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January 11, 2011

Walking Away From Liquidity

With big tech companies awash in cash, nearly every analyst out there is predicting that the M&A market will heat up in 2011.  At a (pre-blizzard) conference I attended today run by Gridley & Co, this theme was reinforced, with rosy predictions of an M&A boom.

If this boom comes to pass, everyone will cheer.  Yet a strong M&A market won't be a panacea for all.  It will cause good companies to face perhaps the singular hardest decision in their lives:  whether to walk away from an opportunity for positive liquidity. 

Two of my companies have just gone through this process.  In each case, a strong unsolicited offer came in that would have yielded "VC-like" returns (5-10x) and many millions for the founders and senior executives.  But in both cases, everyone around the table unanimously, courageously (and hopefully not foolishly) voted to turn down the offers and walk away.  Having just lived through two of these episodes in the last few weeks, and having lived through many others in the past, I thought I'd share a few observations on this classic conundrum.

When to sell a company is one of the hardest decisions a board and entrepreneur face, and it's a decision made even more difficult if there is a lack of alignment around the table.  If different investors have invested at very different prices, or if the entrepreneur has not made money before and this is their first shot, there can be greater tension inserted into a naturally tense situation.  For example, if the Series A investor has a blended average post-money valuation of $20 million across three rounds, they may be happy with a $100 million exit.  But the Series C investor who just invested at an $80 million post-money valuation would be bitterly disappointed.  Meanwhile, the founder who owns 10% is looking at a $10 million payday - a heady sum for someone who still has a mortgage and is worried about saving enough money to pay for her kids to go to college.

It's all very theoretical, of course, until an actual offer is put on the table and everyone starts to calculate their share of the proceeds.  There is no easy answer to help determine which path to pursue, but here are five considerations that can help an entrepreneur frame the decision:

  1. Passion. Do you still love running the business? Does it feel like you can’t imagine doing anything else with your life? Do you still feel like you have something to prove or do you feel tired and worn out?  Do the problems in the business energize you or drain you?
  2. Belief.  Do you still believe in the business’s potential? Does it appear that the major proof points are still ahead of the company?  Do you feel as if the value will be meaningful greater after you have achieved a few more milestones - and that those milestones are well within reach?
  3. Economics.  How much is the offer as compared to what it might be a year or two from now if the company were to successfully execute on its plan and hit its numbers? What might the company’s value be in a year or two if it falls short of its plan by 30 percent? How would you assess the probability of either path and then calculate the expected value of holding on for a few more years as compared to taking the money off the table by selling now?
  4. Dilution Risk.  Does the business require more capital and, if so, can that additional capital be raised easily at a reasonable (and therefore not too dilutive) price?  What must the business be valued at after the additional capital to be equivalent to your dilution-adjusted payout today?  In other words, let's say you own 10% today and can sell for $100 million.  If your post-financing ownership will be 5%, then you are betting that you can sell for more than $200 million down the road.  Risk adjust this number and take into account the time value of money, and then assess the trade-off.
  5. Team.  Do the people around you (i.e., your management team, your VCs, your family) want you to sell out or are they encouraging you to keep going?  When you look your team in the eye and tell them they are walking away from $x million each, do they stiffen their spines and project bravado - or do they look at you longingly, with regret?

It can be hard for VCs and entrepreneurs to be aligned in these situations, because the VCs have the luxury of a portfolio approach to investing in start-ups - they are looking for home runs that can move the needle on their funds.  Entrepreneurs, on the other hand, have no such luxury.  This may be their one shot to change their lives and their family's lives.  

I have found that the entrepreneurs who have made good, not great, money in the past are more likely to be both hungry and risk tolerant enough to go for the big win.  Having saved enough money to pay down their mortgages and pay for the kids' colleges, these entrepreneurs are willing to take more risk to make the kind of money that can really change their lives.  That sweet spot tends to be $2-5 million in liquidity.  More and more, I have seen investors show a willingness to allow partial liquidity for founders who have built enough value to raise money at high prices to soften the sting of walking away from an outright sale.

So the next time you hear about how robust the M&A market is going to be, remember that the real trick is for founders and boards to find that right balance between taking advantage of the robust market, and putting their collective heads down and focus on trying to build a big company. 


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Great points. I'm hoping to come back to this list when I need it to actually make this decision.

I wonder why the old-school VC perspective is so against the entrepreneur taking money off the table. I have a hard time seeing most workaholic entrepreneurs taking it easy just because they managed to sell a couple of million in stock. I'm assuming that's the fear, right? In my opinion, aligning incentives to go for it is much more important.

From the outside looking in, I think about most startup exits the way I think about M&A in general - in terms of information asymmetry. I tend to assume that the entrepreneur thinks they're at a risk-adjusted top in the fortunes of the company, so they sell high.

Well said. Just a quick question about your example with the Series C investor. I was under the impression that very late stage VCs invest at high valuations since there's much less risk. As a result, unlike earlier stage investors, they aren't expecting 5x or 10x returns.

So my question is what are C and subsequent round VCs expecting in terms of returns? If a 100M exit on 80M post money is "bitterly dissapointing", what would be "palatable" and what would be "ideal."

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Most late stage investors are still
looking for strong multiples.  Perhaps not > 10x, but they will still
underwrite their investments with 3-5x in mind.  Putting all that energy and
working into due diligence and closing and only to get $1.20 for every $1.00
spent is a losing proposition.

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I think investors are always nervous when
they see the entrepreneur sell as they are worried that it will dampen their
motivation and send a signal that they are a “seller” vs. a “buyer”.  Personally,
I’m happy to see the entrepreneur take some money off the table in the right
circumstances, and even encourage it, so that they can have more confidence to
go for it and not always have their spouse hounding them about how a
multi-million dollar payout would change their lives.

This is amazing list like the previous one..
Thank you for this post..

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