The cheerful stewardess on my red-eye to Argentina was delivering her pre-flight speech. Her soothing voice washed over me as I sat in a window seat, reading a business plan for a technology start-up on my laptop.
“There are 10 emergency exits on this Boeing 777 aircraft: 4 in the front, 4 in the back, and 2 located over the wings.”
The plan I was looking at was intriguing: good team, unique-looking product, some initial traction. But as I reread the summary, something about it was bothering me, nagging at me.
“Keep in mind that your nearest exit may be behind you. If cabin visibility is reduced, lighted strips along the floor of the cabin will lead you to the nearest exit.”
As the stewardess finished her presentation, I stashed my computer in the seat-pocket in front of me and looked around for the emergency exits. As I buckled my seatbelt, I suddenly realized what had been bothering me:
The plane I was sitting in had ten emergency exits. The stewardess, crew, and pilots all knew exactly where they were, and were intimately familiar with the plans and protocol to use them. They had a solid exit strategy.
The start-up I’d been reading about, on the other hand, had zero potential emergency exits.
They had no exit strategy at all.
Investing in early-stage companies can be fun and exciting. It’s a pleasure to see a dream become a reality. But from a financial perspective, true pleasure is when a business becomes a good investment.
Here’s the equation:
You enter an investment by writing a check.
You exit an investment by getting your money back — and hopefully, a multiple of your money.
If you’re exploring making an early-stage investment, one of the most important questions you have to ask is this:
“What’s the exit strategy?”
Get Yourself To An Exit
Airplanes have multiple exit possibilities — 2 over here, 2 over there, 2 in the back; they’re everywhere.
Not so with start-ups. There are only three doors through which a company can exit:
1) The business is acquired by another company.
2) The business goes public in an initial public offering (an IPO).
3) The business becomes profitable, and determines that it doesn’t need all its cash to grow the company’s operations. At that point, it can return money to shareholders in the form of dividends and distributions.
If you’re playing by the odds, it’s unlikely you’ll be rewarded through dividends or an IPO.
Only a small fraction of start-ups end up paying a dividend. Companies that are trying to get as big as they can, as fast they can, tend to use any cash in the bank to fuel more growth.
And very few companies achieve the scale or stability necessary to go public.
Your #1 exit strategy? Acquisition.
Looking For Clues
Unlike on plane doors, exits for start-ups aren’t always clearly marked.
But the clues are often there. Look for a big market. Or a sector that’s growing like crazy. Or one or more potential acquirers who are willing and able to write big checks.
Here’s an example:
By 2012, Facebook had nearly one billion users.
Many of those users spent hours each day on Facebook’s website.
Meanwhile, two major trends were picking up steam: 1) consumers were spending far more time on their mobile devices; and 2) consumers had fallen in love with taking pictures on their phones and uploading them to social networks like Facebook.
In April 2012, Facebook acquired a young company, a photo app called Instagram, for $1 billion.
What did Instagram have that was possibly worth $1 billion?
Well, first of all, they were targeting a huge market: casual photographers. Secondly, they were on the cutting edge of several sectors, including both Mobile and Photography Apps. And thirdly, they had several potential acquirers — including Facebook, Twitter and Yahoo — that were eager, even desperate, to grow their mobile efforts, and could afford to write huge checks.
(They also had very strong early investors. That’s a good indication that an exit strategy exists — but we’ll get back to that topic soon in another post.)
Watch Out For “Lifestyle” Businesses
In contrast to Instagram, the business I’d reviewed on the plane lacked any telltale signs of a potential exit.
It was targeting a smaller, niche audience. Forget about scaling to a billion users like Facebook; this business would have trouble scaling to 10,000 users.
It wasn’t part of a fast-growing sector, the kind of exciting new type of business you might read about on TechCrunch.
And it was nearly impossible to imagine a bigger company buying it; there wouldn’t be much to buy — no big audience, for example, or no special technology.
But with the quality of their team and the unique look of their product, I thought they could eke out a million dollars or so in revenue, and maybe a tiny profit. That could be a nice “lifestyle” business for the small team of founders — i.e., they could enjoy their work, make a decent salary, and have a nice lifestyle.
The only problem is that, from an investor perspective, lifestyle businesses don’t generally come with exit strategies.
Always Be Exiting
Investing in a start-up where you can’t identify the exit strategy is like getting on a plane that doesn’t have the exit doors mapped out.
So when it comes to early-stage investing, make sure you ask the entrepreneur — and ask yourself! — “What’s the exit strategy?”