The best time to start thinking about your company’s exit is at the beginning. There are several reasons for this, the most important of which is positioning your company to be able to find funding when it needs it. Many new founders think they can just wait to see how things go; they will consider an exit when the opportunity arises. If your startup plans to raise money in the foreseeable future, you will not have the luxury of waiting and seeing.
Your company’s exit plan is a significant factor in attracting and retaining investment. Startups that are able to find money to move through the development stage and beyond usually have succeeded at a couple of things: (1) convincing investors that they will realize a return on investment (ROI) of 10x – 100x, and (2) giving investors a reasonable idea of when the expected ROI will be realized. Sure, investors like to count their money on paper as your startup grows. What they like even more is seeing actual money in the bank. Until your startup has an exit event of some type, the money in the bank part will not happen.
So what is an “exit”? In startup vernacular, the term “exit” usually means a sale of the company (or its principal assets) or an IPO (Initial Public Offering). In either transaction, the investors turn their original investment, and any appreciation, back into cash. While IPO’s are certainly buzzy, it is far more likely that a startup’s exit will come with a sale of the company.
The term “exit” is used because it refers to the time that the founders, who were the company’s first investors, and all of the other investors, exit the investment. The founders may think of an exit as leaving the company. In truth, it’s when they cash out – whether they leave or not. It’s the same with investors. They exit a company by turning the investment back into cash – hopefully, a lot more than they started with!
Your company’s business plan should always include a section on exit, even in the company’s early days. Potential investors will want to know when the cash-out comes. You will need to distill your ideas about the company’s future to arrive at an exit strategy. If you think it will be a sale of the company, what kind of sale will it be? Sale to a larger competitor? Sale to an investment group? Sale of the business’ IP or material assets? Sale to employees? Or do you think the company is likely to experience such a high rate of growth (and demand for cash) that it makes sense to “go public”?
“Going public” is shorthand for a sale of the company’s stock in a public offering. A public offering is when a company lists its stock on a stock exchange for sale to the general public. Limited liability company membership interests/units may also be sold publicly, although this is less common that public sale or corporation stock. The company “goes public” by registering a stock offering in accordance with U.S. securities laws. Those registered shares are then listed on a stock exchange, such as the New York Stock Exchange or NASDAQ, for sale to the public.
Startups usually raise money in the early days in private, not public, offerings. In a private offering, the company’s securities are sold under an exemption from registration (i.e., they are not registered). Registration is intended to be the way the company provides information to potential stock purchasers about the company’s business and financial health so that those individuals can make an informed decision about investing. Private investors acquire information about a company by doing due diligence, the results of which they combine with their investment experience to make their decision about investing. In either case, potential investors want sufficient information to evaluate the risk of the investment. When selling to the public, securities laws mandate what information must be given.
Early private investors are concerned about investment risk, but they are also driven by potential returns. Your company’s exit plan provides critical information that potential investors need to evaluate return potential. In other words, potential investors want to know up front when they can expect to cash out, which will factor into their risk-return assessment.
Investors will expect your company to support its beliefs about the company’s exit with information demonstrating that its exit projections are realistic. You may feel that mapping out an exit path for your company is pure conjecture, especially before the company has gained significant market traction. While there is some truth to that feeling, there are a variety of ways you can use available information to support your ideas about your company’s exit.
First, you can compare your company to the experience of similar companies that have gone before. If you have a ride-sharing company, for example, you may be able to compare your company to the experience of Uber or Lyft. Second, you can show transactions involving companies similar to yours, such as previous acquisitions. Last, you can illuminate the competitive landscape to show how your company’s product, service, or technology fills a hole for other companies, making your company a desirable target. In each case, your company uses real world examples to demonstrate that its exit projection is attainable.
In evaluating your company’s exit, you will also want to focus on financial considerations that may impact your exit strategy. To use Uber again as an example, one can point to Uber’s need to access significant cash to explain its choice to exit through an IPO. Uber is expecting to operate at a loss for the indefinite future, and it will need a continued infusion of cash not only to continue to grow, but to stay afloat until it realizes its end goal of deploying autonomous vehicles to transport riders. By using an IPO, Uber was able to access public markets for the huge cash investment needed to support its long-term business model. Had Uber instead projected an exit through acquisition, it would have been much harder to show that it could find an acquisition partner willing to make the large cash outlays necessary to survive until autonomous vehicles become reality. If your company has financial circumstances that will drive one kind of exit over another, those circumstances should be an integral part of your exit planning.
A final step in looking at any exit analysis is to consider the health of the market on which you are relying to acquire your company. With an IPO, you will want to consider prevailing trends in the IPO market as well as the broader market. With an acquisition, you will want to look at the fiscal health of companies you identify as possible acquirors. Do these companies have uncommitted cash on the balance sheet to make such a purchase, or are they mired in debt? Do they have sufficient ongoing revenues to fund an acquisition? Have they made earlier acquisitions to add to their intellectual property portfolio or menu of products and services? If they have made acquisitions, how much did they pay for the target company and what was the likely return to the target company’s investors? Answers to these types of questions will give prospective investors confidence that your chosen exit strategy will support investors’ expected ROI.
Thinking through your exit strategy will have benefits for your company beyond the information it communicates to investors. As you research acquisitions of companies similar to yours, you will gain a more refined understanding of your market and your competitors. You will learn whether competitors are paying to acquire new or needed technology or product categories, and how these acquisitions come about. Was the acquiring company a former customer? Did the acquiring company establish an important business relationship first, such as by being a major licensee of the target’s technology? Your analysis should also identify companies that may have an interest in what your company has to offer. The acquisition patterns in your market – or lack thereof – will help you position your startup most optimally for exit, whenever that time comes.
It may seem counterintuitive at first, but understanding your company’s exit strategy will help you position your company to attract investment and, eventually, to help your investors realize a return on their investment. Investors with a track record of investing in startups are rarely looking to be long-term equity holders. Instead, they operate on a fixed time horizon, expecting that their 10x + returns will be realized within some proscribed period. If your company’s anticipated time to exit is too distant, or expected ROI is too small within investors’ preferred time horizons, investment capital may be hard to find. Understanding these facts will help you think about your company the same way investors will. This insight can be a powerful tool to help you realistically evaluate your company’s prospects and make it an attractive investment opportunity.
This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact an attorney directly.