Do You Have an Exit Strategy for The Startup?

While it may seem counterintuitive to devise an exit strategy while you are still working to grow your startup, being proactive can help ensure that you can reap the benefits of all your hard work...

While it may seem counterintuitive to devise an exit strategy while you are still working to grow your startup, being proactive can help ensure that you can reap the benefits of all your hard work.  Additionally, certain exit strategies can be utilized in the event that you encounter difficulties with other shareholders and/or members of the Company.   

There are several different types of exit strategies. The most common is to sell the business, whether it be to a family member, management/staff, or a third party. Other options include merging with another business, conducting an IPO, and liquidating the business. It is important to carefully evaluate what strategy is your best option, as the decision may be influenced by a wide range of factors, including the nature of your business, the economic climate, and your timeframe for exiting the business.

Merger & Acquisition

One of the most common exit strategies for start-up companies is to prepare the company for an acquisition. In an acquisition, you sell your business to another company, often a larger competitor. While this may seem like an effective exit strategy, it is important to understand both the advantages and disadvantages. 

If you offer a competitive advantage to an acquirer or are able to generate multiple bids, your company can often command a price higher than it may be worth on paper. Since you will negotiate the terms of the acquisition, you may choose to stay on after the acquisition as an advisor or manager. For those who are not ready to fully let go of their “baby,” this can be an attractive benefit. At the same time, you also have the freedom to walk away. If the stress of running your start-up is starting to wear on you, you may have the option of simply walking away and leaving the operations in the hands of someone else.

Despite the advantages, a merger or acquisition transaction can still be risky. First, if there are other shareholders and/or members, their exit rights in the company’s charter documents need to be examined and determined if they are not aligned in selling the company.  Often, there are provisions concerning the right of first refusal or other provisions that address the disposition of equity interests.  Assuming that you are the only equity owner or everyone is aligned, the success of an acquisition transaction relies entirely on the existence of a willing buyer. If your company fails to generate interest, you may be forced to sell for less than you would like or pursue an alternative exit strategy. After investing a great deal of your time and money into a start-up, it can also be difficult to watch another company take over. This is particularly true if the acquiring company makes significant changes to your business model or absorbs your company completely.

Initial Public Offering

Going public via an initial public offering (IPO) can be an extremely lucrative exit strategy. Becoming a publicly-traded company can also help your startup generate additional capital and provide greater public exposure.

While they are often considered the “holy grail” for startups, IPOs are not for everyone. That’s why the majority of companies are private. Before embarking on the process, it is imperative to fully evaluate whether an IPO is your best exit strategy.

First, it is important to understand that the IPO process is complex, expensive, and time-consuming. Companies must retain accountants, attorneys, and investment bankers to assist with the preparations, which can take more than a year. Once all the hard work is done, there is no guarantee that the market conditions will be favorable for an IPO.

Even if your IPO is successful, you may not be able to cash in right away. Many IPOs are subject to a lockup period, which prohibits major shareholders, including founders, from selling their shares for a certain period of time (generally between 90 and 180 days) after a company has gone public.

Finally, once a company becomes public, there is also increased pressure to perform financially. Public companies must also be much more transparent and are subject to additional reporting requirements. For instance, public companies are subject to the oversight of the Securities and Exchange Commission, which requires annual reports and other filings that are then made available to the public.

While not specifically addressed herein, a company can go public through a merger with a Special Purpose Acquisition Company (“SPAC”) that is publicly traded.  Examples of going public via a SPAC are the automotive company Fisker or DraftKings, the fantasy and sports betting company.  Our firm is active in this arena, having represented the underwriters of hundreds of millions of dollars of SPAC IPO securities offerings, including managing underwriters.

Management or Employee Buyout

Once the founders are ready to step away, a startup’s existing managers and employees may be the best equipped to assume ownership. One of the key advantages of management or employee buyout is that these key players understand the company’s products/services, operations, and corporate culture better than an outside buyer. They may also be more motivated for the company to succeed because they already have a vested interest. The sale may also be less cumbersome because you already know a great deal about the company’s potential new owners, and they are intimately familiar with the company.

As with any exit strategy, there are potential downsides. To start, not everyone may be happy about the potential buyout, including managers and employees who are not included in the plan. Similarly, the company can suffer significantly if the deal goes bad before it is consummated. Given the founders’ familiarity with the new owners, it can also be difficult to step away once the business is sold. This is especially true, since a sale to employees usually involves a long-term payout and/or a secured promissory note, with the business itself as the prime collateral.

Additional Options for Small Businesses

For small businesses, liquidation can be a viable exit strategy. While it is generally quick and easy, your startup must have assets to sell in order to generate profits. Additionally, the sale price must be greater than your existing obligations for founders to recoup their investment.

Family succession is another possibility for small businesses. Keeping it “in the family” can allow founders to walk away from the company’s daily operations while still keeping a close eye on its overall success. Of course, family succession only works if you have a family member that is both willing and able to carry on the business.

Last, and least desirable, is shutting down and dissolving the corporate entity.  This may be the only course of action available.  If so, in dissolving the corporate entity be careful not to assign to yourself or your family the remaining assets of the company for which the company does not receive fair value.  This is to protect against creditor claims trailing to the owner based on a claim of fraudulent transactions at a time when the entity was being shut down to avoid paying known creditors.

Key Takeaway for Business Owners

Even if you are not yet ready to even contemplate walking away from your business, you should still have an exit strategy in place, as it may be useful for other events concerning equity holders, and helpful in maintaining focus on how much your company is worth. This can ensure that you will be prepared to act when the time is right.

If you have questions, please contact us

If you have any questions or if you would like to discuss the matter further, please contact me, Michael Sheppeard, or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.