Why is an exit strategy important for entrepreneurs?
Harvesting from Your Venture’s Value
This Article supports our belief that having a harvest goal in mind and creating an exit strategy to achieve it are what separate successful entrepreneurs from the rest. Clearly, the main objective of professional entrepreneurs is to create economic value. It is unfortunate that little attention in the entrepreneurial world has been given to exiting a business venture, or what has come to be called harvesting the business.
In their book, Venture Capital at the Crossroads, William Bygrave and Jeffry Timmons help introduce this topic: “Just like farmers, venture capitalists seed, tend, and feed portfolio companies in the hopes of reaping a bountiful harvest.” The professional entrepreneurs and investors know that harvesting an entrepreneurial venture is the approach taken by the owners and investors to realize terminal after-tax cash flows on their investment. It defines how they will extract some or all of the economic value from their investment.
But just because a venture team can build a successful business doesn’t mean they can become rich from it. Investors who provide equity financing to high-risk ventures need to know how and when they are likely to realize a return on their investments before they commit any funds. They invest not for eternity but on average for three to seven years, after which they expect to make a profit that reflects the scale of the risk they have taken on in making their investment. An exit should be seen as a critical milestone that focuses on the transferring of ownership. It is at this stage in the entrepreneurial life cycle that the capital gains (or losses) occur, or, in other words, that there is a harvest (or exit) from the investment.
Why Is an Exit Strategy Important?
Your exit strategy is important because it helps you define success in business. When entrepreneurs have not thought through an exit strategy, it may be an indicator that they are not focused on the eventual transition of the venture. There is a saying among venture capitalists, “It’s easy to get into an investment, but how do we get out?” And investors do not want an exit strategy to be difficult or bloody. In essence, having a harvest goal and a strategy to achieve it is indeed what separates successful entrepreneurs from the rest of the pack.
Investors will shy away from ventures that do not have an exit strategy because it may be an indicator that the entrepreneur is more interested in building and running a lifestyle business rather than in building a potential high-growth venture.
So like the North Star guiding Columbus across the Atlantic to America, your definition of success should be used as your strategic heading. It launches you off in the right direction, helps keep you on track, but also illuminates the way when you feel uncertain or feel you are off track. Trust us, every stage of the entrepreneurial life cycle becomes clearer and easier to take if you know precisely what you plan to do with the business in the end.
Investors know that millions of people start new businesses every year. They know that the right exit strategy protects wealth, attracts valuable employees, and ensures a smooth transition. The wrong one could mean financial ruin. One study of successful high-tech entrepreneurs found that 60 percent wrote an exit strategy or gave thought to exiting prior to their harvest. Dick Kramlich, general partner at New Enterprise Associates, says his firm actually maps out the exit date with entrepreneurs at the time of every investment.
William Link, co-founder of Newport Beach-based Versant Ventures, believes that the exit strategy is one of the most important aspects of starting a business venture. According to Link, “It gives you, the entrepreneur, a focus for your efforts and allows you to set up your entrepreneurial endeavor with the end in mind. It also allows you to clearly communicate your goals and expectations to your venture team and investors.”
Shaping Your Exit Strategy
Shaping a harvest strategy is an enormously complicated and difficult task. Crafting an exit strategy can never begin too early. Stephen Covey writes in The Seven Habits of Highly Effective People that one of the keys to being effective in life is “beginning with the end in mind.” Although Covey is speaking of one’s personal life, the statement also rings true with respect to the entrepreneurial life cycle.
We share with you some important advice on helping you shape your exit strategy.
– First, you need to determine the personal goals of the lead entrepreneur and the venture team. For each, what defines success for this venture activity?
– Second, research and understand what options are available, and try to plan and fit the options to the venture, and likewise the venture to the options.
– Consider the conditions that will trigger an exit, and the conditions that will preclude an exit. Remember that success comes to those who are prepared and can quickly be positioned to spot and respond to triggering events when they occur.
– Next, with a strong, clear vision that will get you through the tough, challenging seas that lie ahead, go build and grow the venture. Make it happen.
– And be patient, because it will take at least five years and as long as seven to ten years.
– Periodically conduct a formal, realistic valuation of the venture that includes a refreshed list of potential buyers, investors, strategic partners, and even professional service providers. This will not only help you keep your eyes and ears on what is going on in your space, but also provide checkpoints for your exit goals.
It is also important to seek outside professional advice when crafting your exit strategy. It will be difficult to find an objective advisor who can help you not only craft an exit strategy but also keep tabs on your valuation. For example, professional service providers—such as investment bankers or brokers, who deal on a commission-only, success-fee-only basis—will be looking for the quick deal and may not be able to assist early stage ventures with their exit strategy.
Recall from our discussion above that an exit is the transferring of ownership. The discussion below identifies the ten principal exit strategies that are available to entrepreneurs.
Types of Exit Strategies
1. Increasing the free cash flows and milking them. With small businesses it is retained earnings; with venture-backed deals it is paying dividends; with corporate entrepreneurship, it is increasing shareholders’ earnings.
2. Private sale for cash, debt, and/or equity to the management team. Most often through a leveraged management buyout (LBO) or management buyout (MBO).
3. Private sale for cash, debt, and/or equity to the employees. Usually in the form of an employee stock option plan (ESOP). More often, ESOP plans are used as a way to buy out a retiring owner.
4. Family-specific transaction. Transferring to heirs, family members which is more of a personal exit strategy.
5. Partial sales or liquidation of assets. Parts of the venture, like its tangible and intangible assets are sold separately in a piecemeal fashion.
6. Enforced liquidation, bankruptcy and reorganization. In all cases the management and ownership will be out of the control of the original venture team and investors.
7. Strategic sale. To a supplier, customer, or competitor as a part of a of vertical or horizontal integration.
8. Selling to a financial buyer. To a venture capital firm or private equity group either to be restructured and rolled into or merged with one of their portfolio companies, and sometimes to be run as a stand alone.
9. Global integration, merger or acquisition. Companies from overseas could buy the venture to get a beachhead into the US as a part of vertical integration or horizontal integration.
10. Initial public offering (IPO). Long considered the benchmark for venture-backed deals. the IPO Journey is a long an arduous process.