Why Your Cannabis Business Needs an Exit Strategy Even Before You Enter the Marketplace
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- Selling to a strategic buyer
- Selling to a financial buyer
- Going public (IPO)
You should be thinking of these options so you have a clear definition of the type of business you’re building so investors will be interested. Many entrepreneurs lose sight of the fact that they’re an investor in their business just like anyone they seek capital from would be. At some point in time, you made the decision to invest your time, experience and likely your own capital to pursue building your company. So why did you invest in your business? And why would you be confident that the risks you took are going to pay off for you and all the investors over time?
This is where an exit strategy for the company influences an investment decision. Is there sufficient ownership for the capital that’s at risk to produce an adequate return? How you perceive the business providing liquidity for investors (dividends, M&A exit or IPO) will influence the value at which the investor is willing to invest. At the end of the day, investors have options on where to place their capital, and if they invest in your company, they’ll expect to see a return for their investment.
Having alignment with investors is imperative for informing how you’ll build the business together. When you set out to build your company, you had a desired outcome in mind and, most likely, that was to create wealth. Your investors will likewise have a desire to create a return.
Professional investors will articulate the future success of the business through a desired exit strategy. They ultimately want to translate the value created within the company at some point in the future and distribute that value back to the shareholders, thus creating liquidity for their investment. Private companies don’t have liquidity for their shares like companies on a public exchange do, so the investor returns are calculated on how likely it is that the business will be sold or otherwise have excess cash that can be distributed back to the shareholders.
Why do investors focus on a liquidity event, and what does that mean to you and your founding shareholders? Investors will contemplate what the potential for a return on their investment is very early in the process and continue to evaluate this during the due diligence phase. Many factors come into play, such as economic conditions, market trends, regulatory changes, changes in the competitive environment, financial markets, etc. These may impact your company positively or negatively, making forecasting investment returns very difficult and full of uncertainty.
Many investors do, however, set an expectation for what they want to achieve in terms of the return. For example, you may hear an investor state that they’re looking for an eight-times return on investment. They’re taking into consideration the high risk and lower success probabilities of investing in a private company and are stating that they expect eight times their original investment. The reason for making these types of risky investments is that there’s a probability that the return generated will outperform other investments and produce an outsized return.
Returns for private company investments are traditionally viewed in terms of the total return compared to the initial outlay of capital. In addition, the return potential for any single investment can also produce a return that can cover other losses in a portfolio.
For example, an investor has two investments in a portfolio that each required $1 million investment. Company A goes out of business and produces a loss of $1 million. Company B gets sold and produces a return of 4 times the investment, or $4 million. The combined basis for this portfolio is $2 million and the combined return is $4 million. The portfolio then returned two times the investment, which includes the Company A loss.
A word of caution for entrepreneurs: It’s critical that you can speak the language of exits and return calculations, but your job isn’t to do the work of the investor and create calculated investment return expectations for them. In fact, it’s not advisable to present to investors any expected outcomes on their investments.
Many pitch decks will mistakenly show some calculation for how the investors will make money on their investment — this is almost always a bad idea. It’s guaranteed that things won’t work out as everyone thinks they will from day one of the investment, and if you put in writing some target goal for a return on the investors capital, you run the risk of being held accountable for those projections in the future. You don’t want to be in a situation where your shareholders are upset in the future because you didn’t end up realizing the return you promised up front. The way to address this is to share that the company will be looking at a specific exit strategy at some point in the future and that “management believes” there will be a suitable buyer or IPO within some range of times.
Related: How Risky Is Your Cannabis Business?
I’ll remind you again to acknowledge that you are your first investor and there’s no right or wrong strategy if you really believe you can achieve the stated results. The worst thing that can happen is that you’ll state something for the purposes of appealing to an investor and you both go into the investment with misaligned expectations.