Chapter 14

Scaling & Exiting the Venture

Objectives

• Various sources to develop an exit strategy• Exit options available to entrepreneurs• Process of selling a business• Process of launching an initial public offering• Advantages and disadvantages of going public

Introduction

• A liquidity event is when the shares of a company are purchased by a third party and the investors can sell their ownership portions and cash out, preferably at a profit.

• The most common methods of an exit strategy are to sell an equity stake to a partner, sell the business, merge with another company, implement a leveraged buyout, or sell the company to its employees.

• A public offering will scale the business for growth.

Selling an Equity Stake to a Partner

• A well researched and targeted effort is necessary to determine why an alliance partner should purchase a stake and the reason and justification for the sale.

• When the companies have complementary skills, the alliance can accomplish tasks that neither company could do alone.

Implementing the Plan• 1. Identify the objective of the proposed alliance. Also time requirements

and expectations of companies.• 2. Target list of possible candidate companies. • 3. Research the candidates and examine their web sites and press

releases. Determine who is in charge of business development. • 4. Present the finding to key members that will be impacted by the

relationship (software development, IT, marketing, sales) and gather their input, concerns, and interests.

• 5. Develop a non confidential introduction kit and cover letter to send to possible alliance partners. The letter should be short indicating the advantage of the alliance. The goal should be an in person meeting. The first meeting should be at the alliance partners terms and location. A sample meeting agenda is on page 368.

Selling the Business

• The best plan is to build valuable assets and identify them in the selling process.

• Along with determining an acceptable price, the entrepreneur should think of what kind of compensation or payment is acceptable.

• What form of seller employment agreements and non compete clause?

• Be flexible.

Preparing a selling memorandum

• A revised business plan becomes the selling memorandum.

• Outline of a selling memorandum include: executive summary, products and services, marketing, manufacturing, management, employees, historical financial statements, and financial projections (page 370).

Searching for Buyers• The potential list can include individual investors or entrepreneurs, existing

management, other employee groups, competitors, customers, vendors, investment groups, and foreign investors.

• Each of these groups has different motivations to buy and some may be more appropriate than others.

• Professional intermediaries available to identify potential buyers include mergers and acquisitions departments of major investment banking firms (purchase price $25 million or more), commercial banks, smaller independent firms(purchase price up to $5 million).

• Lehman Formula Fee Schedule: Fee of 5 % for the first $1 million of the purchase price, 4 % for the second million, 3% for the third, 2% for the forth, and 1 % for amounts in excess of $4 million.

• The task is usually undertaken on an exclusive basis. Fees are generally guaranteed by the seller, who provides an upfront retainer and a substantial amount contingent upon completion of the transaction.

Evaluating Offers

• In evaluating the prospective offers, sellers should investigate the prospective buyer’s: 1. credentials and track record 2. creditworthiness especially if portion is in stock 3. management style and 4. integrity.

• Initial meeting: Buyer wants to know seller’s motive for selling the company. Seller wants to know if buyer has financial resources to buy the company.

• Negotiating: Key is understanding objectives, strengths, and weaknesses and those of the other party. In a successful negotiation both sides will feel they have won.

Letter of Intent• Confirms interest of the two parties and outlines terms agreed on in negotiation. • Issues in the letter of intent may include:• 1. The purchase price: amount agreed on or formula for computing amount.• 2. What is being purchased: assets, liabilities, and operations that are being transferred to the buyer (and

those that are being retained by the seller).• 3. The structure: sale of assets, sale of stock, merger, or some other structure.• 4. The payout or type of compensation: cash, notes, equity, or some combination of these.• 4. Escrow for contingencies: to cover such items as unrecorded liabilities or recorded items that are only

estimates (allowance for uncollectable accounts).• 5. Other significant terms: contingency payments, covenants not to compete, and employment contracts.• 6. Other required agreements: renegotiated leases and long term purchase contracts.• 7. The purchase agreement: expected timeline. Typically buyer’s counsel will draft the letter.• 8. Due diligence: buyer’s expectation. Management records.• 9. Professional fees: who will be responsible for accountant, attorney, appraiser & investment banker fees.• 10. Exclusivity agreement: for defined period usually 90 to 120 days.• 11. Bust up fees: if someone bids higher, original buyer gets part of increased price. Seller will try to avoid

such a fee.• 12. Applicable law: if parties are in different states, which state law will govern agreement.

Due Diligence

• Typical information requested includes all corporate records (incorporation, by laws, minutes, stock records), material contracts, loan agreements, pending litigation, royalty agreements, labor agreements, leases, commitments, employment contracts, and stockholder agreements.

• Environmental liability is also very important as current owners may be held liable for cleaning up toxic chemicals left by prior owners.

Preparing a Purchase Agreement

• The attorneys will prepare the purchase agreements.

• The documents will give rise to rounds of negotiation to resolve obstacles.

• The purchaser’s attorney usually drafts the purchaser’s agreement.

• The final document will usually be quite lengthy.

Closing the Deal

• Often certain time consuming procedures are a pre requisite to consuming the deal.

• Rather than wait until everything is done, the parties will agree to a deferred closing.

• Typical conditions include fulfillment of key employment agreements, delivery of financial statements, licenses, or rights.

Merge with another Business

• A merger between two businesses ranges from survival to value added services for growth of the new venture.

• Planning a merger requires calculating the values of both businesses and all existing resources.

• It can provide technical know how, greater executive depth, economies of scale, vertical integration, and new market strength.

Public Offering• The IPO process is difficult, the pitfalls are numerous, and the stakes are

high.• Poor market timing and inadequate planning can jeopardize an IPO.• The following questions need to be addressed in making an IPO decision:• Are you ready to share the ownership of your company with the public?• Are you prepared to disclose the company’s most closely held secrets?• Can you live with continued scrutiny of investors and market analysts?• Can you devote 100 % of your time for 6 to 8 months and pay the

substantial fees that it takes for a typical IPO?• Are you prepared to take on the issues, challenges, and responsibilities of

going public?

Benefits of Going Public• Evaluate the benefits to see if they outweigh the drawbacks:• 1. Improved financial condition: Selling shares to the public brings in

equity money that does not have to be repaid immediately.• 2. Benefits to shareholders/investors: Going public offers liquidity to

existing investors.• 3. Management and Employee Incentives: The company can issue stock

options to management and employees.• 4. A path to acquisitions: Going public enhances a company’s financing

alternatives for acquisitions. Public companies often issue stock (instead of paying cash) to acquire other businesses.

Disadvantages of Going Public

• Some of the drawbacks are:• 1. Loss of control: Depending on the proportion of shares sold

to the public.• 2. Loss of privacy: The Securities and Exchange Commission

(SEC) requires disclosure of information about the company.• 3. Demands of periodic reporting: The SEC requires quarterly

financial reporting (Form 10-Q), annual financial reporting (Form 10-K), and reporting of current material events (Form 8-K).

• 4. Initial and outgoing expenses: Underwriters discount or commission is 6 to 10 % of offering price.

Managing the IPO Event

• The IPO event usually lasts between 90 and 120 days - it includes preparing and filing the Registration Statement, going on the road show, and the closing and buying of the company stock.

• An example of timetable for an IPO is given on page 397.

Completing the Registration Process

• The registration process begins when the entrepreneur has reached an understanding with an underwriter on the proposed public offering.

• The financial statements must be audited and should reflect income statements for the preceding 3 years, and balance sheets for the prior 2 years.

• The prospectus which his a part of the registration statement becomes the marketing document for an IPO.

Filing the registration statement• When the company officers and majority of the board of directors have

signed the registration statement, it is filed with the SEC (normally electronically) on the SEC’s EDGAR system.

• In addition the statement is also filed with any state in which the securities will be offered and with the National Association of Security Dealers.

• At closing, documents are executed and stock certificates are exchanged.• Usually company officers, counsel, transfer agent, and managing

underwriters attend the final closing.• The rules also require that a final prospectus be delivered to all

purchasers of the company stock.

Presenting a road show• After the Registration Statement has been filed, the underwriters will

generally take representatives of the company on a travelling road show (dog and pony show).

• These meetings give prospective members of the underwriting syndicate, institutional investors, and industry analysts an opportunity to meet the company management team and ask questions about the offering and the company.

• The participants will probably be the company’s chief executive officer and chief financial officer and the investment bankers who will manage the tour.

• Typically the road show consists of 5 to 7 back to back meetings every day for 2 weeks.

Preparation for the road show

• 1. Twenty to twenty five minute slide presentation, including details of the company’s business, strategy, financial history, management, growth prospects, market, and regulatory environment.

• 2. Determination of which management personnel will present the material and field questions.

• 3. Education of the underwriters team.• 4. Dry run of the road show before institutional sales

and corporate finance presentations are given at selected locations.

Selecting the underwriter

• 1. Experienced industry analyst: experienced in IPOs and the industry you are in.

• 2. Synergy: Right synergy between bankers (underwriter) and management is important.

• 3. Distribution: The investment bank should have the resources of a retail sales force to sell the stock.

• 4. Post IPO Support: A strong track record will indicate how well the investment bank priced recent transactions.

Expenses of going public

• Underwriter’s compensation: Typically 7% of the public offering price of stock.

• Accounting and legal fees: Depends on the amount of work. The company should do as much as possible itself to cut costs.

• Directors and officers insurance: Personal liability insurance that will protect them if a shareholder suit is brought against them.

Delivering value and meeting market expectations

• The challenge after the IPO is to deliver the value that the company promised in the business plan and offering memorandum.

• It involves meeting or exceeding expectations of the market and the stakeholders.

• For the entrepreneur/CEO of a public company credibility is important.• The pressure most public companies face is to maintain short term

earnings growth.• Consequently companies are tempted to maintain share price by

sacrificing long term profitability and growth for short term earnings.• The entrepreneur must plan and implement a business strategy that

balances short and long term needs and communicate the plan to shareholders and the financial community.

Summary• A liquidity event is when the shares of a company are purchased by a third party

and the investors can sell their ownership portions and cash out, preferably at a profit.

• The most common methods of an exit strategy are to sell an equity stake to a partner, sell the business, merge with another company, implement a leveraged buyout, or sell the company to its employees.

• A public offering will scale the business for growth.• A revised business plan becomes the selling memorandum.• Outline of a selling memorandum include: executive summary, products and

services, marketing, manufacturing, management, employees, historical financial statements, and financial projections.

• Professional intermediaries available to identify potential buyers include mergers and acquisitions departments of major investment banking firms (purchase price $25 million or more), commercial banks, smaller independent firms(purchase price up to $5 million).

Home Work

• 1. What is a liquidity event?• 2. What are the most common methods of an exit strategy?• 3. What becomes the selling memorandum?• 4. What is the typical underwriter’s compensation?