41. The Exit (John Huston)

The Full Ratchet Podcast on iTunesNick Moran Angel List

John Huston of Ohio TechAngels joins Nick to cover The Exit. We will address questions including:

  • Huston The ExitHow should angel group leaders think about the exit as a part of their investment strategy?
  • Not every geographic area has produced multiple unicorns or any unicorns for that matter. Why is this a key factor when considering the exit at investment?
  • In the past, your investment group has employed an investment strategy where you establish if VC funding is a necessity or a nicety. Can you talk about how you think about subsequent investment requirements and types of investors?
  • Is it the degree to which a startup is capital intensive that determines whether VC funding is necessary?
  • During the evaluation of a startup for investment, do you have a clear target acquirer in mind engage with strategics?
  • Can you talk about how you engage with strategics to help facilitate acquisition and a startup exit?
  • I’ve talked to a number of folks that disparage angels who are exit-focused or for the “”quick-flip””. Why do you think they have this position and why do you believe they have it wrong?
  • What advice do you have for early-stage investors regarding exits and how to think about the exit very early-on?

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SoundCloud:  http://bit.ly/1ItRUa5


Before we jump in I want to say a big thanks to all of those who voted on the name of our new Angel List Syndicate. The results are in and “New Stack Ventures” was the overwhelming favorite. This was also a great fit for mine and my partner Jeff’s philosophy, so we’re are very happy to announce that the syndicate has been created and is live on Angel List. If you’d be willing to back us that would be great. Whether or not you plan to actively invest, there’s no obligation, it’s just a good way to show support and also monitor our dealflow.

I’ll include something in the newsletter as well that provides some info on how to follow us. Speaking of which, I lost my assistant in late May and had to put the Newsletter on hold until I could find someone to help out. There’s a surprising amount of time that goes into Venture Weekly, publishing audio, doing blog posts and such, so I appreciate the patience with that and am excited to get things going again. So, be on the lookout for the Newsletter tomorrow morning.

Guest Links:

Key Takeaways:

 

1- Four Key Questions when thinking about the Exit

1. What does the company have to look like (ie. what metrics does it have to achieve) in order to have multiple Strategic Bidders with high interest in buying the company?
2. How much capital will it take to get the company to look like that? And is dilutive VC funding necessary to get there?
3. Assuming we could raise the necessary capital to get the company to that point, is the management team capable of getting the company to look like it needs to look.
4. Presume that 1, 2 and 3 are satisfied. So, the goals to get strategic bidders interested are attainable, the management team can get it there and the necessary capital required to get it there can be raised… Is there Exit Goal Congruence? In other words, are the management team and board aligned on the exit expectation? Remember that if the board and founders are not aligned, there will be issues. If the co-founders are not aligned with each other, there will be issues. For John, it’s critical that the key stakeholders agree on the eventual exit from the very beginning.

 

2- The Necessity of Optionality

We spent a bit of time talking about the ability for a startup to get multiple competing VC term sheets at a subsequent round. Without multiple offers, the startup is really at the mercy of the VC and is subject to the cram-down as we talked about on the episode with Gil Penchina. Optionality is required. The startup with multiple options is in great shape to pursue what’s best for them and most consistent with their Exit goals. The startup w/o options or only one option, really has no options and they take a bad deal or die. They get screwed and their early investors get screwed w/ them.

 

3- Three Reasons for a Capital Access Plan

1. Allows them to forecast whether they can hit their necessary hurdle rate (IRR). And remember that John focuses on Internal Rate of Return over Return on Investment. The former consider the total return as a function of time. While the later is akin to a multiple and while many investors like to talk about their return as a 5x or 10x, returns can’t be compared apples-to-apples or evaluated for their true merit without considering the time-horizon in which an investment is made. And as John mentioned, this drives one to focus on an earlier exit instead of just a return multiple.
2. Puts focus on whether subsequent VC financing will be required.
3. Exit Roadmap for allocating resources. If you know the acquires and what they need, money will not be spent in areas that provide no accretive value.

 

 

Tip of the Week:   Startup Quality & Investment Quality

”HIDE/SHOW

FULL TRANSCRIPT

 
   

   
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  • Seph

    I enjoyed the recent Investor Stories segment with John Huston that I went back to give this interview another deep listen. So much to chew on. He really gives a great interview. Some notes below, to supplement your takeaways. All text transcribed from John Huston.

    ——————–

    @9.40
    Who are those strategic bidders in whose hands my venture will have the greatest value?

    @10.25
    I think it’s important in life, in general, to fight hope with evidence.

    @12.20
    We always ask this question before we would ever let them pitch to our membership. Just tell me why somebody wants to be the high bidder to own your company. Is it your installed base, marquee customers, IP, your idea – EBITDA is the wrong answer – is it your team? And if you start thinking about that, then you can hone in on the likelihood that this team will be able to build a company to look like that.

    @12.55-14.00
    There are five basic questions in our opinion that should be asked with every deal.
    (1) What does the company have to look like so that there are multiple drooling salivating cash bidders wanting to be the high bidder to own your company.
    (2) How much capital does it take to get the company to look like that. And by capital I mean both dilutive and non-dilutive. The subset question there is whether or not VC funding under the dilutive category is absolutely essential.
    (3) Let’s presume we could raise that amount of money for this company. Could this management team get it to look like that.
    (4) Presume we raise the money, they get the company to look like that, and there are multiple bidders. Is the management team and the board aligned to actually have a lucrative exit, and is there any evidence to suggest that they have done it before and understand the exit drill.
    (5) And if not, then tell me why I am investing in this company.

    @14.40
    Exit goal congruence or, to say it another way, a realistic understanding of what the final outcome might be for the founder and the team is really essential going in. I think it’s a travesty when Angels don’t interogate entrepreneurs for what they think is a possible outcome. Because to let them think that it’s going to be $100M and drag their families through an awful lot of intensity, telling them that it’s $100M and to walk away with $3M to $5M, we have done a disservice to the entrepreneur and the team.

    @16.55
    If I could ask only one question after I have established that there is enough exit goal congruence to be interested… it would be ==> Can I have a lucrative exit without VC funding, or is VC funding an absolute necessity for an exit?

    @19.00
    If there can’t be an exit without VCs, that adds a very thick additional layer of risk because not only do we have to have the company perform so that it can attract VC funding but it has to perform at such a level so that it can attract multiple term sheets so that the angels can have some hope of not getting crushed.

    @20.00
    The issue is not that VCs are bad. They are only bad if the Angels didn’t know from the outset that they would absolutely be needed. Conversely we love the case where a company perfoms well, and we didn’t think VCs would be needed for the exit, but now to really optimize the idea VC funding is necessary. That’s great, but that’s an example if a nicety as opposed to a necessity.

    @20.50
    The more money [the company] needs to raise, the larger the financing risk, defined as the ability to not just perfom but actually raise it, and raise it on terms that incinerate Angels’ economics. That’s really the concern. We have a great number of companies that have been successful in raising VC capital, just as planned. Unfortunately, too many of those were raised on a basis where our economics totally evaporated. Which is not to suggest that it will not grow into a truly great company, but we already know that it is a lousy investment for the Angel cadre. And that’s what we are trying to avoid.

    @22.30
    I would comport myself exactly like they do if I were [a VC] because my loyalty would be to my LPs. They are doing all the right things, and I do not begrudge them about their behavior whatsoever when they are able to come in and take advantage of the Angels, which is exactly what they should be doing to benefit their LPs’ returns. Then it is the fault of the Angels and management that enables [the VCs] to do that. Because the company has not performed at a level sufficient to get multiple competing term sheets on a basis that does not destroy the Angels’ economics.

    @23.30
    Capital access plan… The most important factor which affects our economics is dilution, putting aside being crushed to common… How much capital does the company need to get to exit? That is what we model in what we call the Capital Access Plan.

    @24.00
    As an example [of the Capital Access Plan], we’re going to raise a $2M angel round and it will get us to survival cash flow / break even. And then we will step on the accelerator and raise a $5M VC round at a 20% uptick in price. And then we think the company will hit the $10M of revenues that we think is essential before any of the targeted strategic bidders will be interested. If you don’t do that and estimate the follow on caital, and play around with what the impact of an uptick or downtick in valuation, there’s no way you can calculate whether there’s a scenario in which [your goals] are achievable.

    @25.40
    We have always demanded that we have preemptive rights or pro rata rights or however you want to call them. Which does not mean that they are always respected. The only defense against being brutalized by follow on funders is dry powder. If you have investor fatigue, even if they have the ability to continue to write checks, they don’t have the willingness. Then you just have to admit or put up with whatever happens to you. Because the new investors are… worried about their returns and not yours, so they will take advantage of you as they should because you are out of gas… There is nothing I have ever seen in any documents that protects me against being brutalized when I am out of money and more money is needed to keep the company afloat.

    @26.55
    It’s not as simple as “can the capital be raised”. It is “can this team raise capital on a basis that doesn’t destroy my economics”.

    @30.20
    The right way to look at [the quick flip] is not that the only exit is a quick flip. The right way to look at it is through the lens of optionaity. I have never had anybody convince me that it is better to have no options than it is to have multiple options. And so the advantage of starting at the outset, from identifying what are the alluring aspects of the company you’re going to build that make you attractive in the eyes of the most likely targeted strategic bidders so that maybe they will want to acquire you and provide your investors a lucrative return. I have never had anybody tell me that hope and pray are better strategies. Just build a great company and then someone will eventually buy you. That happens all the time. But I don’t see how that suggests having a plan, whether or not you choose to execute it when you get indications of interest. I just don’t understand how having a plan is an inferior approach to no plan, hope and pray, and just build a great company.

    @31.35
    There is nothing as great as having people being highly interested in you and you being uninterested in them because you don’t need to exit now. You think that there is much greater growth and value down the road. But that’s an awful lot better situation than having nobody calling you and being impressed.

    @32.00
    The other issue that I have always found quite interesting is the value that an exit road map provides in terms of allocating resources. As an example, if you know who most likely three to five strategic bidders for your company will be and you know how you would fit within their strategic portfolio, you should think long and hard before you spend an awful lot of resources replicating all of the assets they currently have… to build parts of your team that you know will absoulutely not make it through the acquisition or the merger.

    @32.45
    The beauty of an exit road map is that it makes you think long and hard whether you are building strategic value in the minds of the bidders. So it’s a resource allocation discipline. The goal is not to build shareholders’ value. That’s a mere accounting contrivance. The goal is to build buyers’ value. And if you look at it from that perspective then how you spend your money, or how you should spend your money, or more importantly what you should not be spending your money on because it has no value to the acquirers, that becomes much clearer in focus.

    @35.10
    I define a donor as any investor who hasn’t received and cash back yet. And until the exit, angels are always just donors… So I view myself as a donor until the exit. I only become an investor, maybe, hopefully, if I get some money back.

    @36.50
    It’s very comforting to me to look at [angel investing] as uncertainty, ambiguity, and randomness, coupled with luck, playing very very large parts and roles in our outcomes instead of trying to parse and analyze, quantify risk.

  • Seph

    I really enjoyed the recent Investor Stories 48 segment with John Huston, went back to give this interview a deep listen. He gives such a good interview. Some notes below to supplement your takeaways. All text transcribed from John Huston.

    ————————–

    @9.40
    Who are those strategic bidders in whose hands my venture will have the greatest value?

    @10.25
    I think it’s important in life, in general, to fight hope with evidence.

    @12.20
    We always ask this question before we would ever let them pitch to our membership. Just tell me why somebody wants to be the high bidder to own your company. Is it your installed base, marquee customers, IP, your idea – EBITDA is the wrong answer – is it your team? And if you start thinking about that, then you can hone in on the likelihood that this team will be able to build a company to look like that.

    @12.55-14.00
    There are five basic questions in our opinion that should be asked with every deal.
    (1) What does the company have to look like so that there are multiple drooling salivating cash bidders wanting to be the high bidder to own your company.
    (2) How much capital does it take to get the company to look like that. And by capital I mean both dilutive and non-dilutive. The subset question there is whether or not VC funding under the dilutive category is absolutely essential.
    (3) Let’s presume we could raise that amount of money for this company. Could this management team get it to look like that.
    (4) Presume we raise the money, they get the company to look like that, and there are multiple bidders. Is the management team and the board aligned to actually have a lucrative exit, and is there any evidence to suggest that they have done it before and understand the exit drill.
    (5) And if not, then tell me why I am investing in this company.

    @14.40
    Exit goal congruence or, to say it another way, a realistic understanding of what the final outcome might be for the founder and the team is really essential going in. I think it’s a travesty when Angels don’t interogate entrepreneurs for what they think is a possible outcome. Because to let them think that it’s going to be $100M and drag their families through an awful lot of intensity, telling them that it’s $100M and to walk away with $3M to $5M, we have done a disservice to the entrepreneur and the team.

    @16.55
    If I could ask only one question after I have established that there is enough exit goal congruence to be interested… it would be ==> Can I have a lucrative exit without VC funding, or is VC funding an absolute necessity for an exit?

    @19.00
    If there can’t be an exit without VCs, that adds a very thick additional layer of risk because not only do we have to have the company perform so that it can attract VC funding but it has to perform at such a level so that it can attract multiple term sheets so that the angels can have some hope of not getting crushed.

    @20.00
    The issue is not that VCs are bad. They are only bad if the Angels didn’t know from the outset that they would absolutely be needed. Conversely we love the case where a company perfoms well, and we didn’t think VCs would be needed for the exit, but now to really optimize the idea VC funding is necessary. That’s great, but that’s an example if a nicety as opposed to a necessity.

    @20.50
    The more money [the company] needs to raise, the larger the financing risk, defined as the ability to not just perfom but actually raise it, and raise it on terms that incinerate Angels’ economics. That’s really the concern. We have a great number of companies that have been successful in raising VC capital, just as planned. Unfortunately, too many of those were raised on a basis where our economics totally evaporated. Which is not to suggest that it will not grow into a truly great company, but we already know that it is a lousy investment for the Angel cadre. And that’s what we are trying to avoid.

    @22.30
    I would comport myself exactly like they do if I were [a VC] because my loyalty would be to my LPs. They are doing all the right things, and I do not begrudge them about their behavior whatsoever when they are able to come in and take advantage of the Angels, which is exactly what they should be doing to benefit their LPs’ returns. Then it is the fault of the Angels and management that enables [the VCs] to do that. Because the company has not performed at a level sufficient to get multiple competing term sheets on a basis that does not destroy the Angels’ economics.

    @23.30
    Capital access plan… The most important factor which affects our economics is dilution, putting aside being crushed to common… How much capital does the company need to get to exit? That is what we model in what we call the Capital Access Plan.

    @24.00
    As an example [of the Capital Access Plan], we’re going to raise a $2M angel round and it will get us to survival cash flow / break even. And then we will step on the accelerator and raise a $5M VC round at a 20% uptick in price. And then we think the company will hit the $10M of revenues that we think is essential before any of the targeted strategic bidders will be interested. If you don’t do that and estimate the follow on caital, and play around with what the impact of an uptick or downtick in valuation, there’s no way you can calculate whether there’s a scenario in which [your goals] are achievable.

    @25.40
    We have always demanded that we have preemptive rights or pro rata rights or however you want to call them. Which does not mean that they are always respected. The only defense against being brutalized by follow on funders is dry powder. If you have investor fatigue, even if they have the ability to continue to write checks, they don’t have the willingness. Then you just have to admit or put up with whatever happens to you. Because the new investors are… worried about their returns and not yours, so they will take advantage of you as they should because you are out of gas… There is nothing I have ever seen in any documents that protects me against being brutalized when I am out of money and more money is needed to keep the company afloat.

    @26.55
    It’s not as simple as “can the capital be raised”. It is “can this team raise capital on a basis that doesn’t destroy my economics”.

    @30.20
    The right way to look at [the quick flip] is not that the only exit is a quick flip. The right way to look at it is through the lens of optionaity. I have never had anybody convince me that it is better to have no options than it is to have multiple options. And so the advantage of starting at the outset, from identifying what are the alluring aspects of the company you’re going to build that make you attractive in the eyes of the most likely targeted strategic bidders so that maybe they will want to acquire you and provide your investors a lucrative return. I have never had anybody tell me that hope and pray are better strategies. Just build a great company and then someone will eventually buy you. That happens all the time. But I don’t see how that suggests having a plan, whether or not you choose to execute it when you get indications of interest. I just don’t understand how having a plan is an inferior approach to no plan, hope and pray, and just build a great company.

    @31.35
    There is nothing as great as having people being highly interested in you and you being uninterested in them because you don’t need to exit now. You think that there is much greater growth and value down the road. But that’s an awful lot better situation than having nobody calling you and being impressed.

    @32.00
    The other issue that I have always found quite interesting is the value that an exit road map provides in terms of allocating resources. As an example, if you know who most likely three to five strategic bidders for your company will be and you know how you would fit within their strategic portfolio, you should think long and hard before you spend an awful lot of resources replicating all of the assets they currently have… to build parts of your team that you know will absolutely not make it through the acquisition or the merger.

    @32.45
    The beauty of an exit road map is that it makes you think long and hard whether you are building strategic value in the minds of the bidders. So it’s a resource allocation discipline. The goal is not to build shareholders’ value. That’s a mere accounting contrivance. The goal is to build buyers’ value. And if you look at it from that perspective then how you spend your money, or how you should spend your money, or more importantly what you should not be spending your money on because it has no value to the acquirers, that becomes much clearer in focus.

    @35.10
    I define a donor as any investor who hasn’t received and cash back yet. And until the exit, angels are always just donors… So I view myself as a donor until the exit. I only become an investor, maybe, hopefully, if I get some money back.

    @36.50
    It’s very comforting to me to look at [angel investing] as uncertainty, ambiguity, and randomness, coupled with luck, playing very very large parts and roles in our outcomes instead of trying to parse and analyze, quantify risk.

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