Selling Your Tech Startup: A Guide for Founders (Part 2 of 2)
In the venture capital (VC) ecosystem, I've gained a multi-level perspective on VC exits through my roles as a founder in VC-backed companies, an independent board member, investor, and committee member. My experience in financing rounds and acquisitions has given me a deep understanding of how VCs evaluate startups, facilitate mergers and acquisitions (M&A), and navigate the challenges founders face when letting go of their companies (see prior blog post for the founder's perspective).
An M&A exit allows VCs to cash out, serving as the ultimate validation from their partners, limited partners (LPs), and the startup community. VCs reap financial rewards as a company matures into a desirable asset for a larger entity, marking the end of a rewarding journey.
While many entrepreneurs know VCs benefit from successful exits, they may not realize VCs earn income through management fees—a yearly percentage (typically 2%) of the total fund for managing the firm's capital—and carried interest, also known as "carry," which is a share of the fund's return on investment (typically 20% of the profits). This system incentivizes VCs to find promising startups, support them actively, and generate strong returns for the VC firm, LPs, and themselves.
However, M&A can be emotionally taxing for founders, who must relinquish control of their creations, a burden VCs typically do not share as they move on to their next investments. Good VCs often back capable founders who have a track record of successful exits, while others may pursue new deals for further fame and fortune after benefiting from successful founders.
VCs construct their portfolios based on the Power Law principle, where a few outlier successes drive most returns. While founders focus on a single startup's success, VCs manage dozens of investments, knowing most will not yield a significant return. They must be intellectually honest about returning capital to LPs, requiring disciplined risk management.
The decision to sell an investment involves several factors, aiming for significant ROI. VCs consider the company’s performance, market conditions, future growth potential, fund lifecycle constraints, and the need to free up capital for new ventures. Investor expectations, regulatory and tax implications, and personal and professional factors also influence the timing and decision to sell, tailored to maximize returns while aligning with the venture capital firm's broader goals.
After years of moderate exits amid economic uncertainty, the tech industry may see a surge in M&A activity driven by improved market conditions, increased capital availability, and strategic consolidation. However, it's crucial to critically assess VCs' rationales for exiting or passing on M&A opportunities.
VCs might push for exits to capitalize on favorable market conditions and secure returns for their LPs, influenced by fund lifecycle constraints. Conversely, some VCs may advise holding off on selling, believing the company's value could grow further, aligning with long-term vision and growth potential.
Potential misalignment between VCs and founders can occur, especially when VCs prepare to raise new funds and seek to showcase realized returns. Founders may resist selling to retain control, even when it might be optimal. Ideally, lead investors and executives should cultivate a trust-based relationship for open dialogue and mutually beneficial decisions. However, this ideal scenario doesn't always materialize, and founders need to understand the underlying forces at play.
In today's market, founders, boards, ELT, and VCs must factor in secondary markets which are transforming startup landscape by providing interim liquidity through secondary transactions, allowing early investors and VCs to sell part of their holdings and capture returns before a full exit.
In conclusion, selling a tech startup involves complex financial and emotional factors. Founders must understand VCs' motivations, driven by market dynamics, company performance, and personal goals. As M&A activity potentially increases, being cautious and informed about VCs' motivations and recommendations is crucial. Balancing financial rewards with emotional investment ensures decisions align with both long-term vision and immediate goals, leading to a successful exit.