The ‘exit horizon’ is the key to whether a startup is a viable investment

It seems like a simple question: at what annual revenues will your startup become a viable acquisition target?

The question may be simple, but the answer is not. And for investors and founders, it’s the most important question.

Fortunately, there are some easy rules of thumb that most venture investors use. Unfortunately, those rules of thumb are rather generic and don’t fit every every industry. Following them blindly can make good opportunities seem uninvestable.

It’s therefore important for founders to understand the rules of thumb and what you need to present to investors if your startup doesn’t match those rules.

Why the Exit is Key to Investment

If I write you a check for a million dollars to help you build your startup, how do I make money from that investment?

If you don’t have a ready answer, sorry, you failed your funding application. Worse, if you answer, “We’ll pay dividends when we reach profitability,” we’ll chop you up and feed you to the unicorns. Bye.

The only way investors make money is when the startup reaches the “exit” — an acquisition or IPO.

Until the exit, our investment is nothing but a number on your cap table. It doesn’t earn interest. We can’t sell it. Even if the valuation of the company rises, the gains are only on paper. With the rare exception of a secondary sale of stock for unicorns, there’s no way for investors to get even one cent back from our investment until the exit.

Consequently, the exit is the only reason for investors to invest, and therefore, the only thing we really care about. The rest of your pitch boils down to whether your startup can reach a successful exit and generate a big return.

Successful and Unsuccessful Exits

Early-stage investors assume 50% of our investments will fail outright, and another 40% will fail to generate a positive return. That means the one success out of ten needs to return 10x just for us to break even, and 40x to beat investing in the S&P 500 index. So we’re looking to invest in startups with the potential for 40x returns or higher.

The biggest exits come from IPOs on the NYSE or Nasdaq. But that requires revenues approaching a billion dollars. For the 99.9% of startups that will never reach billions in revenues, a successful exit means an acquisition.

But not just any acquisition.

If the startup reaches profitability, the company can be sold to private equity for a small multiple of profits. It’s an exit, though not a great one for investors.

Similarly, the startup can be acquired for the employees (acquire-hire) or to grab the patents, but those are fire sales when the company runs out of cash. They’re exits, but far from successful ones.

So what does it take for a successful acquisition?

If the startup is valued at $10M at the time of investment, a 40x return requires the company be acquired for $400M or more. Even a minimum 10x return requires an acquisition of the startup for $100M.

Only an industry giant with public stock can shell out hundreds of millions to acquire a startup.

Strategic Investments

For an industry giant to pay out big, it needs to see buying the startup as critical. Those reasons include:

  • the startup is bleeding market share from the giant
  • the giant’s most important customers are demanding features the startup has developed that the giant doesn’t have the skills to build in-house
  • the startup’s product will help the giant increase sales of its critical cash cows
  • the giant can leverage the startup to jump into an important new market
  • one of the giant’s competitors is considering acquiring the startup and using them to challenge the giant’s dominance
  • the industry is transitioning to new technology and the giant needs new capabilities to avoid becoming an irrelevant dinosaur

Exit Horizon

At what point will an industry giant be willing to pay hundreds of millions to acquire a startup?

There’s no simple answer. Facebook famously bought Instagram for a billion dollars when the company had only 13 employees and no revenue. That was one of the most successful acquisitions ever. But it’s also extremely unusual.

The truth is that big, bureaucratic companies don’t buy technology. Giants don’t want to take over startup development projects. They have to assume the founders and many of the employees will leave. They don’t want the hassle of dealing with an MVP or v1.0 that may not work and could even hurt their reputation. They want a finished product that’s been battle tested with customers.

What size is that? For companies making tens of billions in revenues, the general rule of thumb is that startups become strategic acquisition targets after they reach $100M in revenue. I call that the “exit horizon.”

At around $10M, the giants start poking around. They might offer some sort of partnership or even consider investing through their CVC to gain an inside view.

At around $25M in revenues, the giants start thinking about whether an eventual acquisition would make sense. But they’ll rarely pull the trigger.

At around $50M, the giants start considering seriously what an acquisition would entail. They might even be pushed into an acquisition at this size, but only if the price is a bargain.

$100M in annual revenue is when the startup blossoms into serious acquisition bait. At this size, revenues start to move the dial for at least a division of the giant. Your startup is beginning to take significant market share from the giant or building a valuable customer base that a giant would like to take over. At $100M, you’re no longer a technology play but a serious player in the industry.

At $100M in revenues, an acquisition also starts to make sense for investors. If the giant pays 5x revenues to acquire the startup (another rule of thumb), a $500M acquisition would bring a 50x return to early investors.

The $100M Threshold

For these reasons, $100M in annual revenue is generally considered the minimum for a successful exit.

Acquisitions under $100M happen regularly. In fact, they account for the vast majority of startup acquisitions. But acquisitions at lower revenues rarely provide the type of success investors are shooting for. That can’t be the goal.

For this reason, the pitch deck is essentially an outline of the startup’s plan to reach $100M in revenues.

But what if $100M in revenues isn’t realistic. Is there any chance for investment?

Well…it depends.

The above analysis assumes the startup will be acquired by a giant with hundreds of billions in revenues. But not all industries are quite so concentrated.

My speciality happens to be in the test & measurement space. In that particular industry, the industry giant is only $50B, and there is a healthy collection of medium-sized competitors in the $10B range that are public companies, too. So in that industry, acquisitions tend to start at around $25M instead of $100M.

Assuming a 5x multiple of $25M in revenues, the company would be acquired for $125M. To achieve a 40x return, the initial investment would have to be at a valuation of $3M with no dilution. That seems highly unlikely these days, so an acquisition at that size would be good but great for investors.

But if the acquisition was at a 10x revenue multiple instead of 5x, an investment at a valuation of $6M or less would be a great success. However, it would not be a success for VCs investing in later rounds at higher valuations. So startups with small exit potentials need to limit fundraising to smaller raises at lower valuations.

But is a 10x revenue acquisition possible? That depends on the industry and the proclivities of the potential acquirers.

What You Need to Tell Investors

When you pitch your startup, investors need to know the revenues where a successful exit becomes viable along with your plan for reaching that revenue threshold. That is the essence of your pitch.

We also need to know what kinds of companies would pay a large multiple of revenues for a strategic acquisition and how much those companies have paid in the past.

You may think it’s too early to be considering exit plans while you’re still figuring out the product. But for investors, especially for niche products that won’t generate billions in revenues, we need to know from the start how we’ll be able to make a return from investing in your startup.