There are many ways to move on from the start-up phase. Some deliver a better return than others, as is explained in our fourth article in our venture capital series.
IT’S time to talk about the end. In previous articles, we discussed assembling a team, building a technology business, and financing it with investment capital. That’s the fun part of entrepreneurship, but inevitably your venture needs to grow up. To do so, it needs to leave the start-up phase behind and, more likely than not, deliver an economic return for its stakeholders. In this article, we will talk about the concept of an exit, methods of achieving it, and the motivations of players involved in the process.
First of all, why would anybody want to “exit” the business they have diligently built over so many years? Isn’t that a bit defeatist? To answer this question, it is important to understand that the term “exit,” in the investment world, does not refer to people leaving the company. That might happen under a few possible scenarios, but investors are really talking about capital rather than people. And capital does need to exit in order to provide a return to investors and to compensate employees for their considerable efforts at salaries that are usually below market. Of course, many a founder will also be tempted by the lure of a bit of cash in their pocket. Exits are therefore about turning intangibles into tangibles – stock into cash.
There are many ways to achieve an exit for your venture: acquisitions, asset sales, mergers, initial public offerings, talent acquisitions, and so forth. And for each of those outcomes there are countless strategies but few consistent rules. The latter is a limitation of the start-up environment. Starting a new company is really hard, and achieving a successful exit is even harder. Thus, there are only a very small number of people who have serial exit experience and practically nobody has lived through enough exits to speak with statistical authority about “exit strategies.” The possible exceptions are fund managers and serial angel investors who might have seen quite a few exit deals, but mostly from the sidelines as, at best, advisors to the executive team.
Despite these limitations, there are some common observations about exit strategies to guide aspiring entrepreneurs on their journey. In this article, we will talk about the different types of exits and the motivations of the sellers. We will also share some tips toward realizing a satisfying deal.
As mentioned above, there are many exit scenarios, but some order can be found by arranging them in increasing value stages – much like the valuation steps discussed in the second article of this series on fund raising. From lowest to highest value – at least generally – we have the following exit types:
Most start-ups fail. So, regrettably, the most common exit is simply the dissolution of the business. Your creditors, including possible venture debt holders, will auction off your assets and the credit-card companies will take whatever is left. Dealing with a failed venture is a topic all by itself, but in the context of this article there isn’t much further to be said about this exit type.
It gets a bit more interesting if your assets are worth a meaningful amount to a buyer.1 For technology ventures, that almost always means that a larger company would like to own your intellectual property without the hassle of buying the entire business. Often that is bad news for the seller, but an asset sale can be a success if the investment has been small so far. Good-quality patents can fetch hundreds of thousands of dollars each, so a small venture can have a successful exit after a modest seed round just by selling its patent portfolio (assuming it has one; this is more common for university spin-offs that start with a lot of patents but without significant financing). Asset acquisitions can also come in the guise of licensing deals, especially in industries like ours where a few big titans do all the manufacturing. An exclusive license paid by a lump sum is nothing but an asset acquisition by a different name.
One step up the value ladder is team acquisitions, often called acquihires in venture jargon. The buyer sees a high-quality team, possibly even with some relevant intellectual property, and wants to bring it all in house. This form of bulk hiring has become quite popular in competitive labor markets such as Silicon Valley, where Google, Facebook, and other tech giants routinely hire teams of 5–25 talented engineers under the guise of an cquisition. The employees and founders get continuous employment and possibly a small bonus, though most of their stock options are usually transferred to their new employer to ensure that they remain “locked in” after the acquisition. Investors usually make a small return, mostly to convince them to support the deal and waive the non-competition restrictions imposed on employees by the original company (this being the principal reason why the buyer cannot just hire all the staff individually).
Serious money starts to flow when the buyer sees strategic value in the start-up – witness the recent acquisitions of Instagram by Facebook and Tumblr by Yahoo for a billion dollars each. Strategic acquisitions of course also happen at lower price points, but all of them inflate value significantly above the tangible value of the assets and team. This intangible value boost, called “good will” in financial terms, represents the benefit that the buyer gets from the integration of the acquired business. Often these are just economy-of-scale benefits where the manufacturing or distribution capability of the buyer allows much higher value creation than the acquired venture can deliver on its own. Examples of other motivations for strategic acquisitions include elimination of competitive threats, protective intellectual property arrangements, accelerated time into a new market, and even branding exercises (the acquisition of Tumblr by Yahoo was arguably a successful $1 billion marketing campaign to signal that Yahoo is “hot” again). Strategic acquisitions, if timed right, maximize the value of technology and hustling while not yet incurring the risks associated with traditional business execution – thus representing by far the most numerous of the successful exit outcomes for technology start-ups.
Revenue Stream Acquisition:
Some start-ups plunge into the world of traditional business execution, succeed in doing so, and actually turn a profit. Such companies are great opportunities for private or corporate equity investors who prefer to leave the execution of the business to the current team. They might integrate some aspects or shuffle the management a bit, but in essence they are acquiring a cash generator. For these deals the buyer will generally estimate the economic value of the business based on some form of discounted cash flow (i.e., an estimate of how much profit the company will be making over the next 5–15 years, with appropriate discounts for risk and time value of money). Good private equity investors might also bring additional value to the company, but in essence this exit option is an exchange of current cash for more future cash. This works because of the time asymmetry of the involved parties. People age, corporations do not – so an offer of $10 million today for a business that stands to generate $20 million over the next decade might very well interest a founder while leaving plenty of upside on the table for the new corporate owner.
Initial Public Offering:
During an initial public offering (IPO), the existing shareholders of a business sell some or all of their stock to the public – often represented by pension funds and other aggregators of public capital. This is the pinnacle of venture success – at least in current start-up culture. Once the bell rings, there are usually massive returns for investors, riches and ongoing employment for staff, and the status of modern-day saints for the founders. Unfortunately, IPOs are also by far the least likely outcome for start-ups due to the very high hurdle of needing massive revenue and/or broad public market hype. Moreover, a company will have ceased to be a start-up – in the sense of questing for a sustainable business model – long before the IPO formally recognizes this graduation with the imposition of regulatory and stock market pressures. Still, it remains an aspirational goal for many start-up founders.
There are numerous variants to the above exit types, but all exits have in common that shareholders have turned their intangible equity into tangible gains and that nothing will feel the same after the exit for any stakeholder. The magnitude of the former and impact of the latter mean that acquisitions become complex emotional affairs even before a buyer comes to the negotiation table.
The type of exit encapsulates the motivation of the buyer, but what about the motivation of the seller? The three principal stakeholders of a start-up – investors, founders, and employees – usually have a shared motivation to reap an economic reward for their labors, but the timing and price that they might be willing to pay for this reward varies considerably. So, the first step toward an exit strategy is to understand the goals and motivations of your own stakeholders.
At first glance, investors have the most straightforward motivation – as much cash as possible for their investment. The story gets a bit more complicated when the dynamics of their investment fund are taken into account. In the last article, we looked at the compensation dynamics of venture capital fund managers and the way these can warp their economic perspective. This leads to a situation where the desire to generate significant cash is influenced by timing factors. Venture capital partners need to invest money and receive a return on that money in the time frame of their funds. On the investment side, they are constrained by the need to invest all the capital of their fund into a relatively small number of companies, as shown in “VC Investment” below. This situation creates considerable pressure for the VC, which will inevitably bleed over onto the company.
On the front end of the timeline, VCs generally dislike exit opportunities that occur before they have a chance to invest most of their capital into a venture – even if the opportunity itself might be quite lucrative (e.g., an early exit offer might yield a 10× return on investment, but if the VC has only put in $1 million so far – out of a $250 million fund – then this just does not move the needle for them even if it might mean many millions for the founders and employees). Founders ignore this aspect of VC dynamics at their own peril. A boardroom drama that frequently occurs is an excited CEO presenting a great acquisition offer that would make everybody rich and even keep all the employees in the business – only to be reined in by the VC. Of course, the VC is not going to flat-out say that the deal doesn’t make him enough money. Instead, the typical response will be to paint the founder as a sellout who does not want to build a billion-dollar company (i.e., one that can absorb a big chunk of money from the VC first…). In fact, this story line has become so much a part of start-up culture that few people understand the underlying self-serving interest anymore.
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A typical 10-year VC fund might have five partners and $250 million under management for a 5-year investment period. In other words, they need to invest $250 million into companies in the first 5 years of their fund and then return a decent multiple on that money in the second half of the fund’s lifetime.Each partner can credibly sit on five Boards of Directors for their portfolio companies, so in the first 2–3 years, they will want to make about 25 investments – each capable of absorbing $10 million over its lifecycle (e.g., a company might take $1 million as part of a Series A financing in the first year, another $3 million as part of the Series B a year later, and finally $6 million in the Series C growth round toward the end of the fund). Of course, some of these investments will fail before reaching the larger rounds, so the ideal investment opportunity for this example fund would be a venture that approaches them in the first or second year of the fund, takes $1–2 million then, and has the potential to take $10–$20 million if it reaches a Series B or C stage (more money than average to compensate for the failed ventures that did not take the full capital reserved for them).
Founders are not subject to the economic peculiarities of the venture capital model, but that does not mean that they do not have an agenda. It is just that theirs is usually driven by ego rather than economics. Most founders have to ask themselves at some point during their start-up career whether they want to be Caesar or Croesus – undisputed ruler or unimaginably rich. Start-ups offer a chance to become both, but not really at the same time. A desire to be Caesar – the ultimate boss who cannot be fired or gainsaid by anybody else – limits the scope of the venture, and thus its financial return, as it restricts the ability to bring in co-founders, investors, and strategic partners. Optimizing for economic gain therefore usually requires quite a few concessions on the control and power side of the start-up structure. Experienced founders tend to understand this trade-off and are usually more comfortable with performance-based structures (e.g., they remain king by virtue of high performance rather than some form of structural protection). Nevertheless, both types of founders exist and their preference will have a massive impact on viable (and available) exit options for the start-up.
With the exception of very early employees in high-growth ventures, most employees will not own enough stock to make truly life-changing returns in most exit scenarios. A common Employee Stock Option Pool will hold 10-15% of an early stage start-up with about two thirds of that going to senior executives and the rest being distributed among other employees. This puts the likely return of even a good exit in the same order of magnitude of annual compensation. As a result, employees generally are more worried about keeping their position than the cash payout of most exit scenarios. If you make $100K per year and the exit results in the loss of your position but with a $50K stock payout, that is just a termination with severance by another name.
Armed with a good understanding of the motivations of your stakeholders, it is time to set the exit plan in motion. By this time, you should have your team of advisors lined up. (See the sidebar, “Advisor Alignment.”) The next thing to understand is that start-ups are bought, not sold. There is no such thing as an efficient market for start-ups. With the exception of a number of exceptional deals, every acquisition is ultimately a buyer-driven process based on an existing relationship. So the first step is to build those relationships.
As early as possible in your venture, you should identify the different types of future acquirers and what they might want from your business. Certain types of companies might value your team quite highly even if your technology is not a perfect match for them. Others will value your technology. And so forth. As an example, when we prepared the exit plan for BrightSide, my last venture focused on local-dimming LED TV, we classified three distinct categories of potential acquirers:
BrightSide had a broad patent portfolio and a strong engineering team. Both pieces would be a powerful asset for technology licensing companies that were trying to enter the display market. The value to them would be a ready-made team as well as the forward-looking revenue potential of our licensing deals (likely at a higher value than we were forecasting them internally, as the larger licensing company would have better leverage than a small start-up).
At the time we had joint development projects with large TV manufacturers and were in licensing discussions with them. In addition to revenue sources, these were also potential exit opportunities with lump sum fees for the license being in the same order of magnitude as the company’s valuation. A potential acquirer like this would care about the intellectual property and not much else.
Specialty Display Manufacturers:
BrightSide made and sold high-end displays for niche applications. This was an early business, but we did hit seven digits and thus opened the door to a potential asset acquisition by a larger niche manufacturer (possibly including a team transfer as well –though usually such companies have a hard time integrating teams of 30–50 people due to their own relatively small size).
The next step is to identify prospects in each category and build initial relationships. These relationships should be continuous and, initially, not focused on the exit at all. Nobody likes salesmen, so start by forming professional bonds, ideally at different levels of the organization. Your first priority is to identify a champion within the organization that can help you through the process and ultimately advocate for your venture within the acquirer. If possible, try to also establish relationships between the engineering teams on both sides. Engineers do not make acquisition decisions by themselves, but they will almost certainly be asked by management at some point in the acquisition process about your team – making engineer-to-engineer relationships invaluable.
Relationships are formed over time, so the best path here is to establish a repeating pattern of engagement. For some acquirer types there might be an opportunity for a formal business relationship prior to the acquisition – such as a joint development project – but for others this can just take the form of going for lunch every 6 months for an update. If possible, try to identify a value-added purpose for the engagement: collaboration at standards meetings like ICDM; meeting up at conferences such as Display Week; joint talks or other presentations such as Display Week Seminars; contributions to open source software projects; participation in the Display Week Program Committee or governance of the Society; and so forth.
Once the relationship is formed, the next step is to explore the appetite of your potential partner for different types of deals. Some of this can be found in the public domain, such as the company’s recent acquisition pattern, but a lot requires dialog with your new connections. Are they hiring? Are there strategic areas identified for expansion? Are their engineers busy on high-priority projects or looking for work? Are they hiring or downsizing? Questions like these provide the canvas on which a good acquisition strategy can be drawn.
With a good relationship and understanding of a company’s needs in place, the discussion will eventually turn to the topic of a partnership or acquisition. Start by exploring the practical boundaries of a possible engagement – what do they want and what do you want? You might need to bracket a price range to make everybody comfortable, but definitive price negotiations usually come later in the process. First, the buyer will want to conduct some amount of informal due diligence, usually by visiting your company, meeting the team, and otherwise digging into your business. This is probably the most delicate period of the acquisition process, full of opportunity to distract your team and possibly causing fatal morale issues (see the sidebar, “Team Involvement”). At this point, you may also want to give some consideration to the concept of competitive tension (see “Maintaining Competitive Tension”).
This period usually ends with the development of a term sheet – a document that, as the name implies, lists the principal terms of a future deal (e.g., price, deal dynamic, team transfers, etc.). A good term sheet is usually the end of the process in terms of negotiation risk, at least if there are not too many skeletons buried in your corporate closet. (For more on term sheets, see the second article of this series, “Raising Capital for Technology Ventures” in the September/October 2013 issue.) Given the finality of the term sheet, this is definitely not the time to be stingy with advisors. Bring in the lawyers, accountants, and other specialists – any structural problems at this stage can be hard to fix later (do not forget to get good tax advice, as different deal structures can have a massive impact on personal wealth gain for founders, even with an identical purchase price).
A Word on Price
Deal pricing is both an art and a science. The corporate development team of the buyer will usually generate lots of spreadsheets with budget forecasts and discounted cash flow calculations (estimating the value of the forecasted revenue of the acquired business). Whether their management team ultimately uses all that information is a different story and, in any case, outside of your control. Your best hope to influence the pricing
process is to establish a strategic rationale for the deal (and coach your champion on how to present it), keep your key assets clean and easy to understand (e.g., intellectual property), and highlight the synergy benefits of the deal. Deals ultimately come down to the eagerness of the decision makers on both sides, so a good narrative is more important than any financial spreadsheet.
The final stage of the process is due diligence. In addition to the development of the final full agreement, based on the term sheet, the buyer will send a horde of experts to poke into all parts of your business. You will inevitably be outnumbered, usually just by the lawyers alone, and the buyer will unfortunately control the process almost entirely. It is therefore critical that you clearly understand the goal of each due-diligence activity and steer as quickly as possible to the relevant check on their list. While some competitive pressure is good, try to avoid salesmanship and instead focus on closing out open issues – at this stage it is no longer about impressing them with the quality of your code but rather about showing them as efficiently as possible that no third-party software sits in your system (and the best way to achieve that might just be to delete your entire repository except the very latest code version…). Checks, not sales.
While all of this is happening, you can turn what little mindshare you have left toward the topic of integration. Will your team get absorbed on day one or gradually integrated over the course of the first year? Try to find relevant counterparts in the buyer’s organization for all your key leaders so that they can start the process of knowledge transfer. Apart from being good form to make the integration as smooth as possible, there is often also an economic incentive to do so (e.g., most deals leave 10–25% of the payout in escrow for 12–24 months to ensure against any problems that might arise).
Eventually, the lawyers will have billed as much as they can get away with, management will become impatient, and enough checks will show on the list – closing day is at hand. The final agreement will be signed by both sides, your shareholders will cast any necessary votes (you did make sure that they are all aligned, right?), and money changes hands. In addition to a good chat with a personal wealth advisor, this would also be an opportune time to take a long vacation and re-acquaint yourself with your spouse, who has likely not seen much of you for several months.
The next article in this venture capital series looks at a more specific area of venture capital: the issues surrounding technology transfer for university researchers. •
1Asset acquisitions, in the context of this article, are used to describe deals in which the assets are the only item of value to the buyer. In transaction terms it is perfectly possible that other types of acquisitions happen to also involve an asset purchase for financial reasons (e.g., the acquirer might want to own the entire business of the seller – a “Revenue Stream Acquisition” in the context of this article – but do so by individually buying the assets and hiring the employees to avoid taking over the liabilities of the original company).
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Advisors are a key part of most exits, whether they are lawyers, accountants, or investment bankers. Most advisors are paid by the hour, so their incentive is obvious. They need only a firm hand when it comes to the management of expenses. Brokers, in all forms, are a different story because at first glance their interests seem aligned with the company’s stakeholders due to the commission nature of their compensation. Regrettably, that is not entirely true for two key reasons: First, brokers make nothing if the deal fails while the stakeholders still get to keep their company. Second, brokers start their investment on the first day of the negotiation while other stakeholders have often invested over several years. Combined, this motivates brokers to close deals as quickly as possible and essentially at any price – whereas other stakeholders might very well be comfortable holding out for better terms. This is a familiar feeling for anybody who has ever hired a real estate agent – their broker – only to feel pressured into a deal!
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Competitive tension is a key element of deal negotiation and often the only leverage available to the seller. Buyers are aware of this and most term sheets contain a no-shop provision that prohibits the seller from continuing negotiations with third parties. It is very difficult to avoid such limitations, but tension can still be maintained through indirect competition: your team might pursue a venture capital investment or a major technology licensing deal in parallel to the acquisition negotiation. Neither would be prohibited by a no-shop agreement but both are usually an effective competitive threat. As a recent example, the $50 million VC investment into Instagram just a few days before its acquisition by Facebook was most likely not a “get rich” scheme by insiders but rather exactly such a manufactured indirect threat to the acquisition.
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Opinions differ on when a CEO should bring a team into the acquisition dialog. Involving them early allows better distribution of the engagement workload, while a later involvement will keep the team focused on the core business for as long as possible. Regardless of your choice, your team will eventually know almost everything about an emerging deal, especially at the senior levels. With that knowledge, the dreams and fears will start to spread: Dreams of getting rich, fears of losing their jobs, since many acquisitions include staff reductions (ironically, the employee functions that would be the most involved with the exit transaction, such as finance and HR, are also often the first functions to be eliminated post-acquisition – causing a difficult misalignment of interest within the exit team of the start-up).Fears are obviously damaging, but the impact of dreams can be even more corrosive. Two of my worst professional experiences were trips home from deal meetings that fell apart at the very last minute (once literally during the final signature meeting). This happens, and it can absolutely devastate the morale of a company if not managed properly. If at all possible, try to only involve those team members who can handle, emotionally and professionally, the ambiguity and uncertainty of strategic negotiations.
This article was originally published on Information Display.