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