Will VCs block an exit?

I had a great question from an entrepreneur this week who is deciding whether or not to take VC into his business. He heard that VCs want 10x returns and if you accept VC$ then you need to deliver that. He was worried that VCs block sales that don’t deliver the required returns.

This question comes on the heels of an apparently great talk by Randy Smerik at Startupfest last week. Randy says that in 90% of the cases where VCs can block a sub-par exit they will. I don’t know how much direct experience Randy has in this. Maybe he’s heard some horror stories. And yes – it is a distinct possibility. When you accept VC$ they have a veto right over the exit. But, I’ve been around a lot of exits and I have yet to see this right exercised. Here’s why…

The reason this right exits in the 1st place to help VCs manage the only event that brings liquidity on their investments. They want a say in who you sell to and when and at what price. Yes, VCs want the big home run. But it’s a fools errand to bet against human nature. And here’s how human nature works whenever an exit opportunity (of any size) comes along:

If you’ve never had an exit before, then putting a few million in your pocket is life-changing. You’ve probably spent the $ mentally before you get them and have lost the fire to hold off and keep going. You also may have been grinding away at your startup for a while (in most cases, it takes years of hard, smart grinding to create something worth buying). So, for money and a break it’s super tempting to take the exit.

As an investor, I know this and would have two likely risks to manage: i.) If I block the sale and deny the founders their payday I will have seriously damaged my relationship with them and am not likely to get the same level of execution going forward; and ii.) Replacing founders with “professional” management is like performing a lobotomy – and the patient doesn’t always survive.

Finally, and this is especially true in smaller markets (vs. the Valley), I’m betting on the lifecycle of an entrepreneur. If I only make 2x or 3x now, well so be it. Hopefully the next time that person starts a company, I’ll invest again and he or she will have the financial comfort and experience to go bigger.

Now if you want to take an exit that only returns capital to the investors (i.e. does not deliver any profit) then I might be tempted to block that because what use is getting the capital back? Despite the risks, I’m better off holding out. Also, if you are recommending that deal then our relationship is impacted anyway. When you accept outside investment you’re making an explicit promise to do everything you can to deliver a return that covers the considerable risk angels and VCs take. So, if you recommend a crap deal, you’re braking that promise and all bets are off.

So, I guess that’s the framework to have in your head each time you take outside $ into your business: do you see a path to delivering a solid return based on the capital you have taken in? If it would take a Hail Mary or some huge stroke of luck to get there, then you’re likely headed for trouble. Hopefully investors are doing the same analysis themselves. Finally, you should have open and honest discussions with potential investors to ensure alignment on a bunch of things including the exit. And of course – check with existing portfolio companies (and ideally past portfolio companies) to see if the investors have blocked exits in the past.

  • Elie

    Thank you for the post. I would please like to ask a question regarding exit: If a VC is selling only it's shares in the portfolio company to a third party, does it also transfer all the rights attached to these shares to that third party? i.e. will the veto rights, tag&drag etc. be transferred to the buyer as well?

    • Yes, the rights would transfer. Normally such transfers are restricted in the shareholder agreement. They can't just sell to anyone

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  • Good hit on the lifecycle of the entrepreneur. A 3X return is a solid return no doubt, but part of the startup investing game comes from when you re-up your bet. A kind of double or nothing experience when this entrepreneur potentially comes back around with a new company and 3X can become 6X with experience gained and a strong team. And the next time might be a failure, but the time after will be 9X.

    • Apparently I hit enter long before I meant too. It's nice to see the representation of the smaller markets in this post. We don't share the same plethora of potential investors and entrepreneurs at our door steps all the time and by strengthening the relationship between entrepreneur (and team) and investor, you're moving yourself into a stronger position more often than not.

      • Yep, we have a different reality in smaller markets. If you are in the Valley then it's a filter-based model. Get as much dealflow as possible and hopefully get in on the best ones. Not the same approach here. Much more hands on identification and development of talent

  • That's in the case the startup has good traction, but what happens revenues are not increasing, the startup is not profitable after X years, will VCs still block a potential exit? in which case, the only option that the entrepreneurs face is raise more funding or close the shop

    • It depends. The worst thing an investor can do is to "chase" returns by putting more $ into things that are not happening. Success is never a straight line and sometimes you have to double down before traction really happens, but you still have a feeling about the team and product potential. If your feeling is positive then you put more $ in with an expectation of return. If not, you should not invest more.

      There is no point blocking a sale of a company that is not creating shareholder value. You just own a dud for longer. If it's not going to happen, cut bait, sell it and cut your losses.