An exit is the key measure of a startup’s success. For founders, regardless of whether you’re mission-driven or financially-driven, your company’s IPO or acquisition demonstrates that you built something special. Similarly, for investors, success means generating exceptional cash on cash returns through liquidity events (M&A, IPO, or secondary sale).
In 2023, I began tracking startup exits in earnest after the announcement that MosaicML had been acquired by Databricks for $1.3bn. With Adobe - Figma called off, MosaicML was the most successful strategic acquisition for a venture backed company in 2023…at least so it seemed. After all, the acquisition price was over $1bn (a significant premium to the prior two funding rounds) and the time to exit was incredibly short (~3 years from company inception and <2 years from first fundraise). By all accounts, this should be a career-defining investment for anyone who backed the company. So what went wrong?
As a colleague pointed out, the fund math for Lux Capital, who led MosaicML’s seed round, didn’t make much sense. In short, Lux turned ~$10M into ~$175M, but only returned ~0.25x of their enormous early-stage fund. In other words, Lux will need to find 3 more MosaicMLs just to breakeven.
This case fascinates me to this day. If one of the highest profile strategic acquisitions of the last 2 years couldn’t produce a fund-returning venture outcome for investors, then what was the state of the rest of the market? What do exits look like for founders and investors in a down market and what lessons can be learned?
M&A
I first aggregated all the notable startup acquisitions of 2023, where “notable” is defined as a venture-backed company that 1) was acquired by a strategic and 2) had raised at least ~$10M in venture funding to-date. The following chart illustrates 50+ acquisitions from 2023, including information on the target, the acquirer, and the acquisition price. On the right-hand side, I included details on the most recent venture round prior to the acquisition as well as an estimated return for the lead investor in that round. It's worth noting that the estimated returns are directional in nature, and make several simplifying assumptions when necessary – i) dilution on latest round equals 20%, ii) announced fundraises were completed at a single valuation, and iii) acquisitions were completed in all cash.
Key M&A Takeaways
Mega M&A outcomes increasingly blocked by regulators: The Adobe - Figma acquisition would have been the most successful strategic venture outcome in 2023 had it not come under intense regulatory scrutiny in the UK and EU. The implications are clear – if you want to build the next important tech company, you should assume your only exit option will be to take the company public. Not only does this take away a significant amount of optionality (I would argue there exist many incredibly valuable businesses that can/could never go public), but there’s no guarantee that IPO markets will be favorable (or even open) should you build a successful company.
Estimated median IRR / MOIC for the most recent investors in businesses that completed strategic acquisitions in 2023 is upper bounded by 17% / 1.3x: This is a likely an overestimate, as most acquisitions did not report a price and were immaterial. In short, investors on average are barely (if at all) seeing returns on their investments that exited via acquisition in 2023. From another perspective, the average acquisition price needs to be >3.0x higher than what acquirers are willing to pay today in order for VC’s to achieve a typical return target of 4.0x.
Fund size matters: As noted earlier, the MosaicML deal was a spectacular deal for Lux, but only returned 1/4th of their latest early-stage fund, meaning they would need to back three more similar deals just to give their LP’s their money back, ignoring management fees. I ran through a similar exercise for other “successful” venture acquisitions. Coincidentally, these Seed/Series A deals had been completed by VCs with oversized funds and the math looked even worse.
Valuation matters: It feels like too many VCs have yet to grasp this concept - or at least they don’t apply it in practice. Looking at the above table, multi-billion-dollar exits still would not have returned some of these funds. What should be simple mental math is apparently absent from many IC and LP discussions.
Founders did slightly better than VCs, but its highly context dependent: In acquisitions with a large pref stack where the price is at a discount to the prior round, founders (and employees) likely struggled to capture value from the acquisition. This can be highly demoralizing. Imagine dedicating years building a company that’s valuable, but being unable to receive a financial reward for your hard work. However, in acquisitions with smaller pref stacks and higher valuations, founders will fare better than their investors. Furthermore, it’s worth noting that founders will often renegotiate meaningful economic incentives in excess of existing guarantees as part of the acquisition. The relationship between founder and investor is crucial during these processes. A good VC will work with the founder to reach an outcome that optimizes for everyone. Unfortunately, there are numerous horror stories where VCs work against founders’ interests (e.g., attempting to block founder-friendly deals).
Bad exits today have downstream consequences for future founders: Limited partners are likely to pull back their VC allocation, meaning less capital will be available for founders. Furthermore, VC’s may start avoiding industries (or stages) that struggle to produce fund returning outcomes. Industries like cybersecurity for example, where successful outcomes are significantly dominated by M&A (rather than IPO), may find fewer capital sources willing to invest.
IPO
The IPO market was largely closed in 2023. Instacart, Klaviyo, and Arm were the primary exceptions to this rule. For a brief period of time, their public offerings were seen as a sign that the IPO market for tech was finally reopening. Looking back, these proclamations were premature. Furthermore, for Klaviyo and Instacart, the two traditionally venture-backed companies, performance since IPO has been suboptimal with declines of 17% and 22%, respectively, as of 12/31/23.
Key IPO Takeaways
There are a number of IPO-ready companies unable to go public: Stripe, Databricks, Reddit, Chime, Klarna, Discord…the list of companies that have indicated or are rumored to go public “soon” goes on. It remains to be seen what is needed for a successful IPO market to return. If the public markets stabilize, interest rates are cut as promised, and a few early movers have strong public debuts, perhaps 2024 will shift the narrative in the way that people were expecting in 2023.
IPOs promise to generate liquidity, but not returns: As The Information noted, the Instacart IPO price was far below the implied share price of the numerous investors who backed the company after 2018. IPOs will likely give investors the opportunity to exit their investments, but for many this will still represent a loss.
Antitrust regulation may create a private market “dead zone”: A good rule thumb is that eventually the bad companies will fail, the ok companies will get acquired, and the great companies will IPO. But what happens if you’re a decent company? Too big to get acquired without a regulatory snafu, but too small (or perhaps growing too slowly, or associated with the wrong narrative, etc.) to produce a successful IPO? People talk about the number of “zombie unicorns” created in the ZIRP era, but no one talks about the companies that are better than the zombies but worse than the all-stars. In a world where the IPO market returns, but only tepidly, it’s unclear to me where, and when, these companies will find a home.
A Brief Note on the Secondary Market
The secondary market has been open and active. If you aren’t transacting shares of a high-flying AI company, the secondary market has been a buyer’s market, and there are too many unhappy sellers, several of which are looking to unload entire portfolios at significant discounts. As time goes on and the value potential of each private company becomes more clear, the Bid-Ask spread will narrow and I expect more (fire) sales to continue. However, a proper assessment of the secondary market likely requires a separate post and a lengthy deep dive into opaque data, so I’ll skip it for now.
Parting Thoughts
Throughout this post, I talk about startup exits through the lenses of different stakeholders – founders, VCs, and sometimes VC limited partners. If you fall into one of these camps, it may be easy to ignore the perspectives of the others. For example, founders often don’t spend their time thinking about VC fund math or how limited partners might react to the current exit environment.
But this would be a mistake. The VC – limited partner – founder relationship is symbiotic. All three stakeholders need to be happy for this ecosystem to thrive. As long as tech businesses require venture funding to scale (TBD whether AI changes this dynamic, but that’s a conversation for another day), any negative outcome for a stakeholder, whether investor or founder, is a loss for everyone.