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Millions of exits

This is in continuation of the previous post, in which early-stage investing was discussed in relation to its terminal value counterpart. Maybe less than explicitly, the point was argued that expectations should be not only realistic, but also specific… as much as possible. It does not suffice, for example, to “ballpark” an opportunity as having the potential to become a billion-dollar hit. Contextual questions should rather be asked, and answered, in order to add substance to the guess. For example, who would pay such an amount, when, and why? Under what circumstances were such amounts paid in the past, by whom, and how did these deals turn out for the buyer? What factors have changed, and what has stayed the same; what lessons have been learned, and how will these impact exits in the future? While on the subject of the future, what have been the important sector, economic, and capital market trends, and where are these likely to lead a few years out?

The fact is, as reasonable as such questions may be and as warranted in asking, the answers are enormously difficult and becoming more so all the time. In the case of digital media, having as a sector migrated through a boom, a bust, a follow-on boom, and an economic collapse in the course of some 15 years, throughout which fragmentation and consolidation and new waves of innovation all took place while the industry each day matured a little, lessons of the past don’t tie neatly around analogies of what may lie ahead. Estimating exit opportunities in this context can be a dauntingly tall order. As suggested in the previous post, of which this is a continuation, estimating exit opportunities is nonetheless imperative to the investment evaluation.

Some groups have proposed to address this conflict through a “spray and pray” approach, which is based on extreme diversification and small investment amounts at low valuations. The result has been a proliferation of seed investment vehicles that some observers have referred to as a bubble. Whether this is indeed a bubble can only be known with hindsight, and we are not at the point of knowing yet. Regardless, the aggregate capital allocated to such efforts contains an implicit exit perspective that is based on a more or less traditional scenario – if such a thing is imaginable in a sector that defies predictability – which is to say: Some pretty substantial exits among the crowd of seedlings are presupposed. For all we know, this will prove correct… but if so, it will have been accidental. The past alone cannot be relied upon as a benchmark in the environment described, and current M&A and IPO trends are not pointing to fat transactions soon.

Alternatively, we could revisit the paradigm. Instead of a model predicated upon a seed round, followed by a larger VC round or two, followed by an eventual sale or IPO of undeterminable size, during which time the target company’s revenues and cash flows are small or negligible but growing, let’s instead see if this other variant might work: An early round followed by nothing… and the target company is focused on a recurring-revenue business that leads to predictable (even if modest) profits. Each passing year, when distributed to shareholders, these cash flows are a series of little exits. Each passing year, the cost basis is recovered. Subsequently, the returns pile on. 

Disclosure: No positions.