CVC #17: Exit strategies

The exit market has faced significant headwinds over the past two years, with many startups and investors navigating a challenging environment marked by economic uncertainty e.g. due to increasing interest rates, geopolitical tensions, and fluctuating market conditions. IPO activities slowed down, and mergers and acquisitions (M&A) experienced a very cautious approach as well due to these factors.

In 2022 and 2023, IPO volumes were significantly lower compared to the previous years. According to Ernst & Young (EY), global IPO proceeds in 2022 dropped by over 60% compared to 2021, and the trend continued into 2023 with a further 30% decline. M&A activity also experienced a dip, with global deal value in 2023 declining by approximately 20% from the previous year, according to PwC.

Now in midpoint of 2024, the picture is more promising with signs of increased exit momentum. Such signs include economic stabilization, strong public stock market, slowly decreasing interest rate environment, and increase in filings & M&A activities suggesting a potential rebound.

As such lets take a look together at exit strategies by breaking it down into 3 areas (1) common exit routes, (2) factors Influencing Exit Strategy Selection and (3) how to Prepare a Startup for Exit.

1) Exit routes and factors to consider

Planning an approach to divest an investment in a way that maximizes returns and aligns with the strategic objectives of the startup and its investors is critical. There are different exit routes to consider, each offering distinct pros and cons.

• Initial Public Offering (IPO)

An IPO, perhaps the most well-known exit route, involves offering shares of the invested startup to the public. This can be a lucrative exit, providing significant returns if the company is successful. However, IPOs are subject to market conditions and can be lengthy and costly processes.

Pros:

- High Potential Returns: An IPO can significantly increase the value of the company's shares, providing substantial returns to investors.

- Increased Visibility and Credibility: Going public can enhance the company's reputation, attracting more customers, partners, and top talent.

- Liquidity: Publicly traded shares provide liquidity for investors, allowing them to sell shares more easily.

Cons:

- High Costs and Regulatory Requirements: The process involves significant legal, accounting, and marketing expenses, along with ongoing costs of compliance and reporting.

- Market Volatility: The success of an IPO is heavily influenced by market conditions, which can be unpredictable and outside the company's control.

- Disclosure Requirements: Public companies must disclose detailed financial and operational information, which could benefit competitors.

• Acquisition by a Third Party

Selling the invested company to another company is a common exit strategy, particularly for enterprise technology private companies. This option is attractive when one or more strategic buyers see value in the startup’s technology, market position, or talent.

Pros:

- Quicker Process: Compared to an IPO, acquisitions can be completed more quickly, providing faster returns to investors.

- High Financial Returns: Competitive bidding from multiple interested parties can drive up the sale price.

- Immediate Returns: Investors can receive cash (or third party equity) immediately upon the sale.

Cons:

- Equity-Based Returns: If the transaction is structured with equity rather than cash, investors may not receive immediate liquidity and require to have good understanding of short and longterm value of third party shares (public or private)

- Tax Implications: Equity returns can create complex tax situations, potentially resulting in tax liabilities which are difficult to pay as perceives are in equity and not cash

- Strategic Misalignment: The acquiring company’s goals may not align with the original strategic objectives of the startup, potentially leading to conflicts.

• Acquisition by the Parent Company

Sometimes, the best exit is within the parent company of the CVC, aligning with the initial investment strategy. The parent company may decide to acquire the startup, integrating its technology or talent to drive innovation and growth from within.

Pros:

- Full Access to Assets and Technology: The parent company can fully leverage the startup’s assets and technology to enhance its own offerings.

- Strategic Alignment: Direct integration ensures that the startup's operations and goals are in line with the parent company's strategic objectives.

- Synergies: Combining resources and capabilities can lead to greater efficiencies and innovation. The CVC parent company knows thanks to the CVC investment the startup very well and can value its synergies

Cons:

- Capital Intensive: Acquiring the startup can require significant capital, especially if there are competing buyers.

- Integration Challenges: Merging the startup’s operations, culture, and systems with the parent company can be difficult and time-consuming.

- Retention Issues: Key personnel from the startup may leave if they are not effectively integrated or motivated within the larger organization.

• Secondary Sale

In a secondary sale, the CVC sells its stake to another investor, which could be another strategic investor or a private equity/venture capital firm. This can be a flexible and quicker way to exit an investment.

Pros:

- Flexible Timing: Secondary sales can be arranged at a time that suits both the seller and the buyer, without waiting for market conditions to be optimal.

- Less Market Dependency: Unlike an IPO, secondary sales are less affected by public market volatility.

- Immediate Liquidity: Provides immediate liquidity to the selling investors without the need for a public offering.

Cons:

- Lower Returns: Secondary sales may not fetch the highest possible valuation compared to an IPO or strategic acquisition.

- Contractual Complexities: Existing agreements may grant rights to other investors, complicating the sale process.

- Liquidity Challenges: Finding a buyer can be difficult due to lower liquidity in the secondary market compared to public markets and is often only available for a smaller minority investor and not a wider investor / founder base

• Buybacks

A buyback involves the startup repurchasing its shares. This strategy can be beneficial if the startup has sufficient cash flow and wants to regain equity control, though it is less common due to the need for substantial cash reserves.

Pros:

- Straightforward Transaction: The process is usually simpler and quicker compared to other exit strategies.

- Retains Company Independence: The company remains privately held and under the control of the original founders and management.

- Positive Signal: A buyback can indicate confidence in the company’s future prospects and financial health.

Cons:

- Cash Reserves Required: The startup must have sufficient cash reserves to finance the buyback, which may not always be feasible.

- Lower Returns: The buyback price may be lower than what could be achieved through an IPO or strategic sale.

- Opportunity Cost: The funds used for the buyback could have been invested in growth opportunities or other strategic initiatives.

• Liquidation

Liquidation is often a last resort when the startup fails to meet its objectives. It involves selling off the company’s assets to recover some of the investment. Proceeds first go to debt holders and outstanding bills before equity investors.

Pros:

- Quick Resolution: Liquidation can quickly resolve the situation and return whatever value is left to the investors.

Cons:

- Significant Losses: Typically results in significant financial losses for investors, as assets are often sold at a discount.

Each exit strategy offers unique benefits and challenges, and the optimal choice depends on the specific circumstances and strategic goals of the startup and its investors. Choosing the right exit strategy depends on various factors. Most prominent I would highlight:

• Market Conditions: The overall market environment plays a crucial role. An IPO is more viable during a bull market with an active & successful IPO market. Overall market sentiment is critical for overall investment mode as well on corporate M&A exit route. In times of high (geo-) political and market uncertainty, buyers are usually more cautious and buying offers less attractive.
• Startup Performance: The financial health and growth trajectory of the startup influence the available exit options. High-performing startups with attractive margins, revenue/ ARR growth and Cashflow positive (or healthy run-way when Cashflow negative) have a wider array of attractive exit opportunities.
• Existing investors and cap-table structure: The existing investors influence as well the exit strategy. Are there investors on cap-table, which are at or above the end of their fund lifetime and need to return cash to their investors? Is there a very dominant / majority corporate investors? Those cap-table structures influence the direction and timing of exit.
• Exit partners: Who wants to exit is as well a critical element of the exit strategy. Is it “just” one minority investor or do founders & majority shareholders as well exit. This determines as well the exit strategy. Secondaries are often most suited for limited shares exits.
• Investment Horizon: The intended duration of the investment impacts the choice of exit strategy. Preparation and conducting an IPO takes a longer time period, while M&A transaction could be completed to signing in 4-6 months.

How to Prepare a Startup for Exit

Preparing a startup for exit is a critical process that involves strategic planning, operational optimization, and financial readiness. Proper preparation not only maximizes the exit value but also ensures a smoother transition, whether through an IPO, acquisition, or another exit route.

Here are key steps to get a startup exit-ready:

1. Alignment: Regular alignment on exit strategy and routes among founder(s) and key investor(s) is critical. Even before investing into startup, I recommend having an alignment on their strategy to get an idea what the founders and existing shareholders ideas are around exit, from timing to routes (incl. potential buyers).
2. Strengthen Financial Health: A solid financial foundation is crucial for attracting potential buyers or public market investors. This involves (i) Audited Financial Statements: Ensure that the financial statements are audited by a reputable firm. Audited financials provide transparency and build trust with potential buyers, (ii) Revenue/ ARR Growth: Demonstrate consistent and scalable revenue growth. This shows that the business model is viable and has the potential for future expansion and (iii) Profitability & Margin: Showing that the business is performing on a stable profit margin. Optimize operational efficiencies to manage costs effectively, highlighting profitability or a clear path to profitability.
3. Operations: Streamlining operations and addressing any inefficiencies can make the startup more attractive to potential buyers. I see 3 important operations areas, (i) Operational Processes: Standardize and document key operational processes to ensure smooth transition and integration post-exit (ii)Talent Retention: Develop strategies to retain key talent, as the expertise of the team can significantly impact the valuation and (iii) Technology and Infrastructure: Ensure that the technology stack and infrastructure are robust, scalable, and up-to-date.
4. Strengthen Market Position: A strong market position enhances the attractiveness of the startup. 3 market areas to show your strength would be (i) Customer Base: Grow and diversify the customer base to reduce dependency on a few key clients, (ii) Brand Reputation: Invest in building a strong brand reputation and market presence (B2C and B2B) and (iii) Competitive Advantage: Clearly articulate the startup’s unique selling propositions and competitive advantages.
5. Legal and Compliance Readiness: Ensuring legal and compliance readiness is crucial to avoid last-minute hurdles. (i) Secure and protect intellectual property, including patents, trademarks, and copyrights, (ii) Ensure compliance with all relevant regulations and standards in the industry and have clear audit trail and (iii) Review and organize all key contracts and agreements (incl. client, employment and vendor agreements), ensuring they are up-to-date and legally sound.

Conclusion

A well-crafted exit strategy (or at least idea) is essential for the success of investments. By understanding the various exit options and the factors that influence their selection for specific startup investment, strategic and financial returns can be optimized. Finally, regular alignment and communication on exit plan is critical, timing of this obviously varies on stage of startup and its situation. I see a check-in on annual basis as good minimum.

Happy investing and exiting!