Christina Tamer updated this article with two new steps to formulating a successful exit strategy. The original article was published on August 8, 2017.
Most startups are intensely focused on getting their product to market and solving their customer’s problems. The idea of selling the company isn’t always top of the entrepreneur’s mind. Yet startups often can’t raise money from outside investors without an exit strategy.
Investopedia defines an exit strategy as:
“The method by which a venture capitalist or business owner intends to get out of an investment that he or she has made in the past. In other words, the exit strategy is a way of “cashing out” an investment.”
Ideally, an exit strategy allows an entrepreneur to plan how to optimize a good situation, rather than get out of a bad one, but it is used to plan for both scenarios. Many experts also believe that a well-designed exit strategy will increase the value of a business and help keep the company focused on making returns.
In the high-growth startup world, the exit strategy reflects the culmination of a company’s goals and helps guide its plan to scale. If a startup’s business model requires equity financing from venture capitalists or angel investors, the entrepreneur’s exit strategy is necessary to inform investors about the type of return on investment they can expect, and how long it will take to see a return. Not having an exit strategy, or worse, not having exit opportunities, indicates that it will be difficult for investors to be repaid. While the strategy will certainly evolve over the years, it’s critical for entrepreneurs to identify potential paths to liquidity and plan accordingly.
Christina Tamer, Senior Program Officer at VentureWell, highlighted the most common exits and identified some important steps to take when creating an exit strategy.
The Three Most Common Exits
1) Initial Public Offering (IPO): An initial public offering, or IPO, is the very first sale of stock issued by a company to the public. The goal of “going public” is to raise money for the company, allowing it to grow and expand. IPOs are a significant event, requiring many hours of preparation and sophisticated reporting. Most importantly, the timing has to be right. Despite having everything in order, IPOs don’t always go smoothly. IPOs from companies like Alibaba made billions of dollars right out of the gate, while others, like Facebook, were initially underwhelming and took time to gain traction. That said, IPOs are relatively rare – only 100-200 per year – compared to the number of startups formed each year. IPOs are also tied to economic cycles. For example, there were only 31 IPOs in 2008, compared to over 400 per year during the dot com boom in the late 1990s.
2) Merger: A merger unites two existing companies into one new company. There are several types of mergers – and different motivations for creating them. Most mergers occur to gain market share, expand a company’s reach, or grow into new segments; all of which satisfy shareholders and create value for the companies involved.
VentureWell E-Team, Sisu Global Health, formed as a startup partnership between Design for Innovations for Infants, Mothers Everywhere, Inc., and CentriCycle. The reason for the merger? The founders of each startup wanted to create a pipeline for many different types of technologies that are needed in the developing world.
3) Acquisition: An acquisition is when a company buys most or all of another firm and assumes control of it. The buying company typically aims to absorb the target company’s stock and other assets. Acquisitions can be paid for in cash or by acquiring the company’s stock – or a combination of both. Companies are typically acquired for their assets or intellectual property, their market access, or their talent (also called an aqui-hire). An acquisition is typically the most likely path for a startup to provide liquidity for investors.
Research and work completed by a VentureWell E-Team from Clarkson University in 1999 resulted in the formation of a startup called ATDynamics. Over the years, the company developed a suite of clean technology products engineered to reduce fuel consumption in the global freight transportation sector. In 2015, Stemco, a commercial vehicle parts manufacturer, acquired ATDynamics for their patented and award-winning TrailerTail product.
Key Steps to Formulating an Exit Strategy
Exits are different for every company. While most will go through a similar exit preparation process, the timing and order of these steps will vary based on each company’s goals, values, and the ensuing negotiations. Below are several important steps to consider when thinking about the best exit strategy for your company.
Consider Your Motivation
Every potential buyer wants to understand the motivation of the seller. Why do you want to exit? What are the shareholders hoping to achieve? Having aligned motives makes for a smooth negotiation process and harmonious transition.
Explore Options
Research the acquisitions of any competitors or other companies in your sector to help determine realistic fundraising benchmarks. Identify the active acquirers as well as the companies with complementary offerings that might make strong merger candidates. It’s also important to regularly investigate potential acquiring companies. Research their acquisition history, the reasons behind the deals, and determine if they meet your acquisition criteria.
Know the Industry
A solid understanding of market dynamics is a key success factor. Some companies become too focused on the day-to-day that they forget to ask questions that will help them clarify their vision for the company beyond fundraising and launch. The board of directors can help frame the big picture and figure out where the company fits into the market.
Do the Math
Always be prepared with information on comparable exit transactions including purchase price and milestones completed. While Crunchbase or Pitchbook are valuable resources for gathering such information, it’s important to also continuously monitor industry announcements and trends and gather data through anecdotes in your conversations with peers and colleagues. This will help you build an arsenal of valuable insights. Keep in mind that investors usually work backwards from potential exit value to determine your valuation today. For you, that means it is wise to articulate a reasonable valuation that will account for unknowns in pricing, market dynamics, and other expenses. When crunching the numbers, anticipate an investor’s questions and provide evidence that not only answers their questions, but reassures them that you’ve done your homework on your assumptions.
Focus on Revenue Growth
Startups looking to exit should focus on revenue growth opportunities. Gaining traction within a market is one way to show that the innovation has potential. As a startup grows, these opportunities can be developed into an actionable strategy with the support of their board and shareholders.
It’s also important to identify revenue benchmarks and funding requirements. These goals should be established before the fundraising process begins, as the amount of money raised on the path to exit shouldn’t be more than the potential sale amount. If a company raises more funding than its potential sale price, its valuation may be too high for potential acquirers and partners. Our colleagues at Rhapsody Venture Partners call this “overshooting the moon”.
To avoid this mistake, track valuation trends from the start. Consider how much funding similar companies raised in their lifetimes, what benchmarks they hit, and their final sale price. Find out what the buyer paid as a multiple of the company’s revenue at the time (price-to-revenue multiple).
For more information about valuation trends, read investor and startup blogs and newsletters like TechCrunch, CB Insights, and The Term Sheet by Fortune, and review industry research like PricewaterhouseCoopers’ MoneyTree reports.
Build Relationships with Potential Acquirers
An exit strategy is constantly evolving. It is subject to change as a company grows and pivots. Although you’ll want to identify targets and possibilities early on, markets and priorities will evolve over time. It’s smart to build relationships with potential acquirers or merger partners from the beginning, and find ways to test the waters and work together in some capacity. It’s also not uncommon for buyers to spend a significant amount of time with potential acquisition targets in order to understand the business, customer response, and work philosophy. Take advantage of buyer research opportunities.
Consider the Competition
There’s always a chance that competitors are also seeking an acquisition deal. Take a hard look at your company. Does your innovation stand out in the marketplace? What’s the real asset your company has to offer? Is it your talent, IP, or market access? Why would an acquirer choose your company over the competition? Answering these types of questions can help startups identify the next steps needed to impress acquirers.
Put it in the Pitch
An exit strategy is among the top three things that an investor wants to know about a startup. Presenting a clear, concise exit strategy in your pitch shows that you’re serious. It indicates that you’ve thought about an investor’s role in the company and the value the investor will provide, not just getting them to write you a check.
Since most of a company’s value is gained at the exit, this is where they’ll see a return on their investment. Investors will look for a plan that clearly outlines a path to create value, the necessary milestones, and how the company plans to secure one or more potential buyers. If there is no feasible exit in sight, it’s difficult for investors to feel confident that they will get their money back. Angels, venture capitalists, and other equity investors generally aim for a 10x return on investment within five to seven years in order to receive competitive overall portfolio returns of 2-3x.
Ask for Help
If you’re unsure on how to start thinking about an exit strategy, reach out to industry veterans for guidance. But don’t simply ask, “what should I do?” or expect a crash course on the subject. Instead, talk with them about their experience with exits, whether on the “buy-side”—those that purchased companies—or on the “sell-side”—those that have brought a company to exit as a CEO, founder, or investor. Find out when they started to have exit conversations with potential buyers and how they found the balance between value creation and the market’s willingness to pay.
Look for as many case studies as possible that illustrate what’s been purchased in your industry and why. Try to uncover which milestones were completed when the startup began exit conversations with their board and shareholders, which ones were reached when they began speaking with potential acquirers, and what had been accomplished by the time they completed the transaction. Use the learnings from first-hand experiences to help you develop your own plan and next steps.
How can companies put these steps into practice? Start by participating in an investor readiness training program. These trainings provide the instruction, knowledge, and hands-on experience needed to help companies avoid rookie mistakes and approach negotiations from a stronger, more confident position. They also allow companies to map out the exit possibilities, and determine appropriate milestones.
Our ASPIRE program prepares startups for the investments and partnerships necessary to launch their ventures. Learn more about the program and see upcoming dates and deadlines here.
About the Author
Christina Tamer oversees VentureWell early-stage innovator programs ranging from initial customer discovery in E-Teams to investment readiness in ASPIRE. Previously, she worked with a seed-stage impact investment venture fund. The experiences as an investor in addition to countless hours reading grant proposals, building and tracking startup pipelines, and serving as a startup mentor allow her to support VentureWell’s startups with real world examples, lessons, and insights. She holds a BS in Marketing and an MBA from the University of Massachusetts Boston.