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Early Exits are Good for Everyone
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 many 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.
Comments on Early Exits
From Dunnery Best, CIBC- June 16, 2008
Reply to Early Exits are a Good Thing email sent 20080616
Yes, I agree with your views on early exiting high risk young investments. Or, rather, I think it might be more appropriate to say that I appreciate an early opportunity for a liquidity event, if so desired... Too often capital is tied up for many years, much, much longer than had originally been anticipated.
Your approach is most conducive to continued participation in a difficult area of the marketplace.
From Mark Betteridge, Discovery Parks - June 16, 2008
Reply to Early Exits are a Good Thing email sent 20080616
All I can say is "I wish". NONE of my angel investments has offered an early exit – just the opposite!
From Victor, Schooner Ventures - June 16, 2008
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Basil - I agree - early works well - but the factors are more than just the internet --- key is the need for lots of money and lots of market reach at that next stage - those buying usually have those in place and have enough depth of knowledge to see the leverage in the acquisition...
From Blake Corbet, Haywood Securities - June 16, 2008
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The arguments I read against "early exits" were pretty weak. I am with you on the answer, an early exit boosts returns and everyone wins. And it is in itself a sign of success -- as long as we are defining success consistently.
I thought it was a good article. It raises for discussion a topic not often discussed, as you found in your google search referenced below.
The only downside I could think of from an early exit would be if that exit is an IPO that comes too early and ends up weighing down a nascent company with too many additional public company costs and distractions.
From Ron Klopfer - June 20, 2008
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This is an interesting and important topic; good on you for leading a conversation about it and thanks for seeking my input.
While I’d personally draw greater satisfaction as an entrepreneur from growing a company that would contribute to the local economy over long term (versus a quick flip), I am firmly in support of early exits where and when they present themselves. Here are a couple of related ideas that are on my mind:
- The fact that the UBC study measured higher percentage returns for BC at earlier stages of exit tells me that there is a problem with how the entrepreneurs and owners of tech startups (across all jurisdictions) perceive their chances of success through the later stages of growth. These stats show that shareholders in other geographies are overestimating their expected returns (probably by underestimating their risk) when they think about holding on for a late-stage acquisition or IPO. If that’s the case, then the BC crowd is particularly savvy, relative to the broader market, in optimizing the timing of our exits. I haven't read the entire UBC study, so perhaps this point about perceived outcomes has been made already.
- This discussion seems to imply that early-exit entrepreneurs have a choice: sell now, or sell later. If only it were that simple. In cases where a startup is courted with an early-exit opportunity, it's because competitive pressures in their market space are demanding consolidation, economies of scale, or accelerated R&D. In other words, the very presence of an early exit opportunity probably indicates that the company would likely be unable to go it alone in its industry at that point in time. The frequency of early exits here may say more about the industries in which we participate and the kinds technologies we develop, rather than the risk tolerance of our entrepreneurs.
- Venture investors typically have a 5-7 year return horizon, and will probably be in favour of taking an exit within that time window. Any founder or entrepreneur that blocks a reasonable acquisition against the wishes of her investors, and then fails to deliver a comparable return down the road, won't raise another dime in this town. For the entrepreneur, the stakes are pretty high, from a long-term career perspective, in rejecting an acquisition - irrespective of financial risk/reward.
- If we view early-stage companies as a "product" that our province "manufactures", then selling those companies at a 5x return on invested capital (i.e. 80% gross margin) is a pretty good business model. Leveraging that "margin" through reinvestment into new, better-financed startups ("R&D") by the newly enriched shareholders… that's pure gravy.
From Roger Killen - June 23, 2008
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I am 100% behind early exits for non-lifestyle businesses.
From Fred Speckeen, AERS, Inc. - June 25, 2008
Reply to Early Exits are a Good Thing email sent 20080616
Thanks for the invitation to comment. I am close friends with an effective CEO who has been extremely effective at building value in his company, increasing cash reserves, building markets, rolling out new products etc. More than 25% of his time is spent dealing with founders and certain BOD members who are constantly looking for quick cash wins. There’s been tremendous time wasted over the years chasing these rainbows, and it's cost the company in performance and talent – it reminds me of the old mantra of startups pre dot-com bust 'microsoft will buy us', but we know that Microsoft failed to show up in time for many...
I think part of the negative feeling about 'early exits' is not that they happen, but the amount of energy that is wasted in small companies pursuing and dreaming of early exits/cash windfalls rather than simply focusing the organization’s attention and efforts on the creation of value – an activity that is just hard work without a lot of sex appeal :-) Maybe the acceleration created by the internet also contributes to shorter attention spans?
Thanks for the invitation to contribute my 2 cents.
From Siegfried Luft, Zeugma Systems July 2, 2008
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I think there is a distinct difference between building a company that has an early exit and building a company FOR an early exit. When you look at the different stakeholders in the transaction, not all benefit from an early exit when the company was designed for just such a transaction. The stakeholders include the Investors, the executives, the employees, and of course the acquirer.
A company/product built to address a true market, will see all stakeholders benefit. The investors and executives cash out early. The employees make some money and have a job going forwards. The acquirer gets a new product, market, or technology and the expertise to build their business. An all around positive experience.
Often, when the intention is specifically an early exit, the investors and executives might make money, but the acquirer soon finds they were sold a false bill of goods, and as a result the employees soon find themselves out of work. It is this scenario which carries the negative stigma in my opinion. Because there is no longevity for the business, any acquired expertise in the local market dissolves. Overall this is not a good thing. Success breeds more success, while failure breeds failure.
Peter Kemball, Acorn Partners- July 3, 2008
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Early Exits Yes & No
As you may know we are early exit specialists, 45 – 60 days on invoices 3 -6 months on SR & ED claims! The cost to us is that we have to go out and find new deals and I suggest that this is also your issue. Clearly we like repeat business from customers because the transaction costs are significantly reduced. This allows us to act as a substitute for equity to some degree.
On an equity basis we like "continuing"” exits and if we target an IRR of 50% it has to start after three years and amount to the initial investment at the end of year 3. A delay of a year causes a large reduction in the IRR but a solid ongoing annual income stream is still a good return. So early is better for the founders and managers, they pay less per year. If you can use one or two SR & ED refunds to return capital this helps reduce the annual amount paid but places the burden of locating another good deal back on the investor, the kind of burden shifting that is often used, e.g., IKEA furniture.
The problem with early exits occurs with the realities of the sales cycle. There is an initial period during which you learn what works followed by planning it out, staffing up, and execution. A two year exit is not usually sufficient. So early exits are bad for building a business to last.
In sum it is a question of the combination of: nature of the investment opportunities available; the nature of the capabilities of the individuals – few of us are Bill Gates – and whether or not one is a builder or a trader. Both can be profitable if you can limit losses!
From George Hunter - July 4, 2008
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This is a topic that is probably too complicated to discuss in an e-mail exchange but here are some thoughts.
- The value (goodness of badness) of exits like any judgment of a single transaction within a complex and dynamic system depends entirely on your POV.
- The use of the adjective 'early' conveys a positive spin on the 'exit'. Another adjective 'premature' also describes the exit but implies the forgone value, money left on the table by leaving early. Even more negative adjectives can be used as you have indicated. So while exits are an inevitable and necessary part of the business cycle and important for circulating assets (money and people) their value is really dependent on the observer’s POV.
- From the POV of the direct participants, particularly investors, getting your money back with a little extra is a great thing, in particular because good investors are risk balancers and don't like to see their money out on a limb for any longer that is absolutely necessary. This risk calculation is in part dependent on an (often subconscious) assessment of external risk factors, a factor that is very relevant in the BC context. More of this in a moment.
- The stage at which an exit takes place reflect the sound judgment of market players given the current conditions surrounding the company and are thus symptomatic of the health of the community.
- From the POV of the larger system (community) early exits at least ones that involve the loss of the opportunity to the community are much less advantageous. A good (but not excellent) analogy is the export of raw logs. This practice is excellent for the loggers and brokers who make a lot of money off the transaction but is not supportive of the industry as a whole, as it forestalls the secondary processing opportunities and other value added activities that contribute to reinvestment in the industry.
- In the case of (too) early tech exits the opportunity costs to the community can be great. Among leaders, a culture of lesser success emerges. Fewer large companies are formed with a resultant reduction in overall R&D capacity and less R&D support re-enters the academic community. Fewer people gain skills in larger company operations, sales & marketing finance etc. The VC community is weakened. The growth of the industry is reduced leading to less visibility at home and abroad. Public support declines as does political clout. The combination of all of the preceding leads to the subtle change in the perception of background risk that I mentioned in (3).
- A complex community such as technology has to be viewed as an integrated whole. If it's healthy, one should expect to see positive development and growth across the community. Current companies should achieve and exceed the level of growth and prominence of their predecessors, new flagships should be emerging, new community leaders should arise and become prominent spokespersons for a clear industry agenda, public visibility and an international image should be apparent, political support should increase and concerns around early exits should not exist. I don't have the data to be definitive on the preceding as it relates to the BC industry but my current perception (POV), as an interested but somewhat distant observer, is that this is not the case. I certainly would be happy to be proven wrong on this.
- To be clear, I still believe in the potential of the BC industry and its ability to reinvent itself. There are many bright young minds with great ideas and lots of ambition in this province. Let's hope they get a chance to achieve their ambitions here.
