There has been much discussion these days about the changing landscape of early stage investing and how it impacts valuations and exits, so I wanted to share a brief story I heard yesterday from an investment banker.
As a pre-cursor to the story, I want to re-iterate my own thoughts on generating returns for LPs. As we all know, the early stage asset class is defined by making a series of investments, seeing most of those investments fail, and then having one or two exceptional companies generate most, if not all of the returns.
At Scout, we’ve realized a few things that help us outperform the industry:
(1) The fewer complete failures we have, the better the overall performance of our fund. This means that when our companies experience challenges or fail to deliver the product or revenue to become a great company, we try to figure out how to find a soft landing and recoup some percentage of our investment. In fact, out of our failures, we have only had 1 company where we received no cash returned. In all other cases, we received $0.15 on the dollar, $0.35 on the dollar, and so on. While this might not seem meaningful, this cash is very valuable to pay legal expenses, audit fees, and, in general, allow us some recycling of capital.
(2) The higher the valuation of the company and the more capital they raise, the fewer the exit options that exist. While this seems intuitive, many entrepreneurs are so valuation focused, that they are willing to take piles of cash at a high valuation, without regard to how this might alter their liquidity event. Quite simply, as the valuation increases, the pool of potential acquirers in the respective portfolio company’s industry decrease. It might look something like this:
Acquistion Price Number of Acquirers
$25MM to $100MM 500
$100MM to $500MM 100
$500MM to $1B 25
$1B and up 5
So, now the story from yesterday:
A very well known venture backed company with over $1B in revenue decided it was time to sell their business. They retained a top tier investment bank to initiate the M&A process. As they received acquisition offers, presumably over 10x revenue, the management team and Board rejected the offers as not high enough and continued to looked at other potential acquirers offers. Two of the potential acquirers said they were not interested, the next acquirer offered 70% of the original offer, and the last acquirer offered even less. In an industry with only a few mammoths with the cash flow and infrastructure to acquire companies of that size, the company left billions on the table and will continue to run a company in an industry that is well versed in “fads.” Meanwhile, the first potential acquirer went on to acquire another related businesses at a fraction of the cost with the idea to inject the resources it has to build it bigger and better than the aforementioned company.
So what is the lesson here?
Don’t get greedy – 10x revenue and a $10B+ acquisition price is a great return for entrepreneurs and investors alike.