In 2007, the ratio of exits to new investments was one out of 6.9. In 2010, it was one out of 7.7. The past couple of years, this ratio has hovered around one in 10. And so far in 2017, there have been 11.5 times as many investments as exits. As Pitchbook noted in the report that produced these numbers: “The investment-to-exit ratio has grown to the largest we've ever seen.”
Clearly, we in venture face an exit challenge.
Venture has never seen more money flowing in, more new funds, larger funds, more LPs. And yet, as a group we seem to be getting weaker, rather than stronger, at our most fundamental task: generating valuable exits from our investments.
Now, it’s easy to rationalize the weakness in exits (humans, as my mentor Bill Ziff used to say, are adept at rationalizing just about anything). Exits are down, this excusing argument goes, not because we are doing anything wrong, but because the investment market is so robust. So much private capital is available to startups that we investors are satisfying company needs deeper into their lifecycles than ever. The value that, in the past, might have gone to an acquirer or the public markets, now goes to the LPs in venture funds.
While, like all rationalizations, this argument has truth in it, I reject it and think other venture investors should as well. Holding more future value is NOT the same thing as actually turning companies into cash. As another of my mentors is fond of saying: “You can’t eat IRR.” Our focus as early stage investors should be on moving companies to liquidity as efficiently as possible.
So, what do we do about the exit crisis? Some thoughts:
Develop a genuine multi-stage ecosystem. Venture has always been a walled garden. Firms exist at every stage of new company development. But then, once companies mature, there is no real bridge toward appropriate forms of long-term financing. We are allowed only two routes over this chasm: big company acquisition and IPO. But aren’t there other options? P/E funds? Management buyouts? At Social Starts we’re considering bringing on an Exit Partner to focus on having relationships with non-venture investors every bit as strong as we have with our peers. Years ago Apax and Redleaf (where I was a partner) experimented with being firms that could handle every stage of a company’s lifecycle. I think we need to revisit their ideas, at least through a mesh of relationships, if not in a single integrated firm.
Consider new forms of initial investment. We should also be open to new forms of early stage investment. Since we only buy preferred shares, we can only monetize them in a sale or IPO. In truth, this has broken down some already among the most successful startups, with private market sales becoming more common, though often at daunting discounts. Still, is buying equity the only way we can imagine delivering investor value? We have had a couple of cases recently where founders of accelerating startups have sold an interest in their future lifetime income, in lieu of doing an interim raise on founder-unfriendly terms. This kind of arrangement produces, essentially, an annuity for a fund. Working for a percentage has worked in Hollywood for decades. Worth considering? Perhaps. In any case, this seems like a time to be open to radical new approaches.
Recognize the long-term potential of ICOs. I’ve written recently about my skepticism toward the anointment of Initial Coin Offerings as the panacea for startup fund raising. I think these instruments are going to require much development before they are really ready for prime time. Still, ICOs, given their essential open market structure, do represent a new kind of potential exitless exit. As long as there are buyers seeking ICO instruments, their holders can sell. This would allow funds to engineer their exits in an entirely new way. Funds could even, in theory, manage separate exits for different LPs based on that investor’s unique needs. While I urge short-term caution toward ICOs, I encourage long-term openness to their potential to engender core change in venture.
Why not open investment after the earliest stage? In the past couple years, there has been extreme focus on opening up the earliest stages of startup financing to new populations. Kickstarter campaigns and equity crowdfunding have brought new, small investors into the process of getting companies started. There seems to be something of a paradox here: the bare beginning is the riskiest, most information-parched point in a company’s lifespan. It’s where small, non-professional investors have the greatest chance to lose their money. Why isn’t equal attention being paid to bringing more investors in on the exit end of the scale? At the later stage, investors have plenty of information about a company, its management, its revenue sources and prospects. Wouldn’t it make sense to have crowdfunding instruments through which new investors can buy in to developed companies and early investors can exit? Seems like some fund manager should innovate in this gap.
Get over the myth that profit hamstrings ultimate value. I must preach to my peers the Social Starts gospel of profit. We believe in it. We think companies that make more than they spend are terrific. We don’t believe focusing on profitability always represents an entrepreneur taking his/her eye of the main prize of ultimate growth. Wild growth that doesn’t eventually produce profit is illusory in any case. We are seeing that today with the downward revaluations of so many over-pumped money-losing Unicorns. So, we venture investors should keep in mind that behind the IPOs and acquisitions our ultimate goal should be producing companies that make money. If we do that, all the other issues can settle out. Not that this is the traditional venture goal, but in the end, good old-fashioned dividends or company shares buybacks do represent forms.
We love early stage, we believe in the American treasure of our inventor’s infrastructure, but these companies have to turn into cash in order to be worth supporting.