When should you sell your business?

Last week’s news that CA purchased Wily Technologies for $375m reminded me of a working theory that I’ve had for a while (which generally seems to be supported by market experience over time), which is that there are generally two time frames in a company’s life where it can extract the most value from being acquired. Below is my version of the ‘exit value curve’ for a software/technology business where the x-axis is time and the y-axis is value:

The drop in value should probably be a lot sharper after the initial euphoria phase (but this image took me long enough to produce and I didn't want to redraw it), but the basic idea is that companies are generally most valuable to a potential acquirer right as the technology is proven and then again as the company reaches scale (certainly most valuable releative to the money and time invested).

The 'technology proof' phase is the time after a company has built an inital product and installed it in a handful of key accounts but before the company has started dreaming of its billion dollar IPO; realized how difficult it is to sell to non-early adopters; taken more venture money and therefore raised the bar on their exit; hit a zero bookings quarter; shut their doors; etc. There’s a range here that depends on the company, the time its taken to get to this stage and the money that’s gone into the business but generally I’m describing businesses that have real bookings, but less than around $5m in revenue. The poster child in the last few years for a company being purchased in this stage was Appilog who was bought by Mercury for $49m, but more recent deals that fall into this category include a bunch of Web 2.0 companies bought by GYMAAAE (link from Brad) such as Truveo (by AOL) and del.icio.us (by Yahoo!).

Then comes what Gartner would call the trough of disillusionment but what entrepreneurs would more likely call the long hard slog (this is the part of the graph that is circled). Plenty of businesses don’t even get to this phase and a lot who do find it an extremely hard place to be. This is the ‘prove it’ stage of the business - where you need to figure out how to scale every aspect of your company – starting with sales but including product delivery and development as well as support, marketing, etc. You’ve also probably taken a bunch more money (possibly an 'expansion round' but just as likely through an 'inside financing').  Your value in this stage probably goes down – certainly on a relative metric basis, but probably on an absolute basis as well. You’re trying to build a real business now and you’ve moved past the technology experiment stage and the euphoria of your initial PO’s and handful of first customers. You work hard to grow your business and have success at it, but scaling sales is harder than you thought and that great channel partner that really had promise didn’t pay off exactly as you’d hoped. If you’ve taken more money (say your Series C) you’ll find it harder to exit in this stage at a valuation that is attractive to both your investors and your team and instead may have to opt for seeing the business through to the next phase (or if you are forced to sell you will do so for a modest multiple of invested capital).

If you execute well and stick with it, however, you may just emerge – as Wily did – on the other side of this slog. While running your business doesn’t exactly get easy, you now have real critical mass and market validation/adoption. Your revenues are well into the double digits and you’re probably cash flow positive even as you re-invest in your business to keep your growth up. The Wily deal is a good example of the kind of value that can be created for a business that reaches this stage of its growth. Teams and investors that stick with it are generally rewarded in this phase of their development with solid investment returns.

Obviously there are plenty of variations to the story this graph shows, and different markets reward technological promise vs. customers in different ways. Along the same lines, different individuals, investors and management teams have varying views on what constitutes a good early exit or even a good later-stage exit and success will depend on a number of factors including a team’s ability to execute and the financing strategy employed to fund that execution.

I'll write more on how this dynamic affects financing strategy in general and VC investing specifically in the next few days.

As always, your feedback is encouraged.

(thanks to Ross for the assist with Illustrator on the graph)

Comments

[Dave Jilk]

You realize that you've just described "Crossing the Chasm" but from the finance/investment point of view?

[John Ives]

I have a similar, but different dialog with individual investors, management teams and founders. I couch the subject in terms of returns to whatever class of shares is appropriate (Y-axis) depending on the audience. If I believe the listener recalls their high school calculus, I speak in terms of local and global minimum and maximum.

[alan shimel]

Seth - while overall I agree with what you have said here, I think some companies are like those lucky girls you went to school with who were always pretty and never went through that awkward, ugly stage. So much regarding valuations are timing and market driven. Another factor is geographic location. I think companies based in the valley or even NY have inherently better chances of MA activity early and even at that ugly stage then companies based in other areas.

[Chris Yeh]

Whether to sell earlier or later also depends on one's perspective and goals.

I think that while selling out for $500 million is more attractive than selling out for $50 million, as a non-rich guy, I would take the bird in the hand, figuring that once I'm a millionaire, I'll have an easier time starting the next venture.

Whether one gets $5 million or $50 million out of a deal makes a difference, but not like the difference between having $5 million and nothing.

[larry]

Excellent post. This was (unfortunately) my experience EXACTLY. Lofty early offers, then tough stagnant times after a few years (when we sold at the bottom), followed by a massive run-up afterwards, as evidenced by lower quality competitors fetching massive valuations. At least I have this education now...though I'd much rather have the cash!

[James]

Great post Seth. This is a topic that definitely warrants more discussion. I have posted some thoughts on my blog:

http://purevc.typepad.com/pure_vc/2006/01/the_best_time_t.html