Most entrepreneurs don’t start a business with different exit options in mind. But at some point, everyone faces an exit discussion. The reason? It could be age, a partner disagreement, lack of progress or an offer you simply cannot resist.
In 2015, a major law firm politely declined to work for a US investor aiming to make a bid for King, a Swedish online gaming developer behind Candy Crash Saga. The law firm could not see how a mobile game could be worth the money negotiating for?
King’s founders were eventually offered a whopping $5.9 billion dollars to exit their company. Activision Blizzard, a French-owned US gaming developer behind successes like World of Warcraft, was targetting King’s creative process and mobile competence, being stuck in PC platforms. King’s CEO Riccardo Zacconi, product wizard Sebastian Knutsson and King’s other co-founders remained employed with King but exited their shareholding early 2016.
What’s an exit? An exit is the event when entrepreneurs or investors leave the business, selling their shares to someone else. It can be a bit more complicated when co-investors with different time perspectives are involved. We will explore that as well.
This article aims to explore what the 7 best exit option is for you, the entrepreneur. First however, let’s discuss how exit options can have different meaning to entrepreneurs and to outside investors.
Beware, exit options have different meanings to different people
The lifestyle entrepreneur stays with his business to the end. If you operate a family-owned business, you probably only need to consider exiting your ownership at the generational shift . Family business owners often, but not always, pass their ownership on to the next generation.
If you, on the other hand, is a serial entrepreneur, then you probably consider multiple exits from your businesses. Also at much earlier stages. Usually when you aim for the next venture. It is common that serial entrepreneurs lose interest and move on to their next venture only after a few years.
Another situation are businesses that have involved venture capital financing. That is a path when life gets very much process oriented once venture capital has made an investment. There is an industry standard process with continuous funding rounds every 12 – 18 months. Old investors exit the business and new investors join the business. The workload and necessary management attention for these founding rounds often come as a surprise to many entrepreneurs. Not without emotions and stress.
In other words, who you are and in what circumstances you operate play a considerable role for when and how you typically need to consider an exit from your business. You shall also bear in mind, with external investor it’s no longer your business. It’s your joint business, with quite a few rules and covenants carved in stone.
Financial investors manage other people’s money. They need to exit after a few years only once they have reached their financial return. Some are early-stage investors, others are mid-stage investors while some are late stage investors. Private equity may follow-up with an acquisition once the business out growth venture capitals target size.
A partial exit is also an exit option
It’s very common that the entrepreneurs themselves do not change as much as their business change. To let go to grow, to stop doing and stop instructing and instead leverage the business by becoming an inspirational team leader is a trait that is difficult for those used to make things happening themselves. Statistically, the entrepreneur is the most common reason why small businesses stop growing, albeit at different points.
The second most common reason why small businesses stop growing is lack of resources, often fueled by lack of sufficient cash flow to invest.
Venture capital firms are the masters in arguing that they can help fund the business for growth, injecting capital to a particular business.
Want to bring external capital into the business? It’s seldom an option to combine external funding for growth with the entrepreneurs making a partial exit at the early stage of a business. The investors need to ensure that the entrepreneurs are fully committed to the tasks ahead. It’s more common to make partial exits at later stages of maturity once revenue, customer acquisition and margins are growing in a steady pace.
The company would issue new shares that the investor buys and thereby injects new capital into the company. The entrepreneurs may also sell some of their own shares to the investors and monetize from their hard work while remaining a shareholder in the company. The entrepreneurs make a partial exit.
An exit can be premature
Entrepreneurs know how emotional a possible exit can be, even when only exploring an exit as a thought of mind. It doesn’t help to get older, plainer, saner, wiser. It’s still a difficult consideration and decision to make.
“It’s been like a roller-coaster. I have not been able to sleep. I have spent all my time the last few months thinking and planning this exit. We were not prepared.” Experienced entrepreneur, confidential.
There are factors to consider when it comes to an exit, emotional considerations included. If the company has a high dependency on the entrepreneur, an exit could have serious, negative effects on the future performance of the company.
Perhaps a fair share of the sales depends on personal relationships between the entrepreneur and the company’s customers? Or the products or services are reliant upon a skillset and experience possessed predominantly by the entrepreneurs?
In such a dependency scenario, it could prove difficult to find a buyer willing to assume the inherent business risk. The valuation of the company would, and should, also be negatively impacted by these dependencies.
There are contractual and financial methods to solve such a situation with a buyer of the business but first solving the real dependency risk is of course best. One possible solution could be to include an earn-out mechanism as part of the share purchase agreement. A requirement for the entrepreneur to continue being operationally involved in the company for a certain period of time after the acquisition is also a common provision.
Exit options from a venture capital point of view
A venture capital fund invests in start-ups and mid-size businesses to add capital for growth. Usually, they acquire a minority stake at an early stage, either as a seed investment or as early-stage funding. Once the business reaches different milestones and grows, so do the follow-up investments in the following funding rounds.
Venture capital investments are financially driven and ownership periods are relatively short, often 4 -10 years per investment. Don’t forget that venture capital investor’s core business is to manage other people’s money. Technically, they act as investment advisors to an investment fund that has general partners as investors.
Venture capital investors not only specialize in different industries, but also in different maturity phases of a business. Seed investors may co-invest in the later A-round and maybe also in the B-round. After that they exit, they sell their shares to another investor specialized in later stages of business maturity.
On average, a venture capital investor stays on as an investor for eight years before exploring their exit options. Unlike entrepreneurs, financial investors have clear exit strategies that follow the stages of maturity they specialize in.
What are funding rounds?
Exit strategies for venture capital funds follow certain phases in the development of the company. Understanding these different phases is critical for an entrepreneur seeking funding from these types of financial investors.
The phases of founding rounds are called seed financing, series A-round, series B-round, series C-round, etc. Each of these phases have industry standard milestones like Minimum Viable Product (MVP), Go To Market and Sales Expansion.
Investors are increasingly keen to see milestone fulfilments in shorter sprints, providing funding for shorter periods like 12-18 months. This is not without challenge to entrepreneurs that needs to include considerable time for each fund raising.
In each successful funding round, existing investors choose to exit or to retain their ownership. However, a business that does not reach the next industry standard milestone will run into severe funding problems. This is something to consider carefully before bringing on board a company’s first financial investors.
The alternative is of course to finance the startup phase and the sales expansion on once own merits. I.e. with earned cashflow combined with tight cost control, if possible.
A highly skilled financial services entrepreneur with a background as a lawyer suddenly found herself with a much smaller ownership share than she had expected. Actual share dilution can be more savage than initially understood. Each new funding round and share issue come with a higher valuation than before. Although the value of the shares owned by our entrepreneur was growing, her influence decreased as more and more shares were issued. Her number of shares remained the same.
When will venture capital use their exit options?
It does not necessarily signal that investors no longer believe in the business to succeed or fail once an early-stage investor chose to exercise his exit options. The investor may simply focus on early stage investments while the business, hopefully, progress to the next level.
When the company has reached a later stage with growing revenue and cash flow, early stage investor will seek to exit the business. They sell their shares to cash in on the value growth. As mentioned, venture capital investor’s core target is to make a financial cash return to their own fund investors.
Selling to a private equity investor that targets fewer but larger investments can become an exit option. Other exit options include industrial sales to a competitor, to a larger corporation or to a financial institution. As a last resort, an Initial Public Offering may also be an alternative (a stock listing, an IPO).
For most financial investors, exit strategies are driven entirely by underlying financial return requirements. Almost everyone of them will follow the above pattern, industry standard milestones and funding rounds.
The operational responsibility to develop the company remains entirely with the entrepreneur and the team within the company. Private equity owned businesses are sligthly different with investors providing considerable industrial support to their investments.
An entrepreneurs 7 exit options
An entrepreneur’s exit options will vary, but here is the list of the 7 different exit options:
- Generational change, i.e. transferring ownership to a younger family member.
- Employee share programs.
- Management or employee buy-out.
- Merging or being sold to another company.
- Selling shares to a financial investor, most often but not necessarily, as part of a financing effort.
- Initial Public Offering (IPO), listing the company on a stock exchange for shares to be publicly traded.
1. Generational shift
It is a common desire of many entrepreneurs that their business shall remain within the family also after they have retired. Transferring the ownership of the company to a younger family member is certainly an exit options available. Personal interest, ambitions, competence, energy and drive amongst the next generation potential owners is the most important exit consideration to be made.
Entrepreneurs considering a generational shift as their exit option should carefully consider whether they want the next generation to assume operational responsibility? Sons and daughters do not always share the same passion as their parents. That is often the case if they have not been involved in the business already from an early age.
Transferring a company to a family member with the intent that the successor will assume operational responsibility of the company requires long-term preparation, nursing and coaching. Its highly beneficial to identify, involve and train the intended successor years in advance of the transfer.
Successors shall be coached and trained. Do so will make them learn the trade, to gain experience and to develop a passion for the business. This is so often necessary to secure credibility and loyalty amongst employees, partners, suppliers and customers.
It’s also essential to agree with the new generation owners on whether the previous owner shall remain in any advisory or operational role after the ownership transfer has been completed. It is often overlooked that each generation in a family-owned business inherently will have different views and priorities regarding the future development of the company, it’s governance and leadership style.
2. Employee share programs
Most founders keep the ownership of the company tightly to them self. In certain tech industries, competence are scares and expensive and employee shareholder programs can be very valuable as a method or recruiting and retaining key employees. It is less common with broad, general employee ownership programs as is used in some listed very large mature companies.
Employee share programs can be structured in many ways. Direct ownership from day one is less common. Share options that is to be earned and that are linked to a deferral structure is usually preferred by the founders. It requires the employees to perform towards agreed milestones before earning their share rights. These share rights are deferred one to three years before they can be executed into shares, In this way employees get tied to the company.
Employee share programs is usually not considered as one of the exit options available for entrepreneurs. It does mean however that the founders shareholding is diluted. The net effect can be a partial exit, at least in terms of control, if employee share programs are used aggressively.
3. Management or employee buy-out
As an alternative to generational change, selling the company to one or more key employees holds the potential for a smooth transition. Why? Because these employees are already familiar with the company, its customers and suppliers, its business philosophy and plans for the future.
A management or employee buy-out could also be made in the form of a step-wise ownership transition. This result in little negative disruption to the business and can be structured as part of the financial for the new owners. Financing can sometimes be arranged with a combination of cash, promissory notes and debt financing.
The challenge similar to a generational change, is to identify, groom and finally agree the terms of sale with these key employees.
A management or employee buy-out requires a high degree of transparency over a period of time. It also requires the entrepreneur to prepare the new owners as well as the company for the change in ownership. This exit option may not yield the most profit for the founder but can definitely be a great option in many cases.
4. Merging or being sold to another company
This isn’t an option suitable for all companies and entrepreneurs. An absolute prerequisite is that the business is an attractive addition to another company.
There are numerous challenges to realize a successful merger: timing, price, management, cultural fit, product and service fit, to name a few. This exit strategy is sometimes difficult to plan simply because the entrepreneur may find it difficult to invite possible merger candidates to the table.
On the positive side, being acquired or merged with another company could be a highly profitable exit option owing to possible synergies between the two businesses. A merger could also create the option to retain some level of involvement for a certain period after the merger. Either as a consequence of the sales price mechanism in the agreement, a so-called earn-out model, or simply because the entrepreneur wishes to retain a minority stake in the new merged entity.
5. Selling shares to a financial investor
Financial investors include venture capital and private equity, as already mentioned. Venture capital prefer to invest in the company to help bring financial resources for growth. This is not really an exit option to a founders unless in a late stage of the business. Private equity investors on the other hand often prefer full control which defacto mean an exit option for current owners.
Pros and cons bringing financial investors into a business make for an entirely new article of its own:
- Financial investors invest to exit and they will exit once the business has reached its growth milestones.
- Assuming successful growth, it’s unlikely that the entrepreneur will be able to buy-back any shares from the financial investor once the business has started to grow and the value has increased. The price for those shares would have grown out of reach for most entrepreneurs. The value of the shares the value of the shares should have increased, however.
- At some point, also the last financial investor will need to make an exit to return cash to its investors. Such a final financial exit will either be to an industrial investor or with an IPO. At this point, the entrepreneur will most likely need to follow the majority owners in their exit decision.
During these series of funding rounds with different new share issues to fund growth of a business, the entrepreneurs will sometimes have the option to exit his ownership to such financial investors. Initially this will a null or partial exit option since the entrepreneur will be critical for the success of the business.
6. Initial Public Offering can include exit options (IPO)
Listing the company on a public stock exchange has the potential to create significant financial profit for the entrepreneur. It’s a highly complex and risky process however. Many factors come into play in determining whether an IPO will be successful.
There has been a shift in exit strategy during the last few years:
- On one hand, lower tier listing options have emerged on Nasdaq and alternative stock exchanges. These lower tier equity listings have attracted young and relatively immature businesses. Lower hurdle rates on financial performance, reporting and overall administrative quality attract these kind of companies. Professional investors however, argue that companies that choose to list on these lower tier listings may be of dubious quality.
- Many professional investors and entrepreneurs end up divesting bilaterally to an industrial investor or to a large private equity investor. That is often the preferred alternative compared with an initial public offering. The reason being that these exit options are faster, less costly, less time-consuming and almost always give a similar or higher valuation than a stock listing. Professional investors have also become sensitive to poor listing performances, with shares trading at lower prices than at the initial public offering. A poor performance is bad publicity for investors dependent upon institutional investors that also invest on the stock exchanges.
On the other hand, an initial public offering can also be one of several attractive exit options for a company with many small shareholders. Companies often use stock-related incentive programs to attract and reward key employees. A stock listing is one of the exit options that gives different shareholders different alternative cash-in options.
7. Liquidation as an exit option
This is not an exit option per se, but rather a consequence of the lack of other options for an entrepreneur. Liquidating a company means closing down the business and selling as many assets as possible. This exit route doesn’t typically yield any great financial return for the entrepreneur. The consequences for employees, suppliers and customers can also be considerable.
If all alternative options have been explored, liquidation as an exit option is relatively time efficient and simple to execute. Legal, tax and financial advice are important.
How to plan once exit options?
How should an entrepreneur actually start his exit planning given what has been said about careful planning of an exit?
Planning an exit includes contemplating a few questions which may help guide the entrepreneurs towards their best exit option:
- Ambition, both personally and with the business itself. This may include a retiring founders’ potential ambition to remain on a part-time bases as an industrial advisor to a private equity investor.
- Timing, from a personal, business and macro point of view.
- Event-driven, are there new opportunities?
- Value maximization ambitions that may or may not include co-owners to be able to maximize value
Another concern to consider and to plan for is if the performance of the company is highly dependent on the current owner. Such dependencies should be mitigated by involving and nursing other key employees. Those prepare the company, its customers and partners for a future exit.
Most entrepreneurs run on full speed up to the very last day of their ownership. That’s the way most entrepreneurs live and breathe. Its important to plan and organize the business to be independent on current founders already before an exit. Once the exit is done, the business is out on its own and the business needs to be operated by its own management team.
The most successful exits are well prepared: commercially, financially and legacy-wise. Such preparation can easily take a few years. Preparations would include organizing and formalizing parts of the business, to recruit new key employees and to nurse new leaders so that the current entrepreneur or founding team can let go without hurting the business going forward. A well prepared business has the most exit options to choose from.