[EP 064] Exits for Tech Startups: what it looks like and why it needs to be considered sooner

Joanna: Hi, it’s Joanna Oakey here and welcome back to the Deal Room podcast, a podcast brought to you by our commercial legal practice Aspect Legal.

Well today we are talking all about tech startups and what their exit looks like, given just around the corner we have StartCon so we thought it would be perhaps a good topic to bring to you our audience today in this theme of tech startups and their exits. To talk about this, I have brought along the fabulous Oscar Jones from Copperstone Capital.

Hi Oscar, welcome along to the Deal Room podcast!

Oscar: Good morning Joanna! Nice to be here.

Joanna: It’s great to have you. It’s great to have you. Okay Oscar maybe, why don’t you kick this off perhaps and just give us a really quick snapshot of who you are, your background, and how you work in this area.

Oscar: Yeah, sure. I basically joke that I’ve never had a real job in my life. I’ve always been a consultant, but I’ve had about 30 years of consulting experience, working right the way through from some of the largest companies through to startups.

I guess I started doing capital raising about 8 years ago and I found that one of the key parts of capital raising is trying to convince investors that they’re going to get their money back through some sort of exit. But most founders had very very little understanding of what sort of exit was possible for them, so they would typically say are we going to exit via a trade sale or an IPO in a number of years’ time.

This, of course, was really not realistic. The number of companies that go on to do an IPO as an exit are very very small. We can talk about that later, and a lot of companies never exit. They just go along without really achieving anything or they fail, so it sort of brought my focus particularly to. I’ve done a few M&A deals, and it brought my focus specifically to saying we could really improve the whole tech startup ecosystem if we had a more robust way of exiting and allowing founders to take that experience and then apply it again and then apply it again. So that’s sort of what brought me to that space.

Issues in the current startup ecosystem

Joanna:] What a fabulous comment! I think that’s such a great perspective, Oscar. I think we’re going to have fun talking about this subject today.

Getting into the subject I guess of where we’re going today, why are we talking about tech startups and their exit? Because StartCon I guess is all about startups. It’s about starting. So where does that get us to exit and why do you think that it’s important for startups to be thinking through clearly right at that startup phase about their exit?

Oscar: Okay. Well there are a couple of really interesting sort of stats that are based around how much employment small and medium companies provide to the Australian economy. I think everybody understands innovation is a key part of driving an economy and we’ve got some real challenges in Australia for being able to grow and develop companies pass the startup stage.

Everybody is spending money on early stage startup. The government spending lots of money on incubators and accelerators. But once you get kicked out of that, you’re pretty much on your own. Even the rules around R&D tech expenditure claiming and the rules around the employee share schemes all basically cut out the 50 million dollar revenues so we draw support quite early.

Joanna: And of course 50 million is still a fairly good size for an organisation. Certainly, we’re not talking about them as startup I guess at that point.

Oscar: No, you’re quite right. But the issue is that the real powerhouse of employment are those fast growing companies and if you’re growing 40 to 60 per cent per annum, it doesn’t take very long before you smash through a 50 million dollar revenue ceiling. Particularly with those companies that are trying to address a global market, that’s one of the reasons why they want to tend to move offshore. So rather than make companies have to go offshore to deal with this, one of the other options of dealing with this is to actually sell the company to a larger company that has the resources, that has the capital to be able to drive the company to the next step.

Joanna: Yeah, absolutely. I guess what you’re saying here is effectively it’s the whole starting with the end in mind, which is one of those common sort of sayings that we hear but it’s often harder to do and something that we see less often than appears by the ease of the statement. Right?

But I guess why is it that do you think the business owners you know creating these startups, really fast moving startups, aren’t thinking so clearly about the end? And I guess firstly it’s because education is driven that way, but…

Exit isn’t the end

Oscar: Well I think it’s more fundamental than that. I think one of the issues is we call this an exit. Now an exit has a connotation of being the end, the last thing you do and that isn’t the case. Let me give you a couple of examples.

If I’m an angel investor, I would invest in 10 or 15 companies, maybe more if I got a lot of funds. I do that because I know that I have to play a portfolio, because I know that only 1 in 5, 1 in 10 are actually going to do anything for me.

As a founder, I’ve got a very very different focus. I’ve only got one company. I’ve got to make this company work. However, we can get a founder to basically diversify their career path if you like by getting them to exit the first few a bit earlier than they would normally do. Put some money in the bank. That can be a life changing decision for a lot of founders who otherwise are struggling on the red line because startups don’t give you much money coming back, and it gives them experience of running the whole way through the cycle – start up, growth, and exit.

I think that’s a big part of it, that people don’t think of it like that because they’re so focused on getting the technology ready, getting it up that the last bit is forgotten and it’s I think a bit of a natural human way we think.

Joanna: That’s a really good point. I really like the idea behind all of that. It really makes sense, and in fact when I’m talking to business owners who seem to have been really successful in their exits, rarely is it their first exit.

Usually when I’m talking to someone that’s built a really super strong business and developed a really successful exit, most often they’ve done it a number of times before so that really hones in I think and proves the point that you’re talking about here. It’s certainly something that I see anecdotally.

Benefits of engaging the right advisors early

Oscar: And the other thing of course, and I’ll give M&A advisors a bit of a pat on the back here. If you can bring an adviser in a bit earlier, then they can often help you with structuring the business so that you get a better exit.

Because most owners haven’t focused on the exit, there are often things that need to be done and some of those things actually can take a couple of years. Just establishing better growth profiles, making sure that you’re focused on the things that matter to a potential buyer rather than things that maybe you would need just to grow the business. There are a number of elements that need to be focused on.

Joanna: I completely agree with what you’re saying here because once again these experienced business owners that I’m talking about or all these owners who are experienced in exits, what I hear again and again and again is them saying the first time round they tried to do too much themselves. And as they move through you know various attempts at building and selling businesses or new examples of their own building and selling business, they learnt the importance of early engagement with people who knew what they were doing apart from they themselves knowing what they were doing. It’s fascinating I think you know moving from someone who really understands the importance of early engagement of the right advisors.

Importance of market research

Oscar: Well I think there’s one other big thing as well that I think most business owners probably are not too much aware of and that is if I’m going to develop a business, I’m going to do customer research, I’m going to know what my customer wants in terms of the product that I’m going to build. I would never dream of trying to build a product without knowing what the customer might be like or who I’m targeting and doing a fair bit of market research. Yet the number of times I hear businesses say oh we’ll build the business and when it’s right to exit, somebody will magically appear who will pay us lots and lots of money for what we’ve done.

That isn’t the reality unfortunately. And what’s fascinating is that companies, if they’re buying a business, there are sweet spots for various companies. So if you’re a company that has a 100 million dollar market capitalisation, then buying a 5 million dollar business is a straightforward event. It probably is within the authority of the CEO to execute.

But if you’re going to buy a 50 million dollar business and you’re only a 100 million market cap, that is going to be an agonising decision for the board to make because it’s going to change the nature of the buying company as well. So what happens is that as a startup grows, the potential buyers change, and a small startup may be targeting a business that’s a mid-sized business in Australia. But if they grow past a certain point, those businesses will no longer be able to buy them. And you’re starting then to look at large businesses or you’re starting to look overseas for the purchaser.

Cross-border deals are more difficult to do than intra country deals, so there are some real challenges about understanding who the potential buyer is at any stage and how many of them are there. If you’ve got just one buyer, they’re in the box seat. If you’ve got two or three buyers with deep pockets, you’re in the box seat.

Considerations for deciding when to exit

Joanna: Yeah, absolutely. And look, maybe if we could have a bit of a chat about what some of those indicators are of perhaps a point that the startups should be recognising maybe as signs for thinking about a sale or exit.

Oscar: Yeah, sure. Well I can talk a little bit about for example if you’re building a software as a service company. There are actually three or four different phases that you go through.

If for example you’re pre revenue, then really the only thing that people might be interested in is buying your team. They’re not interested in buying your idea or your early product stages.

Now teams can be very very profitable. The current rate for an artificial intelligence developing team is about 1 1/2 million dollars per person. So that can be quite a good exit. But of course, you lose any upside.

What drives software service company or SAS companies is their annual recurring revenue, their ARR. And if you’ve got an ARR of around about a million dollars and you’ve got initial traction and you’re one of the darlings of the market, you can exit for 25 to 100 million dollars, because people are buying the upside potential.

But if you then go and grow that business a bit more, you’ve lost that early opportunity and the way that people value the businesses will change and you start to move down to maybe a 5 to, for a very good business, 10 times your annual recurring revenue, your ARR. And of course, at 2 million dollars, that puts you between 10 and 20 million dollars, which is less than the amount you would have received for a million dollars of revenue so you have a dip in evaluation.

Understanding that you’ve got those local points in your growth where it makes sense to exit, and then as you grow your revenue of course, once you get above about 10 to 15 million dollars revenue, then you’ve got a proper business. And so, they’re going to be valued on more standard business metrics around cash flows and growth.

If you say no at one point in time, be aware that you’re going to have to continue to grow the business maybe for up to 3 or 4 years before you get back and above that same valuation. I guess everybody’s got to, they’ve got to look at that themselves and see what the opportunities for them are if they sell and what else they can do to really make that decision properly.

Joanna: Well I guess you know clearly then it’s about having an eye on where your business is in comparison to where the market is and what levers will actually have an impact on price and what impact your growth plans will have on the value of the business moving forward, and obviously in conjunction with people who understand where the market is.

If we’re talking then to these startups who are at that early phase, what would you say to them in terms of how they can start thinking about what their exit looks like? How can they get educated? How can they understand what to do and what to look out for?

Matching potential buyers to the company at any stage

Oscar: Well, like everything else, it’s about research. It’s about understanding not just where you are now, but what it might look like when you get to the next highest point.

For example, I’ve got a client at the moment who is at that early stage of about a million dollars and they want to push on to the next stage. The problem is the industry they’re in. We’re going to probably run out of buyers in Australia for them at that that next stage. The focus we now have to do is to start researching international companies, and saying how big are they, what would it look like if we get to that 10 million dollar revenue, what would it look like as an acquisition for them? Is it too small for them? You know that’s the next problem, that sometimes companies see things as being too small.

The cost of due diligence is not insignificant for a lot of companies, and so they want to get something for it. Preferably, make it an impact on their earnings or potential earnings down the track to make it worthwhile. So again, it’s not a linear relationship. It’s about matching the potential buyers to the stage that the company is at and recognising that if you miss that, then the next stage might not come around for a while and it’s going to be a very different set of buyers and they’re going to be buying on different criteria.

Joanna: I guess the next question is Oscar, you know quite often businesses will get to this point where they’ve got the business to where they can at the moment, or they have the energy to so next they’re either looking at exit or they need more capital in the business.

In fact, I had a meeting with a client, a new client yesterday who is going through this process right now, in relation to their SAS company. What’s your recommendation as to when you’re best looking at external capital versus looking at maybe pitching this in terms of an exit.

Conflicting objectives between founders and capital providers

Oscar: Yeah, I think that that comes down to the founders in particular understanding both the risks and the rewards. The fact is that only maybe 1 percent of companies that are funded are ever going to get to a stage where they’re the next Atlassian or the next unicorn. Most companies are not going to reach that, and there are risks along the way.

As long as owners understand those risks, and the sorts of risks I’m talking about are if you bring in venture capital, they are going to want to drive your business hard to try and get it into that 1 percent. Because that’s where they get their big returns from that justify most of their returns in their portfolio.

There’s been a few reports in the paper lately about the self-driving car start up, Zoox. The Australian who started it, Tim Kentley-Klay has just been sacked as the CEO. Now he’s a founder whose vision and drive got the company up to being considerably large. They’ve just had a 500 million dollar series B capital race, so this is not a small company.

But the founder is in a position where he’s got a minority shareholding. He’s no longer running the company. Yes he’s on the board, but that’s a limited influence on the company, and the main reason given was he didn’t have the skills to be able to manage and drive what is now become quite a large business. This is not unusual.

The founders often have conflicts with the capital providers and they sometimes get pushed out. We’ve got to understand that the founders and the capital providers do have different objectives because a capital provider is investing in a portfolio and they need to make the portfolio work. They’re not so concerned about the individual companies working.

As I said before, the founder has only got this company, so he gets locked in with a VC fund that wants to run it for another 7 years and is going to go for broke. He’s basically locked into that.

As long as you understand the risks and the rewards, that’s really where I’m coming from. I wouldn’t necessarily suggest exits every time but be aware that most of the exits are trade sales not IPOs. Most of them are, and a considerable proportion of them, are by founders who have not raised capital, which gives us another interesting dynamic.

Joanna: And certainly, to your points there, I think one of the real risks for founders dealing with a new direction of the business as most usually happens if they’re getting a lot of capital on board, is that the founders are used to making their own calls. I think this is often the problem, right?

They’re used to being the creator and the driver, and now suddenly there’s all of these other people that they have to and rules that they have to fall in line with. That can create real issues from an emotional and motivational level as well.

Oscar: And I think the reason why everybody talks about Atlassian as an example of how to do it, is the founders of Atlassian did not need any capital. They didn’t have to go to the capital markets and raise capital to keep the company afloat. When they did finally decide to raise capital, it was purely to scale globally. So they were in the box seat when it came to dictating the terms. And look, I’ll take my hat off. Those guys have managed to do a tremendous job of transferring from a startup to a massive company, and obviously done it extraordinarily well. It’s not that it can’t be done. It’s just that it’s not the normal.

Joanna: Yeah. Well yes, I think absolutely you’re right. There’s a lot of people out there though who use that as their big motivational force. But certainly, I would absolutely agree it’s certainly not the norm. Are there any sort of parting words Oscar that you would like to add to this discussion?

Oscar: I think be aware that you get your money back in a start up on the exit, generally. Having a good solid plan from day one and keeping it up to date and keeping your advisors close to you so that you are maximising the value, will see an enormous improvement in both the number of startups that you see and also the price that founders can achieve on those things. I think that’s really the bottom line.

Getting in touch with Oscar

Joanna: Some really wise words there from your Oscar, and I think we should note for any tech startups that are listening along to this episode. If you’re at StartCon, I think you’re going to be there aren’t you Oscar?

Oscar: Yes, I am. Yes, I’ve got a small stand there.

Joanna: So head along and make sure you look out for Oscar Jones at Copperstone Capital if you want to have a chat about your tech start up and your exit plan for the future or lack thereof perhaps, maybe.

Oscar: Well hopefully after listening to this, we might see a few more exit plans being produced.

Joanna: Absolutely. Earlier on in the piece. That’s right.

And Oscar if people want to, our listeners want to connect with you or maybe even take advantage of this session that I know that you offer a complimentary session to explore exit, how can they go about finding you?

Oscar: Yeah, sure. I’m always happy to talk to tech startups. On my website there’s a facility that you can request a consultation. We take about an hour and we go through various number of things. Most people find it quite helpful just in terms of understanding and being able to sort of position themselves on the exit, so that’s on the website.

Joanna: Yeah. And so that website is copperstone.com.au and we’ll have links to all of these in our show notes, and of course if you’re at StartCon, make sure you pop into Oscar’s stall and say hi to him.

Thanks Oscar! Thanks so much for coming along to our show today! And look Oscar I’d love to have you back again. Maybe the next time we can be talking about what the mechanics of a startup exit looks like so stay tuned for that episode where we talk further to Oscar about these concepts of developing an exit plan and understanding exit for startups.

Oscar: Thank you Joanna! Delightful pleasure as always.

Joanna: Well that’s it for our episode today all about tech startups and what their exit looks like. Just as a recap in this episode we talked about tech startups needing to look at their exit earlier.

We touched on the issues of everyone talking about the startup phase, but not the exit phase, and why exits are just as important as the start up in terms of understanding when you’re going to be able to drive the most value out of a business.

If you’d like more information about this topic, then head over to our website at thedealroompodcast.com where you’ll be able to see an outline of this podcast episode if you want to read it in more detail. There you’ll also be able to find details of how you can contact Oscar Jones and we’ll also have a link through to his website at Copperstone Capital.

And on that website, you’ll also be able to find details of how to contact our lawyers at Aspect Legal if you or your clients would like to discuss any legal aspects of sales or acquisitions. We have a number of great services that help businesses prepare for a sale or an acquisition and to get into the transaction itself. We work with clients both big and small and have different types of services depending on size and complexity, so don’t hesitate to book an appointment if you want to find out how we can assist.

And finally, if you enjoyed what you had today, firstly make sure you have subscribed on iTunes or your favorite podcast player, and secondly maybe consider leaving us a review. We’re always so grateful to get reviews from our listening audience and it also helps us in getting this message along to more people listening in to this podcast.

Well look thanks again for listening in today. You’ve been listening to Joanna Oakey and the Deal Room podcast. See you next time!