Tech Capital Partners Blog

Fred Wilson recently wrote a series of posts detailing the economics of a Venture Capital Fund (Economics, Gross and Net Returns, When One Deal Returns The Fund, Allocating Follow-On Capital). In his posts, Fred discusses how VCs get paid and what levels of exits are required in order to generate acceptable returns. Fred’s series of posts got me thinking about exits and I thought I would share some of my thoughts on the topic.

In very general terms, exits usually fall under one of the following categories:

Bankruptcy
Obviously not a good result. A bankruptcy occurs when a company does not have assets available to settle its liabilities. A company can elect voluntarily to declare bankruptcy or a creditor can apply to the courts to have bankruptcy proceedings start. In either case, a third party (called “a receiver”) is hired to liquidate the assets and distribute any proceeds to the creditors.  Whether or not a VC will realize any proceeds in a bankruptcy depends on the nature of the investment and the extent to which there are other creditors. In broad terms, the receiver get their fees paid first followed by the  government for things like payroll withholdings and sales tax. Next come the secured creditors - a VC may get some proceeds here if they hold secured debt or preferred shares. Last to be paid are the common shareholders and it is very unlikely in a bankruptcy that there will be anything to distribute to this group. So in summary, not a good result for anyone.

Orderly wind-up
This is similar to a bankruptcy but in this case the decision to close the business is made while there is enough cash to settle with the creditors. The liabilities are paid out and then, like in a bankruptcy, any remaining assets are distributed to shareholders in order of priority (i.e. preferred shareholders before common shareholders).  Again, not usually a very good result for the VC or the founders.

Public Offering
This is what many founders aspire to and in fact, like many VC firms, we expect our companies to act like they will be public companies one day. The process to go public is not easy and we are big believers in making things as easy as possible from day one. For example, securities regulators and stock exchanges have rules regarding stock options and stock option plans. Why not make your plan and option grants comply with public company requirements from day one so that there is one less thing to worry about in the event you eventually take the company public?

I believe there is a misconception about how people make money on an Initial Public Offering (IPO). Lets say you are the founder of a business and own one million shares, the company goes public at a price of $30 per share. You get $30 million right? Not so easy. On paper you are “worth” $30 million but you won’t be able to liquidate those shares. On the public offering, the underwriters (the brokerage firm that sells the stock) will require that all shareholders agree not to liquidate their shares for a certain period of time (say six months). For a VC, this is not ideal but it is understood it is part of the deal. What often happens is right before the lock-up period expires, the underwriters will try to arrange a sale for any investors who want to sell to avoid having a large block of shares hit the open market. Unfortunately, management will not usually be able to participate in this share sale. The markets don’t like to see founders selling large blocks of stock as it sends the “wrong message” (i.e. why don’t the founders believe in the upside potential of the stock?). If the stock is very sought after, the underwriters may agree to allow the founders to sell a small piece of their shareholdings but the reality is that as a public company it will be very difficult to realize all of your “paper wealth”. This is the catch 22 for founders –  most aspire to be public companies but the reality is it becomes tough to actually liquidate their shares. Once the company has a track record as a public entity founders should be able to sell shares using a predetermined formula (e.g. 1% of your holdings on the 10th of each month). From a VC perspective the IPO is usually a good result as it provides liquidity.

Financial sale
The sale to a financial buyer, usually a private equity firm, is unusual for early stage technology businesses because financial purchasers are looking for companies that are cash flow positive - a rarity in the tech world :). Usually a financial acquirer will fund the purchase through a combination of debt and equity. The debt lenders will base the amount they are prepared to lend on historical results and future cash flow projections, making positive cash flow a must. I sit on the board of Q9 Networks which recently announced it has agreed to be acquired by a private equity firm. I chaired the special committee of the board that dealt with the sale. After the transaction closes I will share some more thoughts about private equity acquisitions. From a VC perspective a financial sale usually provides immediate liquidity.

Strategic sale
In our experience, this is the most likely exit for VC backed technology companies. Strategic sales occur when another company buys your company for strategic reasons. The reasons can be any of the following:

• The purchaser needs to enhance their product offering and does not have time to develop internally so buys a company that has already completed development (buy vs build).
• The purchaser wants to make sure their competitors do not have access to your products or technology.
• Your technology is so proprietary it is unlikely the purchaser would have been able to develop the solution internally.
• Your technology/product will allow the purchaser to generate significant “pull through” revenue. i.e. the purchaser believes that by combining your product with their existing product they will now have a competitive advantage that will allow them to win significant new business and/or differentiate themselves from competitors.

Assuming the acquirer is paying in cash or is publicly traded, a strategic sale is usually a very good result for the VC because we are able to liquidate our investment immediately. For founders the liquidity will vary. Sometimes an acquirer will require the founders/senior management to put their proceeds in escrow with the amounts being released over time. This escrow ensures the founders remain with the business during a transition period. In other cases, the founders are able to fully liquidate and they are retained through new employment contracts and/or equity in the acquirer.

So which of the above should you aspire to? Ultimately I think you want to make sure you have options and never be in a position where you are forced in a specific direction. The overall advice we give to our founders is: “build the company on the assumption it will go public but recognize that a strategic sale is more likely so don’t do anything that will make a sale difficult.” I will cover what this means in a future post.

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