50 Questions: How does a VC think about exit strategy?

Twenty-first in a series of weekly posts by myself and Nicholas Lovell of Gamesbrief which answer the fifty questions you should ask before raising venture capital.  We expect the series to run for a year after which we will collate the posts into a book.  You can find the rationale behind the series here, and the list of questions here.  We welcome your comments on any and every aspect of what we are doing.

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Venture capitalists only make money if they exit companies successfully, and in this context ‘successfully’ means at a big profit for the investors within a few years of making the original investment.  Making a big profit quickly usually means that the company exits at a high valuation relative to its revenues and profits (if indeed there are any profits).

These sorts of exits aren’t achieved by many companies and the term ‘exit strategy’ is a short hand phrase used to describe the analysis that goes into determining how likely a company is to achieve a high value, high multiple exit in a relatively short period of time.

The first output of this analysis determines whether an investment is attractive in the first place.  Many companies are unlikely to ever achieve a high value exit and are therefore not good prospects for VCs.  The second output is the likely size of the exit which is a function of forecast revenues and profits and likely exit multiples.  This has a bearing on the valuation at which the VC will invest.  I wrote about this in detail before when answering the question How does a VC value a business?, but in summary the higher the forecast exit the higher the entry valuation.

The first part of the exit strategy considers the attractiveness of the company on a stand alone basis, and looks at the following questions:

• Is it operating in a large and/or fast growing market?
• Does the company have potential to grow in the years after acquisition?
• Is it the market leader?
• Does it have significant advantages over its competitors?
• What are the profit margins/what might the margins be once the company reaches scale?
• What elements of the business would it be difficult for an acquirer to replicate organically (e.g. intellectual property, network effects, customers in new geographies/verticals)?
• Quality of management – will acquirers pay more to capture key individuals?

The second part of the exit strategy looks at how the company fits with potential acquirers, considering the following questions:

• How many potential buyers are there?
• Do they have a track record of making acquisitions?
• What would be there logic for acquiring the company (e.g. account control, cost synergies, revenue synergies, protecting their existing business)?
• How are comparable businesses valued (both on the stock markets and in M&A)?
• Will the company be a candidate for IPO in the time frame of the investment (mostly a function of revenue scale, profits and growth)?
• Will the company have partnerships with acquirers that create an element of intimacy/dependency?
• What is the geographic fit with potential acquirers (most like to acquire close to home)?

When we invested in buy.at we felt good about the potential exit because we were confident the business could become the leading independent player in the UK market and have nascent businesses in other geographies, and because we could see a number of potential acquirers who wanted to round out their online advertising offerings with an affiliate play (AOL, Yahoo, Google, Microsoft and many offline media groups).  In the end we sold the business to AOL who had the full suite of ad offerings except an affiliate network and who were confident they could grow our fledgling US business very quickly by pushing it through their US sales force.

Lovefilm in contrast had a narrower range of exit options and hence the potential for an IPO was much more important.  In the end the company was acquired by Amazon but there wasn’t a long enough list of other potential suitors to have an exit strategy based on M&A.

When we make an investment we consider all of the elements above but the quality of information on the acquirer universe is rarely great and the performance of the company over the life of the investment is always highly uncertain, so a deep formal analysis would be pointless.  Rather, as with many things in venture, we pull together all the information we can and use that to inform our gut feel as to how the exit will most likely turn out.