Business entities, funding and exit strategies
BUSINESS FORMATION & FUNDING OPTIONS
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1. Exit Strategy1 In this last section of Topic 2 we will gain a general overview of an exit strategy. After having looked at the various funding options for your enterprise, we also must think of what is the best exit strategy for you – either as an investor or as an entrepreneur; considering that you may be wearing two hats – and what that means for the investor or the enterprise. What Is an Exit Strategy? So what is an exit strategy and why is it important?
An exit strategy is a contingency plan that is executed by an investor, trader, venture capitalist, or business owner to liquidate a position in a financial asset or dispose of tangible business assets once predetermined criteria for either has been met or exceeded.
An exit strategy may be executed to exit a non-performing investment or close an unprofitable business. In this case, the purpose of the exit strategy is to limit losses.
An exit strategy may also be executed when an investment or business venture has met its profit objective. For instance, an angel investor in a startup company may plan an exit strategy through an initial public offering (IPO). This means that we will issue shares and offer them in an exchange, typically the London Stock Exchange, New York Stock exchange or similar. What it means is, that the company is no longer private but the peoples (public) will own shares of your company. Can you think of famous publicly listed companies? – Tesla, Apple, Microsoft, Facebook etc. are famous publicly listed companies which started in a garage in the backyard of a garden!
Other reasons for executing an exit strategy may include a significant change in market conditions due to a catastrophic event; legal reasons, such as estate planning, liability lawsuits or a divorce; or for the simple reason that a business owner/investor is retiring and wants to cash out.
Business exit strategies should not be confused with trading exit strategies used in securities markets.
1 https://www.investopedia.com/terms/e/exitstrategy.asp
BUSINESS FORMATION & FUNDING OPTIONS
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KEY TAKEAWAYS
• An exit strategy, broadly, is a conscious plan to dispose of an investment in a business venture or financial asset.
• Business exit strategies include IPOs, acquisitions, or buy-outs but may also include strategic default or bankruptcy to exit a failing company.
• Trading exit strategies focus on stop-loss efforts to prevent downside losses and take-profit orders to cash out of winning trades.
Understanding Exit Strategies An effective exit strategy should be planned for every positive and negative contingency regardless of the type of investment, trade, or business venture. This planning should be an integral part of determining the risk associated with the investment, trade, or business venture.
A business exit strategy is an entrepreneur's strategic plan to sell their ownership in a company to investors or another company. An exit strategy gives a business owner a way to reduce or liquidate their stake in a business and, if the business is successful, make a substantial profit.
If the business is not successful, an exit strategy (or "exit plan") enables the entrepreneur to limit losses. An exit strategy may also be used by an investor such as a venture capitalist to prepare for a cash-out of an investment.
For traders and investors, exit strategies and other money management techniques can greatly enhance their trading by eliminating emotion and reducing risk. Before entering a trade, an investor is advised to set a point at which they will sell for a loss and a point at which they will sell for a gain.
Money management is one of the most important (and least understood) aspects of trading. Many traders, for instance, enter a trade without an exit strategy and are often more likely to take premature profits or, worse, run losses. Traders should understand the exits that are available to them and create an exit strategy that will minimize losses and lock in profits.
Exit Strategies for a Business Venture In the case of a startup business, successful entrepreneurs plan for a comprehensive exit strategy in case business operations do not meet predetermined milestones.
If cash flow draws down to a point where business operations are no longer sustainable and an external capital infusion is no longer feasible to maintain operations, a planned termination of operations and a liquidation of all assets are sometimes the best options to limit any further losses.
BUSINESS FORMATION & FUNDING OPTIONS
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Most venture capitalists insist that a carefully planned exit strategy be included in a business plan before committing any capital. Business owners or investors may also choose to exit if a lucrative offer for the business is tendered by another party.
Ideally, an entrepreneur will develop an exit strategy in their initial business plan before launching the business. The choice of exit plan will influence business development decisions. Common types of exit strategies include initial public offerings (IPO), strategic acquisitions, and management buy-outs (MBO). An MBO means that the existing management buys-out the shareholders and continues to run the company privately and either finances the takeover from their own personal wealth, through bank loans or by bringing in another cornerstone investor which can be a private individual, a foundation or a Venture Capital or Private Equity Fund.
The difference between a Private Equity Fund and a Public Equity Fund is that the private equity fund is an asset manager that manages private money whereas a public equity fund is an asset manager that manages public money (typically from governments) that invests into private firms. Famous Public Equity Funds are the Qatar Investment Fund who invests in all sorts of businesses and Industries such as car, luxury brands and even Football Clubs.
The exit strategy that an entrepreneur chooses depends on many factors such as how much control or involvement the entrepreneur wants to retain in the business, whether they want the company to continue to be operated in the same way, or if they are willing to see it change going forward. The entrepreneur will want to be paid a fair price for their ownership share.
A strategic acquisition, for example, will relieve the founder of their ownership responsibilities, but will also mean giving up control. IPOs are often considered the ultimate exit strategy since they are associated with prestige and high payoffs. Contrastingly, bankruptcy is seen as the least desirable way to exit a business.
A key aspect of an exit strategy is business valuation, and there are specialists that can help business owners (and buyers) examine a company's financials to determine a fair value. There are also transition managers whose role is to assist sellers with their business exit strategies.
Exit Strategies for a Trade When trading securities, whether for long-term investments or intraday trades, it is imperative that exit strategies for both the profit and loss sides of a trade be planned and diligently executed. All exit trades should be placed immediately after a position is taken. For a trade that meets its profit target, it could immediately be liquidated or a trailing stop could be employed in an attempt to extract more profit.
Under no circumstances should a winning trade be allowed to become a losing trade. For losing trades, an investor should predetermine an acceptable loss amount and adhere to a protective stop-loss.
BUSINESS FORMATION & FUNDING OPTIONS
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In the context of trading, exit strategies are extremely important because they assist traders in overcoming emotion when trading. When a trade reaches its target price, many traders become greedy and hesitate to exit for the sake of gaining more profit, which ultimately turns winning trades into losing trades. When losing trades reach their stop-loss, fear creeps in, and traders hesitate to exit losing trades causing even greater losses.
There are two ways to exit a trade: by taking a loss or by making a gain. Traders use the terms take-profit and stop-loss orders to refer to the type of exit being made. Sometimes these terms are abbreviated as "T/P" and "S/L" by traders.
Stop-losses, or stops, are orders placed with a broker to sell equities automatically at a certain point or price. When this point is reached, the stop-loss will immediately be converted into a market order to sell. These can help minimize losses if the market moves quickly against an investor.
2. Exit options for startups and investors2 Startup acquisitions The main exit strategy for startups is to sell the company to a bigger one for a profit. The same goes for investors. The buyer takes over the startup using cash or stock as a compensation, and key executives and employees from the startup often stay at the company for a period of time in order to be able to cash out and vest their stock. Exits provide capital to startup investors, which can then return the money to their limited partners (in the case of Venture Capitalists) or to the investors themselves (in the case of business angels). Startup acquisitions are much more frequent in the US than in Europe, but lately there’s been a significant surge in the number of European acquisitions. A different type of acquisition that is very common in Silicon Valley is acquihires (acquisition + hiring). In this case the buyer is not so much interested in the product as it is in the team, the talent. Acquihires often lead to the closure of the products and services that have been acquired and employees end up being transferred to a company usually receive significant hiring bonuses. Acquihires tend to happen at an earlier stage in comparison to big startup acquisitions, which means that they often provide less capital to business angels and Venture Capitalists.
2 https://startupxplore.com/en/blog/exit-strategies-for-startups-and-investors/
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Let’s float in the stock market: IPO as an exit strategy As we’ve mentioned before, there comes a time for mature and established technology companies where raising more capital from VCs or private equity firms is no longer an option. So, what comes next? An IPO. As explained in the earlier part of this paper, IPO stands for ‘initial public offering’ and it basically means that a company starts floating on a stock market, selling a significant number of their shares in the process to institutional and non-institutional investors. These large companies are that VCs dream of, as they often provide large sums of capital to all parts involved (founders, early employees and investors). For a long time the NASDAQ and Wall Street have been the main markets for European startups looking to IPO. However, in recent times companies such as eDreams Odigeo, Zalando, or Rocket Internet have chosen the Madrid, Frankfurt or London stock exchanges to go public. An interested trend in the startup world when it comes to going public is that more and more companies are taking longer to IPO. This is a consequence of the high amount of capital available in the startup market from Venture Capitalists, private equity firms and other investment institutions. Mergers & Acquisitions Also commonly known as M&As, these transactions usually imply a merging with a similar and larger company. This type of exit is often chosen by big companies that are looking for complimentary skills in the market, and buying a smaller startup is a better way to develop a product than creating it in-house. M&As are less common than IPOs and straight acquisitions; in the first half of 2014 there were only 4 mergers and acquisitions in Europe. Not selling a startup: milking the cow In the same way that not every startup needs to raise money from VCs and business angels (bootstrapping is a viable alternative), not every startup needs to sell itself to a bigger company to provide a return to founders, employees and investors. Companies that are able to establish a solid business model and scale might choose to stay independent and reinvest the profits in the company. Part of those profits can also be distributed amongst investors as a dividend, providing liquidity to outside partners while avoiding the public markets and the obligations that come with it. 3. The big question: when is the right time to exit? This is a question that i soften asked at conferences and private meetings between investors and startups. When should I sell my company, When is the right time to look for buyers? As an Investor, when should I start looking for a return on my investment?
BUSINESS FORMATION & FUNDING OPTIONS
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And the truth is that there is no universal answer for all of the above. Startups want to sell for as much money as possible (so do investors) and buyers want to spend as little as possible, so both parties need to find a balance. Common sense says that for startups to maximize their selling price they should look for an exit when their growth rates are high instead of when they’re very profitable. However, as Business Insider recently explained “lower-valued startups take less time to scale and less VC money to fuel, which means founders will likely own higher percentages of their companies when they sell”. This implies that these founders might be better off selling for €20 million when they own a big chunk of the startup instead of waiting for a €200 million price tag, as by then they might only own a small percentage of the stock. Each entrepreneur and investor should consider the circumstances of their ventures and make a decision based on that. There’s no secret formula, but what’s for certain is that entrepreneurs and investors, sooner or later, will look for an exit.