What happens when VC backed businesses can't find an exit but are profitable?

Why don't you take a loan or find investors who want a revenue stream? If I were in your shoes I would try to run as lean as possible and get one year of a profitable business completed, and then consider a loan.

Get your books in order, then go to a bank for a loan or at least talk to a banker or two.

You'll be far better off than with VCs involved and based on what you wrote no VC will want to invest, because as you point out, there is not enough return.

You are better off with no VCs anyway - they are looking for a liquidity event - you may not want that.

Take small loans as you need them rather than one HUGE sum up front. Given the revenue you have you might be able to make it work.

Let us know how it goes.

Most VCs put in a redemption clause which allows them to sell their stock to the company after a long period of time (7 to 10 years). If the company doesn't have the cash, then it's in trouble, as the VCs can effectively seize the company and sell of the assets, but they're unlikely to do so in practice since no experienced VC wants to deal with trying to sell off a company without founders.

Your best bet is to be straightforward with your potential Investors. They might get spooked, but better to know that now rather than later. The game theory goes something like this:

1) Everyone aims for a big exit

If that fails, then: 2) VCs pressure founders for small exit

If that fails but company is profitable: 3) VCs attempt to redeem their stock with the company

If VCs have no redemption rights or company doesn't have enough cash: 4) VCs take a smaller amount for their stock and go away

If that fails: 5) VCs write off their investment, quit the Board, and consider the company a failure

It sounds like you want an Angel investor, not VC.

I know this sounds pedantic, but "VC" generally means someone looking for 10x return over 5 years, and you can't provide that, nor does it sound like you necessarily want to, and that's OK!

Angels are much more flexible because they are (generally) just accredited investors and therefore are interested in a variety of things. You could get money in the form of a warrents for example, where the Angel either decides to be paid back via (relatively) high interest rate (years from now) -- which makes sense if you're profitable but don't have a sensible exit -- or can choose to keep the stock, which makes sense if you're doing better than expected or if it's sensible that you could exit.

And yes some Angels are interested in a revenue stream, essentially a loan with high interest (due to high risk) and probably with some delayed properties (e.g. nothing paid in year 1, then ramps up or somesuch).

I actually started a VC-funded company that ended being profitable but not growing. Yes sometimes they just let it run -- which isn't a terrible thing, but if you're not growing you're dying, especially with corporate culture. In my case it was worse -- although we were profitable, we weren't going to hit that 10x over 5 number, so they shut down the whole company and gave our (profits!) cash to another startup (which never acquired a single customer).

You know, not that I'm bitter or anything. :-)

P.S. I know lots of angels and do a little investing myself, so contact me separately if you want to take this another step further.

It sounds like you have a good business, but one that is not appropriate for venture capital.

Don’t raise venture capital. Your business does not have the profile to generate the right return for a real venture capital fund. VCs are looking to fund businesses that can grow to fifty plus million dollars in revenue and that can be exited for hundreds of millions. Venture capitalists would typically choose to run a good small company into ground trying to turn it into a large business, even if it dramatically increases the risk profile of the business. It is how they make their money.

Secondly, I understand that you may need capital to grow your business, but raising $2 million for a company with the growth profile that you’ve described means you will likely have to give up a huge chunk of the business. Assuming your growth projections are good, if you only grow to $4 or $6 million in revenue, the investor will need to own a very large percent of your business to get a decent return. If I were you I would try to find a way to grow with much, much less capital. Of course, this is probably easier said than done!

So, to answer your original question – what would a VC do if you were stuck at $2 million in sales: A good VC would try to change the management team and find a group that could get the company to $50 million in sales. If this is not possible the VC would usually seek a quick sale of the company to a competitor to try to recover their original investment. Keep in mind that VCs purchase preferred stock, and in a liquidation OR very low priced sale they would likely get their money back plus some large percentage of the left over proceeds, leaving the founders with pretty much nothing. The mechanism for forcing an exit is the redemption clause in the stock agreement, which all good VCs get when making a preferred investment. The mechanism for getting the majority of the proceeds in a low value exit is the conversion clause in the stock agreement, plus (many times) a participation feature.

I’ve blogged about businesses that should not raise venture capital before: http://www.startable.com/2008/09/26/dont-raise-venture-capital/

If you take money but it's at a valuation that is high enough that the VC does not have a majority stake and you're lawyer is on top of things you should never be in a position where the VC can shut you down or make you sell against your will. Most VC's will want the right to stop you from selling or diluting them in ways they don't agree with but that's all the control they will really have.

The thing you have to remember is that when you take VC money you are really making a commitment to the VC's that you will get them a good return. Yes, sometimes it does not work out but you really have to try as best as you can to get them a good exit. If you're not willing to do that then you should not be taking their money. The option of just making it a good profitable ongoing business really goes away when you take VC money.

Because of this it's a much bigger decision that it appears. There are many people that think they will take VC money and figure out the rest later but once you take the money you've already made the decision that you are on your path to some exit.

My recommendation is that you run the business a little longer until you get a better feel for what you want long term. There are a ton of advantages to running a small profitable business in term of flexibility and fulfullment to the founders and employees. I would not rush into giving up on that.

Of course, a good VC would figure all of this out when you talk to them. They'd grill you right away about the exit, and what the plans were. About what their control would be and you would probably agree together that it does not make sense but not all VC's are good VC's and some invest when they should not.

I would really want to thank everyone for some great insight.

I will get back to you on this and get in touch with those interested, although it might take me another 3 to 6 months.

If anyone has more info on this, I would really like to hear it.

Thanks again and speak soon!

Regards,

Pierrot Altman (just a nickname!)

I agree with Dane and would just add that there is one other exit path that VCs do consider and that is a strategic sale. It is not quite the home run that an IPO represents but risk/return can still be attractive to them. However, whether this is an attractive path for you personally is an open question.