Raising Entrepreneurial Capital

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Raising Entrepreneurial Capital

• Chapter 7 Exit Strategies
• Opportunities for Early Stage Investors
• to Monetize Their Investment
• A Comparison of Options and Methods

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Exit Strategies

• Topics Covered in this Chapter
• Mergers and Acquisitions
• Management Buyouts and Earnouts
• Selling Shares to the Public
• US Stock Exchanges and Listing Requirements

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Exit StrategiesBasic Considerations

• Every business plan seeking to raise eternal
  capital must specify a range of convincing exit
  options.
• The entrepreneur may never want to exit the
  business, yet the outside investors definitely
  will.
• Every exit plan must specify how, when, and
  how much.
• Actual exit is called a liquidity event.

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Differing PerspectivesEntrepreneur vs. Investor

• The entrepreneur typically has a very long term
  view of building the business and may not want to
  exit at all.
• Venture capital investors typically want to exit
  at a profit in 3-7 years.
• These two perspectives should be reconciled
  during the initial funding process to prevent
  unhelpful disagreements later on.

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Exit Strategies Valuation

• How Much will depend upon market conditions at
  the time of exit (liquidity event) and the
  multiples typically used in that industry.
• Know what valuation methodologies are used in
  your industry, e.g., multiples of 4-6 times
  earnings are common for medium-sized
  manufacturing companies.
• Multiples can vary based on how good or bad the
  market is for exit.

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Most Likely Exit Options

• A realistic exit option will increase the
  attractiveness of your proposal. For most
  companies, an IPO is not a realistic option.
• Other options include
• Acquisition by a strategic buyer
• Earn-out (buy-out) by management
• Debt-equity swap
• Merger with a similar firm

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Acquisition by a Strategic Buyer

• Strategic means that the buyers interest goes
  beyond simple financial considerations.
• Increase market share
• Add to product line
• Eliminate competition
• Enter a new market or territory
• A financial buyer simply seeks to make a profit
  by selling the company later.

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Acquisition by a Strategic BuyerEquity Sale

• Buyer acquires all assets and liabilities of the
  company, including contingent liabilities, if
  any.
• Acquisition is often by means of a stock for
  stock share swap.
• Share swaps are especially popular when equity
  markets are strong.

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Acquisition by a Strategic Buyer Stock Swap Pros

• Typically tax free
• Opportunities for increasing value in a rising
  stock market
• Does not require cash.

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Acquisition by a Strategic Buyer Stock Swap Cons

• Shares come with restrictions. They vest over
  time and can not be sold immediately.
• The buyers shares, if publicly traded, usually
  go down in such an acquisition, even if only
  temporarily.
• Movement in share prices during negotiations
  makes the purchase price a moving target.

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Growth Through Strategic Acquisition

• Some very successful companies plan a significant
  portion of their growth through acquisitions.
• The goal is to create synergies.
• The selling price for a strategic acquisition is
  typically higher than for a strictly financial
  sale because the target company offers extra
  value to the purchaser.

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Exit Options Earn Out 1

• If the company is generating significant positive
  cash flow, it could offer to buy out investors
  with company earnings.
• Comparable to a public company buying back its
  own shares on the open market.
• Investors might be happy with this arrangement,
  especially if they achieve their targeted return
  on investment and there are no other viable
  alternatives.

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Exit Options Earn Out 2

• An earn out can also be used to sell the venture
  to another company.
• Usually means that the entrepreneur must agree to
  stay with the company for up to five years,
  effectively working for someone else, in order to
  earn out the purchase price.
• The purchase price may be higher this way than a
  simple cash offer, but it comes with risks.

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Exit Options Debt-Equity Swap - Pros

• In this scenario, creditors accept equity shares
  in the company in exchange for their loans
  (notes, bonds, mortgage liens). For an otherwise
  profitable business, this can
• Reduce interest payments and increase free cash
  flow.
• Improve the balance sheet and profitability.
• Improve the companys valuation.

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Exit Options Debt-Equity Swap - Cons

• Can be a desperation move taken by a management
  with no other options.
• Effectively, the creditors may be exchanging
  their loans for nearly worthless, perhaps
  illiquid, equity.
• Existing equity holders are often diluted to near
  zero.
• Still, can give the company a chance to survive.

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Exit OptionsMerger

• Marriage of equals? There is nearly always one
  dominant partner.
• The basic objective is to increase shareholder
  value through a combination of product and
  operational synergies, cost reductions, and
  increased market share.
• Due diligence is critical, as the role of
  clashing corporate cultures is often overlooked
  or minimized.

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Exit OptionsLiquidation

• The business could simply sell off the assets,
  pay off all debts, and cease operations.
• Normally, this is seen as an option for
  businesses with no value as a going concern.
• Liquidation does not necessarily mean failure
  sometimes done voluntarily with no remaining
  debt.

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Other Potential Buyers

• Individual buyers may be interested in running
  the business themselves. May ask for
  seller-financing (beware).
• Equity Group buyers are groups of professional
  investors who may see unrealized potential in
  your company, or potential for synergies with
  other companies they own.

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More Potential Buyers

• Partners Existing partners, if any, may be
  willing to buy out a retiring or leaving partner.
  There should be a mechanism in the partnership
  agreement to cover this situation.
• Family members A desire for continuation of
  ownership, plus tax considerations, often mean
  more to family-owned businesses than to others.

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ESOP

• Employees can buy their company, or a large
  portion of it, through an Employee Stock
  Ownership Plan (ESOP).
• An ESOP can offer liquidity without taking the
  company public, as well as produce certain tax
  benefits.
• ESOPs are not a perfect solution for everyone. If
  the company fails pension funds can be lost.

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Going Public - Pros

• The lure of going public is enormous in times
  of rising stock prices.
• An IPO usually creates much greater liquidity and
  increased enterprise valuation.
• Public companies often have a significant
  advantage in hiring talented people, as they can
  offer stock options.

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Going Public - Cons

• The IPO is not necessarily an immediate exit
  strategy for the entrepreneur. Shares and share
  options vest over time, and are often locked
  for a period of time.
• In a falling stock market, going public may be
  seen as a desperation move, and your issue may
  attract few buyers.

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Going Public is Expensive

• Publicly held companies have very significant
  legal obligations to report accurate information
  to shareholders.
• This is expensive, time-consuming, and sometimes
  contrary to the way an entrepreneur thinks of
  his business.
• Intangible costs of the IPO process include being
  a serious drain on management time and attention.

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Going PublicConstraints

• For the entrepreneur, the primary goal is to
  retain a controlling interest in the company
  after the IPO.
• The good news is that removing the venture
  capitalists from the equation via the IPO creates
  a more level playing field and should give more
  control to the entrepreneur.
• The worst case is losing control and being
  removed from management!

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Going Public Considerations

• Once the company has established itself and begun
  to show profits, the perceived investment risk
  may be low enough to attract investors on the
  public equity markets.
• IPOs are often undervalued by as an inducement
  for investors to take a chance on an unproven
  company.

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Listing RequirementsNational Stock Exchanges

• The New York Stock Exchange (NYSE) generally
  requires the following as a minimum for listing
• 400 holders of 100 shares or more.
• Total of 1.1mil common shares publicly held.
• Market value of publicly held shares of
  40,000,000 for IPOs.
• Aggregate pre-tax earnings for the last three
  fiscal years of 10.0 million.

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Listing RequirementsNational Stock Exchanges

• NASDAQ offers separate standards for initial and
  continued listings. Its Standard 3 for initial
  listing offers a basis for comparison
• Aggregate pretax earnings of 11 mil over the
  past three years
• Aggregate cash flow of 27.5 mil over the past
  three years
• Total of 1.25 mil shares publicly held.
• Publicly held shares worth 45 mil.

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Listing RequirementsComparison of Exchanges

• During the IPO craze of the 1990s, the
  technology-oriented NASDAQ grabbed a
  disproportionate share of new listings.
• Even so, the NYSE still dominates in terms of
  total value of listings, as many of the hot IPOs
  of the late 90s are now bankrupt or delisted.

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Alternative Forms of Listings

• NASDAQ Capital Market exchange offers an
  alternative listing opportunity for companies
  that do not meet requirements of major exchanges.
  
• The OTC Markets Group is a private exchange one
  step down from the NASDAQ Capital Market. There
  is very little regulation. Listing requirements
  and liquidity are low.

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The IPO Process Overview

• Going public is a costly, tedious, and
  uncertain process, especially in a difficult
  market.
• Management will lose a measure of control after
  going public, as well as come under additional
  scrutiny by shareholders and regulators.

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The IPO Process Climate Change

• A solid track record and excellent growth
  prospects are generally expected by investors,
  though during the IPO craze of the 90s, companies
  with no revenue and no saleable products or
  services were routinely floated at large
  valuations.
• Many of them are now out of business or trading
  for pennies on the OTC.

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The IPO ProcessBuilding the Team

• Lawyers and accountants must be hired to advise
  and provide due diligence in their respective
  areas.
• Your investment banker, also called an
  underwriter, will lead you through the IPO
  process.
• Only you have your best interest at heart.

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Selecting the Underwriter

• Choosing the right underwriter for your venture
  is the key to a successful IPO.
• In effect, you are hiring a salesman. They must
  know the product (you), the market (potential
  investors), and the sales process relevant for
  you.
• There are significant differences among
  investment banks, as measured by their past
  success, size of typical deals, and the markets
  in which they deal.

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Underwriting Process

• In an underwritten offering the underwriter buys
  the shares and resells them on the day of
  issuance. They have a strong incentive to price
  the offering to sell.
• In theory, the underwriter could be left holding
  unsold shares in their own account, something
  they will do virtually anything to avoid.

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The IPO ProcessNegotiating the Offer

• You and your underwriter must agree on the total
  amount to be raised, price of shares, and the fee
  structure.
• The best answer to how much to raise is As much
  as the market will bear.

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The IPO ProcessNegotiating the Offer

• Enterprise valuation, not the share price, is the
  real issue. If you sell 20 for 5 million, you
  are expecting investors to believe your company
  is worth 25 million. You must have a plausible
  story to convince them of that valuation.
• As a modest-sized company, you will probably have
  little room to negotiate fees. It is more
  important to ensure that the underwriter will pay
  attention to your issue.

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The IPO ProcessNegotiating the Offer

• You should obtain a Firm Commitment from your
  underwriter. This means they agree to purchase
  the entire issue and resell it to investors.
• The alternative, a Best Efforts agreement,
  suggests that your offer is unattractive or you
  are talking to the wrong underwriter.
• Underwriters are risk averse.

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Cultural Differences

• IPO Share prices typically range from 10-20.
• In Britain, many companies are listed at under 1
  per share because British shareholders like the
  idea of being able to own thousands of shares for
  very little money.

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The IPO ProcessProspectus

• The prospectus is a formal document with a
  prescribed format which must be filed with the
  SEC
• Preparing the prospectus is an intense and
  tedious process, requiring assistance of CPAs and
  lawyers familiar with the process.
• The potential legal liabilities associated with
  making forward looking statements are severe.

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The IPO ProcessFinding Buyers

• The lead underwriter normally forms a syndicate
  of underwriters to ensure that all shares are
  sold on the date of issuance. This also disperses
  ownership, a positive thing for your company.
• The underwriter arranges a Road Show for
  management to pitch the company to investors in
  major cities in the US, Europe and Asia.

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The IPO ProcessFinding Buyers

• Many IPO buyers are flippers, institutions or
  private individuals whose sole business is to buy
  IPO shares at the issuance price and sell them
  the same day in the secondary market for a
  profit.
• They receive share allocations in exchange for
  commission income to the underwriters from other
  trading or investment banking activity.

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The IPO ProcessFinding Buyers

• An IPO is not declared final until about seven
  days after the day of issuance.
• In practice, the underwriter performs a useful
  and valuable service, but their interests are
  extremely short term.
• The underwriters primary objective is to create
  a first day pop which means underpricing.

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Open IPOs

• The Open IPO uses a Dutch Auction process to
  price the issue. Essentially, buyers bid for
  specific numbers of shares at a price of their
  choosing. When sufficient bids are received to
  sell all shares, the shares are then sold to all
  successful bidders at the lowest price bid from
  the group.
• This procedure has yet to gain popularity.

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Going PublicAlternative Methods

• Reverse Merger
• In this process, an existing public company
  acquires a private company shell, or legal
  entity. It has no operations, probably no assets
  except some cash, and hopefully no liabilities,
  especially contingent ones.
• This is a cheap way to go public, but it
  entails significant risks and is generally
  considered a bad idea.

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Going PublicAlternative Methods

• Direct Public Offering
• In this method, the company sells shares directly
  to the public, often via the internet. SEC filing
  requirements are less than IPOs.
• For very small offerings that do not appeal to
  underwriters.
• Investors must beware that there is almost no
  liquidity for the shares.
• The hope is that liquidity will result from a
  subsequent listing on an exchange.

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Forms of DPOsSCOR/ULOR Offerings

• SCOR, or ULOR, are Small Corporate or Uniform
  Limited Offering Registrations.
  State-administered.
• Raise up to 1 million during 1 year.
• Detailed business plan replaces SEC prospectus.
• Costs for professional fees are still
  significant, and legal liabilities of company
  officials can be severe if mistakes are made in
  the filings.

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Forms of DPOsSB-1 Offerings

• SB-1 offerings are regulated by the Federal
  government. They require a formal prospectus and
  financial statements according to GAAP. Companies
  may issue up to 10 million in stock if sales are
  not more than 25 million.

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SB-2 OfferingsRegulation A

• Can raise an unlimited amount
• Requires prospectus with audited financial
  statements.
• Basis for Regulation A and D offerings.

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SB 2 OfferingsRegulation A Offerings

• Federal equivalent of a SCOR offering
• Two years of financial statements are required
  and they may be unaudited.
• Exempt from SEC filing requirements
• Limited to 5 million raised in a 12 month period
• States may require offer be limited ti accredited
  investors

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SB-2 OfferingsRegulation D-Rule 504

• Rule 504 allows a company to raise up to 1
  million in a 12 month period through selling
  shares.
• No Federal regulation, but must notify the SEC
  with a Form D.
• Must comply with applicable State regulations.
• Must sell to accredited investors.

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Summary

• There are many options for a liquidity event.
• Entrepreneurs must think carefully about the most
  realistic and plan accordingly from the beginning.