When founders are pitching for venture capital investment, the topic of exit strategies is often raised as founders are eager to provide reassurance that they have their sights on a liquidity event that will deliver a return to their investors.
But VCs are much less interested in the end goal than founders might think. In fact, the nature of VC investment is more of a “get rich slow” strategy where investors buckle themselves in for what is sometimes a 10-year ride – the average lifespan of a VC fund.
VC investors are generally very patient people. They are willing to wait for the right opportunity to return the fund, confident that founders who build a meaningful and enduring company will have no shortage of options to exit the business or provide an opportunity for investors to exit.
As the fund nears the end of its life and VCs look to deliver a return to their own investors, they will generally explore three different options to exit with the founder:
Initial public offering (IPO)
An IPO occurs when the company offers its shares on the public market.
“Going public” is a strategy that makes up fewer than 10% of exits. An analysis of software as a service (SaaS) companies over the last 20 years found the average time from start-up to IPO was almost nine years.
Some take considerably longer such as Aussie unicorn Atlassian, which was founded in 2002 and went public some 13 years later.
There are of course some well-known companies that have exited much sooner – Netflix IPOed four years after being founded in 1997 and Google went public just five years after being founded in 1998. These are certainly in the minority.
Although there have been some much-publicised IPO “flops” such as Uber, it is generally the case that public excitement and high demand for a stock can drive up its valuation, and higher valuations that mean less dilution for existing shareholders.
The downside of an IPO is that often investors are locked in to selling their shares for six to 12 months after the IPO to prevent price volatility. The process of listing is expensive and time consuming, and there is an onerous burden in the legal and regulatory obligations required of listed businesses.
A trade sale is a more common exit route than an IPO. Estimates suggest this accounts for around 80% of exits.
This is the sale of the startup to a larger company who is eager to take advantage of synergies in products or services, intellectual property or market share they may be able to leverage for the benefit of their existing business.
A trade sale enables the business and its investors to get immediate liquidity instead of relying on the public markets. Some founders favour trade sales as they are protected from market risk when they know the price they are getting for the business and they are relieved from the reporting burdens of running a public company.
One consideration for founders is that liquidity preferences may mean less upside for founders than early investors, especially in cases where the value of liquidation preferences exceeds the market value of the business.
Secondary market sale
For VC investors who find themselves with an investment in a business that is not ready to be bought or floated, a secondary market sale of their stake is an additional exit possibility.
This occurs when the VC sells their stake in the business to another investor be it an existing investor, a growth equity or PE firm.
A VC will generally opt for this strategy if the company is not yet ready for trade sale or an IPO, and the VC investor, for any number of reasons does not want to extend the life of the fund or their involvement in the business.
This allows the VC a clean and fast exit to distribute cash to their own investors. Secondary sales have become sought after for investors with the number of IPOs falling as start-ups stay private longer. For the same reason, investors, founders and employees may want to cash in their holdings if the plan for an IPO or trade sale isn’t imminent.
Although this process has increased in popularity, the price is determined by supply and demand. Often the startup’s existing shareholders have first refusal rights on secondary shareholdings and if existing financially motivated shareholders turn down their right to buy shares this may not send a positive message to other potential buyers.
Buyers on the secondary market may also be wary of the restrictions in place and this may act as a deterrent to attracting new investors.
While VCs care less about the exit strategy than many founders may believe, it is still wise for founders to understand where their startup fits in terms of fund timing.
With a typical VC fund lifespan of 10 years, startups who receive an investment earlier in the life of the fund will have the benefit of more time before needing to deliver returns to investors than those who are added to the fund later. Those closer to the five-year mark may need to give this serious consideration, depending on the VC investor.
The steps required to move towards any successful exit are the same steps that are undertaken by a business that is capturing a market, growing rapidly and enjoying early signs of success.
These steps might include creating an independent board, ensuring financial reporting systems and controls are fit for a growing business, ensuring the business is optimised for growth and fine-tuning the company’s strategy.
If founders ensure these foundations are in place, the exit will take care of itself when the time is right.
- Benjamin Chong is a partner at venture capital firm Right Click Capital, investors in high-growth technology businesses.