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The Inevitable Exit and how to Prepare for it

06/12/2021

Even traditional SME founders starting a business supposed to last their whole career will one day retire and need to wonder what to do with their business. This is even more relevant to high-growth startups, whose founders often aim to exit after a couple of years.

There are many ways for founders to exit a business, ranging from the succession to a family member to an IPO (initial public offering), as well as the sale to strategic investors or managers. The aim of this blog post is to allow founders to broadly envisage what kind of exit they will one day face and give them concrete tools to prepare for this as early as possible.

To achieve this, we’ll distinguish two broad categories of businesses: on the one hand, ventures that need to dope their growth with equity financing, and on the other hand, bootstrapped businesses, where the founders’ resources are enough to fuel the target growth without their shareholding being diluted.

Typical Exits for Equity Financed Ventures

Equity Financing in General

Here, we are referring to companies that have received resources contributed by third-party investors in exchange for equity (usually in the form of shares). Typical companies concerned are tech startups or scale-ups that need outside funding to bring their product to market or scale their business.

From a general perspective, equity investors – irrespective of their preferred maturity stage – are quite risk-averse. This translates by the willingness to invest in targets with flawless management processes and housekeeping, especially in later stage investments. This is because messy housekeeping and processes are often considered a sign of deeper issues with the target.

A good example is a company that has no written employment agreements: from a legal perspective, this is perfectly acceptable; however, it increases uncertainty and risk for a prospective investor with respect to potential HR litigation. This particular example may not be a deal-breaker, but it could lead to a lower pre-money valuation to account for the risk.

Venture investors typically seek a high growth exit within a short period. Founders should be aware that their investors will tend to push strongly for fast growth and quick exits, so their respective visions need to be aligned.

Typical Exits for Equity Financed Ventures

Given that ventures typically receive equity financing based on steep growth plans, they will usually have grown exponentially by the time that they reach the exit phase. Their enterprise value will, at that point, often be high enough to limit the circle of potential purchasers.

This widely hinders the possibility of trade sales to individuals (including the company’s management, for example) or SMEs. Therefore, typical exits for equity-financed ventures include the following:

  • Strategic buy-out from an existing investor: Should one of your shareholders have invested based on strategic considerations (their business is linked to that of the target, e.g. as a competitor, client, supplier, etc.), then they could become interested in buying out the other shareholders, including the founders.
  • Strategic buy-in: Strategic investments in your business could be shaped as a purchase of the entire share capital by a third party. This could be a very interesting exit strategy, especially if your company’s existing investors joined mostly based on financial considerations.

The typical example of a strategic buy-in would be the purchase of a high-growth software scale-up by one of the so-called GAFAM Big Tech companies.

  • Initial public offering: If your business has grown extensively, one possible exit could be an initial public offering of its stock. This kind of exit is quite rare, and it’s very difficult to foresee if this is a realistic option before a rather late stage of growth.

How to Prepare for these Exits

These exit plans have in common that they will be led by people who are used to purchasing businesses and well advised. Therefore, they will be meticulous in the due diligence process and will usually consider small flaws in your structure, management, or housekeeping as high risk signs. Furthermore, small issues that they consider risky could be enough to break the deal or highly reduce the enterprise value.

Companies concerned by these exits should therefore strive to have flawless and comprehensive housekeeping and documentation, be well structured and ensure that risk is minimized. Examples of subjects that the management team should be mindful of include:

  • corporate housekeeping:
    • yearly general meetings;
    • quarterly board meetings from the beginning, where discussions are held and documented about the operations of the past quarter and the perspectives for the next;
    • every decision that is the board’s responsibility being documented in the form of a resolution or minutes;
    • delegation to management based on clear board regulations;
  • HR-related matters (well thought out employment contract and good employee management, clear internal employee rules and regulation);
  • written contracts being established and verified for the company’s relationships with its suppliers, clients and employees;
  • data protection policies being put in place and enforced;
  • other regulatory questions being mapped out and adequately dealt with.

The other important consideration for purchasers of equity-financed ventures is the entire business’ value is captured when the deal is closed. This means that the company’s know-how and business should, to the extent possible, not be linked to the founders. Should this not be the case, then the deal could be aborted altogether, or at the very least, the enterprise value could be strongly discounted. Furthermore, it could force the founders to stay involved in the company for much longer after the closing of their exit.

From the company’s onset, its founders should therefore aim to put the entire value of the business in the company and make it independent from their persons. Depending on the concerned field of activity, the following tactics could be considered:

  • developing digital marketing strategies rather than relying on the founders’ networks to grow the company’s business independently from the founders;
  • document the founders’ know-how and create processes that can be executed by other qualified persons after the founders’ exit;
  • creating redundancies for the business’ vital functions; and
  • provide for sufficient incentives to retain the company’s key employees.

Typical Exits for Bootstrapped Ventures

Bootstrapped Ventures

A “bootstrapped” business is one whose equity was financed by its founders’ resources. Most traditional SMEs in Switzerland are bootstrapped and quite a few (tech) startups as well.

This can be possible either because the founders have access to considerable resources or because the target venture doesn’t require high set-up costs before its product or service goes to market.

An example of a bootstrapped tech startup could be one founded by persons who have already developed software that is in the beta stage (typically in the course of a Ph.D.). They won’t need important outside resources to start having satisfactory organic growth and may therefore not need equity financing.

The downside of bootstrapping a venture is that its growth may be slower or at least less steep. The upside is that the founders retain 100% ownership of their business.

Based on the above and provided the target business model allows it, it is advisable to avoid seeking equity financing if possible.

Typical Exits for Bootstrapped Business

A bootstrapped business’s growth is often less exponential than that of an equity-financed venture, so exit options are slightly different and involve a wider array of potential purchasers.

Typical exits for bootstrapped businesses include the following:

  • A management buy-out or MBO is an exit whereby existing company managers (who may or may not be shareholders) purchase it from its founders. The advantage of this type of exit is that the purchaser perfectly knows the business, and therefore (i) very little due diligence is needed (ii) the pass-over can be more progressive and (iii) the representations and warranties given by the founders can be more limited. The difficulty in MBOs can be financing the purchase price, which often needs to be leveraged by a loan from a third party (bank) or the selling founders.
  • Management buy-ins or MBIs are similar to MBOs, but the incoming managers only become involved in the business after the closing of the transaction. Hence, it is a form of strategic acquisition by a natural person that wants to own their business.

MBIs often have the same financing issue that arises in MBO, but they don’t share the same advantages in terms of simplicity, as the purchaser doesn’t know the business.

  • Strategic or financial buy-in: Given that bootstrapped businesses are by definition owned by their founders, strategic or financial purchases will come from a person who was not previously involved as a shareholder. This means that such purchasers will need to get familiar with the company and feel confident that the business will be able to continue without significant risks after the exit of its founders.
  • Traditional family or closely related persons’ successions, which can often even be free (i.e. to the founder’s children). In these types of transactions, a progressive and bespoke pass-over is often possible, making them quite different from others and easier. Tax considerations often drive the structure and process in these exits.

How to Prepare for the Exit of a Bootstrapped Business

Typically, bootstrapped ventures can do with more simplicity in their organization since they won’t need to adapt to the specific needs of equity investors. For example, incorporating the business as a limited liability company can be an interesting option (as the minimum legal capital is CHF 20’000.- rather than CHF 100’000.-).

We would still strongly advise bootstrapped businesses to establish clear, visible and well-kept business and legal processes. This is especially important if a buy-in could be an option, be it strategic, financial or management. Indeed, these purchasers will jump at the occasion to discount the company’s valuation or differ some payments, should they have any legitimacy to such demands. The arguments invoked often include unclear processes, any kind of risk or the founders being material in the venture’s success.

Should you feel that an MBO or traditional succession are the most likely options, then we would advise involving the potential successors as soon as possible in the business’ management. That way, you’re giving them a taste of their future and making the pass-over very progressive, which will make the transition easier for everyone involved (including the employees, clients and suppliers). Getting your successors involved in the company’s management will also allow them to know its processes, thus allowing you some slack on their formality. To involve your potential successors, you can consider putting ESOPs in place and including the relevant persons in the company’s governance, for example, by giving them a seat on the board of directors.

Key Takeaways

From the very beginning of a business venture, the founders should try to gain as much visibility as possible on their long-term goals, including the exit. They should, however, constantly adapt their exit expectations depending on how the business evolves. For example, a big client or grant could mitigate the need for equity financing and allow for sufficient organic growth, which may alter the exit perspectives.

In practice, we suggest that founders prepare comprehensive and honest long-term financial projections of their business’ development as a part of their business plan. That way, they will gain visibility on the target growth and financial resources needed to achieve it and, based on this information, decide whether bootstrapping the business is an option or whether equity financing is needed.

If the need for equity financing is probable, then processes, as well as corporate and legal housekeeping, should be as clean as possible from the beginning. Furthermore, to the extent possible, the business should be incorporated as a corporation (Aktiengesellschaft / société anonyme), which is much better suited to receiving equity financing (namely because of the flexibility possible for its capital and governance structure). Furthermore, to maximize valuation, the founders should strive to make the business’ success independent of themselves.

If the founders believe that bootstrapping is possible, then they can consider a lighter structure. Incorporating as a limited liability company (Gesellschaft mit beschränkter Haftung / société à responsabilité limitée) becomes an option, allowing for lower capital requirements (CHF 20’000.- rather than CHF 100’000.- for a corporation). The legal and corporate housekeeping will still need to allow the business to run safely, but they may be slightly less comprehensive and detailed. Finally, potential successors of the business should be considered early so that they can be involved in a way that will facilitate the exit when the time comes.

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