Enticing Investors

Early-stage investors need to know how they'll get a return on their investment in your company, and IPOs aren't the answer.

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Several recent questions from readers have focused on "what's a good exit strategy" to propose to the investors of your new venture. It's amazing how many entrepreneurs are content to simply propose that the firm hopes to eventually go public, at which time the original investors can realize marketable value for their stakes in the firm. But that response is perhaps the most generic and overplayed strategy when it comes to formulating a plan for financing your new business. The ratio comparing the dozens of IPOs in the United States every year to the thousands of new ventures launched is a minuscule percentage. Yet more than 70 percent of all formal business plans presented to angel investors and venture capitalists name "going public" as the primary exit strategy for the proposed company. And many of these expect that event to happen within just four years from the launch date.

Let's start with the definition of--and rationale for--the exit strategy. First, this provision in the business plan outlines a method by which the early stage investors can realize a tangible return on the capital they initially invested in the venture. The entrepreneur spells out a "reasonable" scenario by which a later round of funds is expected to be raised, through which the stockholders can sell their shares and realize a capital gain. Second, the intent is to suggest a proposed window in time that investors can tentatively target as the "investment horizon" of their involvement in the early-stage funding deal. The founding team wants to assure investors that the venture will grow to a point whereby the initial investors can cash out their stakes at a high return on investment, given the significant risks they assumed when they decided to fund the start-up.

The problem in projecting an exit strategy is you're basing it on several major assumptions. The speed of market penetration, the ability to sell at expected price levels, the costs of doing business, the margins on sales, the management team's ability to arrange consistent deals, and the impact of competition and other economic factors collectively affect the new venture's projected market share and bottom line. Certainly, when these are all aligned in the most optimistic configuration, the firm will experience significant market share, consistent high-growth sales rates, strong profit margins and positive earnings. And such a scenario in the first two- to three-years is typically the story told by firms that eventually go public.

But the overwhelming majority of new ventures are unable to realize their most optimistic projections. So if an IPO is no longer a realistic possibility, what other exit strategies are available for early-stage investors? There are four basic categories of exit strategies besides the IPO, and these comprise the more typical ways that investors get to cash out as the venture makes forward progress. In order of occurrence, these are:

  • Acquisition. The venture initiates contact with a large supplier, distributor or major competitor (perhaps one with a more widely diversified product or service line). The pitch is that the venture could add valuable cash flow to the acquiring company once operations are synthesized into the larger scope of operations of the acquiring firm. At the close of the deal, the purchase price buys out the original investors at a premium on their initial investment. The deal is built on the premise that the target needs the acquired firm to make the next leap of growth. As such, the terms of the transaction will likely be more favorable to the acquiring company. But a fair sales price based on post-deal increased sales and profits to the buyer should allow the original investors to realize a good return on their investment.
  • Earn-Out. The venture begins to generate consistently strong positive cash flow. The management team then initiates a monthly or quarterly buy-back of investors' common shares at a premium over the initial investment cost. Typically, an earn-out can be accomplished over three of four years and provide the original investors with a strong internal rate of return (IRR) as company sales expand and costs decline due to increased operating efficiencies. The purchase price is often scaled upward incrementally over time, as investors provide the luxury of "time" for the management team to complete the deal.
  • Debt-Equity Swap. If the original funding was through a loan (promissory note, bonds, mortgage-lien financing), the founders can incrementally trade common shares for portions of the principal on the debt. This slowly reduces the interest due over time (as the face value of the loan decreases), and also rearranges the balance sheet as liabilities are eliminated and replaced with equity positions. This "call feature" allows the owners to decide at what pace--and at what price--the debt is retired. If the firm is doing very well and has prospects for being acquired at a premium, debt-holders have an incentive to switch to equity positions.
  • Merger: Similar to the acquisition, in this exit strategy, the venture initiates negotiations with another firm, but this time the deal is based on mutual needs and benefits. One firm might have strong manufacturing capabilities and the other an excellent sales or distribution pipeline into the market. The two firms might be doing well in separate markets, and the deal will open up these complementary markets to each company's products and services. Whatever the rationale, the transaction will likely involve cash changing hands to arrive at the new company structure, and original investors can typically make their shares available for sale to close the deal.

Remember, investors are very aware that you cannot guarantee an exit strategy. But you can offer them more than the wishful thinking that you'll make an IPO in three years.

David Newton is professor of entrepreneurial finance at Westmont College in Santa Barbara, California. He is the contributing editor on growth capital for Industry Week Growing Companies and a moderator on small-cap stocks for eRaider.com. His books include Entrepreneurial Ethics(Kendall-Hunt) and How To Be a Small-Cap Investor(McGraw-Hill), named November 1999 book-of-the-month by Money magazine and a 1999 Top 10 book by Forbes. His latest book is How To Be an Internet-Stock Investor (McGraw-Hill). He has written or contributed to more than 80 articles for publications including Entrepreneur, Your Money, Business Week and Solutions, and has been a consultant to emerging, fast-growth entrepreneurial ventures since 1984.

The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.

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