Chapter 7: The Exit Strategy
If you expect to have investors, they will require an investor-oriented exit strategy since their infusion of capital is all about the return on their investment.
When investors put a certain amount of money into your company, they want to be reasonably certain that they can pull even more money out at the exit – whether it is a public offering (IPO) or acquisition. Accordingly, addressing exit strategy is a key element of your pitch to investors. They will want to hear data and the exit strategy about comparable companies in comparable markets to assess the viability of your plan.
Specifically, investors want to know that you are aiming for a particular multiple of revenues. There are many resources that can help you figure out a realistic range of multiple for your business model. Many of these resources specialize in business valuation and offer their reports and services within narrow industries.
Typically what you are looking for here is a certain number multiplied by revenues. So, for example, if you are an engineering firm, you are likely looking at an acquisition rather than an IPO where the average multiple is 5X revenues. That means if your company is earning $10 million in revenues annually, then a reasonable sale price would fall around $50 million based on the sale of similarly situated engineering firms. This tells investors that when you reach acquisition, they can receive a return on their investment of five times that they invested.
The upshot is simple: if you want investors, you need to provide them with a compelling exit strategy. No exit strategy means no return for an investor. And while there are many financially stable companies that are still in growth mode, that alone does not mean that an acquisition or IPO is part of the plan. In fact, for some of these companies, their business model deters either exit strategy.
If, however, you are seeking an exit, there are certain steps you will need to get acquainted with to ensure that your company is properly prepared when the time arrives. While it is always advisable to adhere to best practices, it is an absolute necessity when considering an exit strategy or dissolution. So let’s talk about what each option requires and how you can position your company to optimize returns for both investors and founders.
Mergers and Acquisitions
A merger is technically a combination of two companies that extinguishes both entities resulting in a new company. An acquisition occurs when one company purchases another entity. Sometimes the acquired entity is blended into the acquiring company, while other times it becomes a subsidiary or affiliate.
When a startup is acquired by a larger company, investors should receive a return on their investment – meaning that the company was acquired at a profit to founders and investors. Cash or stock, or both, is used for compensation.
Investors typically receive capital at the conclusion of an acquisition. Key founders, managers, and employees, on the other hand, usually receive stock and are required to continue their employment with the buyer for a certain period of time.This allows the purchaser to obtain from pivotal employees of the target company the benefit of critical operational know-how and other valuable expertise. It also provides time for the sellers’ stock to vest, thereby aligning the interests of the new and old companies.
Walking Toward Acquisition
When is the right time to consider selling your company and what steps do you take to move in that direction? This section highlights the prominent stages and mechanics of positioning your company for acquisition.
The best time to sell your company is when you are financially and organizationally strong. A business that is stagnant or struggling is not going to be a very attractive target to a buyer, so the time to think about selling is when business is growing and finances are healthy.
For some businesses, this kind of thinking can be challenging. After all, why would you want to lose both control of your company as well as the opportunity to earn even higher profits? The answer comes down to asking yourself what you want.
For some entrepreneurs, building a company is all about enhancing job stability, increasing predictability, and possessing control. These business models are often created on the foundation of a revenue and tax structure designed to maximize owner income; preparing the company for acquisition is not the goal. These are typically LLCs who sometimes resist lucrative offers from courting buyers; they simply do not want to surrender control of their company or reduce their salary in exchange for a potentially more profitable opportunity.
For other companies – whether LLCs or C-corps – acquisition is the goal. In contrast, they seek to incorporate best practices, elevate compliance to a top priority, and create a business model that is inviting to investors and future purchasers.
Acquisition is a time-intensive, highly distracting process. When you are certain that you want to sell your business, you will need to understand value. A company’s value is often determined by its financial or strategic value, and sometimes both.
For most startups, particularly in a high tech industry, an entity’s value is more strategic. The buyer’s interest is typically based on filling a complementary need, or it is a preemptive move designed to prevent your acquisition from the purchaser’s competition. However, even when a buyer’s motive is more strategically based, they will still want to see positive cash flow and sound operations.
Determining Genuine Offers
When a buyer is genuinely interested in purchasing your company, they are usually organized and persistent. Typically you will see a term sheet demanding a relatively short deadline for response (not more than several business days).
The two chief issues to address are retention and valuation. If you know that your company has an estimated value of $20 million, a $15 million offer will immediately tell you that you need go no further.
If you receive a realistic offer, you will need to fully share crucial financial and proprietary information with your potential buyer. This requires having them execute a nondisclosure agreement to prevent information vital to your company and business model from being indiscriminately shared.
Once you have protected your confidential information, you are ready to negotiate term sheets. Engaging an experienced business attorney will greatly enhance your ability to fortify your business and legal interests. Resist any efforts to pressure your company to capitulate to pressure. Your goal is to maintain your leverage and assert your bargaining power whenever needed to achieve the best possible outcome.
Since term sheets invariably contain contingency clauses, acquisition is not finalized unless and until all of the terms and conditions have been satisfied. The central term of whether a deal closes typically pivots on the completion of the due diligence investigation.
Conducting adequate due diligence is imperative to the future success – and longevity – of an acquiring company. Therefore, potential buyers need to take their time to be as thorough as possible in ensuring a sweeping and competent investigation.
Numerous books of extreme length have been written about how to conduct a proper due diligence inspection. To minimize risk exposure, a comprehensive examination is required. Here, again, it is strongly recommended to enlist the aid of qualified legal counsel. Here are some of the more prominent considerations to acquaint you with the process.
The central purpose of an acquisition due diligence examination is valuation and risk assessment. The three primary areas that are assessed for risk and valuation are legal, financial and operational.
Risks of Inadequate Due Diligence
Acquiring companies often find out too late that their investigation left a lot of rocks unturned. The results of a weak investigation generally fall into the following categories: (1) unanticipated costly integration, and (2) inheriting considerable legal liabilities that were not uncovered. The result is paying too much for the target, which does not quite have the value initially believed to have possessed.
Components of Adequate Due Diligence
The two primary components of a sound due diligence investigation are: (1) document review, and (2) field work.
The buyer will want to ensure that it has retrieved all the documents it needs in order to accurately assess your value. Boxes of seemingly endless files will be requested, causing disruption to your business. This, however, is necessary to enable a sufficient assessment of the real value and risk exposure of your business. If you have been diligent with your legal compliance and well organized, then accessing the records should be easy, minimizing disruption.
Be prepared for an investigation of the backgrounds of key founders, executives, and employees. A thorough examination often begins with probing the backgrounds and reputations of key management, as well as the acquirer’s general reputation in the industry with vendors, creditors and customers, and among staff.
Document Review and Analysis
This entails your buyer making certain that it has all the documents it needs for a thorough assessment of risk and valuation; and further, that the files are scrutinized for errors, omissions, and any other impairments. A meticulous examination of the records should also generate many questions that they will follow up on both in writing and as part of the interviewing process.
Key Constituents of a Strong Due Diligence Team
A robust list of questions is an integral part of an investigation, as is requesting a comprehensive list of documents. Your buyer’s legal team will be be prepared with a substantial list of items and questions that includes detailed sub-examinations of the following individuals:
- Business and Industry Professionals
- Marketing Professionals
- Human Resources
- Finance & Accounting
- Compliance/Risk Management/Insurance
- Tax Professionals
The following is a sample of the types of documents you will be asked for in connection with a due diligence investigation:
- Organizational Records (e.g., incorporation documents, structural/governance documents, jurisdictional qualifications/standing & status)
- Financial (e.g., liens/encumbrances, loans, notes, investments/holdings, real estate records such as deeds, leases, zoning variances/compliance, etc.
- Regulatory Compliance Records (everything including anti-money laundering, foreign account tax compliance, privacy, supply chain, labor, OSHA, SEC, anti-corruption and bribery-notably the FCPA (Foreign Corrupt Practices Act)
- Employment Records (e.g., EEO and health & safety compliance, benefits, subcontractor agreements, confidentiality agreements, non competes, I-9 compliance)
- Insurance Policies (e.g., D&O, E&O policies)
- Legal (including past, existing and potential litigation – both by and against the company)
- Business (e.g., marketing strategies and procedures, customer lists, sales & distribution, purchase & sales orders, product & vendor contracts, production processes, R&D, operational controls/best practices, market position & SWOT assessment (strengths/weaknesses/opportunities/threats) as part of the market analysis)
- Intellectual Property (e.g., licenses, copyrights, registrations, filings – past, pending or contemplated)
- Management (e.g., compensation packages, employment contracts, benefits, management/shareholder agreements, stock options)
Due diligence can be disruptive to both the buyer and target company. It is certainly time consuming, often costly, and always a monumental inconvenience. However, with compatible synergies, the result can be well worth the investment of financial and other resources.
Initial Public Offering (IPO)
Some startups aim to position their companies for public offering. The idea here is that the startup becomes prosperous enough to enable it to register for selling stock to the public over a public market such as the NYSE or NASDAQ. IPOs are typically directed by a company’s Chief Financial Officer (CFO) at least three years ahead of the target date. Here are the pillars you need to build and perfect to adequately prepare your company for the big day :
Develop flawless financial controls
Financial processes need to be error-free. Ensure accountability with monthly balance sheets and income and cash flow statements presented at board and management meetings. Identify strengths and weaknesses in your processes and reporting. Avoid reinventing the wheel by tapping into the expertise of your board members and using recent IPO financial statements to gauge the progress of your financial reporting mechanisms.
Develop the right board
As mentioned in Chapter 5, your board of directors should include members with the quality of experience that will serve your company’s exit strategy. If you have been planning for a public offering, then having directors with public company experience should be paramount. Also as previously mentioned, you will need individuals with a robust background in audit and compensation who can serve on that committee as the company expands. These are also the same individuals who will be motivated to ensure that executive compensation is reasonable and financial processes perfected.
Develop a top notch senior executive team
Two of the most crucial members of your senior management are your CFO and general counsel when executing your exit strategy. Your CFO will ideally be selected with IPO experience as a prerequisite. Your general counsel is vital to buttoning up your regulatory and legal compliance. These two positions are load-bearing walls supporting the rest of the team. You will also need strong leadership in human resources, marketing, operations, and product development.
Bankers and lawyers and accountants (oh my)
If you want to go public, this is the trinity you will need to shepherd you through the process. Financial reporting is uncompromisingly stringent, legal and regulatory compliance rigorous, and tax and valuation matters exacting. For example, Financial accounting Standard (FAS) 109 (specifically, Interpretation 48), demands that a business discloses income tax risks. Preparing for Form S-1 submission to the SEC holds a company accountable for tax structuring, particularly when considering an expansion. At the same time, Sarbanes-Oxley requires financial, legal, and senior management to engage in active risk assessment and compels public disclosure of exposure to specified risks.
Once all of the documents have been submitted to the SEC for review (notably, the Form S-1), the company should proactively engage in developing investor relations. This should include highlighting best practices (including any movements beyond compliance, which are usually advisable); presenting market analysis (including projected revenue and expected net income); and market position (including filling an unmet market demand or other deficit). During this time, you will want be vigilant to maintaining your website and an appropriate level of social media engagement, focusing on transparency, authenticity, and accountability.
An alternative to the investor-oriented exit strategy is one where the company’s owners decide it is time to wind up business and dissolve the company. This is usually a voluntary event, as opposed to bankruptcy, for instance.
Winding up business is a legal term that means the business is ceasing all of its operations; only those activities that are necessary to settling claims, paying creditors, collecting balances, and related matters, are continued until the final dissolution.
For an LLC or S-corp, the state’s Secretary of State office will require some documentation accounting for the financial status of the company prior to it issuing formal certificate of dissolution. Some states allow this to be filed online, while others require a hard copy submission.
Some of the financial accounting will include satisfying the following IRS requirements:
- Filing final federal tax deposits
- Filing final quarterly or annual employment taxes
- Issuing final wage and withholding information to employees
- Reporting W-2 information
- Reporting capital gains and losses
- Reporting shareholder shares (e.g., K-1s)
- Filing final employee benefit/pension plan
- Reporting 1099 information
- Reporting subcontractor financial information
- Reporting dissolution / liquidation
- Requesting S-corp election to terminate
- Reporting business asset sales
- Reporting sale or exchange of property used in the business
Finally, the company will file a certificate of dissolution with the Secretary of State in the state in which they have located and all states in which they are conducting business. A filing fee is invariably required to be submitted along with the certificate. Upon dissolution, the company ceases to exist.
Chapter 7 Checklist
In summary, we covered how to…