For entrepreneurs pitching investors: make sure you’ve included “exit” thinking.
I see a lot of entrepreneur plans with the usual stuff on how the product/service will be developed, how it will be marketed, how much capital is needed, and how the business will grow. The frequently missing item is the exit analysis: is there a plausible path for $1 invested to be worth $10?
Investors invest to generate a return. You can build a business with the greatest {revenue|users|uniques|units sold|subscribers} in the world, but if it’s not valuable, it doesn’t matter. Some basic exit analysis against comparables (public companies, acquisitions of similar companies, funding rounds) may surface investment flaws, such as: low-margins, poor scalability (e.g. many services-centric businesses), and capital inefficiencies (e.g. $50m needed to make a company worth $100m).
Avoid the embarrassment in the VC conference room: do your exit analysis homework.
as important for the entrepreneur, do the analysis of *your own position* if/when an exit occurs
say the company works for 5 years before an exit, valued at $150 million, and does 3 rounds of funding over those years, raising a total of $30 million (say, $6 million A, $10 million B, $14 million C.)
what’s your ownership position at the end? not your ostensible position, your TRUE position — that what you own of what is left after all the special terms of the preferred shareholders get paid off.
and is it going to be worth 5 years of your time? even if you are 25 years old, 5 years is a big chunk of your prime earning years.
say the preferred shareholders own 70% of the company at the end. so they get 70% of $150 million, right? well, maybe. say they owned “participating preferred shares,” meaning they get their $30 million out first, PLUS 70% of the balance. thats $30MM plus $84MM for a total of $114MM. Leaving $36MM to be split amongst the founders and management and employees. And say you the founder own 10% of the company. You receive 10% of $120MM, or a $12MM windfall for five years work. Not bad!
Maybe the exit is only $100MM. Then the preferred shares are worth $79MM out of $100MM, and you get 10% of $70MM, or $7MM. Still pretty awesome, but still a much bigger delta than initially meets the eye.
Etc.
Bottom line, if you can’t imagine a great exit for yourself personally, either the deal terms being offered aren’t worth it, or else the startup idea itself isn’t worth it for you and investors.
OOOOOOPS! my bad math. In the second example, the founder gets 10% of $21MM (NOT $70MM) meaning the founders windfall is only $2.1 million for 5 years. A borderline case for many people, as (one would hope) that super talented brilliant entrepreneurial people aspire to rewards much greater than that, even after baking in whatever salary one gets paid for the 5 years…
Great point; preferred stock mechanisms, especially participating preferred, can really eat into common stock returns.
I usually suggest that entrepreneurs make a payoff graph. First make a table of who makes what at various exit points (e.g. $5m, $10m, $15m, etc.).
Then graph it. You’ll end up with a pretty clear picture of things.