How to build a startup that’s ready for acquisition

There are many reasons to found a startup. There are many reasons to work at a startup. But there’s only one reason a company gets 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, scaling. Traditional lenders (banks) think that startups are too risky for a 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, VCs, and hedge funds).

At its core, a VC 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 founder’s 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.

They raise money from their investors (limited partners like in pension funds) and spread their risk by investing in a number of startups (called a portfolio). In exchange for limited partners investing capital for long periods of time, VCs promise them large returns that are unavailable for most forms of investment.

Here’s some quick VC math: On average, if a VC invests in 10 early-stage startups, 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 30x return to provide the venture capital fund a 20 percent compound return. And that’s 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  (ex. helping pioneers succeed). So, the returns they’re looking for may be lower.

The deal with the devil

What does this mean for startup founders? If you’re 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, which is approximately between seven and 10 years. (A liquidity event means that the equity—the stock—you sold your investor can now be converted into cash.)

This happens in two ways:

6 steps to acquisition

The time to prepare for an acquisition is on day one

Above all, don’t panic or demoralize your employees

Lessons learned