You’ve Built It, They Came, Now What? Corporate Exit Strategies
By Elizabeth Hofheinz, MEd, MPH
Whether you are a one-time or a serial entrepreneur, you need to know how to exit gracefully, not to mention profitably, from the room. If you trip, it could be expensive to the ego and wallet alike.
Says Ron Yagoda of DryAz Consultants, LLC, “The mistake a lot of entrepreneurs make is emphasizing an exit strategy when first starting a company. The message I try to deliver is this: How you get out is secondary to building a viable business model. If you go into a business thinking, ‘Oh, I’ll flip it in two years,’ you’re taking the wrong approach. There are too many things that could change in two years.”
Not to say that you shouldn’t think about exit strategies along the way. Ron Yagoda: “You will be made aware of the issue of exit strategies by your investors. At some point, they want a return on their investment. And the type of investor you have may dictate the type of exit or liquidity strategy you take. This is because one or more of your VC investors may need liquidity by a certain date. You may, however, have a VC who has an open-ended fund and will stay as long as the company is growing—even after it’s gone public. To reiterate, building the company is the most important thing you can do; the second thing is your exit strategy.”
As for your departure choices, Ron Yagoda spells out the details:
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IPO – Although it has a glamorous tinge, going public has its downsides. First of all, do you have a predictable business model with sufficient growth to justify being a public company? If you are going forward with an IPO, recognize that fundamentally, the company is no longer private and you will have to make significant public disclosures about its business. It is no longer yours—and you are now accountable to public shareholders.
Additionally, the big pay day you may be looking for could be further out than you think. Chances are that most underwriters will not allow you, as the founder/CEO, to sell any stock on the IPO. They will more than likely put restrictions on when you can sell and how much you can sell. It could be 180 days or more before they will allow you to sell any stock. Once you’ve reached that point, it’s important to be cognizant of the fact that this may be your first and last sale if you are trying to sell a significant portion of your holdings. That sale may kill the stock price because investors could fear that there is something wrong with the company, its earnings, or its outlook—they know that you know more about the company than anyone.
You also must ask yourself if you have the psychological makeup to go to the proctologist four times per year, i.e., deal with being a public company. Can you handle every analyst on Wall Street criticizing you and asking a multitude of questions after each quarterly earnings call?
Examining the pluses of going public, one important point is that you have created valuation and liquidity for some, but not all investors. Another point is that this is usually attractively priced capital that will give you balance sheet flexibility. Not to be underestimated is that an IPO may bring credibility to your business model. Now your sales force can tell surgeons, distributors and others that the company’s shares, for example, are listed on the New York Stock Exchange. This can be a real door-opener.
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Acquisition - With this option, there’s no proctologist, but you are selling your baby. Are you sure you’re ready to sell? If so, the next question is, ‘How do I go about this?’ Chances are good that if your business is doing well and you attended the big conferences, business development people from potential acquirers have come to visit your booth. Before jumping ahead, however, it is wise to hire an investment banker or some other qualified person to run the sale. You will pay substantial fees, but unless you are experienced, a professional can usually negotiate a better deal than you could alone.
Once you have made the decision to be acquired, ask yourself, ‘Where are my responsibilities? Customers? Employees? Shareholders?’ Think about what you need to do for each constituency. It’s not that simple. The acquiring company may want to shut down your operation and move it across the country. How do you feel about that? Are they going to take care of your advisors? Is that important to the success of the company?
When it comes to discussing form of payment of the acquisition, other dynamics come into play. If company X is offering you cash and company Y is offering stock on the NYSE, the latter may be a good choice because it is a tax-free exchange with no taxable liability. You may have liquidity because it’s a publicly traded company. You may be given a registration statement that will allow you to sell shares in the open market. However, that is not necessarily a guarantee of the price that you will receive when you sell. The acquirer’s stock may go down as well as up; you have no control over how that stock trades.
If you are in negotiations to be acquired for stock, while they are doing due diligence on your company, you need to be doing due diligence on them. Why? Because in effect, they’re not really buying your company. You are using your assets, everything you’ve built in your company, as currency to acquire their stock. They are trading those assets for that stock.
From a personal standpoint, you are not diversifying your assets. Let’s say they’re offering $100 million and you own 20%, meaning that you will get $20 million in this stock. If that is 95% of your net worth and you have no say in the company, that doesn’t sound like such a good deal. What, if any, will your role be in the acquiring company? Think of it this way: if you had $20 million in cash, would you go out and buy $20 million worth of that stock when you have no future role in the company? If the answer is yes, then fine. However, if the answer is no, then you better know your path to liquidity before you sign anything on the bottom line.
You should research how liquid the security is. Do your professional advisors think the acquirer’s stock is over or under priced? Honestly, if a company thought it was undervalued, they wouldn’t use it as currency to buy your company-they would use cash. By using their stock they’re inferring that it may be overvalued. Remember, they’re selling that stock to you for your assets. You should have your advisors do a thorough analysis of the company’s prospects.
Turning to the cash option, like my mother told me, cash is always fashionable. You will want to assess whether or not the valuation is fair. Your negotiations should address issues such as earn-outs, contingencies, indemnifications, escrows, and guarantees. If there is an earn-out, for example, what will your future role in the acquiring company be in assuring that it is met? If you have no role going forward, your ability to impact the likelihood of success with an earn-out is low. The acquiring company may also want to hold money in an escrow agreement. Maybe they will buy the company for $100 million, but give you $80 million now, $10 million in 6 months and $10 million in 18 months.
Because your company is private and there are no public documents, the buyer is relying on your audited statements and your guarantees that there are no undisclosed lawsuits or liabilities. They may want an indemnification against anything you haven’t disclosed, including, for example, FDA issues. This indemnification and/or escrows could stretch in time and apply to the largest shareholders.
In the end, you will likely receive severance pay and may be asked to stay on for a transition period. Although some companies retain the founder after an acquisition, it is rare in most device companies because those in the management tier usually aren’t the reason the company is being acquired–it’s generally the IP and the product development people. Lastly, be clear about whether this is a purchase of assets or a merger. From an accounting viewpoint this is an important distinction and may have tax ramifications.
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Liquidation – There may be times that the pieces of the company are worth more than the whole. It’s particularly helpful if the company is very diverse. For example, if you have a multi-platform technology, you could sell the orthopedic business to one company, the urology business to another, and the cardiology sector to yet another. Liquidation generally is more applicable for businesses that are in trouble. If you have $50 million invested and the company is worth $20 million, you likely want to pick door number three.
Looking back over the choices, Ron Yagoda says, “An IPO is not a panacea. In orthopedics there are few successful small IPOs. In most cases, the companies ultimately have been acquired by larger entities. Mitek and Innovasive Devices were purchased by ETHICON, Inc., a Johnson & Johnson company; Oratec was bought by Smith and Nephew; Bionx Implants was acquired by ConMed. In many cases, after the company’s IPO, the founders were unable to achieve any degree of personal liquidity and ultimately sold their companies at prices lower than the initial IPO price.”
Sounding another note of caution, Yagoda notes, “Selling your company to another private company for stock can be dangerous unless you have guarantees of liquidity. You are essentially becoming a minority shareholder in another private company.”
“On another note concerning the IPO route,” advises Yagoda, “just because an underwriter says they are going to take you public doesn’t mean the deal will actually go through. When I was CEO of Orthopaedic Biosystems, Ltd., at one point we were on the road to an IPO. Although we had an underwriter and had done all the necessary work, we had no control over market factors. Both the Russian debt crisis and a multi-billion dollar hedge fund going bankrupt caused our deal, and those of 350 other companies, to go south. Yet we still had to pay the lawyers, the printer, the auditors, etc. Another possibility is that the underwriter may come back to you and say, ‘We can only do the deal at a $X valuation, not a $2X valuation.’ In that case, you’re now dealing from a position of weakness. Are you dependent on that IPO to fund the business? If so, and the deal falls through, you’re in trouble. That’s when your good VC investors will be useful—they will continue to fund you. They’re your plan B. Overall moral of the story: There are no guarantees.”
So, if you’re just starting out, remember this: Build a solid, exciting company now and you will stand a better chance of profiting later. Says Ron Yagoda, “If you create a company that’s viable and successful, then you create value for your shareholders.”
If you are further down the road, however, and thinking of exiting, get out your Rolodex and call an advisor—or maybe two.
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