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Raising Entrepreneurial Capital

Chapter 7: Exit Strategies

Opportunities for Early Stage Investors to Monetize Their Investment:A Comparison of Options and Methods

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Exit Strategies

Topics Covered in this Chapter Mergers and Acquisitions Management Buyouts and Earnouts Selling Shares to the Public US Stock Exchanges and Listing

Requirements

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Exit Strategies:Basic Considerations

Every business plan seeking to raise eternal capital must specify a range of convincing exit options.

The entrepreneur may never want to exit the business, yet the outside investors definitely will.

Every exit plan must specify “how”, “when”, and “how much.”

Actual exit is called a “liquidity event.”

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Differing Perspectives:Entrepreneur vs. Investor

The entrepreneur typically has a very long term view of building the business and may not want to exit at all.

Venture capital investors typically want to exit at a profit in 3-7 years.

These two perspectives should be reconciled during the initial funding process to prevent unhelpful disagreements later on.

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Exit Strategies: Valuation

“How Much” will depend upon market conditions at the time of exit (“liquidity event”) and the “multiples” typically used in that industry.

Know what valuation methodologies are used in your industry, e.g., multiples of 4-6 times earnings are common for medium-sized manufacturing companies.

Multiples can vary based on how good or bad the market is for exit.

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Most Likely Exit Options

A realistic exit option will increase the attractiveness of your proposal. For most companies, an IPO is not a realistic option.

Other options include: Acquisition by a strategic buyer Earn-out (buy-out) by management Debt-equity swap Merger with a similar firm

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Acquisition by a Strategic Buyer

Strategic means that the buyer’s interest goes beyond simple financial considerations. Increase market share Add to product line Eliminate competition Enter a new market or territory

A financial buyer simply seeks to make a profit by selling the company later.

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Acquisition by a Strategic Buyer:Equity Sale

Buyer acquires all assets and liabilities of the company, including contingent liabilities, if any.

Acquisition is often by means of a stock for stock share swap.

Share swaps are especially popular when equity markets are strong.

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Acquisition by a Strategic Buyer: Stock Swap Pros

Typically tax free Opportunities for increasing

value in a rising stock market Does not require cash.

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Acquisition by a Strategic Buyer: Stock Swap Cons

Shares come with restrictions. They vest over time and can not be sold immediately.

The buyer’s shares, if publicly traded, usually go down in such an acquisition, even if only temporarily.

Movement in share prices during negotiations makes the purchase price a moving target.

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Growth Through Strategic Acquisition

Some very successful companies plan a significant portion of their growth through acquisitions.

The goal is to create synergies. The selling price for a strategic

acquisition is typically higher than for a strictly financial sale because the target company offers extra value to the purchaser.

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Exit Options: Earn Out 1

If the company is generating significant positive cash flow, it could offer to buy out investors with company earnings.

Comparable to a public company buying back its own shares on the open market.

Investors might be happy with this arrangement, especially if they achieve their targeted return on investment and there are no other viable alternatives.

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Exit Options: Earn Out 2

An earn out can also be used to sell the venture to another company.

Usually means that the entrepreneur must agree to stay with the company for up to five years, effectively working for someone else, in order to earn out the purchase price.

The purchase price may be higher this way than a simple cash offer, but it comes with risks.

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Exit Options: Debt-Equity Swap - Pros

In this scenario, creditors accept equity shares in the company in exchange for their loans (notes, bonds, mortgage liens). For an otherwise profitable business, this can: Reduce interest payments and

increase free cash flow. Improve the balance sheet and

profitability. Improve the company’s valuation.

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Exit Options: Debt-Equity Swap - Cons

Can be a desperation move taken by a management with no other options. Effectively, the creditors may be

exchanging their loans for nearly worthless, perhaps illiquid, equity.

Existing equity holders are often diluted to near zero.

Still, can give the company a chance to survive.

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Exit Options:Merger

Marriage of equals? There is nearly always one dominant partner.

The basic objective is to increase shareholder value through a combination of product and operational synergies, cost reductions, and increased market share.

Due diligence is critical, as the role of clashing corporate cultures is often overlooked or minimized.

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Exit Options:Liquidation

The business could simply sell off the assets, pay off all debts, and cease operations.

Normally, this is seen as an option for businesses with no value as a going concern.

Liquidation does not necessarily mean failure – sometimes done voluntarily with no remaining debt.

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Other Potential Buyers

Individual buyers may be interested in running the business themselves. May ask for seller-financing (beware).

Equity Group buyers are groups of professional investors who may see unrealized potential in your company, or potential for synergies with other companies they own.

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More Potential Buyers

Partners: Existing partners, if any, may be willing to buy out a retiring or leaving partner. There should be a mechanism in the partnership agreement to cover this situation.

Family members: A desire for continuation of ownership, plus tax considerations, often mean more to family-owned businesses than to others.

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ESOP

Employees can buy their company, or a large portion of it, through an Employee Stock Ownership Plan (ESOP).

An ESOP can offer liquidity without taking the company public, as well as produce certain tax benefits.

ESOPs are not a perfect solution for everyone. If the company fails pension funds can be lost.

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Going Public - Pros

The lure of “going public” is enormous in times of rising stock prices.

An IPO usually creates much greater liquidity and increased enterprise valuation.

Public companies often have a significant advantage in hiring talented people, as they can offer stock options.

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Going Public - Cons

The IPO is not necessarily an immediate exit strategy for the entrepreneur. Shares and share options vest over time, and are often “locked” for a period of time.

In a falling stock market, going public may be seen as a desperation move, and your issue may attract few buyers.

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Going Public is Expensive

Publicly held companies have very significant legal obligations to report accurate information to shareholders.

This is expensive, time-consuming, and sometimes contrary to the way an entrepreneur thinks of “his” business.

Intangible costs of the IPO process include being a serious drain on management time and attention.

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Going Public:Constraints

For the entrepreneur, the primary goal is to retain a controlling interest in the company after the IPO.

The good news is that removing the venture capitalists from the equation via the IPO creates a more level playing field and should give more control to the entrepreneur.

The worst case is losing control and being removed from management!

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Going Public: Considerations Once the company has established itself

and begun to show profits, the perceived investment risk may be low enough to attract investors on the public equity markets.

IPOs are often undervalued by as an inducement for investors to take a chance on an unproven company.

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Listing Requirements:National Stock Exchanges

The New York Stock Exchange (NYSE) generally requires the following as a minimum for listing:

400 holders of 100 shares or more.

Total of 1.1mil common shares publicly held.

Market value of publicly held shares of $40,000,000 for IPOs.

Aggregate pre-tax earnings for the last three fiscal years of $10.0 million.

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Listing Requirements:National Stock Exchanges

NASDAQ offers separate standards for initial and continued listings. Its Standard 3 for initial listing offers a basis for comparison:

Aggregate pretax earnings of $11 mil over the past three years

Aggregate cash flow of $27.5 mil over the past three years

Total of 1.25 mil shares publicly held.

Publicly held shares worth $45 mil.

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Listing Requirements:Comparison of Exchanges

During the IPO craze of the 1990’s, the technology-oriented NASDAQ grabbed a disproportionate share of new listings.

Even so, the NYSE still dominates in terms of total value of listings, as many of the hot IPOs of the late 90’s are now bankrupt or delisted.

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Alternative Forms of Listings

NASDAQ Capital Market exchange offers an alternative listing opportunity for companies that do not meet requirements of major exchanges.

The OTC Markets Group is a private exchange one step down from the NASDAQ Capital Market. There is very little regulation. Listing requirements and liquidity are low.

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The IPO Process: Overview

“Going public” is a costly, tedious, and uncertain process, especially in a difficult market.

Management will lose a measure of control after going public, as well as come under additional scrutiny by shareholders and regulators.

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The IPO Process: Climate Change

A solid track record and excellent growth prospects are generally expected by investors, though during the IPO craze of the 90s, companies with no revenue and no saleable products or services were routinely floated at large valuations.

Many of them are now out of business or trading for pennies on the OTC.

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The IPO Process:Building the Team

Lawyers and accountants must be hired to advise and provide due diligence in their respective areas.

Your investment banker, also called an underwriter, will lead you through the IPO process.

Only you have your best interest at heart.

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Selecting the UnderwriterChoosing the right underwriter for your venture is

the key to a successful IPO. In effect, you are hiring a salesman.

They must know the product (you), the market (potential investors), and the sales process relevant for you.

There are significant differences among investment banks, as measured by their past success, size of typical deals, and the markets in which they deal.

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Underwriting Process

In an underwritten offering the underwriter buys the shares and resells them on the day of issuance. They have a strong incentive to price the offering to sell.

In theory, the underwriter could be left holding unsold shares in their own account, something they will do virtually anything to avoid.

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The IPO Process:Negotiating the Offer

You and your underwriter must agree on the total amount to be raised, price of shares, and the fee structure.

The best answer to how much to raise is: As much as the market will bear.

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The IPO Process:Negotiating the Offer

Enterprise valuation, not the share price, is the real issue. If you sell 20% for $5 million, you are expecting investors to believe your company is worth $25 million. You must have a plausible story to convince them of that valuation.

As a modest-sized company, you will probably have little room to negotiate fees. It is more important to ensure that the underwriter will pay attention to your issue.

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The IPO Process:Negotiating the Offer

You should obtain a Firm Commitment from your underwriter. This means they agree to purchase the entire issue and resell it to investors.

The alternative, a Best Efforts agreement, suggests that your offer is unattractive or you are talking to the wrong underwriter.

Underwriters are risk averse.

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Cultural Differences IPO Share prices typically range from

$10-20.

In Britain, many companies are listed at under $1 per share because British shareholders like the idea of being able to own thousands of shares for very little money.

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The IPO Process:Prospectus

The prospectus is a formal document with a prescribed format which must be filed with the SEC

Preparing the prospectus is an intense and tedious process, requiring assistance of CPAs and lawyers familiar with the process.

The potential legal liabilities associated with making “forward looking statements” are severe.

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The IPO Process:Finding Buyers

The lead underwriter normally forms a syndicate of underwriters to ensure that all shares are sold on the date of issuance. This also disperses ownership, a positive thing for your company.

The underwriter arranges a “Road Show” for management to pitch the company to investors in major cities in the US, Europe and Asia.

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The IPO Process:Finding Buyers

Many IPO buyers are “flippers,” institutions or private individuals whose sole business is to buy IPO shares at the issuance price and sell them the same day in the secondary market for a profit.

They receive share allocations in exchange for commission income to the underwriters from other trading or investment banking activity.

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The IPO Process:Finding Buyers

An IPO is not declared final until about seven days after the day of issuance.

In practice, the underwriter performs a useful and valuable service, but their interests are extremely short term.

The underwriter’s primary objective is to create a first day “pop” which means underpricing.

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Open IPOs

The Open IPO uses a “Dutch Auction” process to price the issue. Essentially, buyers bid for specific numbers of shares at a price of their choosing. When sufficient bids are received to sell all shares, the shares are then sold to all successful bidders at the lowest price bid from the group.

This procedure has yet to gain popularity.

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Going Public:Alternative Methods

Reverse Merger In this process, an existing public

company acquires a private company “shell,” or legal entity. It has no operations, probably no assets except some cash, and hopefully no liabilities, especially contingent ones.

This is a cheap way to “go public,” but it entails significant risks and is generally considered a bad idea.

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Going Public:Alternative Methods

Direct Public Offering

In this method, the company sells shares directly to the public, often via the internet. SEC filing requirements are less than IPOs.

For very small offerings that do not appeal to underwriters.

Investors must beware that there is almost no liquidity for the shares.

The hope is that liquidity will result from a subsequent listing on an exchange.

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Forms of DPOs:SCOR/ULOR Offerings

SCOR, or ULOR, are Small Corporate or Uniform Limited Offering Registrations. State-administered.

Raise up to $1 million during 1 year. Detailed business plan replaces SEC

prospectus. Costs for professional fees are still

significant, and legal liabilities of company officials can be severe if mistakes are made in the filings.

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Forms of DPOs:SB-1 Offerings

SB-1 offerings are regulated by the Federal government. They require a formal prospectus and financial statements according to GAAP. Companies may issue up to $10 million in stock if sales are not more than $25 million.

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SB-2 Offerings:Regulation A

Can raise an unlimited amount

Requires prospectus with audited financial statements.

Basis for Regulation A and D offerings.

SB 2 Offerings:Regulation A Offerings

Federal equivalent of a SCOR offering Two years of financial statements are

required and they may be unaudited. Exempt from SEC filing requirements Limited to $5 million raised in a 12

month period States may require offer be limited ti

accredited investors

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SB-2 Offerings:Regulation D-Rule 504

Rule 504 allows a company to raise up to $1 million in a 12 month period through selling shares.

No Federal regulation, but must notify the SEC with a Form D.

Must comply with applicable State regulations.

Must sell to “accredited investors.”

Summary

There are many options for a liquidity event.

Entrepreneurs must think carefully about the most realistic and plan accordingly from the beginning.

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