By Charlie Kroll
So you’re considering whether to sell your company — either soonish, or someday. Congrats: Founding a company is no small feat, and building enough value to exit is something to be proud of.
I’ve been through it myself, and I learned a few things along the way. If you’re thinking about an exit now or in the future, here are some ideas and suggestions to keep in mind.
You’ve probably been told (by investors, peers, your legal team, and countless “how to be an entrepreneur” books) that you need an exit strategy. I’m not a believer. Instead of building something to sell, focus on building something great. If your company’s valuable, differentiated, and sustainable, the exit options will usually take care of themselves.
To state the obvious, you cannot fire an investor. So it’s important to think carefully about what you’re looking for in an investor, and to do your due diligence.
Some venture capitalists like to swing for the fences. They’ll be OK with a small probability of a huge outcome. Others specialize in doubles and triples: decent, but not spectacular, returns from more of their portfolio.
There’s no best approach, but you want to make sure your risk appetite matches your VC’s, so you’re not at odds about whether to take an offer someday. Besides asking them outright, you can typically look at their exit history on Crunchbase and assume they will look to stick with their pattern.
Another consideration is where they are in their fund life cycle — all things being equal (and they never really are), you want to go with a fund earlier in its life cycle, rather than being the last investment in an aging fund. This will give you more runway to build the business without the limited partners clamoring for a return.
Then you have other considerations: How founder-friendly is the investor known to be? Do they have a history of replacing founders at the first sign of trouble? Do they insist on founder-unfriendly terms (see “mind your cap table” below)? If they’re getting a board seat, will they put a junior person on your board who has no power to make decisions?
“The details may seem small, but they can have big consequences — for your shareholders, and for you.”
Be careful with preferred stock negotiations when you’re raising money for your business. Some investors will ask for complex structures or steep liquidation preferences, which can let preferred stockholders get paid a disproportionate amount before others in a liquidation. Too many investors with those kinds of rights, and it can seriously devalue your own stake in the company if/when you exit.
Avoid terms that issue additional shares or value to investors below a certain exit or IPO price — or the dreaded “participating” liquidation preference, in which the investors get their money back (or, in some cases, a multiple of their money) plus a dividend, and then share proportionately in what’s left. That’s basically like being double (or triple, or quadruple) paid.
I have friends who ran well-known companies who had to negotiate carve-outs with their boards, since investors’ liquidation preferences made their personal stakes worthless at then-current valuations. Look at what happened to FanDuel, for example: $465 million sale, nada to the founders or common shareholders.
Fortunately, these have become less common now that founder-friendly “West Coast terms” have become more popular and the late-stage VCs have more competition from family offices, public market investors, and strategic investors.
Most good venture deals today are done with clean terms, like a simple 1x non-participating preference. That’s when all shareholders get paid proportionately to ownership, assuming the purchase price at least exceeds the money raised. (I’m oversimplifying here, but this is the general idea.)
Of course, sometimes you have to sacrifice in order to get the financing you need, but it’s usually a good idea to avoid these kinds of terms (and the investors who insist upon them) when possible, even if it means compromising on valuation in order to keep things simple.
Make sure you have no verbal agreements for compensation with employees or vendors inside or outside the company. Any undisclosed bonuses, option grants, or vendor payments will probably end up coming out of your (and other selling shareholders’) consideration if you exit
As you’re getting ready for an exit, make an inventory of any stakeholders (employees, vendors, investors) who might have expectations that are different from what’s reflected in your written documents. It’s best to clean those up before starting acquisition discussions.
If you receive restricted stock (rather than options) as part of your compensation, look into taking advantage of the 83(b) tax code election. It lets you pay income tax on the fair market value of the stock when it’s granted, instead of on its (ideally higher) value on the day it vests. That can be a good thing or a bad thing. If your company has sufficient traction and you think that the value of the company is going to go up, the 83(b) election can save you a lot of money in taxes down the line.
In 2017, Bumble founder Whitney Wolfe Herd turned down a $450M offer from Match. That turned out to be a smart move — Forbes now values the company at $1B. One wonders whether the Instagram founders regret selling for $1B, when the company is now estimated to be worth 100 times that under Facebook. And then countless others tell stories of what they used to be worth on paper, and now they regret not taking the offers they got.
It’s not a science. I know founders who have really struggled with whether to sell their companies for tens of millions of dollars, because it feels like a failure compared to what they read on TechCrunch, even if it might be a life-changing amount of money for them at an important time. Bottom line is there’s no amount of money that’s “too low” to sell for — or “too high” to hold out for.
There are plenty of cases where a founder wants to sell, and the investors don’t. One solution is the secondary sale, in which the founder takes some money off the table by selling some of her shares to an outside investor. This can give you the liquidity you need, while letting the company stay independent to continue growing.
Secondary sales have become more common lately, especially as companies wait longer to go public. Sometimes, they’re part of a fundraising transaction. Other times, they’ll be done off-cycle as a one-off. Typical parameters I’ve seen include capping the amount a founder can sell at no more than 10-15% of their shares, and not usually exceeding $5 million regardless of percentage. This cap works to make sure the founder continues to have a strong vested interest in the success of the business.
Secondary sales of common stock are usually done at a discount between 0-30% of the last preferred price — on the lower end, if there’s lots of demand for the shares, or if the company has made a lot of progress since the last funding round.
But be careful, since secondary sales can lead to 409A implications — which could mean the fair market value of the company’s common stock can be reset upward because of your secondary sale. That can be bad for the rest of the common stockholders and option holders because a higher fair market value means a higher strike price on future option grants.
When a secondary sale is done part of a larger funding round, you might be able to argue that it was part of the negotiation, not tied to the underlying value of the common shares. (Of course, that’s situation-specific, and you’ll need an attorney with real expertise to help navigate these issues). But at a high level, secondary sales can be a good alternative to exit, and investors are becoming increasingly amenable to them.
Building a team of top-notch professionals to help you navigate your personal situation is critical. Your personal lawyer and accountant will be advocates for you, separate from those representing the company. And professionals in those lines of business have seen hundreds of startups and can advise you on what’s “market” for employment terms for exiting founders.
Deciding you want to exit isn’t a choice made lightly. Even though everyone’s experience is different, I found it helpful to get perspective from people who have been through it. Talk to other founders who’ve exited, listen to their stories, and use them to help you figure out what’s important to you. It can be really validating to hear firsthand that other people were uncertain, too.
And if you’re nervous about telling your investors that you want to exit, you might call other founders they’ve invested in who have been through it. Hopefully, their firsthand experiences will give you a better idea of what to expect. This could help you frame the conversation in a way that causes less friction.
If you aren’t careful, some well-intentioned decisions meant to seal the deal could come back to bite you. The details may seem small, but they can have big consequences — not just for your shareholders, but for you, too. Don’t rush through them, and get expert advice along the way.
You might be pressured, for example, to put some of the money you’d made from the acquisition on a vesting schedule that’s dependent on your continued employment. This can be a very normal, but very expensive proposition — because it could turn what would have been long-term capital gains into ordinary income (with significantly higher taxes).
For another example, many founders don’t know about a provision in the tax code that exempts some or all capital gains tax on stock in certain private companies held for more than five years. (You can do a Google search for “Qualified Small Business Stock”). If you’re coming up on year five of your startup, you may want to consider the timing of a potential acquisition, and the impact it could have on taxes for you and other early shareholders. Taxes don’t typically drive these exit decisions, but it’s one of the considerations, and all else equal, there are some scenarios where it could pay to wait.
A good accountant and attorney can help you navigate tricky issues like these.
Many entrepreneurs find that their whole identities are associated with their companies. After so many years of building and leading, it can be hard to imagine not introducing yourself that way anymore.
It’s OK to be vulnerable with your network — let them know you’re considering your next steps, and ask for advice and introductions. (If you’re like most entrepreneurs, you’ve made many introductions for them in the past, and were happy to do it.)
And then there are the quality-of-life decisions. Most important: What do you want to do next? Do you want to start on the next thing right away? Do you want to take time off? Most acquirers will ask you to stay on for at least a year or two, which some founders struggle with. I have friends who’ve brainstormed are already onto the next thing before the ink is dry on the merger agreement, while others are burned out and go into hiding for a while.
For me, taking time off was an important way to decompress and get some perspective. I’d meant to take up to a year off, but I started feeling antsy after a couple of months. Knowing I didn’t want to rush back in and make a hasty decision, I opted to take a long trip in Indonesia, which forced me to unplug before co-founding a new company.
That company turned out to be Ellevest.
Charlie Kroll is the co-founder and president of Ellevest. He’s spent his career around startups, going back to a dorm room idea that grew into financial tech leader Andera, and board roles at Venture for America and Brown’s Entrepreneurship Program.
Originally published at www.ellevest.com