Opinion, Berkeley Blogs

What founders need to know: You score funding for a liquidity event – start looking

By Steve Blank

There are many reasons to found a startup. There are many reasons to work at a startup. But theres only one reason your company got funded. Liquidity.


The good news

To most founders a startup is not a job, but a calling.

But startups require money upfront for product development and later to scale. Traditional lenders (banks) think that startups are too risky for a traditional bank loan. Luckily in the last quarter of the 20th century a new source of money called risk capital emerged. Risk capital takes equity (stock ownership) in your company instead of debt (loans) in exchange for cash.

Founders can now access the largest pool of risk capital that ever existed in the form of private equity (angel investors, family offices, venture capitalists (VCs) and h edge funds.)

At its core venture capital is nothing more than a small portion of the private equity financial asset class. But for the last 40 years, it has provided the financial fuel for a revolution in life sciences and information technology and has helped to change the world.

The bad news

While startups are driven by their founders passion for creating something new, startup investors have a much different agenda a return on their investment. And not just any returns, VCs expect large returns. VCs raise money from their investors (limited partners like pension funds) and then spread their risk by investing in a number of startups (called a portfolio). In exchange for the limited partners tying up capital for long periods by in investing in VCs (who are investing in risky startups), the VCs promise the limited partners large returns that are unavailable from most every other form of investment.

Some quick VC math : If a VC invests in ten early stage startups, on average, five will fail, three will return capital, and one or two will be winners and make most of the money for the VC fund. A minimum "respectable" return for a VC fund is 20 percent per year, so a 10-year VC fund needs to return six times their investment. This means that those two winner investments have to make a 30-times return to provide the venture capital fund a 20 percent compound return and thats just to generate a minimum respectable return.

(By the way, angel investors do not have limited partners, and often invest for reasons other than just for financial gain -- such ashelping pioneers succeed --and so the returns theyre looking for may be lower.)

The deal with the devil

What does this mean for startup founders? If youre a founder, you need to be able to go up to a whiteboard and diagram out how your investors will make money in your startup.

While you might be interested in building a company that changes the world, regardless of how long it takes, your investors are interested in funding a company that changes the world so they can have a liquidity event within the life of their fund, about 7-10 years. (A liquidity event means that the equity (the stock) you sold your investor can be converted into cash.) This happens when you either sell your company ( M&A ) or go public (an IPO.) Currently, M&A is the most likely path for a startup to achieve liquidity.

Know the end from the beginning

Heres the thing most founders miss. Youve been funded to get to a liquidity event. Period. Your VCs know this, and you need to know this too.

Why dont VCs tell founders this fact? For the first few years, your VCs want you to keep your head down, build the product, find product/market fit and ship to get to some inflection point (revenue, users, etc.). As the company goes from searching for a business model to growth, only then will they bring in a new professional management team to scale the company (along with a business development executive to search for an acquirer) or prepare for an IPO.

The problem is that this dont worry your little head strategy may have made sense when founders were just technologists and the strategy and tactics of liquidity and exits were closely held, but this a pretty dumb approach in the 21st century. As a founder, you are more than capable of adding value to the search for the liquidity event.

Therefore, founders, you need to be planning your exit the day you get funded. Not for some short-time let's flip the company strategy, but an eye for who, how and when you can make an acquisition happen.


Step 1: Figure your startup generates value

For example, in your industry do companies build value the old fashion way by generating revenue? (Square, Uber, Palantir, Fitbit, etc.) If so, how is the revenue measured: bookings, recurring revenue, lifetime value? Is your value to an acquirer going to measured as a multiple of your revenues? Or as with consumer deals, is the value is ascribed by the market?

Or do you build value by acquiring users and figuring out how to make money later (WhatsApp, Twitter, etc.) Is your value to an acquirer measured by the number of users? If so, how are the users measured (active, month-on-month growth, churn)?

Or is your value going to be measured by some known inflection point? First-in-human proof of efficacy? Successful clinical trials? FDA approvals? CMS reimbursement?

If youre using the business model canvas, youve already figured this out when you articulated your revenue streams and noted where they are coming from.

Confirm that your view of how youll create value is shared by your investors and your board.

Step 2: Figure out the likely acquirers

petal-diagram If you are building autonomous driving aftermarket devices for cars, its not a surprise that you can make a short list of potential acquirers auto companies and their tier 1 suppliers. If youre building enterprise software, the list may be larger. If youre building medical devices the list may be much smaller. But every startup can take a good first cut at a list. (Its helpful to also diagram the acquirers in a Petal Diagram.) When you do, start a spreadsheet and list the companies. As you get to know your industry and ecosystem, the list will change.

Its likely that your investors also have insights and opinions. Check with them as well.

Step 3: List business development, technology scouts and other people involved in acquisitions and note their names next to the name of the target company.

  • All large companies employ people whose job it is to spot and track new technology and innovation and follow its progress. The odds on Day One are that you cant name anyone. How will you figure this out? Congratulations, welcome to customer discovery.Treat potential acquirers like a customer segment. Talk to them. Theyre happy to tell anyone who will listen what they are looking for and what they need to see by way of data or otherwise for something to rise to the level of seriousness on the scale of acquisition possibilities.
  • Understand who the key opinion leaders in your industry are and specifically who acquirers assemble to advise them on technology and innovation in their areas of interest.
  • Get out and talk to other startup CEOs who were acquired in your industry. How did it happen? Who were the players?
  • network-diagram

    Its common for your investors to have personal contacts with business development and technology scouts from specific companies. Unfortunately, its the rare VC who has already built an acquisition roadmap. Youre going to build one for them.

    After awhile, you ought to be able to go to the whiteboard and diagram the acquisition decision process much like a sales process. Draw the canonical model and then draw the actual process, with names and titles, for the top three likely acquirers.

    Step 4: Generate the case

    Your job is to generate the business case for the potential acquirer, that is, to demonstrate with data produced from testing pivotal hypotheses why they need is what you have to improve their business model (filling a product void; extending an existing line; opening a new market; blocking a competitors ability to compete effectively, etc.).

    Step 5: Get noticed

    Figure out what conferences and shows these acquirers attend. Understand what is it they read. Show up and be visible as speakers on panels, accidently running into them, getting introduced, etc. Get your company talked about in the blogs and newsletters they read. How do you know any of this? Again, this is basic customer discovery. Take a few out to lunch. Ask questions what do they read? how do they notice new startups? who tells them the type of companies to look for?

    Step 6: Know the inflection points

    Timing is everything. Do you wait seven years until youve built enough revenue for a billion-dollar sale? Is the market for machine learning startups so hot that you can sell the company for hundreds of millions of dollars without shipping a product?

    For example, in medical devices the likely outcome is an acquisition way before you ship a product. Med-tech entrepreneurship has evolved to where each VC funding round signals that the company has completed a milestone and each milestone represents an opportunity for an acquisition. For example, after a VC Series B-round, an opportunity for an acquisition occurs when youve created a working product, you have started clinical trials and are working on getting a European CE Mark certification to get approval.

    When to sell or go public is a real balancing act with your board. Some investor board members may want liquidity early to make the numbers look good for their fund, especially if it is a smaller fund or if you are at a later point in their fund life. If youre on the right trajectory, other investors, such as larger funds or where you are early in their fund life, may be happy to wait years for the 30 times or greater return. You need to have a finger on the pulse of your VCs and the market, and align interests and expectations to the greatest extent possible.

    You also need to know whether you have any control over when a liquidity event occurs and who has to agree on it. Check to see what rights your investors have in their investment documents. Typically, a VC can force or even block a sale. Make sure your interests are aligned with your investors.

    As part of the deal you signed with your investors was a term specifying the l iquidationpreference, whichdetermines how the pie is split between you and your investors when there is a liquidity event. You may just be along for the ride.

    Dont panic or demoralize your employees

    The first rule of "Fight Club" is you do not talk about Fight Club. The second rule is you DO NOT talk about Fight Club! The same is true about liquidity. Its detrimental to tell your employees who have bought into the vision, mission and excitement of a startup to know that its for sale the day you start it. The party line is, Were building a company for long-term success.

    Do not obsess over liquidity

    As a founder theres plenty on your plate finding product/market fit, shipping product, getting customers. Liquidity is not your top of the list. Treat this as a background process. But thinking about it strategically will effect how you plan marketing communications, conferences, blogs and your travel.

    Remember, your goal is to create extraordinary products and services and in exchange theres a pot of gold at the end of the rainbow.


    • The minute you take money from someone their business model now becomes yours.
    • Your investors funded you for a liquidity event.
    • You need to know what multiple an investor will allow you to sell the company for.
      • Great entrepreneurs shoot for 20 times.
      • You need at least a 5-times return to generate rewards for investors and employee stock options
      • Atwo-timesreturn may wipe out the value of the employee stock options and founder shares.
        • You can plan for liquidity from Day One
        • Dont demoralize your employees.
        • Dont obsess over liquidity, treat it strategically.