Lesson 12
Exit Strategies for Angel Investors
In this chapter, we delve into the world of angel investing, focusing on the crucial aspect of exit strategies for angel investors. Whether you’re new to angel investing or a seasoned investor looking to refine your approach, understanding how and when investors exit their investments is essential for making informed decisions in the dynamic startup landscape. Join us as we explore the intricacies of planning for successful exits and navigating the challenging terrain of failed investments.
Key Takeaways:
- Planning for Investor Exits: It’s crucial for startups to consider the timing and method of investor exits from the beginning. Investors often expect to see an exit strategy to ensure their interests are a priority.
- Ways Investors Exit: Investors can exit through trade sales, share sales, management buy-outs, or Initial Public Offerings (IPOs), depending on their goals and circumstances.
- When and Why Investors Exit: The timing and reasons for investor exits vary based on factors like investor type and investment nature. Understanding these factors is essential for planning.
In a research project conducted in the Fall of 2012, the focus was on understanding the various types of exits within an angel investment portfolio. At that time, there were 17 exits in the angel group’s portfolio (now approximately 24 exits). Roughly half of these exits were positive, while the other half returned less than the original investment. The research examined key data points for each company, including:
- Time from initial investment to exit
- Total number of rounds of investment
- Types of investors (e.g., Angels, VCs, Corporate Investors, Friends & Family)
- Amount of capital returned to investors
The research aimed to provide valuable insights into what angel investors could expect within their portfolios regarding exits. In this chapter we explore how and when investors exit their investments in startups. We will speak about both the good and the bad.
Planning for Investor Exits
Investment from external sources can open doors to new opportunities for businesses. However, it also brings higher expectations, as investors typically seek returns, and this is most likely to occur when they exit their investments. The timing and method of an investor exit can vary based on the business, industry, and the investor’s goals. Therefore, considering the exit strategy right from the start is a prudent approach for you and your business.
The Importance of Planning for an Exit
Most business plans incorporate an exit strategy for investors. Over time, you may need to expand or adjust this strategy due to unforeseen circumstances or market changes. Investors usually expect to see your exit plans, if only to ensure that their interests and financial well-being are a priority for you.
While you don’t need to provide an excessively detailed exit strategy, it’s beneficial to communicate your intentions clearly to investors. However, it’s crucial to maintain realistic expectations. While investors appreciate ambition, they are unlikely to support plans that appear unattainable. Investors want to see that you understand the journey you’re embarking on together.
Ways Investors Exit
Investors can exit their investments through various methods, depending on the circumstances:
- Trade Sale or Buy-Out
Some businesses start with the intention of a trade sale or buy-out. Investors may have been brought on board precisely for this reason – to build the company into an attractive proposition for larger investors or organisations.
- Share Sale
Investors, such as Angel Investors, may exit by selling their shares to a third party, which could include Venture Capital firms, Private Equity firms, or Corporate Venture Capital investors. This exit method may involve more complex negotiations but can help earlier investors secure their exit.
- Management Buy-Out
Investors can sell their shares back to the business itself, known as a management buy-out. This exit strategy is more common among larger or more mature businesses and often involves significant sums of money. Timing can be crucial, especially if both the owner and investors want to sell.
- Initial Public Offering (IPO)
Another option is taking the business public through an Initial Public Offering (IPO). This provides an opportunity to raise additional capital from new investors, and early investors may also have the chance to sell a portion of their investment. An IPO can result in either a full or partial exit for investors.
When and Why Investors Exit
Investor exits and the timing of those exits can vary widely based on factors such as the type of investor and the nature of the investment:
– Angel Investors: Angel investors typically expect to be involved with a business for 3–8 years, making something to work towards. The exit timeline can be flexible, allowing for a longer-term approach.
– Equity Crowdfunding: Equity crowdfunding investors may have different motives, influencing their exit strategies. Some may exit after product development, while others might wait for specific milestones. However, some crowdfunding investments have seen exits in less than a year.
– Private Equity: Private equity investors typically seek an exit within five years. They may invest in established companies with the aim of selling for profit or in distressed businesses with a turnaround strategy.
– Venture Capital and Corporate Venture Capital: Venture capitalists (VCs) expect exits but take a longer-term approach. They invest in early-stage businesses and anticipate a timeframe of 5–10 years for the business to grow and become sellable. Corporate Venture Capital exit timescales can be more complex and depend on various factors, such as business growth and innovation.
Planning for investor exits is a critical aspect of your business strategy. The method and timing of exits depend on the growth trajectory you envision for your business. Therefore, selecting the right type of finance and understanding investor expectations from the outset are essential steps in the process.
Existing a Failed Business
We have spoken about the good ‘exit’ scenarios, about the bad side of exits, what happens when the business fails, how does an investor exit then? It’s essential for angel investors to be aware of the different ways in which investments can falter to make informed decisions and learn from these experiences. Here are some common scenarios of angel investing failures:
- Fail Fast on Seed Only
– Characteristics: This scenario often occurs with early seed-stage investments.
– Description: In these cases, the invested company raises a small amount of capital based on an innovative idea. However, shortly after the investment, it becomes apparent that the technology doesn’t work as expected, or there’s little interest from customers.
– Outcome: Angel investors decide to stop funding the company as it struggles to secure additional investment from other sources. While losing all invested capital in a seed deal is disappointing, the relatively small initial investment minimises the overall loss in time and money.
– Typical Scenario: Less than £1 million is invested in the company, and it takes less than 18 months for the investment to fail.
- Fail After Multiple Angel Rounds
– Characteristics: This is one of the most common scenarios for failed angel investments.
– Description: In this situation, angel investors identify a promising team with an excellent product. The company makes some initial progress but falls short of raising a large follow-on financing round. Angel investors, including the original ones, contribute to multiple bridge rounds to help the company reach key milestones.
– Outcome: Over time, these bridge rounds add up, and investors find themselves investing two to three times the initial amount. Often, this cycle continues for four years or more as the company underperforms. At this point, old investors are eager to exit, and new investors are reluctant to join. If fortunate, investors may sell the company at a discounted price to another firm, but this usually results in significant losses.
– Typical Scenario: £1 million to £3 million is invested in the company over a 3 to 5 year timeframe.
- Fail After Angel and VC Rounds
– Characteristics: This scenario involves promising startups that experience growth challenges.
– Description: Angel investors participate in the seed round, and the company initially shows promising signs of product/market fit. The company attracts venture capital (VC) interest and closes a Series A financing round with a significant valuation increase.
– Outcome: Unfortunately, the initial success doesn’t translate into sustainable growth, leading to stagnation. Despite the company’s struggles, VCs often force a pivot or management change, followed by additional financing rounds. Angel investors’ initial stakes get diluted unless they invest more funds at increasing valuations. Ultimately, the company is either sold or shut down, resulting in zero returns for the angel investors.
– Typical Scenario: £10 million to £20 million is invested in the company over a 7 to 10 year timeframe.
- Zombie – Cash Flow Positive, but Slow Growth – No Liquidity
– Characteristics: This scenario involves companies with slow but steady growth, remaining cash flow positive but lacking liquidity.
– Description: These companies experience gradual revenue growth, reaching millions, while staying cash flow positive. However, their growth rates remain in the low single digits, and they struggle to attract significant capital for growth. Additionally, these companies often go unnoticed by potential buyers.
– Outcome: Angel investors in such companies end up holding their investments much longer than expected. These “zombie” companies might be disguising themselves as lifestyle businesses, with founders content with their salaries and not motivated to sell. In such cases, angel investors are advised to collaborate with other stakeholders to create an exit plan.
– Main Reason for Difference with VC-backed Companies: Venture capitalists (VCs) have a fixed timeline to distribute fund assets to their investors, typically within 10 to 13 years, which incentivizes them to force the sale of underperforming companies. Angel investors may lack this external pressure, resulting in longer holding periods.
– Recommendation: If you’re an investor in such a company, working with other investors and the CEO to devise an exit plan is crucial.
These scenarios highlight the complexities and uncertainties associated with angel investing. While failures can be disheartening, they offer valuable lessons and insights for future investments. Successful angel investors understand that the journey includes both successes and setbacks, and each experience contributes to their growth and knowledge in this dynamic field.
Test Yourself :
- What is the significance of planning for investor exits?
- a) It is not necessary to plan for investor exits.
- b) It ensures investors have no involvement in the business.
- c) It helps prioritise investors’ interests and financial well-being.
- d) It guarantees immediate returns for investors.
Answer: c) It helps prioritise investors’ interests and financial well-being.
Explanation: Planning for exits ensures that investors’ interests and financial well-being are considered, making it a priority for the business.
- What is one way investors can exit their investments?
- a) Share buy-back
- b) Hiring new management
- c) Increasing funding rounds
- d) Product development
Answer: a) Share buy-back
Explanation: Investors can exit by selling their shares back to the business itself, known as a share buy-back.
- Why is it important for angel investors to be aware of different investment failure scenarios?
- a) To avoid investing in startups altogether
- b) To justify their investment decisions to others
- c) To make informed decisions and learn from experiences
- d) To increase their investment portfolio quickly
Answer: c) To make informed decisions and learn from experiences
Explanation: Understanding different failure scenarios allows angel investors to make informed decisions and gain valuable insights from their experiences.