In 1998, a new type of game show was aired in the United Kingdom. Rather than a panel of contestants competing to answer rapid-fire questions, the new show involved a single contestant who was often given a seemingly unlimited amount of time to ponder each question. In fact, contestants were even given a chance to call a friend and poll the audience for help.
The payout was also unique. Rather than walking away with cheap, garish prizes and a diminutive handful of cash, contestants had a legitimate opportunity to win £1,000,000.
Entrepreneurs who experience promising initial success also play a similar game. Would-be suitors often swoop in and make unsolicited offers that would result in the Founders becoming paper “Millionaires.” Although such offers are always flattering and provide meaningful validation that the adVenture is pursuing an exciting opportunity, they bear careful consideration.
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Million Dollar Offer
In the very early days of Expertcity, the Founders were offered a “small fortune” for the code which eventually became the genesis of GoToMyPC and later GoToMeeting. Although the offer was gratifying, it was clear to the Founders that this windfall would ultimately fall far short of the value that could be created by productizing the technology and generating substantial user adoption.
A similar experience occurred at a cloud computing company where I acted as an addVisor. The company was approached by a Big Dumb Company (BDC) who made a nominal acquisition offer within months of the company’s founding. The startup was so nascent that the sale would have been considered a short-term gain for tax purposes, which would have significantly reduced the Founders’ proceeds, making their small fortune even smaller.
Nearly every successful entrepreneur is offered a relatively modest amount of money for their adVenture during its early days. Such offers often come from a larger company once the startup begins to gain traction with customers and prove its value proposition. The Million Dollar Question is often posed before the company has raised money from institutional investors. As described in Venture Debt, sophisticated investors generally say “No” to the Million Dollar Question, as they typically demand a higher return than can be obtained by selling a company in its early stages.
Entrepreneurs faced with the Million Dollar Question should keep the following factors in mind when they evaluate the proposition.
Take Home Pay – All that matters is the amount of money you net, not the size of the initial offer. In addition to taxes, a number of factors will chisel the proceeds from the sale of your young company, including: transaction fees, escrow amounts, splits with other Co-Founders, option-holding employees, and investors’ participating preferred provisions. A low seven-figure offer can very quickly be reduced to a few hundred thousand dollars per Founder; certainly a nice payday, but hardly life changing.
Long Term Value – Look at your adVenture objectively, in the same manner as a Venture Capitalist (VC). As described in What The Heck Are My Stock Options Worth?, VCs typically evaluate their investments based on their best guess as to the startup’s ultimate exit value. This exercise requires you to estimate the following variables:
- Total money invested
- Total options granted to employees
- Approximate valuations of each future funding round
- Approximate valuation upon exit
- The amount of time and effort required to reach an exit
- A discount factor that represents the percent probability your estimations will prove accurate
Depending on the estimated value of your adVenture’s eventual exit, it might be more lucrative to accept a small windfall now, rather than hope for a potentially larger outcome at some indeterminate point in the future. To determine this, you must apply a reasonable discount factor to your estimated outcome: The higher the discount factor, the more attractive the Million Dollar Question.
Golden Handcuffs – Even if you go through the above analysis and determine that the outcome will likely be larger if you sell your adVenture at a later date, you and your team must have the energy required to create the future value. If you sell your company early in its life, you will likely be asked to remain with the company for some minimum tenure after the sale in order to comfort the BDC that it will attain its targeted return on its investment. Thus, when you sell a young company, you often trade an adVenture for a job. This may reduce your downside, but it severely limits your upside and you may find yourself playing Beach Volleyball in a gym.
To Flip Or Not To Flip
The term “flip” is used derisively by institutional investors to describe the sale of young companies. It is derived from the stock market in which day traders “flip” shares quickly after purchasing them in order to generate short-term gains.
Although “flipping” is looked down upon by many venture investors, it may be the ideal exit strategy for your adVenture. The key is to determine if your company’s solution is a feature, a point solution product, or a platform.
Some companies are predicated on a feature, rather than a full-fledged product. In such cases, the company can either build a product around the feature or attempt to sell the feature to a company that has a suitable product that would augmented by the feature.
For instance, in the early days of marketing GoToMyPC, we competed with an open-source solution called Virtual Network Computing (VNC). When we initially released GoToMyPC it was essentially a feature, as was VNC – both allowed users to access their desktops remotely. However, while VNC remained a feature, we added a number of additional features to our remote access capability, such as enhanced security, file transfer, remote printing and firewall penetration capabilities. The combination of these features resulted in a product which had broad consumer applicability while VNC remained a niche feature utilized primarily by a small number of technically proficient users.
Per the chart below, the technology underlying GoToMyPC became a platform upon which we eventually built a family of products, such as: GoToMeeting, GoToWebinar and GoToAssist.
Have Your Cake And Eat It – You can leverage your adVenture’s near-term success without selling your business by raising institutional funding and negotiating that a portion of the proceeds be allocated directly to you. For instance, you might raise $5 million in total, with $1 million allocated to the Founders and other key employees, while the remaining $4 million is invested into your adVenture. Although I would be reticent to invest under this scenario, I have been involved as a non-investing Board member in companies where this approach has worked. Mark Suster, an entrepreneur and investor I deeply respect, wrote a very thoughtful entry on this subject here.
Earn Out – The Earn Out aspect of an acquisition is a mechanism entrepreneurs can use to increase their company’s ultimate acquisition price. When nascent startups are acquired, Earn Outs can reduce the BDC’s risk while allowing you to capture some of the future value that lies ahead of your adVenture.
Such provisions are usually based on mutually agreed upon, quantifiable goals, such as prospective revenue, net income, or total customers, to be attained subsequent to the acquisition. Such Earn Outs are generally a relatively small percentage of the overall purchase price when a mature startup is acquired; ten percent or less is typical. In such cases, they often serve to bridge the seller and buyer’s bid/ask spread. The less mature the company, the larger the typical Earn Out as a percentage of the total purchase price. In some cases, an Earn Out can be as large as fifty percent of the total acquisition price of a young company.
The Answer Is?
The “Do you want to be a millionaire?” question is always intriguing and flattering. Just like the game show contestants, careful consideration should be taken when evaluating this query. Unfortunately, unlike the game show, you cannot ask a friend for help. Only by honestly evaluating your adVenture’s ultimate potential and assessing your ability and desire to create such future value, can you properly answer the Million Dollar Question.
John Greathouse has held a number of senior executive positions with successful startups during the past fifteen years, spearheading transactions which generated more than $350 million of shareholder value, including an IPO and a multi-hundred-million-dollar acquisition.
John is a CPA and holds an M.B.A. from the Wharton School. He is a member of the University of California at Santa Barbara’s Faculty where he teaches several entrepreneurial courses.
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