Make turn at next exit: a roadmap for startup investing

Angel investors as a whole have done exceptionally well lately.  A recent study by Prof. Robert Wiltbank that made noise in the angel scene claims that angel investors make 2.5x their investment in just 3.5 years when diversifying properly – which, if you think about it, is a ridiculous nearly 30% year over year return and more than double the returns of the S&P 500 over that same timeframe.

How do angels make money?

Angel investors make money when a startup they invested in exits, but what exactly qualifies as an exit?

From an investor’s perspective, an exit is an event where the investor realizes gains or losses from original investment through a liquidation event, public offering, or a merger.  Sometimes exits are highly profitable events where investors receive a 20 or 30 times return on investment– in the VC/investing world these are called home-runs.  However, more often than not, returns from individual startup exits are more modest, or negative, and as such don’t receive press attention.  Finally, there are also those exits that startups are notoriously famous for producing and every investor should try to avoid – the big old zeroes like pets.com.

Pareto’s famous 80/20 rule – or, in our case, 90/10 rule

With those three exit scenarios in mind, in theory, the bulk of a profitable startup portfolio’s returns come from a home-run or two that more than offset the total losses.  Italian economist Vilfredo Pareto is credited as the first to formally state this basic rule of thumb.  Pareto found that 80% of the land in Italy was owned by 20% of the population.   Many investors believe this 80-20 rule (as it has since been dubbed) applies to investing as well – 80% of the returns come from 20% of the investments.

In fact, a closer look at Prof. Wiltbank’s study mentioned above (the 2.5x to return to angels) shows that while large exits (>30x) only accounted for a very small percentage of the startups in the study, nearly 90% of the returns to investors came from only 10% of the Exits (5x return and up).

So when and how do investors get their money out?

Unlike in the public markets where you can cash out whenever you want, with a startup there isn’t necessarily another investor who is willing to buy your shares and cash you out.

So how do angel investors cash out? And how long a timeframe are we talking about?

Let’s first address the Timeframe for exits:

An exit might be years away, so generally speaking, angel investing is a bad idea for anyone looking to make a quick buck.  That being said, recently there have been a few exceptions to the rule, most notably Instagram which not even 1.5 years after the Series A funding round exited for around $1 billion.

On the other extreme, Mapquest took 33 years to exit. While a range of 30 years for exits is relatively large and might not be too helpful, according to an analysis of all the exits up to 2012 on startup database, peak exits occur for startups around 1.5 and 7.5 years.

The 3 types of profitable exits:  Mergers, acquisitions, and going public

I. Mergers

A merger is the combining of two or more companies, generally by offering the stockholders of one company securities in the acquiring company in exchange for the surrender of their stock. (source: Investopedia)

1. Mergers – Ken Smith, a startup consultant with 10 successful exits, explains that by joining forces two smaller struggling startups make for a far sexier takeover target for the following related reasons. First, for a startup, time often becomes its worst enemy, especially early on when a startup is fighting for its life to survive and competing for an insubstantial share of the market.  By combining resources and talent, Smith reasons that two smaller companies might complement each other and be able to compete for a more reasonable market share. While the idea of two little guys joining forces to become a corporate giant sounds nice, the number of successful mergers that lead to big paydays for investors is very small. Even assuming that two companies can put aside their corporate culture differences, there may still be a lack of cohesion amongst the founders/corporate leadership—as TECworks puts it, with stubborn founders sometimes “1+1=0”.  Founders have put their lives on hold for this dream of being the next big thing and convincing them to sacrifice their dreams is often too tall a task.
2. Successful merger but not an exit – A recent example of a successful merger is Grubhub and Seamless, two internet companies that facilitate orders for restaurants and collect a percentage.  These two competitors were both en route to separate IPOs and their recent merger makes them far more attractive – at least that’s what their shareholders believed as they maintained their ownership instead of letting one side buy out the shares from the other.  Because no cash was received by investors this is not considered an exit.   It is most certainly an important development and positive news for the new company and its shareholders but not technically an exit.

II. Acquisitions

An acquisition is a corporate action in which a company buys most, if not all, of the target company’s ownership stakes in order to assume control of the target firm (source: Investopedia). This is the road most taken to startup heaven.  Think Google acquiring Waze for just shy of $1 billion ($966 million cash) in June, Facebook acquiring Instagram for a similarly gigantic sum, or Yahoo’s recent acquisition of Tumblr for over $1 billion cash(!). While the vast majority of acquisitions are much smaller, hitting it big here is the most common way for investors to get huge paydays.

Big Companies do make acquisitions, but just how many do they make and how actively are they seeking acquisitions?

An article in Techcrunch back in May 2013 described the current state of the Tech giants struggle to either “Buy or Die.”  While respected VCs like Mark Suster argue that this attitude can be detrimental for corporate culture, make no mistake about it, corporate giants have been actively acquiring recently.  Google, the pack leader, has already made 16 acquisitions in the first half of 2013 for a total of just over $1.3 billion (Waze was about $1 billion of it).  Rather than fall behind, even Apple has made 9 acquisitions since October (mostly small non-disclosable), which CEO Tim Cook noted was an increase over the 5 or 6 a year they had been doing previously. Perhaps most notably, Yahoo has made a real push with 20 acquisitions in the past 13 months.  While everyone talks about Facebook’s acquisition of Instagram, in 2012 Facebook only made 4 acquisitions.  A few days ago, HP mentioned that they are looking for acquisition targets between $100 million and $1.5 billion. And lastly, IBM is in the process of acquiring Trusteer for close to $1 billion.

Okay, so big companies do make large acquisitions every year, but how does the 2012’s exit scene compare to 2011?

In Israel, 2012 had fewer exits (50) than 2011 (63), but the average exit size grew from $81 million in 2011 to $111 million in 2012, and the total $ from exits increased from $5 billion to $5.5 billion. (source)

America saw a similar trend in 2012.   While the number of disclosed M&A exits decreased from 2011 levels in 2012, the average M&A exit increased from $142.6 million to $178.9 million.

III. Going Public

Going public is the process of selling shares that were formerly privately held to new investors for the first time. Otherwise known as an IPO – Initial Public offering (source: Investopedia).  In fact, 2012 “represented the strongest annual period for IPOs, by dollar value, since 2000.”

1. IPO – Going public usually equates to investors getting a nice payday.  Early investors who gave tens or hundreds of thousands of dollars to companies like Facebook [see Reid Hoffman’s $40,000 investment into Facebook now worth $375 million or Ram Shriram whose $100,000 or $200,000 investment in Google led to over 5 million shares at IPO].  While IPO might mean that early investors are getting a sizeable payday, cashing out is difficult and an IPO is very costly.  Furthermore, the market for IPOs plays a role as well.
2. Reverse Merger/Takeover/IPO – In this scenario, a private company takes over a public company, using its public status to gain quick access to capital markets.  This is a much quicker EXIT than an IPO otherwise would be – see the Conduit/Perion reverse merger unfold over the coming months.  The advantages of a Reverse Merger over an IPO are that it’s a quicker, cheaper, simpler alternative to IPO which at the end of the day for investors means getting your money out quicker.

The Not-so-good Exits

Not all startups taste greatness, in fact the majority are destined for far less.  While the above sections have detailed a startup’s most favorable outcomes, this section details two far less glamorous fates: acquihires and soft-landings.

1. “Acquihires” – Acquisition Hires – These early exits occur when a startup is acquired strictly for its talent.  According to Mark Suster, a prominent VC, acquirers will pay around $1 million per engineer.  While both the angels and the team tend to do okay in these types of acquisitions, Suster contends that this trend may have adverse effects for the acquiring company as loyal employees are suddenly bypassed by 20 year-olds who become vital new members of the team.
2. “Soft Landings” – These are the dreaded total losses.  Investors likely won’t get their money back and the focus is to preserve both employees and the assets.  How a founder deals with these difficult situations impacts whether or not he can go back to the same investors for his next venture.  Unfortunately, many founders act selfishly putting themselves first and taking what little is left.  This is not generally considered a best practice and will impact those founders’ abilities to go out and raise money again in the future. (source)

Success, next exit

While all investors are hoping to have a portfolio full of “home runs”, it is a rare investor that truly has the “Midas touch.”  In fact, more often than not, the majority of your portfolio will consist of strikeouts and singles.  Nonetheless, data has shown that angel investors have still made impressive returns.  Successful angels don’t just blindly pull the trigger either, they perform deep due diligence on investment opportunities and have a unique set of criteria that any investment must meet before being selected (see OurCrowd’s criteria here).

At the end of the day, while it is certainly an exaggeration to claim that returns from startup investing are purely binary, it would seem that home-run portfolios tend to belong to those investors not afraid to swing for the fences.

 

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