Selling Out

August 26, 2010

Ive been thinking lately about how founders should decide when it is time to sell their startups and how to put aside the different incentives that often drive these decisions.  Large VC funds have a strong appetite to fund entrepreneurs that want to swing for the fences.  This was evident in Sand Hill Road criticisms of Aaron Patzer for deciding to sell Mint for only $170MM and the coining of the term The Patzer Problem; describing entrepreneurs that are viewed as selling too early, where the return looks great for the Founders and perhaps smaller investors, but is disappointing for larger funds.

This post was also influenced by criticism I’ve heard of the East Coast, where entrepreneurs and investors are viewed as having less appetite for risk, selling startups early at the first good offer.  Bill Warner has shared some interesting thoughts on this topic and calls for Boston to strive toward more home runs in the interest of building a healthier entrepreneurial ecosystem. 

Contrasted to the Patzer Problem and the calls for East Coast entrepreneurs to aim for grand slams, is the story of Zappos, where Tony Hsieh ultimately conceded that he was pressured to sell the company to Amazon due to his investors desire for liquidity.  Finally my thoughts were advanced by the much covered decision of FourSquare to take capital rather than sell to Facebook or Yahoo.  The debate was fraught with value judgments of whether they would be selling it too early on the one hand or irrational not to sell on the other.

Understandably, investor and management self interest and incentives are very much at play in the discussion of when to sell. All of this talk of differing incentives has caused me to revisit our sale of Brontes to 3M in 2006.  We did sell early, but Im convinced that we did not only act on our own incentives.  I genuinely think that as a board we considered an objective view of when was the right time to sell the company.  That is the duty of loyalty which board members have to the companys shareholders.  A board member should be explicit about his own incentives, but put them aside to attempt to objectively measure whether accepting an offer to sell the company is the right outcome for all shareholders.  But how does a board member figure out whether it is in the interests of the shareholders to sell?  Ambitious startups have so much potential, yet are typically backed with expectation of eventual liquidity.

We did this by thinking hard about the risk that we had in front of us versus the amount we were being offered for the company.  Personally, I also considered the offer in the context of the dilution we would face as we attempted to build revenue and move to cash flow breakeven.  We had lots of clarity on that dilution, as we had a $25MM Series B financing in escrow when we sold.  With a refresh of the option pool that amounted to 40% dilution, which meant that to our existing shareholders the $95MM offer was the dilution adjusted equivalent to $160MM offer after our next round.  In other words, existing shareholders would have the same return after the financing only if we could clear that hurdle. 

Now measure the progress of the company.  We felt we had game changing technology, which was deep and defendable.  We had the potential to completely shift the way a market functioned.  We had evidence the technology worked and the system was in full beta in a form that was pretty much finalized for go to market.  Clinical results might take a while and have some rough patches, but experts would agree from in-vitro quantitative measures that the system would work clinically.  In other words, we were at a peak of hope.  We were not going to be paid anything extra for early revenues.  Such a revenue ramp was already assumed into the price.  The question was how long it would take the economic reality to catch up with hope and help us surpass the dilution adjusted offer of $160MM? 

Our best guess was three years.  Our first year plan was $3MM in revenue and our second was roughly $8MM.  It would only be in our third year of sales that wed cross the $15MM in revenue we expected was necessary for reality to fully catch up with hope to believe someone would possibly pay more than $160MM for the company.  In other words, if we hit our plan for the next three years, our company would be worth roughly what we were being paid per share today.  With all the inherent risk in our plan for the next three years, I still think thats a no brainer scenario for selling.

Value creation at a startup is non-linear.  Startups have inflection points where value increases significantly and meaningful future progress is assumed into the price of the company.  These are peaks of hope.  Startups don’t typically appreciate in value against these peaks simply by meeting a plan.  Reality needs time to catch up to the hope.  Another major inflection point needs to take place to surpass that peak in order to get a meaningfully higher price. The right question is how far away is that next peak and how much dilution will be endured in that time.

Based on this thought process, I think a rough and somewhat objective rubric can be established for when to sell: based on your plan, how long will reality take to catch up with the hope? Time is an important measure of risk in that startup visibility rarely stretches beyond 12 months. When an offer, based on reasonable multiples, is compensating a company for the past year’s performance, selling is about liquidating the asset.  When a company is being paid a standard multiple against a high confidence next year plan, selling is still largely about liquidity but does offset a year of risk in the plan.  When that multiple is applied to the next two years of risk, the board should be giving very strong consideration to selling.  At three years, I think it really is a no brainer. 

Hard to know, but I’d guess that the Patzer Problem was more about VC interests than whether it was a no brainer for shareholders, on a dilution adjusted basis, to sell Mint for $170 million.  I wonder how many years of Mint’s plan they were being compensated ahead of.  Probably they were at a peak of hope.  If so, it was a good time to sell.

Note: Obviously, this is a rough rubric and it is difficult to determine fair multiples for any early stage company.  Also, it can be argued that most of the shareholders are usually represented at the board level and therefore board members are justified in largely acting in their own best interests.  Im not as big a fan of that argument, because most companies are started with some friends and family capital, which is not represented on the board.  Also, employees must be considered.  Of course, price is only one consideration when it comes to selling a company, particularly for the employees.  These issues are highly complex and the post is a simplification, but I belive the key point is to get beyond the discussion of individual interests and get an objective view of the offer measured against the risk.