Randy Smerik on Being Ready to Be Bought

I was happy to catch Randy Smerik (a Year One Labsmentor) on Stage B (in the Fat, Funded and Growing track of the International Startup Festival) this past Thursday, July 14.

The takeaway message from Randy’s well-researched presentation (slides to be made available soon) was that the best time to think about making a successful exit for your startup is right at the beginning.

Looking back on the past decade of activity in the startup world, Randy provided convincing evidence that despite the news-making stories of giant oversized exits and acquisitions that make founders happily rich, the vast majority of firms (90%) that will make it to a successful exit are likely to find their way out through, a merger and acquisition (M&A) at valuations typically less than $20M, with a median of $10M for the past 5-6 years. Keeping this fact in mind right from the outset of your startup is not only a smart thing to do, it is essential if you – the founder, managing partner or member of the founding management team – want to manage the process rather than have it be managed for you by someone else who will not have your best interests in mind.

Most companies get bought for less than $20m and have fewer than 20 employees

It is critical to think about your exit strategy as you are thinking about taking investment, or deciding how much money to put into the company and where in the world you will set it up. Two key facts standout:

  1. If you are successful, you will probably be bought
  2. When you are bought it will be in the $20m range

By far the biggest startup company gobbler out there is Google whose list of acquisitions is more than any other company on the planet. Interestingly, the vast majority of Google’s acquisitions are of companies with fewer than 20 employees, and for less than $20m – and most are pre-revenue.

While many companies have come to Randy saying “I can’t raise money, I don’t have any revenue yet”, he believes that being pre-revenue is probably the best time to raise money. “You are selling on upside, on the promise, the vision – with no quarterly or monthly sales figures to explain.” In some cases having revenue can even be perceived as a liability. “You absolutely, positively do not have to have a revenue stream to be a successful M&A candidate.”

Plan for the M&A exit

If you are running a startup you often hear things like, “don’t worry about the exit, swing for the fences, You Can Do It!, never say die”, says Randy, and this is often and largely because the traditional VC model encourages you to do just that. That model, according to Randy, is broken.

While VCs can help you and your company it is critical for you as the founder and CEO to know what you are getting into before you take VC money. Reviewing the current trends in the VC world, Randy pointed out that VC firms are getting much bigger (from an average size of $50m in the 90s to $400m now with some super funds managing billions of dollars). The principals in these firms – the ones you want to be dealing with as they are the decision-makers – are going to need companies they can pour a lot of money into. Keeping in mind that the VC model is based on the widely held belief that only 20% of the companies invested in will hit homeruns, baked into the model is the implicit understanding that 80% will die. In other words, of the 10 companies a traditional VC will be investing in, they expect 8 of those 10 to fail and the remaining 2 to give them the 10x to 30x multiples they are looking for. And it can take a long time for that homerun to hit: 7 or 8 years or more.

The real reason all the entrepreneurs VCs invest in are coached to keep swinging for the fences and never say die is that until they figure out which 2 of their 10 companies is going to be their big winners, VCs need to make sure all the companies give it their all. As a founder of one of these companies, not having an exit plan – and the decision-making power when an opportunity for a successful M&A exit arises – can be a very costly mistake.

The real-world example Randy gave was of a firm that was started with $500k of family, friends and angel money and given a pre-money valuation of $2m, or post-money valuation of $2.5m. In this startup the CEO owns 40% of the shares, the rest of the founding team owns 40% and the angel investors have the remaining 20%.

The company starts to do well and before too long it needs more money to continue growing and taking advantage of its potential. So the CEO starts looking for VCs and finds a firm willing to inject $3m into the firm and not only that, but give it a valuation of $10m – 4x its current valuation giving it a post-money valuation of $13m. As CEO of this company you are feeling pretty great and don’t mind that the VC firm has also negotiated for itself the right to veto any exit offers. The CEO and founding team now each have 31%, the angels 15% and VCs 23%.

Time passes, the company gains momentum and catches the attention of a buyer who offers $40m for the firm. Wow! The CEO and founders are feeling overwhelmed. They can each make $12m on the deal, the angels get 6x return and the VCs 3x return. And they veto the deal because they see that the company is attractive, still growing and they want their 10x. Life after the veto is not pleasant for the CEO who will likely be replaced with another who can better manage the growth of the company.

While every situation is different and not all VCs are cut from the same cloth. In 90% of the cases where the VCs have the power to veto a deal that is not optimize for their target returns – they will. This underscores just how important it is to have a solid exit plan in place before this happens that keeps decision making power for exits in the hands of the founders.

Planning for a successful exit is not a distraction – it is a core business process

Wrapping up, Randy drove home his key message that even if you are not planning on exiting any time soon, it is imperative to keep your company looking attractive to buyers (strong team, great differentiated product and well articulated plan for growth) and ensure that you share a consistent exit plan with anyone investing in your company.

“Anyone who tells you not to worry about the exit is crazy and has probably never had a successful exit.”

For more information about core business process. Click here.

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