Exit Strategy - part 2.

Exit Strategy - continued from Adrie's blog on Monday 4th Jan. 2010

There are a number of types of Exit you can choose to execute. Thinking about the most desirable option for your organisation and your vision is key so that you don’t head down a path that in the end will not deliver the results you were hoping for.

In short – here are the main options you have:

Sale for Cash

Advantages: it’s cash and that’s that. Once it is in your account, it cannot be reneged on, nor is their any ambiguity about the sale and when it takes place exactly.

Disadvantage: It may be a smaller amount then other options since it has to be stomped up in one immediate transaction by the buyer.

This option has always had my preference since, as I mentioned, it is entirely clear for all parties concerned. And you hand over control of the company as soon as you receive the money.

Earn out

This is a way of selling a company that seems to be favored by Anglo-Saxon companies in particular.

Advantages: it can substantially increase the amount paid for the company

Disadvantage: you will have to be committed to continue working for a number of years in an environment that is no longer your own, where you no longer exercise control or leadership.

Often all difficulties that result from the integration of two companies, result in a lower then expected pay out for you in the end. With any Earn-Out you have to be clear on whose company it is whilst the earn-out period is ongoing.

It is actually quite common for the proposed earn-out period to be around three years – which, as far as I am concerned, is much too long to be comfortable, as time goes on the issues, and therefore the stress, increase and your motivation and enjoyment of what you are doing will decrease.

A good example is another company I had been with since inception. The company, whose main business was co-location and fibre networks, had only been in existence for a year when it got a seemingly great deal from a Telco to buy them. Although I felt it was too early, and we had not yet generated enough revenue ourselves, the offer – containing a share swap and an earn-out – seemed very good and the management team in the end decided to take it. It was the start of a horrible period – as soon as the deal was signed, management had to suddenly work in a very different, competitive culture with some people that really didn’t want us around. It took about 3 months before most of us were actually leaving the company altogether, earn-out or not so in the end we ended up selling for a much lower price then it seemed at the time the deal was done. Not only that, but the market bubble burst within 6 months of our shares vesting – luckily enough I had happened to time at least half the sale right and sold at the highest point. The rest tumbled all the way from US$80/share to US$2/share.

When you do an Earn-Out, always take a good hard look at the cash component. If that alone seems too low a price – then don’t sell. The earn-out component should be a bonus, not make up the bigger part of the price you get for the company.

Share Swap

A share swap can be a very interesting proposition if you yourself have a decent voice in the newly formed organization. To make sure you know what you are letting yourself in for though, make sure you do as thorough a Due Diligence on the other company as you would expect them to do on yours in order to map out the risks and the benefits of a joint future.

A Share Swap can be a way to ensure scalability of your company (and the other’s) in order to achieve a much higher valuation. I built an IT company by doing roll-ups (a series of share swaps and acquisitions) this way – when I set out we had 100 employees and a totally different valuation then when I finished with 1000 employees and playing in a different league altogether. The benefit of the scale is that you become an interesting prospect in turn for larger players in the industry, who tend to have more money.

The disadvantage is that you will not free up any liquidity and you become dependent on the whole organization and may face all the issues you have of integrating the various parts. Not only that, as the above example shows – you cannot always predict how much you will actually get for your company. It may work out great, if you are in a rising market but since often there will be a vesting period, it is another risk that you should take into account when considering the deal.

When doing a roll-up, make sure you do your own Due Diligence on the companies you are acquiring including such things as:

[br]
• tax/inland revenue obligations, fines or due amounts as well as pension obligations. These amounts can be rather substantial if the company in question did not reserve the right pension/401K  amounts for instance.
• Sales Agreements – be sure to check the deals signed to ensure they are valid and actually committed deals rather then wishful thinking by the sales executives.
• Employent contracts – depending on the country and its’ laws, you have to know what you are taking over.
• The same goes for other contracts such as leases on buildings and/or cars.
  

IPO

Floating your company on the Stock Exchange is a very interesting process in which you potentially generate the greatest value for the organization. But a successful flotation depends on a large number of factors most of which you cannot control such as the market circumstances, economy, industry performance, ability to measure your company againt competitors, image, investors’ appetite, perception etc.

Before you consider an IPO you have to question thoroughly if your company is ready for it, since it will require an enormous input, effort and time from your organization, your management team and your financial administration. It is also a very expensive process – you can easily count on a couple of million you’ll need to spend on accountants, lawyers, Nomads (advisors/placement agents) and so on.

Doing an IPO can be a crucial decision in your organisation’s history – you gain access to the capital markets and it can be beneficial for your image. However, following an IPO you also will have to deal with the transparency it creates, the visibility to anyone at all of your company and it’s runnings. You have to have achieved a certain stability as a company and you do need to make sure your growth expectations and forecasts can be met. If not, those that create your market will quickly turn away from your stock and liquidity will dry up.

The advantage of a floatation is the access to the capital markets. The biggest (personal) disadvantage to a founder or shareholder that it can take a long time before it generates true liquidity and only then little at a time as it would give a negative signal to the markets if the founder suddenly sold all his/her stock.

Valuation

The valuation of your company (or the one you may be acquiring for a roll-up) is one of the most difficult matters possible. Often you will hear all sorts of formulas you can use – but I believe that they are only valid for well-established businesses, or one with a recurring steady income stream. In those cases Discounted Cash Flow (a build up of the value based on future income streams) the most often used.

However, where it concerns a new business, or even one in a new industry, with a lot of innovation but little to no revenue/profits – the value is not likely to be in its revenue but of a more strategic nature to the acquiring company. Or in other words – the value is more or less what someone wants to give for it. It could be based on IP or on the client base a company is able to build or a market it is operating in. I have always operated in the IT segment/market – but IT really is a label that covers many different areas – such as Hardware which gets a standard valuation based on a factor of 0,5 x revenue. Or IT services, which might get 1x revenue.

But it is just as easily possible that you will see a factor 80 being used if the company looks to fill a need for the acquirer, whatever that may be.

Conclusion

The choice of Exit will be a different to every single founder, or organization and it will be based both on personal and business factors. As someone once said to me “There is always a buyer out there – the art is in finding him”.

Above all, it is very important to be realistic as far as the price you ask and the terms you agree to. I have often come across people, founders mostly, that confuse market value with emotional value.

Make sure you are guided by professionals, be patient, and choose wisely. Thus you can avoid being confronted with all sorts of negative issues and even claims/lawsuits post your Exit.

Don’t count your pennies before you have earned them. Most of the mistakes I have seen are simply because people get greedy and want too much out of it. A happy buyer who feels as if the deal was fair for both, will be much less likely to create a fuss over small issues then one who feels they are being taken to the cleaners.

Lastly – don’t make the mistake many of the newly rich make – starting another venture almost immediately. Relax, recover first, empty your head and then decide what you would like to do. Keeping your treasure is possibly even harder then gaining it in the first place.

Marion and Adrie

See also part 1. Posted on Monday 4th January by Adrie.

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Contributing

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  Darshan Sanghrajka

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  Henk Redmond

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  Sven Jonker