Early-stage investors need to know how they'll get
a return on their investment in your company, and IPOs
aren't the answer.
What's a good exit strategy to propose to the investors
of your new venture? It's amazing how many entrepreneurs
are content to simply propose that the firm hopes to eventually
go public, at which time the original investors can realize
marketable value for their stakes in the firm. But that
response is perhaps the most generic and overplayed strategy
when it comes to formulating a plan for financing your
new business. The ratio comparing the dozens of IPOs in
the United States every year to the thousands of new ventures
launched is a minuscule percentage. Yet more than 70 percent
of all formal business plans presented to angel investors
and venture capitalists name "going public"
as the primary exit strategy for the proposed company.
And many of these expect that event to happen within just
four years from the launch date.
Let's start with the definition of--and rationale for--the
exit strategy. First, this provision in the business plan
outlines a method by which the early stage investors can
realize a tangible return on the capital they initially
invested in the venture. The entrepreneur spells out a
"reasonable" scenario by which a later round
of funds is expected to be raised, through which the stockholders
can sell their shares and realize a capital gain. Second,
the intent is to suggest a proposed window in time that
investors can tentatively target as the "investment
horizon" of their involvement in the early-stage
funding deal. The founding team wants to assure investors
that the venture will grow to a point whereby the initial
investors can cash out their stakes at a high return on
investment, given the significant risks they assumed when
they decided to fund the start-up.
The problem in projecting an exit strategy is you're
basing it on several major assumptions. The speed of market
penetration, the ability to sell at expected price levels,
the costs of doing business, the margins on sales, the
management team's ability to arrange consistent deals,
and the impact of competition and other economic factors
collectively affect the new venture's projected market
share and bottom line. Certainly, when these are all aligned
in the most optimistic configuration, the firm will experience
significant market share, consistent high-growth sales
rates, strong profit margins and positive earnings. And
such a scenario in the first two- to three-years is typically
the story told by firms that eventually go public.
But the overwhelming majority of new ventures are unable
to realize their most optimistic projections. So if an
IPO is no longer a realistic possibility, what other exit
strategies are available for early-stage investors? There
are four basic categories of exit strategies besides the
IPO, and these comprise the more typical ways that investors
get to cash out as the venture makes forward progress.
In order of occurrence, these are:
Acquisition. The venture initiates contact with
a large supplier, distributor or major competitor (perhaps
one with a more widely diversified product or service
line). The pitch is that the venture could add valuable
cash flow to the acquiring company once operations are
synthesized into the larger scope of operations of the
acquiring firm. At the close of the deal, the purchase
price buys out the original investors at a premium on
their initial investment. The deal is built on the premise
that the target needs the acquired firm to make the next
leap of growth. As such, the terms of the transaction
will likely be more favorable to the acquiring company.
But a fair sales price based on post-deal increased sales
and profits to the buyer should allow the original investors
to realize a good return on their investment.
Earn-Out. The venture begins to generate consistently
strong positive cash flow. The management team then initiates
a monthly or quarterly buy-back of investors' common shares
at a premium over the initial investment cost. Typically,
an earn-out can be accomplished over three of four years
and provide the original investors with a strong internal
rate of return (IRR) as company sales expand and costs
decline due to increased operating efficiencies. The purchase
price is often scaled upward incrementally over time,
as investors provide the luxury of "time" for
the management team to complete the deal.
Debt-Equity Swap. If the original funding was
through a loan (promissory note, bonds, mortgage-lien
financing), the founders can incrementally trade common
shares for portions of the principal on the debt. This
slowly reduces the interest due over time (as the face
value of the loan decreases), and also rearranges the
balance sheet as liabilities are eliminated and replaced
with equity positions. This "call feature" allows
the owners to decide at what pace--and at what price--the
debt is retired. If the firm is doing very well and has
prospects for being acquired at a premium, debt-holders
have an incentive to switch to equity positions.
Merger: Similar to the acquisition, in this exit
strategy, the venture initiates negotiations with another
firm, but this time the deal is based on mutual needs
and benefits. One firm might have strong manufacturing
capabilities and the other an excellent sales or distribution
pipeline into the market. The two firms might be doing
well in separate markets, and the deal will open up these
complementary markets to each company's products and services.
Whatever the rationale, the transaction will likely involve
cash changing hands to arrive at the new company structure,
and original investors can typically make their shares
available for sale to close the deal.
Remember, investors are very aware that you cannot guarantee
an exit strategy. But you can offer them more than the
wishful thinking that you'll make an IPO in three years.
By David Newton