Do VC’s Guess The Exit At The Beginning?

Question: You often hear to leave out the possible exit scenario when you pitch. Brad states that its because its usually wrong. I suspect most VC’s discuss likely exits with their partners before making an investment, what percent of the time do you guys generally "guess" the exit on the front side of the investment?

A: (Brad): I’m going to answer this from an early stage VC perspective.  I’ve never been a later stage VC nor have I been a buyout guy, so I won’t try to answer for people doing those types of investments. 

Back in prehistoric times when there was a tech IPO market, early stage VC’s used to want entrepreneurs to answer the question "Is your companies destined to exit via M&A or an IPO."  I’ve always thought this was a stupid question, as the answer is "I’ll take either one!"  As homo sapiens evolved, the argument about M&A or IPO raged on fiercely.  Pre-Internet bubble, many VC firms (including mine) would often do extensive exit analyses upon each investment round, building complex models stacked on top of detailed assumptions about the future performance of the company, the future multiples in the market, and a range of execution of the company from "flawless" to "pretty good."  These analyses usually had an IRR result and a cash on cash return result for each potential outcome.

Almost all of these analyses are total baloney.  I suppose they give some people comfort that they basing their investment decision on sound economic analysis, but since there are so many variables that are outside anyone’s control, they tend to be meaningless.  In addition, almost all of these analyses (at least the ones I’ve been exposed to, including many from other VC firms), have incredible bias in their assumptions which help support either (a) an affirmative decision to make the investment or (b) a justification for a particular valuation range.

In 2001, the IPO vs. M&A debate cooled for a while when the IPO market vaporized.  It emerged again briefly in 2004 and 2005 with a new wave of IPOs, but almost anyone that had an exit in the 2004 – 2007 time frame preferred cash from an M&A transaction to IPO stock (with a few notable exceptions, such as Google.) 

VCs fantasize about the day a vibrant small and mid-cap tech IPO market will once again exist.  Let’s hope this fantasy becomes a reality.  In the mean time, I expect more and more people – especially if they’ve read Nicholas Taleb’s Fooled By Randomness and The Black Swan – will realize that making early stage VC investment decisions based on complex forecasting exercises is – well – foolish.

  • This is interesting. Let's just say that I am involved in another market that is similar to tech VC, but different. This market also involves speculative, value add investments, and investors would be right to require +/-25% IRR returns.

    My thought is that you do the models not because they are going to be right with any regularity. Think about it. If you are truly operating in a market that requires returns in the 25% range, then you are involved in such a high level of risk that it would be idiotic to assume that you are going to get it right very often. It wouldn't be any different than trying to forecast exactly what days of the year it is going to rain and try to do it on January 1.

    But just because a model is wrong, doesn't mean you throw the baby out with the bathwater. Models are helpful because the process of putting it together makes you ask important questions about the investment. In creating assumptions for the model, you have to de-construct the investment.

    Could you do this without the model? Sure, and I'm sure a lot of successful investors do. But throwing out models simply because they are often wrong misses the point I think.

  • You said that even your firm used to do these models. John had a good point about how it helps to break down the investment to ask important questions that may come up. So even though you're dealing with seed-stage, pre-profit companies, have you (specifically) done away with these exit forecasting models? Or is there something else that replaces them now?

    • My previous firm (Mobius Venture Capital) used to do these types of models.

  • Exit modeling helps guide the early stage investor to the next milestone – an exit or the next level of financing. It is more or less similarly indicative like the Vegas line on a basketball game. As an investor you still need to refine the line based on your own specific skills, or knowledge.

    That said, the people, their ideas and our confidence in their ability to execute trumps any type of exit or even valuation modeling…

  • Interesting comments. I was talking with an investor, I was not pitching or giving a presentation (after all he was an investor in health care primarily). He was asking me about my business, plans, goals, etc and asked what my exit strategy was. I have thought about it and it has changed over a certain time period. I do have a couple scenarios in my business plan although I truly believe that the right investor for my company will be one where we work together and when it's closer to the exit everything will be more clear or work out.

  • Adam Laufer

    Do you think the reverse merger will emerge as a preferred exit strategy moving forward?