Recently at the Westchester Angels we screened a promising company that eliminated themselves with one phrase. When we asked how the investors would make money the presenter responded that we should ask our financial advisors. That was the wrong answer and the end of the conversation.
Early stage investors know how they will make their money: through exits. Given the risks in this stage of investing, angels need to aim for a 30 times return on their investment. This means that a company needs to grow quickly and go through a liquidity event, generally a sale, before the investor sees any money at all.
Most entrepreneurs are concerned about earning enough money to survive. Good ones are laser-focused on connecting products and customers and filling a need in the market. They are often not thinking about selling the company, but they should be, right from the beginning.
When investors ask how they will make money, they want to see that the entrepreneur is thinking about preparing themselves for the sale. They want to know that the company can be sold, that there will be a market not just for the product but for the company itself.
In fact, the market for the company itself is more important. The worst outcome for an Angel investor is when a portfolio company becomes a “lifestyle business.” Complete failure may sound worse, but at least a complete failure ends. A lifestyle business continues along, earning just enough to keep itself in business, maybe with some moderate growth but with no big future.
These businesses can drain investors”™ time and resources and yield very little, generally zero, return.
Smart entrepreneurs able to raise early money from angel investors will have a clear vision of when the exit will happen and who will be acquiring.
Often the first idea is to plan for a public offering. But the IPO is the Mt. Everest of business growth; many companies start out aiming for the IPO summit but very few will ever make it. It might happen, and everybody would be happy if it does, but it isn”™t a strategy.
Entrepreneurs should instead look for logical acquirers of the business. These are companies that are already in the industry space and for whom the entrepreneur”™s solution is either a threat or an extension of their product line.
One example comes from a food company that the Westchester Angels screened. They had identified major food companies with publicly stated strategies of acquiring startups that made products in the same category as those the startup was developing. They showed that similar startups had found acquirers willing to pay significant premiums and demonstrated a pattern of acquisitions.
The details of an exit strategy always depend on the situation, but a good exit strategy will:
- Identify who will acquire the company. This should be as specific as possible, the more detail the better.
- Explain why they would be compelled to acquire. The new product may be a threat or a complement to their current offering.
- Give an idea for the price the acquirer may be willing to pay. This will usually be a multiple of earnings. By showing the growth in earnings and applying a multiple, investors can calculate their expected returns.
- Provide a timeline for exit, explaining when it may happen.
- Show a strategy to deliver the exit. This should explain how the entrepreneur is marketing not just to customers but also to future acquirers, making them aware of the startup”™s existence.
The clearer and more convincingly this exit strategy is presented the easier investors can estimate their returns and invest. As unlikely as it is the IPO possibility is always out there, everybody knows that an IPO is possible, just extremely unlikely. The exit strategy is more realistic and much more tangible.
The one mistake entrepreneurs should never make is to tell investors to consult their financial advisors in order to understand how they make money. That will definitely encourage investors to look elsewhere.
Jeff Loehr is a principal consultant at Stratist Consulting in White Plains, a firm that helps businesses of all sizes design strategies, business models and execution plans, and a founding partner of the Westchester Angels, an investment group that brings early-stage investors and startups together. He can be reached at jeff.wbg@stratistconsulting.com.
This column is part of a series leading up to “Pitching to the Angels,” an event for investors, startups and spectators hosted by Westfair Communications and the Westchester Angels April 21. Find out more at westfaironline.com/events.
