Venture Capital | Part 7/7: Exit
Now your investment has been made, and business has grown, and it’s time to reap what you had sown. This is the most exciting part of it for a VC, because this is where everyone on the team that made the deal gets a carried interest (i.e. a huge payout on the money the fund has made with that investment) — and who doesn’t love that!
Exits can happen in different ways, and one of the key ways this happens is through the secondary market.
What is a secondary market?
A secondary market is any financial market in which investors buy and sell securities (such as stocks or bonds) that have already been issued by a company. It is “secondary” to a primary market, where securities are issued and sold directly by the company. In other words, when the initial purchaser of a stock sells that security to another investor, the security moves into a secondary market.
1. Mergers & Acquisition
Mergers and acquisitions (M&As) are the most typical way for venture-backed enterprises to leave. Companies constantly combine and acquire one another.
Most VC exits (especially in recent years) are realized when portfolio companies are acquired by larger, often public, cash-rich companies. In an acquisition, one company buys another, taking a controlling stake of its share and the rights to the assets.
In a merger, two companies are combined, each being treated more or less as an equal. While combinations called mergers happen all the time, they are rarely actually mergers of equals. Even if the financial structure portrays a picture of two equal companies being combined, one of the two parties typically takes control of the other in one way or another.
(Side note: VCs have a strong preference for selling portfolio companies for cash, rather than shares of the acquiring company because the value of the buyer’s shares can change over time and reduce the effective purchase price.)
- It is the easier and less expensive alternative to going public.
- The buying company may want to increase their geographic footprint, eliminate competition, or acquire talent, infrastructure or product.
- Business owners can maintain control over price negotiations and set their own terms, and entertaining multiple bids may be able to drive the price up even further.
- Owners often continue to work as administrators or advisers after an acquisition occurs — this can improve handoff and continued growth and experience.
- M&A processes can be time-consuming and costly, and regularly fail.
- When a startup is acquired, it must give up its larger aim of becoming its own major, public corporation.
- M&A aspects require complicated activities such as evaluating businesses and arranging stock purchases.
- The purchasing company may dramatically restructure the acquired business. As a part of the restructuring process, companies can lose their identity.
Think of an IPO as the end of one stage in a company’s life-cycle and the beginning of another — many of the original investors want to sell their stakes in a new venture or a start-up.
An initial public offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance for the first time. An IPO allows a company to raise equity capital from public investors.
An IPO is a new round of equity financing, similar to any previous Series A, B, or C round: new shares are issued at a specific price. These shares will divide present owners, but the total valuation of the company will increase as a result of the offering.
Key IPO Terms
Like everything in the world of investing, initial public offerings have their own special jargon. You’ll want to understand these key IPO terms:
- Common stock — Units of ownership in a public company that typically entitle holders to vote on company matters and receive company dividends. When going public, a company offers shares of common stock for sale.
- Issue price — The price at which shares of common stock will be sold to investors before an IPO company begins trading on public exchanges. Commonly referred to as the offering price.
- Lot size — The smallest number of shares you can bid for in an IPO. If you want to bid for more shares, you must bid in multiples of the lot size.
- Preliminary prospectus — A document created by the IPO company that discloses information about its business, strategy, historical financial statements, recent financial results and management. It has red lettering down the left side of the front cover and is sometimes called the “red herring” or “DRHP”.
- Price band— The price range in which investors can bid for IPO shares, set by the company and the underwriter. It’s generally different for each category of investor. For example, qualified institutional buyers might have a different price band than retail investors like you.
- Underwriter — The investment bank that manages the offering for the issuing company. The underwriter generally determines the issue price, publicizes the IPO and assigns shares to investors.
- An IPO, or initial public offering, as an exit plan offers the highest return potential for the rare company that has the ability to evolve into an industry leader, producing steadily expanding sales in excess of $50–100 million per year.
- This increases the company’s exposure, prestige, and public image, which can help the company’s sales and profits.
- Other avenues for raising capital, via venture capitalists, private investors or bank loans, may be too expensive.
- The company gets access to investment from the entire investing public to raise capital.
- IPOs can give a company a lower cost of capital for both equity and debt
- Attracts and retains better management and skilled employees through liquid stock equity participation (e.g., ESOPs)
- Gives them the opportunity to raise additional funds in the future through secondary offerings
- IPOs are expensive, and the costs of maintaining a public company are ongoing and usually unrelated to the other costs of doing business.
- The company becomes required to disclose financial, accounting, tax, and other business information. During these disclosures, it may have to publicly reveal secrets and business methods that could help competitors.
Buybacks in Venture capital usually take the form of a liquidity event — Conversion of an illiquid asset (stock in a business) into a liquid asset (cash).
Management Buyout (MBO)
A management buyout, or MBO, involves the purchase of all or part of a company by its existing management team, usually with the help of external financing. In most cases, the management team takes full control and ownership of the business and the old owners retire or move on to other ventures.
The most common reasons for an MBO are:
- The old company ownership wishes to exit the business.
- A parent company wishes to divest itself of a subsidiary or a business division.
- The company is in distress or has gone into receivership, but still has potential.
- The management team perceives greater business opportunities under new ownership.
- A management buyout indicates minimal disruption and a continuation of ‘business as usual’
- It eliminates the time-consuming task of finding a trade buyer, reduces the due diligence time and speeds up the transaction.
- There’s no need to approach competitors and disclose sensitive or proprietary information.
- They can leave the company in “safe hands”. (Which can be important when the seller has a strong emotional attachment to the business).
- For managers wishing to buy, an MBO gives them ownership of a business they already know. This removes the uncertainty of a start-up, and the risks associated with the purchase of an unknown entity.
- Because the buyers in an MBO are already closely associated with the company, their continued presence can be soothing to existing customers, partners, vendors, and employees.
- An MBO protects sensitive and proprietary information.
- Private secondary markets tend to be more opaque, less accessible, and less liquid than public markets.
- Trades occur less frequently
- In situations where a company is being sold from distress or administration, funders may question the role of the management team in the company’s performance.
- The transition from a managerial to an entrepreneurial position can be challenging for some buyout teams.
- The lack of a centralized marketplace and public disclosures makes price discovery more difficult.
- Having fewer participants in a non-centralized secondary market makes it more difficult to match supply and demand
Other types —
A Buy-In Management BuyOut (BIMBO) is when an outside management team joins a company (buying-in) while also buying out the existing management team.
A management and employee buyout (MEBO) is a corporate restructuring initiative that occurs when both management and select employees join together to take over an existing firm.
A smaller and similar way to do this is a stock buyback. Stock buybacks are a win-win exit strategy for both startups and VCs. A stock buyback occurs when a corporation purchases stock from an angel or venture capital investor. In this exit, the VCs receive their funds directly from the firm rather than through new investors in an IPO or another company in an M&A.
Apart from all these strategies that are mostly positive, one also has the option to just stop funding the company if things don’t work (bankruptcy, etc.) Usually, these terms are decided upon previously and is a sad, sad state of affairs with the goal of just cutting losses and moving on.
This draft is part of a 7-piece series focusing on the inside of the VC industry. It is told by a current VC associate, to help entrepreneurs lift the curtain. The goal is to learn to raise better by speaking the language and giving VCs what they look for. It will include —
- Sourcing | Where good founders like to work, play, rest
- Pitch Deck | What we look for in Ideas
- Initial Meeting | What do we look for in People? On Founder Market Fit
- Due Diligence | How Heavy is the Past? — Data in VC, Financial analysis of VC firms
- IC | The Art of Making Good Decisions
- Deploy | Term sheets
- Exit | Ways to do it