Startup Mythology: The High Growth Exit - 1

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Startup Mythology: The High Growth Exit - 1
I'm getting out the software business to open a chain of barbershops. Here's my plan:

First, I'm going to need a seed round to open my first location. The business can't take off unless I build a user base, so I won't charge for haircuts.

The seed money will cover the salary for me and two barbers, but, once our free haircuts service starts getting popular, I'll have to go in for a series A. This will allow me to open a regional chain.

By the time we get to a series C or D and make the business national, our investors will start asking how we intend to make money. The plan will be to put up those TV screens that show local, targeted advertising. We could have done this from the beginning, but we don't want our user base to feel marketed to. We'll still be well into the red at this point, but at least it'll look like we're trying to do something about the deficit.

Eventually, we'll either have to take Totally Free Barbershops, LLC public or sell it to an established competitor like Fantastic Sams or Supercuts. I'll take my payout and someone else can figure out how to turn a barbershop into a profitable business.

I mean, there's got to be some way to do it.

-- And scene.

When Twitter closed its first day as a publicly traded company on November 7th, every stock tracking application and many financial news outlets reported that TWTR had seen a 73% growth from its initial public offering price.

This was loopholed financial math at its finest.

The stock closed that day at $44.90, 3.4% lower than the initial price that you and I could have bought it for when it opened for $46 that morning. The only people who almost doubled their investment that day were the firms that funded the IPO, mainly Goldman Sachs.

Of course, employees and founders holding stock options and equity in Twitter made out like bandits—except most of the $2.5 billion net worth of primary shareholder, Evan Williams, is the theoretical value of his stock. With only 16.9% control of the company before the IPO, he and his co-founder, Jack Dorsey, only had slightly above half of the sum equity owned by their top six financial backers.

Don't get me wrong, it's an amazing deal to turn a yet to be profitable company into millions of real dollars and billions worth of stock, but how reproducible is this model, both in method and payout amount?

Most startup exits happen by acquisition, and the price is rarely more than somewhere in the low eight figures. While it's a noble aim to bring a world changing service like Twitter to market, following their investment model would be foolish for many organizations. Rapid growth is only a requirement for a very select group of business models. Here's some examples:

1. A business is in a highly competitive industry, so they need to spend large amounts of money on marketing to stand out from the crowd. Web example: Facebook

2. A product is easily duplicated, so they need to quickly identify themselves as the industry standard. Web example: Twitter

3. Their revenue model won't be effective until their user base is massive, and they'll need a lot of time and resources to get there. Web example: Linkedin

With the fact that most people will never sell a business for billions of dollars, let's do some math on what would be considered a very successful, $30 million acquisition of a high growth startup.

The founder of a company that has taken a full set of investment rounds usually owns around 10% of his or her company. A full acquisition would leave this founder with $3 million.

Acquisitions of this size are often not paid for wholly in cash, so let's say the acquisition was 50% cash and 50% stock. The investment contracts would guarantee all available cash going to investors first, so the founder would be left with $3 million dollars of stock in the acquiring company.

He or she would more than likely be unable to sell the stock or leave the company for at least a year or two. If he or she felt this was not the best deal for the company, it wouldn't matter, as majority control would be in investor hands, and they would probably want their exit.

This isn't really a bad deal, and we'd probably all take it if we had the opportunity. But there's another, often better, model available to us: the bootstrapped startup.

Let's go through the motions with a company that has a single owner and is bringing in $1 million in revenue a year with a total overhead of $750,000. The founder took an angel round of $250,000 for 10% of the company, but has taken no other investment since.

Because further investment is a last ditch option, the founder has worked lean, only spending money where absolutely necessary. The company has been built through traditional practices, growing a list of paying customers over five to ten years (the same as the rapid growth company).

The founder has added employees as needed, and has taken home a modest, but very livable income. He or she can employ two senior level employees with salaries in the six figures and two or three junior/mid-level employees in the five figures. The rest of the overhead is for operating costs, bringing the total to somewhere around $500,000.

The company's revenues have reached a point where the founder can reinvest a quarter of total earnings into sales and marketing, moving overhead to $750,000. Perhaps he or she has even been able to buy back some, if not all of the angel investor's equity.

The business is growing at a steady rate and has been targeted by an acquirer, who will use the product as an addition to their own offering. Because there is real revenue putting the company in the black, and there are few, if any, investors who need to see gains, the offer is $5 million in cash.

Even if the founder has given the employees equity, he or she would've had to given away a total of 40% of the company before lowering the payout to the same amount earned only in stock through the rapid growth model.

Because the founder owns the majority of the company, he or she can shape the deal to be not only better for the equity holders, but better for the community. The simple fact is that bootstrapped companies are more likely to stay in the cities they are founded in, even after acquisition, because their founders are more able to add larger caveats to contracts.

One need only look at the massive building Citrix is building in downtown Raleigh to see the local benefits of acquired, bootstrapped startups.

There's no one-size-fits-all solution for building a business, and there's always room for a gray area, but the balance of the conversation in our area's startup scene is firmly in the rapid growth corner. Personally, I'd rather see six $5 million companies in the Triangle than one $30 million company.