We see most investments being celebrated at the time of entry. It is a true milestone for a founder, but the journey has only just begun for an investor. It is often said that investors are in the business of exits.
And a good exit is the ultimate pot of gold that investors yearn for. Hence, it is no surprise that exit evaluation is a key criterion for any serious investor while evaluating an investment and continues to be a key focus area post-investment.
Let’s break this down a bit further. There are broadly two aspects in evaluating a potential exit from a portfolio company:
- Exit potential or the possible exit routes such as IPO, trade sale and more
- Exit returns or the expected value at the time of exit
Exit potential essentially focuses on where the founder and investor see the exit coming from. Investors typically seek an exit via an IPO (Initial Public Offering), a trade sale or strategic sale of the business, and a secondary exit from investors in subsequent rounds, also known as a financial exit. Each of these routes has advantages and limitations in the context of the industry, size of the company, time horizon and other parameters.
Trade sales and secondary exits are the most common form of exits realised by investors. Despite a significant increase in IPO activity that year, these accounted for 60% of the total VC exit value in 2021. A trade sale is most efficiently executed where there is alignment with the founder and management team. Early-stage investors in high-growth startups who expect to raise multiple rounds of capital are more likely to exit through a secondary sale.
Many founders consider an IPO listing as a landmark event and most consider it a fitting proxy for success. However, listing a company on a stock exchange requires advanced planning. Usually, companies eyeing an IPO start to prepare two to four years ahead of the target listing timeframe.
This includes, among other things, strengthening governance practices such as reporting, board structures, internal controls, and audits. There are regulatory requirements to be met as well, in terms of track record and compliance. Needless to say, IPOs have a strong linkage to the external macro environment and economic cycles.
Consider this: IPO funding fell by 56% in 2022 compared to 2021 as a result of rising geopolitical tensions, inflation, and recessionary fears. This had an impact on exits for PE/VCs who were expecting their portfolio companies to be listed, and IPO timelines had to be pushed back due to market factors.
In addition to all these, not all companies are suited for listing, especially on the main stock exchange. Public market investors seek scale and profitability over time, making an IPO exit difficult for investors participating in the company’s early stages. According to Inc42, it takes about 13.8 years for an Indian startup to go public.
It is also important to evaluate the exit strategy in the context of the expected returns which are in turn determined by the holding period and exit value. Some investors triangulate the entry valuation with the expected exit returns before making an investment.
The Building Blocks Of An Exit Strategy
The following factors are essential for an investor to consider while building an exit strategy.
- Founder’s Ambitions: Exits are the primary responsibility of any founder taking external capital and naturally, they are the drivers leading this effort. Encouraging discussions with founders on exit pathways early in the investing journey helps avoid conflicting situations later.
- Milestones and course correction: Typically, companies are guided by a three-year or a five-year business plan which has been underwritten at the time of investment. While the progress of the portfolio companies is tracked on a monthly or quarterly basis, it is important to revisit this business plan at regular intervals post-investing. This exercise may help in tweaking the exit strategy, if required.
- Monitor the industry: Keep an eye out on the competition, their milestones, fundraising journey and valuation benchmarks. It is smart to establish early connect with potential acquirers and/or funders as it gives them time to spend with the company to understand the business, organisation structure and culture.
- Positioning is key: Have a clear vision of the problem statement and how well the company addresses it. Market leaders that can scale to become large companies will command a different exit approach compared to niche market players who can become good acquisition targets.
- Hedge the risk: It is not always possible to predict the exit route at the time of investing. Hence, it is preferable to explore more than one exit strategy in the initial phase of the investment journey and zero down on the most suited course as the company’s growth pans out. Also, while most exit strategies look to optimise a good situation, protecting the downside risks is equally important. Investor rights like drag along, put options, accelerated exits in case of serious mismanagement and in some instances board and operational control can act as a negative incentive for a founder to actively scout for exit opportunities.
- Take help from experts: Leverage the ecosystem of advisors and investment bankers to corroborate the exit strategy. They are a good port of call when taking strategic decisions that may impact exit assumptions and when the time comes, can even assist the company and the investor in securing an exit.
Every investor’s endeavour is to generate great returns. A good exit track record is crucial for the investor to raise capital from LPs (Limited Partners) and contributes to the growth of the PE/VC industry. The formulation of an exit strategy plays an important role in achieving this outcome.