Introduction to Venture Capital (Part III)
The Basic Concepts of VC — Profit Realisation via Exit
Now, we understand the basis of VC and venture, how it works, and the stages of its business. This article focuses on the final stage of VC, exit, continuing on the previous topic — Introduction to Venture Capital (PartII) — where the phases of VC were discussed.
Exits
(1) VCs Exit Investments
(2) Common Exits Strategies for VCs
(3) Common Exits Strategies in Global Markets(1) VCs Exit Investments
The primary goal of VC firms is to exit a company once they receive their expected returns, selling their company to other investors rather than remaining to invest long-term. In general, the most popular exit strategies are initial public offering (IPO) and mergers and acquisitions (M&A).
To maximise return on investment, many companies choose to reach critical milestones before beginning the exit process, for instance, possessing a solid customer base and a clear future vision. Also, exiting wisely and at the right time can reduce the investor’s losses even when a business is unsuccessful.
In terms of plans for an exit, different industries may have different timing to reach full exit potential. To illustrate, SaaS companies typically exit after nine years, whereas gaming and e-commerce firms can often exit after four or five years. Additionally, the exit timing depends on market conditions, the company’s finances, and the preferences of the team and investors.
(2) Common Exits Strategies for VCs
1/ Initial Public Offering (IPO)
It is advantageous for VC firms to exit through IPOs, for instance, generating a large amount of capital over a short period due to the increase in share value. With help from the GPs, the business can go through an IPO at the right time, where LPs gain a part of the return.
For start-ups, it is an ideal way to raise capital for growth and expansion. Going public would allow the company to attract more customers and increase its brand recognition. However, IPOs may limit managers’ control and input into organisational and strategic decisions.
2/ Mergers and Acquisitions (M&A)
M&A benefits companies and VC firms. Specifically, due to the potential synergies and the strategic fit these buyers have, the businesses are usually valued highly and offered premiums. Exiting a business venture through this strategy is an ideal option for LPs.
An acquisition occurs when one company buys another, giving the acquirer a majority stake in the business. In most cases, it is done through mutual agreements; however, a hostile takeover may happen when the acquirer intends to buy more than 50% of the target company’s shares. The acquirer usually pays premiums over the current market value generating profit for the existing stakeholders.
A merger is combining two companies into one, and two financing methods are available: purchase and consolidation. A purchase merger is similar to an acquisition, which merges the acquired company’s assets into its business. A consolidation merger, on the other hand, occurs when firms of the same size combine into one entity.
3/ Special-Purpose Acquisition Companies (SPACs)
SPACs represent one of the unique ways to go public for a startup. Initially, SPAC raises cash through a trust IPO and then searches for private companies to acquire or merge with to turn the private companies into publicly traded ones.
SPAC activity exploded in 2020. In 2021, with 558 SPAC registrations for a cumulative total of just over $135 billion, more than doubling YoY, despite the financial performance and regulatory scrutiny slowing down SPAC activity as the year progressed.
4/ Management Buyout (MBO)
An MBO occurs when existing company managers buy shares from the investors, either the total or majority stakes of a company, as there will be better rewards, and they will have more control if they own the company rather than be employees. It is an attractive exit strategy for investors who will stay in the company instead of retiring.
Existing company managers can fund either by other investors or by new buyers. The organisation would benefit from the buyout since managers wouldn’t have to learn about or manage the organisation. Also, due to their stake in the company, the managers would develop long-term strategies that would benefit the organisation.
5/ Secondary Sale
The VC firms and LPs who invested in the earlier stage can sell their holdings to existing or new shareholders to exit from the business at any point. The reason for selling is to exit the company once their objective of earning a return has been achieved. Furthermore, since the shares are not listed on public exchanges, they are traded on private equity secondary markets.
6/ Liquidation (write-off )
Liquidation is an involuntary exit, which is unfavourable for VC firms. It occurs when a company fails and distributes its assets to its claimants to pay them. Therefore, VC firms must pay attention to the liquidation preference in the contract that specifies the order in which claimants can be paid.
VC involves high risks and rewards; even the best-positioned companies can fail due to unanticipated market risks. In fact, few startups survive, whereas the remaining ones are usually liquidated.
(3) Common Exits Strategies in Global Markets
Global exit shares in 4Q22 were retrieved by Europe, followed by the US and Asia. Overall, all the deal trends of IPOs, SPACs, and M&A were down in 2022.
Regarding the percentages of each exit strategy for the US in recent years, VC-backed IPOs accounted for 12% of all VC-backed exits in 2021. Despite the big year for venture-backed IPOs, from 2004 to 2021, M&As still accounted for the majority of venture-backed exits, accounting for an average of 92% per year.
In China, IPOs have been the most popular exit method for VCs, given that M&As are a less feasible alternative exit option in the nation.
There are two primary reasons for this phenomenon. Firstly, the M&A process is more uncertain due to the need to obtain regulatory approvals. Secondly, some local governments may obstruct M&A activities by using their administrative powers, especially for state-owned companies.
While Chinese regulators recently have made progress toward facilitating venture-backed exits through IPOs and M&As, institutional barriers remain in the stock market. For this reason, further development of China’s VC market requires improved financial institutions, strong investor protection, and effective dispute resolution.
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Click here:
Introduction to Venture Capital (Part I)
Introduction to Venture Capital (Part II)
