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Five Year Plans and Exit Strategies

Friday, May 25th, 2012 | Posted by Jon Kolko

Some of my students had a chat with a prospective investor regarding seed capital, and the conversation turned to five year plans and exit strategies. They had neither. I realize it’s mildly heretical, but I don’t think either are valuable tools for social entrepreneurs. Here’s why.

A five-year plan is an artifact of large-scale “traditional” venture capital, and is – at least for the recipient of the venture money – a completely arbitrary time horizon. For the VC, however, it’s a critical length of time. Rob Day, of Black Coral Capital, explains the mechanics of how this works in a great post (forgive the long excerpt, but it really nails it):

The time from initial investment to exit typically has to be 5-7 years at MOST — preferably much less. Factor into the equation that an exit is most likely only going to come once a company has significant and growing revenues, and not when the technology is simply brought to market, and very quickly the VC’s decision-making starts to be clear… the reason for the 10 year fixed life of VC funds is not only because of the LPs’ needs for liquidity, but also because of the time value of money.  Discount rates (not that they’re often used in the industry, but still…) are really high for venture capital investments.  That reflects the high risks associated with launching any new business, along with the high expected returns of the asset class… a VC who knows that the technology in question should work (there’s rarely any “science risk” associated with an internet startup, after all, just market and execution risks) expects to achieve a minimum 40% IRR at least 35% of the time. What I just explained is where the oft-mentioned “5x” (or in other words, “we look for investment opportunities that we think will at least grow to 5x our initial investment”) comes from in venture capital. Because if you return at least 40% IRR over 5 years on a million dollars, you’ve turned it into $5+mm.  If you do that with the kinds of success rates Fred Wilson talks about (let’s say 35% 5x investments, 35% 1x investments, and 30% wipeouts, to vastly oversimplify), you will have returned 17% per annum, not including the management fees, etc.

This speaks to the unique perspective of both parties in the venture equation. Say you are a startup looking for money. Your focus is, predictably, on yourselves and your prospective investor:

But their focus is on their LP’s (limited partners – the people that put the money into the fund in the first place), and on maximizing their return:

And, their focus is on hedging their risk across a number of investments:

The “five year plan” theoretically gives them a view into your likelihood of returning the magic 5x return. But while you’ll write your five year plan from the small, focused perspective of your own company, it will be considered by the funder in the context of all of their other investments.

The (until recently – .pdf link) unspoken joke is that the VC typically doesn’t actually generate the return they expect for their LPs, and I’ll argue it’s because predicting market dynamics five years out is, on a broad level, easy enough to prove useless, and on a detail level, impossible.

Consider that five years ago (May 2007):

  • The billion dollar company Instagram didn’t exist, and wouldn’t exist for three more years
  • George Bush was still president
  • The “global financial crisis” was just beginning
  • iPhone 4 hadn’t been released yet
  • Justin Bieber hadn’t been discovered yet

Back in 2001, I worked at a company that was first called allmystuff, and later reinvented as Contextual. The company raised about 11M from Dell Ventures, TL Ventures, Austin Ventures and AV Labs. The money was raised in October, 2000, and the board voted to close the company in March, 2002. The five year plan didn’t include two planes crashing into buildings in New York.

I’m not arguing that “black swan” events should preclude entrepreneurs from trying to plan and strategize. I’m arguing that, for a brand new business, any quantitative metrics tied to activities outside of a four-month window are completely made up, and I think most people know that. But we go through the process of the five-year plan because the VC asks for it, because they’ve always asked for it, and maybe, because it makes them feel like they are Doing A Good Job.

Fred Wilson from Union Square Ventures has said “Start-ups should be hunch-driven early on and data-driven as they scale.” I completely agree, and at a stage where an entrepreneur is asking for seed money, scale should be about the furthest thing from their mind. The five year road map is a distraction, and when someone asks for one, it should remind you of their intent: 5x, five year return, and a broad focus across their portfolio. You’ll be but one drop in a much larger bucket.

The other side of the coin is the “exit”. An exit implies a large liquidity event: an IPO or an acquisition. It’s how the funders get their money out. An “exit strategy” is the plan for the monumental event that will occur in approximately five years. For design-led social entrepreneurism, the idea of an exit reinforces the problems of design tourism: that you’ll fly into a problem situation, move some post-its around, and solve homelessness. But as I’ve written about before, wicked problems demand a long-term focus and an emphasis on depth. The entire idea of a timeline, as rational as it may be for things like budgeting and resourcing, doesn’t make a lot of sense. Instead of pursuing an exit, I encourage my students to pursue a stay-the-course attitude. It requires dedication and patience, and that’s intimidating and scary. But I just don’t see society making progress on these large, consequential issues in short bursts.

Stop worrying about exiting and planning a five year strategy. Start focusing on impact, today.

 

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