There are two main ways in which a company can make an exit, i.e. offer a return on investment to its investors: an IPO (initial public offering) or a buy-out (acquisition)
In the case of an IPO, the company offers institutional or individual investors the opportunity to buy a share of the company on the financial markets. At this stage, the company becomes "public". In the tech world, this usually means that the company is now positioned as a market leader after several years of growth and success. An IPO is complex, time consuming and expensive and few companies succeed.
As for acquisitions, they are more common than IPOs and a good way to get a return on investment, regardless of the startup's stage of development. They can happen for many reasons. Team acquisition, merger with a competitor, bringing innovation to a larger company etc. There are many other reasons why a company gets acquired and these acquisitions also allow investors to see their money again.
Waterfall Model and Return on Investment
In investment, a "waterfall" refers to the order in which investors are repaid after a small exit. This means that returns are lower than the amount raised over the life of the company. Typically, repayment occurs in this order:
- First, to the holders of the debt, such as banks and other lenders (suppliers of risky debt fall into this category)
- Second, to the preferred shareholders, i.e. outside investors such as business angels and venture capitalists
- And finally to the ordinary shareholders, the founders and employees themselves.
Most of the time, when a company has a profitable exit, the preferred shareholders convert to ordinary shares. This is called conversion on an individual basis. Once everyone owns common stock, they get a return on their investment based on the share of the company they own.
Return on Investment
Returns on your investment are often expressed in multiples. Let's say you invest €20,000 in a start-up, which sells for €200 million a few years later. You ended up owning 0.25% after all the other rounds, so you got €500,000. That's 25 times your initial investment. That's an incredible result. A return of 10-50x or more is considered a win for a business angel.
Carried" or "carry " interest
Typically, investors earn money on the percentage of the company they own - for example, by taking 1% of the startup's sale price if they own 1%. A new compensation mechanism comes into play when syndicates or venture capital funds are involved, called "carried interest" or "carry" for short.
Carry interest is expressed as a percentage of a profit. If you are making an investment in a business angel syndicate, there will probably be a business angel lead who typically takes 15-20% carry to do the majority of the work of sourcing, evaluating and investing.
Carry is only relevant when a company has made a successful exit or is starting to repay investors. Think of it as profit sharing. The first step is always to repay investors in full (see the section on stunts above). Once the company has repaid the investors, the carry comes into play. In syndicates, funders pay carry in advance for any profitable investment. It is a reward for doing the right thing.
Let's take a concrete example: Let's say you are a syndicate leader who has backed an investment in a start-up company and you get a 15% carry. You lead a syndicate of €100,000. The company sells for €100 million after raising €25 million. You hold 5%. Your profit is €4.9 million (the €5 million being your 5% of the sale, minus the €100,000 initially invested by your syndicate). 15% of that €4.9 million (€735,000) goes to you as lead manager; that's what you carry. 80% of that €4.9 million (€3.92 million) goes to your backers, split according to how much each of them has personally invested.