There reaches a point in the lifecycle of a startup when entrepreneurs and shareholders face a dilemma: give up all or part of their stake in the company – an “exit” – or continue to actively grow the business. We often associate an “exit” with selling the startup to a large company or exercising stock options, but, in fact, there are several common types of exits:
-
IPOs (Initial Public Offerings): shares in a private company are sold to the public
-
Private sale (to VCs or private equity): private capital is invested in return for a stake in the company
-
SPAC (Special Purpose Acquisition Company): a corporation is formed for the sole purpose of raising capital to acquire another company
Choosing an exit strategy is a critical decision – one with implications for entrepreneurs, employees, and investors.
Early Formulation: A Key to Success
While, intuitively, choosing an exit strategy seems like a later stage decision, it should actually be one of the cornerstones of your business plan from the get-go. A solid exit plan, formulated early on, is essential to an entrepreneur’s ability to attract investors – and the ability to grow and scale the startup. With return on investment coming only with an exit, investors demand to know both:
-
That you plan to exit
-
How you plan to exit
In the high-growth startup world, an exit strategy reflects the culmination of a company’s goals and helps guide its plan to scale. It informs investors about the type of return on investment they can expect and how long it will take to see a return. Formulating an exit strategy from the outset doesn’t mean that you will blindly have to implement it later on. The strategy will, most likely, evolve over the years and, ultimately, be influenced by short-term trends in the market – but having an exit strategy in place helps keep entrepreneurs on track and is critical to attracting investors.
The Top 3 Exit Strategies for Start-Ups IPOs
When a privately owned company first sells shares of stock to the public via the primary markets, it is known as an IPO (initial public offering). The lead-up to an IPO involves increased public scrutiny as well as extensive paperwork and financial disclosures –a complex process which is usually handed over to an investment bank. The fair value of the shares is set by an industry analyst through the intricate process of an IPO valuation which is based, largely, on timing and market demand. Once shares are sold, the company’s ownership transitions from solely private ownership to – in part – public investors in order to raise capital. After an IPO, the business continues to operate much as it did before though, as a public company, with heavy regulation and ongoing performance scrutiny. Management continues its responsibilities and can generate additional funds and liquidity by releasing additional shares at a later date. If you want to continue your role in the company, can risk lower evaluation or interest than anticipated, and can handle the regulation and public eye, an IPO may be the right exit for you.
Private Sales – VC’s, Private Equity, Mergers, Angels
A 2nd common exit strategy for startups is by private sale – to a VC, private equity firm, angel investor, or a company which merges the businesses. Unlike IPOs which are, by nature, speculative, private sales of the activities of a business are based on a fixed share price, with consideration given when the transaction is completed. Payment is made in any negotiable “currency”- in cash or in securities owned by the purchaser that can be redeemed.
Employees who received stock options as part of their employment package (ESOP) can exercise their options at the time of the sale and will receive compensation like any other shareholder –in cash or in shares of the acquiring company.
Need to raise capital but not ready to exit your involvement in the startup? The terms of the sale agreement often require you to stay for a minimum period of 1-3 years after the company’s acquisition, in order to ensure continuity and creation of value for the buyer. Some founders enjoy this arrangement – they can continue developing their business without the responsibilities of the day-to-day operations. On the other hand, for serial entrepreneurs, this may not be the ideal strategy.
SPAC
SPACs (Special Purpose Acquisition Companies) are a popular exit strategy into public markets. SPACs, shell companies formed with the sole purpose of raising capital, aren’t operational – they provide a cash source to identify a merger target and facilitate its access to public markets without going the traditional IPO route.
Usually, SPACS are formed by investors – sponsors- with expertise in a particular sector who look for deals in that area. Acquisition targets aren’t identified as to avoid extensive disclosures during the IPO process. SPACs seek underwriters and institutional investors before offering shares to the public.
Funds can only be used for an acquisition, and the SPAC has 2 years to complete a deal or it faces liquidation, having to return investment capital. After the transaction, the SPAC is usually listed on a major stock exchange.
Advantages? Selling to a SPAC can add up to 20% to the sale price as compared to a typical private equity deal and can be a faster, more straightforward IPO process, guided by an experienced partner, with less fluctuation in share price.
Drawbacks? Sponsors generally keep 20% of the equity so there is dilution for the acquired company. Since deals must be consummated within 2 years, it’s in the sponsor’s interest to complete an acquisition at almost any price. Currently, it’s a suitor’s market since there are so many SPACs in the market today.
To sum up… founders work hard to develop their product and grow their company in order to build something of value. And, investors expect significant return on their capital.
While there’s no secret formula for the right timing and strategy for an exit, what is for certain is that entrepreneurs and investors will, sooner or later, look for an exit.
Exit strategies should be considered from the inception of a startup – and evaluated as the business develops.