apitalism is about making money and venture capital is about making BIG money in very risky investment markets. Venture capitalists, who often invest their money early in the evolution of an enterprise and must hold these investments for long periods until they come to fruition, require exit or liquidity opportunities.
These are opportunities to “cash out” and reap the immense financial rewards that the venture capitalists require to cover the other 8 out of 10 ventures in their portfolio that will likely fail. In essence, it is like being in a casino. A good venture capitalist will know when to quit while they are ahead. This is very much an art form. Startup valuations are riddled with uncertainty and can waver dramatically. Understanding how to exit an investment is as important as understanding how to invest in one and undeniably part of the science and art of venture capital.
An exit opportunity is a liquidity event that enables founders, venture capitalists and financial stakeholders to reap capital gains from their investments in the high risk and very illiquid world of startups and entrepreneurial finance. Capital has many forms and a liquidity event involves the transformation of an illiquid asset (equity in a startup) into a liquid asset (cash).
Most venture capital funds make their earnings as capital gains from the sale of equity investments. Without a variety of exit opportunities, it is difficult to attract investment in startups due to the high risk of the sector—90% of startups will fail. A central advantage of the United States as a market for venture capital, isn’t just its technological dynamism but the fact that its capital markets are sufficiently large enough and well diversified enough to provide venture capitalists with myriad exit opportunities.
Aside from the inherent risks of startup investing—uncertain markets, rapidly changing technologies, the difficulty of displacing entrenched competitors, and the vagaries of trying to find a strong product-market fit—a critical factor that makes exit opportunities so important in venture capital is time. The typical venture capitalist must hold their investment for seven to ten years before the business is sufficiently viable.
This illiquidity is intrinsic to venture capital and a major reason why it is so risky. Companies in different industries will have different timelines to profitability with startups in the biotechnology and deeptech space often renowned for taking much longer to mature. The venture capitalists face pressures to generate a strong return for their investors and they are aware of the high failure rate so from their perspective, the more different opportunities that they have to exit or cash out the better.
For example, investing at the earliest or seed stage can be uniquely risky especially because this is the hardest stage at which to value a company. As a consequence, convertible debt is becoming an increasingly popular venture investment tool at the seed stage. Convertible debt involves an investor granting a startup a loan with a specific principal amount, interest rate along with maturity date by which the principal and interest must be repaid.
The venture capitalist then has the option to convert to equity if the startup is promising and goes on to have an equity funding round or if they don’t like how things are going, they have the flexibility to mitigate their risk by calling the debt at maturity and withdrawing from the financing of the startup. There are other types of exit opportunities but this highlights the risk-reward dynamic that is part and parcel of such transactions.
Types of Exit Opportunities
Aside from the previously mentioned convertible debt, there are several other types of exit opportunities in the venture capital industry. The most popular type and the one that the venture capital industry is uniquely famous for is the Initial Public Offering (IPO). Through an IPO, a company sells its shares to the public for the first time.
Initial Public Offering (IPO)
If the stock performs well upon sale, fortunes can be made as their value appreciates. But there are also many examples of IPOs that flounder as stocks grossly underperform because of a failure to accurately assess market demand or time the market properly. Due to the vast amounts of capital available to firms that can go public, this is the largest potential return available to venture capitalists but it is an option that is best for companies that are capable of maturing into market leaders with revenues in the tens of millions of dollars and a clear path towards profitability.
The public markets can be very unkind. For example, online course provider Coursera closed with a stock price of $45 when it IPOed on March 31, 2021 but its stock has since declined to $14.36. The fintech Robinhood had a stock price of $38 for its IPO on July 28, 2021 but is now only valued at $18.21 while mortgage technology firm Blend Labs has seen its stock decline from $18 when it had its IPO on July 15, 2021 to $3.09 at present. While the changing fortunes of these firms demonstrate how difficult it is to sustain competitive advantage in dynamic startup markets, they also show why exit opportunities are so important to venture capital investors.
Those VCs who sold their stock soon after the 90 to 180 post-IPO lock up period made a fortune while those who remained at the gambling table have lost major sums of money. So much can happen—COVID-19, rising interest rates, recession, or even war that a good venture capitalist will mitigate risk by having investments that are being exited as well as investments that are illiquid in their portfolio. VCs are not value investors like Warren Buffet who hold onto investments for decades—they want to become liquid as soon as possible due to the risky nature of the markets in which they operate.
Secondary Market
Another form of exit is the secondary market. A secondary market is a non-stock exchange marketplace where investors can buy and sell share in private companies. They are a viable option for investors who want to sell their equity in a startup before it goes public via IPO. However, it can be difficult to find a buyer of shares in a secondary market because the natural concern on the part of the buyer is why does one want to sell before the IPO.
Buyback
A buyback is another exit opportunity for investors. Under a buyback, a company will repurchase shares of its own stock from investors. The venture capitalists receive their cash out funds directly from the startup rather than from new investors in an IPO. This can be an expression of confidence in the future of the enterprise or due to a desire on the part of insiders to maximize control of the startup. However, due to the fact that it is an opaque transaction with fewer bidders available, the return on the investment accorded to the seller is normally less.
Acquisition
Aside from IPOs, being acquired by another company is the most popular exit opportunity. It simply entails the purchase of a startup by another company. The founders and venture capitalists are typically ready to move on and relinquish control over what they have built. The acquiring company is normally seeking to obtain a strategic advantage within its industry and views the startup as essential to that goal. The advantage to the founders and venture capitalists is that they can cash out very quickly without going through the onerous IPO process but the disadvantage is that there are normally lower returns.
After all, higher returns are normally associated with higher risk and there is more risk in an IPO. Most startup acquisitions occur at the Series A stage.
Two of the most strategically important acquisitions in the history of tech are Google’s November 2006 purchase of YouTube for $1.6 billion and Facebook’s 2012 acquisition of Instagram for $1 billion. Both of these firms were relatively small when they were acquired and had ample room to grow but the strategic reality is that the ability to search for video was so important to the dominant search engine and the ability to share photos and videos was so important to the leading social media company that if they had not been acquired, they would have almost certainly faced stiff competition from an internally incubated solution at Google and Facebook.
It was simply better to sell early than die late because over time they likely would not have survived competition with these deep-pocketed competitors. The YouTube and Instagram acquisitions also highlight how the top tech firms are becoming venture capitalists in their own right with corporate venture capital arms who are constantly looking to partner with, learn from and acquire startups that have the capacity to disrupt their industry or add to their competitive advantage.
Often times the human capital within the acquired firm is valued just as high as the intellectual property with the founders and key technical staff from the newly integrated firm often being offered positions in the broader company. While there is less financial upside in exit through acquisition, there is also less risk and less expense than doing an IPO.
Tips for a Successful IPO
In order to successfully leverage initial public offerings (IPOs) as an exit strategy, startup founders and their venture capital investors need to have a successful plan because this process is costly, complex, and imbued with many regulatory bottlenecks in spite of the potential upside. The first step is to prepare the startup for an IPO. This requires helping it to achieve consistently strong financial performance, compliance and governance before the IPO.
Predictability is a sine qua none for a successful IPO as consistent results that can serve as a proxy for future earnings are the first thing that potential investors will look for. With that in mind, good companies establish strong and accurate financial and performance metrics well before an IPO. They develop the habit of gathering and maintaining excellent information on the company’s customers, profitability, revenue growth, etc. because this information informs strategy and can be harnessed to tell a compelling story to potential investors.
Secondly, it is imperative to build a strong IPO team. To meet the robust regulatory requirements of an IPO, it is essential to assemble a highly competent and experienced team of accountants, auditors, investment bankers and lawyers. Selecting the right underwriter is of particular importance as they should have a strong track record and profound expertise in the startup’s industry. That expertise will inform the selection of an initial offering price which is of paramount significance with regards to cultivating investor interest while simultaneously ensuring that the company obtains the funding required to achieve strategic objectives and enabling venture capitalists to profitably cash out of their investment.
Collectively, these professionals will be responsible for making sure that the company provides the information required for regulatory compliance. They must be detail oriented with a strong understanding of the data points and processes that the regulatory authorities will be scrutinizing prior to the IPO. The hallmark of being a successful public company is transparency as this personal phenomenon—your company—is now being opened to the general population so the startup’s business is no longer its business but everybody’s business. This process can be very difficult both personally and professionally but it is the price that one must pay for the wealth accrued in an IPO.
Figuring Out Your Exit Strategy
In figuring out how to exit, the importance of due diligence should not be underestimated. There are different ways for a venture capitalist to exit an investment opportunity which is why it's important to evaluate the risks and rewards associated with each. The goal in this analysis should always be to maximize the returns on the investment while mitigating risks.
Secondly, financial due diligence is essential. Good venture capitalists don’t just analyze the financial statements of their portfolio companies and track performance over time, they also work with founders to design key performance indicators that provide the best insight into the true financial health of the company and set goals that are sound and help to position the company for a successful exit.
Thirdly, in rapidly changing markets, market intelligence has emerged as an increasingly important strategic function even for startups. To exit a market, a startup must first survive and compete effectively within it. While there is ample information to be derived from industry reports, it may be best to consider building an internal market and technology intelligence team to monitor changes in the core industry and related sectors so as to mitigate the potential for disruption and help to translate that knowledge into action.
This could also be a functionality that the venture capitalist offers to its portfolio companies as part of its value proposition. In addition, successful exits require meeting legal and regulatory requirements as they pertain to mergers and acquisitions, IPOs, the sale of securities, capital gains taxes, and intellectual property rights. Consequently, this is a core capability for all businesses. It is important to understand the legal risks and processes before deciding on the best exit opportunity to pursue.
Finally, it is important to conduct due diligence on the operational capabilities of the firm. In venture capital, the idea is to grow a firm that is large enough to capitalize on an enormous market opportunity. This requires that the startup be operationally sound with a strong capacity to scale and sound organizational processes so that it can grow rapidly but efficiently. This capacity is what potential acquirers and investors will be investigating as they examine the future prospects of the startup.
A critical factor in successful exits is strong alignment amongst the various stakeholders involved in building and financing the startup. Towards that end, it is essential that from the outset all of the stakeholders arrive at a consensus regarding how they would best like to exit that includes a clear and realistic assessment of the company’s value proposition, the dynamics of the market and related success drivers, growth potential and the risk profile of the company.
What is the best way for a firm like this to exit that provides the best return on investment but also allows for the realization of personal ambitions? This will by definition involve evaluating both quantitative and qualitative factors including profitability, revenue growth, the number and characteristics of the customer base, company culture, capacity for technological innovation, product pipeline and potential for social impact. It is better for these conversations to take place from the outset and evolve over time than for the company to arrive at a potential exit opportunity and the discover that the various stakeholders have serious, fundamental disagreements over how best to proceed.
This is especially important because relationships between the various stakeholders usually have legal ramifications in that they are codified in shareholder agreements, term sheets, the politics of governance boards and the brute force reality of equity power. There is an inherent need for the capacity to compromise so founders and venture capitalists should look for these characteristics as they seek partners to build a company with as they will become particularly essential when it is time to productively exit the investment.
Communication and integrity are also a salient part of this process as it is important for all parties to be aware of changes in the company so that they can arrive at the best decision regarding whether or not they should adjust their exit strategy accordingly. The failure to meet KPIs may make it less than ideal to IPO or seek acquisition while an unexpected acquisition offer may emerge that changes the appeal of a planned IPO. The reverse can be true as well but the constant is that all of the stakeholders need good, accurate information to assess which exit strategy is best.
Typically, founders and venture capitalists will remain involved with a company even after they exit it whether it be through acquisition or IPO. They have spent years building the enterprise and their attachments will always run deep and their utility, particularly on the technical side, will always be essential.
This is especially true in that there a usually legislated holding periods for the sale of stock after an IPO and acquisitions must usually obtain government approval. In addition, some acquiring companies may be more interested in the human capital of the firm than the technological capital as the people who built the technology have more future value than the technology itself. Hence, a post-exit transition plan is key. Such a plan should encompass issues that pertain to all aspects of the exited company including technology, personnel, legal, financial and even cultural if the company is being acquired by another firm.
Arguably the most important stakeholder in an exit strategy is the founder. The founders play the most hands-on role in building the company and while venture capitalists have multiple options in their portfolio, for the founder this one startup is their core interest. It is therefore essential that the investor’s return on investment expectations be in alignment with the founder’s vision, values and mission.
If the venture capitalists have a very short-term focus because they need to improve their numbers so that they can raise a new fund while the founders are playing the long game with world changing technology that requires great patience despite immense profitability potential then that needs to be taken into consideration.
The venture capitalists must adapt, sell their equity in the secondary markets or use a tool like convertible debt that allows them to take a wait and see approach and cash out when the risk profile of the company exceeds what the venture capitalist will tolerate. Ideally, the founder’s vision and the venture capitalist’s financial goals should be in harmony from the outset. The founder-investor fit is as essential as the product-market fit. Of particular importance are questions like:
- Why did the founders start the company?
- What is the founder’s long-term vision?
- Do the founders want to stay involved or move on to other projects? Are they lifers?
- What is the stage and growth potential of the startup?
- How mature is the product, the market, and the team?
- How scalable and profitable is the business model?
- What are the risks and opportunities for growth?
- How competitive and dynamic is the industry?
A good exit strategy is one in which all parties but especially founders win. Venture capitalists will have other opportunities but for the founders this one startup is normally their only chance. Moreover, few truly successful entrepreneurs are in it only for the money. The best are driven by far more.
How to exit an investment is as important as how to invest in one. There are many different options whose advantages and disadvantages must be understood to make the best exit decision. But what is most imperative for the various stakeholders involved in building the startup is to have alignment from the outset. Issues of character come into play as integrity, good communication and a capacity for compromise so that consensus can be achieved is essential.
Planning and preparation are essential but so too is the ability to capitalize on emerging opportunities. Successful exits are the result of long-term planning, excellent personnel who are good people, a keen awareness of the internal dynamics of the company and market conditions as well as short-term opportunism.
