Investors’ exit expectations: What entrepreneurs need to know

Many would have come across this humour that did the rounds in social media. A zoo where the entry price was traditionally modest, the licensee came up with this enterprising idea to increase collections. Free entry was announced to the zoo for all on a public holiday. The zoo was bursting at the seams with the holidaying public, all the entry gates would be closed. An announcement was made that wild animals would shortly be released from the cages and the exit gates would be opened only to those willing to pay a heavy price! It would not be difficult to imagine the stampede such a situation would have caused.

This, to some extent, reflects the plight of investors who invest in ventures in India. Easy to get in, but arduous to exit. Esoteric valuations in further rounds can boost the egos of venture founders and existing investors, but investors can see the real money only when they exit. If the prospects of exits are dim, the music will stop and that is not good news for founders.

The topic of exit has two parts to it: the first is time to exit and the second is returns realised at the time of exit. Given the closed ended nature of many of the venture funds, the time to exit is equally important as the returns at the time of exit. In this article, I highlight key factors that entrepreneurs need to be aware of in terms of the exit expectations of investors.

Mean duration

Duration is the time taken for an investor to get an exit from the time of investment. The average exit duration for all VC investments in India has been 4.55 years. If we look at the exit duration for different sectors, we can see interesting trends. First, venture capital flow is dominant in those sectors where the exit prospects are brighter. Start-ups in the software and internet services category at close to 25 per cent constituted the highest percentage of the total companies that have given an exit. This explains why this sector has received the highest amount of venture capital. Fintech and payments, and consumer products and services stand second and third, respectively. Together these three sectors contributed to more than half of the total. Edutech, hyperlocal and logistics, internet marketplace and e-commerce, and media, advertising and gaming accounted for only around 10 per cent of the sample.

Second, the average investment duration between sectors does not differ significantly, though the maximum duration of investment varies widely between sectors. While founders might think that specific characteristics of their sectors may demand higher gestation periods for investment, the investors by and large push for an exit timeframe that is line with the industry average. The implication is that, irrespective of the sectors, the expectation of investors on investment duration is fairly homogeneous.

Investment duration

Has the average duration for exit changed over time? The number of companies receiving investment has increased, and so has the number of companies providing an exit. However, the plot between year of investment and exit duration for investors shows a clearly visible declining trend.

This shows that investors have been able to get quicker exits in recent years. But when we plotted the year of exit against average investment duration, apart from a slight decrease during 2004-10, the average duration for exit was around five years.

These results indicate a contrasting pattern – viz., while the investors have been keen to accelerate their exits, the duration to realise exits have not changed much over the years. If not, it has only slightly increased in recent years. The inference is that there is more pressure on entrepreneurs to provide quicker exits for the investors, in an environment where exits have been increasingly difficult.

Summary

Prospect of an exit is an important criterion in investment decision making in venture investors. The ability to provide an easy exit is dependent on so many factors such as the industry, market fads, the performance of the venture. Start-up founders should clearly highlight the exit possibilities to be able to get venture investment successfully. While it fructifies or not is a different story, the fact that the entrepreneur knows that this not a made for each other partnership for ever gives a lot of comfort to the investor.

The writer is a Professor at IIT Madras, an Associate at Harvard Kennedy School, Harvard University and co-founder of YNOS.in