Why do investors ask about this?

By John Paul
important aspect of raising capital that investors usually focus on, but many entrepreneurs just don’t understand.

I first shared this lesson about two years ago, but as my mailing list gets larger this question keeps coming up.

I think today is another opportunity to address this very important topic.

The most recent version of this question is from Thomas, who’s based in Arusha, Tanzania.

Here it is:

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"Hi John-Paul,
How this 26 year old trader went broke

Thank you for your valuable Friday lessons.

My question is about exit strategy. It’s a common question/requirement I’ve noticed from the investors I started approaching after I completed your free course.

So, when an investor asks: “What is your exit strategy?” what do they mean?

I’m not sure why they ask this because my business is my passion and I’m not willing to leave it at any time.

Your explanation here will be appreciated.

Thank you."

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Again, thank you for bringing my attention to this important point, Thomas.

Because you bothered to ask, thousands of people on my email list will have the opportunity to truly understand what an exit plan is, and why it’s important to investors.

So, what is your exit plan?

When a potential investor asks you this question, what does he/she really mean?

What the investor really means is: “When and How will I get my money back?

Remember, except you're asking for a freebie (grant, donation, etc.), most investors are only interested in giving you money because they expect to get that money back, including a return or profit on their investment.

And in the case of banks and professional investors like venture capital, angel investors and private equity investors, exit plans are VERY important.

These professional investors need to know the exit plan because they need to pull that money out of your business and invest it in other businesses that need the money.

They don’t expect to keep their money in your business forever. That’s why they need to know WHEN and HOW they will get their money back.

So, when an investor asks about your exit plan, here’s what he’s thinking:

If I invest this $50,000 in this young man’s business, when will I get the money back, and how much return can I make on top of this investment?

And the only way the investor can answer this question is to ask you.

If you’re clueless about the exit plan, then it means you’re not even sure if and when the investor could get his/her money back.

Now, when it comes to exit plans, there are 5 major options you have to help an investor exit your business.

I’ll discuss each of them here so you fully understand which one best suits your situation.

Option 1: A stock market IPO

An IPO means an Initial Public Offering.

It’s a term used to describe the first time a private business becomes publicly quoted on the stock exchange.

Almost every country has a stock exchange. It’s the place where anyone can buy shares in any company, as long as it’s quoted on the exchange.

In most developed countries, a stock market IPO is the traditional and most common exit plan for investors.

An IPO is an opportunity for early investors in your business to sell some or all of their stake in your business to new investors

For example, when Facebook did its IPO in 2012, it was an opportunity for early investors in Facebook to reap the returns on their investment.

Peter Thiel was one of the first investors in Facebook. He invested $500,000 into the company in 2004 for a 10% stake.

When Facebook did its IPO, it was an opportunity for Mr. Thiel to exit most of his investment plus the massive returns he made.

He made over $1 billion from that exit, just 8 years after he gave Mark Zuckerberg $500,000.

But if you’re in a developing region of the world, like Africa, stock market IPOs are not yet so common for a range of reasons.

Option 2: Sell all or part of the company

Let’s say an investor gives you $100,000 for a 15% stake in your business.
In 5 years’ time, another investor may be interested in investing in your business because they like the potential of the business.

Let’s also say this new investor wants a 15% stake in your company too.

But this time, 15% of your company is now worth $500,000.

This could be an opportunity for the first investor who gave you $100,000 to exit the business. That first investor can sell his own 15% stake to the new investor.

Under this arrangement, the old investor exits the business with $500,000 and you get nothing.

But if the new investor wants a 20% stake instead, then you can sell him 5% from your own stake and keep the money, or re-invest it in the business.

There are also scenarios where you sell the whole company and exit with all your investors.

Option 3: Buy out the investor

A variant of Option 2 is to buy out the investor instead.

In the future, based on the performance of the business, you can buy the investor’s stake using cash from the business.

Most times, the buyout price is negotiated in advance, or it could be agreed at the time the investor is ready to exit the business.

Option 4: Phased or periodic payouts

Let’s say an investor decides to invest $150,000 in your business.

An exit plan could be to pay back the investor $50,000 every year for the next 5 years.

That means they get a total of $250,000 which includes a $100,000 return on their initial investment.

Another variant of this option is to pay the full $250,000 in bulk in 5 years’ time.

Under this arrangement, the investor knows how much money they’ll be getting, and the business has freedom to grow without the burden or pressure of paying out money every year.

This option works for both equity investments and loans.

Option 5: Dividend payments

Some investors may not really have a strict deadline for their exit. They may just be okay with dividend payments.

So, let’s say an investor gives you $100,000. She may prefer that you pay her a 10% dividend on her investment every year.

That means, every year, you will be paying $10,000 in dividends. And this amount is totally separate from the initial investment of $100,000 which can be realised using any of the other options listed above.

This dividend arrangement is similar to the interest you pay on a bank loan which is separate from the loan principal.

One more thing…

Now that you know what exit plans and options are, you need to be really careful before you commit to any of the options described above.

If you’re going with Options 3, 4 or 5, for example, you need to be sure your business can actually afford the amounts you are promising.

If you promise a 15% dividend payout, or commit to buying out an investor in 3 years’ time, you need to be sure the cash flows from the business can support that promise.

But what I usually recommend is that you propose 2 or 3 different exit options to potential investors and let them decide which works best for them.

However, I can guarantee that they will be quite impressed that you have thought about exit strategies, which is quite rare among inexperienced entrepreneurs.

As I always say, you should always think like an investor if you ever hope to get his/her money.

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