The Exit Decision in Venture Capital. How to Choose Exit Timing and Exit Route

Table of Contents

I. List of Figures

II. List of Abbreviations

1. Introduction

2. The Choice of Exit Route
2.1. Exit Route Alternatives
2.2. Factors that influence the Choice of Exit Route
2.2.1. ET vs. VCF – The ET’s Preferences
2.2.2. VCF vs. ET
2.2.2.1. The VCF’s Cash Preference
2.2.2.2. Fund Termination
2.2.2.3. VCF’s Reputational Incentives
2.2.3. VCF vs. Acquirer
2.2.3.1. Ability of new Owners to resolve IA and value the Venture correctly
2.2.3.2. Degree of Innovation
2.2.3.3. Ability of new Owners to monitor and discipline the ET
2.2.3.4. Development Stage of Venture at Exit
2.2.4. Additional Factors
2.2.4.1. Venture Quality
2.2.4.2. High-Technology Ventures
2.2.4.3. Transaction Synergies
2.2.4.4. Transaction Costs
2.3. Is there a Pecking Order of Exit Routes?

3. The Choice of Exit Timing
3.1. Efficient VC Investment Duration Framework
3.2. Factors that influence Exit Timing in the Real World
3.2.1. VCF vs. Acquirer
3.2.1.1. Stage of Development at first Investment
3.2.1.2. Venture Quality
3.2.1.3. High-Technology Ventures
3.2.2. VCF vs. ET
3.2.2.1. Funds available to the VCF
3.2.2.2. Pre-Planned Exits, Unsolicited Offers, and VC Fund Termination

4. Empirical Evidence for the Relationship between Exit Timing and Exit Route
4.1. Rank Order of Exit Routes with regard to Investment Duration
4.2. IPO and Timing
4.2.1. The Grandstanding Theory
4.2.2. Cyclicality of Valuation in IPO Markets
4.2.3. Market-Timing vs. Market Conditions
4.3. Trade Sale and Timing

5. Conclusion

III. Appendix

IV. References

I. List of Figures

Figure I: Relative Attractiveness of Exit Routes to the VCF

Figure I: Optimal VC Investment Duration

Figure III: Discontinuity and Shifting of the PMVA and PMC Curves after (internal/external) Shocks

II. List of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

1. Introduction

The divestment process plays a critical role in the Venture Capital (VC) business model. Typically, a VC invested venture is not able to pay dividends prior to its exit as the business has not fully matured yet. Therefore, a Venture Capital Firm (VCF) generates virtually all of its income by realizing capital gains at the time of the venture’s exit. This indicates that a VCF heavily depends on a successful divestment transaction - in most cases, a poor exit execution leads to an inferior return on investment which in turn can ruin the VCF’s overall performance. A VCF therefore plans its exits carefully and evaluates its strategic choices. In this context, the two most important exit decision variables considered by a VCF are the choice of exit route and the choice of exit timing. By choosing the right exit route and pursuing good exit timing, a VCF can significantly increase its proceeds for a given venture. But what factors should be considered to successfully exit a venture with regard to exit timing and routing? And how are these strategic choices interrelated? The primary focus of this paper lies on answering these questions by drawing together the empirical research on these two dominant strategic exit choices.

The remainder of this paper is structured as follows: Section 2 examines the first of the two major strategic levers - the choice of exit route. I will first introduce the most common exit vehicles available to exit a VC investment. In a second step, a detailed analysis of the factors influencing the choice of exit route is conducted. In this context, I will demonstrate that Information Asymmetry (IA) among the parties involved is a key factor in the divestment process. Lastly, I will introduce a framework that tries to determine the optimal exit route in a more general fashion. Section 3 investigates the second major strategic lever - the choice of exit timing. To do so, I will first investigate a framework that supports our understanding of the optimal venture capital investment duration. However, this framework is heavily assumption based. These assumptions are subsequently relaxed to identify additional factors that influence the choice of exit timing. Once again, it can be shown that IA plays a key role in the exit timing strategy. While Section 2 and 3 examine each strategic lever mostly independently, Section 4 focuses on the interplay of both variables. I first investigate whether or not a chosen exit route is able to forecast average investment duration. In a next step, the focus is on the relationship between exit timing and specific exit routes. In this context, IPOs as well as trade sales and their implications on exit timing are examined in more detail. Section 5 concludes.

2. The Choice of Exit Route

2.1. Exit Route Alternatives

When exiting an investment, the first major strategic question a VCF faces, deals with the choice of an appropriate exit route for its investment. Typically, there are five exit routes employed by a VCF to exit a venture. Each alternative comes with different characteristics and advantages.

In an Initial Public Offering (IPO), shares that once were held privately are sold to the general public for the first time.¹ Applying this very common exit route, the VCF exits its investment via the public markets by floating its stakes. However, it remains important to note that the VCF usually does not immediately withdraw its investment after the initial quotation. This is due to two main reasons: Firstly, there are legal requirements that prevent a VCF to cash out quickly after the IPO by selling a large proportion of its shares. These so-called lock-up restrictions limit the VCF to sell only a small portion (only a few percentages) of their share in the IPO.² Secondly, the VCF wants to promote a favorable outlook on the venture by holding on to its shares. Liquidating the shares quickly after the lock-up period could signal mistrust regarding the ventures prospects. In many cases an IPO is regarded to be the superior exit route as it usually yields significantly higher returns than all alternative exit mechanisms.³

In a Trade Sale, the venture is sold as a whole to a third party. Usually, the acquirer is a strategic investor, acting as a larger player in the same or a similar industry. Such a strategic acquirer could be a supplier, competitor, or customer who wishes to integrate the venture’s business in its own.⁴ In many cases a trade sale is the preferred form of exit if an IPO is not feasible.⁵ Sometimes a trade sale can actually yield returns that exceed those of an IPO. This can be the case if in- depth or industry insider knowledge is required to properly value the venture’s potential.⁶ Possible synergy effects can also lead to a higher valuation of the venture.⁷

A Secondary Sale is a transaction similar to a trade sale. However, only the VCF sells its shares to another party; typically another strategic or financial investor. Other investors usually remain invested in the venture. Secondary sales often occur when the venture still needs assistance for further growth. Also, they are likely to be executed when the VC fund approaches termination: As the VCF sells its investments in low or medium performing companies that neither attract public nor private investors, it frees tied up capital required for fund repayments.⁸

In a Buyback, the Entrepreneurial Team (ET) repurchases the shares held by the VCF. This exit route is considered to serve only as a backup exit option and is primarily applied if the venture cannot achieve an exit in one of the above mentioned ways.⁹ Buybacks are often hard to conduct, as the ET is usually forced to raise debt capital to finance such an endeavor.

When a business ceases its operations due to insolvency or any other reason, a Write-off, or liquidation, is carried out. Since this is the most unprofitable exit alternative, a write-off is executed only if there is no other exit option available.¹⁰

2.2. Factors that influence the Choice of Exit Route

There are numerous factors that affect the exit route decision. Many of these factors are influenced by a high degree of IA between the parties involved. The principal-agent theory can help identifying those. According to CUMMING/MAC- INTOSH (2001) four major principal-agent-relationships can be identified in the venture divestment process. Firstly, the VCF (agent) might have an incentive to favor its own interests over those of its investors (principal). Secondly, the ET (agent) might have an incentive to favor its interests over those of the VCF (principal). Thirdly, the VCF (agent) conversely can have an incentive to favor its interests over those of the ET (principal). Finally the VCF as a vendor of the ven- ture (agent) and the prospect acquirer (principal) are in a principal-agent-relation- ship.¹¹ In this paper the factors arising from the latter 3 principal-agent-relation- ships are investigated in more detail. While different interests are the main motivation for the second and third agency problem described here, IA is the strongest factor influencing the fourth principal-agent-relation. Finally, there are additional factors that cannot be ascribed to either of the above mentioned principal-agent-relationships but yet are important exit route determinants.

2.2.1. ET vs. VCF – The ET’s Preferences

Each exit route poses different challenges on both, the ET and the VCF. However, while the VCF is mostly concerned with maximizing the proceeds from its investment, each exit route alternative has a more profound impact on the ET. For instance, consider the following two exit route alternatives: While the ET fully regains control over its venture in a buyback, it completely loses control after a trade sale. Hence, the ET has to consider more fundamental aspects when deciding on an exit vehicle. As this divergence of interests can bear potential for dispute, it remains important to contractually clarify who has a say when deciding on the exit route. During the typical VC investment cycle, contractual power shifts in favor of the VCF. Throughout the initial phase of the investment relationship, VCFs have no rights to initiate an exit. However, they posses valuable veto rights, that restrict the ET to force an exit. During later stages, the VCF exerts more direct control and obtains powerful contractual exit rights.¹² Yet, the VCF will most likely not force a certain exit route if the ET strongly disfavors it. In fact, the ET’s preference should remain an important factor; ignoring those preferences could severely damage the VCF’s image.

A trade sale could be the reason for a conflict between the ET and the VCF as the control of the venture is completely transferred to the acquirer; the ET might just not want to give up all the freedoms, control, and benefits stemming from managing the venture. In this context BLACK/GILSON’S (1998) implicit contract theory states that an IPO allows the ET to regain control over its venture as the VCF agrees to return the control to the ET. This return of control is achieved as the ET retains a sufficient proportion of its shares while the remaining shareholder structure becomes heavily fragmented and thus less efficient and effective with regard to exerting control over the venture.¹³ In this context, an IPO should be a favorable alternative for ETs that wish to remain in charge of their venture. It remains interesting to note that family-owned ventures also seem to favor IPOs over private exit routes. This confirms the implicit contract theory as family-owned ventures highly value and treasure their ownership and control over their business.¹⁴

2.2.2. VCF vs. ET

2.2.2.1. The VCF’s Cash Preference

As stated earlier, the VCF is primarily concerned with maximizing the Internal Rate of Return (IRR) of its investment in the venture. However, another important factor VCFs have to consider is liquidity. This is due to two main reasons: Firstly, the VCF’s limited partners prefer returns in a liquid form at fund termination. The VCF therefore tries to appeal to its investors’ preferences aiming at exit routes that entail a high degree of liquidity. Secondly, a liquid exit allows the VCF to re- invest the proceeds of the investment if the fund’s remaining lifetime is sufficiently long.¹⁵ IPOs are typically seen to be the superior exit route with regard to liquidity, even though there are a number of liquidity constraints. Firstly, the VCF usually is not allowed to sell a large portion of its shares at the time of the IPO due to lock- up restrictions. Secondly, the VCF might continue to face difficulties selling larger proportions of shares even after the lock-up period has elapsed. This can become an issue if the market of the venture’s securities is illiquid, and therefore exhibits price pressure on the VCF (i.e. the achievable sales price is significantly lower than the market price of the security).¹⁶ Nevertheless, shares of a publicly traded company are considered to be relatively liquid assets compared to the proceeds of the alternative exit routes.

Liquidity after arranging a trade sale can vary significantly, depending on the characteristics of the acquirer. In some circumstances, a trade sale can yield higher liquidity than an IPO. This could be the case, if the acquirer is a liquid publicly listed company that pays in cash or in its own, highly liquid shares. However, the acquirer could also be a less liquid publicly traded company or even a private company lacking a vivid market for its shares. The same holds for secondary sales as the new investor may or may not be able to prepare a liquid compensation for the VCF. In a buyback, the ET will most likely raise debt capital to cash out the VCF. The ET will usually have trouble financing such an endeavor and thus will not be able to cash out the VCF immediately, in most cases. ¹⁷

2.2.2.2. Fund Termination

A VC fund is usually a closed end investment fund that terminates typically 10 years after inception.¹⁸ If a VC fund proceeds its termination date, a VCF might be forced to choose an exit route that allows it to cash out quickly. This so called fire sale problem is likely to entail inferior forms of exit routes. A fire sale usually comes with lower proceeds and does not fully capitalize on the potentials of the venture. For instance, a firm that could be a suitable IPO candidate in a few years might be sold in a trade sale, simply because a trade sale can be executed more quickly. Similarly, a venture that would be suitable for a trade sale in the near future could be sold off quickly through a buyback or a secondary sale.

2.2.2.3. VCF’s Reputational Incentives

VCFs desire to maintain good relationships and good reputations within their industry. This is due to the fact that VCFs are likely to re-engage in business relations with the same partners (e.g. investors, investment banks, auditors, lawyers) during follow-on investments. Furthermore, good reputation increases the VCF’s attractiveness with regard to ETs seeking VC financing.¹⁹ Finally, good reputation in the capital markets can reduce IA which in turn can reduce the level of underpricing in an IPO.²⁰ These are all good reasons for especially young VCFs to increase their reputation and their visibility in the VC industry. Gompers (1996) argues that an IPO is the preferred exit route of young VCFs to establish a track record in order to attract future investors. He coins such a behavior grandstanding.²¹ This behavior is plausible as IPOs usually receive wide-spread media coverage and often remain of public interest even long periods after the IPO.²² It seems likely, that any VCF prefers an IPO over other forms of exit routes with regard to reputational incentives. However, this incentive should be even more pronounced for unseasoned VCFs still establishing a track record.

2.2.3. VCF vs. Acquirer

2.2.3.1. Ability of new Owners to resolve IA and value the Venture correctly

By the time a venture is exited, the level of IA between the vendors and potential acquirers remains high. According to Cumming/MacIntosh (2003b) this is due to the relatively short track record of the venture that has not been able to prove the viability of the business model, yet. Potential buyers therefore require an information discount that depends on the level of IA as they are not perfectly able to assess the true value of the venture; the higher the level of IA, the higher the information discount. On the other hand this implies that those buyers who are best able to overcome IA should be the highest valuing bidders. Hence, an exit route that minimizes the IA of potential acquirers should lead to a higher valuation of the venture and therefore should maximize the proceeds for the VCF. IPOs are accompanied with the highest level of IA. Typically, IPO investors are institutional investors that lack the industry specific knowledge compared to strategic acquirers that operate in the same industry. Hence, these investors should require a high information discount. However, VCFs can, to some degree, mitigate these unfavorable conditions by keeping a large proportion of their shareholding in the venture for some time after the IPO. Also, they can recruit prestigious intermediaries such as underwriters or accountants that are able to certify the venture’s quality.²³ Yet, in an IPO, IA remains high.

The typical acquirer in a trade sale is a strategic acquirer that operates in the same or related industry. Such an acquirer has a good understanding and in- depth knowledge of the industry he is operating in.²⁴ This knowledge can strongly mitigate IA issues. Also, due to the nature of a trade sale, both negotiating partners have a high bargaining power. Hence, a strategic acquirer can demand access to inside information of the venture which again reduces IA. Therefore, a trade sale should be a very favorable exit route with regard to this factor. Similar to a trade sale, the bargaining power of the potential acquirer is elevated in a secondary sale when compared to an IPO. However, as the purchaser in a secondary sale does not acquire the entire venture but only the VC shareholding, his bargaining power to demand undisclosed information should be weaker compared to an acquirer in a trade sale. Hence, a secondary sale should be superior in resolving IA between purchasers and sellers compared to an IPO, but inferior compared to a trade sale. In a buyback IA between the sellers and purchasers should not be an issue since the ET arguably knows its venture better than anyone else. However, since effecting a buyback usually requires debt capital, the future relationship between the creditors of the venture and the ET again is likely to be characterized by a high degree of IA. Hence, IA should be high in case of a debt financed buyback and very low in case of an equity financed buyback.²⁵

2.2.3.2. Degree of Innovation

Related to the aforementioned factor is the degree of innovation of the venture’s business. If the venture’s business can be classified as rather conservative, information about the markets, products and technologies should be publicly available as there is an established market for the products and services offered by the venture.²⁶ If the venture’s business is innovative, potential acquirers have difficulties accessing information regarding the venture’s products, markets, and technologies.²⁷ This increases the information discount demanded by potential acquirers. Again, strategic investors should overcome IA more easily compared to outside investors. Therefore, the same ranking of exit routes should apply here as for the aforementioned factor making a trade sale the preferable exit route.

2.2.3.3. Ability of new Owners to monitor and discipline the ET

Potential acquirers ascribe additional value to exit routes that allow them to monitor and discipline the ET after the acquisition has been executed. In general, managers are disciplined more effectively by a controlling (non-managerial) shareholder than by a fragmented group of shareholders.²⁸ After an IPO, the shareholder structure tends to atomize with the ET being a major shareholder. Hence, general theory suggests that the ability of the new co-owners to monitor and discipline the ET in such a setting is limited. On the other hand, the VCF itself remains a large shareholder for some time after the IPO.²⁹ Thus, the VCF could continue to fulfill the monitoring and disciplining task of the ET. However, the VCF’s monitoring ability is impaired after the IPO for two main reasons: Firstly, the VCF is more experienced (and therefore more effective) monitoring a privately held company that is going to be exited rather than a publicly traded company that has been exited. Secondly, the VCF does not have an incentive to monitor the ET on a long-term basis as it seeks to exit the investment in the short or medium term.³⁰ This is consistent with Black/Gilson’s (1998) implicit contract theory that states that the control over the venture is returned to the ET by the VCF.³¹ In a trade sale this is completely different: The new owner of the venture has both the incentive and the ability to monitor and discipline the ET as it exerts full control over the venture. After a secondary sale, the VCF’s shares are sold to a new strategic or financial investor. Thus, the overall shareholder structure in principal remains unchanged. However, the new investor is likely to experience some drawbacks with regard to monitoring and disciplining abilities compared to the former investor. This is due to the fact, that the former investor was able to build a strong relationship with the ET, having a strong leverage over the ET and being able to exercise valuable informal powers (such as strong persuasive influence). In case a buyback is financed via equity, this factor is not an issue, as the ET clearly has the ability and incentive to monitor its own business. However, in case the buyback is financed via debt, the creditors (usually institutional investors) lack the expertise required to efficiently monitor the venture. Thus, they provide debt capital only in exchange for a high risk premium.³² Concluding, a trade sale should be the most favorable exit route with regard to the ability of the new owners to monitor the ET, followed by a secondary sale, and an IPO. For a buyback it depends on the financing structure.

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¹ See Cumming/MacIntosh (2003a) p. 513

² See Gompers/Lerner (1998) p. 2167

³ See Bygrave/Timmons (1992) pp. 27f

⁴ See Cumming/ MacIntosh (2003b) p. 6

⁵ See Gompers/Lerner (2000) p. 6

⁶ See Cumming/MacIntosh (2003b) pp. 47-50

⁷ See Cumming/MacIntosh (2001) p. 456

⁸ See Eckermann (2005) p. 71

⁹ See Bartlett (1999) p. 88

¹⁰ See Wang/Sim (2001) p. 340

¹¹ See Cumming/MacIntosh (2003b) p. 4

¹² See Smith (2005) pp. 319f; 338f

¹³ See Black/Gilson (1998) pp. 260f

¹⁴ See Wang/Sim (2001) p. 353

¹⁵ See Cumming/MacIntosh (2003b) p. 36

¹⁶ See Gompers/Lerner (2000) pp. 263f

¹⁷ See Cumming/MacIntosh (2003b) p. 41

¹⁸ See Sahlman (1990) p. 490

¹⁹ See Cumming/MacIntosh (2003b) p. 66

²⁰ See Megginson/Weiss (1991) pp. 892f

²¹ See Gompers (1996) pp. 136f

²² See Cumming/MacIntosh (2003b) p. 67

²³ See Cumming/MacIntosh (2003b) pp. 14f

²⁴ See Chemmanur/Fulghieri (1999) p. 271

²⁵ See Cumming/MacIntosh (2003b) pp. 17f

²⁶ See Eckermann (2005) p. 111

²⁷ See Petty et al. (1994) p. 44

²⁸ See Gilson/Kraakman (1991) p. 872

²⁹ See Lin/Smith (2001) pp. 254f

³⁰ See Cumming/MacIntosh (2003b) pp. 21f

³¹ See Black/Gilson (1998) pp. 260f

³² See Cumming/MacIntosh (2003b) pp. 22f