If a VC follows on it will add about ten years to the exit.
Fascinating new data from the bankrupt law firm Brobeck shows that "outcomes are inferior when angels and VCs co-invest".
Angels alone are "as likely as the VC backed firms to have successful liquidity events".
The optimum strategy is ‘Angels or VCs but not both’.
Checklist to determine whether an individual company should be financed with Angels only or VCs.

The video is online here.

Start at the End - Your Exit Strategy - New Ventures BC Seminar Series

Thu, 24 Sep 2009 00:38:03 GMT

It's the eve of the New Ventures BC Awards ceremony, and I've just posted the edited video of the last talk in this year's New Ventures Seminar Series: Start at the End - Your Exit Strategy.

Some of the highlights:

Your exit is the culmination of all the hard work you do as an entrepreneur.
How big companies think and grow. Why this is exceptionally good news for entrepreneurs.
M&A exits are happening earlier than ever before.
You don't need to grow your company to any specific size before you sell it - it doesn't even have to be profitable.
All you need to do before you can sell is to 'prove the model'.
The best time to sell is probably earlier than you think.
Please don't make the mistake I did - don't "ride it over the top" and wait too long to start your exit.
Do you even need investors to make it big today?
Why this is a golden era for entrepreneurs.
Why your first choice should be to bootstrap if you possibly can.
If you really do need capital, what are your options?
The classic view of the venture capital industry and what it looks like today.
Angel group syndication. Angel groups are now investing as much as $5 to 10 million in some companies.
Angels finance 27 times more startups than traditional Venture Capital funds.
Friends and Family investors invest much more than angels or VC funds.
There is no shortage of capital today - despite what you might have heard.
Why you need an exit strategy right from the beginning - and certainly before you contact your first prospective investor.
Developing an exit strategy - the most important element in your business plan.
Accepting money from a traditional Venture Capital fund adds about a decade to the exit timeline.
The unwritten contract between entrepreneurs and traditional Venture Capital investors.
The Unintentional Moonshot - 92% of exits don't work for traditional Venture Capital funds.
This means entrepreneurs and angel investors have two choices:
1. angel investors only and an exit in 3 to 5 years, or
2. traditional Venture Capital funds and an exit in 10 to 14 years.
Statistically, entrepreneurs should pick angels or VCs - but not both.
Checklist to determine whether your company would be better off financed by angels or VCs.
Conclusions for entrepreneurs and your optimum strategy for success.
Start at the end.
Good luck with your venture.

I hope you find this video valuable - its online here. I hope to see you at the awards ceremony tomorrow.

M&A Advisers Should be Local to Reduce Transaction Failures

Tue, 21 Jul 2009 21:44:39 GMT

When CEOs and boards begin to look for an M&A adviser, they often start in one of the big financial centers, like New York or Boston. It’s a natural mistake – and one that’s often expensive and regularly fatal.

One of the dirty secrets of the M&A adviser business is that many M&A transactions fail to complete. It’s impossible to find statistics on this. Every M&A advisory firm keeps their failure rate a closely guarded secret – many probably don’t even calculate failure rates.

For over a couple of decades now, I have been asking every CEO, board member and investor I know to share their M&A successes and failures. My twenty years in YPO also provided lots of perspective on M&A transactions gone well – and otherwise.

About One Third of Planned M&A Transactions Fail (under $100 million)

From what I’ve learned, about a third of M&A transactions fail. This is a rough percentage, but I am pretty sure somewhere between a quarter and a half of planned transactions never complete.

Failure Increases with Distant M&A Advisers

After hearing about the success and failure of around a hundred transactions, I realized there was a pattern. The M&A transaction failure rate increases as the distance from the company to the M&A adviser grows.

The reason is that the relationship between an M&A adviser and a company, CEO, board, their accountants and their lawyers is intimate and intense. It takes even the smartest M&A adviser a long time to really understand the value in a company, its strategic value and to determine who the best potential buyers are. Much of this work has to be done at the company.

The middle part of an M&A adviser’s job can be done remotely – that’s the prospecting, qualifying and sales funnel building. But in the latter stages of the M&A process, during the auction, negotiation and closing the M&A adviser will be working close to full time to help the CEO and board close the transaction. Most of this work has also to be done in the same city as the company. This is in part because the selling company’s lawyers and accountants are usually in the same city as the company.

Another reality of M&A transactions is that inevitably, ‘stuff happens’. In some of the transactions I’ve been involved with, the deal looked dead several times. These 'near death experiences' require immediate action to rectify. It could be to reconsider the strategy, work through an unexpected change in the agreement and/or to work through the business - and psychological - implications of whatever has changed. This type of work is almost always unexpected, but requires face to face action on short notice. That’s often not possible if the M&A adviser has to get on a plane. Failing to bridge even one of these potentially fatal changes usually means the transaction is doomed.

The really good M&A advisers know this and will plan to spend half of their time in the same city as the company during the first third of the process and most of their time in the same city during the last third.

There are other M&A advisers who think they can do most of that work remotely - with only weekly visits to the company. Those are the ones that CEOs and boards have to be very careful of. Even in today’s hyper connected world, you cannot do a really good job as an M&A adviser without a great deal of face time.

From the data I have gathered, I believe the failure rate doubles with distant M&A advisers. In other words, a hypothetical company using a remote M&A adviser might have a failure rate of 50%, but with a local adviser the failure rate might only be 25%. For another company, the failure rates might only be 40% and 20% respectively.

Distance Matters Less When Transactions are over $100 million

From what I have been able to learn, this effect is reduced when transactions are over $100 million. When an M&A advisory firm is working on a transaction over $100 million, the fees involved are usually a few million. There are also often two or three senior individuals involved with deals over $100 million.

When the fees are in the multi-million dollar range, the M&A advisers can afford to fly to the company almost every week and spend most of their time in hotels for many months. It’s also easier on their lives if they can split this between two or three senior people.

But this just doesn’t happen when the fees are below a million dollars. For sub-million dollar fees, there is almost always really only one senior person on each transaction. The economics, and human costs, just can’t justify more people, or the travel required, on these smaller deals.

Reputation is also More Heavily Weighted Locally

There is another dirty secret of the M&A adviser relationship that comes into play here. Professional M&A advisers know that every deal doesn’t end up closing. They build their business models, and manage their sales funnels and calendars, based on their knowledge that somewhere around a third of the deals they sign up to do will probably fail. These M&A advisers will still do OK on the deals that fail because their direct costs will be covered by the work fee.

Part of optimizing their business is knowing when to stop working with a company because the probabilities of success are too low. This is usually 6 to 9 months after they sign on. At that point, if the transaction looks like it’s not going to close pretty soon, many M&A advisers will start to reduce the amount of time they spend on the company. Instead they will devote their time to other companies with new work fees and where they feel the probabilities of success are higher.

This is Especially Likely When the First LOI Doesn’t Close

In every M&A transaction, the company has to select a single prospective buyer when it’s time to accept an offer and sign a binding LOI (letter of intent). At that point, they have to contact the other interested parties on the short list and tell them they cannot continue the process with them.

From the time the LOI is signed to closing is often around three months. If the deal falls apart after a month or two, the other prospective buyers have usually moved on to other opportunities and it’s usually very difficult to get them back to the table.

When this happens, the M&A adviser has to go back and rebuild the sales funnel. This is when I have seen many M&A advisers throw in the towel – especially when they are busy. (If it was purely a matter of economic self interest, they shouldn’t - they have already invested a lot of time with the company.)

The challenge is that they will usually have already contacted most of the best prospects. If they have to go back to the same buyers, the perception will be that they did not succeed the first time. This makes it much more difficult to build momentum on the second pass. It’s also psychologically much more difficult for the M&A adviser. So they usually move onto a ‘fresh’ deal and blame the failure on the company, valuation expectations or a ‘difficult’ CEO or board.

It’s Much Easier to Give Up on a Remote Company

Part of the dirty secret is that it is much easier for the M&A adviser to give up on a company when they are further from the company’s location. When M&A transactions fail, quite a few people will hear about it. But those people are usually geographically close to the company. The negative impact to the M&A adviser’s reputation will be similarly localized.

If the M&A adviser is geographically close to the company, they will be much more likely to stick it out to protect their reputation.

This is another factor that is much less important for transactions over $100 million. With these larger opportunities, local effectively translates to most of the country.

For Under $100 million You Really Need a Local M&A Adviser

Many CEOs and boards engage remote M&A advisers because they think that somebody from New York or Boston must be better than someone who lives within driving distance. In my experience, the real factors are mostly psychological – it’s like that old adage about a consultant just being a regular guy a long way from home.

The difference in a simple consulting job might not be significant, but when it’s your company being sold, and it’s under $100 million in value, you really need an M&A adviser that is close to home.

Early Exits - Your Golden Opportunity in HD Video

Fri, 10 Jul 2009 23:37:55 GMT

The Okanagan Research & Innovation Centre invited me to Kelowna to talk about early exits.

The title of my talk is "Early Exits - Your Golden Opportunity". It's online in full high definition video.

This is the link to the full post.

Angel Investors Blogs

Wed, 17 Jun 2009 16:01:04 GMT

For a few years now, I have wondered why there aren’t more blogs written by angel investors. This is my answer to the question, and the first list of angel investors' blogs.

Angels are More Important than VCs

One of the reasons I’ve been perplexed by the scarcity of angel investor bloggers is because I think angels are more important to entrepreneurs, and the economy, than traditional Venture Capital investors.

Angels invest about the same amount of capital each year as VCs, but angels invest in 27 times more startups. It’s because angel investors provide this critical early stage capital, and are involved in so many more young companies, that I believe they are more important to entrepreneurs, and the economy, than traditional VC funds.

The Search for Angel Bloggers

I am not the only one who has wondered why there aren’t more angel investor bloggers.

Jeff Clavier asked the question two years ago in Angel investor blogs: where are thou?

He was following up on two posts by David Beisel VCs and Angels, Where are the Angel Bloggers? and Continued Conversation about Angel Bloggers.

A couple of years ago, Don Jones from VentureDeal started a Feedburner network called ‘Angel Capital.’ I don’t think it ever grew beyond Don and me.

Three years ago, the Entrepreneurship Blog posted 65 VC & Angel Investor Blogs; but a review of that list did not seem to include any active angel investors' blogs.

VC Bloggers

Right from the beginning of the blogging phenomenon, there has been a large number of VC bloggers.

Just recently, Larry Cheng wrote a great post: Global VC Blog Directory – Ranked By # of Google Reader Subscribers. He ranked 115 VC blogs by their number of Google subscribers. I hadn’t seen that as a way to rank blogs before, but it makes sense to me. Cheng’s article provided me with the impetus to build the first list of angel bloggers below.

Why Aren’t There More Blogs by Angel Investors?

Venture Blog suggests some reasons there aren’t more Angel Investor Bloggers.

I think the reasons there are so few angel bloggers are pretty simple:

1. Angels eat what they kill - OK, I may be a little jealous here, but I remember what it was like when I ran a VC fund. I actually got a paycheck. Every month. No matter what. Angels only get paid when they sell an investment for a profit. So I think angels just have less time to blog.

2. Angels are a little older - Many angel investors are in their late 50s and sixties. Many are considerably older. They just never got caught up in the blogging ‘movement.’

3. Angel investing is not a primary activity - Most angels aren’t full time investors. Their other interests also mean they have less time to write about angel investing.

4. Angel investing is still quite new - The angel investment ‘industry’ today is at about the same stage of development as the venture capital industry was in the mid 1980s.

A Special Note About The Frank Peters Show

First, Frank and I are not related. The Frank Peters Show blog deserves a special mention in this list. Frank’s excellent blog on angel investing may be the most widely followed blog for angels.

His site is unique because it’s a podcast. Frank publishes ‘radio shows’ about angel investing once a week or so. He doesn’t publish an RSS feed, so I can’t compare his blog on my list. In an email to me, Frank said: "iTunes matters to me, 22% of my audience comes in from iTunes."

The First List of Angel Investors' Blogs

This is the first draft of the Angel Investor Blog List.

I’ve blended two rankings - the number of Google Reader subscribers (like the VC list) and the Alexa rank (smaller is better). Rankings are from June 17, 2009.

Please help me complete and update this list. If you know of an angel investor blog that should be included, submit a comment below or send me an email. Thanks for your help on this resource.

Rank	Blog Title	Google Reader Subscribers	Alexa Rank
1	AngelBlog	350	434,632
2	The Frank Peters Show	N.A.	1,686,963
3	Angel Investing, Entrepreneurship & Learning	69	1,958,903
4	The Angel Angle	22	1,164,435
5	Venture Hype - Where Angels Ignite	18	716,549
6	Angelsoft Blog	17	Subdomain
7	Rose Tech Ventures	N.A.	1,032,267
8	NZ Angels	N.A.	1,018,871
9	National Angel Capital Association (NACO) blog	14	1,912,818
10	Angel Investor - Bill Payne & Associates	10	2,992,498
11	Ask the Angels	10	1,228,545
12	National Angel Capital Association	10	5,128,753
13	CommonAngels - Adventures in Startups & VC	9	7,150,228
14	Common Stock Not	7	5,862,893
15	MyVirtualAngelWorld.com	6	4,922,224
16	Angel Investment Journal	3	3,654,593
17	Angels Den - Angel Investment Blog	3	N.A.
18	Angel Investment Journal - Angel Investing and Entrepreneur Blog	2	3,304,784
19	Business Angel Blog	1	1,954,056
20	Early Stage Deal Blog by Bill Payne	1	N.A.
21	Startups and Angels	N.A.	N.A.

This is a link to the Google bundle for the RSS feeds that are available. An OPML file is available here.

Apologies in advance if I have left anyone out or transcribed any of this data incorrectly. Please post a comment or email me your suggestions, updates and error corrections. Thanks very much.

M&A Advisor Fees

Wed, 17 Jun 2009 00:35:17 GMT

This is an excerpt from my new book: Early Exits - Exit Strategies for Entrepreneurs and Angel Investors (But Maybe Not Venture Capitalists).

Several people have mentioned how much they appreciate this section of my book. It’s surprisingly difficult to get information about M&A advisor fees for exit transactions. Few professionals post their rates. I am not sure why this is, and even less sure that it makes sense in today’s hyper-connected world.

Part of the reason I am posting this excerpt is to gather more data.

M&A Advisor Fees and Transaction Size

M&A advisor and business broker fees increase with the size of the transaction, but not in direct proportion. The amount of work required to complete a larger exit can actually be less than that of a smaller transaction. Where this becomes interesting is at the smaller end of the transaction size range.

The professionals that do merger and acquisition (M&A) transactions fall into three rough categories:

At the upper end of the range, there are the investment banks and accounting firms with teams devoted to M&A.
In the middle range there are boutique firms that usually include three to seven professionals.
At the smaller end of the transaction range, most exit transactions are performed by individuals or two to three person firms.

It’s much easier to understand the pricing mechanisms for exit transactions if you look at it from the perspective of the professionals doing the transactions. Very large firms have offices in downtown towers with real human receptionists and assistants. The boutique firms have smaller offices in less expensive buildings and have automated phone attendants and no assistants. The individual professionals answer their own phones.

For a transaction to make sense for the big firms with downtown offices, the total fees have to be in the $1 to 2 million range. For the boutique firms, the minimum fee size is in the $500,000 to $1 million range. Individual practitioners can afford to do exit transactions where the fees are only a few hundred thousand dollars.

Typically, the big firms will compete most aggressively for exit transactions above $100 million because these transactions will produce several million dollars in fees. The $20 to 75-million range is the optimum range for the boutique firms. Smaller transactions are usually done by individuals. These numbers shift up or down depending on how busy the firms are.

The standard M&A advisor fee model includes a work fee and a success fee. In some cases, it may also include a contingency or break fee.

M&A Advisor Work Fees

Work fees are paid by the company up front or, sometimes, monthly over the first four to six months. This covers the M&A Advisor's direct costs during the initial stages, as well as their contribution to the preparation of the selling documents and due diligence materials.
For larger transactions, the work fees are usually $100,000 or more. For boutique firms working on a $20 to 30-million exit transaction, the work fees are usually in the $50,000 to $75,000 range. At the lower end of the transaction spectrum the work fees don’t usually go below $50,000 because no matter how small the transaction there is still a fixed amount of early work that has to be done.

It’s very unusual for a firm, or even an individual practitioner, to undertake an exit transaction without a work fee. Part of the reason is that anyone involved with exits has seen a situation where, at the time of the initial engagement, the shareholders and board are enthusiastic about an exit, but by the time an offer gets to the table the shareholders have reconsidered.

Often this happens precisely because the advisor or broker has done a good job, and has shown the current shareholders that the company is worth significantly more than they thought. This alone can often result in shareholders changing their minds and deciding to continue to own the company for a while longer.

The work fee is a fair way for the professionals to protect their initial investment in helping to facilitate a transaction. It is also a test of how serious the sellers are to actually sell the company.

M&A Advisor Success Fees

Success fees for exit transactions in the $10 to 30-million range are typically 4-6% of the final exit value. This means that the business broker who successfully completes a $25-million exit transaction will usually be paid a fee at closing of about $1 million.

For transactions over $100 million, I have heard of success fees that are in the 2-3% range. This means that a broker executing a $100 million exit will typically receive a success fee in the $2 to 3-million range.

Where success fees become more challenging is in the smaller size transactions because the amount of work required to execute a $5-million exit is not significantly less than the effort required for a $25-million exit. It takes just about as much manpower in either case and in some ways the smaller sizes are actually more work.

Why Smaller Transactions Are Often More Work Than Larger Ones

It can be even more difficult to sell a $5-million company than a $25-million company because the buyers for smaller companies tend to be either the junior people in the large company acquisition teams, or the CEOs and CFOs of medium-size companies. Their relatively lower experience levels, or lack of availability, means that these transactions often require more time from the advisor or brokers.

So even the smaller boutique firms will not usually want to undertake an exit transaction in which the selling price will be less than $10-million. Even at a 6% success fee, a $10 million transaction will only deliver a $600,000 success fee. This is approaching the minimum economic size that even the smaller firms can undertake.

This is why transactions in the $5 to $25-million range are often done by individuals who have developed expertise in this area.

Because of the amount of work involved in a $5-million transaction, the success fees are often in the 7-10% range.

While the amount of work required to perform exit transactions is similar whether the company is valued at $5 million or $100 million, the fees for large brokerage houses are higher due to their overhead and prestige.

Please Share Your Data

I'd appreciate hearing from you about your experiences with M&A Advisor fees. The only way I have been able to aggregate this information is by asking CEOs, board members, investors and M&A advisors that I meet. If you have a data point you can share, please either leave a comment below or email me directly.

It’s Easy for US Angels to Invest in Canadian Companies under the New Tax Treaty

Wed, 10 Jun 2009 18:45:20 GMT

I just finished a very interesting web conference: Cross-Border Co-Investment for Angel Investors: What You Need to Know to Invest in Canada.

Matey Nedkov de Lacamp got the ball rolling for this idea while we were together in Atlanta at the National Angel Capital Association Summit in April. Bryan Watson from the Canadian Angel Capital Organization put together the web conference. Many thanks to you both.

There were over 30 people on the call including a number of tax lawyers on both sides of the border.

I was very pleased to learn how the new tax treaty between the US and Canada works for angel investors. This was especially interesting for me because I am a member of the executive of the Bellingham Angel Group. About a third of the investments from the Bellingham angels are in Canadian companies.

This is my understanding from the web conference as it relates to US angels investing in Canadian companies:

If a US angel invests directly into a Canadian company there are no additional taxes to pay at the time of the sale.

When the exit occurs, some buyers may decide to withhold 25% of the non-Canadian investors’ proceeds and then send these to the Canadian Tax authorities under Section 116. The buyers do this to protect themselves, because if some shareholders were not US residents, the investors would not be protected by the new treaty and some taxes might be payable in Canada.

Neither the US investor, or the buyer, absolutely has to withhold, or remit, this amount. If they are comfortable that the US investors are US residents, then there will be no tax to pay and no need to withhold the 25%.

For individual angel investors, or for small sized angel funds, it is a simple matter to show they are US residents.

The only time Section 116 becomes problematic is with large funds, like Venture Capital Funds, where there are many investors, international investors, corporate investors etc. In these cases, the paperwork to show that all of the investors are in fact US residents becomes burdensome. In these complex cases, the buyer may not be comfortable and may decide to submit the 25% withholding to the Canadian tax authorities.

In conclusion: for US resident angels investing in Canadian companies there are no forms to fill out. If the buyer is sophisticated there should not be any withholding when the company is finally sold.

If the buyer is not comfortable that the US investors are US residents they may withhold 25% of the proceeds that are due to the non-Canadian investors. If they do, it will take a few months for the angels to get the last quarter of their proceeds.

This is my understanding of the web conference. Please confirm this with your tax advisor.

I will post a link to the PowerPoint slides and audio recording when they are available.

I’d appreciate comments from anyone who is knowledgeable in this area.

Don't Blow the Biggest Deal of Your Life

Sun, 24 May 2009 23:09:00 GMT

This post is a video series from a talk I gave to the Entrepreneurs Organization Vancouver Chapter.

It's the first time I've had the courage to describe all of the things I did wrong on my first exit transaction.

It's also the story of the first time I lost several million dollars.

I compare my first exit to a more recent one where everything was perfectly planned and executed.

This is the link to part 1 of the videos.

Maximize Exit Value Video Series

Thu, 21 May 2009 17:28:15 GMT

My latest post is a video series of a talk I gave on Maximizing Exit Value at the Angel Capital Association Annual Summit in Atlanta.

Topics include:

When can you sell? It may be much earlier than you think.
Developing an Exit Strategy. Every company needs an exit strategy - ideally before the first investor.
Maximizing Value - things you should be doing now to maximize the value you ultimately get for your company.
It's often possible to sell a company for 50% more.
The role of the M&A Advisor and other professionals. How much they will cost and why it's a good investment.
Secondary sales - why it's often a good idea to find a buyer for some founders stock before the exit.
Planning for a Successful Exit - the list of things that should be done long before you start the exit.
Why you should be afraid of the 'reps and warranties'.
The Exit Timeline - how long does it take to design and execute and optimum exit

This is the link to part 1 of the videos.

Exit Strategies Videos

Mon, 18 May 2009 22:46:47 GMT

My latest post is a video of a talk I gave on Exit Strategies for Angel Investors and Entrepreneurs at the Angel Capital Association Annual Summit in Atlanta.

Topics include:

The Current Environment for Exits
The Fact that Most Exits are Under $20 million
Why M&A Exits are Happening Earlier
Why Companies Don’t Need As Much Capital
The Differences Between Angels and VCs
Why Most Companies and Angel Investors Don't need Venture Capital
The Optimum Strategies for Angels

This is the link to part 1 of the videos. There is also an iPhone and low resolution set of the videos that starts here.

Venture Analysis – Access Your Startup’s Feasibility and Fundability

Mon, 11 May 2009 13:25:44 GMT

This post is an enthusiastic endorsement of a new service for entrepreneurs called a “Venture Analysis”.

I run an angel fund, belong to three angel groups, blog about angel investing and am an Entrepreneur in Residence at Simon Fraser University. As you can imagine, I meet a lot of enthusiastic entrepreneurs and see way too many business plans.

The entrepreneurs in most new ventures need some type of help. I often feel like I could clone myself a dozen times and still not have enough space in my calendar to help the entrepreneurs in the ventures I am personally excited about. Unfortunately, I can’t clone myself and I already have a good sized portfolio. So I do my best to make introductions and connect entrepreneurs to people who are knowledgeable in the areas they need help.

Several times a week, I wish there were more places I could send promising entrepreneurs for assistance with their very early ventures. My dilemma is that I know how much help the entrepreneurs need. I also know they don’t have much money.

There are legions of consultants who work with young companies. Some are truly excellent. None that are good are inexpensive. (Anybody that actually adds significant value to an organization deserves to be fairly compensated.) In many cases, a little help in the formative stages can literally make the difference between failure and huge success. This early input can be the most valuable because it can affect the corporate DNA and influence the development of the business plan when it matters the most.

This post is about an excellent new resource for entrepreneurs at the seed and start-up phase offered by Bill Payne. Bill is probably America’s leading angel educator. I’ve been through a dozen full, or half day, sessions that Bill has taught. All were excellent.

At the Angel Capital Association meeting in Atlanta in April, Bill received the very prestigious Hans Severiens Award - the highest award that I know of for Angel Investors.Bill is certainly one of the most knowledgeable and experienced angels in the world.

Bill’s new Venture Analysis helps entrepreneurs “appraise the feasibility and fundability of new venture ideas.” You can read all about it here.

I think Bill charges far too little for this input – the Venture Analysis only costs $250. I think its worth much more and for some entrepreneurs Bill’s early input will be worth millions.

Bill’s not paying me anything to write this. I am doing it because I know Bill and I think he can make a big difference for a lot of aspiring entrepreneurs. I’d appreciate hearing what you think of Bill’s Venture Analysis - whether you’ve used it or not.

Please leave a comment below or email me privately. Much of my day is invested in helping entrepreneurs. If you come across similarly excellent resources please send me a link.

Angels Finance 27 Times More Start-ups Than VCs

Fri, 01 May 2009 16:42:22 GMT

It’s amazing how many entrepreneurs think venture capital funds are the primary source of funding for seed and start-up companies.

VCs only fund 400 to 600 seed or start-up companies per year in America.

Angel investors fund about 16,000 seed / start-up companies per year in the US - about 27 times more.

Scott Shane makes an important contribution to our understanding of entrepreneurship, angel investing and venture capital in his new book Fool’s Gold published earlier this year. Scott is the A. Malachi Mixon III Professor of Entrepreneurial Studies, Department of Economics, Weatherhead School of Management at Case Western Reserve University.

Fool’s Gold is based on solid academic research and debunks several myths about early stage company financing.

Scott references National Science Foundation data that showed US VCs funded 612 seed or start-up companies in 2004 (pg 115). This was 23.7% of the total 2,578 US VC deals that year. That is in the same range as the PWC Moneytree number of 424 seed/start-up investments by US VCs in 2007.

Angels fund many more companies and a larger percentage are at the seed and start-up stage.

In 2003, the Federal Reserve did a study on Small Business Finances. The Fed data estimates that angels fund about 50,700 companies each year in America. The Center for Venture Research (CVR) has been conducting research on the angel market since 1980. The CVR is a multidisciplinary research unit of the Whittemore School of Business and Economics at the University of New Hampshire. They report that 55,480 entrepreneurial ventures received angel funding in 2008 – in the same range as the number above from the Fed study.

In an email to Scott I asked: “On page 114 you reference data from the Entrepreneurship in the United States Assessment study that says 35.5% of angel investments are in pre-revenue companies. I appreciate that ‘pre-revenue’ is not precisely the same as seed/start-up, but if we take those as roughly equivalent, would you agree that angels invest in about 35% x 50k = 16k seed/startup companies per year?

And that if angels fund about 16,000 seed/startup companies per year and VCs fund about 600, then angels fund about 27 times more seed/startup companies per year?

Scott responded: "I think that 27:1 is about right for the ratio of angel to VC seed and start-up stage investments." This is very good news for entrepreneurs and the economy.

There has been a lot written about the traditional venture capital model being broken and the reduction in venture capital financing all around the world. With VCs financing only about 4% of seed and startup-up companies, the decline of traditional venture capital funds shouldn’t be a serious problem for early stage companies - or the next phase of growth in the global economy.

Angel Investing is Where VC was 25 Years Ago

Thu, 23 Apr 2009 23:52:11 GMT

The angel investment ‘industry’ today is at about the same stage of development as the venture capital industry was in the mid 1980’s.

Last week, I was at the Angel Capital Association annual conference in Atlanta. It was exciting to share ideas with 400 of the most active angel investors, and angel group leaders, from all around the world. There were surprisingly large contingents from South America and Europe.

I presented a half day workshop on exit strategies for angel investors and introduced my new book www.Early-Exits.com.

Few people appreciate that angels invest about as much money as venture capital funds do each year – about $25 billion in the US. The ratio seems to be similar worldwide. Entrepreneurs, government officials and the general population consistently underestimate the importance of angels to the financial ecosystem and the growth in the economy.

The biggest reason is that angel investing is still a relatively new phenomenon – the first angel groups were only formed about ten years ago. The graybeards at the ACA conference all agreed that a decade ago, there were only about 20 angel groups in North America. Interestingly, two of those earliest groups formed here in Vancouver.

As I attended sessions, and had conversations, on everything from deal structures to term sheets and deal flow to exits, it occurred to me that I had been in similar conferences about 25 years ago. Back then I was listening to parallel conversations about the development of best practices - but then it was in the venture capital industry.

When I was a young entrepreneur, part of our plan was to finance our growth with venture capital. We didn’t know anything about raising venture money and back then there were only a couple of books published on the subject. The internet hadn’t been invented, so I couldn’t read blogs or subscribe to twitter feeds.

To learn, I attended venture capital conferences. Back then, those conferences weren’t for the companies at all; they were for the guys starting and growing venture capital funds. The industry was so young that most of the conference organizers didn’t mind me attending as long as I paid the full fee.

I recall sitting in rooms with about the same number of attendees and listening to a similarly small number of presenters who were willing to share what they had learned.

In the early to mid 1980s, the average venture capital principle only managed about $3 to 5 million. That felt like the same ballpark amount that the senior guys in Atlanta last week had to invest (ignoring inflation.)

At the conference last week, there were enthusiastic discussions about forms of investment, term sheets, pre and post investment relationships with entrepreneurs and VCs, portfolio management and valuation.

Those are the fundamentals. The basics. At ten years into the development of the angel capital industry, we are just starting to have the important discussions about how angel capital works, how we can best help entrepreneurs grow new companies and how we will contribute to the 21st century economy.

Just about the same place the venture capital industry was 25 years ago.

There was open discussion in Atlanta about the fact that lots of angels haven’t made money yet. Lots have lost most of their portfolio. Some have given up because they haven’t been successful.

That shouldn’t surprise anyone. Today’s angel investors are the pioneers. We are just starting to figure out what works and what doesn’t. It will be another five or ten years until we have accepted best practices. We angels have a fascinating decade ahead.

Angel investors are especially important at this point in the history of the world. The traditional venture capital model seems to be broken. The global economy is not as healthy as we’d hoped.

I have no doubt that a decade, or two from now, as the boomer demographic is coming to the end of their peak angel investment years, it will be recognized that angels and entrepreneurs played a large role in revitalizing our global economy.

Start Up Now - Enterprize 2009 Keynote Video

Mon, 16 Feb 2009 23:05:48 GMT

As part of putting something back, I often speak to university students about starting companies - ideally while they are still at university.

Last Saturday I gave the Awards Dinner Keynote speech at Enterprise 2009.

Enterprize is Canada's largest student business plan competition. This year's event was a huge success and drew excellent teams of competitors from all across the country. There were about 400 people at the awards dinner.

The video of my speech is available here.

VC Return Numbers are Bogus

Tue, 10 Feb 2009 18:33:33 GMT

There has been a lot of excellent blogging and valuable dialog recently about the Venture Capital Model Being Broken.

Everyone is trying to figure out what happened to the VC industry, and many are making suggestions on how it might be fixed. Unfortunately, a lot of this work is based on bogus data.

Erick Shonfeld's post "A Scary Line Has Been Crossed for VCs" on TechCrunch picked up on some provocative writing by Adeo Ressi, founder of The Funded.com, in his talk at Harvard Business School. This graphic from The Funded got a lot of attention and coverage in the old media.

Fred Wilson wrote an excellent post in response to Claire Cain Miller's article in the New York Times titled "Venture Capital Returns Dip Below Zero." Part of Fred's argument is the data below, from Thomson Reuters and the National Venture Capital Association. Like Fred, I have referred to this data many times. It is regarded as the best available data on many financial asset classes.

The perspectives illustrated in the graphics above seem contradictory. So what's really going on?

In my opinion, nobody really knows because the data on VC industry returns is bogus.

When you look at the returns on an index like the NASDAQ or S&P 500 you can trace back all of the underlying source data to accurate financial information submitted by the public companies as required by law. You can be reasonably confident that every company in these indexes has submitted recent, accurate financial information.

The same is not true of the venture capital industry.

When I ran a family of VC funds, I would get calls all the time from Thomson asking us to submit our data. At first, I dutifully submitted our information. Then I got busy with our portfolio, so I delegated it to one of our junior team members. I was never sure they actually knew how to complete the information forms.

Then we got even busier and nobody in our organization had the time to report all of the detailed information that Thomson was asking for. Thomson would call often. They would track me down at conferences and offer to buy me drinks. I believed in what they were doing and sincerely wanted to help, but I just couldn't find the resources to submit the information they needed.

It bothered me and I occasionally wondered how they could aggregate meaningful data if funds like ours didn't submit their information. I asked one of the Thomson team at a conference once. They looked at the floor and mumbled something about "that being a problem in their industry."

Then one day at a national VC conference the truth hit me like a hammer between the eyes.

I was watching a presentation on the latest statistics on the Canadian industry's dismal investment returns. I kept thinking to myself that the numbers couldn't be that bad. Then the main researcher said something to the effect that there was a bias in the numbers.

The glass-half-full-entrepreneurial-optimist in me leapt on his words and I thought to myself: "Ah, ha! I knew it couldn't be as bad as those numbers up on the screen."

Then the researcher went on to explain that the bias came from the fact that "under performing funds tend not to report". My brain churned for a second as I tried to assimilate that statement. Then it dawned on me. The bias in the data meant that the actual returns were worse than what the numbers showed - possibly much worse.

Since then, I've asked several of my VC friends about this. Some had never wondered about the accuracy of the industry statistics or worried about this bias. Many weren't submitting their data either. There is no question that human nature makes it much less likely that an underexposing fund will report, but some of my friends with good results were often not reporting either simply because of the huge amount of effort it requires.

There has been widespread criticism of the venture industry for not publicly reporting their returns. As the private equity asset class has exploded over the past decade or two, the regulators have tried to improve disclosure. Until we have full disclosure, we will never really know how the venture capital industry is actually doing.

If any of you think I am missing something here, please add a comment.

Optimum Share and Option Vesting

Wed, 28 Jan 2009 02:38:44 GMT

I believe vesting is the most important element of corporate structure. It is essential to ensuring that both entrepreneurs and investors are treated fairly and equitably. Vesting has incredibly powerful effects on the group psychology, culture and corporate performance. I have seen many companies literally fail due to flaws in their vesting.

Widespread employee ownership is still a relatively new concept. Even as recently as the 1980's, there was still debate on the degree to which employee equity ownership affected corporate performance.

Today, it is widely accepted in North America that companies with broad employee ownership create larger increases in shareholder value.

After a couple of decades of experience, and a few good analytical studies, there is now a broad consensus on the range of equity that is reasonable for a new CEO, or other senior employee, to expect when joining a company.

Even though there is now reasonable agreement on the ideal magnitudes of equity ownership, there is still discussion on the optimum vesting formula.

In my opinion, the most fair and equitable structure, and the one that maximizes the alignment between the founders and the investors, is to vest:

50% of the shares daily over a three year period; and
The other 50% when there is a sale of the Company.
All vesting for senior employees accelerates on a sale of the Company.

The rest of this post describes the evolution of vesting and the elements of contracts and psychology that make this formula optimum.

Is Angel or VC Financing Best?

Sun, 25 Jan 2009 00:34:38 GMT

Entrepreneurs and directors frequently ask me whether angel or VC financing would be best for their company. Fortunately, the answer is usually easy to determine based on the characteristics of the company and its current shareholders.

The Corporate DNA of angel investors and venture capital investors is quite different. It's rare to find a situation where one choice is not clearly better.

The table below describes the tests to determine whether angels or VCs are a more desirable source of financing for your company:

Characteristics of the company and current shareholders	Best Funding Source
Characteristics of the company and current shareholders	Angel Investors	Venture Capital Funds
Amount of capital required to prove the business model [2]	Under $3 to 5 million [3]	Over $3 to 5 million
Years before being able to execute an exit	2 to 5 years	10 to 12 years [4]
Most likely value of the company at the time of the optimum exit	Under $50 million	Over $100 million
Willingness to relinquish control of important financial decisions	Not always required	Almost always required

The rest of this post has the notes to this table and a list of other great artilces on this topic.

VC Mandatory Moonshot - The Unwritten Terms

Wed, 21 Jan 2009 00:00:31 GMT

Most entrepreneurs don’t even know that a VC is likely to block an exit when they accept the VC’s money. I didn’t when I started out —and neither did my friend who I describe in "Why VCs Block Good Exits".

In my first company it wasn’t until the final extraordinary general meeting, when the shareholders were voting to approve the exit transaction, that I actually realized how aggressively a VC will try to block an exit.

VCs design their investment agreements to give them the power to block exits. VCs worry that after they invest, the entrepreneurs will want to sell the company for something that might give the entrepreneurs a 100x return and the angels a 10x return but only a 3x return for the VCs. This concern was one of the reasons that VCs wouldn’t invest in Brightside.

My previous post, at the link above, has more on why VCs block good exits.

The Legal Mechanisms

VCs usually build in more than one way to block exits:

The most effective way VCs block exits is with the terms in their preferred shares. Like my younger self, most first-time entrepreneurs have no idea how multiple share classes really work. For example, when I was starting out, I did not understand that different classes of shares each have to vote separately to approve important transactions. Usually, the VCs are the only ones with the pref shares, so they effectively have a built-in veto.
VCs can also effectively block exits by dominating the boards of the companies in which they invest. This is usually a contractual commitment of their investment.
They will also have terms and conditions in their investment agreements that allow them to make the decisions about when a company can exit.

Even the Y Combinator Docs Provide an Exit Veto

Paul Graham and Y Combinator are making enormous contributions to the evolution of entrepreneurship and early stage investing. Y Combinator invests very small amounts of money into early stage companies through an innovative, modern incubator model.

I admire Paul Graham for posting their term sheets and financing agreements. Even these simple agreements for very small, first financings contain absolute veto powers on exits:

"So long as any of the Preferred is outstanding, consent of the holders of at least 50% of the Preferred will be required for any action that: ... or (iii) approves any merger, sale of assets or other corporate reorganization or acquisition."

I am not saying this is wrong. In an earlier post on Preferred vs Common Shares I point out that in some situations preferred shares are necessary to be fair to the investors. Even where there is a board in place, there may still be situations where it makes sense for the investors to have veto power on exits. There is, however, no way to solve the fundamental conflict of interest when holders of preferred shares sit on boards. Nor is there a way to repair the fundamental lack of alignment between common and preferred shareholders.

My point is that every entrepreneur and board must fully understand how their exit options will be impacted before accepting any pref share investment.

A Chilling Perspective from a Law Professor

For a fascinating, and chilling, perspective on how venture capitalists view entrepreneurs and exits, read this paper "Control and Exit in Venture Capital Relationships" by Gordon Smith of the University of Wisconsin Law School.

Smith has obviously spent a lot of time working with VCs. Some of his language provides an invaluable perspective into how VCs control exits.

The rest of this post includes some excerpts from this paper that every entrepreneur and director should read before accepting a preferred share investment.

How VCs Block Exits

Mon, 19 Jan 2009 17:19:04 GMT

My previous post, at the link above, has more on why VCs block good exits.

The Legal Mechanisms

VCs usually build in more than one way to block exits:

The most effective way VCs block exits is with the terms in their preferred shares. Like my younger self, most first-time entrepreneurs have no idea how multiple share classes really work. For example, when I was starting out, I did not understand that different classes of shares each have to vote separately to approve important transactions. Usually, the VCs are the only ones with the pref shares, so they effectively have a built-in veto.
VCs can also effectively block exits by dominating the boards of the companies in which they invest. This is usually a contractual commitment of their investment.
They will also have terms and conditions in their investment agreements that allow them to make the decisions about when a company can exit.

Even the Y Combinator Docs Provide an Exit Veto

I admire Paul Graham for posting their term sheets and financing agreements. Even these simple agreements for very small, first financings contain absolute veto powers on exits:

My point is that every entrepreneur and board must fully understand how their exit options will be impacted before accepting any pref share investment.

A Chilling Perspective from a Law Professor

Smith has obviously spent a lot of time working with VCs. Some of his language provides an invaluable perspective into how VCs control exits.

The rest of this post includes some excerpts from this paper that every entrepreneur and director should read before accepting a preferred share investment.

Why VCs Will Block Good Exits

Sat, 17 Jan 2009 01:20:18 GMT

A friend of mine founded a tech startup about five years ago. His investors were several prominent VCs. The company had an opportunity to be acquired by a much bigger company at a price that would have produced a return for the VCs of about 300% (i.e. 3x).

The management team was eager to sell because much bigger players were moving into their market and they had concluded that it would be much harder to win new contracts in the future. They also believed that because the big players were getting excited about their space, they would probably get the best valuation now.

But the VCs were Blocking the Sale

My friend couldn’t understand why his board was blocking the sale. He asked me why the VCs on his board couldn’t see the situation they were in and appreciate the opportunity for a great exit that was right in front of them.

I explained that it wasn’t the VCs who were missing something; it was my founder friend who didn’t get it.

The full post explains what my friend didn't understand when he selected venture capital investors to fund his company.

Exits with VC and Angel Investors

Thu, 18 Dec 2008 23:14:00 GMT

The most important new data on angel investing comes from Robert Wiltbank of Willamette University and Warren Boeker of the University of Washington.

Robert Wiltbank is one of the world's pre-eminent researchers on angel and VC investment.

One of the fascinating aspects of this research is how VC investors affect the exits of angel-backed companies.

When I first saw this data, it leapt off the page at me.

This graph shows what the greybeard VCs and angels have known for a while. If your company has VC investors, they will reduce the probabilities of an exit that would produce a 1-5x return for the angels. That exit might have produced a 100x return for the entrepreneurs (because they paid much less than the angels for their shares).

Having VC investors does increase the probabilities of exits above a 5x return.

But there is no free lunch. The data shows that after a VC invests your chances of failing completely also increase significantly.

The other important factor, which unfortunately this data doesn't show, is that adding VC investors will also increase the time until a successful exit by about a decade.

This is an important message in my new book: "Early Exits - Exit Strategies for Entrepreneurs and Angel Investors - But Maybe Not VCs".

VC Fund Lifetimes

Tue, 16 Dec 2008 01:09:39 GMT

My previous post was about how it takes about a decade longer to exit in companies with venture capital investors.

That's much longer than most entrepreneurs and angel investors would guess.

Most VC funds are designed for ten year lifetimes. In actual practice, it takes significantly longer to actually exit the investments and shut down the typical IT VC fund.

The actual distribution of VC fund lifetimes is show in the graphic below.

The rest of this post explains why entrepreneurs often scare off angel investors by saying they are planning on a VC round.

Exits With Venture Capital Investors

Wed, 10 Dec 2008 16:20:47 GMT

My previous post showed how the math behind venture capital funds determined venture capital exit times. The post included a simple model to show what the median exit times really meant to entrepreneurs and angel investors.

That model illustrated how the decision to accept equity from venture capital investors statistically extends the time to exit for the angels by something around 12 years.

The graph below illustrates that happens to the time to exit, and probability of exiting, without and with venture capital investors. This graphic shows this from an angel investor's perspective. The times are even longer for the entrepreneurs and friends and family investors.

The rest of the post explains more. The full story will be available in my book: "Early Exits - Exit Strategies for Entrepreneurs and Angel Investors - But Maybe Not VCs".

Venture Capital Exit Times

Fri, 05 Dec 2008 18:15:00 GMT

My two previous posts described how venture capital investors will want to invest too much and exit only for very high returns.

Why are those bad things for entrepreneurs and angel investors?

They can be very bad because they make:

1. Venture capital exit times extremely long - much longer than you probably realize

2. The risk of actually achieving an exit increase dramatically

This post describes why these factors make venture capital exit times so long.

If the successful venture capital investments need to return 30x on average, or at the very least 10x, to generate a minimum VC return of 20% per year, how long will the VC fund have to hold the investment before an exit?

The graph below shows how many years it takes to generate a minimally acceptable VC fund return from the winning investments.

Some companies will create increases in share value faster than 30 or 40% per year, but these are extremely rare. Everyone who has run a company knows that generating consistent 30 to 40% annual increases in value requires a great deal of hard work and some luck.

This is especially true when you realize that these are not just the increases in the overall enterprise value, but instead the increase in the per share value of the company. The difference of course is the additional dilution from any future financings or employee equity plans.

The 8 to 10 years shown in the graph above seems almost impossibly long. Could it really take that long? The rest of this post shows actual data on venture capital exit times and describes what that really means for entreprenuers and angel investors.

Venture Capital Funds - How the Math Works

Fri, 05 Dec 2008 01:22:36 GMT

Why the Size of Venture Capital Funds Matters to Angels and Entrepreneurs

My previous post was titled Venture Capital Firms Are Too Big. That post provides one important piece of data necessary to answer the really important question of why the size of venture capital funds matters to angel investors and entrepreneurs. This post describes the second key element.

Venture Capital Fund Math

Peter Rip of Leapfrog Ventures describes some of the math behind venture capital funds in a fascinating post titled ‘Traditional Venture Capital Sure Seems Broken – It's About Time.’ It provides some outstanding insight into how the math behind venture capital funds affects the way venture capital fund managers make investments and how they behave after they invest.

This post is a high level summary of how the math works for a typical venture capital fund.

In a Typical Fund the Returns are From 20% of the Investments

In a typical VC portfolio, most of the returns are from 20% of the investments. This is just a statistical fact - a law of nature. Statistically, if a VC makes ten investments, two will be winners and create most of the gains in the fund.

The Minimum Respectable Return on a VC Fund is 20% per year

A minimum 'respectable' return for a VC fund is 20% per year. This is set by the expectations of the investors in VC funds, the relative risk levels compared to other investment classes and the performance achieved by other venture capital fund managers.

What this Means for Angels and Entrepreneurs

This minimum acceptable return has profound implications for entrepreneurs and angel investors. It means that if company has venture capital fund investors, they will almost certainly block an opportunity to sell the company unless the price gives the VCs a 10 to 30x return.

The full post explains more of the math behind venture capital funds.

Venture Capital Firms Have Gotten Too Big

Wed, 03 Dec 2008 22:45:08 GMT

Many bloggers have been saying recently that the VC Model is Broken. One of the most important reasons is that Venture Capital Firms are just too big.

Why Venture Capital Firms Got Too Big

In the 20th century, technology companies often required tens or hundreds of millions of dollars to build out and prove. Companies like Intel, Microsoft, Amazon and Google required hundreds of millions of dollars to scale up to the size where they were proven winners. This was one of the factors that led to venture capital firms becoming ever larger.

Being a VC fund manager was also a great job for the fund principles, once the fund was large enough. Most VC funds are structured so the fund managers charge a management fee of about 2.5% of the value of the fund each year. The management fee pays the salaries of the fund managers and their support staff. A small VC firm usually has four partners and some support staff. This means that the annual operating budget for even a small fund quickly grows to more than $2 million per year.

Most VC managers believe a fund under $100 million isn’t economical. The goal of most VC managers is to grow the fund to several hundred million, in part, because then they can start pull down some very attractive compensations. This is another reason that venture capital firms have continued to grow.

The graph below shows how these trends have led to the phenomenal growth in the size of venture capital firms over the past 30 years.

What This Means for Entrepreneurs and Angel Investors

For most startups it means that venture capital firms probably aren't the best source of funding - or that they aren't even a desirable source of funding. The full post, available here, begins the explanation of why this is. This is also an important part of my upcoming book: "Early Exits - Exit Strategies for Entrepreneurs and Angel Investors - But Maybe Not VCs".

Capital Structure Projection for Angel Investors and Entrepreneurs

Mon, 27 Oct 2008 13:09:45 GMT

For the purposes of this post, the term capital structure is simplified to include only shares. Later in a company's lifecycle, the capital structure may also involve various forms of debt.

Capital Structure and Share Register

All jurisdictions have a legal requirements for the share register to list all of the current shareholders of a company. This post provides an example of how to create a share register.

Capital Structure Projection is Necessary for a Meaningful Financial Projection

To build a meaningful financial projection for a company, and to predict the future value of the shares of the company, you need a projected capital structure (i.e. projected share register). The capital structure projection shows the effects of future financings on the number of shares outstanding, and the percentage ownership for the founders and investors. It is important for company founders and investors to agree on the projected capital structure as a confirmation that the entrepreneurs and investors are aligned and effectively communicating about future financings and the exit strategy for company. It is surprising how often the investors and founders have not in actual fact communicated clearly on these critical alignment questions.

A Projected Capital Structure is Psychologically Healthier

Another benefit of working with a capital structure projection is that is is psychologically healthier for founders to understand the realities of dilution and percentage of the company they will own after the third or fourth financing, rather than the percentage they own at startup. Most of the time, founders will fix the percentage of the company they owned at startup in their mind without factoring in the inevitable dilution from future rounds of financing. This often leads to a negative psychological reaction to issuing new shares to raise equity financing - regardless of whether it is accretive.

If you have not lived through the realities of dilution before, the easiest way to understand it is to spend some time working with a projected capital structure that incorporates a company's future financial requirements. The example share register available here includes several rounds of equity financing, typical of a successful angel backed company.

Investor Perception

The projected capital structure is one of the first impressions an investor receives when starting due diligence on a company. If the projected capital structure is complete, logically laid out and effectively formatted, prospective investors will feel like the company is organized, compliant and managed by entrepreneurs who understand how future rounds of financing will affect their company and their shareholdings.

Gaps in Undertanding

Tue, 21 Oct 2008 01:18:09 GMT

Why do so few startups succeed?

One of the reasons is the "Gaps in Understanding" between the angel investors, VCs and entrepreneurs – individuals with wildly disparate natures, who have to work together for a company to be successful.

Startups Need Different Types of People

Most entrepreneurs need angel investors or VCs to succeed. Similarly, angel investors and VCs need entrepreneurs to succeed. Angel investors, VCs and entrepreneurs are all part of the same entrepreneurial ecosystem. Unfortunately, relationships between entrepreneurs, angel investors and VCs often become strained, substantially reducing the probability of success.

If you’ve seen, or taken part in, the disagreements between the warring factions of entrepreneurs and investors across the boardroom table, you might think age is the primary source of conflict. While age is sometimes a factor, disparity of experience is most often the culprit. Vastly different life experiences creates ”gaps in understanding” between angel investors, VCs and entrepreneurs - neither group fully understanding the motivations, economics or time horizons of the other. In the case of a fledgling company, not addressing these gaps in understanding can be fatal.

When I was an entrepreneur I could not understand our investors

When I was an entrepreneur, I just couldn't understand our angel and venture capital investors. Our angel investors were especially frustrating. My co-founder and I used to go for lunch together and complain bitterly about their meddling. We wished they would just leave us alone to run the business.

Click here for the full post.

Case Studies on Exit Transactions

Fri, 22 Aug 2008 16:57:53 GMT

The most interesting way to learn about any business process is to study real world examples of what other companies have done. In most exit transactions, the really interesting information - for example the purchase price - is not usually disclosed.

Fortunately, in situations where either the buyer or seller are public companies, all of the high level data is in the public domain.

The case studies in this section describe exit transactions I’ve done where either the buyer or seller was public. Each of the examples highlights one of the exit strategy principles described my earlier articles.

A Well Designed and Executed Exit Can Increase Value by 50%.

All of these case studies illustrate how a well-designed and executed exit transaction can increase the final selling price of a company by 50% or more.

The Importance of Multiple Bidders

The Nexus, Parasun and Sunaptic transactions all show how a competitive bidding situation can increase the final selling price.

Strategic Value

The Nexus, PCS Wireless and Sunaptic exit transactions are examples of how the final selling price can be increased by finding a buyer that can sees a high strategic value in the acquisition.

Excellent Business Brokers

While it’s hard to isolate this factor (and I might be biased) all of these transactions also illustrate that psychology and the skill of the selling team are big factors in achieving that extra 50+% value increase on an exit.

The full case studies on exit transactions are available here.

Sometimes an exit works out better than anyone dared to hope

Sat, 16 Aug 2008 21:04:41 GMT

This is the story of how the PCS Wireless exit worked out fabulously well for several of the participants even after the company looked like it wasn’t going to be a success.

In this exit transaction case study the shareholders and executives had just about given up hope that they would recoup their investment. The company had been a high flyer with a market cap of over $100 million. But when the big Telcos decided to use CDMA instead of TDMA for their cellular networks, the stock cratered.

The CEO asked me to sell the company. I was the original founder and at that time was looking for another interesting project. Even though the business was not doing well, I found another wireless company that saw significant strategic value in the PCS Wireless technology.

The transaction worked out so well, that our lawyer, who had become a director, made $5 million on an embarrassingly small option position.

This story illustrates that in technology companies things can go from looking great, to looking pretty bleak to looking pretty darn good again within a just a few years. Often an exit transaction is the thing that makes all the difference.

This is a link to the PCS Wireless story.

Startup Essential To Do List

Tue, 12 Aug 2008 00:06:15 GMT

This post is dedicated to a team of promising young entrepreneurs who asked me recently if they could all just “put some money in a bank account” to launch their startup. I wanted to say 'yes' because I know how much other work they have to do to build a successful company. But instead I had to warn them that there were several essential elements of their corporate structure they had to get right - now - to maximize their probability of success.

This question comes up frequently, so I started this list to help other entrepreneurs ensure they don't miss one of the essential structural components.

Why it's not easy to structure a startup

Structuring a startup correctly is a challenge. In the early days, companies don’t have money to hire excellent lawyers and tax advisors. Startups can’t usually attract experienced mentors or advisors. As a result, crucially important elements of the structure often get missed or are done the wrong way.

Structuring builds the foundation and the corporate DNA

Structuring errors often cause companies to fail. The most heartbreaking examples are when the company continues for several years, often showing great promise, and then the structuring flaws, built in during the startup phase, cause it to collapse.

Here’s a good analogy - rebar is the network of steel reinforcement bars inside structural concrete. Imagine someone constructing an apartment building. In the early days, there are no renters, so there is no revenue. The builder wants to save as much money as possible until the building is at least partially occupied, so he decides to save money on the foundation by leaving out the rebar - hoping he can come back and add it later. He finishes the building, and from the outside it looks just fine. Tenants start to move in and revenues increase. The builder now has the money to add the rebar to the foundation, but of course, it’s no longer possible. But it still looks fine. More tenants move in. The additional weight causes the foundation to crumble and the building to collapse.

The reason this is a good analogy is that many of the structural inadequacies in a company are also very difficult to fix after the company is launched - especially if there are external investors. The company will often still look just fine, often for years. But the flaws, like the missing rebar, are still there – genetic defects in the company’s DNA. Invisible failure mechanisms that often cause the company to collapse.

Structuring problems scare off investors

As an angel investor, I do due diligence on every aspect of a company before I invest. In the majority of cases, I see serious structural flaws. Experienced angels know how difficult, and expensive, these are to fix.

Most of the time, the investors will just go on to look at the next investment opportunity rather than try to help rectify serious structural flaws. In many situations, the investors won’t even explain the flaws to the entrepreneurs because even the explanation can be a lot of work, and it’s never enjoyable to explain to a group of aspiring entrepreneurs that their company has problems.

It would be easy to write an entire book just on the situations I have seen where structuring errors caused companies to flounder or fail completely. But it would depressing to write and not much more fun to read.

Instead, in the hopes of helping the next generation of startups avoid these problems, this is a list of the things that are essential for every startup to build into the structure of the company to ensure it has a strong, stable foundation.

The startup essential to do list is available here.

Exit Strategy – Selling A Business Can Increase Its Value by 50+%

Wed, 23 Jul 2008 00:42:51 GMT

This very valuable concept is one of the most challenging for investors and entrepreneurs to intuitively understand. I didn’t ‘get it’ until I was fifty. It’s not that I am slow to learn, it’s just that, like a lot of things in life, it takes a few dozen experiences before the lesson really sinks in. When those experiences are about selling a business, it can take decades to accumulate the wisdom.

An extraordinarily valuable lesson for both entrepreneurs and investors is that when you sell a business a well designed and executed exit strategy can easily increase the business valuation by 50%, and sometimes by 100%.

Yes, that is correct. The business valuation can easily increase by 50 to 100% just because you sell the business.

Another way to look at this is that the exit transaction, which occurs right at the end, can make you half again as much money as all of the years of hard work that went into the business from the founding until you cash out. For example, let’s suppose you have worked very hard for three or four years to build a company that is fairly valued at $10 million based on standard financial valuations. By designing and executing the exit well, you can often sell that business for $15 million, or possibly even $20 million. This is not a fluke or random occurrence; it happens all of the time. (The important factor to keep in mind here is ‘well designed and executed’.)

Yes, I know it doesn’t seem intuitively obvious, which is why I’m writing this article.

My First Business Sale – Nexus Engineering

The first time I experienced the 50% business valuation increase was when we sold the company I co-founded in grad school - Nexus Engineering. We managed to sell it for about 50% more than everyone expected. I thought it was a fluke – a lucky accident. It wasn’t until I had seen the same 50+% business valuation increase about a dozen more times, and talked with dozens of smart guys who had each sold businesses a dozen times, that I appreciated this 50+% business valuation increase can, and should, happen much of the time.

Business Valuation Is Not Created Linearly

One of the ways to intuitively appreciate how extra value is created by the exit transaction is to extend a more familiar concept about how business valuation increases earlier in the company lifecycle. Significant valuation increases usually occur in discreet steps rather than through smooth linear growth. These steep value increases occur when individual strategies are successfully executed. Familiar examples are strategic partnerships, marketing alliances, acquisitions, new locations and new products or services. These strategic initiatives almost always create more fundamental business valuation than all the hard work on execution that most of the company employees spend most of their days working on.

A well designed and executed exit transaction is the last, and usually largest, strategically driven increase in business valuation.

This non-linear increase in business valuation is described here.

Markets for Selling Companies are Very Inefficient

The market for selling a business is very ‘inefficient’. This is one of the reasons a well designed and executed exit can easily increase the business valuation by 50% or more.

The market for selling companies is inefficient because:

there are very few buyers and sellers,
the market is illiquid, and
information is not easy to access

This post describes the market inefficiencies when selling a business and uses the residential real estate and NASDAQ markets as counter examples. It explains how this market inefficiency can contribute to a 50+% business valuation increase when you sell the business.

Strategic Value can be Very Different to Different Acquirers

One of the most important reasons selling a business well can increase the business valuation is the high degree of variability in the ‘strategic value.’ Very loosely, that is the increase in the value of a target company over its ‘financial value’. This page includes more on increasing strategic value during a business sale, including ways to discover and communicate it to prospective buyers.

Great Business Brokers can Significantly Increase Business Valuation

In part because it’s such a big transaction, there is a lot of mystique around selling a business. It’s true that the numbers are very large, the largest of all sales. It is also true that these are the most complex of ‘complex sales.’ But other than the size and complexity, selling a company is a pretty standard marketing and sales process.

It still all comes down to people. It’s people who make the decisions to buy and sell businesses. No matter how big the business for sale, these individuals, like all other investors, have psychological imperfections that make them susceptible to a well designed and executed sales pitch.

This means the skill of the sales people, or business brokers, working with the board and CEO to sell the business can have a large effect on realizing that final 50+% increase in business valuation.

No matter what it costs, engaging the very best business brokers always delivers a very high return on investment, this page explains why.

Selling a Business Well Requires Multiple Bidders

Companies are sold not bought.

Every time you sell a business the exit strategy must include a bidding process. An active bidding process ensures safety, predictability, negotiating strength, price maximization and good governance. This post describes each of these elements in a successful company sale and explains how they contribute to the extra 50+% business valuation.

Recent Case Study - Parasun

In my BC Tech Fund portfolio, I invested in 9 companies. About three years after the first investment, three of the nine had a liquidity event - one went public and two were acquired. This was not a happy accident; it was a necessary component of the portfolio strategy. In that fund, I both selected companies I thought could execute early exits and worked actively with the boards and CEOs to sell the businesses.

The Parasun case study is posted here.

Recent Public Company Examples

There are very few private company case studies that illustrate how selling a business well can increase the business valuation by 50% or more. Even when it happens, it’s not easy to quantify the difference in the business valuation before and after the exit transaction. That’s one of the reasons this concept is so unfamiliar to most private company investors and entrepreneurs.

Fortunately, the same dynamic occurs regularly in the public company markets. This page describes a few recent public company examples which clearly show the business valuation increase when selling a company.

Summary

One of the most valuable lessons for both entrepreneurs and investors is that when you sell a business a well designed and executed exit strategy can easily increase the business valuation by 50%, and sometimes by 100%.

Exit Strategy - Creating Strategic Value

Mon, 21 Jul 2008 17:09:40 GMT

Another reason a well designed and executed exit strategy can increase the business valuation by 50% or more when you sell a business is the ‘strategic value’. The only reason any company buys another company is because they believe:

they can increase the value of the company being acquired, and/or
the acquired company will increase the value of their company.

Different prospective acquirers will have different elements in their businesses which will allow them to increase this strategic value. The most successful company sales are where the combination of the two businesses increases the total business valuation faster than either company could achieve alone. In other words, when 1 + 1 = 3.

One of the most obvious examples of strategic value is reducing competition. This was a very popular driver for company acquisitions a hundred years ago. Many of the most successful entrepreneurs of the 19th century created enormous wealth by concentrating ownership in business verticals, thereby reducing competition and allowing price increases. In some cases, the railroads and steel industries for examples, the concentration of ownership was so egregious that these business people were often referred to as ‘robber barons’.

More recently, many of Microsoft’s company acquisitions have been viewed as Bill Gates reducing competition. The American government, and some in Europe, dragged Bill Gates into court in an attempt to reduce his monopolistic influence in the global economy.

Today, the US government tries to prevent mergers and acquisitions that will reduce competition. Often, when you sell a business today the company being acquired, and the acquirers, will have to complete a Hart-Scott filing to show that what they are planning will not result in reduced competition.

But let’s be realistic, acquisitions to reduce competition happen all the time. Even today, one effective way to sell a business is to sell it to a competitor. This type of company sale requires some significant skill and protective tactics, but it’s still a great element in an exit strategy.

A better example of how strategic value can increase business valuation is when companies have complementary products or services. A classic situation is where a larger company has an existing customer base who could be users of a target company’s products. Some familiar examples are eBay’s acquisition of PayPal, Yahoo’s acquisition of Flickr, or just about any of Google’s acquisitions. Other good examples are the acquisitions here.

Another excellent way to unlock strategic value when you sell a business is to find a company that would like to develop a similar product or service, but will pay to reduce their ‘time to market’. Big companies grow more by company acquisition than by internal R&D. Part of the reason is because big companies are not very good at innovation. The other part is that being fast is often better than being good. Big companies can usually get to market fastest by buying one of the established leaders in a market vertical. For a big company, a one or two year lead can often be worth tens, or hundreds, of millions of dollars of increased business valuation.

Why should the buyer pay the seller more? Good question, but in practice they will. An important part of the marketing and sales job when you want to sell a business is to discover, and communicate, the full strategic value to the buyer. During this discussion, the prospective buyer will inevitably say something like: “Sure, I see the additional value your business will bring if we acquire you, but we are not going to pay you for that.” In other words, the buyer doesn’t see why they should pay you more for the extra strategic value they will generate in the business, post acquisition.

It’s a fair point, and the best response is to concede gracefully. But the reality is that once the prospect sees this ‘extra’ strategic value, and they realize the business is worth more to them than to another bidder, they will be willing to increase their offer to acquire the company.

Another way to look at it is that once the buyer realizes that 1 + 1 = 3, they will be willing to pay more than ‘1’ for the business. They might even split the difference and pay ‘1.5’. (Obviously the math here is way too simple, but I hope it illustrates the point.)

Helping discover and communicate this ‘extra’ strategic value to the buyer is one of the most valuable skills required to sell a business well. In most cases, it is the selling team that first discovers and fully appreciates the strategic value and it’s fair impact on the business valuation. In my experience, it often takes the selling team weeks, or even months, to get the prospective buyer to appreciate this ‘extra’ strategic value.

There are several reasons the sellers usually see the value first and that it takes so long to communicate. The buyers are often very large companies, with many tightly focused divisions. The people in the ‘M&A department’, for example, are usually not technical or industry people. It’s not at all unusual for the senior team in the company being sold to have a better understanding of the technology, industry dynamics and future trends than the ‘professional business buyers’ in the M&A department. Fully developing an appreciation of the strategic value and fair business valuation in the collective mind of the buyer generally requires consensus building among a number of people in several different departments. In a Fortune 500 company, building that consensus might mean getting the M&A team, CFO, several VPs and division heads, the CEO and some board members onside. Even with a concerted effort from an excellent sales team, and a high level champion inside the prospective acquirer, this process can easily take three to six months.

Discovering and communicating the strategic value of an acquisition is one of the most significant reasons that well designed and executed exit plans often take one or two years to sell a business well.

It’s also a big part of the reason that a well designed and executed exit transaction can often increase the price received when you sell a business by 50% or more.

Exit Strategy - Every company sale should have multiple bidders

Sun, 20 Jul 2008 22:41:13 GMT

Many entrepreneurs think that when their company is ready to be acquired, a buyer will knock on their door and make an offer. This does happen, but less often than someone knocking on the door of your house asking to buy it. Even if an unsolicited offer does come in, boards should almost never approve a company sale when there is only one bidder because the price will almost certainly be too low. Even if the buyer actually did pay a fair price, there would be no way to avoid the perception that the price was too low and the board did not do its job properly.

In almost every private company, or small public company, if an unsolicited offer is made it’s usually a lost opportunity. This is because there is almost never enough time to get other bids before the first party loses interest.

Successful company sales almost always involve a competitive bidding process.

There are several reasons why a bidding process is essential to sell a company well:

Safety
Predictability
Negotiating strength
Price maximization
Effective governance

Each of these points is developed further in the full post on my blog.

Exit Strategy - Selling my first company

Sun, 20 Jul 2008 18:39:34 GMT

I started my first company, Nexus Engineering, when I was still a grad student. A little over ten years later, the board decided it was time to sell. The company was the second largest manufacturer of cable TV headends in the world. The number one and number three in our vertical were Fortune 500 companies.

Our exit strategy was to sell our company to a Fortune 500 company in the defense business. At that time there was a general perception that the war business had seen its best years and that big defense companies should be diversifying more into peaceful businesses. After a year of hard work, we were at the term sheet stage with a Fortune 500 defense company who wanted to enter the cable television business. But I was feeling uneasy.

About six months earlier we had three companies on the bidders list. But, as usually happens, for one reason or another, two of the three had dropped off. We really only had one interested potential buyer.

Time was not on our side - after being cash flow positive for almost a decade we had been hit hard by the junk bond credit crisis that started in mid 1990. Almost all of our best customers were financed by junk bonds, many minted by Michael Milken himself. When the Fed decided to terminate the junk bond business to prevent the real estate market from blowing up, all of our customers in North America, and Europe, suddenly stopped buying at the same time.

To make matters worse, we had a venture capital shareholder, and board member, working aggressively from the inside on a hostile takeover of the company.

We had a layer of subordinated debt in our capital structure. When the junk bond crisis hit, we were offside on some of the covenants. Luckily, I had developed a friendly relationship with our lender. He called me one day to warn me that one of my directors was trying to buy our subdebt from them. That was all he would say, but it saved me.

I probably would have figured it out anyway, because my VC director, and his wife, had suddenly started to wine and dine my other directors. They even entertained one of my original investors who was a gentleman farmer and who this VC once described as about as "useful as a cabbage" as a board member.

I knew that if my last interested buyer got sidetracked, or even delayed, I was dead. All of the value in my shares, my founding partners’ shares and my angel investors’ shares would be wiped out by my VC investor.

The outcome of the story, and a summary of what I learned, is on my blog at this link.

Exit Strategy - Selling a Business and Inefficient Markets

Sat, 19 Jul 2008 14:24:48 GMT

The market for selling a business is very ‘inefficient’. This is one of the reasons a well designed and executed exit can easily increase the value of a business by 50% or more.

The best way to illustrate this is with a counter example - the residential real estate market. Most of us are familiar with selling a house. If you contacted the top ten realtors in your area and asked them what you could sell your house for, you’d probably get answers within 5% of each other. Similarly, if you could find a number of buyers who were currently in the market for a house just like yours, and they had recently spent time looking at comparable properties, they could also give you a very accurate estimate of the selling price for your home. This is because the market is ‘efficient’. This means the market has lots of buyers and sellers, is relatively liquid and information is readily available.

A ‘liquid market’, or one with good liquidity, is one where transactions happen frequently and with good predictability. The NASDAQ stock market is a good example. If you own shares in a NASDAQ listed stock you can post them for sale at the market price and you will usually have a buyer within a few minutes.

In an efficient market it’s very difficult for a buyer to find properties that are significantly undervalued. This is the fundamental premise behind the ‘efficient market theory’. A practical outcome of the efficient real estate market is that the price you can get for your house isn’t going to change much regardless of how you market the property or which real estate broker you choose (my apologies to real estate brokers everywhere.)

In contrast, the market for selling a business is inefficient because:

there are very few buyers and sellers,
the market is illiquid, and
information is not easy to access.

‘Market depth’ is the term that describes the number of buyers and sellers. When you sell a technology business, there are probably only a few hundred suspects, and a couple of dozen potential buyers in the world. From a buyer’s perspective it’s even worse. For example, if your corporate strategy is to purchase an established photo sharing site like Flickr, video sharing site like YouTube or URL sharing site like Del.icio.us, there are probably only a few companies like those available for purchase at any one time. This relative scarcity of sellers and buyers means a buyer may have to pay substantially more than a 'typical value' to successfully acquire one of the few properties for sale.

From a sellers perspective, finding those dozen or so prospective buyers that are ‘in the market’ for a business like yours is an enormous amount of work. This is exacerbated by the reality that most of the best buyers won’t even know they want to buy a particular business until someone gets their attention and shows them why they should be interested. Another way to say this is that companies are ‘sold, not bought’.

The market for buying and selling companies is also very illiquid. In contrast to the NASDAQ market where transactions only take minutes to complete, or the residential real estate market where sales usually only take a few weeks, selling a business (the right way) often takes one or two years. There are many reasons for this including:

lack of available information
the time required to contact suspects
the time it takes to explore a fit
the complexity of the non-monetary term negotiation
the months required for due diligence and
of course the delays related to the legal process on both sides.

The third factor contributing to the inefficiency of this market is the difficulty in accessing Information. Every market needs information on:

who the potential buyers are
what properties are for sale
information on those properties and
data on comparable transactions.

In the real estate market, for example, all of that information is available online except for the names of the potential buyers.

In the market for buying and selling businesses, none of this information is readily available. For example, if you wanted to buy a company like Flickr, YouTube or Del.icio.us, there is no website where you can do a search for companies like those for sale. Similarly, if you wanted to sell a business like those, there is no website you can go to find prospects who are in the market. Some entrepreneurs have tried to sell their businesses on eBay or Craig’s List, but we just aren’t there yet. We might be one of these days, but I suspect the market for buying and selling businesses will remain too small for online matching to make sense for the foreseeable future.

This scarcity of information isn’t just a problem during the matching phase of a business sale transaction. Even after a buyer and seller have found a good fit, lack of information is still a significant challenge.Even the simplest element of a transaction - the price - is difficult to find information on. Even if you could build up a list of prices on similar transactions, the information you really need is not just the selling price, but also details on the main value drivers in the transaction, like revenues, profits, growth rates, etc. Using the residential real estate market as a comparable again, it’s easy to find a website listing the details of comparable property sales in your neighborhood. You can see the selling prices along with the size of the lot, age, number of square feet in the home, number of bedrooms or bathrooms and a dozen other key metrics.

I recently spent a half day looking for a list of Web 2.0 acquisition prices that compared selling price to number of pageviews, unique visitors, ad revenue, etc. I found one, which looks like the only one, but it only includes about a dozen transactions, and there is only complete information for a few of the companies.

This lack of market efficiency is, like a lot of things in life, both good and bad. It means that it is an enormous amount of work to sell a company really well. But it also means that a well designed and executed exit transaction can increase the selling price of your business by 50% or more.

Exit Strategy - Investor Psychology and Great M&A Advisors

Thu, 17 Jul 2008 02:35:43 GMT

I’m not sure I should be typing this. It’s something I hate to admit about myself.

But the reality is all investors are subject to the same psychological imperfections. It doesn’t matter whether they are grannies buying ten shares of Google, or hotshot CEO’s acquiring billion dollar companies, none of us are so perfect that we are not susceptible to a great sales pitch.

I can admit it…. it just happened to me… again. I consider myself an astute investor focused on the fundamentals. I’d recently been watching a local company with a good CEO, but wasn’t absolutely convinced on the model or that it was a good investment.

One of my close business friends was working with the company to syndicate a financing. We had lunch to discuss a variety of topics. When I brought up this company I still thought the chances of me investing were one out of three.

My friend told me it was too late. The financing was sold out. I immediately took the bait. All of a sudden I really wanted to invest. I heard myself calling in favors and almost begging for an allocation. I wanted twice as much as I thought my maximum investment would be before I sat down. My friend wouldn’t promising me anything, but said I could talk to the guy managing the ‘book’ (the list of investors.)

When I contacted the fellow who actually knew how the financing was going, he wasn’t even sure when it was closing. He showed no sense of urgency and seemed really happy to pencil me in (add me to the list of investors.)

Right then I knew my good friend had sold me using one of the oldest tricks in the book.

We all want to buy something everyone else also wants. Even more, we want to buy something that is in such demand it’s hard to get. All (us) investors are herd animals.

I was a little unhappy with my friend for using such crude tactics on me. I knew exactly which of my human imperfections he used to close me, but I didn’t reconsider, or even reduce my investment. I guess I’m just not that perfect.

The other side of the coin about us all being susceptible to being sold is that in every business there are a few salespeople who are just truly great. My friend is certainly one. They are usually about 3x better than the average salesperson. Even when they have exactly the same pool of suspects (potential buyers) and exactly the same product or service to sell, they will close three times more than the other salespeople. I have seen this first hand in dozens of companies and situations.

The reason these ‘great’ salespeople are that much more productive is because they can connect to those universal parts of human psychology that make us susceptible to a good sales pitch. Some of these great salespeople do this with an unconscious competence - in other words, they don’t even realize what they’re doing. If you ask them, they just shrug their shoulders and say they are just ‘connecting with the buyer’ or ‘having fun selling’. But what is really happening is much more subtle. These great salespeople can more effectively build a relationship and interface at an almost non-verbal level with the prospective buyer. They often know intuitively when and how to close the transaction.

In industries with inefficient markets, and more elastic pricing, these great sales people regularly get much higher prices for exactly the same product. These are the sales people who are often described as being able to sell ‘ice to Eskimos”.

These are the people you want on your team when it’s time to sell your company. Their sales skills alone can account for a significant part of the additional 50 to 100% increase in price that is possible in most company sales. Once you appreciate how they can make that much difference in the sales price of your company, no matter how much you have to pay them, it’s an incredibly attractive return on investment

Update on Director Compensaton - Executive Chairman Compensation

Tue, 15 Jul 2008 14:48:41 GMT

There is still very little data available on director compensations in small and medium sized companies. In the fall of 2006, I did a director compensation survey for angel financed companies in my area. The results correlated well with the small amount of other data I could find.

One of the interesting results of that survey was a bifurcation in director compensations.

This graphic illustrates the distribution of compensations from that survey. From the anecdotal survey data, and discussions with some of the survey respondents, it seemed that some companies paying low compensations were doing so in part because they had not attempted to recruit new board members recently.

Over the past year and a half, it has been interesting to see some of those companies move up to market rates as they recruit new directors. Many more CEOs and directors have also been talking about how much smaller the pool of recruitable directors is.

Most of the companies that I have discussed board compensation with are private and their compensation information is not in the public domain. One public company that recently recruited new directors is MetroBridge.

This four year old tech company provides very high speed internet services using fixed broadband wireless. It went public with a CPC transaction in mid 2007. They recently recruited an executive chairman.

According to their publicly available information, the compensation for their executive chairman included a retainer of $150,000 per year. The meeting fee for the chairman was $2,250 per board meeting, which probably added another $20,000 depending on the number of meetings.

The total cash compensation was approximately $170,000 annually. In this case 150,000 options were also provided annually. My understanding is that this was for a nominal 40% time commitment.

In my conversations with other directors, this is now a typical executive chair compensation package for a company with an under $10 million valuation (or market cap).

These numbers are even higher than the chair compensations from the 2006 survey. This is probably due to a combination of:

the increasingly popular “executive chairman” title and position,
more companies who have actually tried to recruit directors and discovered how challenging it is, and
even further compensation increases due to increased director time commitments and liabilities.

This is reinforced in a recent report by Foley & Lardner that stated: "overall annual director fees have increased an average of 70 percent for small companies, 98 percent for mid-cap firms and 93 percent for S&P 500 companies between 2001 and 2006."

Based on this data and the discussions I've had, it seems likely that director compensations will continue to rise.

Exit Strategy - Acquisitions are usually under $30 million

Tue, 01 Jul 2008 17:05:12 GMT

The really interesting story these days about tech exits is not the small number of really big acquisitions, it’s the big number of smaller acquisitions. For the typical entrepreneur and angel investor, these smaller transactions are an excellent way to make several million dollar capital gains and should be part of every company's exit strategy.

I’ve written before on why this is a great time to plan an early exit. The tech M&A market is hot. Big companies know they are better at acquiring than developing new ideas in house. And big companies have lots of cash.

The financial media, and most bloggers, write about the really big startup exits like Club Penguin, YouTube, Skype and MySpace. Those are certainly exciting exits and great startup stories.

But for the other 99.99% of entrepreneurs and investors, the really exciting news is the large number of tech startups being bought for under $30 million. Many of these exit transactions are so small they aren’t even press released. In my own portfolios, where I have been generating some solid early exits, recent transactions have been in the $15 to 30 million range.

Several smart VC bloggers have also been writing about this trend over the past few years. I tried to find some quantitative data to illustrate what’s going on in early tech acquisitions, but I wasn’t successful. (I found one database that looked promising but didn’t feel like parting with several thousand bucks to back up this post. I also figured that many of the smaller transactions wouldn’t be included anyway.)

The best reference I found was an article by Om Malik titled “The New Road to Riches” which was in Business 2.0 a couple of years ago. He reports that the Mergerstat database, which includes about 5,000 tech acquisitions per year, showed an average selling price of $12 million.

I spent some time on Google searching for recent acquisitions of tech companies and quickly pasted this list together. Most of these are pretty big successes that millions of us use every day. They are also great startups that all sold for $30 million or less.

Google bought Adscape for $23 million (now Adsense)
Google bought Blogger for $20 million (rumored)
Google bought Picasa for $ 5million
Yahoo bought Oddpost for $20 million (rumored)
Ask Jeeves bought LiveJournal for $25 million
Yahoo bought Flickr for $30 million (rumored)
AOL bought Weblogs Inc for $25 million (rumored)
Yahoo bought del.icio.us for $30 – 35 million (rumored)
Google bought Writely for $10 million
Google bought MeasureMap for less than $5 million
Yahoo bought WebJay for around $1 million (rumored)
Yahoo bought Jumpcut for $15 million (rumored)

Why is this happening now?

One of my friends in a Fortune 500 company explained it to me this way (paraphrased): We know we aren’t good at new ideas or startups. We basically suck at building business from zero to $20 million in value. But we think of ourselves as really good at growing values from $20 million to $200 million or more. It’s a different skill set than starting things. If we see an acquisition priced at $100 million, then our view is that it’s already out of our sweet spot for adding value. But at $20 million, it’s really easy for me to get it approved.

How should this affect the exit strategies for entrepreneurs and angel investors?

It seems pretty clear that the optimum strategy for tech startups today is to design the company, and its corporate DNA, so everyone is aligned around the idea of an exit transaction in the under $30 million range. The good news is that these exits can often be completed in just a few years from startup. They also have a much higher probability of success than swinging for the fences and hoping for a big NASDAQ IPO.

This exit strategy is nicely summarized in “The New Homerun” by Tom Stein in Mergers & Acquisitions magazine, May 2008. He said: “Startups must be content with hitting singles or doubles, that is, a buyout of $50 million.”

As an angel investor that works well for me. What do you think?

Exit strategy – It’s a great time to sell a tech company

Mon, 23 Jun 2008 22:55:42 GMT

This is a very good time to sell your technology company - so good you might want to accelerate your exit strategy.

There is a very interesting article in the April 7, 2008 issue of Business Week titled: “Ravenous for Small Tech”. The article reports that while the change in value of mergers and acquisitions in 'all sectors' is down 51% in 2008, compared to last year, the value of 'high technology' M&A is actually up 132%.

In a May 2008 article in Mergers & Acquisitions, Tom Stein said: “2007 will be hailed as the biggest year for acquisitions of venture-backed technology since the dot.com days.”

Why is this happening now and how should this affect your exit strategy?

The main reason the M&A market is so active is acquisitions are now the best way for large companies to grow. This is summed up nicely in a quote from Vivek Mehra, general partner at the venture capital fund August Capital in Silicon Valley: "Big companies stink at innovation, and they know it."

Acquiring works so well that many big companies are now spending more on acquisitions than R&D. Take Microsoft for example, according to Tom Stein: “Microsoft is seeking 20 companies, worth $50 million to $1 billion, and will spend more on acquisitions in fiscal 2008 than on R&D for the first time in its history.”

Cisco also prefers to “buy rather than build.” They have acquired 125 companies since 1993.

These big companies have large internal divisions completely devoted to buying companies.

It’s also a great time to be acquired because large companies are sitting on loads of cash. So much it’s actually a problem for company management because shareholders want them to either invest the capital to create growth or to distribute it to the shareholders as dividends. Distributing cash is considered an admission of defeat for tech company management because it shows they don’t have any ideas on how to invest cash to increase shareholder value.

Big companies are also trying desperately to re-energize the entrepreneurial cultures that got them started in the first place. This is described well in a December 2005, Business 2.0 article: “The Flickrization of Yahoo!” The story is about how Bradley Horowitz, the head of Yahoo's developer network, decided to offer Flickr's founders $30 million for their startup. Horowitz invited Butterfield and Fake to Silicon Valley in late 2004. They had lunch in the Yahoo cafeteria and immediately hit it off. "I met Stewart and Caterina and fell in love," Horowitz recalls. "It was beyond Flickr. I saw them as kindred spirits, entrepreneurs who could infect Yahoo with that small-company focus.”

Last summer, a partner and I completed a very successful sale of one of our portfolio companies, Parasun. Working on that transaction left no doubt in my mind that the market is hot. The bidding was very active and we ended up selling the company for about 50% more than the founders and board had set as the exit strategy goal less than two years earlier.

Another great example is the announcement of the acquisition of Hostopia on June 19, 2008. This Toronto based hosting company was trading around $5.00 per share just prior to the acquisition announcement at $10.55 per share – double what it was trading for.

Nobody can predict the future. This may be almost the peak of the tech M&A market, or it might be a trend that will last several more years. If you have been thinking about your exit strategy, this looks like a very good time.

Early exits are a good thing

Mon, 16 Jun 2008 17:31:03 GMT

Whenever I hear an entrepreneur, or angel investor, say “early exit” they have a really big smile on their face. Even some of my VC friends beam when they talk about the jump in their returns if they've gotten lucky with some early exits.

But when I first blogged about early exits all of the comments were negative. Even though the phrase is spoken all the time, Google produces surprisingly few hits on “early exits”. The more commonly used keywords are ‘built to flip’ and most of that writing is also negative.

In my experience, almost everyone wins in an early exit – the entrepreneurs, the employee share and option holders and the angel investors certainly do. I do acknowledge there are times when early exits are not good for the venture capital investors.

Recent research from the UBC Sauder School of Business shows that in BC and Alberta we are really good at early exits. This is one of the reasons BC has some of the highest returns on startups and venture investments of any state, or province, in North America.

There are some outstanding examples of early exits in BC. Early exits helped make my early stage venture fund a top performer. Early exits also boosted the returns in my new angel fund and provided our early investors a 100% return of their capital in just over two years.

So why are most writers so negative? In my opinion, it’s just a byproduct of our human resistance to change - to progress.

The internet has accelerated everything; product and company development cycles, investor time horizons and employee attention spans. Early exits are a natural consequence of the internet. And the trend is still accelerating.

The internet has given entrepreneurs an unprecedented opportunity to rapidly launch and exit their startups. The most successful entrepreneurs, directors and investors will find ever better ways to design and execute early exits.

If you know of some other early exit stories in BC, I’d really appreciate a quick email so I can add them to my list of BC early exit successes.

If you have an opinion on early exits, please share your thoughts by posting something here.

Startup Funding - Avoiding the Pitfalls in the Friends and Family Round

Thu, 05 Jun 2008 18:46:53 GMT

Most successful tech startups raise their first capital from friends and family investors.

Friends and Family financings are always the easiest to complete - often taking less than two months from start to finish. Friends and Family rounds usually raise $25,000 to $150,000 in total – the amount depends a lot on who your friends and family are.

The only problem is that most people who invest in Friends and Family financings probably shouldn’t.

Well meaning, but inexperienced, entrepreneurs often treat their friends and family investors unfairly and damage their future fundability.

Guidelines on how to avoid the startup funding pitfalls are available at this link.

The most common way entrepreneurs get into trouble and end up treating their friends and family unfairly is by over-valuation. This causes serious structural problems that must be rectified before the next round of financing. Some of the ways to avoid this common mistake, and to fix it if necessary, are described at this link on startup funding valuation.

All financings and share sales are governed by securities legislation. Entrepreneurs must know what the legal requirements are before accepting that first dollar of investment, even if it's from a family member. An outline of startup funding legal requirements is available here.

Startup Funding - Sources of Financing

Thu, 05 Jun 2008 18:35:42 GMT

Over 90% of successful tech companies are financed in pretty much the same way:

1. Startup funding from Friends and Family investors, then

2. Angel Investors and Angel Funds, followed by either

3. Venture Capital, or

4. Public Venture Capital

The way these inter-relate by amount of financing, and age of company, are illustrated at this page on Startup Financing Sources.

Angel Investor and Angel Fund Returns

Sun, 18 Nov 2007 04:45:55 GMT

Angels invest about the same amount of money each year as venture capitalists. There is lots of data on VC returns, but very little on how angel investments perform.

The largest ever study on angel investor returns was released this week.

The good news is that angel investors are enjoying some excellent returns. This link has the full story.

Director compensation in early stage companies

Wed, 23 May 2007 14:38:51 GMT

Have you noticed how fast director compensations have risen over the past few years?

There's not much data available, especially for angel investor backed companies, but many believe director compensations have increased by several hundred percent since the governance debacles of the late 1990s.

This post includes the results of a survey of director compensations in early stage companies and recommends best practices for director compensations.

Recruiting good directors and building great boards

Thu, 10 May 2007 14:37:20 GMT

Board recruiting is increasingly challenging. This is happening at a time when its never been as important to have a high quality, engaged board.

According to Fortune Magazine May 16, 2005: "Turnover has reached record highs, with 50% of outside directors quitting at Fortune 1,000 companies." This is in part because there is now a much broader recognition of the liability associated with being a director.

Recruiting directors is also harder because it now takes boards more time, and work, to discharge their fiduciary responsibilities.

While its not possible to accurately quantify, many believe that the available pool of good quality, recruitable directors is only one third as big as it was five years ago.

The results are that recruiting directors takes longer and companies are having to significantly increase director compensations.

This post has some suggestions on how to recruit good directors.

Boards are more important than CEOs

Wed, 02 May 2007 14:35:28 GMT

Good boards are more important than good CEOs.

One reason this is true is that boards hire and fire the CEO. Boards also approve the corporate strategy.

When the investors make a lot of money, its probably due to an outstanding CEO. But if a company fails, it's probably the board's fault.

Today, at the beginning of the 21st century, in this new post-Enron world, really good boards have never been more important.

Exchangeable shares

Thu, 19 Apr 2007 14:34:20 GMT

Exchangeable share deal structures solve some of the challenges angels have been having over the past five years.

Exchangeable shares solve the biggest problem with convertible notes - the unfair discount - while maintaining their simplicity and cost effectiveness.

Angel investment is different

Mon, 02 Apr 2007 14:33:21 GMT

Angel investing, and other early stage investing, is different. Angel investors have a much bigger impact on an organizations future than venture capital investors. Alignment and fairness are critically important to the development of a healthy enterprise.

Another consideration is cost. In the first rounds, the total capital invested might only be a few hundred thousand dollars. The legal fees should only be a few thousand. This necessitates clean, simple documentation that is much shorter than standard venture capital investment agreements.

Optimum financing strategy for angel investors and entrepreneurs

Tue, 20 Mar 2007 14:31:41 GMT

Opinions on the optimum financing strategy are as varied as opinions on restaurants or politics. Some of the inputs to the optimum financing strategy are unknowable. But assuming stable macro-economic conditions, and a successful business, there actually is an optimum financing strategy.

Share registers and electronic shares

Mon, 05 Mar 2007 15:28:45 GMT

Every company is required by law to maintain a complete and current share register. Today, there is no question that the share register can be an electronic file as long as it meets the other requirements in the act. Share certificates can also be electronic. This is obviously the case because public companies do not maintain paper based share records any longer.

CEO Updates for Shareholders

Sat, 17 Feb 2007 15:26:54 GMT

At a recent meeting of Angel Investors, there was lots of debate on valuations, terms and portfolio management, but one thing everyone agreed on was that companies could raise their next round more easily if they did a better job of regular communications with shareholders. Every company, regardless of whether they are private or public, should e-mail a monthly "CEO Update to Shareholders."

Reports to Shareholders

Mon, 05 Feb 2007 15:26:06 GMT

An essential element in the implicit agreement between a company and an investor is that the invesor will receive regular, meaningful information on how the company they invested in is progressing. For public companies, the securities regulators impose very rigid obligations on CEOs, CFOs and boards to keep investors updated with full, plain and true disclosure. Failures to disclose accurately or in a timely manner can result in severe personal liabilities for all directors and officers. In private companies, there are far fewer regulatory requirements on officers and directors to disclose and rapidly disseminate information. But most shareholders are just as interested in how the company is doing.

The Corporate Structure

Mon, 22 Jan 2007 18:24:23 GMT

A company's corporate structure is like a building's foundation. If the foundation is flawed, it may not be immediately apparent. But as the structure grows, there is an increasing likelihood that the structural flaws will lead to a complete collapse. This happens much more often with companies than with buildings.

Share and option vesting

Sat, 30 Dec 2006 15:23:16 GMT

Widespread employee ownership is still a relatively new concept.

Even as recently as the 1980's, there was still debate on the degree to which employee equity ownership affected share price.

Today, it is widely accepted in North America that companies with broad employee ownership create larger, and more rapid, increases in shareholder value.

After a couple of decades of experience and a few good analytical studies, there is now a broad consensus on the range of equity that is reasonable for a new CEO, or other senior employee, to expect when joining a company.

Even though there is reasonable agreement on the optimum magnitudes of equity ownership, there is still discussion on the optimum vesting formula.

Shareholder alignment

Sat, 23 Dec 2006 14:34:06 GMT

Alignment is critically important to entrepreneurial and investor success.

Alignment is still a relatively new concept. A full appreciation for alignment is a prerequisite for optimum corporate structuring.

Alignment is all about human behavior and group psychology. It's often very difficult to describe to young entrepreneurs.

Most angel investors agree that until you have been closely involved with a dozen or two early stage companies, the full impact of alignment is hard to appreciate.

Corporate DNA

Fri, 03 Nov 2006 13:29:00 GMT

Companies certainly have cultures. They also seem to have DNA. Corporate DNA is formed early on in a corporation's life-cycle. But unlike most living creatures, a company's DNA can change later in life. Corporate DNA, like all other DNA, determines, to a large extent, the characteristics and success of the organism

Being fair and equitable

Sat, 07 Oct 2006 07:45:13 GMT

Being fair and equitable is much more than a philosophical or ethical principal - it is also essential to maximizing shareholder value.

Welcome to AngelBlog

Mon, 19 Dec 2005 16:38:58 GMT

This site is devoted to the development of best practices for angel investors and entrepreneurs. Its goal is to facilitate profitable, fair and enjoyable interactions between angels and entrepreneurs.