How does a VC think about exit strategy?

Venture capitalists only make money if they exit companies successfully, and in this context ‘successfully’ means at a big profit for the investors within a few years of making the original investment.  Making a big profit quickly usually means that the company exits at a high valuation relative to its revenues and profits (if indeed there are any profits).

These sorts of exits aren’t achieved by many companies and the term ‘exit strategy’ is a shorthand phrase used to describe the analysis that goes into determining how likely a company is to achieve a high value, high multiple exit in a relatively short period of time.

The first output of this analysis determines whether an investment is attractive in the first place.  Many companies are unlikely to ever achieve a high value exit and are therefore not good prospects for VCs.  The second output is the likely size of the exit which is a function of forecast revenues and profits and likely exit multiples.  This has a bearing on the valuation at which the VC will invest. 

The first part of the exit strategy considers the attractiveness of the company on a stand alone basis, and looks at the following questions:

  • Is it operating in a large and/or fast growing market?

  • Does the company have potential to grow in the years after acquisition?

  • Is it the market leader?

  • Does it have significant advantages over its competitors?

  • What are the profit margins/what might the margins be once the company reaches scale?

  • What elements of the business would it be difficult for an acquirer to replicate organically (e.g. intellectual property, network effects, customers in new geographies/verticals)?

  • Quality of management – will acquirers pay more to capture key individuals?

The second part of the exit strategy looks at how the company fits with potential acquirers, considering the following questions:

  • How many potential buyers are there?

  • Do they have a track record of making acquisitions?

  • What would be there logic for acquiring the company (e.g. account control, cost synergies, revenue synergies, protecting their existing business)?

  • How are comparable businesses valued (both on the stock markets and in M&A)?

  • Will the company be a candidate for IPO in the time frame of the investment (mostly a function of revenue scale, profits and growth)?

  • Will the company have partnerships with acquirers that create an element of intimacy/dependency?

  • What is the geographic fit with potential acquirers (most like to acquire close to home)?

It is recommended that an owner start planning for a sale at least three to four years in advance. Sometimes, even five years is not long enough. It is very easy to become overly attached to a business, so it will be difficult to see how the business really looks to an outsider.

Selling a business on the open market is the most popular exit strategy for small businesses. Unfortunately, it has been estimated that 75 percent of US businesses do not sell.

Source: The Equity Kicker

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