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Corporate FinanceVenture Capital Exit Routes

Comparing the most popular methods of releasing venture capital

By: Koen Vanhaerents (Brussels) and Helen L. Shroud (London)

Contact Information is provided below

Private equity houses (or venture capitalists) set up funds which are used principally toinvest in equity and equity-related securities of companies in the private sector (investeecompanies). Whilst the venture capital market has in the past been to some extent volumedriven, fund managers now tend to make fewer investments, concentrating on quality deals ofhigher value. In addition to wanting to maximise returns, they need to demonstrate thatperformance has been consistently good so as to be able to attract new money from theirinvestors for further funds. The pressure to make sure that each investment pays off isconsequently greater.

An inherent part of the investment strategy of a venture capitalist is the timing of the saleof its interest in the investee company (the exit). Typically, investors look for a return betweenthree and five years after the original investment. Statistics published by the European VentureCapital Association indicate that the average actual exit takes place after eight years.

Timing is also of vital concern to the management team. Management will not want theexit to take place at a time which does not suit the business or their own vested interests.

Another vital aspect of the process is the choice of method of exit. The methodultimately chosen will impact on the venture capitalist, the investee company and itsmanagement. However, the parties often give insufficient attention to exit planning at the timethe investment is made.

There is no foolproof way of guaranteeing how an exit will happen. The investmentcycle involves too many uncertainties for that. However, parties to the investment can try to putthemselves in the best position to take advantage of opportunities which arise. All parties willderive advantages from factoring into the original negotiations decisions which will influence theend of the investment arrangement.

It is therefore important for all parties to address:• The range of exit methods commonly used.• How and by whom the decision as to timing will be made.• Other contractual devices which can influence the ultimate outcome.

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• The relative advantages and disadvantages of the principal methods.

Exit MethodsThere are two principal types of exit route:

• A trade sale. A trade sale is a sale of the shares or business assets of an investeecompany by way of a private sale agreement.

• An initial public offering (IPO). An IPO is the offering of shares to the public, normallyfollowed by the listing of the shares on a stock exchange.

The general perception is that an IPO will generate a higher price than a trade sale.However, this is not necessarily the case and there are in fact advantages and disadvantages forall parties in both trade sales and the IPOs (see boxes “Advantages and disadvantages”). Thecapital gains tax consequences for the seller vary from country to country. However, as ageneral rule, the sellers’ position is the same on a trade sale as on an IPO.

Other exit options are:• Recycling - a sale to co-investors or other private equity houses (secondary buy-out).• A buy-back by the company or management.

As market conditions become more turbulent, the number of IPOs seems to be decreasing. Theexpectation is that the number of trade sales and secondary buyouts will increasecorrespondingly. Moreover, there is increased competition between venture capitalists as thelevel of investment increases but the number of appropriate deals decreases.

Advantages and disadvantages: IPOs

IPO advantages

Popular with management. An exit through the stock market seems to be favoured bymanagement, since it allows them to remain in place and in control. Having a range ofinstitutional shareholders is often preferable to management rather than one shareholder withideas on future direction which are different from their own. Also attractive stock optionsplans might be linked to a flotation of the shares.

Dual track. Preparations for an IPO often provoke a pre-emptive trade bid whichallows the venture capitalist to follow a dual track approach.

Retained shares. Investors may continue to share in the future growth through theirretained shares.

Position of underwriters. Normally no warranties on the business have to be given bythe venture capitalists to the underwriters. However, in certain jurisdictions the seller mayhave a statutory liability which could go beyond liability as to valid share title. In addition,the venture capitalist company may have placed one of its own employees or managers as adirector in the target company and he or she may retain liability under the prospectus.

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IPO disadvantages

x Higher costs. There will be additional costs for the selling shareholders and thecompany such as the preparation of the prospectus and investment bankers’ fees.

x Market risk. Illiquidity of the markets or an unexpected downturn may result in anIPO being aborted.

x Image. The message has to be simple. For certain companies, it may prove difficultto convince the market and the analysts of the real worth of the company.

x Less than full exit. Often an IPO does not provide for a full, clean exit. The venturecapitalists are often required to show confidence in the future growth of the company.Indeed, sometimes only a partial sale is possible at flotation, often just sufficient to recoverthe initial investment, either directly or in the green shoe (or over-allotment option) period(see below “Preferential flotation rights”). After the IPO, liquidity may be restricted, eitherthrough contractual or regulatory obligations or as a result of the state of the markets.

Ongoing risks. A continued shareholding results in continued risks:

x The special rights normally granted to venture capitalists at the outset of theirinvestment to protect their interests are usually abolished on an IPO. Underwriters andmarket authorities tend to dislike the continued existence of special rights for certainshareholders. The special rights may include board representation with veto, tag-along andinformation and inspection rights.

x Continued board representation may result in additional liability, which cannot alwaysbe covered by insurance.

x Potential restrictions on the subsequent ability of the investor to sell the shares mayapply under insider dealing restrictions at the time when the director representing the venturecapitalist is an insider. Quite often, a shareholders’ agreement is entered into with the (other)controlling shareholders covering matters such as board representation rights, special pre-emptive rights and transparency issues.

Preparing for exit

The parties may take several precautions at the outset of the investment to prepare theway for a trade sale or IPO. The investee company and its management should be aware of theobligations and incentives relating to the ultimate exit which they are likely to be asked to takeon by the venture capitalists. They will need to consider the impact of these on their ownposition both for the duration of the investment and on the exit itself.

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Common devices used in investment agreements in relation to exits include:• Exit control covenants.• Management covenants.• Ratchets.• Put options.

Exit control covenants. It is fairly standard to see a covenant from management and theinvestee company acknowledging that:• The investor is subscribing for shares to make a return on its investment.• Management will therefore use reasonable endeavours to arrange a trade sale or flotation

before a certain date.

In practice this type of clause may be difficult to enforce. Ascertaining what is meant byreasonable endeavours is not a straightforward process. It might be extremely difficult to provebreach unless management went so far as simply refusing to discuss the issue. Also, ifmanagement is being difficult when a sale is initiated, a prospective purchaser may be put off.However, an exit covenant will at least help to focus minds on the exit strategy throughout thelife of the investment.

The covenant may be made more effective by including specific arrangements as to howand by whom the exit will be controlled. The investment documentation may specify:• Who has the right to force an IPO or trade sale. For example, 15% of the shareholders or

the majority of the shareholders.• The method of establishing the selling price, for example, through a pricing committee,

the composition of which can be agreed in advance.• Who is allowed to sell how many shares and when.

Often sophisticated procedures are set up to demand, in particular, an IPO subject tospecific time limits for making the demand and minimum intervals between two demands.Clauses of this type sometimes provide for the appointment of an investment bank to make anIPO report covering the IPO value, the timing, the required reorganisation and other relatedissues. Sometimes, the request for an IPO has to be accompanied by a commitment by aninvestment bank to underwrite the transaction.

A sanction mechanism may have to be provided to make the arrangements work. Thiscould be achieved through a put option in favour of the investors against any shareholderrefusing to co-operate (see below “Put options”).

Management has vested interests in the exit decisions which will ultimately be taken,particular in relation to:• The life cycle of the company. Management may have strong views at any given time on

whether a sale, merger or flotation is the next step for the business.• Management’s own job security (see boxes “Advantages and disadvantages”).• Effect of timing on any performance-based ratchet (see below “Ratchets”).

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Advantages and disadvantages: trade sales

Trade sale advantages

Premium. Notwithstanding a widespreadbelief that IPOs provide for good returns, atrade buyer may also be willing to pay apremium for reasons such as synergy, marketshare or market entry.

Simplicity. The procedures involved in atrade sale tend to be cheaper than an IPO andquite often faster and simpler. However, if atender procedure is used, the process mightbecome complex and take more time.

One buyer. Only one buyer has to beconvinced of the deal. In an IPO investmentbankers and the public at large have to behandled.

Full exit. Trade sales will normallyprovide for a clean, full exit.

Trade sale disadvantages

x Management opposition. Management oftenopposes a trade sale, especially if it has asubstantial stake in the company or if existingmanagement may not fit into the managementculture of the trade buyer. They will be aware thata change in the ownership of the company mayresult in them losing their jobs.

x Confidentiality. In most cases the bestcandidate buyers are often close competitors. Thedue diligence process might therefore becomfortable. It could result in the disclosure ofconfidential information which, notwithstandinggood confidentiality agreements, is transferred tothe competition.

x Warranties and indemnities. Purchasers fromventure capitalists should be aware that certainprivate equity companies apply and enforce a strictno-warranties policy (see below “Negotiatingwarranties”).

Management may therefore wish to negotiate into the investment agreement an elementof control or influence over the decision making process. Similarly, mezzanine and bank lendersmay wish to influence the ultimate choice of exit route. The influence of the latter would dependon how heavily endebted the investee company is and on its relationship with its banks.

Management covenants. The venture capitalists will not want to discover unexpectedrevelations about the investee company when due diligence enquiries are being answered, aprospectus is being prepared or a data room is being set up for a controlled auction (see box“Controlled auctions”).

Venture capitalists will therefore seek to ensure that the target company covenants in theinvestment agreement to produce regular management and financial information in line withstrict reporting standards. The covenants will often mirror the reporting requirements the venturecapitalists themselves owe to their own investors. Not only is this good corporate practice in anyevent, but the venture capitalists will be in a position to monitor through the life of theirinvestment just when is the optimum time for an exit.

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Ratchets. This mechanism allows management to share in the growth of a company byeither an actual or a notional redistribution of their shares and the venture capitalists’ shares onany exit. The distribution is usually calculated by reference to a target rate of return to theventure capitalist.

To make the covenant more effective from their point of view, venture capitalistssometimes construct the ratchet so that it becomes less attractive for management if an exit hasnot been achieved within a certain period, whether or not the target rate of return has been met.

Put options. A further alternative is to require management or the investee company (orboth) to buy the venture capitalist’s shares if no exit has been achieved within the defined period.This is intended to provide for the situation where the market is static or illiquid, but is onlyeffective if management is financially capable of funding the purchase of the shares or theinvestee company is legally able to do so.

There are normally local law requirements on exactly how the investee company canpurchase its own shares. Buybacks are only permitted in most jurisdictions if certain, fairlystringent, criteria are met (see FirstSource “Share buybacks” EC, 1998, III(2), 15).

This may not in any event be the best route from the venture capitalist’s point of view:• Fixing a price at the outset (whether absolutely or by means of a formula) may not reflect

the actual value of the company at the time of the buyback.• There may also be a concern that management may sell on to a third party for an

increased price. This concern could be addressed by some form of clawback or anti-embarrassment clause which would allow the venture capitalist to claim a proportion ofthe increase in value on any subsequent sale. Encapsulating in a contract what is meantby an increase in value is not, however, straightforward and such clauses may run tomany pages of drafting to ensure all possible disposals have been covered.

SEC registration rights

If exit through an IPO on the US securities markets is envisaged, the venture capitalist may seek appropriateregistration rights in the investment documentation. These will be required not only in respect of US securities,but also for foreign securities which are offered in the US.

US law requires that securities of companies cannot be sold to the public unless the sale of those securities hasbeen registered with the US Security and Exchange Commission (SEC) or unless the sale is exempt fromregistration. Only the company, rather than individual shareholders, may register with the SEC.

In order to be able to create an obligation on the part of the company to cause the registration of a subsequentsale, shareholders routinely request that the company in which they are considering making an investment grantthem registration rights.

There are several kinds of registration rights. The two most common are:

• Demand registration rights These allow a shareholder to demand that a company register the sale of itssecurities if certain preset thresholds are met.

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• Piggy back registration rights These allow a shareholder to include the registration of a sale ofsecurities on a registration statement filed by the company for the sale of the company's securities. Inthis way the shareholder makes use of the registration process already in progress. This is more cost-effective for the company and reduces the number of registrations the company may have to make.

In most European countries, registration rights are not required. Usually, if the company is the subject of anIPO and obtains a listing of its shares, all other shares of the company, at least those of the same class, are alsoconsidered listed or can very easily be listed without the need for a further complex listing procedure.

Planning for trade sales

There are certain issues of forward planning which relate specifically to trade sales,including:• Negotiating warranties.• Piggy back (or tag along) clauses.• Come along (or drag along) clauses.• Limiting contingent liabilities.• Earn outs.• Non-compete clauses.

Negotiating warranties. When negotiating a trade sale a purchaser will require warrantiesas to the state of the business. Warranties and the associated disclosure of information whichlimits their scope play a part in allocating risk between the parties and determining the price thepurchaser will pay for the business.

Venture capitalists are likely to argue that they will not give warranty protection to apurchaser of their shares, other than a warranty that they actually own the shares. This is aconscious approach which is often adopted despite the fact that it may act as a depressant on theprice. It is sometimes argued that the price discount resulting from this policy is often largerthan the actual amounts which might have to be paid by the venture capitalist sellers ifreasonable warranties and indemnities were given with appropriate disclosure.

The arguments generally put forward by the venture capitalist are that:• It is difficult for investors who are not involved in the day to day running of the company

to quantify potential exposure under the warranties.• If the venture capitalist gives warranties on exit, it will be prevented in practical terms

from distributing the proceeds of sale to its investors until the limitation period for claimshas expired.

• Venture capitalists may be seen as deep pockets, especially where management is theonly other shareholder or where management continues to be involved in the business.

It is fairly common for the venture capitalists to try to pre-empt any argument on thisissue by including an acknowledgement by management in the investment agreement that theventure capitalists would not be required on an exit to give any warranties other than as to title toshares.

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In practice, therefore, the burden of giving warranties on a trade sale exit often falls onthe management team. Management tends to resent this position as the perception is that theventure capitalists are receiving the same return as them and that they are not being compensatedfor the increased risk.

Whether management at the outset of the investment or a purchaser on exit can persuadethe venture capitalists to give warranties will depend to a large extent on relative negotiatingpositions Where they are persuaded, they are still likely to seek financial caps and tightly drawnlimits on duration.

The following options are available as a means of dealing with venture capitalists'reluctance to give warranties and the buyer's reluctance to accept warranties from managementonly:• An asset deal followed by the liquidation of the target when the contractual limitation

periods have expired. In an asset deal, assets (and related liabilities) are sold by theshareholders. In this scenario the shareholders may therefore escape having to giverepresentations and warranties, but have to wait for the liquidation proceeds remainingafter the settlement of the liabilities which were left with the target.

• Putting a fixed amount in escrow as the sole amount available for recovery under thewarranties and indemnities, subject to a fixed period for claims.

• Entering a contribution agreement to try to ensure that management pays first in order toencourage greater attention by management to potential claims.

Controlled auctions

Investors are constantly having to be creative in finding an exit route which gives them asmuch flexibility as possible. The last five years have seen a considerable increase in the numberof controlled auctions. This procedure involves the following steps:

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The preparation of an information memorandum on the company being offered for sale. Thememorandum is not as detailed as a prospectus on a flotation but its contents are usually the subject ofsome verification by lawyers and financial advisers. Confidential information will be disclosed at thisstage. The sellers should consider drawing up a confidentiality letter (see FirstSource "Confidentiality

letters", EC, 1996, 1(3) , 23).

Prospective purchasers lined up by financial advisers are asked to make anindicative offer for the target on the basis of this document.

Bidders in the higher range are invited to proceed to limited due diligencein a data room and are asked to confirm their bids and submit their

proposed amendments to the sale documentation which the seller's lawyerswill have prepared.

A preferred purchaser is usually selected on basis of price offer andproposed contract amendments. However, it is not uncommon to have

further rounds if there is enough interest.

The preferred purchaser is given exclusivity for detailed negotiations.

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The advantages of this process for the sellersare:

The disadvantages are:

• Maintaining control over the legaldocuments and the timing of theprocess.

• Keeping confidential documents fromcompetitors at the early stages, toavoid "fishing expeditions".

• The ability of the financial advisers touse the perceived competition to keepthe price up.

• Cost• Having to put in place substantial

infrastructure with no guarantee of anultimate buyer.

• Sometimes the process takes control ofthe transaction. Often it is better toconduct a bidding war with a fewinterested parties and then proceedstraight to a regular trade sale.

• Considering insurance cover for liability under warranties and indemnities.

Piggy-back (or tag along) clauses. This type of clause requires management to ensurethat if they receive an offer for their shares, the intending purchaser also acquires the venturecapitalist's shares on the same terms. This is very common where the venture capitalist has onlya minority stake. It may also be coupled with an absolute veto for the venture capitalist on anyshare sale by any other shareholder. Thus it will be able to choose whether to refuse to let thesale proceed or sell along on the same terms.

Come-along (or drag alone) rights. The come-along clause is almost the reverse of thepiggy-back clause. It enables a venture capitalist to ensure it can sell all the shares of theinvestee company. If it finds an exit for its shareholding it can require all the other shareholdersto sell their shares on the same terms.

Since this could operate unfairly where a venture capitalist has only a minorityshareholding, it is often used where it has over 50% of the shares or is drafted to apply onlywhere it an persuade other venture capitalists or other shareholders who together own at least50%, to sell. The percentage will vary according to the particular deal structure.

Limiting contingent liabilities. The venture capitalists will strive to ensure that the exitsale agreement does not make them directly liable for any future liabilities of the company andthat no obligations have been inadvertently accepted by the use of the words "jointly andseverally" anywhere in the document.

On an asset sale, whilst the venture capitalist may not have given any warranties to thepurchaser, it may nonetheless find itself as a shareholder in the remaining shell company. Theventure capitalist in this situation may face liabilities which have not been passed on to thepurchaser either because the purchaser would not accept pre-transfer liabilities or because certainidentified actual or contingent liabilities have been retained.

Earn outs. Venture capitalists tend to dislike compensation which is deferred and linkedto future results (earn-outs). Management control of the company will often no longer be in the

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hands of the management backed by the investor as the purchaser usually insists on taking overthe management on completion. Also, extremely difficult issues can arise in the calculation ofan earn-out, especially in relation to tax.

If the compensation is linked to objective factors, deferred compensation tends to bemore acceptable. Factors could include:• The fact that no previously undisclosed liabilities surface within the limitation period.• The outcome of an application for a vital licence or patent.• The outcome of the renegotiation of certain contracts.

Non-compete clauses. In a trade sale, the buyer tends to ask the venture capitalists for anon-compete clause. The purpose is to restrict them from re-investing into the same sector,making use of inside knowledge acquired through the target. A venture capitalist will thinkcarefully before agreeing to this as it will not wish to restrict future investment potential of itsfunds or the activities of its managers.

It may instead ask the purchaser to rely on an obligation that it will not poach employeesor customers of the business.

It is sensible also to consider alternatives, such as the use of a Chinese wall whichrequires the venture capitalist to ensure that information resulting from one investment is notused to structure an investment in a similar business area. Contractual documentation may alsoinclude a prohibition on particular investment managers being involved in the structuring ormanagement of a competing investment.

Planning for IPOs

Often the investment agreement will not determine on which market the IPO will takeplace as a number of complex and unpredictable issues will influence that decision. Theemergence of different markets for growth companies, such as AIM, EASDAQ and EURO.NM,is a relatively recent development (see FirstSource "EASDAQ" EC, 1996, (I(2), 22).

From the issuer' s point of view, the decision will depend to some extent on acomparison of the rules in each market on:

• Thresholds for admission.• Costs of maintaining the listing.• Publication of financial information.• Dual listings on other markets.• Multi-jurisdictional IPOs.

The devices which may be used, preferably at the time the investment deal is structured,to make the company more suitable for an IPO. The investment agreement may contain anobligation to convert the company from one company form into another or an obligation to set upa holding company of which the shares can be floated. Also, arrangements can be made in order

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to ensure compliance with corporate governance rules, such as the appointment of independentdirectors, an audit committee and a remuneration committee.

Preferential floating rights. Venture capitalists are able from time to time to obtain preferentialflotation rights which allow them to exit before the other shareholders. Preferential rights mayapply at the time of the IPO or in the over-allotment option (or "green shoe"). The over-allotment option is an option granted to the underwriters to obtain from the company or theselling shareholders additional shares up to, for example, 39 days after the IPO. The option isalso used by the underwriters to stabilise the price of the shares in the period just after the IPO.

Allocating costs. It is usually appropriate to make arrangements to determine who will pay thecosts related to the IPO. Quite often the company is obliged to cover them, although from timeto time the selling shareholders pick up certain costs. The costs concerned include:

• The fees, commissions and discounts for the investment banks.• Legal fees of the counsel to the issuer.• Legal fees of the counsel to the selling shareholders.• Listing and quotation fees.• Printing expenses.• Accounting fees.• Roadshows.

Minority protection. Investors aiming at an IPO exit are likely to be anxious to make sure thatthe minority protection granted to certain minority shareholders automatically lapses on an IPO.They will want to know that an IPO cannot be blocked by a minority.

Such investors will want the investment agreement to provide for the lapse of:

• Any special minority veto or pre-emption rights at board or shareholder level.• All other transfer restrictions and preferences as far as dividends or liquidation rights are

concerned. This is often achieved by converting preferred stock into common stock atIPO. This technique is easier to implement in common law, rather than civil law,jurisdictions.

Minority shareholders may wish to resist these moves and protect any residual rights they havefor the long term (see FirstSource "Minority squeeze outs" EC, 1998, III(3), 29; EC, 1998 III(4),29; EC, 1998, III(7)., 53)).

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About the Authors:

Koen Vanhaerents, PartnerOffice: BrusselsPractice Group: Venture Capital & Private EquityEducation: University of Leuven (B.A., 1985; Lic. in Law, 1986);University of California at Berkeley (1987)

Contact: koen.vanhaerents@bakernet.com

Helen L. Stroud, PartnerOffice: LondonPractice Group: Corporate Education: University of Manchester (1980);College of Law at Chester (1981)Contact: helen.stroud@bakernet.com

Regional Contacts:We welcome you to learn more about our venture capital and private equity capabilities, wherever your businesstakes you. For further information, please contact:

Global North America Bruce Zivian (Chicago office) Marc Paul (Washington DC office)1-312-861-8940 1-202-452-7034

Asia Pacific Europe/Middle East Kien Keong Wong (Singapore office) Marwan Al-Turki (London office)65-434-2688 44-20-7919-1823

*This article is based on presentations given by the authors at a seminar hosted by the firm's European VentureCapital Group in Paris in October 1998.

**This article is provided for informational purposes only and should not be deemed as legal advice or a legalopinion.