What is Your Road to Exit?
by Peter Vroom
A look at Exit Strategies starting with what is an Exit, why do you need to think about it now, when may it happen, how will you get to it, and what must you do to prepare…
What is an Exit?
An Exit may be for one or more or all of the shareholders to dispose of their interest in a business.
Various terms are used, ‘trade sale’ is common in Australia, ‘acquisition’ is the term used in the US, as is ‘corporate transaction’.
Company constitutions and shareholder agreements are commonly set up to predefine how an exit will work as between the shareholders in a business, for example a ‘drag along clause’ to ensure that minor shareholders can not block a share or business sale transaction that is approved by the majority of shareholders.
When does an Exit become relevant?
Founders of a business may be vague on this until they reach some personal limit at which point they ‘want out’. This may be a result of deciding ‘this is a good time to get out’, ‘I’ve done what I set out to achieve’, ‘I’ve had enough’, ‘I’ve reached the limit of my contribution’, ‘I don’t want to move or do a long commute’, or some other event such as illness or other change in personal circumstance.
External investors have Exit as part of the focus and plan from day 1 of investing in a business.
The 3Fs (Friends, Fools, and Family) may take a more casual or longer view of things, but they may also suddenly want their money out for personal reasons.
Angel investors tend to be in for the longer run, perhaps 5 years or more, although nowadays everyone’s horizons are shortening.
Venture Capital (VC) investors are a mixed breed, some look for quicker turns, others like the idea of keeping the money working for longer periods of time. This makes it challenging for founders.
The Exit timing may be related to a ‘window of opportunity’ in an industry or market. For example, a new and more innovative technology makes products based on older technology impossible to sell and the investment to go to the new technology is out of reach.
The passing of time may introduce risk and diminish the value of the reward to investors. Or vice versa. Many factors can affect this, including legislative or industry development factors that may be foreseeable, or ‘external’ factors such as major currency exchange movements and ‘economic meltdowns’ or recessions.
The best approach to business is to be well positioned for an Exit at all times and to make the most of the opportunity quickly when it arises. A deal is not done until the money is cleared into your bank account! This approach and the actions to achieve it must be planned and this is what we will now look at. J
Just letting the road take you along is a sure fire way of not making the most of an Exit. It’s leaving things to chance. It’s not being prepared when the time or opportunity comes.
Experience shows that there is definite benefit in terms of a better result for shareholders and other stakeholders in the business through a planned and proactive approach to Exit.
There is also the fact that a casual approach will not attract investors, or suitable investors or partners in the first place. The worst kind of investor you can have in an early stage business is a ‘dumb investor’ meaning they only add money but no other value to your business.
Business is hard enough without creating more obstacles for yourself!
The Financial Road to Exit
Traditionally businesses in Service Industries, Distribution, Manufacturing, and Retail focus on building revenue and profit and generally take the ‘Financial Road’ leading to business Exit.
It’s a hard and expensive slog ‘building out’ such a business. First the products or services, and then the customers, sales, and cash flow.
Working out how to sell and deliver them consistently and profitably. Perhaps finding (and needing to train, incentivize, and manage) distributors or agents in remote locations.
Finding and managing the human and cash resources required. Note that unless customers pay up front, you will need more cash as you grow in order to fund the increasing turnover.
Collecting and managing cash and things associated with cash such as exchange rates as well as potentially transfer or withholding taxes, is a central requirement.
Raising more cash (unless it’s in the form of debt that can be repaid) is likley to involve dilution of the founder and early shareholders. US statistics show that at IPO, founders will typically have been diluted to down to around 3% of the company.
The whole ‘building out’ process before such a business becomes large enough and has predictability in regards to revenue and profit is likely to involve many years.
Markets see such businesses in terms of ability to generate profit in the hands of current or new owners.
The word you will see often in the financial press is ‘EBITDA’ meaning Earnings before Interest, Tax, Depreciation, and Amortization. Many companies are bought on valuations based on their EBITDA earnings record and projections, with different multiples of earnings applying to different industries (and also varying according to the business climate at the time).
Listing the business on the stock exchange (also known as Initial Public Offering or ‘IPO’) can provide the founding and early stage investors with an Exit once they are allowed to sell their shares after a lock up period (called ‘escrow’).
Pure services companies (lawyers etc) are commonly bought on a multiple of annual fees.
Buying a business with predictable revenue and profit is seen as involving lower risk. It also generates a lower return to the seller but, of course, the actual dollars may be very large if the business has grown to be a big one. The question for the founders and early stage investors is, how will they fare after many years of waiting for a return and, possibly, several rounds of needing to invest more or be diluted?
Are you on this road? Is it taking you to the place you want to go?
The Strategic Road to Exit
Businesses in newer industries such as ICT, Electronics, Biotech that have unique and differentiated intellectual property (IP) and intellectual capital may have the basis to take the ‘Strategic Road to Exit’.
This path to Exit does not involve the effort, time, and cost of ‘building out’ the business.
The focus is on innovation and creating ‘differentiated intellectual property’ and building deep knowledge or ‘intellectual capital’ around it and its applications.
A key part of the strategy is to develop a list of target companies to be approached as potential strategic partners at the outset.
The Strategic Exit strategy is to provide the ‘missing piece’ for another company that has the market reach and financial strength to leverage your innovative IP to the extent that you never could.
The strategy is implemented using a ‘corporate development’ (as distinct from ‘business development’) approach. This starts with creating the right messages on the company’s web site and collateral to support the potential of a Strategic Exit.
The corporate development approach includes creating market ‘buzz’ by building relationships and trust and correctly positioning the opportunity you present with key market influencers in your industry segment… the people who are respected for their insights by internal influencers and decision makers of companies on the target list.
Targets are then approached with a focus on OEM / licensing discussions that in turn may lead to exclusivity and acquisition discussions.
The strategic path to Exit needs clear and consistent corporate development focus from beginning to end. A licensing deal done along the way on terms that are unacceptable to a real target acquirer can destroy the strategy.
Once there is strong interest, the approach includes playing on ‘fud’ (fear, uncertainty, and doubt) to help establish ‘competitive tension’ amongst a number of target companies.
The Strategic Exit path absolutely requires that the team has the right skills to execute a ‘corporate development’ strategy and plan over a period of one to two years, sometimes longer.
Achieving a Strategic Exit probably requires assistance from people with a proven track record for the critical stages.
Remember this is not building something and hanging out a ‘for sale’ sign with a price on it. It can not be done in typical ‘M&A’ style in three to six months leading to a transaction based on EBITDA multiples because there is unlikely to be any revenue to speak of.
Companies buy strategic assets that provide the ‘missing piece’ for their value and leverage potential in their hands, i.e. the leverage value to them. Other than proof of concept, it has nothing to do with revenue or customer base that you may have acquired along the way.
The result can be an acquisition at a price much higher than that possible based on EBITDA. At the same time the strategic road to Exit can be shorter in time and involve less dilution to founders and early stage investors.
Note that an IPO is not a practical option for a Strategic Exit play except at such times that the market becomes overheated and investors behave more like punters and will put some of their money on almost and bet at any risk. This was the scene pre the dotcom bust.
Are you on the Strategic Exit road? Are you on track to maximize your Exit?
Exit Strategy Summary
Summarizing the key points about the Financial versus the Strategic Exit roads.:
Financial Road
•Similar businesses already exist
•Low competitive differentiation
•Not considered strategic
•Buyer will ‘run as is’
•M&A ‘for sale’ approach
$ = EBITDA multiple
Strategic Road
•Innovation culture and support
•Differentiated technology / process
•Hard to duplicate
•The ‘missing piece’
•‘Corporate development’ approach to an Exit
•$ = Leverage value to larger corporation