If you’ve been watching the recent wave of shows on disgraced startups (from Theranos to WeWork), you might be under the impression that startup founders have no sense of responsibility.
In my experience, however, the opposite is much more common: Entrepreneurs tend to feel guilty about things that are just part of startup life. For instance, many founders feel quite badly about merely admitting that they wouldn’t say “no” to a good enough acquisition offer, or telling their investors they’d do so.
Why does it matter if founders tell investors that they might take an exit before their company reaches IPO scale? I think the reasoning goes something like: “What’s good enough for me might not be good enough for my backers,” or a life-changing amount of cash for a founder might be too small an investment multiple for an investor.
And sometimes, these concerns are not just guilt rearing its head, but also the fear that VCs won’t let an acquisition go through if it happens too early in a startup’s lifecycle.
There are many reasons to stick it out at your startup, but if you’re worried about your investors when faced with an exit, here’s why you shouldn’t be.
In VC Land, 1 > 10
Letting people down is never pleasant, but that’s how it can feel to sell a startup early. Will investors be disappointed that your company never fulfilled its destiny? Well, yes, but only to a certain extent, and that’s where portfolio math comes into play.
Investors hedge their bets by making many investments, though they still hope that each of those bets pay off. However, they also know that it won’t happen. They’re in the game fully aware that that some of their investments will simply have to be written off, and a handful more will land somewhere in between success and outright failure.
But investing in startups still makes sense, because outliers will return their original investment value many times over.
In venture capital, big home runs have become a fixture. They have a name, too: “Fund makers,” and they signify an investment that generates more liquidity than the entire fund backing it.
In a 2014 post on TechCrunch, VCs John Backus and Hemant Bhardwaj coined a new term for these fund makers: “dragons.” They encouraged fellow investors to favor them over unicorns. “Unicorns are for show. Dragons are for dough,” they wrote.
It appears dragons are quite common in top portfolios. In a 2021 blog post, Christopher Janz, of VC firm Point Nine, referred to a data point that has been floating around in the venture industry: “I remember that in one of our first meetings with Horsley Bridge (our first and largest institutional LP, and a great supporter for almost a decade), they shared data with us showing that virtually all VC funds with a >3x return have at least one fund-returner investment,” Janz wrote.
So if a single investment is going to generate such disproportionate returns, investors really don’t have to lose sleep if their other portfolio companies sell for a 3x, 6x or 10x multiple.
That also explains why early exits shouldn’t be a problem for investors. Allowing an early exit doesn’t mean that VCs are violating their fiduciary duty toward their limited partners, because everyone involved understands portfolio mechanics.
“To a first approximation, a VC portfolio will only make money if your best company investment ends up being worth more than your whole fund,” Peter Thiel reportedly taught in his CS183 Stanford class. He pointed to Founders Fund’s 2005 fund, where “the best investment ended up being worth about as much as all the rest combined.”
As for angels, it is their prerogative to be diversified and educated enough to know that this is just part of the game.
Recycle all the things!
Time is another element of VC math that founders don’t always consider — a 3x multiple in six months is not the same as a 3x multiple in three years.
Indeed, getting liquidity early in the cycle of a fund means getting fresh capital that can be reinvested right away — a concept known as “recycling.” This often means early exits are not such a bad deal for VCs.
Founders are seldom familiar with the notion, but even for VCs, it can take time to fully understand its impact.
“‘Recycling’ was one of the topics in VC fund management that took a while to sink in,” Semil Shah, partner at Lightspeed Venture Partners, tweeted. And its importance can’t be understated. “We’re still recycling Fund 1 (2013-2015),” Homebrew partner Hunter Walk replied to Shah’s tweets.
This concept doesn’t apply to just money: If you allow us the analogy, founders, too, can be recycled. A founder can come back to the same VC to pitch a new startup after they exit their first company.
VCs are typically keen to invest in second-time founders, especially ones they already know, and that’s a strong reason not to burn bridges by vetoing an early exit.
We should note that “early” here isn’t synonymous with young. For instance, when ERP company Holded accepted an acquisition offer from Norwegian group Visma, it was already five years old. But only a few months before this, the Spanish startup had raised a €15 million Series B round led by Elaia Partners.
Despite this time frame, this how Elaia partner Pauline Roux reacted on Twitter:
It was a short journey together @bernatripoll @Javifondevila 🥲but we'll pursue it another way for sure👍! Huge congrats to this (really) amazing @holded_ES team, who deserves so much!! https://t.co/j2ffmRFHQO
— Pauline Roux (@RouxPau) June 18, 2021
We don’t know for sure what multiple Elaia earned, but in a recent interview, Holded CEO Javi Fondevila described the deal value as “an amount we couldn’t refuse.”
Financials aside, Elaia had another motive for being graceful about the acquisition: Fondevila is well-known in Spain’s tech scene, and venture capital is a business of reputations.
So go get the bag
For entrepreneurs who find Holded’s decision inspiring, it is worth keeping in mind that its Series B round was raised in late 2020, when the market was more bullish. This made investors less demanding — or from another angle, less careful.
In contrast, a company that raised in recent months might have accepted less favorable terms from investors. Depending on liquidation preferences and other provisions, an early exit under these terms might not leave money on the table for founders.
But it can still make sense for founders to entertain acquisition offers, perhaps even more so in a climate where fundraising and running a company has suddenly become much harder.
One thing is for sure: If you are fundraising, now is a good time to wonder if you should rather seek a suitor. Once you close your next round, that option may not be entirely off the table, but it could be a lot less attractive.
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